Start of Construction

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1 Start of Construction Brought to you by Winston & Strawn s Tax & Energy Practice Groups 2013 Winston & Strawn LLP

2 Today s elunch Presenters John Lorentzen Tax Chicago JLorentzen@winston.com Andy Ratts Tax Chicago ARatts@winston.com 2013 Winston & Strawn LLP 2

3 Introduction Tax credits for wind and many other renewable energy resources come to an end this year. However, when the credits lapse, for the first time they will nevertheless remain available for projects the construction of which begins this year. This creates significant planning opportunities that must be implemented by the end of Winston & Strawn LLP 3

4 Roadmap This presentation will cover: Background on energy tax credits Recent guidance from the IRS that creates planning opportunities for taxpayers How to take advantage of those opportunities 2013 Winston & Strawn LLP 4

5 2013 Winston & Strawn LLP 5 Background

6 Credits Available Production Tax Credit: Under Code section 45, a taxpayer can receive a tax credit (the PTC ) for renewable energy produced by the taxpayer at a qualified facility and sold by the taxpayer. Investment Tax Credit: Under Code section 48, taxpayers can elect to treat qualified property that is part of a qualified investment credit facility placed in service after December 31, 2008, as energy property for which an energy credit (the ITC ) is allowed Winston & Strawn LLP 6

7 Qualifying Energy Resources Wind This presentation will focus on wind because it is the resource most commonly being funded. Closed-loop biomass Open-loop biomass Geothermal energy Municipal solid waste Qualified hydropower production Marine and hydrokinetic renewable energy 2013 Winston & Strawn LLP 7

8 Investment Tax Credit for Solar & Other Energy Sources Code section 48 already provides a 30% credit, with respect to periods ending before January 1, 2017, for certain property: Qualified fuel cell property Certain solar energy projects A 10% credit is available for these projects beginning on January 1, Qualified small wind energy property A 10% credit is available for certain thermal energy projects, qualified microturbine property, and combined heat and power system property, but only with respect to periods ending before January 1, This presentation does not address this energy property Winston & Strawn LLP 8

9 History of Uncertainty and Instability in Investment The PTC is a credit with an expiration date that regularly comes up for renewal. Because of uncertainty over whether the credit will be extended, investment in renewable energy usually increases as a result of frantic activity just before the credit lapses, and then drops dramatically.¹ 1. Source: American Wind Energy Association 2. Graph: Union of Concerned Scientists 2013 Winston & Strawn LLP 9

10 Political Climate Despite the past uncertainty surrounding the renewal of the PTC, there was generally an expectation that it would be retroactively reinstated. However, with the current political situation, there is no longer general acceptance on both sides of the aisle. The success of the energy credits has led to stress on incumbent energy providers. Exelon, for example, was vocal in its opposition to the extension of the PTC. Its activities in opposition to the extension of the credit ultimately led to its removal from the Board of the American Wind Energy Association, the industry trade group. This demonstrates that there are powerful actors who oppose the PTC and ITC and may attempt to exert their influence to achieve their political goals, including bringing the PTC and/or ITC to an end Winston & Strawn LLP 10

11 Electricity Delivered at a Lower Price Due to Tax Credit Success The addition of wind and solar energy at zero marginal cost shifts the dispatch curve to the right. As a result, the price of electricity at the same level of demand decreases ( price suppression ), as shown in Figure 1. This effect of renewable energy on the market has been confirmed by several studies, including studies by PJM Interconnection, PEO/Exelon, New York State Energy Research and Development Authority, and Tudor, Pickering, Holt, & Co., Energy Investment & Merchant Banking. Ultimately, price suppression drives down energy providers profit margins. Source (Figure 1): Richard W. Caperton, The Center for American Progress 2013 Winston & Strawn LLP 11

12 Beginning of Construction Requirement Under the American Taxpayer Relief Act of 2012, to qualify for either credit, construction of the qualified facility must begin before January 1, Two methods to satisfy this requirement under IRS Notice : 1. Begin physical work of a significant nature ( Physical Work Test ) 2. 5% Safe Harbor Only one method needs to be satisfied to establish the beginning of construction. However, as will be discussed further, it is recommended that, if possible, a taxpayer satisfy both tests Winston & Strawn LLP 12

13 Physical Work Test Work must be performed by the taxpayer or by other persons under a binding written contract that is entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in the taxpayer s trade or business. On-site and off-site work may be taken into account. However, off-site manufacturing is only taken into account if (i) the manufacturer s work is done pursuant to a binding written contract and (ii) these components are not held in the manufacturer s inventory. Things that are not taken into account: Preliminary activities. These include planning or designing, securing financing, exploring, researching, obtaining permits, licensing, conducting surveys, environmental and engineering studies, clearing a site, test drilling of a geothermal deposit, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings and foundations). Inventory. Physical work of a significant nature does not include work to produce property that is either in existing inventory or is normally held in inventory by a vendor Winston & Strawn LLP 13

