On December 22, 2017, the tax reform bill known as the Tax Cuts and Jobs Act (H.R. 1) (the "Tax Reform Act") was signed into law. Prior to its enactment, the renewable energy industry was deeply concerned about proposals in the House of Representatives (the "House Bill") and the Senate (the "Senate Bill") that, if enacted, would have had significant adverse effects on the utility of both the renewable energy investment tax credit (ITC) and energy production tax credit (PTC).
Most of these unfavorable proposals were withdrawn, and the Tax Reform Act largely preserves the benefits of the ITCs and PTCs. The final version of the Tax Reform Act also partially alleviated the negative effect that the so-called base erosion anti-abuse tax (the BEAT) would have had on the ITC and PTC, but only on a temporary basis, creating significant uncertainty for certain taxpayers considering tax equity investments. This article describes the (i) general business provisions relevant to the renewable energy sector and (ii) renewable energy credit specific provisions.
Business Tax Reform Effects on the Renewable Energy Sector
Corporate Tax Reform
The corporate tax rate was reduced from 35 percent to 21 percent. Unlike many other provisions of the Tax Reform Act, the new corporate tax rate does not expire. However, going forward, net operating losses (NOLs) can only be used to offset 80 percent of taxable income. Furthermore, such NOLs cannot be carried back but can be carried forward indefinitely (the prior law allowed NOLs to be carried back two years or carried forward 20 years). The new rules only apply to NOLs generated in taxable years beginning after December 31, 2017. As a result, NOLs generated before that time can continue to be used to offset 100 percent of taxable income and may be carried back.
The Tax Reform Act also provides that (i) contributions to a corporation in aid of construction or any other contribution as a customer or potential customer and (ii) any contribution by a government entity or civic group (other than contributions made as a shareholder) are taxable income to the corporation. Thus, utilities and other corporations receiving state assistance in the form of contributions must treat such contributions as taxable income.
Deduction for Pass-Through Income
The Tax Reform Act provides a new deduction for individuals, estates and trusts equal to 20 percent of the taxpayer's "qualified business income," which results in an effective top tax rate of 29.6 percent (based on a new maximum individual rate of 37 percent). The deduction does not apply to investment-related income.
For taxpayers with income over a certain threshold, (i) the deduction phases out for income from so-called specified services businesses in which the principal asset is the reputation or skill of the employees or owners, and (ii) is limited to 50 percent of the taxpayer's allocation of the W-2 wages paid by the business, or (iii) the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis in certain tangible, depreciable property used in a trade or business for the production of qualified business income. The phase-out begins for taxpayers with taxable income over $315,000 (for married taxpayers filing jointly) or
$157,500 (for individuals) and phases out completely for taxpayers with an additional $100,000 of income (for married taxpayers filing jointly) or $50,000 (for individuals).
Non-corporate taxpayers owning interests in partnerships engaged in operations in the renewable energy sector may be eligible for the 20 percent deduction on allocations of partnership income.
The rules expand and extend bonus depreciation. Under the new rules, "qualified property" acquired and placed in service after September 27, 2017 is eligible for 100 percent depreciation in the year such property is placed in service. The 100 percent bonus depreciation begins to phase down in 2023 for most qualified property (2024 for certain long- production-period property) and phases down 20 percent per year until it is eliminated entirely in 2027 (2028 for certain long-production-period property). In the taxpayer's first taxable year ending after September 27, 2017, the taxpayer can elect to apply a 50 percent bonus depreciation rate instead of 100 percent.
"Qualified property" eligible for 100 percent bonus depreciation includes depreciable property with a recovery period of 20 years or less as well as property with a recovery period of at least 10 years if such property has an estimated production period of at least one year and a cost of at least $1 million. The new rule also expands the definition of "qualified property" to include used property that is newly acquired by the taxpayer. However, it excludes property used primarily in "regulated public utilities businesses." A regulated public utilities business includes trades or businesses that furnish or sell (1) electrical energy, water or sewage disposal services, (2) gas or steam through a local distribution system, or (3) transportation of gas or steam by pipeline, if the rates for the furnishing or sale have been established or approved by the United States or any state government, political subdivision, or any agency or commission thereof.
