On June 22, 2018, the Internal Revenue Service (IRS) issued much-anticipated guidance to help developers of, and other industry participants in, solar, qualified fuel cell, qualified microturbine, combined heat and power, qualified small wind and geothermal heat pump facilities determine whether and when the beginning of construction requirement is satisfied for the investment tax credit (ITC) under section 48. This guidance, Notice 2018-59, is in large part consistent with six prior beginning of construction notices issued for wind facilities – Notice 2013-29, Notice 2013-60, Notice 2014-46, Notice 2015-25, Notice 2016-31, and Notice 2017-4.¹

Highlights of Notice 2018-59 include the following:

• Provides two methods for taxpayers to establish the beginning of construction: (1) starting physical work of a significant nature and (2) paying or incurring 5% or more of the total project cost.
• Includes a continuity requirement (also referred to as a continuous construction or continuous efforts requirement). As with prior guidance, there is a 4-year safe harbor; beyond 4 years, a facts and circumstances analysis must be used. 
• Provides specific examples of physical work that may be used to satisfy the physical work test for solar facilities and for each of the other section 48 ITC-eligible facility types. 
• Includes rules for transferring section 48 ITC-eligible facilities for which the beginning of construction requirement had been satisfied.
• States that no rulings will be issued regarding the Notice or the beginning of construction requirement.

Background

Historically, all qualifying renewable energy projects were required to be placed in service by a specified date (which was extended on numerous occasions) to be entitled to the ITC or the section 45 production tax credit (PTC). However, since 2012, Congress has introduced various “beginning of construction” date requirements for ITC or PTC eligibility but left to Treasury and the IRS to define when construction will be treated as having begun.

More specifically, the American Taxpayer Relief Act of 2012, as amended by the Tax Increase Prevention Act of 2014, included a change in the deadlines for PTC-eligible facilities that required a taxpayer to have begun construction of a qualifying facility by the end of 2014 to qualify for the PTC (or ITC in lieu of PTC).

The Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) (1) extended the beginning of construction deadline for non-wind section 45 PTC-eligible facilities to the end of 2016; (2) provided for a long-term extension for wind facilities with a ramp-down of the credit amount based upon the year in which the taxpayer begins construction of the project; and (3) provided for a long-term extension for the ITC for solar facilities, with a ramp-down of the credit amount based upon the year in which the taxpayer begins construction of the project and the year in which the project is placed in service.²

The Bipartisan Budget Act of 2018 (2018 BBA), passed by Congress and signed into law on February 9, 2018, (1) extended the ITC for the remaining section 48 ITC-eligible facilities dependent on meeting deadlines for beginning construction on energy property and placing it in service and (2) extended the PTC under section 45 (and ITC in lieu of PTC) for the following facilities if construction began by December 31, 2017: closed-loop biomass, open-loop biomass, geothermal, landfill gas, trash, qualified hydropower, and marine and hydrokinetic facilities.

The current landscape of the timing requirements for section 48 ITC-eligible facilities is summarized below:

The current landscape of the timing requirements for the PTC (and ITC in lieu of PTC) eligible facilities is summarized below:

Since enactment of the American Taxpayer Relief Act of 2012, and in response to subsequent legislation and taxpayer feedback, the IRS has released a series of Notices regarding the beginning of construction requirement. To date, each prior Notice addressed the beginning of construction requirement for wind facilities. Notice 2018-59 provides guidance on the beginning of construction requirement for solar, qualified fuel cell, qualified microturbine, combined heat and power, qualified small wind and geothermal heat pump facilities.

Two Methods for Establishing Beginning of Construction

Notice 2018-59 provides two methods to establish that construction of energy property has begun for ITC purposes – starting physical work of a significant nature (Physical Work Test) or paying or incurring 5% or more of the total cost of the energy property (5% Safe Harbor). Construction will be deemed to begin on the first date that either method is satisfied, and both methods require continuous progress towards completion of construction (Continuity Requirement).

Physical Work Test

The guidance states that construction has begun when the taxpayer begins physical work of a significant nature. The determination of whether construction has begun is a facts and circumstances analysis. The Physical Work Test focuses on the nature of the work performed rather than the amount of work or the cost thereof, and the Notice confirms that there is “no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test.” Physical work can either be performed by the taxpayer directly or by other persons under a binding, written contract, and the work may be performed on-site or off-site.

The Notice provides as examples of off-site work of a significant nature the manufacture of components, mounting equipment, and transformers. The Notice also provides examples of on-site work for different types of energy property. For example, for solar energy property, on-site physical work of a significant nature includes the installation of racks or other structures to affix photovoltaic (PV) panels, collectors or solar cells to a site.

Notice 2018-59 identifies two categories of activities that do not qualify as physical work of a significant nature: preliminary activities and inventory activities. The guidance provides examples of preliminary activities that would not qualify, including planning or designing, securing financing, and obtaining permits and licenses. The guidance also states that physical work of a significant nature does not include work performed, either by the taxpayer or by another person under contract, to produce components of energy property that are in existing inventory or are normally held in inventory.