14 5% Safe Harbor Taxpayer must pay or incur (within the meaning of Treasury Regulation (a)(1)) 5% or more of the total cost of the facility before January 1, For purposes of determining when an accrual basis taxpayer can treat the amount of any liability as incurred, the all-events test is not treated as met any earlier than the taxable year in which economic performance occurs with respect to the liability. See (c)(1)(ii) and (d). Economic performance occurs when services or property is provided to the taxpayer. A taxpayer is permitted to treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property if the taxpayer can reasonably expect the person to provide the services or property within 3½ months after the date of payment. A taxpayer is also permitted to treat property as provided to the taxpayer when the property is delivered or accepted, or when title to the property passes. We recommend that risk of loss also pass to the taxpayer Winston & Strawn LLP 14

15 5% Safe Harbor cont d The method used by the taxpayer to determine when property is provided is a method of accounting that must comply with the rules of Treasury Regulation section (e). Thus, the method of determining when property is provided must be used consistently from year to year, and cannot be changed without the consent of the Commissioner. However, taxpayers often cannot determine with sufficient certainty their method of accounting or have the wrong one. For this reason, create a new taxpayer such as a corporation or a regarded partnership, which should be able to freely elect a new method of accounting Winston & Strawn LLP 15

16 5% Safe Harbor cont d The 5% Safe Harbor stems from the rules regarding the start of construction for bonus depreciation and is consistent with the 5% safe harbor used by the Treasury with respect to the cash grant program. Uncertainty originally existed because the 5% safe harbor with respect to the PTC and ITC also required continuous construction, which was a departure from the cash grant program and bonus depreciation rules. However, as discussed below, if a taxpayer satisfies the 5% safe harbor, the taxpayer will be deemed to satisfy the continuous construction requirement if the facility is placed in service before January 1, Winston & Strawn LLP 16

17 Binding Written Contract A taxpayer may rely upon work performed under a binding written contract (after that binding written contract is executed) in determining whether the Physical Work Test or 5% Safe Harbor has been satisfied. However, in a major departure from the cash grant program, the definition of a binding written contract originally required that the contract not limit damages to a specified amount (e.g., no liquidated damages provisions are allowed). The cash grant program had allowed liquidated damage provisions, as did other grandfathering rules for federal income tax purposes, in recognition that such a provision is a normal, prudent commercial term, and would be negotiated regardless of the federal income tax benefit that hinges on the contract meeting the grandfathering requirements. Fortunately, in an update to IRS Notice , the IRS clarified its position and stated that a contractual provision that limits damages to an amount equal to at least five percent of the total contract price will not be treated as limiting damages to a specified amount. Consequently, the IRS adopted the same 5% liquidated damages threshold that it uses in the bonus depreciation regulations and the Treasury uses with respect to the cash grant program Winston & Strawn LLP 17

18 Continuous Construction / Continuous Efforts Tests In previous years, a facility was eligible for the PTC only if placed in service by a particular date. For example, Code section 45(d) as of December 31, 2008, stated that a wind facility was eligible for the PTC if originally placed in service after December 31, 1993, and before January 1, Now, by contrast, eligibility for the credit depends on when construction begins. As of October 2013, Code section 45(d) states that a wind facility is eligible for the PTC if originally placed in service after December 31, 1993, and the start of construction of which begins before January 1, As mentioned above, the Physical Work Test and 5% Safe Harbor tests are used to determine when construction begins. Under both of these tests, the taxpayer must make continuous progress after it has begun construction toward completion until placed in service. This test is called the Continuous Construction test for purposes of the Physical Work Test, and the Continuous Efforts test for purposes of the 5% Safe Harbor. Facts & circumstances nature of these tests has in the past created uncertainty about whether a project complies. A recent IRS Notice, Notice (the Notice ), provides additional guidance as to how taxpayers can comply with the Continuous Construction and Continuous Efforts tests. This creates more certainty for taxpayers, creating significant planning opportunities Winston & Strawn LLP 18

19 2013 Winston & Strawn LLP 19 Opportunity

20 Notice Notice provides guidance as to how taxpayers can satisfy the Continuous Construction and Continuous Efforts tests. If a facility for which construction has begun by January 1, 2014, under either the Physical Work Test or the 5% Safe Harbor is ultimately placed in service before January 1, 2016, the facility will be deemed to satisfy the Continuous Construction test and/or the Continuous Efforts test. A transfer of a project after construction has begun will not prevent a project from qualifying for the PTC or ITC. This allows for significant tax planning opportunities Winston & Strawn LLP 20

