In Other News - January 2007
SEVERAL KEY TAX INCENTIVES were extended by Congress in December. Congress gave developers of renewable energy projects another year to qualify for production tax credits. The credits in 2006 were 1.9¢ a kilowatt hour for generating electricity from wind and geothermal steam or fluid and 1¢ a kWh for generating electricity from biomass, landfill gas or municipal solid waste or from turbines added to an existing dam. They run for 10 years after a project is put in service. The amount is adjusted each year for inflation. The credits are worth about 33¢ per dollar of capital cost in a typical wind farm in present-value terms. The deadline had been December 2007 to place projects in service. The new deadline is December 2008. Congress also pushed back the deadline to put commercial solar projects and fuel cells in service and qualify for a 30% investment tax credit. The investment credit is claimed entirely in the year the project is put in service. The deadline to qualify is now December 2008. Solar projects completed after that date still qualify for an investment credit, but the amount drops to 10%. The investment credit can be claimed not only on solar electricity projects, but also equipment that uses sunlight to supply hot water. The tax credit allowed on fuel cells is limited to $500 per kilowatt of capacity. There is no credit for fuel cells installed after 2008. Congress authorized another $400 million in “clean renewable energy bonds.”These are bonds that state and local governments, electric cooperatives and Indian tribes can use to borrow money for a wind farm, solar project, biomass or geothermal power plant or other project that, if it were privately owned, would qualify for production tax credits. The bonds do not require any interest payments. Rather, the lender can claim tax credits each year tied to the outstanding principal amount of the loan. Congress authorized $800 million in such bonds in the Energy Policy Act in August 2005. Anyone wanting to use the bonds to finance a project had to apply to the Internal Revenue Service for an allocation by last April. The IRS allocated all the available bond authority in late November. The government received 709 applications asking for a total of $2.6 billion in bond authority. A total of 610 awards were made. Of the awards, 434 were for solar projects. The largest single award was $33 million to an electric cooperative. The largest amount awarded for a municipal project was $3.2 million. The latest Congressional action will open the door for another round of allocations in 2007. E85 — a vehicle fuel that is 85% ethanol — is subject to federal excise tax when sold at a reduced rate of 13.25¢ a gallon. The special rate was scheduled to expire on September 30, 2007. Congress extended it through December 2008. It also extended a special rate of 12.35¢ a gallon for vehicle fuel that is at least 85% methanol or alcohol made from coal. Most ethanol in the United States is made currently from corn. Many people expect the next wave of ethanol plants to use cellulosic material like bagasse, corn stalks and switchgrass. The Energy Policy Act in 2005 let anyone investing in a “refinery” to make liquid transportation fuels deduct 50% of the cost immediately when the plant is put into service. (The other 50% of the cost is recovered over time as depreciation.) There had been some uncertainty about whether the 50% deduction could be claimed on ethanol plants that mash corn into alcohol. Congress suggested in December that it can only be claimed on ethanol and biodiesel plants that turn corn or other biomass “via gas” into liquid fuel. However, it let the 50% deduction be claimed on plants that make cellulosic ethanol, regardless of the process. A cellulosic plant must be put in service by 2012 to qualify. Owners of batteries that make coke or coke gas — for example,at steel mills — can claim tax credits of $1.17 an mmBtu on the coke or coke gas they sell to third parties. The credits can be claimed on four years of output.The coke battery must be put in service by 2009. (The credits used to be called “section 29 credits” by were renumbered section 45K in August 2005.) Credits of this sort are liable of being phased out if oil prices return to levels reached during the Arab oil embargo in the 1970’s. In December,Congress voted to free coke and coke gas projects from any risk of a phase out. However, it also made clear that only steel coke qualifies for the credits — not petroleum coke.The credits are capped at $23,200 a day per coke facility. Projects built on Indian reservations qualify for faster depreciation. For example, a wind farm can be depreciated over three rather than five years. The deadline to place projects in service to qualify had been December 2005. It has now been extended to December 2007.A wage credit for hiring Indians to work in jobs on the reservation was also extended for wages paid or incurred through December 2007. Finally,Congress authorized the US Treasury Department to allocate another $3.5 billion in “new markets tax credits”in 2008.The credits had been expected to be fully allocated with the 2007 round of credits. New markets credits are tax credits that are supposed to induce equity investors to invest money in storefront lenders — called community development entities, or CDEs — to businesses in low-income areas. Each investor receives a tax credit for 39% of his equity investment. The credit is spread over seven years. Some larger financial players have organized CDEs for making loans and applied to the Treasury for tax credit allocations.The government allocated $2 billion in credits in each of 2004 and 2005 and $3.5 billion in 2006. Another $3.9 billion will be allocated in 2007 and $3.5 billion in 2008. (The $3.9 billion for 2007 includes $400 million in credits for projects in the Gulf states hit by Hurricane Katrina.) Applications for 2007 allocations must be submitted by February 28.
