Viewing Notice 2020-12 Through the Lens of Notice 2013-29 and Notice 2018-59: How is “Beginning of Construction” Guidance for Section 45Q Carbon Capture Credit Projects Different from Wind and Solar Precedents?
In February 2020, the IRS issued Notice 2020-12, which provides long-awaited guidance on when a “qualified facility” or carbon capture equipment, in each case within the meaning of section 45Q, is considered to have “begun construction.” This question is of paramount significance because section 45Q allows a carbon capture credit for carbon oxide that is captured using carbon capture equipment that is originally placed in service at a qualified facility, and a qualified facility means an industrial or direct air capture facility, the construction of which began before January 1, 2024 (among other requirements). Moreover, either the installation of the carbon capture equipment in question must have been contemplated in the original planning and design for the qualified facility, or the carbon capture equipment also must be constructed before January 1, 2024.
In general, Notice 2020-12 closely resembles its counterparts in the renewables space, which consist of several notices issued beginning in 2013 for the production tax credit under section 45 (the “PTC Guidance”) and Notice 2018-59 for the investment tax credit under section 48 (the “ITC Guidance”). Both section 45 and section 48 address numerous renewable energy technologies, but the statutes are most visible for their applicability to wind and solar projects, respectively. Similar to its companion article on Revenue Procedure 2020-12, this article examines the main ways in which Notice 2020-12 departs from its forbears and poses the question of what, if anything, such differences might mean for wind and solar guidance going forward.
Like the PTC Guidance and the ITC Guidance, Notice 2020-12 permits a taxpayer to establish the beginning of construction of a qualified facility or carbon capture equipment either by starting physical work of a significant nature (the “Physical Work Test”) or by paying or incurring 5% or more of the total cost of the qualified facility or carbon capture equipment (the “5% Safe Harbor”). Under either method, the taxpayer must make continuous progress towards completion once construction has begun (the “Continuity Requirement”), either through a continuous program of construction (for the Physical Work Test) or through continuous efforts to advance towards completion (for the 5% Safe Harbor), although the Continuity Requirement is deemed met if the qualified facility or carbon capture equipment is placed in service within a specified period of time (the “Continuity Safe Harbor). Within this framework, Notice 2020-12 departs from prior “beginning of construction” guidance in several subtle but potentially meaningful ways.
- Onsite physical work. Physical work of a significant nature may either be onsite or offsite. The PTC Guidance provides, as an example of such onsite physical work, “the beginning of the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete pads of the foundation,” and also states that the physical work must be “used as an integral part of the activity performed by the facility.” Fencing is not integral, only certain roads (e.g. O&M access roads) are integral, and a building is not integral unless it is “a structure that is essentially an item of machinery or equipment” or a structure that houses property integral to the facility, if the structure is so closely related to such use that it can clearly be expected to be replaced when the housed property is replaced. The ITC Guidance for solar projects contains similar rules (other than the provision regarding excavations of foundations), and also states that onsite physical work of a significant nature may include the “installation of racks or other structures” to affix PV panels, collectors, or solar cells to a site.
In its nonexclusive list of examples of onsite physical work of a significant nature, Notice 2020-12 appears to set a higher standard for excavation-related work. Instead of requiring one of beginning excavation of foundations, setting of anchor bolts into the ground or pouring of the concrete pads of the foundation, as in the PTC Guidance, Notice 2020-12 refers to “excavation for and installation of foundations,” which is described as including the setting of anchor bolts and the pouring of the concrete pads. However, unlike the PTC Guidance, which only considers physical work performed on buildings in restricted situations, Notice 2020-12 takes into account the excavation and installation of foundations for “buildings to house equipment necessary to the project.”
In addition to excavation work, Notice 2020-12 also lists, as onsite physical work of a significant nature, the installation of a system of gathering lines necessary to connect the industrial facility to the carbon capture equipment, or to other equipment necessary to the qualified facility, before transportation away from the qualified facility for disposal, utilization, or use as a tertiary injectant; the installation of components “necessary for carbon capture processes,” including membranes, dehydration systems, engines, and “other types of gas separation, liquidation, or processing equipment”; and the installation of equipment and other work necessary for the disposal of qualified carbon oxide in secure geological storage at the geological storage site. While these situations have no direct analogue in the wind or solar space, it is observed that while the PTC Guidance and the ITC Guidance hinge on the concept of whether physical work is on tangible property that is “integral” to the activity performed by the project, Notice 2020-12 focuses on whether an item is “necessary” for carbon capture processes, connection to carbon capture equipment, or the disposal of carbon oxide, as the case may be. The significance of this change in word choice, if any, is not immediately clear.
