As the COVID-19 pandemic continues to disrupt project development timelines generally, solar and wind projects that rely on federal income tax credits to obtain financing are particularly sensitive to manufacturing and construction delays due to rules relating to the eligibility of a project to qualify for those tax credits. Many stakeholders in the renewable energy industry had hoped that Congress would address some of their concerns by extending certain deadlines with respect to the investment tax credit ("ITC") for solar projects and the production tax credit ("PTC") for wind projects, but the third COVID-19-related stimulus package, called the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, enacted into law on March 27, 2020, includes no such relief. There are three immediate tax-related concerns that face the industry.
Start of Construction
First, in the case of a solar project, to be eligible for the full ITC (i.e., at 30%), construction of the project must have started prior to 2020. Under an IRS safe harbor, a taxpayer is treated as having started construction of a project once the taxpayer has paid or incurred 5% of the total cost of the project (the "5% Safe Harbor"). As a result of this rule, the end of 2019 saw a flurry of taxpayers "safe harboring" equipment, such as panels and inverters, to subsequently be installed in projects. However, under general tax law principles, an accrual basis taxpayer that pays for equipment is not treated as incurring the cost of the equipment for purposes of the safe harbor until the equipment is provided (which is typically achieved through actual delivery), which was often impractical where the taxpayer was attempting to safe harbor the equipment in the waning days of 2019.
In many instances, taxpayers took advantage of a special rule that allows an accrual basis taxpayer who pays costs in one year to treat the costs as having been incurred in such year, even though the equipment for which such costs were paid will not be delivered until the subsequent year, if the owner reasonably expects delivery within 3 ½ months of the payment. Significantly, actual delivery within the 3 ½-month delivery window is not required, as long as the taxpayer has a reasonable expectation of delivery within that window as of the payment date. Whether the owner has a reasonable expectation of delivery is a fact-specific inquiry, but typically safe harbor contracts will include contractual features, such as liquidated damages for late delivery, that help establish a reasonable expectation. The emergence of COVID-19 may result in delivery of safe harbor equipment occurring outside the 3 ½-month window. This late delivery may invite additional scrutiny from investors and the IRS, but as long as the safe harbor agreement would have passed muster for establishing a reasonable expectation of delivery as of the time of payment for the safe harbor equipment at the end of 2019, it is unlikely that the reasonable expectation of the taxpayer would be affected by the subsequent outbreak of COVID-19.
However, it may be more difficult for taxpayers to rely on the reasonable expectation rule for deliveries in 2021 if COVID-19 makes delivery expectations unreasonable towards the end of this year. To address this concern, the Solar Energy Industries Association has advocated in a letter to Congress1 that all equipment delivered by the end of 2020 or 2021, as applicable, would qualify as project costs incurred in the previous year as long as the respective projects are placed in service by the end of the ITC phase-down period and such equipment was ordered and paid for in the previous year (i.e., 2019 and 2020, respectively). This is a possible solution for Congress and the IRS to consider.
Continuity Safe Harbor
Second, under the 5% safe harbor described above, as well as an alternative method to start construction by starting physical work (the "Physical Work Test"), IRS guidance requires continuous progress towards completion. In the case of the 5% Safe Harbor, this requirement may be satisfied by facts and circumstances that demonstrate continuous efforts to advance towards completion of the facility, including paying or incurring additional amounts included in the total cost of the facility, entering into binding written contracts for components or future work on construction of the facility, obtaining necessary permits, and performing physical work of a significant nature. In the case of the Physical Work Test, the facts and circumstances must demonstrate a continuous program of physical work of a significant nature. However, in response to taxpayers' request for certainty, the IRS established a continuity safe harbor, pursuant to which the continuity requirement is satisfied if a project is placed in service within four calendar years after the year in which construction of the project began. In the case of wind projects, the last year to start construction to be eligible for the full PTC was 2016, so projects that started construction in 2016 must be placed in service no later than the end of 2020 to be eligible for the continuity safe harbor. Although the continuity safe harbor is taxpayer-friendly, the 4-year window provides no allowance for delays that are beyond the taxpayer's control.