UTILITY RELOCATION PAYMENTS continue to cause trouble at the IRS. A city worked with a private developer to build a mix of single-family homes, town houses, condominiums and rental units on a parcel of land.Two high-pressure gas pipelines ran across the land and had to be moved to make way for the construction.The city reimbursed the pipeline company for the cost of moving them. The IRS ruled privately that the utility had to report the reimbursements as income. The utility had insisted that the city pay a “tax gross up”in addition to reimbursing it for the cost of the move. The city argued that the reimbursement was similar to government grants that are treated as nonshareholder “contributions to capital.” Such grants are not taxable income. The IRS disagreed. It said a payment must have as its primary motivation “the benefit of the public as a whole” in order to fall in this category. It said this one did not because the motivation was to help a private developer. The case is addressed in Private Letter Ruling 200647002.The IRS made the ruling public in late November. The parties asked the wrong question of the IRS. A utility can normally deduct its costs to move equipment.However, under a line of cases that the courts were describing as “well established” by the 1930’s, moving costs cannot be deducted when the company will be reimbursed for them, but the reimbursement does not have to be reported as income,either. In addition, if the city could have used its power of eminent domain to force the utility to move the gas pipelines, then it is possible that the pipelines were “involuntarily converted.” Compensation paid in such an involuntary conversion does not have to be reported as income, provided it is reinvested in similar property. Spending on the move would have been considered such a reinvestment.
CALIFORNIA said in December that it will appeal a state court decision that an annual fee on limited liability companies is unconstitutional. The court said the “fee” is a tax. The fee is a maximum of $11,790 for LLCs with incomes of more than $5 million.The court said what makes the fee unconstitutional is the state makes no effort to determine how much of an LLC’s income was earned in California. Taxes can only be imposed on income from a source in California. Governor Arnold Schwarzenegger vetoed a bill in September that would have fixed the fee retroactively by linking it to the amount of California income. The state could be required to refund as much as $1 billion if it loses the appeal. LLCs doing business in California should file protective refund claims in case the state has to pay refunds.The statute of limitations on refunds is four years. There is still time to file protective claims as far back as 2002. SOURCE RULES for determining where income is earned are important. The more income that a US company can report earning outside the United States, the more foreign taxes the company will be able to claim as a credit to reduce its US income taxes. The IRS explained in regulations in late December how to determine where income is earned that a company receives from a project on or under the high seas, in outer space or involving cross-border communications. The regulations interpret sections 863(d) and (e) of the US tax code. It will be hard for US companies to claim that ocean or space projects produce any foreign source income. Income received from such projects by US persons will be treated as earned entirely in the United States.The ocean is defined as the area outside territorial waters of any country,meaning more than 200 miles offshore. The rule makes sense since such income is unlikely to have been taxed by another country. A US company cannot ordinarily convert ocean or space income into foreign source income by investing through an offshore subsidiary. That’s because a subsidiary that is owned more than 50% by US shareholders will be treated like a US person for this purpose. There is one possible out.The income will turn into foreign source income to the extent the company can show that the income was tied to tasks performed, resources employed or risks assumed in a foreign country. This rule is a trap for foreign companies involved in projects on the oceans or in outer space that have a US connection. Some of their income may end up being taxed in the United States as US source income based on the same principle. A television company that has its programs broadcast by satellite into other countries does not earn income from an activity in outer space if it merely pays someone else to transmit the programming; the satellite operator does. However, it does have space income if it leases transponders or capacity on the satellite to make the broadcasts. The IRS said it is still studying how to treat income earned from leasing shipping containers. This will be addressed separately in the future. US telephone and internet companies that earn income from “international communications” must treat the income as earned 50% in the US and 50% abroad. However, communications are considered to take place entirely in the US if they are between two points in the United States or between a point in the US and the high seas or outer space. Foreign telecom and internet companies with offices in the United States will have US source income — and have to pay tax on it in the United States — to the extent their income is tied to the US office. The IRS acknowledged that itmay be hard in today’s world to figure out where telephone calls or internet use starts and ends. It said it will accept any “consistently applied reasonable method.”
