The market reacts to possible US tax reforms
The possibility that Congress will overhaul the US tax code is already having a number of effects on the market.
Corporate tax reform is unlikely to start moving through Congress before the spring. It is unlikely to reach the President’s desk before December 1 at the earliest.
The House tax committee staff has been working to convert a 35-page blueprint released last June into bill language. The House plan would make five major changes of consequence to the project finance community. It would reduce the corporate income tax rate to 20%, allow the full cost of assets purchased to be deducted immediately, deny interest deductions, exempt export earnings from income taxes, and deny any cost recovery on imported goods and services.
The most controversial part of the House plan is the “border adjustment” or treatment of imports and exports. Economists say that the dollar would strengthen enough to offset the additional tax burden on importers. US retailers and oil refiners have lined up against the plan. President Trump “does not love it.” He has seemed more interested in import tariffs. The border adjustment would raise roughly $1.2 trillion in additional taxes. Without it, the plan is too costly.
The Senate tax committee chairman, Orrin Hatch (R-Utah), suggested in a speech to the US Chamber of Commerce in early February that the Senate will write its own tax bill. Hatch said “at least half the Senators” have reservations about the border adjustment. Four economists that are the godfathers of the plan released a 98-page paper through Oxford University in late January explaining how the tax would work.
Progress has stalled while Congressional Republicans await a Trump plan that the President has promised to release in late February.
The House plan would have a number of effects.
The tax rate reduction would mean less tax equity will be raised on renewable energy projects in the future. Tax equity accounts for roughly 50% to 60% of the capital stack for the typical wind farm and 40% to 50% for the typical solar project. Any reduction in the percentage of tax equity will have to be made up with more debt or equity.
Lower tax rates would also ultimately reduce the supply of tax equity, although how much is unclear. Three banks account for roughly 40% of the US tax equity market. It is unclear to what extent they will be constrained by tax capacity, even at lower rates, or whether any limit on the amount they invest is tied more to the need for risk diversification. Tax equity yields are a function of demand and supply. A dip in supply while demand remains constant could lead to slight upward pressure on yields.
Debt would be more expensive. Some companies are moving to sign up corporate or construction revolvers so that interest remains deductible. Transition rules should normally shield companies from a loss of interest deductions on outstanding debt. However, a substantial modification of the terms of an existing debt would lead to loss of interest deductions, since the company would be considered to have entered into a new loan.
Many wind companies signed “PTC components” contracts in 2016 in order to qualify for production tax credits at the full rate on wind farms they will build over the next four years. Follow-on agreements are being negotiated for the rest of the turbines. Developers may pressure vendors to supply turbines from US factories.
The vendor may be the one exposed in cases where final assembly occurs in the United States from imported parts. Backers of the border adjustment argue that it is equivalent to a value-added tax, but with the ability to deduct wages. If true, then a turbine vendor assembling equipment in the United States from imported parts could find itself paying US income taxes on close to its gross receipts because of inability to treat the imported parts as a cost of goods sold. Whether it works this way in fact will depend on how the House tax committee staff decides to implement the border adjustment. There is more than one way to do it.
The last time Congress overhauled the US tax code in 1986, project developers rushed to sign binding contracts to lock in tax benefits ahead of the first vote in the House tax committee. The US constitution requires tax bills to originate in the House. Congress does not usually hold out a carrot to induce companies to invest and then withdraw it after they have already committed to investments. The 1986 Tax Reform Act repealed the investment tax credit and slowed depreciation allowances, but it had numerous transition rules that let companies that signed binding construction contracts or power purchase agreements that committed them to projects complete the projects, within time limits, and still claim the tax benefits on which they were counting when signing such contracts.
It is a tougher call this time for developers whether to lock into contracts. There is no protection from tax rate changes. “Anti-churning” rules can be expected to prevent anyone who locked into an investment from claiming any faster depreciation that is allowed under the newly revamped tax code.
There is the potential for a freeze in some types of investment to await better cost recovery.
