Energy Taxation: Impact of the Tax Cuts and Jobs Act

Congress has passed the tax reform bill, known as the "Tax Cuts and Jobs Act", and President Trump signed it into law on December 22, 2017.  The Act contains wide-ranging changes to the tax law that affect many industries.  For the energy industry, the changes have not proved to be as harmful as some feared earlier in the legislative process.  Nevertheless, there is a lot that is new to consider.  We discuss below those provisions of the Act that we believe will have the most important effect on both the renewable energy and fossil fuels industries.

Rate Change:  New Corporate Tax Rate of 21%

The headline change coming from the legislation is a corporate tax rate cut to 21%.  This rate cut is obviously helpful to corporate taxpayers such as oil and gas majors, but renewable energy projects that hope to raise money from tax equity investors may find less appetite for such investments due to lower tax bills reducing the investor's aggregate need for tax credits and since the value of the tax benefit of depreciation deductions flowing from such projects will now be lower.  To the extent that a renewable energy project is sufficiently far along that depreciation deductions have trailed off and income is now being allocated to the tax equity investor, the lower corporate rate will mean that the tax equity investor's after-tax income is now greater and it will more quickly approach the point where its IRR is satisfied (the "Flip Date").  With respect to more recent renewable deals that were priced and sized with respect to (i) production tax credits spread over a 10-year period or (ii) 5-year MACRS depreciation, the Flip Date may be deferred.

Because of impending tax legislative changes, many renewable energy deals that were signed in the latter half of 2017 may call for a "repricing" if there is a change in the corporate tax rate or other tax benefits.  As a result, it can be expected that the parties to such deals will be negotiating the adjustments necessary to address the new tax profiles and tax equity investors are likely to be looking for additional cash flow to make up for the reduced tax benefit.

Along with the change in rate, the Act repeals the corporate alternative minimum tax.  The corporate alternative minimum tax, and the ability to use tax credits, such as the PTC and the ITC, against the tax, has been a key incentive driving corporate investors in renewable energy projects.  The Act does allow corporate taxpayers to claim a refund of any remaining minimum tax credits that would have been usable in subsequent years had the alternative minimum tax remained in place (50% refundable in 2018 through 2020 and 100% refundable starting in 2021).

Rate Change:  Pass-Throughs

As a nod to those businesses that want a tax cut similar to the one given to businesses conducted in corporate form, Congress reduced the tax on income from "pass-throughs," which are defined as sole proprietorships, partnerships (and LLCs taxed as partnerships) and S corporations.  The Act reduces the tax by allowing individuals to take a deduction from income of 20% of the income received from pass-throughs.  The other 80% of the pass-through income is taxed at regular rates.  Assuming the highest individual tax rate of 37% is applied to the 80% of the income that is passed-through, pass-through income would be taxed at a blended rate of 29.6%.

The amount of income that can be deducted, however, is limited to the pass-through owner's share of certain jobs-related amounts:  the limitation on the deductible amount is the greater of (i) 50% of the pass-through business's payroll (W-2) amount or (ii) 25% of the payroll amount plus 2.5% of the unadjusted basis of the business's capital assets.

If, as first proposed, the limitation were solely 50% of payroll, many businesses in pass-through form but with little or no payroll would have been unable to take the deduction.  For example, the 50% of payroll limitation would have made the deduction essentially unavailable to unitholders in publicly traded partnerships (often referred to as "master limited partnerships" or "MLPs").  Most MLPs are large oil and gas related businesses that create many jobs but that are not direct employers; MLPs usually set up a separate but affiliated entity to function as the employer.  The Act makes clear that the payroll limitation on the pass-through deduction does not apply to MLPs, just as it does not apply to REITs.  With this change, the pass-through income deduction will be available for all individual partners in MLPs.

The second formulation of the limitation caps the deduction at 25% of payroll plus 2.5% of the "unadjusted basis" of the business's assets.  It is designed to help businesses in pass-through form that may have significant investment but few employees.  For example, real estate businesses (other than REITs, which are excepted from this limitation) would have had difficulty with a limitation based solely on payroll.  Note that the limitation is based on the unadjusted (i.e., undepreciated) basis of "qualified property," which is defined as tangible, depreciable property held for use in the trade or business, subject to an age limitation of the later of 10 years or the last year of the cost recovery period.  Thus, the original purchase price or cost basis of the property is allowed to generate the limitation amount regardless of prior cost recovery deductions. 

The deduction is not available to partners in service businesses, above certain income levels.  A service business for this purpose is defined to include law, accounting, brokerage, consulting, investment management firms, securities traders, health or other businesses where the principal asset of the business is the "reputation or skill of one or more of its employees." Architectural and engineering firms are allowed, however, to take the deduction.

