LIBOR transition to risk-free rates and aviation finance
On July 27, 2017, the FCA announced that they would no longer compel or persuade banks to make submissions to LIBOR as from the end of 2021.
At least a dozen provisions in the final tax bill released Friday night by US House and Senate negotiators will affect transactions in the power and broader infrastructure markets.
The bill is expected to pass both houses early this coming week and to be signed into law by President Trump before Christmas.
The existing tax credits for renewable energy remain unchanged.
The House had voted to make it tougher for renewable energy projects to be considered under construction in time to qualify for tax credits. The final bill leaves in place the existing phase-out schedules for tax credits and the existing Internal Revenue Service policies on what it means to start construction.
The House wanted to roll back production tax credits for wind projects to the 1992 level of $15 a megawatt hour and not to adjust the credit amount for future inflation. The change would have applied to projects that start construction after Trump signs the bill.
The House also wanted to eliminate a permanent 10% investment tax credit for solar and geothermal projects after 2027.
None of these provisions made it into the final bill.
Tax credits for "orphan" technologies -- fuel cells, CHP projects, geothermal heat pumps, fiber-optic solar property -- and for nuclear power plants were not extended. Most of these tax credits expired at the end of 2016. Nuclear power plants must be in service by the end of 2020 to qualify. The House wanted to extend the already-expired tax credits and to waive the in-service deadline for new nuclear power plants, but the Senate, facing harder choices to make the math for its bill work, jettisoned them in favor of taking some of them up in a separate "tax extenders" bill before year end. The separate extenders route is looking doubtful after House leaders threw cold water on the idea and for lack of time.
The corporate tax rate will be reduced from 35% to 21% starting in 2018.
The change should make operating projects more valuable because the owners will be able to keep more of the revenue from electricity sales after taxes.
It could accelerate or slow down flip dates in tax equity financings, depending on how much time has elapsed since the tax equity financing closed. The earlier in the deal the tax rate is reduced, the more likely the flip date is to be extended.
The lower tax rate will reduce the amount of tax equity that can be raised to help finance wind, solar and other renewable energy projects. Such projects qualify currently for a tax credit worth at least 30¢ per dollar of capital cost and depreciation worth 26¢. The depreciation will be worth less at a 21% corporate tax rate than at 35%. Tax equity accounts currently for 50% to 60% of the capital stack for a typical wind farm and 40% to 50% for a typical solar project. These percentages will be lower in the future. Developers may try to fill in the gap with more debt.
In many tax equity deals that closed in 2017, investors sized their investments based on a higher tax rate. Many such deals require a one-time repricing at the end of 2018 (or sooner after the tax bill is enacted). The fact that Congress settled on a 21% rate means developers may end up having to give the investor a larger share of future cash flow to resize the investments.
Renewable energy companies worried that a new base erosion anti-abuse tax, called BEAT, could further reduce the amount of tax equity by making it harder for tax equity investors who are subject to the new tax to know, when a tax equity deal closes, whether they will receive the tax credits on which they are counting.
The base erosion tax requires an annual calculation. Tax equity investors will not know until the end of each year whether they will have to pay back tax credits on which they were counting that year.
The final bill subjects more banks potentially to the tax, but limits the potential for it to claw back tax credits to 20% of renewable energy and low-income housing tax credits claimed during the period 2018 through 2025. Credits claimed after 2025 are at risk of being fully clawed back, but the expectation is that Congress will vote by then to extend the "80% fix" that has left only 20% of tax credits exposed to a claw back.
The aim of the base erosion tax is to prevent multinational companies from reducing their US taxes by "stripping" earnings across the US border by making payments to foreign affiliates that can be deducted in the United States. An example of such a payment is interest on an intercompany loan or a payment to a back office in India for services.
The goal is to ensure that multinational companies do not use cross-border payments to reduce their US taxes to less than 10% of an expanded definition of taxable income.
Large corporations would have to calculate two amounts each year: A and B.
If B is less than A, then the US government will collect the entire gap as a tax.
A = 10% (11% for banks and securities dealers) of the corporation's taxable income after adding back two amounts: deductible cross-border payments to affiliates and a percentage of any tax losses claimed that were carried from another year.
