This is an extract from a recent brief “The Role of Safe Harbor for Energy Tax Credits: Guardrails, Not Loopholes” by the American Council on Renewable Energy (ACORE).

As clean energy demand rises due to AI, cloud computing, and reshoring of manufacturing, private investment in energy infrastructure has become increasingly essential. Clean energy projects require significant upfront capital, often involving intricate planning and financing mechanisms. These projects are only financially viable if they become operational and generate power over time. Consequently, investors and lenders apply rigorous due diligence, including reviews of technical specifications, legal permits, environmental risk, long-term offtake contracts, and financial models before committing capital. At the heart of energy tax credit compliance are IRS safe harbor provisions, which establish clear standards that private actors must meet to begin construction and ultimately qualify for incentives like the Investment Tax Credit (ITC) and Production Tax Credit (PTC).

Energy Project Finance Overview

Consistent with other categories of critical infrastructure, clean energy projects involve extensive planning processes with multiple stakeholders, including project sponsors, investors, debt providers, offtakers, equipment suppliers, and labor contractors. Project sponsors typically raise external sources of capital from multiple parties to finance the upfront costs of these projects. 

Even before financing considerations, these parties must advance through numerous steps in the project development process, from initial site selection, design, and engineering, to permitting and interconnection approvals. Assuming successful navigation of these phases, which can take months to years depending on the size of the project, the parties will typically enter into multi-year contracts known as power purchase agreements (PPAs) with a utility or corporate offtaker. PPAs facilitate the purchase of energy generated by a project at a fixed rate and tend to range 10-20 years.

To meet these milestones, these energy projects require substantial private capital to be secured and deployed before the federal clean energy tax credits are claimed, though tax considerations factor into the overall project’s financial planning. As a result, private market actors that provide this upfront capital have a strong incentive to ensure that projects are completed on time, and that they will be performing assets that generate electricity – if they do not, then the long-term agreed upon returns from the project will not materialize.

Role of Private Actors in Ensuring Projects Move Forward

Given the multi-year, capital-intensive nature of energy projects, project sponsors and other parties must carefully consider project economics, risk allocation, and potential financial structures before moving forward. As part of this planning and project development process, financing parties conduct substantial technical, tax, and commercial diligence. In addition, these parties often require the project developer to enter into a long-term offtake agreement with a creditworthy counterparty to lock in the sale of electricity generated by a project, full warranty coverage, confirmation from third party engineers as to the ability to operate the project over a long period of time, review of the environmental risks, and assurance as to full permitting authorizations and land use rights.

After the extensive analysis to quantify a project’s long-term financial viability is performed, banks and other lenders offer debt, such as bridge loans, to cover a portion of a project’s capital costs, while various investors may provide equity capital in exchange for partial ownership. Labor and equipment contracts, particularly engineering, procurement, and construction (EPC) contracts, are often secured early in the financing process as a prerequisite for lenders, creating visibility into a project’s scope, cost, timeline, and operational soundness.

“Safe Harbors”— Guardrails, Not Loopholes

Generally, a federal tax credit is a dollar-for-dollar reduction in the amount of tax owed by a taxpayer. It is different from a deduction in that it is applied after a taxpayer’s income is calculated. Credits are provided under federal tax law for engaging in private sector economic activities for which the government has warranted a reduction in tax liabilities, such as energy generation. 

To ensure taxpayers understand the types of activities and investments that qualify for credits, the IRS issues rules and guidance that taxpayers must follow to validly claim such incentives. These guardrails, frequently referred to as “safe harbors,” are a longstanding concept in U.S. tax law and provide clarity and reduce the risk of litigation. They also play a vital role when extraordinary circumstances occur that lie outside of a taxpayer’s control, such as sudden downturns in financial markets, or in areas that deal with highly complex facts and circumstances, such as real estate accounting and tax partnerships. 

Failure to comply with IRS rules and guidance can result in audits, disqualification of credits, and other enforcement activities. For this reason, financing parties are keen to ensure strict compliance with such rules and act as gatekeepers – essentially performing an audit function given the heavy economic and reputational implications of maintaining good standing with IRS standards and procedures. While federal tax credits such as the Investment Tax Credit (ITC) or Production Tax Credit (PTC), as well as other tax policies such as depreciation, are factored into the financials of an energy project, many of the essential procedural steps in project finance occur before credits can be formally applied or monetized. 

