House tax bill: effect on market
A draft tax-cut bill released Thursday by the chairman of the House tax-writing committee is a mixed bag for the power industry and infrastructure trade.
There are provisions affecting renewable energy companies, the tax equity and debt markets, partnerships, interconnection payments to utilities, inbound US investment, cross-border payments between related companies, cross-border earnings stripping, funding for infrastructure projects and other activities.
The House tax committee will "mark up" the bill starting Monday and then send it to the full House for a vote. The contents may shift by Monday as the committee works to keep the revenue loss within bounds. Republicans leaders are eager to move the bill quickly through Congress. The Senate has already started working behind closed doors on its own version.
Financings of wind projects may stall until the measure ultimately clears Congress.
The bill will also complicate life for developers bidding on new power contracts.
Wind projects qualify for 10 years of production tax credits at a declining fraction of the full the PTC rate of $24 a MWh, depending on when they start construction. Projects that were under construction by December 2016 qualify for tax credits at the full rate. Projects that start construction in 2017 qualify for tax credits at 80% of the full rate.
The IRS said construction could start in one of two ways. A developer could incur at least 5% of the project cost. Or it could start physical work of a significant nature at the site or at a factory on equipment for the project.
Many developers took delivery of turbine components or dug turbine foundations, put in roads or had work start at the factory on transformers as a way of starting construction in 2016 or an earlier year.
The House bill casts doubt on whether many of these projects qualify. It would require "continuous construction" of projects after construction starts.
The IRS has also been requiring continuous work, but it said it would not make developers prove such work on any project that is completed within four years. The IRS also allows companies that started working by incurring at least 5% of the project cost to prove only "continuous efforts" on a project. The House bill would walk back both of these IRS policies. The change is retroactive.
The bill would also roll back the PTC amount to $15 a MWh, with no future inflation adjustments, for any project on which construction starts after November 2, 2017, according to a summary of the bill prepared by the committee staff, or after the bill becomes law, according to the actual bill language. A developer who cannot prove continuous construction on projects on which it started construction before this year could restart construction in 2017, but the tax credits for which the project would qualify would suffer not only from the declining phase-out percentage, but also from the rollback of the underlying credit amount.
The American Wind Energy Association warned attendees at its annual finance conference in late Octobe not to panic if the House bill backtracks on the phase-out deal the industry negotiated for production tax credits at the end of 2015. It is optimistic that the Senate will act as a "firewall" and preserve existing law. However, it also warned against complacency.
Investment tax credits
Solar fares better.
The bill would preserve the current phase-out schedule and amounts for the solar investment tax credit. Solar projects qualify for a 30% ITC if under construction by December 2019. Projects that start construction in 2020 qualify for a 26% credit and in 2021 qualify for a 22% credit.
"Orphan" technologies -- fuel cells, CHP projects, geothermal heat pumps, fiber-optic solar property -- would be given an extension of their ITCs on the same solar phase-out schedule.
Projects would have to prove "continuous construction" after construction starts to qualify for tax credits. However, this is not an issue for projects that are put in service by 2019.
The permanent 10% investment credit for solar and geothermal projects would be repealed. That was expected. However, it would not be repealed for projects that start construction by 2027.
Residential solar credits would be extended past 2019. Residential solar equipment purchased by homeowners would qualify for a 26% tax credit if put in service in 2020 and 22% credit in 2021. This could help prolong the current growth in direct sales of solar rooftop systems.
Corporate tax rate
The corporate tax rate would be reduced to 20% starting in 2018. It is 35% currently.
This may complicate tax equity transactions that closed earlier this year where investors sized their investments based on a higher tax rate. Many such deals require a repricing once a tax reform bill is enacted. The lower tax rate means less value from the depreciation on projects. The developers may end up having to give back cash to resize the investments. However, the tax rate may not settle ultimately at 20%. The tax cuts in the bill add up to $5.5 trillion over 10 years. The budget resolution under which the tax bill will be considered requires finding $4 trillion in new revenue so that the bill does not add more than $1.5 trillion in total to the national debt. The Senate will be under pressure to phase in the tax rate over time to manage the cost.
Income that individuals receive from partnerships, S corporations and other pass-through entities will be taxed at a 25% rate, rather the top rate of 39.6% that applies to ordinary income.
The bill has "guardrails" to prevent lawyers, doctors and other professionals from turning what is essentially compensation into more lightly-taxed income.
Passive investors in partnerships will be assumed not to be receiving compensation. Income received by active partners will be assumed to be 70% compensation and 30% return on investment. Only the latter would qualify for the lower pass-through rate. An active partner could opt instead for use of a formula and treat as an investment return the share of his or her income in a year equal to 700 basis points above the federal short-term rate times the partner's share of the tax basis the partnership has in its assets. Personal service businesses like law firms could use the alternative formula, but not the 70-30 approach.
The bill would allow the full cost of equipment to be written off immediately rather than depreciated over time.
The change applies to equipment acquired and put into service after September 27, 2017.
Equipment that straddles September 27 -- it was acquired or was under a binding contract to be acquired before September 27 and is put in service after -- would qualify for an immediate write off of from 50% to 30% of the cost, with the rest of the depreciation to follow, depending on the facts.
Full expensing would end in December 2022. Most assets would have to be in service by then to qualify. However, assets, like transmission lines, gas pipelines, and gas- or coal-fired power plants would have another year through 2023 to get into service, but only the tax basis built up through 2022 could be written off immediately.
