Beginning of Construction Rules May Enhance Tax Credits

March 12, 2024 | By Dorian Hunt, Head of Renewables, Deanna Harris, Partner, M&A Tax and Ori Noiman, Vice President, M&A Tax

Many of the tax incentives in the Inflation Reduction Act (“IRA”) were designed to incentivize the construction and operation of renewable energy and energy transition assets. To do so, Congress enacted new credits and enhanced certain existing credits. In some situations, the maximum credit allowable is five times the base credit amount. The enhancement generally is available only if the project in question satisfies the relevant prevailing wage and apprenticeship requirements of § 48 (the “PW&A Requirements”).¹ In this article, we describe the PW&A Requirements, but then turn our focus to an exception to that general rule that allows increased credits for projects that “began construction”² before January 29, 2023 – even for projects that do not meet those requirements (the “BOC Exception”). As you will read below, the advantages of starting construction before a certain date vary considerably from credit to credit. Those stakeholders operating among various asset classes and credit types must be cognizant of myriad flavors of the BOC exception, what they enable, and their limitations.

Overview of the PW&A Requirements

Section 38 provides that a taxpayer is allowed a tax credit for a tax year in an amount equal to the sum of – (i) the business credits carried forward to the tax year, (ii) the business credit for the current year, and (iii) the business credit carryback to the tax year; the computation under § 38 includes the investment credit described in § 46. Section 46 itself is not a specific credit, but rather a conglomeration of credits including the § 48 energy credit.

Section 48 generally provides that an energy credit is equal to the energy percentage of the basis of each energy property placed in service during the tax year. Although § 48 has existed for more than 60 years, it was significantly amended by the IRA; at the same time a variety of other credits were added or amended. In particular, the IRA allows an increased credit amount for certain energy projects that satisfy the PW&A Requirements.

The PW&A Requirements apply (in whole or in part as noted) to:

1. The § 30C alternative fuel refueling property credit;
2. The § 45 renewable electricity production credit;
3. The § 45Q carbon oxide sequestration credit;
4. The § 45V clean hydrogen production credit;
5. The § 45Y clean electricity production credit;
6. The § 45Z clean fuel production credit;
7. The § 48 energy investment credit;
8. The § 48C advanced energy project credit;
9. The § 48E clean electricity investment credit;
10. The § 45L new energy efficient home credit (prevailing wage requirements only); and
11. The § 45U zero-emission nuclear power production credit (prevailing wage requirements only).

If the relevant PW&A Requirements are satisfied, the amount of the available credit is multiplied by five. Thus, in the case of the § 48 energy credit, energy property otherwise eligible for a six percent-of-basis investment tax credit would receive a maximum credit of 30 percent if the PW&A Requirements are met. Similarly, for energy property otherwise eligible for a two percent-of-basis credit would be eligible for a 10 percent-of-basis credit (together with the 30 percent enhanced credit, the “Enhanced Credit”). A similar system of enhancement is in place for production tax credits.

The Enhanced Credit generally is available with respect to any of the above-listed credit-eligible properties that meet the PW&A Requirements. To satisfy the prevailing wage aspect of the requirements, a taxpayer must meet certain requirements with regard to any laborers and mechanics employed by the taxpayer or any contractor or subcontractor (the “Relevant Employees”) in connection with the – (i) construction of any energy project; and (ii) alteration or repair of that energy project for the credit period (typically 5, 10, or 12 years – depending on the credit type) beginning on the date such project is originally placed in service. To meet the prevailing wage requirement, the Relevant Employees must be paid wages at rates not less than the prevailing rates for construction, alteration, or repair of a similar character in the locality in which the energy project is located as most recently determined by the Secretary of Labor. To meet the apprenticeship requirements (if applicable), taxpayers must ensure that not less than the applicable percentage of the total labor hours of the construction, alteration, or repair work with respect to the facility is performed by qualified apprentices.

In August of 2023, the Internal Revenue Service (the “IRS”) and the Department of Treasury (“Treasury”) proposed regulations that define “construction, alteration, or repair” for this purpose (the “Proposed Regulations”).⁴ Under the Proposed Regulations, the term means construction, prosecution, completion, or repair as defined in 29 CFR 5.2, which very broadly defines the term as including (in relevant part) as all types of work done in the construction or development of a project. Under such an expansive definition, this could include something as minor as painting, or as major as completely demolishing the project.

