1603 Grant Program: Treasury Department Releases New Guidance Concerning the Beginning of Construction Requirement

Background

Last week the U.S. Treasury Department (Treasury) released additional guidance – in the form of frequently asked questions and answers (FAQs) – relating to the “beginning of construction” requirement for specified energy property of facilities intended to qualify for the federal grant (the grant) under section 1603 of the American Recovery and Reinvestment Act (Recovery Act).

The FAQs follow the revised program guidance released in March 2010 (the revised guidance), that substantially modified Treasury’s original July 2009 guidance (the “original guidance” and, together with the FAQs and the revised guidance, the guidance) as to the beginning of construction requirement. Against the backdrop of Treasury’s earlier guidance and the slow movement by Congress on current legislative proposals to extend the 1603 grant program, the FAQs provide much needed and timely guidance for developers and investors who are planning to construct grant eligible projects.

Under section 1603(a) of the Recovery Act, in order for specified energy property of facilities not placed in service in 2009 or 2010 to qualify for the grant, the taxpayer must begin construction of such facilities before January 1, 2011. The FAQs echo the original and revised guidance that the beginning of construction requirement can be satisfied in one of two ways:

1. By performing sufficient physical work on the specified energy property based on the facts and circumstances (the “physical work of a significant nature test”); or
2. By satisfying a 5% cost safe harbor (the “safe harbor test”).

For either test, the FAQs affirm the revised guidance that work performed, or costs paid or incurred (as the case may be), by the applicant and by other persons pursuant to a binding written contract are taken into account (to be binding, a contract must be enforceable under state law and cannot limit damage in the event of a breach to less than 5% of the total contract price). Moreover, in the case of work performed for an applicant under a binding written contract, the FAQs confirm the earlier guidance that for either test – only work undertaken after the contract is entered into is counted.

Scope of Physical Work. In determining whether the physical work of a significant nature test has been satisfied, the FAQs affirm that only physical work on the specified energy property is counted. Thus, physical work on non-qualifying property, such as buildings or employee parking lots, does not qualify.

As to the amount of physical work necessary with respect to such specified energy property, the FAQs provide generally that “any physical work on the specified energy property will be treated as the beginning of construction even if such work relates to only a small part of the facility.” This is a helpful clarification and should provide taxpayers some level of comfort when the time comes to commence physical work on the project. In addition, the FAQs reiterate that physical work of a significant nature does not include preliminary activities – identified in the earlier guidance as planning or designing, securing financing, exploring, researching, 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).

If a contractor is manufacturing property for a number of customers, the FAQs additionally provide that the contractor must “reasonably demonstrate that physical work has started” on the property that will become specified energy property of the applicant. The FAQs specify that the determination of whether a method is reasonable will depend on the relevant facts and circumstances. For this reason, applicants that enter into any binding written contracts with manufacturers or other vendors for specified energy property should include appropriate contractual provisions to require such third parties to maintain and provide to the applicant the records necessary for the applicant to demonstrate that sufficient physical work has been expended on the applicant’s specified energy property prior to 2011.

Examples of Work that Qualifies. Against this backdrop, the FAQs indicate that the following work should constitute physical work of a significant nature:

• Physical work on a transformer that increases the voltage of electricity produced at the facility to the voltage needed for transmission (because power conditioning equipment is specified energy property);
• Laying the foundation for one wind turbine that is part of a larger wind farm;
• Starting construction on onsite roads that are used for moving materials to be processed (e.g., biomass) and roads for equipment to operate and maintain the qualified facility;
• Construction of a structure that is essentially an item of machinery or equipment or a structure that houses property used as an integral part of a qualified activity if the use of the structure is so closely related to the use of the housed property that the structure clearly can be expected to be replaced when the property it initially houses is replaced; and
• The manufacture of solar panels under a binding written contract after such contract is entered into by the applicant and the manufacturer.

Examples of Work that Does Not Qualify. In contrast, the FAQs indicate that the following work should not constitute physical work of a significant nature:

• Physical work on a transmission tower located at the site (because the transmission tower is not specified energy property);
• Construction of roads for access to the site, or roads used solely for employee or visitor vehicles;
• Preliminary work such as clearing land, obtaining permits or putting up fencing;
• Dismantling and removing an existing facility in order to construct a new qualifying facility; and
• Test drilling of a geothermal deposit.

