Depreciation bonus questions answered
Depreciation bonus regulations that the Internal Revenue Service issued in September 2019, and then tweaked in September 2020, answer a number of questions that have been coming up in M&A and tax equity transactions.
A large tax-cut bill enacted in late 2017 allows the full cost of equipment to be written off immediately rather than depreciated over time. This is called a 100% depreciation bonus.
Such a bonus may be claimed on equipment acquired and put into service after September 27, 2017.
Equipment that straddles September 27, 2017 — it was acquired or was under a binding contract to be acquired before September 27 and is put in service after — qualifies for an immediate write off of from 50% to 30% of the cost, with the rest of the depreciation to be taken over time, depending on when the equipment is put in service. Straddle equipment qualifies for a 50% bonus if it was put in service in 2017, 40% in 2018, 30% in 2019 and 0% after that.
The 100% bonus will end in December 2022, but then phase down at the rate of 20% a year through 2026. Most assets must be in service by then to qualify for any bonus. However, assets, like transmission lines, gas pipelines, and gas- or coal-fired power plants will have an extra year to get into service, but only the tax basis built up through the deadline without the extra year will qualify for whatever bonus applies.
The 100% bonus can be claimed on both new and used equipment. However, the used equipment cannot be acquired from a related party, meaning from another company with whom the buyer has more than 50% overlapping ownership.
Regulated public utilities do not qualify for a bonus. Real estate businesses have a choice: they can choose between a 100% bonus or being able to borrow without a new limit on interest deductions.
A depreciation bonus has been available at different levels since late 2001. Most tax equity investors have been uninterested in claiming it, except in 2017 when Congress was expected to reduce the corporate tax rate and investors tried to accelerate deductions to take them against the high rate. Tax equity investors would rather spread their scarce tax capacity over more projects than use up tax capacity immediately as deals close.
Companies can opt out of the 100% bonus and depreciate assets over time. The bonus is automatic unless an election is filed not to take it. The election is made at the entity level and binds the entity to the same choice for all assets put in service that year in the same asset class. Thus, for example, an election can be made not to take the bonus on equipment that would otherwise be depreciated over five years, while keeping the bonus on other assets. Similarly, one partnership can choose to take the bonus while another partnership formed by the same developer can choose a different path.
Corporations that join together in filing a consolidated tax return are treated as a single company. Elections made by the parent corporation bind the entire group of corporations.
The regulations answer a number of technical questions that modelers have been asking in M&A and tax equity transactions.
Many projects in the power and other infrastructure sectors are owned by limited liability companies that are treated as partnerships for US tax purposes. In addition, most tax equity raised in the renewable energy market takes the form of partnership flip transactions. (For more information, see “Partnership flips” in the April 2017 NewsWire.)
When someone buys a partnership interest at a premium to the remaining “basis” the partnership has in a project, the buyer can depreciate the premium by having the partnership make a section 754 election to step up basis.
Bidders in M&A deals ask whether this step-up depreciation can be taken entirely in the year the partnership interest is purchased. The IRS said yes, in most cases.
The step-up depreciation is considered depreciation on used property if the project was already in service. A bonus can be claimed on used property, but not if the buyer owned an interest in the property earlier. The IRS does not look through a partnership for this purpose. Thus, for example, a partner who has a 30% interest in a partnership that increases to 50% by buying an additional interest from another partner can claim the bonus on any step-up depreciation on the additional 20% interest. The buying partner must not have owned the partnership assets directly before they were put in the partnership within the last five years. The buying and selling partners cannot be affiliates.
The IRS also said it does not matter if the partnership opted out of the bonus for the year someone buys or increases a partnership interest. A separate election would have to be made by the partnership not to claim a depreciation bonus on the step-up.
Tax equity issues
A tax equity partnership may be put in place in one of three ways.
The developer may be treated as contributing the whole project to a new partnership with the tax equity investor. Alternatively, the investor may be treated as having bought an undivided interest in the project from the developer, with both the developer and investor then contributing their undivided interests to the partnership. Finally, both the developer and investor may make capital contributions to a new partnership that the partnership uses to buy the project company.
If the project was already in service in the first two models — as opposed to the project-company-sale model — then depreciation on the asset must be split between the partner making the contribution and the partnership based on the number of months that each owned the asset during the year of contribution. The depreciation for the month in which the asset is contributed belongs to the partnership.
