In Notice 2018-59, the IRS provides additional guidance on the Section 48 investment tax credit (ITC) to reflect the extension and modification of the credit by the Consolidated Appropriations Act, 2016 (the 2016 Act) and the Bipartisan Budget Act of 2018 (the 2018 Act). The Notice provides guidance for determining when construction begins on energy property, which prior guidance did not cover.

Background

Section 48(a) provides an investment tax credit (ITC) for two categories of energy property. The first category is property listed in Section 48(a)(3) (Section 48(a)(3) energy property). Section 48(a)(3) property consists of solar energy, fiber-optic solar energy, geothermal energy, qualified fuel cell, qualified microturbine, combined heat and power system, qualified small wind energy, and thermal energy properties. The second category is property that is part of a renewable energy facility described in Section 45(1), (2), (3), (4), (6), (7), (9), or (11) and is treated as energy property under Section 48(a)(5) (Section 48(a)(5) energy property). Section 48(a)(5) energy property can qualify for either the production tax credit (PTC) under Section 45 or the ITC under Section 48, but not for both. Section 48(a)(5) energy property consists property that is part of a wind, closed-loop biomass, open-loop biomass, geothermal, landfill gas, trash, qualified hydropower or marine hydrokinetic facility.

Before the 2016 Act, Section 48(a)(3) energy property generally had to be placed in service by a specified date to qualify for the ITC.¹ On the other hand, Section 48(a)(5) energy property could qualify for the credit if construction on the property began before a specified date. As a result of the changes made by the 2016 and 2018 Acts, the availability and amount of the ITC for Section 48(a)(3) energy property now depends, in most cases, on the date on which construction begins. In addition, a placed-in service date continues to apply to solar, fiber-optic solar, qualified fuel cell and qualified small wind energy property. For these properties, the ITC is not available or is available only in a reduced amount if the property is placed in service after December 31, 2023. Notice 2018-59 contains a helpful table summarizing the beginning-of-construction and placed-in-service requirements for Section 48(a)(3) energy property. The table is reproduced in Appendix A, which is attached to this Alert.

The IRS has provided extensive guidance on the application of the beginning-of-construction requirement for Section 48(a)(5) energy property. See Notices 2013-29, 2013-60, 2014-46, 2015-25, 2016-31, and 2017-04. Notice 2018-59 provides similar guidance for Section 48(a)(3) energy property.

Notice 2018-59

Notice 2018-59 permits taxpayers to establish that construction on Section 48(a)(3) energy property has begun by either: (i) starting "physical work of a significant nature" (the Physical Work Test) or (ii) meeting a safe harbor by paying or incurring 5% or more of the total cost of the facility (the 5% Safe Harbor). Under both methods, a taxpayer must make continuous progress towards completion once construction has begun (Continuity Requirement). The Physical Work Test, the Five-Percent Safe Harbor, and the Continuity Requirement all correspond to similar provisions in the guidance on Section 48(a)(5) property.

Physical Work Test

The Physical Work Test is satisfied when physical work of a significant nature begins. Whether and when a taxpayer has begun construction of energy property will depend on the relevant facts and circumstances, and the test focuses on the nature of the work performed, not the amount or the cost. Thus, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test. The work may be performed by the taxpayer or, as discussed later, for the taxpayer by other persons under a binding written contract that is entered before the manufacture, construction or production of the property. In addition, the work may be performed on-site or off-site. The Notice specifies that physical work of a significant nature does not include preliminary activities, even if the cost of those preliminary activities is properly included in the depreciable basis of the energy property. The Notice also provides that physical work of a significant nature does not include the production of components that are either in existing inventory or are normally held in inventory. The preceding rules are derived directly from prior notices relating to Section 48(a)(5) energy property. The examples of on-site and off-site physical work provided in Notice 2018-59 differ from those in the prior notices, which were primarily directed at wind facilities. The Notice lists manufacture of components, mounting equipment, support structures such as racks and rails, inverters, and transformers (used in electrical generation that step up the voltage to less than 69 kilovolts) and other power conditioning equipment as examples of off-site physical work. The Notice also includes a non-exclusive list of examples of on-site physical work categorized by different type of energy property. That list is reproduced in Appendix B, which is attached to this Alert.