PAPER COMPANIES complain that the IRS policy of allowing production tax credits on only the net amount of electricity supplied to the grid will reduce credits for power plants at paper mills by half. Many paper mills burn lignin from spent chemicals used in the papermaking process, bark and wood chips in boilers to produce steam. The steam is then run through a steam turbine to generate electricity. Electricity output at a typical mill can vary from 10 megawatts to more than 50 megawatts. The US government allows production tax credits of 1¢ a kilowatt hour to be claimed as a reward for generating electricity from “biomass.” Credits can only be claimed on electricity a mill sells to a third party, but not on electricity the mill consumes itself. The IRS said in October that such tax credits can only be claimed on the net amount of electricity that is supplied to the grid. The American Forest & Paper Association complained in a memorandum sent to the US Treasury Department by email in late November that 110 paper mills it surveyed in 2004 sold four million megawatt hours of electricity to the grid and bought back 2.3 million. The trade association estimates, production tax credits could not be claimed on slightly more than half the electricity the paper industry generates from biomass and sells to nearby utilities. The issue is certain to spill over to Congress.
A DEBT-EQUITY SWAP between a US company and the Mexican government produced income for the US company, but because the IRS guessed wildly at the amount, a US appeals court let the company off. Kohler Co., a US maker of plumbing fixtures, planned in 1986 to build a plant to manufacture such fixtures in Mexico. Mexico was buckling under the weight of foreign debt.Mexican sovereign debtwas trading at a steep discount to face value. The government put an enterprising program in place to reduce its debts without having to use scarce foreign currency reserves. If a foreign company planning to invest in Mexico would purchase existing Mexican debt, then the governmentwould exchange the notes at a favorable rate for pesos; the pesos had to be invested in Mexico. Kohler bought Mexican sovereign debt with a face amount of $22.4 million from Bankers Trust Co. for $11.1 million. It then traded the notes with the government for pesos worth $19.5 million at the exchange rate in effect at the time. The IRS said Kohler had to report the $8.4 million difference as taxable income. A US appeals court said Kohler had some amount of income, but the IRS claim that Kohler had $8.4 million in income failed to take into account the restrictions on how the pesos could be used. The court called the effort by the IRS to prove the pesos were worth the full $19.5 million “pathetically short of the mark.”It called the claim by Kohler that it received no more value than the $11.1 million it paid for the notes from Bankers Trust “equally pathetic.”It said the burden would normally be on Kohler to prove that it did not have the income the government said it did, but the government had to pick a number that was at least plausible on its face in order for the burden to shift. In this case, the court said, the government insisted on “all or nothing, lost all, so gets nothing.” The case is Kohler Co. v United States. The appeals court released its decision in late November. Kohler and the IRS agreed that the swap was a taxable exchange, but they disagreed about the amount of income it produced. The court was not sure the swap was a taxable exchange. Another US appeals court said that a US company had no income in a 1997 case called G.M.Trading involving the same Mexican swap program. It said the value the US company received in the swap fell into the category of some government grants that are not taxable to the recipient because they serve a government purpose and leave the taxpayer no better off economically. An example is where a government reimburses a railroad for the cost of elevating its tracks above a highway. Such grants are called nonshareholder “contributions to capital.” The court in the Kohler case did not buy that analysis. It thought the better way to report the transaction would have been for Kohler to take a tax basis in its Mexican plant of only $11.1 million.Thatway, any additional value would be taxed as gain when Kohler makes a future sale of the plant.
A FORECLOSURE SALE of the Great Plains coal gasification project triggered more than $1 billion in income and some recapture of tax credits for the owners. The owners were five interstate gas pipelines. The projectwas built in the early 1980’s in North Dakota to turn lignite into gas of high enough quality that the gas can be put into interstate pipelines. It has been operating since 1984. A partnership of the pipeline companies built the plant using $550 million in equity contributed by the pipelines and another $1.45 billion borrowed from a US government entity called the Federal Financing Bank. The US Department of Energy guaranteed repayment of the loan. Gas prices dropped precipitously just as the project was nearing completion. By August 1985, the project had defaulted on the loan, and the Department of Energy ended up two months later having to repay the Federal Financing Bank $1.57 billion in principal and unpaid interest. The Department of Energy bought the project in June 1986 in a foreclosure sale by exchanging $1 billion of its debt claim against the project partnership. It later wrote off the remaining debt in exchange for the shares of a separate company that managed the project. In 1988, the government resold the project to an electric cooperative in North Dakota called Basin Electric. The pipeline companies argued that they made a sale of the project to the government for only $1 billion and not the full $1.57 billion in outstanding debt. The US Tax Court disagreed. The rule is that when a “recourse”debt is involved, the borrower realizes only the market value of his assets in a foreclosure sale. (A debt is recourse if the lender can pursue the partners personally for repayment of the loan.) However, with a “nonrecourse” debt — or debt where the lender is limited to foreclosing on specific collateral — the borrower realizes the full amount of the debt in the foreclosure sale.The debt in this case was not explicitly labeled.However, the court said itwas nonrecourse in substance because the government was unable to pursue the partners individually for repayment. The court sided with the pipeline companies on the question of when the plant was sold to the government. The pipelines claimed both a 10% investment tax credit and separate 10% energy tax credit in 1984 when the plant went into service. Such tax credits vest ratably over five years.Thus, for example,if the plantwas sold one year after it went into service, then 80% of the tax credits would have been recaptured. The pipelines argued that the foreclosure sale was not completed until November 1987 when the US Supreme Court declined to hear an appeal of the foreclosure. A sale is not final while it is still being appealed (and the sale date does not relate back once the appeals are exhausted). The IRS argued that the appeal was a sham with no purpose other than to delay when tax credits would be recaptured.The court declined to be drawn into a debate over motives. The case is Great Plains Gasification Associates v.Commissioner.The court released its decision on December 27.
