A New Depreciation Bonus
The United States adopted a 30% “depreciation bonus” in March in the hope of persuading US businesses to invest in new plant and equipment.
It only applies to new investments during a window period that started last September 11. Power companies tried immediately to figure out ways to claim the bonus on projects that they already have under development. The bonus is part of an economic stimulus bill that President Bush signed into law on March 9. It would reduce the cost of new power plants by as much as 5.39%.
The stimulus bill also opened the door for companies that will report net operating losses on their tax returns for last year — or that can generate such losses this year — to get refund checks from the US Treasury for taxes they paid as far back as 1996.
Other parts of the bill affect smaller segments of the project finance community.
The depreciation bonus only applies to new investments made during a window period that runs from September 11, 2001 through the end of either 2004 or 2005.
Assets must be placed in service by the end of the window period in order to qualify for the bonus. Most alternative fuel projects face a deadline of 2004 to be placed in service. Most gas- and coal-fired power plants, gas pipelines and transmission lines have until December 2005.
The key to the later date is that the project must be depreciated for tax purposes over a period of 10 to 20 years. The project must also be expected to take more than a year to build and cost more than $1 million. Thus, for example, a simple-cycle gas-fired power plant built on an Indian reservation would have to be in service by December 2004 to qualify (since it qualifies for special 9-year depreciation by virtue of being on an Indian reservation). Project developers who are facing the shorter deadline may be able to buy more time by electing slower tax depreciation.
A company will not be able to claim the bonus if it was committed to the investment before last September 11.
It is unclear how to apply this principle to many power projects. The Internal Revenue Service is expected to issue guidance sometime this summer.
The economic stimulus bill distinguishes between two kinds of assets — those that a company “acquires” and those that it “self constructs,” or builds itself.
The depreciation bonus does not apply to assets that a company “acquires” under a “binding” contract signed before September 11. Just because a contract was signed before September 11 does not mean it was “binding.” For example, a contract that requires the buyer to give a notice to proceed before work starts, or that allows the buyer to cancel at will without a meaningful penalty, is not yet binding on the buyer when the contract is signed.
In the case of property that a company “self constructs,” the depreciation bonus does not apply if construction “began” before September 11.
It appears Congress intended that all power plants would be treated as “self constructed.” If this interpretation holds, then when the construction contract or procurement contracts for parts were signed does not matter; the key is when construction began on the project. The House Ways and Means Committee said in its report on the economic stimulus bill:
Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer [i.e., self constructed].
Under this definition, all custom-made equipment that a company contracts with someone else to have built is self constructed. A company only “acquires” equipment that it buys off the shelf. This is a broader definition of “self constructed” than Congress has used in the past. The IRS could still adopt a narrower approach when it issues guidance this summer. Congress is also working on some technical corrections to the new law that, if enacted, would have retroactive effect.
Until Congress or the IRS says otherwise, developers should assume that power plants are self constructed. A project will not qualify for the bonus — at least as long as it remains in the hands of the company that was developing the project on September 11 — if construction “began” before September 11. Construction began if physical work of a significant nature started at the site. The work must go beyond mere site preparation. The IRS has sometimes also treated construction as having begun when assembly of major components for the project starts offsite. It is not clear whether it will do so in this case.
There are many unanswered questions that will have to wait until the IRS issues guidance this summer. For example, many developers signed contracts for multiple turbine slots before September 11. Work may or may not have started on the turbines. In some cases, even where a turbine was built, it was not yet designated for use in a particular project. It is unclear whether the fact that work started on a turbine will rule out claiming a bonus on the cost of the turbine or whether it might even taint the rest of the project.
The IRS is also expected to address this summer whether a new purchaser of a project who acquires it during construction can claim the bonus, even if the original developer who sold it to him could not. The new purchaser was not committed to the investment on September 11.
The depreciation bonus is an acceleration of tax depreciation to which the owner of a project would have been entitled anyway.
The owner gets a much larger depreciation deduction the first year and smaller ones later. His depreciation allowance in the year the project is put into service is a) 30% of his “tax basis” in the project (basically the cost of the project) plus b) depreciation for that year calculated in the regular manner on the remaining 70% of basis. For example, without the bonus, the first-year depreciation deduction on a coal-fired power plant that cost $100 million to build is $3.75 million. With the bonus, it is $32.625 million. Depreciation in later years is reduced commensurately, since only $100 million in depreciation can be claimed in total.