B = the corporation's regular tax liability reduced by all tax credits other than an R&D tax credit.
The problem for tax equity investors is that entering into tax equity deals has the potential to create a gap by reducing B. More tax credits will reduce B.
House and Senate negotiators decided that B does not need to be reduced by 80% of renewable electricity production credits, investment tax credits for energy assets or low-income housing credits or, if less, 80% of the gap between A and B if B were reduced fully for these tax credits. The 80% number was the most they felt they could afford.
All tax credits -- including the R&D credit -- will reduce B after 2025.
The tax rate for calculating A will start at only 5% in 2018 (6% for banks and securities dealers), making 2018 something of a transition year when the tax is less likely to be triggered. The rate will increase after 2025 to 12.5% (13.5% for banks and securities dealers). Thus, a gap is more likely after 2025 when A will be a higher number and B will be a lower number.
Manufacturers with global supply chains complain that the tax will discourage them from manufacturing in the United States because cross-border payments to affiliated components suppliers will end up being added to A.
Cross-border payments to affiliates are not added to A if the US collected a 30% withholding tax on the payment at the border. Many types of cross-border payments are subject to US withholding taxes, but the rates are often reduced due to tax treaties. A reduced rate means part of the cross-border payment would be added back.
Some cross-border derivatives payments and some cross-border payments for services that merely compensate an affiliate for the services at cost would also not have to be added to A.
The calculations will have to be done only by large corporations.
Deductible cross-border payments must amount to at least 3% of a corporation's deductions for the year for the corporation to be caught up in the provision. It is 2% for banks and securities dealers. The corporation would also have to have average gross receipts over the prior three years of at least $500 million. All related companies with more than 50% common ownership are treated as a single corporation for purposes of these tests. However, only income earned in the United States is taken into account.
The tax equity market should continue to function. However, one consequence of BEAT is some tax equity investors may try giving credit for only 80% of tax credits in pricing through 2025 and zero after 2025. This may cause wind developers, whose BEAT issues are more acute than solar, to switch to investment tax credits or move to a "pay-go" structure for tax credits after 2025. An investment tax credit is claimed entirely in the year the tax equity deal funds, giving the investor a better chance of predicting its BEAT exposure for the year than trying to project BEAT exposure out 10 years in deals with production tax credits.
Most investors in existing tax equity deals are at risk for any tax credits that are clawed back under BEAT. The credits are credited against their returns even though the investors may not receive them in fact.
The bill will allow the full cost of equipment to be written off immediately rather than depreciated over time.
The change applies to equipment acquired and put into service after September 27, 2017.
Equipment that straddles September 27 -- it was acquired or was under a binding contract to be acquired before September 27 and is put in service after -- will qualify for an immediate write off of from 50% to 30% of the cost, with the rest of the depreciation to follow, depending on when it is put in service. Straddle equipment qualifies for a 50% bonus if put in service in 2017, 40% in 2018, 30% in 2019 and 0% after that.
Full expensing will end in December 2022, but then phase down at the rate of 20% a year through 2026. Most assets must be in service by then to qualify for any bonus. However, assets, like transmission lines, gas pipelines, and gas- or coal-fired power plants would have an extra year to get into service, but only the tax basis built up through the deadline without the extension would qualify for whatever bonus applies.
Expensing is essentially a 100% depreciation bonus. There is currently a 50% depreciation bonus, but it only applies to new equipment. The 100% bonus can be claimed on used equipment. However, the used equipment cannot be acquired from a related party, meaning from another company with whom the buyer has more than 50% overlapping ownership.
Regulated public utilities do not qualify. Real estate businesses have a choice: they can choose between a 100% bonus or being able to borrow without a new limit on interest deductions described in the next section.
Most tax equity investors have been uninterested in the existing 50% depreciation bonus. They would rather spread their scarce tax capacity over more projects. However, most have been claiming it in 2017 as a way of mitigating the effects of potential future tax rate reductions. It is better to deduct as much as possible in 2017 before the tax rate goes down.
