Depreciation Bonus Clarified

Depreciation Bonus Clarified

April 07, 2015

The Internal Revenue Service answered many questions that US companies had about when a “depreciation bonus” can be claimed on new power plants, transmission lines, LNG terminals, toll roads and other new infrastructure projects in regulations the agency issued in September.

The depreciation bonus is a limited-time offer by the US government to reward companies that spend money on capital improvements during a “window period” that started September 11, 2001 and ends in December 2004 or 2005, depending on the project.

The bonus is the right to deduct 30% or 50% of the cost of new capital improvements immediately. The remaining cost is deducted over the normal depreciation schedule.

The tax savings from a 50% bonus are worth as much as 9% of the capital cost of a project.

Projects must be completed during the window period to qualify. Only spending on assets that will be used in the United States or in US possessions like Puerto Rico and the US Virgin Islands qualifies. The Bush administration hopes that an increase in such spending will help revive the US economy.

Only New Equipment

The bonus is a reward for spending on new equipment. For example, about 95% to 97% of spending at a typical power project is for equipment as opposed to a building. Only the spending on equipment would qualify.

There is no bonus for investing in an existing facility — “existing” means it was already in operation when the taxpayer made the investment — with three exceptions. First, new improvements to an existing plant qualify. Second, a project developer without the tax base to use the bonus can transfer it (along with the remaining depreciation) to another company by selling and leasing back a project within three months after the developer put the project into service. Third, a project developer can contribute the project to a partnership with a new investor at any time during the same tax year the project went into service. The investor will get a share of the bonus. The IRS will require that the bonus be allocated between the project developer and the partnership based on the number of months that each owned the project during the year.

Some companies had wondered whether it would be possible to create a bonus where the project developer could not have claimed one — for example, because the project developer got started on the project too early to qualify — by selling the project to someone else during the window period and leasing it back. The IRS appears to have intended to say no. It wrote an “anti-churning rule” into the new regulations. However, the anti-churning rule is not well drafted. It rules out sale-leaseback transactions to create bonuses in cases where the project developer (or a related party) signed a binding contract to “acquire” the project from someone else, but not where the project developer is considered to be “self constructing” the project. The vast majority of infrastructure projects are self constructed. The anti-churning rule applies retroactively to when the bonus was first enacted.

During the last few years, too many gas turbines were ordered from manufacturers than are needed today. Some merchant power companies have had to take delivery of the turbines, but then parked them in warehouses. If a developer were to buy one of these turbines today and use it, he could claim a bonus on the cost of it. That’s because the turbine was never put into service by anyone. Property is not considered used equipment until it has been in service.

On the other hand, if a developer bought a used turbine from a utility to incorporate into a new power plant, a bonus could not be claimed on the cost of it. A bonus cannot be claimed on used equipment.

This raises the question whether companies need meticulously to catalog whether used parts are used in the construction of their facilities. The answer is no. A company should determine whether parts that are large enough to qualify as separate “components” of a project are used property. The IRS did not try to define “component” in the new regulations. Smaller parts are considered subsumed in a larger property, and unless more than 20% of its value is tied to the cost of used parts, the larger property is considered entirely new. Thus, for example, if a developer bought an older wind farm and rebuilt it using the latest generation of wind turbines, the entire project should qualify for a bonus — including the cost of acquiring the existing project — as long as the existing equipment does not account for more than 20% of the value of the wind farm after reconstruction.

Previously Committed?

The bonus is supposed to encourage new investment after the terrorist attacks on the Pentagon and the World Trade Center. Therefore, a taxpayer cannot claim a bonus on any investment to which he was “committed” before September 11, 2001.

The power industry spent more than a year talking to senior Treasury and IRS officials and staff on Capitol Hill about what it means to have been “committed.” Most power plants and other infrastructure projects have such long gestation periods that any project that is completed during the “window period” for the bonus would necessarily have had to have been under development before the terrorist attacks.