Bonus Depreciation

The Act provides for 100% bonus depreciation, i.e., complete expensing and write-off, for property acquired and placed in service after September 27, 2017, and before January 1, 2023.  The 100% bonus depreciation is phased down by 20% each year for property placed in service in years beginning after 2022.  The phase-down is pushed out a year for certain property deemed to take longer to place in service, such as gas pipelines and transmission lines.  This additional depreciation is a significant benefit to all capital asset intensive industries and the energy industry is certainly capital asset intensive.

Importantly, bonus depreciation can be taken for property that is used; there is no requirement that the original use of the property commence with the taxpayer.  Therefore, a taxpayer can purchase used property that is operating and currently in service and immediately write off the purchase price.  In order to "prevent abuses," however, there is a rule that the acquisition of the used property cannot be an acquisition from a related person or entity.  For this purpose, a related person is one that is more than 50% owned or controlled.

The availability of bonus depreciation for renewable energy property will increase and frontload the tax benefits passed through to tax equity investors in renewable energy projects that are acquiring or placing in service property in 2018 and for four years thereafter.  Taxpayers are allowed to elect out of application of the bonus depreciation provisions, however, if slower depreciation is desirable, for example, because the bonus depreciation could overwhelm a tax equity investor's capital account.

With respect to property that was acquired before September 27, 2017, the previous depreciation rules apply, that is, 50% bonus in 2017, 40% in 2018, and 30% in 2019.  Property will be subject to the older, less favorable rules, even if it was placed in service after September 27, 2017, if its acquisition was subject to a binding written contract as of that date.  Therefore, for renewable energy projects under construction that have entered into contracts for construction or purchases of equipment prior to September 27, 2017, the new bonus rules might not apply to some or all of the project.  An acquisition of such property by another taxpayer after September 27, 2017, however, could bring the property under the new rules.  The availability of 100% expensing for even used assets that are acquired can be expected to stimulate M&A activity in the energy sector.

Interest Expense Limitation

The Act restricts the deduction for interest expense by corporations (under Code section 163(j)) and puts in place analogous rules to limit the amount of the business interest deduction by pass-through entities.  For corporations, the Act limits deductible interest to 30% of a corporation's earnings before reductions for interest, taxes, depreciation and amortization ("EBITDA") until 2022 and thereafter further restricts the deduction to 30% of EBIT.  The rules do not apply to regulated public utilities, electric cooperatives and businesses with average gross receipts for the prior two years below $25 million.

Analogous rules limit the interest deduction by businesses in pass-through form.  In general, the interest deduction cap is applied to partnerships at the partnership level.  To the extent that the cap acts to prevent an interest deduction, the excess interest is allocated to the partners and may be available to be used by them against other income, although again limited by a fraction, based on the partnership's relative amounts of income and excess interest.

 It is not yet clear the extent to which the interest deduction limitation may affect capitalization of the energy industry.  When interest is entirely deductible, borrowing to finance acquisitions or growth may be more attractive than dilution through issuance of additional equity.  If the earnings are low enough to trigger the new interest deduction cap, however, capitalization through equity issuances may become preferable.  Much of the recent growth in the oil and gas sector has been through private equity funds that have financed their investments with debt.  One can expect that these businesses will be taking a hard look at the impact of debt funding on their tax bill going forward.

What About Renewable and Energy Tax Credits?

There was considerable concern when the House version of the tax bill was originally introduced that the production tax credit (the "PTC"), heavily used by the wind energy industry, would be reduced because the House version proposed to reduce the credit to $15 per megawatt hour.  However, the Senate version was adopted by the Conference Committee and enacted as law, preserving the current PTC.  Similarly, the House proposed to change the definition of "begin construction" which could have restricted availability of the PTC.  The final version of the Act did not include this change, however, so that the current IRS interpretation of the meaning of "begin construction" is not changed by statute.

With respect to the investment tax credit (the "ITC"), House-proposed changes limiting the ITC to 10% for solar property after 2027, were not adopted in the final version of the Act.

On the fossil fuels front, the House-proposed repeal of the marginal wells credit (under section 45I, a $3 per barrel credit for oil from a marginal or low-producing well) and the enhanced oil recovery credit (under section 43, a 15% credit for expenses) was not adopted by the Conference Committee and the final Act.

Net Operating Loss Usage

Under the Act, the use of net operating losses ("NOLs") to reduce taxable income is restricted. Beginning in 2018, NOLs may not be used to reduce taxable income to zero; they may be used against a maximum of 80% of income.  NOLs previously could be carried back to reduce tax in prior years but under the Act they may not be carried back at all, although there is unlimited carryforward to future years with respect to the portion of NOLs limited by the new 80% NOL cap (e.g., the full 20% of any NOLs disallowed can be carried forward indefinitely).  To the extent that tax equity investors value the tax losses that may be derived from a renewable energy project, an inability to effectively use such losses may inhibit investment or alter pricing and investment sizing in the energy sector.