Several particularly important provisions related to safe harbors, and the role of private sector actors in ensuring that they are followed, are:

Beginning-of-Construction Safe Harbors 

The safe harbor concept has been used for decades in areas such as depreciation, tax credits across multiple sectors, and other policies, designed to provide clarity with compliance and reduce the risk of litigation. Longstanding safe harbor requirements have governed the process for U.S. companies to begin construction on energy projects of all kinds, providing important legal and financial certainty regarding the eligibility of such projects for the federal energy tax incentives. IRS guidance released since 2013 outline the current methods available to taxpayers for the purposes of establishing that construction of energy property has begun to claim federal tax credits. There are two tests: Five Percent Safe Harbor and the Physical Work Test. Taxpayers may select one of the two tests, but both are subject to a “continuity requirement.”

Five Percent Safe Harbor: Under this test, construction of energy property will be considered as having begun if a taxpayer pays or incurs five percent or more of the total cost of the energy property. All costs properly included in the depreciable basis of the facility are considered to determine whether the threshold has been met. The Five Percent Safe Harbor incorporates the tax accounting rules under Internal Revenue Code Section 461, which generally specify that costs are paid or incurred when property is delivered to the taxpayer, with a special exception if the taxpayer can reasonably expect solicited services or property to be provided within three and a half months after the date of payment.

Physical Work Test: Under this test, construction of energy property will also be considered as having begun if the taxpayer commences “physical work of a significant nature.” This test is focused on the nature of the work performed, not the amount or the cost. Physical work includes both on-site and offsite work performed either by the taxpayer or by another party under a binding written contract entered into prior to the manufacture, construction, or construction of the energy property. The binding nature of such written contracts further ensures no abuse and good faith development to meet this test. Physical work of a significant nature does not include preliminary activities—such as obtaining permits, securing financing, or completing environmental studies—even if the cost of those preliminary activities is properly included in the depreciable basis of the facility. This means that in order for a taxpayer to appropriately claim any federal tax credits, demonstrable work must have commenced on the project.

Continuity Requirement: Under both the Five Percent Safe Harbor and Physical Work Test, taxpayers must demonstrate either continuous construction or continuous efforts, regardless of which method was chosen to establish the beginning of construction. Whether a taxpayer meets the Continuity Requirement under either test is determined by “the relevant facts and circumstances” or whether a project has been placed in service within four years. As part of this prong, a “Continuity Safe Harbor” generally provides that the Continuity Requirement is satisfied if taxpayers place their project in service by the end of the fourth calendar year following the year in which the Five Percent Safe Harbor or Physical Work Test was satisfied. In other words, not only does a project need to demonstrate that substantial capital and/or physical work meeting the above tests has commenced, progress must be sustained to remain eligible for claiming federal tax credits. Taxpayers and developers are incentivized to complete construction in a timely manner for practical purposes and to meet this requirement, which financing parties and tax return preparers will diligence and validate, respectively.

Key Stakeholders and their Roles in Compliance: For each of these steps, project stakeholders play important roles in ensuring compliance. In general, the primary responsible party is the taxpayer (e.g., project developer), as well as equipment suppliers and EPC contractors, who are responsible for appropriately tracking and documenting progress on the project (i.e., supply chain analysis, documentation of delivery, payments, etc.). Financing parties and other stakeholders, such as tax return preparers, then provide another layer of diligence on the various project milestones and progress, and also provide validation of compliance.

Existing Guardrails Ensure Compliance

IRS safe harbors exist to protect U.S. companies building or financing energy projects from the financial consequences of events outside their control. The existing rules already include a series of prohibitions that further help to ensure clarity and compliance.

For example, under existing rules, taxpayers cannot leverage safe harbors when they:

-Wait for more optimal financial or market conditions

-Cannot secure long-term investors or financing 

-Fail to apply for necessary permits on time 

-Experience delays due to internal resourcing issues or inaction 

-Observe unexpected increases in equipment or labor costs 

-Undertake only “preliminary” work 

-Make purchases or orders under non-binding contracts 

-Provide vague claims of effort rather than objective proof of meeting criteria 

-Attempt to toggle between safe harbor methods and “reset the clock”

These rules are well established in U.S. tax law and well understood by the power industry. Moreover, financing parties and tax return preparers perform additional audit functions to prevalidate compliance in keeping with current IRS rules and procedures.

Conclusion

Existing IRS safe harbors are designed to honor good-faith, diligent investments in domestic energy projects while allowing for foreseeable risks during development and construction. Under the current rules, taxpayers must document their actions in comprehensive detail and absorb responsibility for the penalties of noncompliance. Energy projects seeking to claim federal tax credits are subject to substantial private market oversight and discipline under IRS rules and guidance that have been in place for more than a decade. The interests of private sector project stakeholders ensure compliance with the law and effective completion of projects.

Access the brief here