Advantages of Physical Work of a Significant Nature Test. The foregoing examples illustrate Treasury’s earlier guidance that only work performed on specified energy property will satisfy the physical work of a significant nature test and, more importantly, suggest that the threshold necessary for applicants to satisfy this test may in some circumstances be less than the threshold necessary to satisfy the safe harbor test.

Beyond the examples listed above, the original and revised guidance provide that in the case of a wind facility, on-site physical work of a significant nature begins with the beginning of the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete pads of the foundation. In the case of projects with expected high capital costs, the completion of such physical work could represent less work – on a percentage or amount basis – than the percentage or amount of costs necessary to satisfy the safe harbor test.

Disadvantages of Physical Work of a Significant Nature Test. Notwithstanding the above, the FAQs do provide some important limitations on an applicant’s ability to satisfy the physical work of a significant nature test.

First, the FAQs provide that Treasury will “closely scrutinize any construction activity that does not involve a continuous program of construction or a contractual obligation to undertake and complete within a reasonable time, a continuous program of construction.” Thus, for example, where the foundation for a single wind turbine (which is part of a 50-turbine project) is laid in 2010 but no other physical work is performed on the project until 2012 – the FAQs indicate that such work would likely not satisfy the physical work of a significant nature test because it was not pursuant to a “continuous program of construction.” For this reason, it is important that EPC contracts be drafted in a way to require the contractor to maintain a consistent and customary timeline of construction once construction on the facility has begun.

Second, the FAQs provide that work performed under a binding written contract does not include work to produce components or parts that are in existing inventory or are normally held in inventory by a manufacturer. This is an important corollary to the requirement referenced above that any work performed under a binding written contract be conducted after the contract is entered into between the applicant and the vendor. Accordingly, taxpayers looking to qualify under the physical work of a significant nature test should take appropriate steps – e.g., through representations, warranties and covenants in the EPC or vendor contracts – to ensure that any property constructed for them pursuant to such contracts is newly constructed or acquired by such contractors and not presently existing in inventory (or normally held in inventory).

Scope of Qualifying Costs. Under the safe harbor test, an applicant may treat physical work of a significant nature as beginning when more than 5% of the total cost of the property has been paid or incurred by December 31, 2010. For this purpose, only eligible costs – i.e., costs relating to specified energy property – are counted in determining whether an applicant has satisfied this test.

In the case of property constructed by the applicant, costs of the property are treated as paid or incurred when paid or incurred by the applicant. In the case of property manufactured, constructed or produced for the applicant by another person under a written binding contract, (1) the cost of the property under the contract is treated as paid or incurred when the property is provided to the applicant, and (2) for periods before the property is provided to the applicant, costs paid or incurred with respect to the property by such other person are treated as costs of the property that are paid or incurred when paid or incurred by such other person. In short, costs relating to both self-constructed property and property constructed under a written binding contract are combined in determining if 5% of the total costs have been exceeded.

All Events Test and Economic Performance Rules. For accrual method taxpayers, the FAQs affirm that the all-events test of Treas. Reg. §1.461-1(a)(2) applies in determining whether such taxpayers have “incurred” costs for purposes of satisfying the safe harbor test. For cash method taxpayers, costs are taken into account when paid by the taxpayer.

Under the all events test of Treas. Reg. §1.461-1(a)(2), a cost generally is “incurred” by an accrual method taxpayer when (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability is determinable with reasonable accuracy, and (3) the economic performance test of Treas. Reg. §1.461-4 has been met. The revised guidance had deleted the provision in the original guidance that provided that the economic performance rules applied for purposes of determining whether an accrual based applicant has incurred more than 5% of the total cost of the property – which raised the question as to whether the ordinarily applicable economic performance rules applied in this context. On this point, the FAQs make clear that, with one notable exception, such rules continue to apply in determining whether costs have been incurred by accrual method taxpayers.