Five-Percent Safe Harbor

The Five-Percent Safe Harbor in the Notice states that construction of energy property will be considered to have begun if 5% of the total cost of the property has been paid (for cash-basis taxpayers) or incurred (for accrual-basis taxpayers). The total cost of the property for purposes of the Five-Percent Safe Harbor includes all costs properly included in the depreciable basis of the facility, but does not include the cost of land or any property not integral to the energy property. The Notice also provides rules relating to cost overruns. If cost overruns result in a failure to incur at least 5% of total costs as of the end of a calendar year (the safe harbor year), the property will not satisfy the 5% Safe Harbor for that year. If the property is a single project composed of multiple energy properties, however, the 5% Safe Harbor may be satisfied with respect to some of those properties if the aggregate total cost of those properties is no more than 20 times greater than the amount paid or incurred before the end of the safe harbor year. The preceding rules also derive directly from prior notices relating to Section 48(a)(5) energy property.

Continuous construction/continuous efforts

Notice 2018-59 provides that, if a taxpayer does not maintain a continuous program of construction on a facility (the Continuous Construction Test), the Service will closely scrutinize the facility and may determine that construction has not begun and the Physical Work Test is not satisfied. The Notice also provides that the Five-Percent Safe Harbor does not apply unless the taxpayer makes continuous efforts to advance towards completion of the facility (the Continuous Efforts Test). In both cases, satisfaction of the Continuity Requirement imposed by the Continuous Construction/Continuous Efforts Tests will be determined by the relevant facts and circumstances. In addition, the Notice lists specific factors that may be taken into account in determining whether the Continuous Efforts Test is satisfied. The Notice includes a non-exclusive list of excusable disruptions that will not be considered as indicating that a taxpayer has failed to satisfy the Continuity Requirement. The foregoing rules also follow prior notices. A new rule provides the timing for the excusable disruption determination. If a project consists of a single energy property, the determination is made in the calendar year in which the property is placed in service. If the project consists of multiple energy properties, the determination is made in the calendar year in which the last such property is placed in service.

As under the prior notices, Notice 2018-59 provides a Continuity Safe Harbor. Under this safe harbor, the Continuity Requirement is satisfied for both the Physical Work Test and the 5% Safe Harbor if the energy property is placed in service by the end of the calendar year that is four calendar years after the calendar year in which construction began. Excusable disruptions do not extend the safe harbor. If the safe harbor is not met, satisfaction of the Continuity Requirement depends on the relevant facts and circumstances. The Notice clarifies that the Continuity Safe Harbor does not extend the December 31, 2023 deadline for placing in service fiber-optic solar, qualified fuel cell, and qualified small wind energy property.

Energy property

The notices relating to Section 48(a)(5) energy property relied on the concept of a "facility" in applying the beginning-of-construction rules. The rules in Notice 2018-59 are based instead on the "energy property." "Energy property," however, is defined in much the same manner as "facility." Thus, an energy property generally includes all components of property that are functionally interdependent (that is, the placing in service of each component is dependent upon the placing in service of each of the other components). The Notice states that energy property generally is comprised of all components of property necessary to generate electricity up to and including the inverter. The Notice lists as examples of such components: PV panels (or other arrangements of solar cells); fiber-optics; fuel cells; turbines; boilers; mounting equipment; support structures; tracking equipment; monitoring equipment; transformers (if the step up in voltage is to less than 69 kilovolts); and other power equipment. It also clarifies that solar energy property installed on a single roof is a single unit of property.

As in the notices relating to Section 48(a)(5) energy property, multiple energy properties that are operated as part of a single project (along with any components of property that serve some or all of the properties) will be treated as a single energy property for purposes of determining whether construction has begun. Whether multiple energy properties are operated as part of a single project will depend on the relevant facts and circumstances. Following the precedent of prior notices, the Notice lists various factors that indicate properties are operated as part of a single project, including ownership by a single entity, location on contiguous pieces of land, a common power purchase agreement, a common intertie or substation, common environmental or regulatory permits, a single master construction contract, and common financing. As under the prior notices, the multiple energy properties may be disaggregated in applying the Continuity Safe Harbor. That is, the properties that are placed in service during the safe harbor period will be treated as satisfying the safe harbor. Whether the remaining properties satisfy the Continuity Requirement depends on the facts and circumstances.