- Offsite physical work. The PTC Guidance provides “physical work on a custom-designed transformer that steps up the voltage of electricity produced at the facility to the voltage needed for transmission” as an example of physical work of a significant nature; the ITC Guidance, while also confirming that offsite physical work of a significant nature may include the manufacture of “components, mounting equipment, support structures such as racks and rails, inverters, and transformers and other power conditioning equipment,” contains similar language about custom-designed transformers. As with Notice 2020-12, both the ITC Guidance and the PTC Guidance agree that physical work of a significant nature does not include work to produce property that is either in existing inventory or is normally held in inventory by a vendor. However, the specific reference in the ITC Guidance and the PTC Guidance to a “custom-designed transformer” has created ongoing debate as to whether such guidance should be interpreted to mean that (1) all offsite physical work of a significant nature must be specifically custom designed for the project or (2) no offsite physical work of a significant nature must be specifically custom designed for the project, except for transformers described in the ITC Guidance and the PTC Guidance.
Notice 2020-12 also does not explicitly provide a view on whether offsite physical work must be custom designed for a specific project, but it perhaps goes further than either the ITC Guidance or the PTC Guidance towards blessing offsite physical work that has no bespoke elements. In addition to listing, in its nonexclusive list of offsite physical work of a significant nature, the “manufacture of mounting equipment and support structures such as racks, skids, and rails,” Notice 2020-12 also lists generally the manufacture of “components necessary for carbon capture processes,” as well as the manufacture of both “components” and equipment” that are necessary for disposal of qualified carbon oxide in secure geological storage. In particular, the long list of examples of components considered to be “necessary for carbon capture processes” includes a number of items—membranes, turbines, pumps, motors, filters—that frequently are not custom designed for specific projects.
- Inventory carve-out in Physical Work Test. In the PTC Guidance, the Physical Work Test does not take into account work (performed either by the taxpayer or by another person under a binding written contract) to produce property that is either in existing inventory or is normally held in inventory by a vendor. The ITC Guidance contains a similar rule, but one with a broader reach: work is excluded if it is to produce “components of energy property” (italics added), not just property generally—thus implying that even if the property ultimately contracted for is not itself inventory, physical work can be excluded to the extent that it is to produce a component of the property that is (or would normally be) inventory in the hands of the vendor. Notice 2020-12 follows the approach of the ITC Guidance, stating that work to produce “components of a qualified facility or carbon capture equipment that are either in existing inventory or are normally held in inventory by a vendor” is excluded from the Physical Work Test.
- Preliminary activities. Physical work of a significant nature excludes “preliminary activities,” such as clearing the site and obtaining permits and licenses. Notice 2020-12 contains a nonexclusive list of preliminary activities that is largely similar to the one in the ITC Guidance and the PTC Guidance, but that omits the references to “planning or designing,” “conducting surveys,” “environmental and engineering studies,” and “conducting mapping and modeling to assess a resource.” The impact of this omission is not entirely clear, but it bears mentioning that certain planning costs, described below, are explicitly included in determining whether the 5% Safe Harbor has been met. Additional clarification from the IRS is needed in this regard.
- Inclusion of certain planning-stage costs in 5% Safe Harbor. Notice 2020-12 states that in addition to costs properly included in the depreciable basis of a qualified facility or carbon capture equipment, “[c]osts associated with Front-End Engineering and Design (FEED) activities or other approaches for front-end planning (e.g., the Front-End Loading (FEL) approach) common to projects of similar scope and complexity may also be considered when determining whether the Five Percent Safe Harbor has been met.” In other words, even if such costs are not properly capitalized into the depreciable basis of the property in question, they still can be counted for purposes of the 5% Safe Harbor. The intent behind this sentence is not immediately clear, as engineering and design costs, to the extent properly allocable to a project, are generally required to be capitalized in the project’s depreciable basis in any event. It can be conjectured that the original intent was to make this clarification in the context of the Physical Work Test, given the otherwise unexplained omission of “planning or designing” and certain other activities from the list of “preliminary activities,” but such speculations would require additional IRS guidance to be practically meaningful.
