Tax change risk
Change-in-tax-law risk is getting more attention in deals.
The Trump victory in November and Republican control of both houses of Congress make corporate tax reform more likely in 2017. House Republicans are focused on a tax reform blueprint that they released last June. (For more details, see “House GOP Tax Reform Plan” in the August 2016 NewsWire.)
The plan would reduce the US corporate income tax rate from 35% to 20% and greatly accelerate depreciation on new equipment. Companies would be allowed to “expense” such equipment, meaning deduct the full cost immediately.
However, the centerpiece of the plan is a shift to a destination-based cash-flow tax.
US companies would not be taxed on earnings from exports of goods and services. They would not be allowed to deduct the cost of imports. This could have a significant effect on the renewable energy sector, since a substantial amount of wind and solar equipment is manufactured overseas.
Battle lines are already forming around the denial of cost recovery on imported equipment, with Koch Industries and retailers like Walmart lining up against it.
Republicans on the House tax committee have scheduled two days of meetings in mid-December to focus on how the plan would work.
A November 30 paper circulating in Washington by Alan Auerbach, a Harvard-trained economist, and Douglas Holtz-Eakin, a former director of the Congressional Budget Office, explains. The authors compare the border adjustments to what happens under a value-added tax in Europe. Any VAT paid on goods that are ultimately exported is refunded. Imported goods are fully taxed. The authors argue that denying cost recovery on imported equipment is equivalent to subjecting such equipment fully to US tax.
Interest would not be deductible under the House tax plan, so companies with more debt in their capital structures would generally fare worse and those with higher capital investment would fare better because of expensing, but firms that have both high debt and high capital investment in imported equipment would be much worse off.
The paper suggests the dollar should strengthen, taking some of the sting out of the loss of cost recovery for imported equipment since that equipment will be cheaper to purchase; it will cost less in dollars.
Companies that export a lot may end up with large tax losses for their costs in the United States, but no income.
It appears the Trump team is gravitating toward the House plan. Two possible differences are Trump called during the campaign for a 15% corporate tax rate, and he proposed to give US companies a choice between cost recovery and deducting interest.
The risk of corporate tax reform is playing out a number of ways in deals.
Sponsors already take the risk of a shift in tax rate in most tax equity transactions in the renewable energy market.
Increasingly lately, they also take the risk that the depreciation calculations will change. Any acceleration of depreciation will work to their benefit.
There has been more focus since the election in tax equity transactions where there is more than one funding on the point in the legislative process at which the tax equity investor can stop funding. For example, in the solar rooftop market, the tax equity investor makes continuing investments over a year as new tranches of solar systems are added to the financing. This has led to debate over whether funding can stop when either house of Congress passes an adverse tax law change or whether funding can stop earlier: for example, when a tax committee first votes or the House Republican tax plan is first released in bill form.
The last time Congress did a comprehensive overhaul of the US tax code was in 1986. It repealed the investment tax credit, effective at the end of 1985, and it slowed down depreciation allowances effective in March 1986. There were numerous transition rules to let companies that committed to investments before the effective date see their investments through with the old tax benefits.
The key was the companies had signed binding contracts. For example, the fact that a company signed a binding construction contract or a power purchase agreement committing to build a particular project was enough to entitle the company to transition relief.
Tax reform bills tend to start moving through Congress without transition relief. The Joint Tax Committee staff expects companies that would be treated unfairly by a tax law change to come describe their situations. The committee staff can then fashion broad transition rules to cover deserving cases. The tax committee chairmen also tend to use transition relief as leverage to pick up votes for the larger package of tax reforms.