5% Safe Harbor

Construction of energy property will be considered to have begun if the taxpayer pays or incurs (depending on the taxpayer’s method of accounting) 5% or more of the total cost of the energy property. The total cost of the energy property includes all costs included in the depreciable basis of the energy property and does not include land or any property not integral to the energy property.

Notice 2018-59 provides clarity on how cost overruns shall be treated for the purposes of the 5% Safe Harbor. For a single project comprised of multiple energy properties (as discussed further below), if the total cost exceeds the anticipated cost such that the amount a taxpayer paid or incurred is less than 5% of the actual total cost of the project when placed in service, the 5% Safe Harbor can be satisfied with respect to some, but not all, of the energy properties comprising the project as long as the total aggregate cost of those energy properties, is not more than 20 times greater than the amount paid or incurred. For a single energy property that cannot be separated into multiple properties, however, if the amount paid or incurred in a given year ultimately is less than 5% of the total cost when the energy property is placed in service, the 5% Safe Harbor will not be satisfied.

Continuity Requirement

Continuous Construction and Continuous Efforts Tests

Both the Physical Work Test and the 5% Safe Harbor have a Continuity Requirement. For the Physical Work Test, the Continuous Construction Test requires continuing physical work of a significant nature – a facts and circumstances analysis. For the 5% Safe Harbor, the Continuous Efforts Test, another facts and circumstances analysis, requires a taxpayer to make continuous efforts to advance towards completion of an energy property. The guidance lists certain facts and circumstances that indicate continuous efforts, including:

• paying or incurring additional amounts included in the total cost of energy property,
• entering into binding written contracts for manufacture of components of property or for future work to construct energy property,
• obtaining necessary permits, and
• performing physical work of a significant nature.⁵

Continuity Safe Harbor

The Continuity Requirement is deemed satisfied if a taxpayer places energy property in service by the end of the calendar year that is no more than four calendar years after the calendar year during which construction of the energy property began (Continuity Safe Harbor Deadline). If the energy property is not placed in service before the Continuity Safe Harbor Deadline, whether the Continuity Requirement of either the Physical Work Test or the 5% Safe Harbor is satisfied will be determined by the facts and circumstances.

Disruptions

Notice 2018-59 lists certain excusable disruptions that will not be considered as indicating a taxpayer has failed to satisfy the Continuity Requirement. That list includes:

• severe weather delays,
• delays due to natural disasters,
• delays in obtaining governmental permits or licenses,
• delays at the request of a governmental entity for public safety, security or similar concerns,
• interconnection-related delays (such as delays relating to the completion of construction on a new transmission or distribution line or necessary transmission or distribution upgrades to resolve grid congestion issues),
• delays in the manufacture of custom components,
• delays due to labor stoppages,
• delays due to the inability to obtain specialized equipment of limited availability,
• delays due to the presence of endangered species,
• financing delays, and
• delays due to supply shortages.

For a single project with a single energy property, whether an excusable disruption has occurred is determined in the calendar year when the energy property is placed in service. For a single project comprising multiple energy properties, whether an excusable disruption has occurred is determined in the calendar year when the last energy property is placed in service.

Transfer of Energy Property

Section 48(a)(3)(B) provides that energy property only includes property the construction, reconstruction or erection of which is completed by the taxpayer or which is acquired and originally used by the taxpayer. If the taxpayer owns the property on its placed in service date, the taxpayer may claim the ITC on energy property it did not own when construction of the property began. As such, a transfer of energy property does not necessarily disqualify the property under the Physical Work Test or the 5% Safe Harbor. However, a transfer solely consisting of tangible personal property between unrelated parties does disqualify the property such that any work performed or amounts paid or incurred by the transferor with respect to the energy property will not be taken into account in determining whether the transferee meets the Physical Work Test or the 5% Safe Harbor.

Energy property originally intended for a certain site may be transferred to another site, and any work performed or amounts paid or incurred at the initial site may be taken into account in determining when the energy property satisfies the Physical Work Test or the 5% Safe Harbor.

Additional Guidance

What is Energy Property?

Expanding on prior guidance, including Revenue Ruling 94-31, Notice 2018-59 defines energy property generally as all components of property necessary to generate electricity up to and including the inverter. Energy property includes all components of property that are functionally interdependent, i.e., if the placing in service of each component is dependent on the placing in service of each other component to generate electricity. Functionally interdependent components that can produce electricity separately from components within a larger energy project are still considered energy property.

The guidance provides that multiple energy properties operated as part of a single project will be treated as a single energy property for beginning of construction purposes. Whether multiple properties are operated as a single project is a facts and circumstances analysis, but Notice 2018-59 provides a list of factors that can be used to determine whether properties are a single project, including whether the properties:

• are owned by a single legal entity,
• are constructed on contiguous pieces of land,
• are described in a common power purchase agreement,
• have a common intertie,
• share a common substation,
• are described in one or more common environmental or other regulatory permits,
• were constructed pursuant to a single master construction contract, or
• were financed pursuant to the same loan agreement.

