Windpower companies, synfuel from coal plant owners , and companies that use lease financing for their projects are breathing easier | Norton Rose Fulbright
Windpower companies, owners of plants for making synthetic fuel from coal, and companies that use lease financing for their projects breathed more easily after reading the fine print in the huge new tax-cut measure that the US Congress enacted in late May.
Others in the project finance community found a few items in the final bill that may affect them.
Congress cut taxes by $350 billion over the next 10 years. President Bush has made the tax cuts the centerpiece of his effort to revive the US economy. The tax cuts barely passed Congress, where they came under heavy criticism for accounting gimmicky that made it look like the tax cuts are smaller than almost everyone expects them to be in fact. A sizable majority in Congress is uneasy about projections that show the federal government running record budget deficits every year into the foreseeable future.
There are four provisions in the final tax-cut measure that affect the project finance community.
First, Congress increased from 30% to 50% an existing “depreciation bonus” in the hope that a larger carrot would induce companies to build more new plant and equipment between now and 2005. Only projects in the United States and in US possessions, like Puerto Rico and the US Virgin Islands, qualify. A 50% bonus would reduce the capital cost of infrastructure projects by as much as 9%.
Second, Congress decided to tax dividend income at only a 15% rate. (This compares to the top rate of 38.6% on most other income.) The change applies only to dividends received by individuals and not by corporations.
President Bush had proposed a much more complicated plan that would have eliminated taxes altogether on dividends, but only on dividends that are paid out of corporate earnings on which the corporation has already paid taxes. The Bush plan would have reduced the value of tax credits that the US government offers as an incentive to build windpower, geothermal, landfill gas, synfuel and other alternative energy projects. That’s because it was at heart a plan to tax corporate earnings once — either at the corporate level or the shareholder level. If the United States is going to have just one tax on corporate earnings, then the tax credits must work against that one tax to be effective. They would not have. The final bill jettisoned this aspect of the Bush plan — to the relief of alternative energy companies.
Third, the final tax bill reduced the maximum tax rate for individuals on their long-term capital gains to 15%. The top rate had been 20%. Long-term capital gains are gains from the sale of assets that an individual has held for more than a year. Corporations will not benefit from the change. Their capital gains are still taxed like their other income (at a 35% rate).
Finally, the tax-cut bill lets any corporation that has an estimated tax payment due to the US government on September 15 this year delay 25% of the tax payment until October 1.
The increase in the “depreciation bonus” from 30% to 50% is a significant benefit, but probably more for windpower companies than developers of other power plants, unless a future Congress extends the deadline for completing projects to qualify for the bonus.
The existing bonus applies to new investments during a window period that runs from September 11, 2001 through 2004 or 2005, depending on the investment. It only applies to new projects. However, improvements to existing facilities also qualify. Construction of the project or improvement cannot have started before September 11, 2001. The project or improvement must be completed by the end of the window period to qualify.
The bonus was 30%. It has now been increased to 50%, but only for projects or improvements on which construction work started after May 5, 2003. Projects on which work started earlier will still qualify for the 30% bonus.
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 — assuming a 30% bonus — is a) 30% of his “tax basis” in the project (basically the cost of the project) plus b) depreciation for the 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 a 30% 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 write-off can be a significant benefit. The benefit is greater the longer the normal depreciation period for an asset. A 50% 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 8.98%. It will reduce the cost of gas pipelines and other gas-fired power plants that are depreciated over 15 years by 7.54%. The cost of a power plant that burns waste would be reduced by 3.61%. Wind farms and biomass projects would cost 2.61% 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. (At last count, 25 states have “decoupled” from the depreciation bonus — they do not allow it to be claimed against state income taxes — and another six allow only a partial or delayed bonus.)
Most alternative fuel projects must be placed in service by December 2004 to qualify for a bonus. Most gas- and coal-fired power plants, gas pipelines and transmission lines have until December 2005. The tax-cut bill did not extend these deadlines.
However, Congress did provide a small additional benefit for anyone claiming a bonus. The rule had been that the bonus can only by claimed on spending on a project through September 11, 2004. That’s true even though the deadline for completing the project to qualify for a bonus is much later. The tax-cut bill allows the bonus to be claimed on spending through December 2004 — or roughly another four months of spending.
The House and Senate negotiators of the final tax-cut bill stuck an unwelcome comment in the “statement of the managers” that they issued with the final bill.