INCOME FROM FOREIGN SUBSIDIARIES was an issue in two states. The New Hampshire Supreme Court told General Electric that it could not deduct dividends the company received from foreign subsidiaries in arriving at its New Hampshire tax base. New Hampshire collects a “business profits tax”from companies doing business in the state. First, it determines the scope of any “unitary business”like GE that has lots of subsidiaries.The income of the entire unitary business is calculated, and then a share of the group income is apportioned to New Hampshire based on the property, payroll and sales of the group in the state. Dividends and royalties paid by one domestic entity in the group to another group member are ignored.The group stops at the water’s edge. Thus, income earned by offshore subsidiaries is not part of the group income that is apportioned. However, it appears that dividends any group member receives from a foreign subsidiary are counted as part of the unitary group’s income that is then apportioned partly to New Hampshire. GE wanted to deduct foreign dividends from the group income. The court said no. It cited a US Supreme Court decision involving Mobil Oil Corporation in 1980 that it said confirms that a state has the right to tax foreign-source dividends that are received by a corporation doing business in the state. The case is General Electric Company v. Commissioner. The court released its decision in early December. The Minnesota Supreme Court grappled with a related issue. A US corporation doing business in Minnesota had a French subsidiary. It filed a “check-the-box”election with the IRS to treat the French subsidiary as transparent for US tax purposes. Minnesota follows a similar procedure as New Hampshire. It first determines the unitary business and then apportions part of the group’s income to Minnesota based on the sales, payroll and property in the state. However, Minnesota law says that the income of any foreign entities that are part of the unitary group in theory are excluded from apportionment (and their sales, property and payroll are also ignored when doing the apportionment). The issue was whether the income from the French entity had to be included when the company opted to treat the French company as transparent for US tax purposes. The court said no. It said the election to treat it as transparent had meaning only for federal income tax purposes.The case is Manpower, Inc. v. Minnesota Commissioner of Revenue. The decision was released in early December.
MINOR MEMOS. A group of power companies is pressing the IRS to relax technical restrictions that could limit their ability to claim tax benefits from “domestic manufacturing.” US companies that manufacture at home are not taxed on 6% of income from such manufacturing through 2009 and 9% after.However, the annual deduction is capped at 50% of wages paid to employees engaged in such manufacturing. Generating electricity is considered manufacturing. Transmitting or distributing it is not. The power companies want the IRS to make clear that employees count as engaged in manufacturing if they are in a separate entity that operates and maintains a project under an O&M contract with the project company. They are asking that wages paid to employees of the contract operator should count as good wages in cases where all the income from both the power project and the contract operator gets folded into the same consolidated tax return . . . . Most large companies use the accrual method of accounting to determine their taxable income. That means they report income or deductions when they “accrue” rather than waiting for cash to change hands. The IRS ruled in late December that an accrual taxpayer who signs a contract in December 2006 for services that will be performed in January 2007 or for insurance that will run from January to December 2007 cannot deduct its payments until they are actually made in January 2007. Three things must have occurred before a deduction can be taken under the accrual method. The taxpayer must be legally obligated to make the payment, the amount must be at least reasonably ascertainable, and “economic performance” must have occurred. The IRS said economic performance occurs under the service contract when the services are performed in January 2007. It said economic performance occurs under the insurance contract when the premium is paid. The ruling is Revenue Ruling 2007-3.