Technical Terminations of Partnerships

The Act repeals a long-time rule applied to partnerships that specifies, if there are transfers within a 12-month period of 50% of more of the interests in the partnership, the partnership will be considered to technically terminate for tax purposes.  The technical termination would trigger a "restart" of depreciation that could be detrimental depending upon the partnership's asset profile and age of its assets.  In many capital asset intensive industries, such as energy partnerships, it is common to prohibit transfers of partnership interests that would cause a technical termination in order to avoid a drop in the depreciation deductions resulting from a restart of the applicable life.  To the extent that such restrictions on transfer had a chilling effect on the market for partnership interests, the removal of the technical termination rule is a positive development, increasing liquidity and market value related to the transfer of energy partnership interests.

Beating the BEAT

The Act contains many changes to the international provisions of the tax law.  One such change is the imposition of a new tax named the "base erosion and anti-abuse tax" or "BEAT."  The BEAT applies to corporate taxpayers earning an average of at least $500 million in gross receipts sourced to the United States for the past three years and that makes at least 3% (or 2% in the case of banks and securities dealers) of its deductible payments to foreign affiliates (50% or more owned or controlled).  A large international bank with significant U.S. operations and earnings that makes large interest payments to its foreign affiliates, for example, would be a likely candidate for the BEAT.  The BEAT is a 10% tax (5% for 2018 and 12.5% for 2026 and thereafter) imposed on the taxpayer's income before reduction by the deductible payments to foreign affiliates.  The taxpayer only pays the tax to the extent it exceeds the taxpayer's regular tax liability, making the BEAT in essence a new "base erosion" minimum federal tax partially replacing in a targeted manner the repealed corporate alternative minimum tax.

When the BEAT was proposed, a question arose as to the effect of PTCs and ITCs.  A taxpayer, such as an international bank that had made a tax equity investment in a U.S. renewable energy project, could find itself exposed to the BEAT because the BEAT applies to the extent that it exceeds the regular tax liability and so a reduction in the regular tax liability through energy tax credits could result in the imposition of the BEAT.  The final version of the Act includes a provision that allows 80% of the energy credits to be taken into account without increasing the BEAT.  After 2025, however, there will be no help in the BEAT calculation from any credits, since all credits will reduce the regular tax, thereby increasing the BEAT.  The fate of any carryforward of the 20% disallowed energy tax credits is a subject of concern and may be addressed by a technical corrections bill.

These rules will put a premium on estimates and projections by tax equity investors to determine whether, in any given year, they will be a taxpayer that is subject to the BEAT, the rate of the BEAT that applies that year, and the usability of credits in that year.  The return on an investment that generates PTCs, which are available for ten years, is more difficult to predict and model than the return on an investment that generates an ITC, available at the time of investment.  Investors may find an investment that offers an ITC more attractive than an investment that generates PTCs because of the ability to more accurately project the value of the ITC to the investor.  Similar to the changes implementing 100% bonus depreciation, the BEAT may impact energy investment pricing, investment sizing, the scope of investment tax appetite and require more complicated distribution and contribution provisions in energy investments relying in part on energy tax credits.

Income Inclusion Acceleration – Potential Impact on Power Purchase Agreements

The Act modifies Code section 451 to require that accrual method taxpayers take income items into income no later than they take the same items into income for financial accounting purposes.  The Act also requires that advance payments (prepaid power purchase agreements) be taken into income by an accrual basis taxpayer when payment is received.  Many power purchase agreements call for upfront payment but the seller takes the payment into income only as and when performance occurs (the power is delivered).  Under the new rule, advance payments must be accrued when received unless the taxpayer makes an election for a partial deferral of one year.  The new income recognition provisions related to power purchase agreements with pre-payments may alter pricing and structure of such agreements.

Section 199 – No More Domestic Production Deduction

The Act repeals section 199, which allowed a 9% deduction from income for qualifying domestic production income.  Renewable energy production qualified as domestic production for this purpose, so renewable projects will no longer generate this benefit.

Cross-Border Sales Now to Be Sourced by Location of Production

The taxation of income from the sale of inventory turns on the source (domestic or foreign) of the income.  The Act revises Code section 863(b) to provide that the source of income from the sale of inventory is based solely upon the location of the production activities with respect to the property.  This means that, for example, sales of electricity, oil or gas produced in Mexico or Canada and sold in the United States will no longer be partially sourced to the jurisdiction where title passes.  Such sales would now be sourced entirely to the foreign country.  The same new sourcing rule applies to sales related to electricity, oil or gas produced in the United States and sold for use outside the United States.