- Energy properties, facilities, and “units” of carbon capture equipment. Similar to the ITC Guidance and the PTC Guidance, Notice 2020-12 contains two rules with respect to the 5% Safe Harbor that hinge on the “level of property” at which each rule is applied. First, if cost overruns in a single project comprised of multiple qualified facilities or “units of carbon capture equipment” cause the project to fail the 5% Safe Harbor, the 5% Safe Harbor nonetheless may be met for some (but not all) units of carbon capture equipment, so long as the total aggregate cost of such property is not more than 20 times greater than the amount the taxpayer paid or incurred; no such partial qualification is permitted if the project consists of a single qualified facility or unit of carbon capture equipment. Similarly, the rule that a qualified facility or carbon capture equipment that contains used components may qualify as originally placed in service so long as the fair market value of the used components is not more than 20% of the total value (i.e. cost of new components plus value of the used components) (the “80/20 Rule”) is applied to each qualified facility or “unit of carbon capture equipment” in the project. Both the ITC Guidance and the PTC Guidance contain similar rules, but apply these rules at the level of an “energy property” and a “facility” within the meaning of section 45(d), respectively. In each case, the energy property or facility generally includes all components of property that are “functionally interdependent,” i.e., 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. The ITC Guidance elaborates that energy property is generally comprised of “all components of property necessary to generate electricity up to and including the inverter” and states that property integral to the generation of electrical energy that is installed on a single rooftop is considered a single unit of property; the PTC Guidance states that in the context of a wind project, a single facility consists of a wind turbine, its tower, and its supporting pad, with such facility being capable of being separately operated and metered and of producing electricity separately. Notice 2020-12 lacks clear analogous guidance about what constitutes an individual “qualified facility” or “unit of carbon capture equipment,” and additional IRS guidance would be useful in this regard.
- 3% rule. In addition to the cost overruns rule discussed above, the PTC Guidance also provides for the same treatment—i.e., 5% Safe Harbor qualification for some, but not all facilities in the project—if a taxpayer has paid or incurred at least 3% of the total cost of the facility before the relevant deadline. Notice 2020-12, like the ITC Guidance, does not have such a rule.
- Consequences of failing the Continuity Requirement. As a practical matter, the wind and solar developer market generally treats the Continuity Requirement as mandatory. Indeed, the requirement is explicitly listed as a requirement to satisfy the 5% Safe Harbor. However, it is occasionally observed that, in both the ITC Guidance and the PTC Guidance, the Physical Work Test does not literally require the Continuity Requirement to be met. Rather, the IRS “will closely scrutinize a facility, and may determine that construction has not begun on a facility” before the relevant date, if the Continuity Requirement is not met. While most taxpayers presumably do not plan into the IRS “closely scrutinizing” their actions, this language can provide incremental comfort in some situations where there is a potential problem with the Continuity Requirement, such as a risk that a project will be placed in service later than originally contemplated, or that a project—perhaps due to the actions of previous owners—may have “accidentally” begun construction earlier than intended. Notice 2020-12, however, does not mitigate the Continuity Requirement, even for projects that start construction using the Physical Work Test, and in fact explicitly states, “Both methods [i.e., the Physical Work Test and the 5% Safe Harbor] require that a taxpayer make continuous progress towards completion once construction has begun.”
- Longer Continuity Safe Harbor. In both the ITC Guidance and the PTC Guidance, the Continuity Requirement is deemed to be met if the energy property or facility (as the case may be) is placed in service by a calendar year that is no more than four calendar years after the calendar year during which construction of the facility began. Notice 2020-12 contains a more generous version of the Continuity Safe Harbor: the qualified facility or carbon capture equipment must be placed in service by the end of a calendar year that is no more than six calendar years after the calendar year during which construction began.
- Transition date for “combination of methods” rule. Since the issuance of Notice 2016-31 and its institution of the four-year Continuity Safe Harbor, the PTC Guidance has provided that if a taxpayer meets the Physical Work Test in one year and the 5% Safe Harbor in a subsequent year (or vice versa), the taxpayer will be considered to have begun construction for purposes of the Continuity Safe Harbor in the earlier year. Under Notice 2017-04, however, this rule applies only to projects that began construction after the date of publication of Notice 2016-31 in the Internal Revenue Bulletin, which was June 6, 2016. The ITC Guidance contains the same rule, which also applies prospectively to projects for which construction began after December 31, 2018 (the ITC Guidance was issued June 22, 2018). Notice 2020-12 contains the same rule, but unlike the ITC Guidance or the PTC Guidance, the rule’s application is not limited to prospective beginning of construction dates.
Potential Takeaways for Wind and Solar Projects?
Most of the differences between Notice 2020-12 on the one hand, and the ITC Guidance and/or PTC Guidance on the other, presumably do not signal any imminent changes in the IRS’s beginning of construction rules for wind and solar projects. Indeed, if the six-year Continuity Safe Harbor in Notice 2020-12 briefly raised hopes among wind and solar developers that an extension of the four-year Continuity Safe Harbor might follow, such hopes were probably disappointed when even a worldwide pandemic merely led to the extension of the Continuity Safe Harbor—for 2016 and 2017 projects only—by a single year.