In general, for property manufactured, constructed, or produced for the applicant by another person under a binding written contract that is entered into prior to the manufacture, construction, or production of the property, the economic performance rules provide that the cost of such property is treated as “incurred” when the property is provided to the applicant. The one notable exception provided by the FAQs is that with respect to property not yet provided to the applicant, the costs incurred with respect to such property are treated as costs incurred by the applicant when the costs are incurred by such other person. Stated differently, an accrual method applicant may “incur” costs directly (in the case of costs it incurs itself) or indirectly (in the case of costs incurred by a vendor under a binding written contract with the applicant).

Accordingly, the mere payment of cash by the applicant to a manufacturer under a binding written contract is not sufficient for such payments to count towards satisfying the safe harbor test. The manufacturer must itself “incur” the costs under the contract on or before December 31, 2010 for such payments to count. The manufacturer will “incur” the costs (1) when the manufacturer performs its own work under the contract, or (2) with respect to property that the manufacturer has subcontracted, when the subcontractor has actually provided the property to the manufacturer (as determined based on the manufacturer’s method of accounting).

For these purposes, the FAQs affirm that, consistent with the economic performance rules, property is treated as provided to the applicant either when title to the property passes to the applicant or when it is delivered to or accepted by the applicant, depending on the applicant’s method of accounting. In addition, the FAQs provide that property the applicant reasonably expects to be provided within 3½ months of the date of payment will be considered to be provided on the payment date. These same rules also apply in determining whether property has been provided to another party – e.g., a third party manufacturer – for purposes of determining whether the applicant has indirectly incurred the costs incurred by such third party. Treasury’s affirmation of the application of these economic performance rules, and specifically the 3½ month rule, represents an important clarification for potential grant applicants.

In order to determine whether costs have been paid or incurred on its behalf by a third party supplier under a binding written contract, the FAQs provide that an applicant may rely on a statement by the supplier as to the amount incurred by the supplier with respect to the property to be manufactured, constructed, or produced by the supplier. Further, the supplier may use any reasonable, consistent method to allocate the costs incurred by the supplier among the units of property to be manufactured, constructed, or produced for the applicant under the contract. The FAQs further state that whether a method is reasonable depends on the all relevant facts and circumstances.

Advantages of Safe Harbor Test. In light of the FAQs and earlier guidance, the safe harbor test may prove more advantageous to applicants in certain circumstances.

First, it appears that using the safe harbor test allows applicants the benefit of costs for work that would not qualify for the physical work of a significant nature test – e.g., certain engineering and design costs should qualify for the safe harbor test. This follows because all costs included in the eligible basis of the specified energy property and only such costs are taken into account in determining if 5% of the total costs have been exceeded. For this purpose, the guidance provides that the eligible basis of the specified energy property is determined in accordance with the general rules for determining the basis of property for federal income tax purposes. Accordingly, the eligible basis of the property should be its cost plus all items properly capitalized by the taxpayer in the depreciable basis of the property, such as direct labor and direct material costs and indirect costs if the costs directly benefit, or are incurred by reason of, construction of the property. Along these lines, the FAQs provide by way of an example that costs incurred by a manufacturer to pay its employees to plan and design a turbine may be included by the applicant for purposes of satisfying the safe harbor test. In contrast, such planning or design costs would not appear to count for purposes of satisfying the physical work of a significant nature test.

Second, unlike with the physical work of a significant nature test, the FAQs provide that if an applicant meets the safe harbor test as of December 31, 2010 – the applicant need not continue work at the site on a continuous basis in order to meet the beginning of construction requirement. As noted above, the physical work of a significant nature test contemplates that physical work must commence before the end of 2010 and be maintained thereafter pursuant to a “continuous program of construction.” The FAQs suggest that no such corollary requirement exists for purposes of the safe harbor test. Specifically, the FAQs provide that if an applicant demonstrates that it meets the safe harbor test as of December 31, 2010 and the facility will not be placed in service until 2012 – the applicant need not continue work at the site in 2011 in order to qualify for payment in 2012.

