Repowering is an opportunity for a developer to requalify an existing wind project for the renewable electricity production tax credit (PTC) for wind projects under Section 45 of the Internal Revenue Code of 1986 based on new placed-in-service and begun-construction dates while retaining some of the existing project assets.
With a number of aging projects that have exhausted or nearly exhausted their PTCs and that are located on sites with a proven wind resource, the industry stands to greatly benefit from this opportunity. However, repowering introduces a number of practical considerations that could be traps for the unwary.
The PTC is an income tax credit equal to $0.024/kWh (for 2017) of electricity produced by a taxpayer from a qualified facility during the 10-year period beginning on the date the facility is originally placed in service.
The PTC had expired as of Jan. 1, 2015, but with the passing of the Consolidated Appropriations Act of 2016 at the end of 2015, Congress revived the PTC and extended it to wind facilities beginning construction before Jan. 1, 2020.
However, although Congress gave with the extension, it took, as well. Unlike previous extensions of the PTC, this extension included a phaseout, pursuant to which the amount of the PTC is reduced by 20% for facilities that begin construction during 2017, 40% for facilities that begin construction during 2018, and 60% for facilities that begin construction during 2019.
Congress likewise extended the investment tax credit in lieu of the PTC for wind projects under Section 48(a)(5) of the tax law, subject to a similar phaseout.
Although the PTC has been extended numerous times since its introduction into the tax law in 1992, this is the first time in its 25-year history that it has been subject to a phaseout.
The phaseout, together with a general climate of uncertainty surrounding tax reform, is driving developers of wind farms and their investors to seek creative ways of qualifying for PTCs.
One such qualification method is the repowering of existing wind farms. A good example of this trend, as reported by North American Windpower, is NextEra Energy Resources’ recently celebrated groundbreaking of the Golden Hills North Wind Energy Center, a completely repowered project, which calls for the removal of 283 30-year-old wind turbines and the replacement of them at the same site with 20 2.3 MW GE turbines.
Placed in service
As noted previously, the PTC is available only during the 10-year period beginning on the date a facility (meaning the wind turbine and its associated towers and supporting pads) is originally placed in service.
A facility that is part of an operating wind farm will have already been placed in service for tax purposes. Therefore, to requalify such a facility for the PTC, the repowering will have to create a new placed-in-service date. Similarly, work on the repowering will trigger a new begun-construction date for the repowered wind farm. Accordingly, to properly evaluate whether repowering a wind farm may enable a developer to requalify an existing project, it is necessary to consider both the beginning- of-construction and the placed-in-service requirements. [adright zone=’190′]
With respect to the beginning-of-construction requirement, despite its critical role in PTC qualification, the tax law does not provide any guidance for determining the beginning-of-construction date.
However, the IRS has published a series of notices to help taxpayers determine what constitutes the beginning of construction. The IRS guidance provides two methods that a taxpayer may use to establish that construction has begun: the physical work test and the 5% safe harbor.
Under the physical work test, construction of a facility begins when physical work of a significant nature begins. The physical work may include both on-site and off-site work and may be performed by either the taxpayer or a third party pursuant to a binding written contract.
The physical work must be on tangible property used as an integral part of the activity performed by the facility, including property integral to the production of electricity (such as a custom-designed step-up transformer or roads for equipment to operate and maintain the facility), but not property for electrical transmission. The IRS guidance makes it clear that the physical work test is a qualitative rather than quantitative test that focuses on the nature of the work performed, not the amount or cost. Accordingly, under a literal reading, beginning work on any activity that constitutes physical work of a significant nature is sufficient for satisfying the physical work test, regardless of the amount, percentage or value of the work performed.
Under the 5% safe harbor, construction of a facility is considered as having begun in the year in which a taxpayer pays or incurs, depending on his method of tax accounting, at least 5% of the total cost of the facility, including all costs properly included in the depreciable basis of the facility and excluding the cost of land and any property not integral to the facility.
Generally, the costs of property or services are not treated as incurred by a taxpayer for tax purposes (and, thus, do not count toward the 5% safe harbor) until the goods or services are provided to the taxpayer.
However, under a limited exception known as the “3½-month rule,” a taxpayer is permitted to treat property or services as provided to him when the taxpayer makes payment to the person providing the property or services, if the taxpayer reasonably expects the person to provide the property or services within 3½ months after the date of payment.
