IRS Provides an ITC Safe Harbor for Projects Under Energy Savings Performance Contract Energy Sales Agreements with Release of Revenue Procedure 2017-19

by Wilson Sonsini Goodrich & Rosati

On January 19, 2017, the IRS released an advance version of Revenue Procedure 2017-19, which provides a safe harbor (the "Safe Harbor") under which the IRS will not challenge the treatment of an Energy Savings Performance Contract Energy Sales Agreement (ESPC ESA)1 between an Energy Service Company (i.e., a service provider) and a federal agency (i.e., a service recipient) as a service contract under Section 7701(e)(3) of the Internal Revenue Code of 1986, as amended (the "Code"). This Safe Harbor clarifies the terms under which a federal agency may purchase energy generated by a renewable energy project, such as a wind or solar project, under an ESPC ESA without jeopardizing an Energy Service Company's right to claim an investment tax credit (ITC) under Section 48 of the Code with respect to the project.

For a taxpayer to claim the ITC, the taxpayer must, among other things, be the owner or user2 of the property giving rise to the ITC at the time it is placed in service, and the property must not be viewed as owned (in whole or in part) or used by a tax-exempt entity, such as a federal agency, unless the property used under the lease is for a term of less than six months. Investors have historically been reluctant to invest in renewable energy projects subject to an ESPC ESA with a federal agency due to certain federal requirements that create uncertainty as to the investor's tax ownership of the project and/or the federal agency's use thereof, and therefore, whether the project is eligible for the ITC. Specifically, an ESPC ESA is required to meet the requirements of 42 U.S.C. § 8287 and OMB Memorandum M-12-21, which, among other things, requires a federal agency to "retain title to . . . [the renewable energy project] at the conclusion of the contract."3 The U.S. Department of Energy has published guidance which deems this requirement to be met if the federal agency: (a) has the right to, and is committed to, purchase the project at the expiration of the contract term at the then fair market value; and (b) pre-funds the project purchase price in a reserve account over the course of the term to ensure that there are sufficient funds to pay the purchase price.4 These requirements created uncertainty as to whether the federal agency might be the owner of the facility as well as whether the ESPC ESA would qualify as a service contract (as opposed to an arrangement that might result in the federal agency being deemed a "user").

The Safe Harbor specifically provides that if the criteria set forth in Revenue Procedure 2017-19 are met, the IRS will not challenge the treatment of an ESPC ESA as a service contract, and thus, effectively lays to rest investors' concerns regarding the eligibility of these renewable energy projects for the ITC by reason of the requirements of OMB Memorandum M-12-21.

The requirements of the Safe Harbor are:

  • The term of the ESPC ESA cannot exceed 20 years and must be consistent with and appropriate for the scope and scale of the renewable energy project.5
  • The contract must satisfy the requirements of 42 U.S.C. §8287 and OMB Memorandum M-12-21 (e.g., title to the renewable energy project must transfer to the federal agency at the end of the term).
  • The federal agency must not attempt to operate the renewable energy project and will immediately notify the service provider (or its designated contractor) of any shutdown or mechanical issue.6
  • The service provider must bear all financial risk for non-performance, except to the extent such non-performance is attributable to temporary shutdowns of the renewable energy project for repairs, maintenance, or capital improvements.
  • The contract price for electricity must not be reduced if operating costs are diminished.
  • Any purchase option must be for the renewable energy project's then-determined fair market value.7

The Safe Harbor contains an example which illustrates that the Safe Harbor will still be available if a reserve account funded by the federal agency but held by the service provider is created for the purpose of setting aside money to fund the federal agency's purchase of the renewable energy project at the end of the ESPC ESA term. Specifically, the example provides that the amount charged by the service provider for each payment period may include both the price of power and an amount for the acquisition of the project at its estimated fair market value at the expiration of the ESPC ESA term. The service provider may set aside the additional amount in a reserve account that it controls and the amount may change for a number of reasons, including periodic reappraisals of the estimated fair market value of the renewable energy project. Any excess amounts in the reserve account may be used to satisfy the final ESPC ESA payments or any termination liability of the federal agency, with any remainder returned to the federal agency.

The Safe Harbor is both more generous and more restrictive than the safe harbor contained in Section 7701(e)(3) of the Code. On one hand, the Safe Harbor specifically permits the reserve account to fund the purchase option (through the example) and provides that the inclusion of any and all requirements mandated by 42 U.S.C § 8287 and OMB M-12-21 will fall within the Section 7701(e)(3) safe harbor. On the other hand, it limits the service contract term to 20 years and requires that it be consistent with and appropriate for the scope and scale of the renewable energy property.

Although Revenue Procedure 2017-19 was slated to be effective for transactions entered into on or after the date of publication in the Internal Revenue Bulletin, under an executive order issued by the new administration, this Revenue Procedure will likely be subject to review by a new appointee before it becomes effective.

1 An ESPC ESA is a contract that provides for the performance of services for the design, acquisition, installation, testing, and (where appropriate) operation, maintenance, and repair of a measure applied to a federal building that improves energy efficiency, is lifecycle cost effective, and involves energy conservation, cogeneration facilities, renewable energy sources, and improvements in operations and maintenance efficiencies or retrofit activities.
2 The ITC can also be claimed by a taxpayer that is a lessee if the owner/lessor would otherwise be eligible for the ITC and elects to pass the ITC through to the lessee. See Section 50(d)(5) of the Code.
3 OMB Memorandum M-12-21, Part III.
4 U.S. Department of Energy, Energy Savings Performance Contract Energy Sales Agreement Fact Case, August 4, 2016.
5 It is not clear or obvious what the criteria is for determining whether the term is consistent with and appropriate for the scope and scale of the renewable energy project.
6 It is not obvious how this particular criterion can be satisfied. Certainly, it would be prudent to include a prohibition against such operation in the ESPC ESA in the event of a shut-down or mechanical failure; however, an overzealous agency employee might act without knowledge of the prohibition. If that happened after the ITC was fully vested, there may be no adverse tax consequences although presumably the ESPC ESA would no longer have the protection of the Safe Harbor.
7 Although the existence of a purchase option or purchase right is permissive under the Safe Harbor, OMB Memorandum M-12-21 requires that the federal agency purchase the project at the expiration of the contract term.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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