Fortunately, the Proposed Regulations provide that construction, alteration, or repair does not include work that is ordinary and regular in nature that is designed merely to maintain and preserve existing functionalities of a facility after it is placed in service. Work designed to maintain and preserve functionality of a facility after it is placed in service includes basic maintenance such as regular inspections of the facility, regular cleaning and janitorial work, replacing materials with limited lifespans such as filters and light bulbs, and the calibration of any equipment.⁵ Thus, if the Proposed Regulations are finalized as currently drafted, the PW&A Requirements are not required to be satisfied with respect to employees or contractors performing routine maintenance. However, maintenance does not include work that improves a facility, adapts it for a different use, or restores functionality as a result of inoperability. To prevent recapture of the excess credit, a project owner will need to draw the line between maintenance and improvement to ensure compliance with the PW&A Requirements.

The BOC Exception

Obviously, Enhanced Credits are highly desirable for sponsors and investors. Fortunately, an energy property may be eligible for an Enhanced Credit even if the PW&A Requirements are not satisfied in two situations. First, under the “One Megawatt Exception,” a qualified facility that has a maximum net output of less than one megawatt as measured in alternating current (determined by reference to the facility’s nameplate capacity) is eligible for an Enhanced Credit under §§ 45 (renewable energy production credit), 48 (energy investment credit), 48E (clean electricity investment credit), and 45Y (clean electricity production credit).

More importantly, a facility generally may qualify for the Enhanced Credit if construction on the facility began before January 29, 2023.⁶ So, what does it mean to begin construction? The IRS included guidance in this regard in Notice 2022-61. That notice incorporates by reference prior notices issued under §§ 45, 45Q, and 48 (together, the “Prior Notices”).⁷ The Prior Notices describe two methods of establishing that construction of a facility has begun – (i) starting physical work of a significant nature (the “Physical Work Test”); and (ii) paying or incurring 5 percent or more of the total cost of the facility (the “Five Percent Safe Harbor”).

Under the Physical Work Test, construction of a facility begins when physical work of a significant nature begins, provided that the taxpayer maintains a continuous program of construction. This test focuses on the nature of the work performed, not the amount or the costs. Thus, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test. Physical work of significant nature does not include preliminary activities – such as planning or designing, securing financing, researching, obtaining permits, conducting surveys, or clearing a site – even if the cost of those preliminary activities is properly included in the depreciable basis of the facility.

Under the Five Percent Safe Harbor, construction of a facility will be considered as having begun if – (i) a taxpayer pays or incurs 5 percent or more of the total cost of the facility; and (ii) thereafter, the taxpayer makes continuous efforts to advance towards completion of the facility. All costs properly included in the depreciable basis of the facility are taken into account to determine whether the Five Percent Safe Harbor has been met.  For property that is manufactured, constructed, or produced for the taxpayer by another person under a binding written contract with the taxpayer, costs incurred with respect to the property by the other person before the property is provided to the taxpayer are deemed incurred by the taxpayer when the costs are incurred by the other person under the principles of § 461.

The Prior Notices provide that, for purposes of the Physical Work Test and Five Percent Safe Harbor, taxpayers must demonstrate either continuous construction or continuous efforts (the “Continuity Requirement”), regardless of whether the Physical Work Test or the Five Percent Safe Harbor is used to establish the beginning of construction. Whether a taxpayer meets the Continuity Requirement under either test generally is determined by the relevant facts and circumstances. However, a taxpayer will be deemed to satisfy the Continuity Requirement if a qualified facility is placed in service within a certain number of years. This is known as the “continuity safe harbor” (not to be confused with the Five Percent Safe Harbor). The number of years relevant to fulfillment of the continuity safe harbor is a function of the credit type and the year construction began, but typically the window is between 4 and 6 years.

In the preamble to the Proposed Regulations, the IRS and Treasury indicated that taxpayers may continue to rely on the guidance in Notice 2022-61 and the Prior Notices in determining when construction or installation begins until issuance of further guidance. Specifically, to determine when construction begins for purposes of §§ 30C, 45V, 45Y, and 48E, principles similar to the Physical Work Test and Five Percent Safe Harbor apply, and taxpayers satisfying either test will be considered to have begun construction. Further, principles similar to those provided in the Prior Notices regarding the Continuity Requirement (including the Continuity Safe Harbor) apply for purposes of §§ 30C, 45V, 45Y, and 48E.

Effect of Meeting the BOC Exception

As noted above, a facility generally may qualify for the Enhanced Credit if construction on the facility began before January 29, 2023. However, the benefit of satisfying the BOC Exception varies depending on the credit at issue. The impact of qualifying (or in some cases not qualifying) for the BOC Exception by credit is as follows.