The bill lets developers opt out of the 100% bonus and depreciate assets more slowly. This will help manage how quickly tax equity investors exhaust their capital accounts in partnership flip transactions. Once the capital account is exhausted, the remaining depreciation shifts back to the developer and could drag tax credits with it.
The bill will make some borrowing more expensive.
It will deny interest deductions on debt starting in 2018 to the extent a company's net interest expense exceeds 30% of its adjusted taxable income. Its income for this purpose means income ignoring interest expense, interest income, NOLs and -- only through 2021 -- depreciation, amortization and depletion. Thus, the limit on interest deductions is less likely to come into play through 2021 than after when the 30% will be 30% of a smaller number.
Any interest that cannot be deducted in a year can be carried forward indefinitely.
The limit on interest deductions will not apply to any business with average gross receipts of $25 million or less.
It will not apply to regulated public utilities. It is elective for real estate businesses.
Congress estimated that 95% of businesses will not be affected through 2021.
The limit is calculated at the partnership level where a project is owned by a partnership. Any interest that cannot be deducted by the partnership because of the limit would be allocated to the partners in the same ratio as net income and loss and held by the partners for use solely to offset any future "excess" income they are allocated by the partnership. These deductions cannot be specially allocated to partners.
They will reduce the "outside basis" of the partner. Once a partner's outside basis hits zero, any further cash distributions from the partnership must be reported by the partner as capital gain.
Only a fraction of the future income allocated to the partner in any year is considered "excess" income that can be offset by the deferred interest deductions that have been moved to the partner level. The numerator of the fraction is 30% of the partnership's income for the year, less the interest the partnership cannot deduct that year. The denominator is 30% of the partnership's income for the year.
The bill does not grandfather existing debt.
The bill will require companies to report income to the US tax authorities, starting in 2018, no later than they report it on financial statements.
This applies solely to companies that use accrual accounting.
It does not apply to prepaid rent in leases, but will apply to original issue discount on debt instruments. Any acceleration of past OID can be taken into account over six years.
The bill has a hierarchy of financial statements. The first place to look for how quickly income is being reported for book purposes is a 10-K or annual financial statement filed with the US Securities and Exchange Commission.
If there is none, then the focus shifts to the company's audited financial statements shown to creditors, shareholders or partners. If there is none, then the IRS will look at filings with other federal agencies.
Foreign companies with US income, but without any of these items, should look at filings with the equivalent of the US Securities and Exchange Commission or with certain other government agencies to be identified by the IRS.
The bill will prevent future use of prepaid power contracts.
In some power purchase agreements, the utility taking the electricity pays in advance for a share of the electricity to be delivered over time. The structure is used mainly where electricity is being sold to a municipal utility or electric cooperative. It is also used to supply natural gas to such utilities.
The generator or gas supplier reports the advance payment over the period the electricity or gas is delivered.
Prepayments are also common in the solar rooftop market.
The bill will require such prepayments to be reported immediately as income or, at best, partly in the year the prepayment is received and the balance in the year after.
Transfers of partnership interests after 2017 will no longer cause a partnership to terminate for tax purposes.
The market goes to great lengths currently to avoid terminating partnerships for tax purposes. A partnership terminates currently if 50% or more of the profits and capital interests in a partnership are transferred within 12 months. The depreciation has to restart, causing some loss in time value of tax benefits.
Individuals will only have to report roughly 80% of income they receive from partnerships, S corporations and other pass-through entities.
The actual percentage is complicated to calculate.
The bill has "guardrails" to prevent lawyers, doctors and other professionals from qualifying.
Partnership and S corporation income is reported on schedule E of individual tax returns in the US. Partners and S corporation shareholders will be allowed to deduct a percentage of that income, thus paying tax only on what remains.
The deduction is 20% of such partnership and S corporation income.
However, it may be less.
First, the deduction cannot exceed 50% of the partner's or shareholder's share of the wages paid by the business to employees as reported on W-2 forms sent to the IRS. If greater, the partner or shareholder can use as its cap 25% of wages plus 2.5% of its depreciable basis in property being used in the business.
This wage cap only applies in years when the partner or shareholder earns more than $415,000 (on a joint return, or $207,500 if single). For individuals earning between $315,000 and $415,000 (on joint returns, or $157,500 to $207,500 if single), the 20% deduction he or she can claim without the wage cap is subject to an alternate adjustment.