The IRS regulations take a generous approach. Most projects should qualify for a bonus as long as work “of a significant nature” did not start at the site before September 11, 2001. Site clearing, test drilling and excavation to change the contour of the land is not considered the start of work at the site. Work “of a significant nature” is considered to commence at the site once work starts on the foundation. The IRS said that driving pilings into the ground counts as work on the foundation. However, it adopted a “safe harbor” under which work is not considered to have reached the threshold “of a significant nature” until the taxpayer has incurred more than 10% of the expected total cost of the project. Spending on “land and preliminary activities such as planning or designing, securing financing, exploring, or researching” design is ignored: it is not counted in either the numerator or the denominator. Thus, if a project is expected to cost $300 million after backing out soft costs that are not allocated to the hard assets and after backing out the cost of the land, design work and other preliminary activities, work is not considered to have reached the threshold “of a significant nature” until the taxpayer has incurred more than $30 million.

The starting point for analyzing whether a project qualifies for a bonus is to decide whether the taxpayer is “acquiring” the project or “self constructing” it.

“Acquired” property qualifies for a bonus only if the taxpayer did not sign a “binding” contract to acquire it before September 11, 2001.

“Self-constructed” property qualifies as long as the taxpayer had not started work “of a significant nature” at the site before September 11, 2001.

Most infrastructure projects are considered self constructed. Congress wrote an unusually broad definition of “self constructed” into the law, and the IRS accepted it in the regulations. Property is considered self constructed as long as the taxpayer signed a contract with the manufacturer to have the property built for him before physical assembly of the property started. Thus, for example, purchase of existing equipment out of inventory would not qualify. However, in the typical power project, the developer signs a construction contract with an outside contractor before work starts at the site. Turbines that a power company signed a contract with a manufacturer to have custom built are self constructed.

The IRS takes the position that the contract signed with the manufacturer or construction contractor before work started had to be a “binding” contract. This means it had to be with a third party. The IRS has argued in the past that a contract signed with a related party is not “binding” since it is too easy for the parties to walk away. The regulations indicate that two companies are considered “related” if they have more than 50% common ownership. A contract is not “binding” if it limits the damages the owner must pay for canceling the contract to less than 5% of the total contract price. It is not a problem if the contract is silent about damages. There cannot be any conditions standing in the way of performance of the contract or the contract is not binding — unless the conditions are outside the control of the parties.

Anyone who is treating his project as “self constructed” had better be careful about amending the contract later. The IRS said “[a] contract will continue to be binding if the parties make insubstantial changes,” thus implying that substantial changes after work “of a significant nature” has already started at the site could turn the project into “acquired” property. In most cases, the taxpayer should not be harmed by a later amendment. As long as the amendment is signed by the end of 2004, it should not be a problem. However, significant amendments should be avoided during 2005 because they might call into question whether the project that is ultimately placed in service in 2005 is the same project to which the taxpayer was committed earlier. To qualify for a bonus, the taxpayer must not have been committed to the investment before the terrorist attacks on September 11, but he must be committed to it no later than December 2004.

Some merchant power companies signed master turbine contracts with manufacturers before September 2001 to buy 10, 15, 20 or more turbines at a time. The IRS said the fact that a company committed to purchase a turbine before September 11 will not taint the rest of the project. Moreover, a bonus can be claimed on the turbine as long as the manufacturer had not started physical assembly before September 11. Components like turbines are treated as separate properties. The same 10% safe harbor on costs incurred before work “of a significant nature” is considered to have started should also apply to each component.

Project Sales

Many power projects have been put up for sale in the past year and a half since Enron went bankrupt. Some of the projects being sold are still under development or construction. The IRS said that anyone who buys a project before it is completed will qualify for a bonus, not only on the amount spent to complete the project but also on the amount paid to buy the work in progress. It does not matter that the original developer would not have qualified for a bonus had he kept the project.