Multiple energy properties operating as a single project and treated as a single energy property for beginning of construction purposes may be disaggregated and treated as multiple energy properties to determine whether a separate energy property satisfies the Continuity Safe Harbor. Those disaggregated properties placed in service before the Continuity Safe Harbor Deadline are eligible for the Continuity Safe Harbor, while the remaining energy properties must undergo a facts and circumstances analysis.

Property Integral to Energy Property

To satisfy the Physical Work Test, physical work of a significant nature must be performed on tangible personal property or other tangible property used as an integral part of the activity performed by energy property. For the 5% Safe Harbor, the cost of property that is not integral to energy property is not included in the total cost of energy property. The guidance gives examples of various kinds of property that are integral to energy property (transformers that step up the voltage of electricity produced by energy property, roads used for equipment to operate and maintain energy property, and structures that are so closely related to energy property that they can be expected to be replaced when energy property is replaced) as well as property that is not integral to the energy property (transmission towers, roads to access the site or for employee/visitor vehicles, fencing and most buildings).

Construction by Contract

Amounts that are paid or incurred for components of energy property manufactured, constructed or produced for the taxpayer under a binding written contract, entered into before the work takes place, are taken into account in determining when construction begins. The guidance provides that a written contract is only binding if it is enforceable under local law and does not limit damages to a specified amount. A contractual provision limiting damages to an amount equal to at least 5% of the total contract price, however, will not be treated as limiting damages. Taxpayers may also assign a binding written contract for a specific number of components of energy property to an affiliated special purpose vehicle that will own the energy property for which such components will be used without disqualifying the work performed or the amounts paid or incurred from being taken into account to determine when construction begins with respect to the energy property. 

Look-Through Rule

Notice 2018-59 provides a rule for both the Physical Work Test and the 5% Safe Harbor that work done or amounts paid or incurred by parties other than the taxpayer under binding written contract may be used to determine whether construction has begun. For the Physical Work Test, on-site and off-site work may be taken into account in determining whether physical work of a significant nature has begun. Non-taxpayer off-site work may be taken into account when done pursuant to a binding written contract if the components are not held in the manufacturer’s inventory. A manufacturer that produces components for multiple energy properties must use a reasonable method to associate individual components with a particular purchaser. For the 5% Safe Harbor, amounts paid by a manufacturer to a third party for energy property or components manufactured for the taxpayer by that manufacturer under a binding written contract with the taxpayer are deemed to be paid or incurred by the taxpayer when the amounts are paid or incurred by the manufacturer under the principles of section 461. 

Repowering Projects and the 80/20 Rule

Energy property may qualify as originally placed in service if the fair market value of used components is not more than 20% of energy property’s total value. For single projects comprising multiple energy properties, the 80/20 Rule is applied to each energy property separately. To satisfy the beginning of construction requirement, however, the Physical Work Test and the 5% Safe Harbor are applied only with respect to new components of energy property. For the 5% Safe Harbor, all properly capitalized costs are taken into account, but the total cost of the energy property does not include the cost of land or property not integral to the energy property.

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¹  For Eversheds Sutherland’s analysis of those prior beginning of construction Notices: Legal Alert: Have You "Begun Construction"?  IRS Issues Guidance for Renewable Energy Tax Credits, Legal Alert: IRS Clarifies "Binding Written Contract" Definition in Renewable Energy Tax Credit Begun Construction Guidance, Legal Alert: IRS Updates Renewable Energy Tax Credit Beginning of Construction Guidance, Legal Alert: Are You Really Sure That Construction Began? IRS Issues Third Notice Regarding Renewable Energy Tax Credit Beginning of Construction Test, Legal Alert: Are You Continuing Construction? IRS Issues Fourth Renewable Energy Tax Credit Beginning of Construction Notice, Legal Alert: IRS Updates Beginning of Construction Guidance for Renewable Energy Tax Credits Extended by PATH Act, and Legal Alert: IRS Further Updates Beginning of Construction Guidance for Renewable Energy Tax Credits

²  For Eversheds Sutherland’s analysis of the PATH Act, Legal Alert: 2015 Tax Extender Energy Industry Impacts: Extends Renewable Energy PTC and ITC, Biodiesel and Other Fuel Credits; Repeals Crude Oil Export Ban

³  For Eversheds Sutherland’s analysis of the 2018 BBA, Legal Alert: Energy tax extenders package passed

⁴  Includes closed-loop biomass, open-loop biomass, geothermal energy, landfill gas, trash, qualified hydropower, and marine and hydrokinetic renewable energy facilities.

⁵  Note that no similar list is provided for the Continuous Construction Test.

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