However, certain of the innovations in Notice 2020-12 discussed above may reverberate in the wind and solar space. One area is that of offsite physical work, typically performed under a contract by a vendor. In its broad and nonexclusive list of offsite physical work of a significant nature, Notice 2020-12 mentions a long list of components necessary for carbon capture processes—including membranes, turbines, pumps, motors, and filters—that are not obviously custom designed. Such acknowledgment may provide implicit support for interpreting the PTC Guidance and the ITC Guidance accordingly.
Another interesting aspect of Notice 2020-12 is its statement that work to produce a component of a qualified facility or carbon capture equipment is excluded from the Physical Work Test if the component itself—rather than the property generally—constitutes inventory of the vendor. This approach, which follows the ITC Guidance, raises a question as to whether the PTC Guidance might be interpreted in a similar manner, notwithstanding that the “component” language does not appear in the analogous rule in the PTC Guidance.
Finally, one of the most intriguing statements in the ITC Guidance and the PTC Guidance—that a taxpayer can still begin construction under either the Physical Work Test or the 5% Safe Harbor without meeting the Continuity Requirement, so long as it passes the “close scrutiny” of the IRS—is absent from Notice 2020-12. How the IRS would interpret the “close scrutiny” language in practice has never been entirely clear, and its omission from Notice 2020-12 might suggest that this language, if operative, might be interpreted strictly against the taxpayer. In the meantime, further guidance from the IRS in all three areas should be encouraged.
 2020-11 I.R.B.
 I.R.C. § 45Q(a).
 I.R.C. § 45Q(d)(1).
 See Notice 2013-29, 2013-20 I.R.B. 1085; Notice 2013-60, 2013-44 I.R.B. 431; Notice 2014-46, 2014-36 I.R.B. 520; Notice 2015-25, 2015-13 I.R.B. 814; Notice 2016-31, 2016-23 I.R.B. 1025; Notice 2017-4, 2017-4 I.R.B. 541.
 2018-28 I.R.B. 196.
 Notice 2020-12 at § 4.
 Id. at § 7.01.
 Id. at § 7.02.
 Id. at § 7.05.
 Notice 2013-29 at § 4.02.
 Id. at § 4.05(1).
 Id. at § 4.05(2).
 Id. at § 4.05(3).
 Id. at § 4.05(4).
 Notice 2018-59 at § 7.02(1)-(4).
 Id. at § 4.02(2)(a).
 Notice 2020-12 at § 5.02(2)(a).
 Id. at § 5.02(2).
 Notice 2013-29 at § 4.05(1).
 Notice 2018-59 at § 4.02(1).
 Id. at § 7.02(1) (“However, physical work on, or costs paid or incurred for, a custom-designed transformer that steps up the voltage of electricity produced at an energy property to the voltage needed for transmission will be considered for purposes of determining whether a taxpayer has begun construction of the energy property because power conditioning equipment is an integral part of the activity performed by the energy property.”).
 Notice 2020-12 at § 5.04; Notice 2018-59 at § 4.04; Notice 2013-29 at § 4.02(2).
 Notice 2020-12 at § 5.02(1)(a)-(d).
 Id. at § 5.02(1)(b).
 Notice 2013-29 at § 4.02.
 Notice 2018-59 at § 4.04.
 Notice 2020-12 at § 5.04.
 Id. at § 5.03; Notice 2018-59 at § 4.03; Notice 2013-29 at § 4.02(1).
 Notice 2020-12 at § 5.03.
 See Treas. Reg. § 1.263A-1(e)(3)(ii) (“The following are examples of indirect costs that must be capitalized to the extent they are properly allocable to property produced or property acquired for resale: . . . (P) Engineering and design costs. Engineering and design costs include pre-production costs, such as costs attributable to research, experimental, engineering, and design activities (to the extent that such amounts are not research and experimental expenditures as described in section 174 and the regulations thereunder).”).
 Notice 2020-12 at § 6.03.
 Id. at § 8.04.
 Notice 2018-59 at §§ 5.03, 7.05; Notice 2013-29 at §§ 5.03.
 Notice 2018-59 at § 7.01; Notice 2013-29 at § 4.04.
 Notice 2014-46 at § 5.01.
 Notice 2018-59 at § 5.01; Notice 2013-29 at § 5.01.
 Notice 2013-29 at § 4.01. See also Notice 2018-59 at § 4.01 (“The Service 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 (as determined under section 6.01 of this notice).”).
 Notice 2020-12 at § 4.01.
 Notice 2016-31 at § 3.
 Notice 2020-12 at § 7.05.
 Notice 2016-31 at § 4.
 Notice 2017-04 at § 4.
 Notice 2018-59 at § 3.02.
 Notice 2020-41, 2020-25 I.R.B.