by Durham C. McCormick Jr., co-lead of renewable energy, McGuireWoods
On 20th December, wind energy projects gained an unexpected extension to the expiring production tax credit when President Donald Trump signed into law the Further Consolidated Appropriations Act of 2020.
Now, projects where construction began in 2020 are eligible for 60% of PTCs, whereas projects that began construction in 2019 are eligible for only 40% of PTCs. The table below summarizes the current phase-out of the PTC:
- Projects that began construction before the end of 2016 – 100%
- Projects that began construction in 2017 – 80%
- Projects that began construction in 2018 – 60%
- Projects that began construction in 2019 – 40%
- Projects that begin construction in 2020 – 60%
The extension and increase of the expiring PTC through 2020 is no doubt a pleasant surprise to wind developers. But, given the 40% PTC rate for 2019 projects versus the 60% PTC rate for 2020 projects, developers are likely to push some projects to establish a 2020 commencement of construction rather than 2019. This is where developers may find themselves ‘whipsawed’ by the Internal Revenue Service’s begin-construction rules.
How the rules work
In 2013, the IRS issued the first part of the ‘begin construction’ framework. Those IRS notices have created a relatively low bar for PTC qualification. A taxpayer merely has to start physical work of a significant nature, or spend at least 5% of the total capitalized project costs, excluding land and other costs not allocated to the equipment producing electricity.
A taxpayer can complete on-site work, such as excavating for wind turbine foundations, pouring foundations, building O&M roadways and setting anchor bolts; can contract for off-site work to be completed, such as starting manufacture of a custom-designed transformer; or can spend at least 5% of the total capitalized costs of the energy producing equipment.
Once this relatively low bar is satisfied, the project is considered to have begun construction and will qualify for the applicable PTC amount for its first 10 years of operation.
At the time, the IRS’s intent was to create a taxpayer-friendly threshold for satisfying the statutory requirement to begin construction of a project by a certain date to lock in a PTC amount before it phased out. The IRS was being favorable to developers and the wind industry.
Managing the current situation
Developers could now be faced with a dilemma to show they did not start construction in 2019 so that they can get higher PTCs if a 2020 beginning of construction could otherwise be established. The IRS did not predict this in 2013 when the begin-construction guidelines were developed.
It could be difficult for a developer when on-site physical work was completed in 2019. This is a strategy commonly used to secure a PTC as this test focuses on the nature of the work performed, with no fixed minimum amount of work or monetary threshold. But any significant physical work completed on-site or off-site could result in an unwelcomed 2019 begin-construction determination.
Alternatively, taxpayers that satisfied the Five Percent Expenditure Test in 2019 might find a different result. This test relies on the final project costs, and a developer could choose to increase the project size in 2020 to ensure it blew the Five Percent Expenditure Test in 2019. Then the developer could start physical construction of the project in 2020 to ensure it separately satisfied the Physical Work Test in 2020.
It is also feasible that the developer could purchase additional equipment in 2020 so the 5% expenditure scale is ‘tipped’ in 2020 based on larger project costs. Note, however, that relying on the Five Percent Expenditure Test a second time could present some pitfalls, given the ability to desegregate some wind turbines into a separate, smaller project to independently maintain the original 5% expenditure in 2019.
It may seem peculiar that different results are achieved based on the methodology for how a wind developer begins construction of a project, even if the intent to begin construction was present in 2019.
This is true because the begin-construction requirements are fact-based, and not based on a taxpayer’s intent. The IRS acknowledged this in the 45Q carbon capture begin-construction notices issued in late February 2020.
In those notices, the IRS stated that a taxpayer that satisfied the Five Percent Expenditure Test in a given calendar year but then ultimately failed the test because of later cost overruns could subsequently satisfy the Physical Work Test by beginning construction of the facility in a later year. This may become a very useful piece of information for wind developers facing a project stuck in a 2019 beginning-of-construction fact pattern.
While the PTC extension through 2020 is welcome, we do expect investors and buyers transacting in projects that began construction in 2019 and 2020 to become cautious as to a developer’s 2019 facts. Parties may begin to look more closely at the developer’s work and expenses in 2019 to ensure the project is not locked into the 40% PTC rate.
Also, the market may require developers and sponsors to hold 2019 construction risk through representations or other cash sweep mechanisms. And who knows? A tax insurance product may even develop around the 2019/2020 PTC disparity.