The regulations give an example of a developer who had started construction of a power plant before September 11. He would not have qualified for a bonus. He sold the project while it was still under construction to someone else for $6 million on May 1, 2003. The new buyer spent another $1.2 million to complete the project during the period May 6 through June 30, 2003. The IRS said in the example that not only could the buyer claim a bonus on the full $7.2 million, but he qualified for a 50% bonus on the $1.2 million to complete construction. (The bonus increased from 30% to 50% on May 6, 2003.) The buyer was limited to a 30% bonus on the $6 million he paid for the work in progress. That’s because he “acquired” the work in progress before the bonus increased on May 6, 2003. The remaining work is considered self constructed and the buyer did not start work on it until the period during which the bonus had increased.

Another common situation in infrastructure projects is where someone buys into a project — for example, as a partner — during the construction period. The analysis of such situations is more complicated than where a project that is still under construction is purchased outright. Someone buying into an existing partnership can claim a share of the bonus to which the partnership is entitled. However, he ordinarily cannot claim a bonus on any premium to buy into the project. (In other words, a bonus ordinarily cannot be claimed on a “section 754 stepup.”) The IRS did not address what happens if the project does not qualify for a bonus in the hands of the original developer. However, it should be possible to structure many buy ins in such situations so that the investor qualifies for a bonus on his share of the project.

A developer who places a new project in service and sells the entire project later the same year to someone else cannot claim any bonus. The bonus is lost. (An exception is where the project is sold in a sale-leaseback within three months after the project went into service.)

Some projects are owned by partnerships. A partnership “terminates” for tax purposes if at least a 50% interest in partnership capital and profits is sold. (The old partnership is considered to disappear and a new one to spring into being with the new partners.) If a project is put into service in a year and, later the same year, an interest in the partnership is sold causing the partnership to terminate, then the bonus is shared among the new partners — not the old ones.

Calculating the Bonus

The depreciation bonus is an acceleration of tax depreciation to which the owner of a project would have been entitled anyway.

The owner gets a much larger depreciation deduction the first year and smaller ones later. The depreciation allowance in the year the project is put into service — assuming a 30% bonus — is a) 30% of his “tax basis” in the project (basically the cost of the project) plus b) depreciation for the year calculated in the regular manner on the remaining 70% of basis. For example, without the bonus, the first-year depreciation deduction on a coal-fired power plant that cost $100 million to build is $3.75 million. With a 30% bonus, it is $32.625 million. Depreciation in later years is reduced commensurately, since only $100 million in depreciation can be claimed in total.

The bonus was increased to 50% in May this year. Congress did this in the hope of giving a stronger spark to the economy. The 50% bonus applies to investments to which a taxpayer committed after May 5, 2003.

The faster writeoff can be a significant benefit. The benefit is greater the longer the normal depreciation period for an asset. A 50% depreciation bonus reduces the cost of assets that are depreciated over 20 years — for example, transmission lines and coal- and combined-cycle gas-fired power plants — by 8.98%. It reduces the cost of gas pipelines and simple-cycle gas-fired power plants that are depreciated over 15 years by 7.54%. The cost of a power plant that burns waste is reduced by 3.61%. Wind farms and biomass projects cost 2.61% less. These calculations only take into account federal tax savings from the depreciation bonus — not also the state tax savings — and they use a 10% discount rate. (At last count, 25 states have “decoupled” from the depreciation bonus — they do not allow it to be claimed against state income taxes — and another six allow only a partial or delayed bonus.)

Other Issues

Most renewable energy projects must be placed in service by December 2004 to qualify for a bonus. Most gas- and coal-fired power plants, gas pipelines and transmission lines have until December 2005.

The deadline for completing a project turns on its depreciable life for tax purposes. A project qualifies for the later deadline if its depreciable life is 10 years or longer and the project is expected to take more than a year to construct (assuming the project costs more than $1 million). The power industry asked the IRS whether developers of projects that qualify for more rapid depreciation — for example, wind farms or power plants that burn waste that can be depreciated over five or seven years — could buy more time by electing to depreciate them over 10 years. The IRS said no.

The bonus can only be claimed on spending through December 2004 regardless of when the project is placed in service.

A bonus cannot be claimed on property that is financed with tax-exempt bonds or that is “used” by a government or tax-exempt entity or that is used predominantly outside the United States or US possessions.

by Keith Martin, in Washington