In contrast, the facts and circumstances determination method expressly permits delays that are beyond a taxpayer's control, such as delays at the written request of a state or federal agency regarding matters of safety, security, or similar concerns, labor stoppages, inability to obtain specialized equipment of limited availability, financing delays of less than six months, and supply shortages. Presumably, supply delays due to COVID-19 would be treated as a permitted delay. However, historically, developers have been wary of relying on the facts and circumstances method due to the lack of defined requirements. For example, is it sufficient to rely on quarterly progress reports or must reports be monthly or even weekly? In addition, in the case of the Physical Work Test, the requirement that only physical work may be used to demonstrate continuity may be difficult to satisfy. Nevertheless, comments made at a Congressional hearing that included an IRS official and informal comments made by at least one Treasury official suggest that the continuity requirement is not an overly strict standard and is intended to root out "zombie projects" and to prevent sponsors from"trickl[ing]" a project along solely for the purpose of "keep[ing] something moving and claiming the PTC at some future date."2 Whether the facts and circumstances method is acceptable as a commercial matter may ultimately depend on a project's specific facts and whether the tax equity investor or other financier is willing to rely on a method that does not provide a bright line. To help prospective investors get comfortable with relying on the facts and circumstances method, the sponsor may want to consider procuring a tax loss insurance policy with respect to satisfaction of the continuity requirement or provide other means of protecting investors from this specific risk.3
An alternative solution may be for the industry to seek an extension by the IRS of the continuity safe harbor. The continuity safe harbor is a creation of the IRS by issuance of a notice, and modification of the IRS notice would not require Congressional approval. A more generous 6-year continuity safe harbor was granted in IRS Notice 2020-12 with respect to the carbon capture credit under section 45Q, so a longer continuity safe harbor would not be unprecedented. A longer continuity safe harbor is arguably necessary for certain segments of the industry, such as offshore wind, which has a longer construction period than typical wind projects, so extending the current continuity safe harbor may be preferred from the perspective of creating uniform rules for renewable energy project development. In fact, in a recent letter to the Secretary of the Treasury,4 a number of Senators have urged the Secretary to consider a temporary extension of the continuity safe harbor to 5 years, arguing that this would address the unforeseen interruptions developers are experiencing due to COVID-19 and provide the certainty businesses need to move forward with existing projects. This is slightly less generous than the 6-year continuity safe harbor advocated by some industry trade groups.5
A more targeted solution would be to seek modification of the IRS notice to permit the tolling of the continuity requirement for delays relating to COVID-19. This would not be the first time that the IRS demonstrated flexibility with respect to the continuity safe harbor to address a specific concern. Recently issued IRS Notice 2019-43 provides that the continuity safe harbor will be tolled and extended for a period of time to account for delays that result from pursuing a modification to a development or construction plan to mitigate significant national security concerns raised by the Department of Defense. Demonstrating delay due to COVID-19 may be more difficult than demonstrating delay due to notification of the Department of Defense, but this difficulty presumably could be overcome through discussions between industry and the IRS.
Third, as the income of financiers of renewable energy projects (particularly tax equity investors) shrinks as a consequence of the economic downturn, there may be less tax to be offset by tax credits and less taxable income to be reduced by depreciation benefits, potentially leading to a sharp reduction in the supply of tax equity. In addition, taxpayer friendly rules with respect to net operating losses ("NOL") were introduced by the CARES Act, which may further reduce the need for additional sources of credits or losses to offset income. Under these new rules, for taxable years beginning before January 1, 2021, NOLs may be used to fully offset taxable income (rather than just 80%). In addition, NOLs generated in 2018, 2019, or 2020 may be carried back up to five years. This is where direct pay in the form of a cash grant or the refundability of tax credits can come into play and provide immediate cash flow to developers or financiers, thus incentivizing them to continue financing renewable energy projects. In a joint letter to Congress, a number of renewable energy trade groups asked for the tax credits to be available for direct pay to facilitate their monetization, similar to the Section 1603 cash grant program, which provided a direct payment in lieu of the PTC and ITC.6
COVID-19 may present a number of challenges to renewable energy project development and financing, but with the industry and the IRS working collaboratively, these challenges should not be insurmountable.
2. See Oversight of the Wind Energy Production Tax Credit: Hearing Before the Subcomm. on Energy Policy, Health Care and Entitlements of the Comm. on Oversight and Gov't Reform, H. of Rep., 113th Cong. (2013) (Serial No. 113-62); Mark Del Franco, Official: U.S. Treasury Contemplates Releasing Additional PTC Guidance, North American Windpower (Sept. 12, 2013).
3. It is worth noting that the continuity requirement, as well as the 5% Safe Harbor and the Physical Work Test, is a creation of the IRS to provide taxpayers with a way to satisfy the start-of-construction requirement under the applicable provision of the Internal Revenue Code of 1986 (the "Code"). However, the Code itself provides no such requirements. Thus, it is theoretically possible for a project not to satisfy the IRS tests and to still be treated as having started construction as a matter of law (i.e., under the Code). Again, whether failing to strictly satisfy the IRS tests is acceptable as a commercial matter may depend on a project's specific facts and the allocation of the related tax risk.
5. See, for example, Letter from AWEA to Congress (dated March 18, 2020).
6 See Letter from the American Council on Renewable Energy, AWEA, ESA, National Hydropower Association, Renewable Energy Buyers Alliance, and SEIA to the Speaker and Majority and Minority Leaders of the House of Representatives and Senate (dated March 19, 2020).
Originally published 5 May, 2020
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