Expensing is essentially a 100% depreciation bonus. There is currently a 50% depreciation bonus, but it only applies to new equipment. The 100% bonus could be claimed on used equipment.
Regulated public utilities and real estate businesses would not qualify.
Most tax equity investors have been uninterested in the 50% depreciation bonus. They would rather spread their scarce tax capacity over more projects. However, most have been claiming it in 2017 as a way of mitigating the effects of potential future tax rate reductions. It is better to deduct as much as possible in 2017 before the tax rate goes down.
The House bill would let developers opt out of the 100% bonus and depreciate assets more slowly. This will help manage how quickly tax equity investors exhaust their capital accounts in partnership flip transactions. Once the capital account is exhausted, the remaining depreciation shifts back to the developer and could drag tax credits with it.
The bill would deny interest deductions on debt starting in 2018 to the extent a company's net interest expense exceeds 30% of its adjusted taxable income. Its income for this purpose means income ignoring interest expense, interest income, NOLs, depreciation, amortization and depletion.
Any interest that cannot be deducted can be carried forward for up to five years.
The limit on interest deductions would not apply to any business with average gross receipts of $25 million or less.
It would not apply to regulated public utilities and real estate businesses.
The House tax committee estimates that 95% of businesses would not be affected.
The limit is calculated at the partnership level where a project is owned by a partnership. Any excess interest deductions being carried forward would remain with the partnership.
The bill does not grandfather existing debt.
Transfers of partnership interests after 2017 would no longer cause a partnership to terminate for tax purposes. The market goes to great lengths currently to avoid terminating partnerships for tax purposes. A partnership terminates currently if 50% or more of the profits and capital interests in a partnership are transferred within 12 months, and the depreciation has to restart, causing some loss in time value of tax benefits.
The bill would tax corporations and partnerships on capital contributions to the extent the contribution exceeds the value of any corporate shares or partnership interest received in return. The committee staff said this is supposed to force companies to pay taxes on reimbursements or benefits from states or municipalities to induce companies to relocate and bring jobs.
The provision may create confusion over whether utilities must report cost reimbursements from independent generators to pay for network upgrades to accommodate a new power plant or storage facility when it connects to the grid. The IRS has not required utilities to pay taxes on such reimbursements on grounds that they are a form of capital contribution from someone who is not a shareholder.
Private activity bonds
States and municipalities would no longer be able to issue "private activity bonds" after this year to finance water, sewage treatment or solid waste disposal facilities, airports, toll roads, bridges and other types of infrastructure projects that involve more than 10% "private business use." An example of private business use is where a private party will own or have a concession over the project. The interest on such bonds issued after 2017 would be taxable.
The bill would replace earnings stripping rules that currently limit the ability of foreign companies with US subsidiaries to "strip" US earnings by capitalizing the US subsidiaries with debt and pulling out the earnings as interest on the debt. Interest can be deducted, so earnings paid out in this form go untaxed to the US subsidiary.
The new limits would apply only to companies that are part of an "international financial reporting group," meaning a group of US and foreign companies that prepares consolidated financial statements and has annual global gross receipts of more than $100 million. The group must have at least one foreign corporation engaged in business in the United States or at least one US and one foreign corporation.
Starting next year, any US member of such a group could not deduct interest to the extent the US corporation's share of the group's global interest expense exceeds 110% of its share of the global EBITDA earned by the group. In other words, its share of global interest expense is disproportionate to its share of global earnings.
The bill would impose a 20% excise tax on any cross-border payments (other than interest) from a US corporation to a related foreign corporation that are members of an international financial reporting group.
The tax applies to payments that the US company deducts or adds to the basis of depreciable assets in the US. It can be avoided if the foreign company receiving the payment files a US tax return reporting the payment as income in the United States. No excise tax would be collected on payments for intercompany services that are billed at cost.
The tax would not apply until 2019.
The bill would move the US closer to a territorial tax system where US companies are taxed only on their income from US sources.
US companies have at least $2.6 trillion parked currently in offshore holding companies.
The bill would subject these untaxed earnings to US tax as if the earnings had been brought back to the US, thereby triggering a tax. All post-1986 net "earnings and profits" would be taxed at a 12% rate to the extent they are being held in cash or cash equivalents and at a 5% rate otherwise. Companies would have to calculate the earnings as of November 2, 2017 and December 31, 2017 and pay US tax on whichever amount is higher.
The taxes could be paid ratably over eight years.
Foreign taxes paid on the earnings would be available for use as an offsetting foreign tax credit, but with appropriate adjustments to reflect the reduced level of US tax.
Foreign high returns
The US will look through foreign subsidiaries of US companies with "foreign high returns" and tax 50% of such returns. A foreign high return means more than a routine return. The US government will look at the amount by which the aggregate net income of all foreign subsidiaries owned by a US parent company exceeds 700 basis points above the federal short-term rate times the aggregate tax bases the foreign subsidiaries have in assets. The asset bases will be adjusted downward by interest expense.
If a tax applies, it will be collected on the earnings to the extent they exceed what the government considers a routine return.
Any taxes paid abroad on the same earnings can be claimed as a foreign tax credit in the United States. However, only 80% of the foreign tax paid would be allowed as a credit.
The provision is directed at high-tech companies that move their intellectual property offshore, but it casts a wider net.
The bill is 429 pages. The goal of simplifying the US tax code appears to have receded.