The faster tax write-off can be a significant benefit. The benefit is greater the longer the normal depreciation period for an asset. Thus, the depreciation bonus will reduce the cost of assets that are depreciated over 20 years — for example, transmission lines and coal- and combined-cycle gas-fired power plants — by 5.39%. It will reduce the cost of gas pipelines and other gas-fired power plants that are depreciated over 15 years by 4.52%. The cost of a power plant that burns waste would be reduced by 2.17%. Windpower and biomass projects would cost 1.57% less. These calculations only take into account federal tax savings from the depreciation bonus — not also the state tax savings — and they use a 10% discount rate.
The depreciation bonus can only be claimed on assets in the United States. Assets used in US possessions, like Puerto Rico and the US Virgin Islands, also qualify. The bonus cannot be claimed on property that has been financed with tax-exempt bonds or that is “used” by a municipality.
Only the first company to put the asset in service qualifies for the bonus. The goal is to encourage US businesses to buy new equipment — not churn used assets. The bonus does not apply to buildings. Power plants are usually classified as only about 3% to 5% “building,” and the rest is considered “equipment.”
Some companies may not be in a position to make efficient use of the tax benefits. Therefore, Congress adopted a special sale-leaseback rule that allows the original user of an asset up to three months after he puts the asset in service to sell it to another company that can use the tax benefits and lease it back. That way, the lessee might share in the bonus indirectly in the form of reduced rent.
Projects that are placed in service after September 10, 2004 through the end of 2005 will only qualify for the depreciation bonus if a binding contract to acquire the project is signed or — in cases where the taxpayer is building the project himself — if construction begins during the period September 11, 2001 through September 10, 2004. For projects placed in service during 2005, the depreciation bonus will only apply to the amount the owner spent on the project through September 10, 2004.
There is already speculation among Washington lobbyists that the deadline to place projects in service will be extended. Five Republican members of the House tax-writing committee plan to introduce a bill in early April to make the depreciation bonus permanent.
The economic stimulus bill opened the door for companies that will report net operating losses on their tax returns for last year — or that can generate such losses this year — to get refund checks from the US Treasury for taxes they paid as far back as 1996.
A corporation can normally carry net operating losses back — and get a refund of past taxes paid — up to two years in the past. The economic stimulus bill authorized a five-year carryback for net operating losses in 2001 and 2002. Thus, 2001 losses could be carried back to 1996.
This could be a significant benefit to Enron — if it paid past taxes — and to western utilities that were caught up last year in the California power crisis.
The US has two different income tax systems for corporations. A corporation must compute its regular tax at a 35% rate and also its “alternative minimum tax” at a 20% rate using a broader definition of income, and then pay whichever amount is greater. The idea was to make it harder for companies not to pay any tax at all. However, a company is given a credit for the extra minimum taxes it pays above what it would have paid in regular taxes, and this credit can be used in future years when the company would otherwise be back on the regular tax to reduce its regular taxes down to the level where minimum taxes kick in.
The new carryback can also be used to get a refund of minimum taxes paid during the past five years. However, the amount of the net operating loss must be recalculated — using a minimum tax definition of loss — before it can be used for this purpose.
A company ordinarily cannot use net operating loss carry-backs to reduce its minimum taxes by more than 90%. However, this limit has been waived in the case of 2001 and 2002 losses.
Section 45 Credits
The stimulus bill extended a deadline for building new projects to generate electricity from wind, “closed-loop” biomass or poultry litter and qualify for a tax credit of 1.7¢ a kilowatt hour on the output. Such projects had to be in service by December last year to qualify for credits. The stimulus bill extended the deadline through December 2003.
The tax credits run for 10 years after the project is placed in service. The credit is adjusted each year for inflation. The figure 1.7¢ was the credit for electricity sold during calendar year 2000. The new figure will be announced in early April.
A “closed-loop” biomass project is a power plant that burns plants grown exclusively for use as fuel in power plants. There are no known such projects in the United States.
There is a chance — if Congress clears the Bush energy plan this year — that the deadline for placing projects in service will be further extended through 2006 and the list of qualifying projects will be expanded to cover other fuels.
Projects on Indian reservations qualify potentially for special depreciation allowances and a wage credit tied to the number of Indians hired to work on the project. The deadline for placing projects in service to qualify for these benefits was December 2003. The economic stimulus bill extended it by one year through December 2004.
US multinationals complain that they have a hard time competing abroad because the United States taxes them on worldwide earnings. Most multinationals — if they are careful — can structure foreign operations in a way that lets them defer US taxes on the earnings for as long as the earnings remain offshore. However, this only works for “active” income — for example, income from a real operating business as opposed to from passive investments. Examples of passive income are interest, dividends, rents and royalties.
Banks complained that interest represents active income for them. Congress adopted a special rule in 1997 that treats income as active if it is from the “active conduct of a banking, financing, or similar business.” The provision is temporary. The economic stimulus bill extended it through December 2006.
by Keith Martin, in Washington