The Bipartisan Budget Act of 2018 (Pub. L. No. 115-123) (the Budget Act) was signed into law on February 9. The legislation took effect roughly seven weeks after President Trump signed into law an Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, H.R.1 (the Tax Reform Act).
Now is an opportune time to examine the combined effects of these new laws on the renewable energy sector. As explained below, our initial view is that the new legislation may have a mix of positive and negative effects. Firms operating in this sector, including developers, operator-operators and lenders, will need to evaluate whether to alter their strategies and their past business practices based on the new legislation.
We describe below the tax provisions likely to be helpful, the provisions that may have mixed impacts, and the provisions likely to be harmful. At this early stage, these judgments are preliminary. It has been only a few weeks since enactment of the Budget Act, and many of the provisions in the Tax Reform Act have yet to be interpreted by the Internal Revenue Service and the Treasury Department. We also recognize that the effects of these new statues will vary by firm.
Subject to these caveats, we describe the key statutory provisions below.
Key Tax Changes and Their Likely Effects
Provisions Expected to Have Positive Effects
Investment Tax Credit: The Tax Reform Act made no direct changes to Code section 48, which provides an investment tax credit (ITC) to taxpayers for placing certain renewable energy equipment into service.1 The legislation did not re-establish the ITCs for power generation technologies that had been omitted from the 2015 legislation extending the ITC for wind projects and solar photovoltaic projects. Nor did the Tax Reform Act codify the IRS’s guidance that seeks to define the beginning of construction, a key qualifying factor for the ITC.2
In previous extender legislation, most or all expiring renewable energy provisions were uniformly extended. The 2015 Protecting Americans from Tax Hikes Act (PATH), however, did not extend all the expiring provisions. Then, in section 40411 of the Budget Act, Congress extended the ITC through 2022, with phase-outs, for the “orphan” technologies that were not included in the 2015 PATH Act. These technologies include solar fiber-optic, geothermal energy, fuel cell, microturbine, small wind and combined heat and power (CHP). The amount of the ITC and the phase-out period varies slightly by technology. For example, with respect to qualified fuel cell, small wind, CHP and microturbines, the ITC was extended to projects beginning construction before January 1, 2022 and placed in service by December 31, 2023. Qualified small wind, fuel cell and fiber-optic solar projects are covered by a phase-out similar to the phase-out that now applies to solar photovoltaic projects. Specifically, if construction begins before 2020 and if the project is placed in service by December 31, 2023, the ITC remains at 30 percent. If construction begins in 2020 and the project is placed in service by December 31, 2023, the ITC is reduced to 26 percent. Lastly, if construction begins in 2021 and the project is placed in service by December 31, 2023, the ITC falls to 22 percent. Under the new legislation, if any qualifying fuel cell, small wind or fiber-optic solar project is not placed in service before January 1, 2024, the ITC drops to zero. (There is a separate phase-out schedule for geothermal projects. For geothermal projects, the ITC never falls below the 10 percent level.)
For these “orphaned” technologies, the provisions of the Budget Act also reinstated the related election given to renewable energy developers. They may claim either the ITC or the production tax credit (PTC).
PTCs: Like the ITCs, the Tax Reform Act did not make any changes to Code section 45, which establishes PTCs, a per-kilowatt-hour credit for energy produced from certain energy sources. Yet section 40409 of the Budget Act includes a one-year extension of section 45 for specified renewable energy projects. In particular, the Budget Act extends the “beginning of construction” deadline to December 31, 2017 for facilities using the following eligible resources to generate electricity: geothermal, closed-loop biomass, open-loop biomass, landfill gas, municipal solid waste, qualified hydropower assets and marine and hydrokinetic renewable energy facilities.
The Budget Act granted a one-year extension retroactively, through December 31, 2017. This does not mean, however, that the projects must be completed in 2017. Rather, “construction” must begin in 2017 to qualify. Additionally, while Congress did not codify the IRS’s guidance on “construction,” Congress did not take any action to modify that guidance.
Bonus Depreciation: The Tax Reform Act completely changes the depreciation system for “qualified property,” including eligible energy equipment, machinery and other tangible assets. For qualified property placed in service after September 17, 2017 and before 2023, a company can deduct 100 percent of the cost of qualified property purchased that generally has a life of less than 20 years. Even for capital investments made after 2023, there are increased depreciation charges. For property placed in service in 2023, 2024, 2025 and 2026, the depreciation charges in the first year are 80 percent, 60 percent, 40 percent and 20 percent, respectively. The new legislation substantially accelerates the write-offs on tangible assets, including assets used in the renewable energy sector.
The Tax Reform Act also allows full expensing on any used assets that are acquired during the covered years. The “original use” requirement has been eliminated. Understandably, these increased depreciation charges are not allowed on purchases of used property from related parties. Nor is the basis of any used asset determined based on the seller’s basis. Additionally, in mergers and acquisitions that are structured as asset purchases or deemed as asset purchases, the new rule may also allow for immediate expensing.
These new depreciation provisions may facilitate mergers and acquisitions in the renewable energy sector. When acquiring the assets of a renewable energy project that is already in operation, it may be possible to use the new bonus depreciation rules created by Congress.
The Reduction in the Corporate Tax Rate
Certainly, one fundamental change in the Tax Reform Act is the reduction of the maximum corporate tax rate from 35 percent to 21 percent. On its face, this reduction should lower costs for many firms and should be beneficial to firms developing, owning and operating renewable energy facilities. Every dollar that is not paid to the IRS is, in theory, a dollar that is available for investment or for distribution to shareholders.