Power companies building gas-fired power plants had worried about whether they would be viewed as having started construction on projects for which they signed contracts to buy turbines before September 11, 2001. The Joint Tax Committee staff made clear in a “blue book” in January 2003 that this is not a problem. The “blue book” said the fact that contracts were signed to buy components for a project before September 11, 2001 does not taint the project. However, the “blue book” was silent about whether the turbine itself qualifies for a bonus. The staff of the tax-writing committees could not agree last January, so they left the issue for the IRS to decide.
The “statement of the managers” says the turbine will not qualify for the 50% bonus. It says “no inference is intended” as to what the rule should have been earlier.
Congress reduced the tax rate on dividends to 15% for individuals in the top tax bracket, but the provision is complicated.
Dividends will be rolled into the calculation of long-term capital gains and netted against capital losses before applying the 15% rate. Under current law, an individual with capital gains must attach an additional schedule to his tax return. First he calculates his long-term capital gains that qualify for a reduced tax rate. Then he must subtract from the long-term gain his long-term capital losses and net short-term capital losses before applying the special rate. Dividends will be folded into the long-term capital gains that get reduced by capital losses.
The 15% rate applies only to dividends received by individuals — not by corporations.
It is retroactive: it applies to dividends received in tax years that started after 2002. It will disappear — or “sunset” — at the end of 2008.
It only applies to dividends received from domestic corporations and some foreign corporations.
Dividends from a foreign corporation qualify only in three circumstances. They qualify if the foreign corporation is incorporated in a US possession, like Puerto Rico or the US Virgin Islands. They qualify if the dividend is paid on shares of a foreign corporation that are “readily tradable on an established securities market in the United States.” An example is dividends paid on American depository receipts, or “ADRs,” that are traded on a US stock exchange.
Dividends paid by a foreign corporation also qualify if the foreign corporation is entitled to benefits under a “comprehensive” tax treaty between its country of residence and the United States, but only if the treaty has provisions requiring the sharing of information between tax authorities in the two countries. The foreign corporation must also be entitled to the treaty benefits on “substantially all” of its income in its tax year in which the dividend is paid. The IRS is supposed to issue regulations listing the foreign countries from whose companies it thinks it makes sense to let dividends qualify for the lower tax rate. In the meantime until the regulations are issued, Congress said taxpayers can assume any tax treaty with exchange-of-information provisions qualifies, except for the US treaty with Barbados.
Certain types of foreign corporations are ineligible. An example is any foreign corporation that the US tax laws label a PFIC — or “passive foreign investment company.” This is a foreign corporation that earns a large amount of dividends, interest or other “passive” income or a sizable percentage of whose assets are the kinds of assets that generate such income. Foreign corporations are ordinarily not PFICs if a majority of the shares are owned by US shareholders.
The individual receiving the dividend must have held the shares for more than 60 days to qualify for the lower rate. Preferred shares — at least ones with a preference on dividends — must have been held for more than 90 days. The holding period is cut short if the individual takes steps to shed the shares or substantially identical shares by granting an option to someone to buy them or if he has an option himself to “put” the shares to someone else. The holding period is also cut short if he hedges his exposure to the shares so that he has a “diminished risk of loss.”
“Dividend” is defined as it has been historically. It is a distribution to a shareholder out of a corporation’s “earnings and profits.” Dividends will qualify for the 15% tax rate even though they are paid out of undistributed earnings that a corporation accumulated in the distant past.
The Bush administration is hoping that the reduction in tax rates on both dividends and long-term capital gains will lead to a quick increase in stock prices, thereby giving a psychological boost to the US economy. The lower tax rates could make raising equity a little less expensive (since the shareholders can expect a higher after-tax return from investing). The cost of borrowing could become a little more expensive if the lower tax rates cause investors to shift capital away from debt and into shares. Municipalities worry that the tax cut for dividends will make it more expensive to borrow in the tax-exempt bond market to pay for schools, roads, hospitals and other public projects since some investors may shift their funds out of tax-exempt bonds and into shares.
Preferred stock should become more popular. One can expect to see more shares in the future that pay close to a fixed return like a debt instrument. The dividing line between preferred shares and debt is already fuzzy. However, with interest that individuals receive taxed at a 38.6% rate and dividends taxed only at a 15% rate, there could be more interest in structuring what are essentially debt offerings to look more like preferred shares. (Each company will have to consider the tradeoff. Earnings paid out as dividends on shares are not deductible by the corporation; only interest is.)
Most independent power companies lack cash to pay dividends — even if they are considered for tax purposes to have earnings out of which dividends could be paid in theory. This could strengthen regulated utility stocks — which traditionally pay large dividends — in relation to independent power company shares.