Generally, multiple facilities that are operated as part of a single project, as determined by the relevant facts and circumstances, are treated as a single facility for purposes of the physical work test and 5% safe harbor. Therefore, starting physical work (or paying or incurring costs) with respect to a single turbine may be sufficient to establish the beginning of construction for the entire project.
Historically, in the waning days of a year in which the PTC was set to expire (or more recently, at the end of 2016, before the phase-down of the PTC was set to be triggered), developers would typically qualify a project via the physical work test by beginning physical work on turbine foundations, roads for operations and maintenance, or a discrete piece of equipment, such as a custom step-up transformer. Alternatively, developers would qualify a project via the 5% safe harbor by incurring costs for turbines or other equipment, often under the 3½-month rule. Tax equity investors, in particular, often prefer the objectivity of the 5% safe harbor over the more subjective physical work test.
As with the so-called “beginning of construction” requirement, the tax law provides no guidance on the meaning of “placed-in-service.”
Treasury regulations broadly provide that property is placed in service during the taxable year that it is placed in a condition or state of readiness and availability for a specifically assigned function. In applying this standard, the wind industry generally relies upon five factors that the IRS has identified as factors in determining that property has been placed in service. These factors include whether all necessary licenses and permits to operate the facility have been approved, the facility has been synchronized, all critical testing of the facility has been completed, the taxpayer has taken control of the facility from the contractor building the facility, and daily operation of the facility has begun.
Placed in service, again
However, satisfaction of the five-factor placed-in-service test is not a bell that can’t be unrung. The IRS guidance expressly allows a previously placed-in-service project to be retrofitted or repowered to requalify for the PTC. Under the IRS guidance, a wind turbine may qualify as originally placed in service even though it contains some used property, provided that the fair market value of the used property is not more than 20% of the wind turbine’s total value (i.e., the cost of the new property plus the value of the used property) – the 80/20 rule.
For purposes of the 80/20 rule, the cost of new property includes all costs properly included in the depreciable basis of the new property. Further, the 80/20 rule is applied to each individual wind turbine (including associated towers and supporting pads), not the project as a whole. Thus, only those individual wind turbines that satisfy the 80/20 rule would requalify for PTCs.[adleft zone=’190′]
With respect to the corresponding redetermination of the begun-construction date for the newly placed-in-service repowered project, the IRS guidance provides that the 5% safe harbor is applied only with respect to the cost of new property that is used to repower the existing facility. Such costs include only expenditures paid or incurred that relate to the new construction, such as the legal fees incurred in negotiating a new turbine supply agreement or an allocation of salaries of employees who worked on the repowering.
As discussed, the beginning-of-construction determination is generally a single determination for the entire project (provided that the individual turbines are operated as part of a single project). Thus, costs incurred with respect to a single repowered turbine could count toward satisfying the 5% safe harbor with respect to all repowered wind turbines in the project. Likewise, physical work performed to repower a single wind turbine could be sufficient to establish the beginning of construction of all repowered wind turbines in the project.
For example, assume that a project consists of 10 wind turbines (that operate as a single project), each with a fair market value of $100. In 2017, the developer projects it will cost $800 to repower the project and incurs costs of $40 to upgrade a single wind turbine. By the end of 2021, the developer has installed new components at a cost of $80 at each of the 10 wind turbines. The value of the original equipment retained in each turbine is $20. Thus, the value of each turbine is $100 when the repowering is complete, and the turbines are placed in service in 2021.
Because the fair market value of the remaining original equipment of each wind turbine ($20) is not more than 20% of each wind turbine’s total value of $100 (the cost of the new components, $80, plus the value of the remaining original components, $20), each wind turbine will satisfy the 80/20 rule and will be treated as placed in service in 2021. Further, the project will be treated as having begun construction in 2017, the year in which the developer incurred the cost of $40 (5% of $800).
As this example illustrates, a critical issue in satisfying the 80/20 rule and requalifying a repowered project is the valuation of the old property that remains incorporated in the repowered wind turbines.
Because the 80/20 rule is concerned with the relative value of used equipment, it introduces a number of valuation wrinkles.
Generally, a taxpayer’s cost is respected as the fair market value of the property for tax purposes. Thus, if a developer were to purchase an operating project from an unrelated third party and repower the existing wind turbines, the portion of the purchase price allocable to the used equipment would be the presumptive fair market value of such equipment.