The wage cap does not apply to income received from master limited partnerships.
Second, the deduction cannot be more than 20% of the ordinary income the partner or shareholder reported for the year from all sources.
The deduction is not available for income that individuals earning more than $415,000 a year (on joint returns, or $207,500 if single) receive from law, accounting, brokerage and consulting firms, medical practices and other businesses where the principal asset is the "reputation or skill of 1 or more of its employees." It is not available to investment management firms, traders or dealers in securities, partnership interests or commodities.
Anyone earning between $315,000 and $415,000 a year (on a joint return, or between $157,500 and $207,500 if single) gets some deduction for income from such businesses, but not the full amount.
The deduction takes effect in 2018. It ends after 2025.
Investors in master limited partnerships can deduct not only as much as 20% of income allocated to them by the MLP, but also gain from sale of MLP interests to the extent the gain is taxed as ordinary income.
Corporations will not be able to use net operating losses incurred after 2017 to reduce income by more than 80% in a year, and they will no longer be able to carry such losses back two years as they have been allowed to do in the past.
Some workout advisers say this will make it more challenging for distressed companies to get back on their feet.
The bill will allow such losses to be carried forward definitely.
The House bill threatened to make it more expensive for independent power plants to connect to the utility grid. This provision did not make it into the final bill.
However, the final bill will require corporations who receive help from a government or civic group to report the contribution as income. In the past, a payment by a town to a railroad, for example, to cover the cost of moving tracks to an overpass above a highway so that trains will not block traffic was not considered income to the railroad. Some people have asked whether property tax abatements fall in this category.
The bill moves the US closer to a territorial tax system where US companies are taxed only on their income from US sources.
US companies have at least $2.6 trillion parked currently in offshore holding companies.
The bill subjects these untaxed earnings to US tax as if the earnings had been brought back to the US, thereby triggering a tax. All post-1986 net "earnings and profits" will be taxed at a 15.5% rate to the extent they are being held in cash or cash equivalents and at an 8% rate otherwise. Companies must calculate the earnings as of November 2, 2017 and December 31, 2017 and pay US tax on whichever amount is higher.
The taxes can be paid ratably over eight years. Eight percent of the tax would have to be paid in each of the first five years starting in 2017, increasing to 15% in year 6, 20% in year 7 and 25% in year 8.
Foreign taxes paid on the earnings would be available for use as an offsetting foreign tax credit, but with appropriate adjustments to reflect the reduced level of US tax.
Mandatory repatriation only applies to US shareholders holding at least a 10% voting interest in the foreign corporation with the undistributed earnings.
US corporations will no longer be taxed on dividends from foreign corporations in which they own at least 10% of the shares by vote or value to the extent the dividends are paid out of earnings earned outside the United States.
This applies to dividends paid after 2017.
The shares must basically have been held for more than a year. The US corporation must have been at least a 10% shareholder during the entire time.
Income from cross-border sales of electricity, turbines and other "inventory" will be treated as earned in the country where the items were made.
This has tax implications. Income that a US company earns, for example, from generating electricity in Canada or Mexico and selling across the border into the United States would be considered foreign-source income. If the Canadian or Mexican project is owned by a local project company that is a corporation for US tax purposes, then dividends of the earnings would not be taxed in the United States.
Until now, income from inventory sales was treated as earned in the country where title passes, with the exception that companies have had a choice of three methods for splitting income from inventory produced in the one country and sold in another, one of which has been to divide it equally between the two countries.
Starting in 2017, the US will no longer allow some cross-border interest and royalty payments to related parties to be deducted.
This would happen if the other country treats the payments as something other than interest or royalties for its tax purposes or the two countries treat the US company making the payments differently: for example, one treats it as a corporation and the other treats it as fiscally transparent or vice versa.
Once the provision is triggered, deductions would be denied in the US to the extent the payment does not have to be reported as income in the foreign country.
Two companies are considered related if there is more than 50% common ownership by vote or value.
On July 27, 2017, the FCA announced that they would no longer compel or persuade banks to make submissions to LIBOR as from the end of 2021.