The 15% tax rate for dividends is temporary. If 2008 approaches with no extension in sight, then companies will have to consider whether to borrow to flush out earnings while their shareholders can still qualify for the 15% tax rate.
Congress also cut the tax rate for long-term capital gains to 15%. “Long term” means gains on investments held for more than one year.
This was not part of the original Bush plan. It should ease the pressure on companies to distribute more earnings as dividends. A shareholder should be indifferent whether he receives his return in the form of a dividend or as gain from the sale of his shares, since the 15% rate applies to both types of returns.
The 15% rate only applies to long-term capital gains received by individuals — not corporations.
It only applies to sales of property in tax years starting after May 5, 2003. Most individuals pay taxes on a calendar-year basis. There are transition rules in the tax-cut bill for calendar year 2003 that work out generally so that gains on sales of property after May 5, 2003 qualify for the lower rates, but the rules are complicated and will require a longer tax return schedule for calculating capital gains.
The rate reduction is temporary. The rate will revert to 20% after 2008.
Installment payments received after May 5, 2003 qualify for the 15% rate, even though the property was sold earlier. Individuals selling property and who expect to be paid in installments by the buyer would be wise to require that all the installments be paid by December 2008 when the lower tax rate expires.
Most US corporations pay their income taxes in four installments during the tax year. The final tax-cut measure includes the following sentence: “Notwithstanding [what the US tax code requires currently], 25 percent of the amount of any required installment of corporate estimated tax which is otherwise due in September 2003 shall not be due until October 1, 2003.” The effect is to let companies that pay taxes on a calendar-year basis keep a little cash for two weeks. Congress expects that this will delay $6.3 billion in estimated tax payments.
Windpower companies, owners of plants for making synthetic fuel from coal, and companies that use lease financing for their projects breathed more easily after reading the fine print in the final tax-cut bill.
Windpower companies and owners of synfuel plants were relieved that the final dividend provision did not undermine existing tax credits for generating electricity from wind or producing synthetic fuel from coal.
The leasing industry had worried about two provisions in the Senate version of the tax-cut bill. Both were dropped from the final measure. One would have had the tendency to require future lease transactions to conform to the IRS “true lease guidelines.” Few transactions today conform. For example, the guidelines bar the lessee from having an option to buy the leased property for a fixed price that is set in advance. The other provision would have put an end to cross-border “service contract leases” by requiring that the service contract be counted as part of the lease term. This would have undermined the economics of such transactions.
Earlier this year, the Senate Finance Committee held hearings and published a voluminous report on the various things Enron did to reduce its taxes. The tax-cut bill that passed the Senate would have put a halt to many of these transactions. However, the Senate language was dropped from the final bill. Senators worried that by putting out a laundry list of what Enron did, they would encourage others to do the same unless Congress took quick action to shut down the transactions on the list. House Republicans and the Bush administration refused to go along.
The House also rejected Senate efforts to require that transactions have “economic substance” in the future before the government will recognize the tax consequences.
Meanwhile, the House had wanted to give corporations the ability to use any net operating losses in 2003, 2004 or 2005 to get refund checks from the US Treasury for taxes they paid as far back as five years in the past. Such losses can be carried back only two years currently. This did not make it into the final bill.
Microsoft and other high-technology companies pushed hard for a provision that would have let US companies bring home earnings that are parked currently in offshore holding companies and pay only a 5.25% income tax. The special rate would have applied only for a year. The proposal passed the Senate, but failed to make it into the final bill.
Finally, the Senate had voted to extend the deadline by one year for building wind farms and power plants that use poultry litter or “closed-loop biomass” to generate electricity in order to qualify for a tax credit of 1.8¢ a kWh on electricity output. The current deadline for these projects is the end of this year. The Senate bill would have extended the deadline through December 2004. The extension did not make it into the final bill. However, a longer extension — through December 2006 — is part of a separate energy bill that passed the House in April and is scheduled for debate in the Senate in June.
House Republicans are already talking about another tax-cut bill this year. In particular, the European Union has imposed a January deadline on Congress to act to replace a tax break for US exporters — called “foreign sales corporations” or “FSCs” — that the World Trade Organization declared is prohibited. January is when the European Union has threatened to slap retaliatory duties on US products. Some provisions that did not make it into the final tax-cut bill in May remain possible candidates for the FSC bill.
However, there is a very good chance that partisan bickering will block any further action on taxes this year. The tax-cut measure that passed in May only passed because it was brought up as part of the annual budget process and, therefore, could pass the Senate with only 50 votes (plus the vote of the vice president to break the tie). Any other tax bills this year will require 60 votes in the Senate, a seemingly impossible hurdle.