Some tax equity investors are already pricing based on a 25% tax rate. For existing partnership flip transactions, the lower tax rate could delay or accelerate the flip, depending on when during the life of the deal it takes effect. The earlier in the deal, the more likely it will lead to delay. Delay means the developer will end up having to use cash on which the developer was counting to get the tax equity investor to the flip yield.
The later in the deal the tax rate change takes effect, the more likely it is to accelerate the flip. Partnership flip documents routinely bar a flip in sooner than five years to comply with Internal Revenue Service guidelines. An acceleration in the flip could complicate wind deals since the flip may occur before the production tax credits have run.
Flip deals signed this year may end up with additional pay-go payments by tax equity investors that are a function of the remaining tax credits, especially for deals that price by assuming a 25% tax rate in event that the rate reductions are delayed or are ultimately not as steep. IRS guidelines limit the permitted pay-go payments to no more than 25% of the total tax equity investment.
Most sponsors already bear the risk that tax rates or depreciation calculations will change in partnership flip transactions in which the tax equity flips after reaching a target yield. In time-based flips where the tax equity investor flips on a pre-set date, the tax equity investor takes tax-change risk. At least one investor in such transactions is now asking sponsors for an indemnity to make up any loss in value of tax losses.
Tax equity investors will want to take the 50% depreciation bonus this year to accelerate deductions against the current 35% tax rate. They should have an interest in closing deals this year ahead of any tax rate deduction.
There could be a pause in the market at some point during the year once statutory language is released while the market digests the contents.
However, if, as many tax lobbyists predict, any tax rate reduction does not take effect before 2018 and is phased in over time to manage the cost, the market could have an incentive to close as many deals as possible this year against the higher tax rate.
Other Structuring Challenges
Full expensing of capital costs will complicate deals after this year. Tax equity investors pay only a fraction of the full project cost for an interest in a project partnership. Each partner has a capital account that limits the amount of depreciation it can claim. Investors will run out of capital account in the first year causing the remaining depreciation to shift to the sponsor. The shift could also drag tax credits with it, making the financings less efficient.
Falling electricity prices combined with the tax rate reduction may bring back project-level debt. It has been rare to find debt at the project level in transactions in the last few years. Tax equity investors have pushed lenders behind them in the capital structure. Most debt today is back-levered debt at the sponsor level. The lender looks to the sponsor share of cash flows to pay debt service. Lower electricity prices are pushing deficit restoration obligations in flip deals to the 40+% range, meaning that investors are running out of capital account before they are able to absorb the full depreciation they want. The main way investors deal with this problem is to agree to invest more when the partnership liquidates in order to cover any negative capital account. This allows them to continue taking tax losses despite having a negative capital account. The 40+% is a promise to invest up to another 40+% of the original investment. Investors are reluctant to agree to DROs that are much higher. Adding debt at the project level is another way to allow the investor to absorb more depreciation.
In deals with multiple fundings, the parties are negotiating how far into the legislative process a proposed adverse tax law change must have moved before it becomes a reason to suspend further fundings. Most transaction documents make it a condition to further fundings that there not have been a materially adverse “proposed change in tax law.”
Meanwhile, developers are wrestling with what cost of capital to assume when bidding for power purchase agreements. It may be hard to get utilities to adjust the electricity price to hold the project harmless from a change in tax law.
In acquisitions — M&A deals — some buyers are asking for “schmuck insurance.” They want a one-time price reset after the tax overhaul bill is enacted. No one wants to feel like a schmuck for having overpaid.
Operating projects should be more valuable because the projected after-tax cash flows will be higher. This could help yield cos. Any appreciation in the dollar caused by the border adjustment will make US assets more valuable while at the same time reducing the value of US companies’ holdings overseas.
Some lenders making tax equity bridge loans in solar deals are demanding a sponsor guarantee in view of the uncertainty. Back-levered lenders are concerned about the potential lengthening of tax equity tenors as more cash shifts to tax equity investors to make up for loss in time value of depreciation due to a tax rate change. However, the shorter the tenor of the back-levered debt, the less likely this will be an issue.