• Section 30C alternative fuel refueling property – If the BOC Exception applies, the project is eligible for the Enhanced Credit for the entire credit period, including for costs of alteration and repair.
• Section 45 renewable electricity production credit – If the BOC Exception applies, the project is eligible for the Enhanced Credit for the entire credit period, including for costs of alteration and repair.
• Section 45L new energy efficient home credit – As noted above, only the wage aspect of the PW&A Requirements applies to the § 45L credit. However, there is no BOC Exception that applies. Thus, the wage aspect of the PW&A Requirements must be satisfied for the Enhanced Credit, regardless of when the facility is placed in service.
• Section 45Q carbon oxide sequestration credit –The impact of qualifying for the BOC Exception is more complicated, because one of three possible rules may apply.
  1. For qualified facilities and any carbon capture equipment placed in service at those facilities for which construction of both began on or after January 29, 2023, the PW&A Requirements apply. Thus, the facility must satisfy those requirements during construction as well as alterations and repairs of both the qualified facility and carbon capture equipment during the 12-year period after being placed in service.
  2. For carbon capture equipment the construction of which began on or after January 29, 2023, that is installed at a qualified facility that began construction prior to that date, the wage aspect of the PW&A Requirements must be satisfied only with respect to construction, alterations, and repairs of the carbon capture equipment itself (not with respect to the facility) during the 12-year period after being placed in service. The apprenticeship aspect of the requirements must be satisfied only during the construction of the carbon capture equipment.
  3. For carbon capture equipment for which construction began before January 29, 2023, that is installed at a qualified facility that began construction prior to that date, there is no requirement to comply with the PW&A Requirements at any time for either the qualified facility itself or the carbon capture equipment.
• Section 45U zero-emission nuclear power production credit – As noted above, only the wage aspect of the PW&A Requirements applies to the § 45U credit. (prevailing wage requirements only). However, there is no BOC Exception that applies. Thus, the wage aspect of the PW&A Requirements must be satisfied for the Enhanced Credit, regardless of when the facility is placed in service.
• Section 45V clean hydrogen production credit – The benefit of qualifying for the BOC Exception is limited because the exception only applies to the wage aspect of the PW&A requirements during construction and the apprenticeship requirements; the BOC Exception does not exempt a taxpayer from the wage requirements with respect to alterations and repairs of the qualified clean hydrogen production facility during the 10-year period.
• Section 45Z clean fuel production credit – The PW&A Requirements generally apply in the same manner as the § 45 renewable electricity production credit. However, the wage aspect of the PW&A Requirements during construction does not apply to a facility placed in service before January 1, 2025.
• Section 48 energy investment credit – If the BOC Exception applies, the project is eligible for the Enhanced Credit for the entire credit period, including for costs of alteration and repair.
• Section 48C advanced energy project credit – There is no BOC Exception that applies. Thus, the wage aspect of the PW&A Requirements must be satisfied for the Enhanced Credit, regardless of when the facility is placed in service.
• Section 48E clean electricity investment credit and § 45Y clean electricity production credit – Because these credits are available only with respect to facilities placed in service after December 31, 2024, it is unlikely the BOC Exception will ever apply to enhance either of these credits.

Conclusion

It is unusual to encounter qualified facilities or energy properties that pencil out without being able to claim an Enhanced Credit. Therefore, understanding the mechanisms by which an Enhanced Credit might be made available is crucial. The BOC exception is helpful in many circumstances, though its relevance diminishes with each passing day. However, for those projects that rely on it, it’s crucial to understand the exception’s scope in the context of each individual credit. Curiously, the efficacy of the BOC exception across technology types is not at all uniform and therefore one must tread carefully.

Footnotes:
¹ All “Section” or “§” references are to the Internal Revenue Code (the “Code”) or the Treasury Regulations promulgated thereunder, as in effect on the date of this article.
² Typically, through satisfying the 5% safe harbor or physical work tests as described in IRS Notice 2022-61 and similar guidance.
³ The amount of recapture is determined under rules similar to the recapture rules in § 50(a). For further discussion of the recapture rules, see “Don’t Be a Casualty of ITC Recapture,” article.
⁴ See, “Increased Credit or Deduction Amounts for Satisfying Certain Prevailing Wage and Registered Apprenticeship Requirements,” REG-100908-23 (August 30,2023)
⁵ Note, however, that the same type of work performed before the facility is placed in service may constitute construction for which prevailing wages must be paid in order to claim the increased credit.
⁶ See, Notice 2022-61, 2022-52 I.R.B. 560.
⁷ See, Notice 2013-29, 2013-20 I.R.B. 1085 (§ 45); Notice 2020-12, 2020-11 I.R.B. 495 (§ 45Q); and Notice 2018-59, 2018-28 I.R.B. 196 (§ 48), as clarified and modified by Notice 2021-41, 2021-29 I.R.B. 17.