As under the prior notices, only work on property that is an integral part of the activity performed by the energy property is taken into account in applying the Physical Work Test. Similarly, only expenditures on such property are taken into account in applying the 5% Safe Harbor. The Notice follows prior notices in classifying property as integral or non-integral. Thus, transformers stepping up the voltage of electricity to that needed for transmission, onsite roads used for equipment to operate and maintain energy property, and certain structures housing energy property are treated as integral, while roads primarily for access to the site or employee or visitor vehicles, fencing, and building are generally treated as not integral.

Contracts and look-through rule

The Notice also follows prior notices in providing that work performed and amounts paid under a binding written contract are taken into account in determining whether construction has begun. Work and amounts paid are taken into account under this rule only if the contract is entered before the work is performed.

A contract is binding for this purpose only if it is enforceable under local law against the taxpayer or a predecessor and does not limit damages to a specified amount. A provision limiting damages to 5% or more of the total contract price, however, will not be treated as limiting damages to a specified amount. The Notice refers to Treas. Reg. Section 1.168(k)-1(b)(4)(ii)(A)-(D) for additional guidance regarding the definition of a binding written contract. In addition to permitting liquidated damages of 5% or more, this regulation clarifies the treatment of contracts under which there may be little or no damages because the contract price does not differ significantly from fair market value. The regulation provides that this fact is not taken into account in determining whether damages under the contract are limited. The regulation also provides that a contract may be binding even if:

— It is subject to a condition (as long as the condition is not within the control of either party);
— There are insubstantial changes to its terms;
— Any term is to be determined by a standard beyond the control of either party; or
— Certain terms remain to be negotiated (for contracts imposing significant obligations on the taxpayer).

If a master contract is entered into and then project-specific contracts are subsequently entered into, the work performed under the master contract may be taken into account in determining when physical work of a significant nature begins with respect to the facility (the Master Contract Rule).

The look-through rule prescribes the extent to which activity by another person under a binding written contract is taken into account in determining beginning of construction. As previously noted, the manufacture of components under a binding written contract will be taken into account for purposes of the Physical Work Test only if the components are not held in the manufacturer's inventory. In addition, if a manufacturer produces components for multiple energy properties, a reasonable method must be used to associate individual components with a particular purchaser. The look-through rule also applies for purposes of the 5% Safe Harbor. If property is manufactured for the taxpayer by another person under a binding written contract, costs incurred by the contractor before the property is provided to the taxpayer are deemed incurred by the taxpayer when the contractor incurs those costs under the principles of Section 461. An example suggests that these principles include, in the case of an accrual-method contractor, satisfaction of the economic performance requirement. The look-through rule goes only one level to costs incurred by the person producing property under a binding written contract with the taxpayer. Production activities by a subcontractor do not count toward the taxpayer's safe harbor.

Additional rules from prior notices

Notice 2018-59 also incorporates rules from prior notices that apply the 80/20 Rule to retrofitted property. Under this rule, energy property may qualify as originally placed in service even though it contains some used components, provided the fair market value of the used components is not more than 20% of the energy property's total value (the cost of the property's new components plus the value of its used components).

Finally, the Notice incorporates the transfer rules from Notice 2013-60. Thus, a taxpayer that owns energy property on the date it is originally placed in service may claim the Section 48 credit with respect to the energy property even if the taxpayer did not own the energy property at the time construction began with the credit claimed limited to the taxpayer's basis in the energy property.

Implications

The Notice adapts the beginning-of-construction rules for Section 48(a)(5) energy property, as set forth in Notices 2013-29, 2013-60, 2014-46, 2015-25, 2016-31, and 2017-04, to energy property described in Section 48(a)(3). Although some differences in the rules are dictated by the different types of property involved (for example, solar panels rather than wind turbines), taxpayers that have followed the guidance in the prior notices will not be surprised by the rules in Notice 2018-59.

One aspect of the guidance in Notice 2018-59 that taxpayers should find particularly helpful is that all the rules relating to the beginning of construction for Section 48(a)(3) energy property are incorporated in a single document, instead of being spread over six notices, as was the case for the guidance on Section 48(a)(5) property.

———————————————

———————————————
ENDNOTES

¹ A permanent 10% credit was (and remains) available for solar energy and geothermal energy property.

———————————————
ATTACHMENTS

Appendix A

Appendix B