Project finance community will be affected by President Bush's May 17 tax reconciliation bill | Norton Rose Fulbright
A TAX RECONCILIATION BILL that President Bush signed into law on May 17 makes a number of changes in US tax laws that will affect the project finance community.
The bill will require every federal, state and local government agency in the United States making payments for “property or services” to withhold 3% of the gross amount of such payments starting in 2011. Thus, for example, payments by federal military bases or municipal utilities for electricity or implementation of energy savings ideas will require withholding.
There are a few exemptions from withholding.
Municipalities that make less than $100 million in payments for “property or services” annually will not have to withhold. Withholding also does not apply to payments of interest, for real property, to another government agency, tax-exempt entity or foreign government, or under contracts with the federal government that are confidential because of national security concerns or the needs of law enforcement or foreign counterintelligence.
Some Republicans in Congress have already called for repeal of the provision. However, Congress adopted it after a Government Accountability Office report disclosed that some government contractors are failing to pay taxes. Also, Congress used it to plug a $7 billion gap in revenue that it had to fill in order to comply with budget targets.
The revenue estimators in Congress assumed that the provision would produce mainly a timing benefit. The government will collect taxes through withholding a little earlier in time than it would otherwise. Most of the revenue increase would come in the first year: 2011.
The bill also imposes a large excise tax on tax-exempt entities, Indian tribes and pension trusts that are parties to some transactions that must be reported to the IRS as potential corporate tax shelters.
The government will start collecting the excise tax immediately (in tax years ending after May 17, 2006). The tax is retroactive in the sense that it applies to potential corporate tax shelter transactions that have already closed. If tax-exempt entities, Indian tribes and pension trusts remain parties in the deals, they will be hit with the excise tax. It is too late to avoid for the tax for 2006. The excise tax will be collected for being a party in three kinds of transactions. The three are so-called “listed transactions” that the IRS has put the public on notice it considers corporate tax shelters, to other transactions in which an adviser to the deal has insisted that the tax structure be kept confidential, and to transactions in which the fees paid by any of the participants are tied to the tax benefits that the participant receives from the transaction.
The excise tax will be collected annually. It is 35% of the net income or 75% of the gross proceeds received by the tax-exempt entity, Indian tribe or pension trust each year — whichever tax amount is greater. The tax increases to the greater of 100% of net income or 75% of gross proceeds if the tax-exempt entity, Indian tribe or pension trust “knew, or had reason to know” that the transaction would attract an excise tax when it became a party to the deal.
It is not clear what it means to be a “party” to such a transaction. Existing IRS regulations already require “participants” in such transactions to report them to the IRS. A person is generally not considered a participant unless he or she reports any tax benefits from the deal on a tax return.
The manager of the tax-exempt entity, Indian tribe or pension trust who approved its participation in the deal will also have to pay a separate $20,000 tax imposed directly on him or her.
Taxable companies that participate in the deal will have to notify the tax-exempt entities that are parties to it in writing of their potential peril.
Private equity funds and hedge funds with tax-exempt entities or pension trusts as investors should be careful about investing in the transactions that Congress has targeted with the excise tax.
However, if they do so, it should not ordinarily cause an excise tax to be imposed on their investors, “absent facts or circumstances that indicate that the purpose of the tax-exempt entity’s investment in the . . . fund was specifically to participate in such a transaction.”
The tax reconciliation bill also extends for another two years through 2010 a special low US tax rate for corporate dividends and capital gains. The rate is 15%. It applies only to dividends and capital gains received by individuals and not corporations.
The bill will make it slightly more difficult for companies in energy and other infrastructure businesses to take advantage of a tax deduction that rewards “domestic manufacturing.” Companies engaged in domestic manufacturing in the United States pay tax currently on only 97% of their domestic manufacturing income. In other words, they can deduct 3% of such income. The taxable percentage will drop to 94% in 2007 and to 91% in 2010. Generating electricity is considered manufacturing. However, transmitting or distributing electricity is not. The amount of deduction a company is allowed each year is limited to 50% of the wages it reports on IRS Form W-2 that it paid its employees. The bill tightens the wage cap by limiting it to wages tied to domestic manufacturing. Thus, for example, utilities will have to allocate wages between their generation businesses and their transmission and distribution businesses.
The bill extends a special rule that allows US banks and other lenders to avoid immediate US taxes on interest their offshore subsidiaries earn from making loans outside the United States. The United States ordinarily looks through offshore subsidiaries of US multinational corporations and taxes them on any dividends, interest or other passive income it sees being earned by the subsidiaries — without waiting for the income to be repatriated to the United States. However, there is an exception from this principle for “active financing income,” or income earned by banks and other lenders in the regular course of business. It is not treated as passive income. The exception was scheduled to expire at the end of 2006. The bill extends it for another two years through 2008.
The bill will also make it easier for US companies to avoid immediate US taxes in the future on some income earned outside the United States. Affected companies are ones with offshore holding companies that, in turn, own other subsidiaries that are treated as corporations for US tax purposes. The US normally looks through offshore holding companies and taxes the US parent on any dividends, interest or other passive income it sees earned anywhere in the offshore ownership chain. The bill makes an exception. For the next three years, the US will not treat as “subpart F income” — subject to immediate tax in the US — any dividends, interest, rents or royalties that one subsidiary treated as a corporation pays to another subsidiary in the offshore ownership chain. However, the subsidiary receiving the amounts must have a large enough interest in the one paying them for the two subsidiaries to be considered related parties. There was already an exception in the tax code for dividends and interest paid between related parties, but both the offshore holding company and the payor had to be in the same country.
It is hard to see how anyone could rely on such a temporary provision for purposes of planning. It applies only for the period 2006 through 2008. Congress could decide to extend it.