#TBT: US Congress Throws Tax Benefits At Project Finance Community
July 16, 2015
Posted in Blog article
This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience. This article first appeared in the September 1999 issue of the Project Finance NewsWire.
by Keith Martin, in Washington
Congress left Washington in early August after passing a $792 billion tax-cut bill with many provisions that are of interest to the project finance community. The bill faces a certain veto by President Clinton.
The real question is whether Republican Congressional leaders and the president will negotiate a smaller tax cut in the fall. If so, then the bill Congress passed will serve as a high-water mark for the negotiations. Here is what is in it that would affect companies involved in power, telecoms, toll roads and other infrastructure projects.
The bill extends a tax credit of 1.7 cents a kWh for generating electricity from wind and “closed-loop biomass” and adds poultry waste to the list of eligible fuels. “Closed-loop biomass” consists of crops grown specifically to be used as fuel in a power plant. Lobbyists had hoped to persuade Congress to broaden the fuels list also to include wood and agricultural waste and landfill gas, but they were unsuccessful.
Existing law requires projects using eligible fuels be placed in service by June 30, 1999 to qualify for credits. The credits run for 10 years after the project is put into service.
The bill extends this deadline for another four years through June 30, 2003.
Under current law, only the owner of the facility qualifies for credits. The bill would make an exception for power plants using poultry waste that are owned by a “governmental unit,” like a municipal utility. In that case, a lessor of the power plant or the operator could claim the credits.
The California utilities won a victory. Congress said tax credits cannot be claimed on electricity from new wind projects put into service after June 30 this year if the electricity is sold under a power sales agreement with a utility signed before 1987. The only exception is if the power contract is amended to limit the electricity that can be sold under the contract at above-market prices to no more than the average annual quantity of electricity supplied under the contract in the five years 1994 through 1998 or to the estimate the contract gave for annual electricity output. “Above market” means for more than the avoided cost of the electricity to the utility at time of delivery.
This is the first time the tax laws have been used to reform power contracts at independent power facilities. The utilities worry that there is the potential for a large number of new wind projects to be built under so-called “standard offer contracts” that they were forced by law to sign in the 1980’s. If all these projects are built, they will add to the utilities’ stranded costs.
The bill would make it easier for US companies to claim foreign tax credits starting in 2002. This would help US businesses compete for projects in foreign countries since they would be less likely to face double taxes (same income taxed both by US and foreign country where it was earned). It would also help with a problem that many US multinationals have earnings trapped in offshore holding companies that they are loathe to bring back to the US for fear that repatriating the earnings will trigger taxes in the US.
The United States taxes American companies on worldwide income. It allows credit in theory to the extent the income was already taxed abroad, but almost no US power or telecoms company is able to claim foreign tax credits in practice.
The main problem is the interest allocation rules. The larger the percentage of a company’s total income that comes from abroad, the more foreign tax credits it is allowed to claim. However, US rules require that a portion of the company’s interest expense on borrowing to finance its operations in the United States be treated as a cost of its foreign operations. This interest is allocated between US and foreign operations in the same ratio as the company’s assets are deployed at home and abroad.
Thus, for example, if a US utility pays $600 million a year in interest on borrowing for its US operations and 6% of its total assets are abroad, then 6% times $600 million, or $36 million a year in costs must be allocated to its foreign operations. This reduces its foreign income in relation to its US income. The company may think it had $X in foreign earnings, but after subtracting allocated interest, the IRS will insist that really a much smaller portion of its income was from abroad. In fact, most US companies end up with a deficit in foreign earnings after this calculation that will take years to burn off. The result is no foreign tax credits.
Current US rules work on the theory that borrowed money is fungible. However, US multinationals complain that the principle ought to work both ways so that a portion of interest expense on foreign debt—for example, borrowing by a foreign subsidiary to finance a project in Brazil—is allocated away from foreign income and treated as a cost of its operations in the US. At first glance, it looks like Congress decided to let US companies allocate back to US operations part of the interest expense of some foreign subsidiaries. The foreign subsidiaries are ones in which the US company or its US affiliates own more than 50% of the shares by either vote or value.
However, this is not quite what Congress did. No foreign interest expense will be charged to US operations. Instead, Congress set up a new formula that reduces the amount of domestic interest expense that will be allocated abroad starting in 2002. In many cases, it reduces it to zero.
The bill would also let US companies take some US debt out of the calculation altogether. A company would be able to elect to treat any domestic subsidiary in the US whose debts are not “guaranteed (or otherwise supported)” by a related company as essentially a standalone enterprise. However, there are two wrinkles. First, this election would have to be renewed every five years. Second, the subsidiary would be limited in the amount of dividends or other distributions it could make on its shares to its US parent each year. The limit is the average dividend it paid in each of the last five years or 25% of its average annual earnings during the last five years, whichever is greater. Even though the foreign tax credit relief in the bill would not take effect until 2002, this limit on dividends applies immediately after the bill is enacted. If the limit is breached, the consequence is that the subsidiary will have to treat an amount of its debts equal to the excess dividend as regular debt subject to interest allocation.
Finally, the bill gives an additional boost to foreign tax credits, but not until 2006. (The Republicans in Congress were so eager to spend projected US budget surpluses that the bill is full of provisions that do not take effect until some time in the middle of next decade.) If, after interest allocation, a company shows a loss from its US operations—an “overall domestic loss”—then once it starts earning positive income again from US operations in future years, it will be allowed to change the label on some of those positive US earnings—relabel them as from foreign operations—until the overall domestic loss is burned off. This will help with foreign tax credits since the more foreign-source income a company has, the more foreign tax credits it is allowed.