Interest Expense Deduction Limitation
The Tax Reform Act imposes a new limitation on businesses' interest expense deductions. Under the new rules, net interest expense deductions are limited to 30 percent of "adjusted taxable income." "Adjusted taxable income" means the taxpayer's taxable income, computed without regard to any NOL carryovers, business interest income or expense, the new deduction for pass-through income (described above) or, solely for taxable years beginning before 2022, depreciation, amortization or depletion.
Thus, net interest deductions are essentially limited to 30 percent of EBITDA before 2022 and 30 percent of EBIT thereafter. Given the high deductions anticipated under the new 100 percent bonus depreciation rules, computing the 30 percent interest deduction limitation on EBITDA rather than EBIT is expected to provide short-term relief for certain highly leveraged, capital-intensive businesses. Disallowed interest deductions can be carried forward indefinitely (although they may be subject to limitation if the business's ownership changes).
The interest deduction limitation only applies to taxpayers with average annual gross receipts for the prior three-year period that do not exceed
$25 million. Furthermore, the interest deduction limitation only covers "business interest," which is defined to exclude regulated public utilities businesses (as defined above). Thus, although public utilities are not eligible for the increased 100 percent bonus depreciation, they are not subject to the 30 percent interest deduction limitation. In the case of taxpayers that are partnerships, the limitation is applied at the partnership level. Business interest disallowed at the partnership level is allocated to the partners, who may deduct such interest in future years, but only against excess taxable income allocated to the partner from the partnership.
Repeal of the Domestic Production Activities Deduction
The Tax Reform Act repeals the deduction for domestic production activities. The domestic production activities deduction previously allowed taxpayers to deduct nine percent of the lesser of their qualified production activities income or taxable income. The deduction included income attributable to qualifying production property that was manufactured, produced, grown or extracted in the United States; electricity, natural gas or potable water produced in the United States; and the construction of real property in the United States. The deduction was limited to 50 percent of the W-2 wages paid by the taxpayer allocable to such domestic production businesses.
Treatment of Renewable Energy Credits under the Tax Reform Act
Retention of PTCs and ITCs
Early tax reform proposals caused significant concern for the energy sector. The House Bill would have removed an inflation adjustment for PTCs, significantly reducing their future value. It also would have modified the phase-out schedule for ITCs and eliminated the permanent ITC for solar energy investment. Furthermore, the House Bill purported to "clarify" the determination of when a project begins construction, which would have curtailed a five percent investment safe harbor provided by the Internal Revenue Service. These changes were dropped by the Senate Bill. The final version of the Tax Reform Act retained the existing ITC and PTC regimes, without change.
Elimination of the Corporate AMT
The Senate Bill also initially contained provisions that could have had a chilling effect on investments in renewable energy products though. For one, the Senate Bill retained the corporate AMT, which would have affected many more corporate taxpayers given the lower overall corporate tax rates. Furthermore, since the ITC did not offset the corporate AMT, and the use of PTCs to offset the corporate AMT was subject to significant limitations, retention of the corporate AMT would have significantly reduced the utility of these credits. The Tax Reform Act eliminates this problem by repealing the corporate AMT.
The Tax Reform Act Adds a New, Potentially Significant Limitation on PTCs and ITCs
More significantly, the Senate Bill included the BEAT, a new minimum tax designed to apply to U.S. corporations that make significant deductible payments to related foreign persons. The BEAT applies to domestic corporations that are members of an affiliated group with average gross receipts of over $500 million over the prior three-year period and deductible payments to related foreign parties representing over three percent of its total annual deductions (two percent in the case of corporations that are members of a group that includes a bank or a registered securities dealer).
