United States: Initial Republican Tax Reform Proposal Includes Tax Cuts And Changes To Energy Credits

SUMMARY

Changes to the energy credits proposed in the Tax Cuts and Jobs Act could impact the eligibility of renewable energy projects that had been relying on the guidance previously issued by the Internal Revenue Service.

IN DEPTH

Yesterday, the House Ways and Means Committee released the House Republicans' long-awaited proposed bill for tax reform, the Tax Cuts and Jobs Act (the Bill). As expected, the Bill proposes significant reductions in the corporate income tax rate, a reduced tax rate for income from partnerships and other pass-through entities, and provides for 100 percent expensing of many capital expenditures. The Bill also proposes amendments to the Section 45 production tax credit (PTC) and Section 48 investment tax credit (ITC), including extending the ITC for certain technologies, eliminating the PTC inflation factor and enacting a statutory "continuous construction" requirement for both credits. This addition, if enacted, could significantly impact the eligibility of renewable energy projects that had been relying on the guidance previously issued by the Internal Revenue Service (IRS). The draft released yesterday is considered the starting place for negotiations in the House, so the Bill is expected to change significantly in the coming weeks.

Significant Changes to the PTC and ITC

The Bill includes a statutory "continuous construction" requirement for both the PTC and ITC. As proposed in the Bill, construction of a facility would not be treated as beginning unless there is a "continuous program of construction which begins before such date and ends on the date that such property is placed in service." This provision could be read to create a new "continuous construction" requirement for projects that intend to satisfy the 5 percent safe harbor provided in the IRS's previous begun construction guidance (the IRS Notices). The IRS Notices offer two methods to establish that a project has "begun construction": (1) The taxpayer can commence physical construction on the project and then engage in continuous physical construction until the project is placed in service; or (2) the taxpayer can safe harbor equipment equal to 5 percent of the total cost of the facility and then engage in "continuous efforts" to advance towards completion of the facility. The IRS Notices state that continuous efforts can be shown by making payments toward the project, getting permits, entering into contracts or continuing physical construction. In other words, the IRS's 5 percent safe harbor does not require continuous physical construction on the facility. The proposed continuous construction statutory requirement could be read to effectively override the 5 percent safe harbor if a "continuous program of construction" is intended to require physical construction from the begin construction date. Further, the Bill indicates that it is intended to apply to taxable years "beginning before, on, or after" the enactment of the Bill. This means that projects that previously took steps to satisfy the 5 percent safe harbor, and have made "continuous efforts" under the 5 percent safe harbor, may not qualify as having "begun construction" if the proposed language is adopted. The retroactive effect of such an interpretation would be highly unusual and will need further clarification. It is also unclear what effect this new continuous construction requirement would have on the four-year safe harbor established by the IRS, under which continuous construction requirements are deemed met if projects are placed in service within this time period.

Based on the language of the proposed draft and the committee explanation accompanying it, it is not clear if the draft intends these results. The IRS has issued multiple IRS Notices detailing how a taxpayer may establish that it has begun construction, including through the application of the 5 percent safe harbor and the continuous efforts rule. The Bill clearly intended to codify the continuity requirements in the IRS Notices, but the draft language raises the question as to whether the Bill intends to override the IRS Notices in their entirety—including the 5 percent safe harbor continuous efforts rule—or whether the Bill's omission and effective override of the continuous efforts rule was inadvertent. This could be a significant change to the renewable tax credit regime, and is likely to be aggressively lobbied by the industry. If the "continuous construction" language of the Bill is enacted, the authoritative weight of the current begun construction guidance and related safe harbors in the IRS Notices would be questionable pending IRS clarification of these issues.

The Bill also eliminates the PTC inflation factor for renewable energy facilities the construction of which begins after the date of enactment. Currently, the law provides for a 1.5 cent PTC per kilowatt hour of electricity produced, and the amount is adjusted annually for inflation (currently at 2.4 cents). We note that the House Ways and Means Committee explanation to the Bill suggests that some projects could "revert" back to the 1.5 cent amount in the middle of their 10-year PTC period, although we do not believe that the Bill as drafted would cause this result. As drafted, a PTC project would either have begun construction prior to enactment, and therefore qualify for the inflation-adjusted amount for all 10 years, or will begin construction after enactment and thus receive the unadjusted rate of 1.5 cents for all 10 years.

With respect to the ITC, the Bill eliminates the credit for solar energy facilities where construction begins in 2028 or later. The proposal retains the current ITC phase-out for solar energy; that is, the ITC is reduced from 30 percent to 26 percent where construction begins in 2020; 22 percent where construction begins in 2021; and 10 percent where the facility is not placed into service before January 1, 2024. As noted above, the Bill also proposes a statutory "continuous construction" requirement for purposes of establishing beginning of construction for ITC projects.