Yet that benefit here may not be as large as it initially appears. Our experience suggests that many renewable energy firms are not currently paying the 35 percent rate, especially in the early years of a project’s operation.
Furthermore, many renewable energy projects are funded partly by tax equity investors. The lowering of the maximum rate from 35 percent to 21 percent may reduce the value of these credits for corporate investors whose own taxes are being reduced. There has already been speculation that, as a percentage of the overall capital supporting each project, the contribution from tax equity investors may shrink. At this point, however, it is still early in the process, and it is uncertain whether this speculation will be validated.
Potentially Harmful Changes
Limitations on Interest Deductibility: Until now, under section 163 of the Code, there was generally no specific limit on the amount of interest that could be deducted each year. The Tax Reform Act now imposes a series of limitations that are likely to have an adverse impact, especially on large, publicly traded energy firms. For taxable years 2018 through 2021, interest expenses may now be deducted only up to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortization. The limit for the taxable years beginning in 2022 is set at 30 percent of the taxpayer’s earnings before interest and tax, which may create a tighter limit on the deductibility of interest.
There are various exceptions that shield particular types of taxpayers. The cap does not apply to regulated public utilities, certain electric cooperatives and taxpayers with average annual gross receipts for the current and prior taxable years that do not exceed $25 million.
Additionally, on the positive side, disallowed interest expenses generally can be carried forward, although they may be subject to limitations under section 382 if the taxpayer is a corporate taxpayer. Equally important, for partnerships, any interest expense that cannot be deducted by the partnership may be allocated to the partners and can be used to offset surplus future income. The application of this rule has raised questions, and IRS guidance may be forthcoming.
Net Operating Losses: The Tax Reform Act imposes significant limitations on the use of net operating losses (NOLs) for corporations. NOLs may now be used to offset a maximum of 80 percent of taxable income for NOLs arising after 2017, and taxpayers may not carry back NOLs to prior years. On the positive side, there are no new restrictions on a taxpayer’s ability to carry forward NOLs.
The new limitations on NOLs may have an impact on the ability to acquire or restructure a troubled firm that has accumulated a large amount of NOLs. The value of the NOLs to a buyer may be reduced somewhat by the restrictions now in place. This in turn may reduce the values assigned to the troubled or failing firms.
The Base Erosion and Anti-Abuse Tax: The Tax Reform Act repeals the corporate alternative minimum tax (AMT). It also makes prior-year AMT credits either partially or fully refundable depending on the year. The AMT was, however, replaced with a new minimum tax, the base erosion and anti-abuse tax (BEAT). The BEAT imposes a tax on companies that significantly reduce their U.S. tax exposure by making cross-border payments to affiliates.
Although the BEAT likely will apply to only a small subgroup of the firms actively involved in the U.S. renewable energy sector, it may impact the tax equity market. The BEAT generally applies to the corporations with both (a) average annual gross receipts for the three-year period ending with the preceding taxable year that are at least $500 million and (b) payments to foreign affiliates that exceed 3 percent of total deductions (or 2 percent for groups that include a bank or securities dealer).
The “base erosion minimum tax amount” is derived by comparing (a) 10 percent of the taxpayer’s income without taking into account deductible payments to foreign affiliates with (b) the taxpayer’s regular pre-existing tax liability (taking into account such payments to affiliates and reducing certain credits). Importantly, the regular tax liability is adjusted to include only 80 percent of the value of an ITC or PTC that was used to reduce the regular tax liability when making the comparison. If the 10 percent amount is larger, the taxpayer must pay the BEAT. (The formula changes over time and is adjusted for affiliated groups that include a bank or securities dealer. The 10 percent of modified taxable income amount is 5 percent for 2018, and 12.5 percent after 2025. The 5 percent, 10 percent and 12.5 percent amounts are increased to 6 percent, 11 percent and 13.5 percent, respectively, for banks and securities dealers).
In any specific year, the taxpayers subject to the BEAT may lose 20 percent of the economic value of the PTC and ITC. This could lead some existing owners of renewable energy projects to consider sales to buyers exempted from the BEAT.
Overall, in the U.S. renewable energy sector, the BEAT may create a competitive advantage for firms that have annual gross receipts below $500 million and that do not take deductions arising from payments to foreign subsidiaries or affiliates. Firms that do not pay the BEAT may be able to bid more for existing assets and may be able to generate more income from the development of new projects.
It may take years to determine all of the combined effects of the Tax Reform Act and the Budget Act. On the most basic level, in the renewable energy sector, there will be economic benefits from the one-year extension put in place for “orphan” technologies. The PTC and ITC will now be available again for geothermal, CHP, landfill gas, biomass, small hydropower facilities and hydrokinetic projects. This will unquestionably provide positive momentum for projects using orphan technologies, especially for projects that began construction in 2017.
Additionally, while it may not be a positive development, the new legislation may encourage changes in the capital structure for new project companies. For companies subject to the new limitations on interest expenses (not including public utilities), there may be pressure to use less debt as a percentage of overall capital. The business interest limitations also may give a competitive edge to smaller development firms with revenues that do not exceed $25 million and are not subject to the limitation. Put differently, the limitations on business interest deductions should not affect regulated public utilities or smaller firms focused on distributed energy projects.
Finally, the new depreciation provisions should be advantageous for many companies that build, own and operate renewable energy projects. Elimination of the original use requirement gives added flexibility. Furthermore, the ability to write off 100 percent of capital expenditures in the first year may facilitate purchases and sales of projects that are already in operation.
1 All references to “section” are to the Internal Revenue Code of 1986, as amended.
2 Of note, the IRS has provided guidance on beginning construction in the past. See Notice 2016-31.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.