However, in many instances, a developer may be interested in repowering a project that it already owns. In this case, there would be no purchase price to serve as a proxy for fair market value.
As an alternative to actual cost, the replacement method may be used to determine the value of the old components based on the cost to the developer to replace them. Although this approach may work as a conceptual matter, the resulting value may need to be adjusted for wear, tear and obsolescence to reflect the fair market value of the old components.
Another alternative would be to use the income method, which values a project based on its projected income. The income approach is a widely used method for valuing a project in its entirety or even individual turbines; however, it would be difficult to use this method to allocate value to specific components of a single turbine.
In addition to issues of methodology, there are a number of specific valuation questions that are implicated. For example, assuming the existing project is eligible for PTCs (i.e., the existing project is still within the 10-year PTC period), is it appropriate to take into account the value of the PTCs that the old project would have generated in valuing the old components?
Should a portion of the value of existing shared equipment or equipment other than the actual turbine (e.g., a step-up transformer, SCADA equipment or transmission lines) be included in the value of the old components? With respect to the latter question, considering that the IRS guidance is clear that the 80/20 rule is applied per facility (which is the turbine together with the associated tower and supporting pad), it may not be necessary to take into account the value of equipment that is not part of the turbine; however, to be conservative, it may be prudent to include an allocable portion of the value of such equipment.
In short, the valuation of an existing project for purposes of the 80/20 rule involves a number of new wrinkles. Thus, developers are advised to work closely with an appraiser to develop a defensible method and approach that will satisfy not only the IRS, but also risk-averse financing parties (including lenders and tax equity investors). Further, as a practical matter, a developer initially will evaluate satisfaction of the 80/20 rule when it first makes the decision to undertake a repowering. Thus, the new spend should be calculated conservatively, taking into account best-case scenarios for spend to ensure that the new spend will, in any case, be at least four times the value of used property. The analysis will need to be finalized once the repowering is complete in order to demonstrate that the 80/20 rule has been satisfied.
Another consideration is the application of the somewhat nebulous economic substance doctrine to repowering. Simply put, the economic substance doctrine looks at both the objective and the subjective non-tax reasons for a transaction. Although the tax law does not define the term transaction, the IRS has stated that for these purposes, the term transaction generally includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan or arrangement and any or all of the steps that are carried out as part of a plan.
This broad definition could arguably apply to repowering a project such that it would be eligible to obtain PTCs (particularly if the repowering is in connection with a tax equity investment). Accordingly, if the only purpose of the repowering is to generate PTCs, the IRS may argue that the repowering should be ignored.
The conservative approach would be for developers to demonstrate a non-tax business purpose for the repowering, such as increased power output that, in turn, results in more revenue from power and renewable energy certificates. This could be the result of a higher nameplate capacity (e.g., bigger turbines), increased efficiency (e.g., newer technology), or an increased capacity factor.
Other non-tax business purposes could include an extended useful life, a new or extended warranty, or lower operations and maintenance costs. In measuring the costs and benefits of repowering, the costs of disposing old equipment should also be considered. If the pure economic case for repowering is not clear, it may make sense to expand the scope of the appraisal to include a comparative analysis of the projected cashflows or net income from the existing project with those from the repowered project.
Beyond the tax and economic analysis, a developer will need to give consideration to a number of practical development issues, such as whether project permits and contractual arrangements for the repowered facility will need to be newly obtained or negotiated or whether the permits, leases and other project contracts for the existing facility can instead be modified or extended.
This will depend on the terms of the permits and contracts, which will need to be carefully reviewed to consider what is and is not permissible. A complete replacement of older turbines with the larger turbines of current vintage may also mean that the meteorological data for the existing project is not sufficient for the contemplated repowered project, as the existing data may have been taken at lower altitudes or is not sufficient to support efficient micrositing for the new turbines. Therefore, obtaining new wind data may be one of the first hurdles to a potential repowering.
The valuation and economic substance issues are far from insurmountable, but they do introduce some additional risk that may not be present in the typical PTC-qualification analysis. It is unlikely that the IRS will issue letter rulings on these valuation and economic substance issues, so developers and investors likely will be turning to counsel for comfort before moving too far down the road on an aggressive repowering qualification strategy.
Jeffrey Davis and Robert Goldberg are partners and Isaac Maron is an associate at law firm Mayer Brown. They can be reached at email@example.com, firstname.lastname@example.org and email@example.com, respectively.