Further clarity could help unlock much needed investment for a significant number of delayed projects.
On May 27, 2020, the Internal Revenue Service issued Notice 2020-40 (“Notice”), which modifies certain rules related to the production tax credit (PTC) available pursuant to IRC Section 45 and the investment tax credit (ITC) available pursuant to IRC Section 48 in light of the COVID-19 pandemic.
The guidance provided by the Notice was highly anticipated. On May 7, the Office of Legislative Affairs at the Department of Treasury sent a letter to Senator Chuck Grassley, the Chairman of the Senate Committee on Finance, stating Treasury’s intention to extend the continuity safe harbor for the PTC and ITC. The letter was in response to a letter to Treasury Secretary Steven Mnuchin on April 27 from a bipartisan group of senators urging him to extend the continuity safe harbor in order to preserve jobs and investments threatened by the COVID-19 pandemic, which has disrupted supply chains, construction operations and permitting, and has delayed projects otherwise on track to be completed on schedule.
The Notice addresses a key timing concern resulting from COVID-19 and associated delays. The Notice allows projects that started construction in 2016 or 2017 an additional year to be completed by extending the continuity safe harbor offered in existing IRS guidance. Under the Notice, if a project started construction in 2016 or 2017, and is placed in service within five years of the end of that year, construction will be deemed continuous for purposes of qualifying for the PTC or ITC. A number of developers and investors had expressed concern that certain projects that were originally intended to be completed by the end of 2020 or 2021 may be delayed to a later year, which could prevent such projects from satisfying the continuity safe harbor and put tax credits at risk.
The Notice also provides assurances for taxpayers that started construction at the end of 2019 by incurring 5% of project costs and made payments for services or equipment with the reasonable expectation of receiving title or delivery within the 3½ month period required by IRS guidance. The Notice provides that if the property is received by October 15, 2020, the taxpayer’s expectation of delivery at the time the payment was made is deemed to be reasonable.
The Continuity Safe Harbor
For a taxpayer seeking to claim PTCs or ITCs, the calendar year when such taxpayer is deemed to begin construction of the facility or property establishes the applicable amount of available tax credit. The available PTCs and ITCs decline over time based on the year of construction commencement, and therefore the determination of the year when construction begins is critical to taxpayers seeking to claim these credits.
Under current law, the PTC is available at a rate of 100 percent for wind projects that began construction before 2017, and then phases down to 80 percent for projects that began construction during 2017, 60 percent for projects that began construction during 2018, 40 percent for projects that began construction during 2019, and then back up to 60 percent for projects that begin construction in 2020. No PTC is available for projects that begin construction in 2021. The 30 percent solar ITC phased down to 26 percent for projects that start construction in 2020 and then will be reduced again to 22 percent in 2021 before it drops down to 10 percent going forward. Solar projects qualifying for a tax credit above 10 percent must be placed in service before 2024.
For purposes of qualifying for PTCs or ITCs, a taxpayer may establish that construction has commenced on a facility (in the case of the PTC) or energy property (in the case of the ITC) in a particular calendar year by demonstrating that physical work of a significant nature has begun (“Physical Work Test”) or, by demonstrating that 5% or more of the total cost of such facility or energy property has been incurred (“5% Safe Harbor”).
In addition to initially satisfying either the Physical Work Test or the 5% Safe Harbor, the taxpayer must satisfy a continuity requirement. Under this continuity requirement, if construction commencement is established using the Physical Work Test, the taxpayer must thereafter maintain a continuous program of construction. If construction begins under the 5% Safe Harbor, the taxpayer must make continuous efforts to advance towards completion of the property. Under prior IRS guidance, a taxpayer was considered to satisfy the continuity requirement for either the Physical Work Test or the 5% Safe Harbor if the relevant facility or property is placed in service by the end of a calendar year that is no more than four calendar years after the calendar year when construction began (now five years under the Notice for projects that began construction in 2016 or 2017, as discussed below).
If the taxpayer fails to complete the project within the applicable safe harbor period, the taxpayer must otherwise prove that it meets the continuity requirement based on applicable facts and circumstances. Proving continuity based on facts and circumstance can be challenging because the standard is somewhat subjective, and there are no clear delineations regarding the scope and detail of the records that would be needed to show the requisite proof. For that reason, generally, tax equity investors require developers to place projects in service within the safe harbor period, rather than rely on continuous efforts. Moreover, many developers banked on projects being placed in service within the relevant safe harbor period and either did not engage in continuous efforts or would otherwise have a very difficult time documenting their compliance with the continuity requirement. These facts make it extremely challenging for projects that fail to be completed within the safe harbor period to secure needed financing.