If the BEAT applies, the U.S. corporation's tax is increased by the excess of:
- 10 percent of its "modified taxable income" (i.e., the corporation's taxable income after adding back its deductible payments to foreign related parties); over
- its adjusted U.S. income tax liability (the "Income Tax Offset").
The 10 percent rate is reduced to five percent for 2018, but increased to 12.5% beginning in 2026. Banks and registered securities dealers add one percent for all years.
Under the Senate Bill, a U.S. corporation's Income Tax Offset was equal to its regular tax liability, reduced by its tax credits, other than the research and development credit, but including ITCs and PTCs. As a result, if a corporation was subject to the BEAT, the BEAT liability would claw back the benefit of ITCs and PTCs. Because a number of financial institutions that could be affected by the BEAT are also investors in renewable energy projects, the BEAT would have eroded the value of tax equity investments and created significant uncertainty for taxpayers considering such investments.
The Tax Reform Act revised the BEAT calculation in a manner designed to protect most, but not all, of the benefit of ITCs and PTCs against the BEAT. Under the Tax Reform Act, like the Senate Bill, the Income Tax Offset is equal to a U.S. corporation's regular tax liability, reduced by its credits.
However, the Tax Reform Act modifies the calculation to add back 80 percent of the lesser of (i) the corporation's available renewable energy ITCs and PTCs or (ii) the corporation's BEAT liability (determined without regard to this calculation). By increasing Income Tax Offset, the taxpayer's BEAT liability is correspondingly reduced. As a result, up to 80 percent of the taxpayer's renewable energy ITCs and PTCs directly reduce its BEAT liability.
For example, suppose a U.S. corporation has taxable income of $100, after accounting for $200 of deductible payments to foreign related parties, and renewable energy ITCs and PTCs of $5. The corporation's regular tax liability on $100 of income is $21. After taking into account its ITCs and PTCs, the corporation's income tax is reduced to $16. Under the Senate Bill, 10 percent of the corporation's $300 of modified taxable income (taxable income of $100, adding back deductible payments to foreign related parties of $200) is $30. The BEAT increases the corporation's tax by $14 ($30 minus the Income Tax Offset of $16), bringing the corporation's total tax to $30 ($16 of income tax plus $14 of BEAT).
Had the corporation not been eligible for the $5 of renewable energy ITCs and PTCs, its total tax would still be $30, since its income tax would be $21 and its BEAT ($30 minus the Income Tax Offset of $21) would be $9. Thus, in these facts, under the Senate Bill, the BEAT would have completely eliminated the benefits of the renewable energy ITCs and PTCs.
Under the Tax Reform Act, however, the benefits of the renewable energy ITCs and PTCs are partially preserved. Using the facts in the example above, the U.S. corporation's regular tax liability on its $100 of income is
$21. After taking into account its $5 of renewable energy ITCs and PTCs, its income tax is reduced to $16. However, the Income Tax Offset is increased to add back 80 percent of the lesser of (i) the corporation's $5 credit or (ii) its $14 BEAT (determined without regard to this provision). Thus, the Income Tax Offset is increased by $4 (80% of $5), bringing its total Income Tax Offset to $20 ($16 plus $4). As a result, under the Tax Reform
Act, the corporation's BEAT is only $10 ($30 less the income tax offset of $20), bringing the corporation's total tax to $26 ($16 of income tax plus $10 of BEAT). The add-back of up to 80 percent of the renewable energy ITCs and PTCs prevented the BEAT from clawing back most of their value.
The 80 percent add-back for renewable energy ITCs and PTCs sunsets in 2026, however. As a result, taxpayer models assessing the value of these credits must analyze their exposure to the BEAT and the likelihood that Congress will extend the protections for renewable energy ITCs and PTCs beyond 2026. Accordingly, renewable energy investors face some uncertainty regarding the future value of tax equity investments, particularly in the case of PTCs that are available over a 10-year period.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.