21 Taking Advantage of this Opportunity 2013 Winston & Strawn LLP 21

22 Example Step 1 Establish beginning of construction before January 1, Take the following steps to satisfy the 5% Safe Harbor: Create a new, regarded taxpayer for the project. Enter into a contract with a vendor to buy 10 wind turbines. Contract could be for component pieces as well, including inventory. Note, however, that work to produce property that is either in existing inventory or is normally held in inventory by a vendor will not count toward the Physical Work Test. Pay for the wind turbines in cash before January 1, Note that an accrual-basis taxpayer does not necessarily need to pay in cash, so long as he has paid or incurred (within the meaning of (a)) 5% or more of the total cost of the facility prior to January 1, Take possession of the wind turbines to ensure that payments qualify for 5% safe harbor for an accrual-basis taxpayer. Ensure title and risk of loss to the property passes within 3½ months of date of payment. Delivery may be accepted by an agent, which can include the vendor. Thus, the 5% Safe Harbor may be satisfied without the property leaving the vendor s factory Winston & Strawn LLP 22

23 Example Step 2 Alternatively, but optimally in addition, satisfy the Physical Work Test before January 1, As mentioned above, if a facility s wind turbines and tower units are to be assembled on-site from components manufactured off-site by a person other than the taxpayer and delivered to the site, physical work of a significant nature begins when the manufacture of the components begins at the off-site location. Ensure binding written contract to perform the work is worded so as to satisfy this test. Begin physical construction on site. Qualifying Roads (a) must be used for equipment to operate and maintain the facility, and (b) must not be used primarily for employee or visitor vehicles Winston & Strawn LLP 23

24 Example Step 3: 5% Safe Harbor If by January 1, 2016, those 10 wind turbines are placed in service, plus up to an additional 190 turbines (assuming total cost with the additional turbines is not more than 20 times greater than the cost of the initial 10 turbines), the 5% Safe Harbor test should be satisfied. Therefore, the begun construction requirement is satisfied. Outcome: eligible to receive the tax credit on the entire facility i.e., all 200 turbines. Under Notice , a transfer of the project after construction has begun will not prevent a project from qualifying for the PTC or ITC. This example demonstrates the opportunity available, as will be discussed Winston & Strawn LLP 24

25 Example Step 3: Physical Work The facility completed by January 1, 2016, that is part of the single facility started by the physical construction should satisfy the Physical Work Test. Therefore, the begun construction requirement is satisfied. Outcome: eligible to receive the tax credit on the entire facility i.e., the project completed by such date. Under Notice , a transfer of the project after construction has begun will not prevent a project from qualifying for the PTC or ITC. This example demonstrates the opportunity available, as will be discussed Winston & Strawn LLP 25

26 Available Opportunity Potential to take a credit on facilities 95%+ of which were paid for after December 31, 2013, when the credit expires. For the 5% Safe Harbor, no need to purchase a site or to have concrete plans by the end of Winston & Strawn LLP 26

27 Lost Opportunity For a grandfathered project not placed in service before January 1, 2016, the Continuous Construction/Continuous Efforts tests will be determined by the relevant facts and circumstances. Ambiguities and issues abound Winston & Strawn LLP 27

28 Action Items By the end of 2013, buy wind turbines (or other components of a qualified facility) in anticipation of satisfying the 5% Safe Harbor. Cash payments if a cash-basis taxpayer Reasonable expectation of receipt of the property by April 15, Contemplate physically achievable mechanic for accepting delivery. Begin on-site construction or manufacture of components off-site to satisfy Physical Work Test Winston & Strawn LLP 28

29 Too Good to be True? Potential for new rules to be challenged retroactively. Notices are generally binding on the IRS, the enforcement agency. Therefore, taxpayers should be able to rely on the Notice. However, taxpayers who rely on IRS Notices should be mindful that they could be affected by subsequent legislation or court rulings. Strive to satisfy both the Physical Work Test and the 5% Safe Harbor Winston & Strawn LLP 29

30 Too Good to be True? Physical Work Test How much work/cost is really sufficient? 5% Safe Harbor Limits to equipment trafficking? Intent really irrelevant? 2013 Winston & Strawn LLP 30

31 Conclusion New guidance increases certainty for taxpayers and allows for significant opportunity if taxpayer s activities before the end of 2013 will be sufficient to establish beginning of construction. Need to take action by the end of 2013 to establish the start of construction. Facility will be deemed to satisfy the Continuous Efforts/Continuous Construction tests if placed in service before January 1, After that, whether a facility will qualify will be determined under a facts and circumstances standard. Aim to satisfy both the 5% Safe Harbor and the Physical Work Test if possible. A transfer of the project after construction has begun will not prevent a project from qualifying for the PTC or ITC. Keep in mind that this significant planning opportunity ends with the year Winston & Strawn LLP 31

32 2013 Winston & Strawn LLP 32 Questions?

33 2013 Winston & Strawn LLP 33 Thank You.

34 Contact Information John Lorentzen Tax Chicago (312) Andy Ratts Tax Chicago (312) Winston & Strawn LLP 34