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Business Tax

IRS guidance on when construction has begun on energy property

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

In a Notice, IRS has provided various rules for determining when construction has begun on energy property that is eligible for the Code Sec. 48 credit.

Background. The Code Sec. 48 business energy credit is a tax incentive to implement the government policy to encourage the production and use of, or conversion to, business equipment using energy sources other than oil or gas (or a derived product) as a primary source of industrial or agricultural energy. Under Code Sec. 48(a), for purposes of the Code Sec. 46 investment credit, the energy credit for any tax year is generally the energy percentage of the basis of each energy property placed in service during the tax year.

In order to qualify for the credit, construction of the energy property must begin before Jan. 1, 2022. (Code Sec. 48(a)(2)(A)(i)(II))

New guidance.Notice 2018-59 provides guidance to determine when construction has begun on energy property that is eligible for the Code Sec. 48 credit. It provides two methods for taxpayers to establish the beginning of construction (Physical Work Test and Five Percent Safe Harbor), a Continuity Requirement for both methods, rules for transferring energy property, and additional rules applicable to the beginning of construction requirement of Code Sec. 48. Here is a summary of some of the guidance.

The two methods. A taxpayer may establish the beginning of construction by starting physical work of a significant nature as set forth under Physical Work Test, below. Alternatively, a taxpayer may establish the beginning of construction by meeting a safe harbor based on having paid or incurred 5% or more of the total cost of the energy property as set forth in the Five Percent Safe Harbor, below.

Both methods require that a taxpayer make continuous progress towards completion once construction has begun. See “Continuity Requirement,” below. (Sec. 3.01)

Although a taxpayer may satisfy both methods of establishing the beginning of construction, construction will be deemed to have begun on the date the taxpayer first satisfies one of the two methods. For example, if a taxpayer performs physical work of a significant nature on energy property in 2018, and then pays or incurs 5% or more of the total cost of the energy property in 2019, construction will be deemed to begin in 2018 under the Physical Work Test, not in 2019 under the Five Percent Safe Harbor. (Sec. 3.02)

Physical work test. Construction of energy property begins when physical work of a significant nature begins. Work performed by the taxpayer and work performed for the taxpayer by other persons under a binding written contract that is entered into prior to the manufacture, construction, or production of the energy property or components of energy property for use by the taxpayer in the taxpayer’s trade or business (or for the taxpayer’s production of income) is taken into account to determine whether construction has begun. Whether and when a taxpayer has begun construction of energy property will depend on the relevant facts and circumstances. IRS will closely scrutinize energy property and may determine that construction has not begun on that property if a taxpayer does not maintain a continuous program of construction. (Sec. 4.01)

The Physical Work Test requires that a taxpayer begin physical work of a significant nature. This test focuses on the nature of the work performed, not the amount or the cost. Assuming that physical work performed is of a significant nature, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test. Both off-site and on-site work may be taken into account for purposes of demonstrating that physical work of a significant nature has begun. (Sec. 4.02)

Physical work of a significant nature does not include preliminary activities, even if the cost of those preliminary activities is properly included in the depreciable basis of the energy property. The Notice sets out a list of what are considered to be preliminary activities. (Sec. 4.03)

Five Percent Safe Harbor. Construction of energy property will be considered as having begun under this safe harbor if:

(1) a taxpayer pays or incurs 5% or more of the total cost of the energy property, and

(2) thereafter, the taxpayer makes continuous efforts to advance towards completion of the energy property. (Sec. 5.01)

All costs properly included in the depreciable basis of the energy property are taken into account to determine whether the Five Percent Safe Harbor has been met. The total cost of the energy property does not include the cost of land or any property not integral to the energy property. (Sec. 5.02)

Continuity requirement. For purposes of the Physical Work Test, a continuous program of construction involves continuing physical work of a significant nature. (Sec. 6.01)

For purposes of the Five Percent Safe Harbor, whether a taxpayer makes continuous efforts to advance towards completion of an energy property to satisfy the Continuity Requirement will be determined by the relevant facts and circumstances. Facts and circumstances indicating continuous efforts to advance towards completion of an energy property may include, but are not limited to:

(a) paying or incurring additional amounts included in the total cost of the energy property;

(b) entering into binding written contracts for the manufacture, construction, or production of components of property or for future work to construct the energy property;

(c) obtaining necessary permits; and

(d) performing physical work of a significant nature. (Sec. 6.02)

Certain disruptions in a taxpayer’s continuous construction or continuous efforts to advance towards completion of an energy property that are beyond the taxpayer’s control will not be considered as indicating that a taxpayer has failed to satisfy the Continuity Requirement. (Sec. 6.03)

The Notice provides a Continuity Safe Harbor. Subject to certain exceptions, if a taxpayer places an energy property in service by the end of a calendar year that is no more than four calendar years after the calendar year during which construction of the energy property began (the Continuity Safe Harbor Deadline), the energy property will be considered to satisfy the Continuity Safe Harbor. Under one of the exceptions, the excusable disruption rules in section 6.03 do not apply for purposes of applying the Continuity Safe Harbor. (Sec. 6.05)

Transfer of energy property. Code Sec. 48(a)(3)(B) provides that energy property is any property the construction, reconstruction, or erection of which is completed by the taxpayer, or which is acquired by the taxpayer if the original use of such property commences with the taxpayer. A taxpayer that owns energy property on the date it is originally placed in service may elect to claim the Code Sec. 48 credit with respect to the energy property even if the taxpayer did not own the energy property at the time construction began. Any Code Sec. 48 credit claimed on energy property will be limited to the taxpayer’s basis in the energy property. Accordingly, except as provided in the next paragraph, a fully or partially developed energy property may be transferred without losing its qualification under the Physical Work Test or the Five Percent Safe Harbor for purposes of the Code Sec. 48 credit. (Sec. 8.01)

In the case of a transfer consisting solely of tangible personal property (including contractual rights to such property under a binding written contract) to a transferee not related to the transferor, any work performed or amounts paid or incurred by the transferor with respect to the transferred property will not be taken into account with respect to the transferee for purposes of the Physical Work Test or the Five Percent Safe Harbor. (Sec. 8.03)

Other rules applicable to Physical Work Test and Five Percent Safe Harbor. An energy property generally includes all components of property that are functionally interdependent (unless such equipment is an addition or modification to an energy property). Components of property are functionally interdependent if the placing in service of each component is dependent upon the placing in service of each of the other components in order to generate electricity. Functionally-interdependent components of property that can be operated and metered together and can begin producing electricity separately from other components of property within a larger energy project will be considered an energy property. (Sec. 7.01)

For components of energy property that are manufactured, constructed, or produced for the taxpayer by another person under a binding written contract, the work performed and amounts paid or incurred under the contract are taken into account in determining when construction begins, provided the contract is entered into prior to the work taking place or the amounts paid or incurred. (Sec. 7.03)

No private letter rulings, etc. IRS will not issue private letter rulings or determination letters to taxpayers regarding the application of this notice or the beginning of construction requirement of Code Sec. 48. (Sec. 1)

References: For the energy credit, see FTC 2d/FIN ¶L-16401United States Tax Reporter ¶484.

Notice 2018-59, 2018-28 IRB

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