The Bill extends the ITC for the so-called orphan tax credits relating to fiber optic solar energy, fuel cell property, microturbine property, combined heat and power system property, small wind energy and thermal energy. Taxpayers need to begin construction before January 1, 2022 on these types of projects. These extensions would match the extension previously made for solar energy property in 2015. For the orphan credits that were historically eligible for 30 percent credits (e.g., fuel cell, fiber-optic solar energy and small wind energy), the Bill includes a phase-out mirroring the phase-out that already applies to solar energy. The other orphan credits would continue to be eligible for a 10 percent ITC. The Bill also terminates the ITC for geothermal energy property where construction begins in 2028 or later.

Reduced Tax Rate for Corporations and Repeal of AMT

As expected, the Bill would reduce the corporate tax rate to a flat 20 percent rate beginning in 2018. Personal services corporations would be subject to a flat 25 percent corporate tax rate. Currently, corporations are subject to graduated tax rates between 15 percent and 35 percent. The Bill also repeals the alternative minimum tax.

Reduced Tax Rate for Income from Pass-Throughs

The Bill proposes a new tax regime for income distributed from pass-through entities (e.g., sole proprietorships, partnerships, limited liability companies and S corporations). Owners of such entities are currently taxed on distributed income at their individual income tax rate. Under the proposal, a portion of net income distributed by a pass-through entity to an owner may be treated as "business income" subject to a maximum rate of 25 percent, instead of ordinary individual income tax rates. The remainder would continue to be subject to ordinary individual income tax rates. Income from passive activities would be fully eligible for the 25 percent rate. For non-passive activities, 30 percent of net income would generally be eligible for the 25 percent rate, although a higher portion of income of capital-intensive businesses could be eligible for the reduced 25 percent rate. Professional service firms such as doctors, lawyers, accountants and others would generally be excluded from the new pass-through regime.

100 Percent Immediate Expensing of Capital Expenditures

As expected, the Bill would allow taxpayers to take an immediate deduction for the full amount of many capital expenditures. This provision would be in lieu of the current "bonus depreciation" rules for certain "qualified property." Those rules require deducting the cost of the qualified property over its depreciable life, with a 50 percent deduction in the first year. The Bill would allow an immediate deduction of 100 percent of the cost of all qualified property acquired and placed in service before January 1, 2023. "Qualified property" generally retains its definition; that is, it includes tangible property which has a recovery period of 20 years or less under the current Modified Accelerated Cost Recovery System (MACRS) depreciation system, as well as certain computer software, water utility property and qualified improvement property. Under the Bill, qualified property would not include any property used by a regulated public utility company or any property used in a real property trade or business. The Bill eliminates the existing requirement that the original use of the property begin with the taxpayer.

Disallowance of Interest Deductions

Under the Bill, every business, regardless of its form, would be subject to a disallowance of a deduction for net interest expense in excess of 30 percent of the business's adjusted taxable income. Any interest amounts disallowed under this provision would be carried forward to the succeeding five taxable years. Businesses with average gross receipts of $25 million or less would be exempt from this disallowance. Additionally, the provision would not apply to certain regulated public utilities and real property trades or businesses.

Repeal of Section 199 Deduction

The Bill would repeal Section 199, which currently provides a deduction for qualified domestic production activities income.

Elimination of New Markets Tax Credit

The Bill also proposes eliminating the new markets tax credit in Section 45D after this year.

Elimination of Technical Termination of Partnerships

The draft legislation repeals Section 708(b)(1)(B), the technical termination rule, which currently provides that a partnership terminates upon the sale or exchange of 50 percent or more of the total interest in partnership capital and profits in any 12-month period.

As noted above, yesterday's draft legislation is likely a starting place for negotiations in the House. The House Ways and Means Committee had provided little detail in advance of the draft, so will likely receive tremendous feedback and commentary from their House colleagues from both parties, as well as lobbyists, industry and other taxpayers. Accordingly, the Bill may be subject to significant revision and rewrite in the coming weeks. While many of the Republican proposals are considered very pro-business—like the reduced corporate and pass-through rates, and the new 100 percent expensing rules—the proposed amendments to the energy credits, if adopted, could frustrate the development of ongoing and future renewable energy projects. We will be closely monitoring the Bill as it works its way through the House in the coming weeks.

Initial Republican Tax Reform Proposal Includes Tax Cuts And Changes To Energy Credits

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