Third, application of the 3½ month rule for purposes of the safe harbor test gives applicants who make advance payments to an EPC contractor at the end of 2010 an additional 3½ months for the contractor to have incurred those costs for tax purposes. There is nothing in the guidance to indicate that applicants get the benefit of the 3½ month rule for purposes of satisfying the physical work of a significant nature test.

Disadvantages of the Safe Harbor Test. The safe harbor test could prove disadvantageous, however, for applicants in certain circumstances.

First, if an applicant’s project costs turn out to be greater than projected – an applicant may prefer to opt for the physical work of a significant nature test instead of the safe harbor test. The FAQs make clear that to satisfy the safe harbor test, the applicant must demonstrate that costs paid or incurred by the applicant or a third party under a binding written contract before the end of 2010 are equal to or greater than 5% of the actual total costs of the specified energy property. The fact that 5% of the reasonably projected total costs are paid or incurred before the end of 2010 is of no consequence if the total costs turn out to be higher. The FAQs mitigate the potential adverse consequences of this rule, however, by providing that if an applicant’s project includes multiple units of specified energy property, an applicant can opt to apply for a grant payment based on some, but not all, the units of property.

Second, as referenced above, the threshold necessary for applicants to satisfy the safe harbor test may in some circumstances be greater than the threshold necessary to satisfy the physical work of a significant nature test. Accordingly, in the case of projects with expected high capital costs, applicants may prefer to satisfy the physical work of a significant nature test – which could require the completion of less work – on a percentage or amount basis – than the percentage or amount of costs necessary to satisfy the safe harbor test.

Application Process.

Timeline. The FAQs affirm that all grant applications must be submitted by the statutory deadline of October 1, 2011. For property that is placed in service after December 31, 2010, but before October 1, 2011, applicants need only submit a single application demonstrating both that construction began on the property in 2009 or 2010 and that the property has been placed in service. For property that is placed in service on or after October 1, 2011, applicants must submit a preliminary application by October 1, 2011, demonstrating that construction on the property began in 2009 or 2010. An applicant must supplement such applications at the time the property is subsequently placed in service.

In the case of a preliminary application submitted by October 1, 2011, the FAQs indicate that Treasury will notify applicants as to whether or not the work performed is physical work of a significant nature or, in the case of applicants relying on the safe harbor test, whether the qualifying costs paid or incurred satisfy the safe harbor.

Documentation Required. For projects relying on the physical work of a significant nature test, the applicants must document the physical work incurred. For example, the FAQs provide that:

[T]o demonstrate that physical work of a significant nature has commenced at the site, applicants should submit a written report from the project engineer or installer, signed under penalties of perjury, describing the project’s eligibility; including a detailed construction schedule; estimated budget for the project and a description of the work that has commenced including any invoices for the work performed. For projects with an anticipated cost basis of $1 million or more, the report must be from an independent engineer. To demonstrate that physical work of a significant nature has commenced under a binding written contract, applicants should submit a copy of the binding written contract and a statement from the contractor, signed under penalties of perjury, describing the work that has commenced and certifying that the work commenced pursuant to the binding written contract.

Similarly, for projects relying on the safe harbor test, applicants must submit a statement from an authorized representative of the applicant signed under penalties of perjury, or for projects with an estimated eligible cost basis of $1 million or more, from an independent accountant, attesting to the method of accounting used by the applicant for federal tax purposes (cash method or accrual method).

For cash method applicants, the FAQs provide that the statement should include the amount that has been paid before the end of 2010; a detailed description of the costs that have been paid; and an estimate of the total cost of the specified energy property and must include evidence of payment such as invoices or other financial records. For accrual method applicants, the statement should include the amount that has been incurred before the end of 2010; a detailed description of the costs incurred; and an estimate of the total cost of the specified energy property and must include evidence of the costs incurred such as invoices or other financial records. If an applicant is relying on costs paid or incurred by a contractor, a copy of the binding written contract and a statement from the contractor, signed under penalty of perjury, of costs paid or incurred and allocated to applicant’s project must be included.

Regardless of whether an applicant uses the physical work of significant nature test or safe harbor test, the FAQs indicate that “additional documentation may also be required depending on the facts and circumstances.”