However, the depreciation bonus works differently in one situation. That situation is where one of the partners owned an interest in the project before the project is contributed to the partnership and the project is first put in service and then contributed to the partnership in the same tax year it went into service. In that situation, the depreciation bonus for the project (or in a wind project, an individual turbine, pad and tower put in service before its contribution) will be split among the partnership and the contributing partner based on the number of months each owned the project or turbine in the year it is placed in service. It is complicated if the contributing partner and the partnership have different tax years. Depreciation allocated to the month in which the partnership is formed belongs to the partnership.
Another basic principle is that a company may not take any depreciation on an asset that it places in service and sells in the same year.
Putting these two principles together, suppose a tax equity investor comes into a project by paying the developer directly for an interest in the project after the project is in service. The developer would not be able to claim any depreciation on the share of the project considered sold to the investor. The investor should be entitled to a bonus even if the project was already in service. A bonus can be claimed on used property. However, any such bonus would remain with the investor outside the partnership. The investor is considered to buy and immediately contribute an undivided interest in a project that is already in service. (However, if the project was originally put in service in the same month these transactions occur, then the bonus may belong to the partnership.) The partnership takes the asset with a zero basis and with a “built-in gain” that leads to something called section 704(c) adjustments inside the partnership. Section 704(c) adjustments are discussed below.
Two other questions people have been asking in tax equity partnership deals have to do with “section 704(c) adjustments” and “excess cash distributions.”
If a project has appreciated in value before the tax equity investor makes its investment, then the partnership will have to make something called “section 704(c) adjustments.” They address a fairness issue. If A and B form a 50-50 partnership with the understanding that each will contribute $50, and A contributes an asset worth $50 that it spent $30 to build and B contributes $50, then it is not a good deal for B because B will end up having to pay 50% of the tax on the $20 “built-in gain” in the asset that A contributed some day in the future when the partnership sells the asset. Section 704(c) requires that A make it up to B by shifting depreciation to B to which A would have been entitled. This has the effect of causing A to pay tax on the built-in gain over the same period the depreciation is shifted.
Partnership agreements choose how quickly to make these adjustments. The most rapid adjustments are through use of the “remedial” method. In that case, the developer reports most of the built-in gain on a wind or solar project over five years in a manner that mirrors the 5-year MACRS schedule.
Now with a 100% depreciation bonus, is it possible that the full built-in gain would have to be reported immediately if the remedial method is chosen? The IRS said no.
Another question the IRS addressed has to do with excess cash distributions. Each partner in a partnership has a capital account and an outside basis. These are two ways to track what the partner put into the partnership and is allowed to take out. They go up and down to reflect what is happening inside the partnership. Once a partner’s outside basis hits zero, then any further cash the partner is distributed must be reported as capital gain. This makes for an inefficient deal structure since cash does not normally have to be reported as income.
Whenever there is such an excess cash distribution to one of the partners, the partnership steps up its “inside” basis in the project. This leads to more depreciation. The IRS said this additional depreciation cannot be taken as a depreciation bonus.
The regulations also address some issues in leasing transactions.
Regulated utilities are not allowed to claim a depreciation bonus on equipment used to supply electricity or services at regulated rates of return. People ask what happens if the utility sells and leases back equipment to a tax equity investor: can the lessor claim a bonus? The answer is yes. The lessor cannot be a regulated utility itself.
An example in the regulations makes clear that a lessee of equipment who exercises a purchase option can claim a 100% bonus. However, the example involves a lease rather than a sale-leaseback. The lessor bought the equipment directly from the manufacturer and then leased it to the lessee. None of the sale-leaseback examples in the regulations addresses what happens if the original transaction was the lessee bought the equipment from the manufacturer and sold and leased it back.
Finally, wind and solar companies have been racing to start construction of projects ahead of deadlines to qualify for federal tax credits. One way to start construction is to start “physical work of a significant nature” on the site or at a factory on equipment for the project. Any such work must not start before a binding contract is in place for the work. People ask whether it is enough that the contract is binding on the developer or whether it must also be binding on the construction contractor or equipment vendor. The IRS said a contract is not considered binding for depreciation bonus purposes unless it is binding on both.