The bill increases “volume caps” on the amount of tax-exempt bonds that each state can issue each year to finance private projects. The current limit is $50 per person of population or $150 million, whichever is greater. The cap is already scheduled to increase over the period 2003 through 2007 to the greater of $75 per person of population or $225 million. The bill would speed this up so that the increase occurs over the period 2000 through 2004. (The cap next year would be $55 per person or $165 million.)
The bill authorizes up to $15 billion in tax-exempt financing to be used for construction or reconstruction of as many as 15 private highway projects. The US Department of Transportation would allocate the borrowing authority. To qualify, a project would have to serve the general public and be located on “publicly-owned rights of way” in the United States, and it would either have to start out owned by a government or revert eventually to a government. The financing could not be used to acquire land.
The bill will let utilities selling nuclear power plants transfer escrowed funds that have been set aside to pay the eventual decommissioning costs for the plants without triggering income taxes on the amount in the escrow account. The transfer would have to be after this year.
It also makes two other related changes. First, current law allows utilities to deduct annual contributions to nuclear decommissioning funds. The utility must get a private ruling from the IRS fixing the amount of its annual contributions. Its deduction is limited to the amount in the ruling or the amount its local public utility commission allows it to pass through to ratepayers as a cost of service, whichever is less. The bill drops the second part of the limit after this year. This was a response to electricity deregulation. Second, some utilities have separate escrows for decommissioning funds that they were not allowed to deduct because their contributions exceeded the limits on deductions. The bill lets these utilities dump whatever they had in these “nonqualified” funds on December 31, 1998 into their regular decommissioning funds and deduct the nonqualified amounts ratably over the remaining useful life of the nuclear power plant starting in 2002. Anyone buying the power plant—and taking over the decommissioning fund—could continue with the deductions.
Current law is unclear about whether a payment to cancel a fuel supply contract is a “capital loss.” Companies have a harder time deducting capital losses than ordinary losses. The bill makes clear that “supplies of a type regularly used or consumed by the taxpayer in the ordinary course of [his] trade or business” are not capital assets. This should have the effect of also clarifying that payments to cancel contracts to buy such supplies are not capital losses. The change applies to payments on or after President Clinton signs the bill.
The bill clarifies that trading in “commodities derivative financial instruments” produces ordinary income for power marketing companies—not capital gain. This should be helpful, since power marketers usually want to avoid mismatches in character between income and loss positions on contracts. (Most of their income is already ordinary income.) A commodities derivative financial instrument” is a contract that is for, or an instrument that is tied to, a commodity like electricity and whose value is linked to an index. “Index” is defined broadly as “objectively determinable financial or economic information” that is not unique to the parties and not within their control.
The bill also clarifies that hedging transactions produce ordinary income and loss—not capital gain or loss—provided the hedge is “clearly identified as such before the close of the day on which it was . . . entered into.” Both provisions apply to any instrument “held, acquired, or entered into,” or “transaction entered into” from when President Clinton signs the bill.
The bill makes it easier for large oil or gas companies like Enron to defer US taxes on income from foreign pipeline projects. Even though the US taxes American companies on worldwide income, it is possible to structure offshore investments so that US taxes are deferred until the earnings are brought back to the United States. However, this works only where the US company will receive active income from the investment—not passive income like interest, dividends, rents or royalties. Transportation fees paid to the owner of an oil or gas pipeline are sometimes classified as passive income in cases where the owner is a large oil or gas company. The bill corrects this. However, the provision would not take effect until 2002.
The bill makes it easier to defer US taxes on income from providing services related to “the transmission of high voltage electricity” outside the US. The problem currently is that service fees are treated as passive income—making US tax deferral hard—if a service company is set up outside the United States to provide the services and it relies on “substantial assistance” from the US parent or other affiliates to provide the services. The bill creates a special exception for these service fees. The provision would not take effect until 2002.
US expatriates receive a so-called section 911 exclusion currently that spares them from having to pay US income taxes on their first $74,000 in wages. The exclusion is increasing at the rate of $2,000 a year and will hit $80,000 in 2002. Thereafter, current law requires it be adjusted each year by inflation. The bill provides for increases of $3,000 a year from 2003 through 2007, by when the exclusion would reach $95,000, and for inflation adjustments thereafter.
The bill extends the so-called R&D tax credit through June 30, 2004. The credit expired at the end of last June. The bill also increases the amount of the credit. Companies that qualify for the credit currently can compute it in one of two ways. Under one approach, the credit is 20% of the amount by which the company increased its research spending above a base. The other way is to compute it under a sliding formula that rewards companies for spending
more than 1% of their gross receipts on research. Effective next year, the credit under this alternative approach would be 2.65% of research spending above 1% of gross receipts, 3.2% of such spending above 1.5% of gross receipts, and 3.75% of research spending above 2% of gross receipts.
US banks, insurers and finance companies that make loans to foreign borrowers have a hard time deferring US taxes on the interest they earn on these loans. US taxes cannot be deferred on passive income. The banks argue that this is active income for them. Congress wrote a temporary “active financing exception” into the law in 1997. The bill extends it through 2004.
The entire tax-cut bill expires on September 30, 2009, with a few exceptions where the provisions cease to have legal effect after December 31, 2008. This is a form of legerdemain to comply with budget targets. The business community has criticized Congress in the past for enacting temporary tax incentives and for making frequent changes in US tax laws because this makes it harder to plan.