SHINE Partners | September 2021
What is the Investment Tax Credit (ITC) for Solar?
Most solar photovoltaic projects in the United States benefit from the Investment Tax Credit (“ITC”), a non-refundable federal tax credit granted to the project’s owners. Unlike a tax deduction, the ITC is used to reduce the project owners’ federal income tax liability on a dollar-for-dollar basis. The amount of the ITC for any project is equal to 26% (in 2021) of the project’s cost basis to its owner. So for a project that costs $1 million to develop and build, its owner should receive roughly $260,000 in Investment Tax Credit to reduce their federal income tax. The ITC applies to both residential solar systems (Section 28D) and commercial/utility systems (Section 48). This entry discusses the commercial/utility ITC.
When is the ITC “created” for a Commercial/Utility Solar Project?
Large solar projects can take up to several years to develop and build and may change ownership one or more times during that period. A common question related to the ITC for such projects is “when exactly is the ITC created, and for whose benefit?” This question is important for many reasons, most notably because:
- the ITC percentage (and therefore the amount of all projects’ ITC amount) changes from year to year. As noted above, the ITC amount is calculated by multiplying the project’s cost basis by an “ITC Percentage,” which is defined by federal law. In 2021 the ITC Percentage is 26%, but it changes from year to year according to a schedule. Currently, the schedule is as follows[1]: 2021 is 26%; 2022 is 26%; 2023 is 22%; and 2024 and on is 10%. Note that this schedule has been changed by congress a couple of times in the past 15 years;
- the tax year that the ITC is created is important to the project owner, whose tax benefits are greatest if they can use the full ITC benefit against their federal income taxes the year it is created, although it can be carried back one year or forward for up to twenty;
- the ITC is not transferable. It goes to whoever owns the Project at the time it is Placed in Service[2], and if the owner (and ITC recipient) transfers or sells the underlying project before they have owned it for five years, the IRS can claw back some portion, depending on how long the owner owned it before transfer.
The ITC Percentage and Safe Harbors:
Because of the potential for uncertainty about what ITC percentage a long-developing project will be eligible for at its completion, the IRS has created certain “Safe Harbors” which effectively allow solar project developers to lock-in the ITC Percentage from the year the project BEGINS construction, rather than the year that it is completed and placed in service. This is valuable because the ITC Percentage is currently scheduled to decline in future years. The IRS will Safe Harbor the ITC Percentage for a solar project if the project owner can “Establish Beginning of Construction” of a project in a certain year using one of two methods:
- The Physical Work Test is the more intuitive of the two tests and requires the project to demonstrate that “physical work of a significant nature” was begun in the Safe Harbor year. The physical work can include work performed on- or off-site as long as it is specific to the project, as well as work actually performed for the project under contract, but it does not include the mere expenditure of money, purchasing of standard commercially available equipment, or development activities (such as surveying, permitting or similar). Further, once physical work has begun, the project must undergo a “continuous program of construction” until the project is placed in service in order to secure this safe harbor. This requirement is to prevent developers from starting physical work solely to safe harbor a high ITC Percentage and then suspend construction to a more convenient timeline.
The Physical Work test has some subjective components, as the IRS notes that “whether and when a taxpayer has begun construction of energy property will depend on the relevant facts and circumstances,” but further notes that the physical work test “focuses on the nature of the work performed, not the amount or the cost… there is no fixed minimum amount of work or monetary or percentage threshold required.[3]” Developers who intend to use this Safe Harbor are well-advised to carefully document the time and nature of their physical work on applicable projects.
- The Five Percent Safe Harbor, on the other hand, focuses on when certain project expenditures are paid and requires that five (or more) percent of a project’s total cost be incurred in the Safe Harbor year. The total costs include all depreciable expenses of the project, which may differ from the project’s basis for the purposes of calculating the ITC. Note that the 5% is an absolute requirement and is calculated as a percentage of the project’s actual total cost upon completion. For that reason, project owners are well-advised to budget for prospective cost overruns when planning 5% safe harbor expenditures, as 5% of a projected project budget can become 4.7% of an actual total project budget. Note that in order for project costs to be considered eligible for securing the 5% safe harbor, they must be pursuant to a binding contract with a third party and must be non-cancellable (except with substantial penalty). This requirement is to prevent developers contracting for project costs in order to secure a Safe Harbor year and terminating/recovering those costs without penalty if the project is not pursued.
Note that a project owner’s tax accounting basis method[4] can be crucial in calculating when 5% Safe Harbor costs are incurred. The dates that certain expenses are incurred are central to determining whether the Five Percent Safe Harbor applies to a particular project. Accrual-method taxpayers incur costs when they accrue (generally, when they are contracted or performed), while cash-method taxpayers incur costs when they are paid for. Thus, a project owner cannot accurately calculate when project costs are incurred without knowing their tax basis.
Either the Physical Work Test or the Five Percent test can be used to establish a Safe Harbor with the IRS that a solar project is entitled to the ITC Percentage of the year that construction began on the project. Awareness and prudent application of these Safe Harbors can mean significant differences in the amount of ITC allocated to the solar project and to the return it can provide to its owners or its tax equity investors.
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[1] as of September 1, 2021, subject to change by US Congress;
[2] ‘Placed in Service’ has a specific meaning to the IRS, defined in 26 CFR § 1.179-4. It is generally considered in most cases to be the date that the Project passes its utility inspection and in interconnected to the utility grid.
[3] IRS Rev Proc Notice 2018-59
[4] Accrual- or Cash-basis; lIRC Section 461
