IRS issues guidance on Section 48 energy investment tax credit

Notice 2018-59 clarifies beginning of construction for ITC

The energy investment tax credit (ITC) under section 48 of the Internal Revenue Code has been an important incentive that has largely funded the growth of the solar industry and certain other types of renewable energy. The credit is computed as the energy percentage (30 percent or 10 percent, depending on the energy source) multiplied by the basis of the energy property when it is placed in service. In order to qualify for the ITC:

• The taxpayer must complete the construction, reconstruction or erection of the property or acquire the property for original use; and
• Depreciation or amortization must be allowed on the property.

In addition, the basis of the property must be reduced by 50 percent of the amount of the credit.

The ITC was scheduled to expire at the end of 2016 for all types of renewables, except for solar and geothermal energy and the credit rate for solar was scheduled to drop from 30 percent to 10 percent. Two legislative provisions gave new life to the ITC:

1. The Consolidated Appropriations Act fof 2016 extended and modified section 48 ITC to phase down the ITC rage for solar energy property for which construction begins after Dec. 31, 2019, and before Jan. 1, 2022, and further limits the credit for solar energy property not placed in service before Jan. 1, 2024.
2. The Bipartisan Budget Act of 2018 modified section 48 by retroactively extending the ITC for certain other renewable energy property for which construction begins before Jan. 1, 2022.

As a result of these enacted changes, the ITC phase-out schedule for the different types of energy property is as follows:

The IRS released Notice 2018-59 to provide guidance around how to determine when construction has begun on eligible energy property for purposes of determining the ITC. Two different methods are provided for taxpayers to determine the beginning of construction: the ‘Physical Work Test’ and ‘Five Percent Safe Harbor.’ Both methods are subject to a ‘Continuity Requirement.’ Construction is deemed to have begun when a taxpayer fulfills the earlier of the two different methods, the Physical Work Test or Five Percent Safe Harbor. Once one method is satisfied, construction has begun and continuity of work or effort must be maintained.

Physical Work Test

Under the Physical Work Test, construction begins when significant physical work has begun. The IRS considers work performed as physical progress made by the taxpayer, or by a third party while under a binding written contract, made prior to construction or production of energy property or components. Each scenario is subject to facts and circumstances and may be scrutinized by the IRS. The Physical Work Test requires that the taxpayer begin work of a ‘significant nature.’ Significant nature of physical work focuses on the nature of the work performed, not the cost. Therefore, there is no minimum amount of work or monetary threshold to determine or satisfy the Physical Work Test.

The Physical Work Test is further segregated into ‘off-site’ and ‘on-site’ physical work. Off-site construction includes component manufacturing, equipment mounting, support structures and other power conditioning equipment. The guidance gives specific examples of on-site work per energy property type, focusing on significant natured work around installation of structures and fixtures after the initial discovery phase. The IRS includes both off-site and on-site physical work as significant work when determining the construction begin date.   

Significant physical work does not include preliminary activities or production of components by taxpayer or third party that are either existing inventory or normally held by a vendor. The IRS defines preliminary activities to include:

• Planning or designing
• Securing financing
• Exploring
• Researching
• Conducting mapping and modeling to assess a resource
• Obtaining permits and licenses
• Conducting geophysical, gravity, magnetic, seismic and resistivity surveys
• Conducting environmental and engineering studies
• Performing activities to develop a geothermal deposit prior to valid discovery
• Clearing a site
• Conducting test drilling to determine soil condition (including the test of strength of a foundation)
• Excavating to change the contour of the land (as distinguished from excavation for a foundation)
• Removing existing foundations, turbines, towers, solar panels or any components that will no longer be part of the energy property (including those on or attached to building structures)

Five Percent Safe Harbor

The Five Percent Safe Harbor method determines that construction on energy property has begun when 5 percent of all costs taken into account for the depreciable basis of the energy property (excluding cost of land or any property not integral to energy property) have been spent. The guidance further explains rules in a ‘cost overrun,’ where a taxpayer underestimates the total cost of the project and at the completion of the project, 5 percent of total cost was not actually spent. In the event of a single energy project with multiple energy properties, the taxpayer may still satisfy the safe harbor requirement for some of the energy properties, but not all, as long as the total aggregate cost of those energy properties is not greater than 20 times the amount incurred by the taxpayer. In the event a single energy project with only one energy property incurs a cost overrun, the Five Percent Safe Harbor threshold is not met and a credit cannot be claimed.

Continuity requirement

For a taxpayer to claim theITC, the continuity requirement must be met after construction has begun. A taxpayer applying the Physical Work Test in determining the project begin date must meet the continuous construction test. In order to meet this test, the taxpayer must continue and maintain physical work of a significant nature.

The Five Percent Safe Harbor method requires a taxpayer must fulfill a continuous efforts test. This test is subject to individual facts and circumstances but may be performed by paying additional amounts included in the total property cost, entering into written contracts for construction, obtaining permits or performing physical work of significant nature.

The IRS guidance provides examples of excusable disruptions to continuous construction or continuous efforts, which will not indicate failure of the continuity requirement. These disruptions must be outside of the taxpayer’s control and may include: delays due to severe weather conditions, natural disasters, obtaining permits, manufacturing of custom components, labor stoppages, financing delays, supply or equipment shortages and interconnection-related delays.

Continuity safe-harbor

If a taxpayer places an energy property in service by the end of a calendar year that is no greater than four calendar years after the calendar year when construction began, the energy property will satisfy the continuity safe harbor. If projects do not meet the continuity safe-harbor then the applicable test, continuous construction or continuous effort test, must be applied.

Transfer of energy property

A taxpayer that owns energy property on the date the energy property is originally placed in service may elect to claim the ITC, even if the taxpayer did not own the property at the beginning of construction. Section 48 credit claimed will be limited to the taxpayer’s basis in the energy property. In addition, fully or partially developed property may be transferred without losing its qualification or construction begin date, in accordance with the Physical Work Test or the Five Percent Safe Harbor, unless transfer is solely of tangible personal property between unrelated parties as defined in section 8.03 of notice.

Additional guidance provided

Additional guidance and examples are provided to further define the following: functionally interdependent components, when a taxpayer can treat multiple properties as a single project, property integral to energy property and qualified work performed by a third party under contract, look-through rule and 20 percent limitation on used property.

This ITC guidance covers many complex concepts. Experience with and understanding of renewable energy projects is crucial to applying these rules correctly. This article is only meant to provide a high level summary of Notice 2018-59. Consultation with a tax advisor experienced in energy ITC projects is advised when applying this guidance.