Due to COVID-19, many developers have faced delays in supply chains, construction operations and permitting, delaying projects completion. Depending on the circumstances, delays could have caused a project that otherwise would have qualified for the four-year continuity safe harbor to fail to qualify, in which case the taxpayer would be required to show continuous construction or continuous efforts, as applicable, under a facts and circumstances determination. This risk was particularly acute for wind projects that began construction in 2016 (the last year the full PTC was available) and faced a December 31, 2020, deadline to qualify within the applicable four-year continuity safe harbor.
Under the revised safe harbor, for a project that began construction in 2016 or 2017, the continuity safe harbor will be satisfied if the project is placed in service by the end of the fifth calendar year after the year in which the Physical Work Test is met or the 5% Safe Harbor was satisfied. If a taxpayer satisfied either test in 2018 or 2019, the four-year continuity safe harbor still applies. Accordingly, this new guidance provided by the Notice will primarily benefit projects claiming the PTC, since the PTC has an earlier phaseout period, which is more directly impacted by the concessions made for 2016 and 2017 projects.
While the PTC is often closely associated with wind projects, the same relief applies to biomass, geothermal, landfill gas, waste to energy, incremental hydroelectric and hydrokinetic projects that began construction in 2016 or 2017.
The 3½ Month Rule
For purposes of meeting the requirements of the 5% Safe Harbor, accrual method taxpayers can take advantage of a rule allowing costs to be deemed incurred on the date of payment, so long as the taxpayer reasonably expects the service or property to be provided within 3½ months of payment.
It is a common strategy for developers to pay for eligible equipment at the end of a year, and then take delivery the following year within 3½ months of payment, in order to claim the cost of the equipment was incurred in the year of payment for purposes of meeting the 5% Safe Harbor. This was particularly true of solar developers at the end of 2019, as many developers attempted to qualify equipment under the 5% Safe Harbor before the amount of the available ITC was reduced at the start of 2020.
As a result of global supply chain disruptions from COVID-19, many equipment orders have been delayed, and were not delivered within the expected 3½ month window. While the rules do not require actual delivery, only a reasonable expectation at the time of payment, there was a lack of certainty as to what would be considered “reasonable.” For example, particularly considering the large rush of year-end orders made by solar developers to beat the ITC stepdown, was it unreasonable to expect that delivery may not be delayed by a short period of time that would push the delivery outside the 3½ month window? Obviously, nobody expected a global pandemic, but arguably, it might not have been reasonable to assume everything would go perfectly in that sort of environment. While it seems highly unlikely the IRS would take such a position in this circumstance, for certain developers that made very large year-end commitments, it was not unreasonable to be somewhat concerned.
The Notice addresses any lingering uncertainty regarding the application of the 3½ month rule in light of COVID-19 and associated delays. The Notice confirms that a taxpayer may take advantage of a reasonable expectation of delivery, and also provides that for payments made on or after September 16, 2019, a taxpayer will be deemed to have had a reasonable expectation that the services or property would be provided within 3½ months after the date of payment if the services or property are actually provided on or before October 15, 2020. Notwithstanding the safe harbor, the 3½ month rule may be satisfied even if the services or property are provided after October 15, 2020, if the expectation at the time of payment was reasonable.
The Notice provides much needed certainty for delayed renewable projects and represents an important victory for renewable energy trade associations that have been pushing for this extension.
A failure to extend the four-year safe harbor window for the continuity requirement could have caused devastating losses throughout the wind industry. This year was expected to be a big year for the wind industry, as the current four-year safe harbor for 2016 PTC projects was expiring at the end of 2020. Accordingly, many projects expecting to meet that deadline began to undertake significant spending at the end of 2019 and early 2020 in anticipation of finishing by the end of 2020 deadline. With the disruptions from COVID-19, many of these projects may not be fully placed into service in time, and some might have potentially lost their ability to claim PTCs entirely, which could have amounted in billions of dollars in losses.
The value of the Notice is a bit more modest for purposes of the ITC (considering the later phasedown period), but the clarification of the 3½ month rule helps resolve any lingering uncertainty around the delivery timeframe of the significant number of orders that were made at the end of 2019 to qualify equipment before the ITC stepdown.
Despite heavy efforts by industry insiders and certain members of Congress, the Notice does not provide any specific relief to offshore wind projects, nor does it allow projects that began construction under the Physical Work Test more time to finish construction by using the more permissive “continuous efforts” standard applicable to the 5% Safe Harbor. Projects that began construction under the Physical Work Test will continue to have to prove actual continuous physical construction to be given more time beyond the safe harbor period.
If you have any questions on this Alert, please contact Pillsbury tax partner Jorge Medina or other members of the Pillsbury Renewable Energy practice team, set forth below.
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