Chairman Brady released his comprehensive tax reform bill (Tax Cuts and Jobs Act or the House Bill), on November 2, 2017.¹ The House Bill has the potential to foster energy development by encouraging the energy sector, which is very capital intensive, to invest significantly in the United States. That being said, the effects of the bill's other provisions on the sector will require further analysis.

The House Bill would, if enacted in its current form, immediately and permanently reduce the statutory corporate tax rate to 20%, while eliminating many current business tax benefits. Further, the US tax system would move to a territorial system of taxing foreign earnings with anti-base erosion provisions targeting both US-based and foreign-based multinational companies. Significantly, the House Bill includes a new excise tax on otherwise deductible payments from US companies to related foreign companies. The adoption of a territorial tax system includes a one-time transition tax on accumulated foreign earnings, determined as of November 2, 2017, or December 31, 2017 (whichever is higher), at a 12% rate for cash and cash equivalents and a 5% rate for illiquid assets, and payable over up to eight years. For an overview of the House Bill, and its potential application to individuals, accounting methods, and various other sector implications, please see Tax Alert 2017-1831.

Many energy sector companies will have to model the effects of the business provisions of the House Bill to understand their net effect. Aggressive across-the-board tax cuts, including the reduction of the corporate rate to 20%, the repeal of the Alternative Minimum Tax (AMT) and various other provisions would be beneficial. Certain limitations on taxpayers' ability to utilize net operating losses (NOLs) and the repeal of the Section 199 deduction for domestic production activities, however, could be detrimental to certain energy companies. Similarly, while the reduction in the deductibility of net interest will discomfit some taxpayers, certain regulated public utility entities, among others, will be eligible for a limited exemption, at least for the debt associated with their operating companies.

General business provisions that could affect energy companies

While the effect of the House Bill's provisions ought to be analyzed on a company-by-company basis, as well as a sector-by-sector basis, many provisions of the House Bill have general applicability to energy sector companies.

Corporate

The House Bill contains many provisions that would affect corporations, including, but not limited to, the following:

— 20% corporate tax rate — The new rate would be effective for tax years beginning after 2017.

— 100% expensing — Taxpayers would be able to expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (with an additional year for certain qualified property with a longer production period). 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.

— Repeal of corporate AMT — The House bill would repeal the corporate AMT. Taxpayers would be able to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020 and 2021. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2022. The provision would generally be effective for tax years beginning after 2017.

— Research credit — The research credit would be preserved without modification from current law.

— Section 199 — The domestic production deduction for qualifying receipts derived from certain activities performed in the United States would be repealed for tax years after 2017.

— Interest limitation — Multiple limitations would be provided through revisions to current Section 163(j) and a new Section 163(n) would be added.

— Net operating losses (NOLs) — The deduction of an NOL carryforward would be limited to 90% of a C-corporation's taxable income for tax years beginning after December 31, 2017. The carryback provisions would be generally repealed for losses generated in tax years beginning after December 31, 2017, except for a special one-year carryback for certain taxpayers (among other provisions for other sectors). NOLs arising in tax years beginning after 2017 would be allowed to be carried forward indefinitely with an interest factor to preserve their value.

— Other provisions to be repealed or modified — Section 179 expensing would be expanded; the like-kind exchange rules would be modified by limiting like-kind exchanges to only those involving real property (to be discussed in further detail); self-created property (i.e., patents, inventions, models, or designs) would no longer be treated as a capital asset and the disposition would be treated as ordinary in character; and a separate provision would repeal the current rule that treats the sale or exchange of certain patents as long-term capital gain.

Pass-throughs

The House Bill includes the addition of a new income tax rate of 25% for individuals who own pass-through businesses. To the extent that an individual has taxable income that would otherwise be subject to a rate higher than 25%, any qualified business income (QBI) generally would be taxed at a 25% rate. QBI means, generally, all net business income from a passive business activity, plus the capital percentage of net business income from an active business activity, reduced by carryover business losses and by certain net business losses from the current year, as determined under the provisions in the House Bill.

Tax Alert 2017-1831 includes more information on: (a) identifying business activities, (b) determining income or loss, (c) separating passive and active activities, (d) identifying specified service activities, (e) determining the capital percentage, (f) determining the applicable percentage, and (g) determining the amount eligible for the QBI rate.

Other pass-through items that may be of interest to energy companies would include: (1) the repeal of partnership technical terminations caused by the sale or exchange of a 50% or more interest in the capital and profits of a partnership under Section 708(a)(1)(B) (the repeal would apply for partnership tax years beginning after December 31, 2017); (2) the repeal of the exclusion from self-employment tax for limited partners; and (3) certain rules related to the deductibility of interest expense.

International

The House Bill's major proposals for the international tax system include: (a) implementing a territorial tax system; (b) imposing a transition tax on accumulated foreign earnings; and (c) imposing anti-base erosion rules. Highlights include:

— 100% exemption for foreign-source dividends — the House Bill would exempt 100% of the foreign-source portion of the dividends received by a US corporation from a foreign corporation in which the US corporation owns at least a 10% stake.

— Repeal of investment in US property — the House Bill would repeal the rules that taxed as dividends the investments made by certain foreign corporations in US property.

— Limitation on losses with respect to 10%-owned foreign corporations — Only for determining loss on the sale of stock of a 10%-owned foreign corporation, a US parent would reduce its basis in the stock of the foreign corporation equal to the amount of any exempt dividend it received from that foreign corporation.

— Mandatory toll charge on tax-deferred foreign earnings — A one-time transitional tax would be imposed on a US 10% shareholder's pro rata share of the foreign corporation's post-1986 tax-deferred earnings, at the rate of either 12% (in the case of accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 5% (in the case of accumulated earnings invested in illiquid assets. A foreign corporation's post-1986 tax-deferred earnings would be the greater of those earnings as of November 2, 2017, or December 31, 2017. The US shareholder could elect to pay the transitional tax over a period of up to eight years.

— Repeal of foreign base company oil-related income as subpart F income — Foreign base company oil income would no longer be subject to immediate taxation in the United States.

— Repeal of 30-day controlled foreign corporation (CFC) rules — Foreign corporations would be considered CFCs as soon as the ownership requirements were met and subject to the subpart F and base erosion rules.

— Anti-base-erosion provisions — The House Bill would impose current US tax on 50% of a US shareholder's aggregate net CFC income (excluding certain items) in excess of extraordinary items from tangible assets. The extraordinary return base would equal 7%, plus the Federal short-term rate of the CFC's aggregate adjusted basis in depreciable tangible property, minus interest expense. Only 80% of the foreign taxes paid on the income would be allowed as a foreign tax credit.

— Excise tax on payments to foreign affiliates — The House Bill would subject all deductible payments, except interest paid to a related foreign company, to a 20% excise tax, unless the related foreign company elects to treat those payments as effectively connected income (ECI) and thus taxable in the United States. Further limitations would apply.

— Foreign tax credit changes — Indirect foreign tax credits would only be available for subpart F income.

— Look-through rule for related CFCs made permanent — The House Bill would make look-through provisions permanent for tax years of foreign corporations beginning after 2019.

Energy sector specific implications

Mining and Metals

The majority of mining and metals companies may be very pleased with what has been released in the House Bill. The bill provides for the repeal of the AMT — along with a mechanism to refund a company's balance of AMT credits over the next several years. Under the House Bill, the ability to claim percentage depletion for mining activities, combined with AMT repeal, would provide increased benefits for many sector companies.

Because of historic AMT adjustments related to percentage depletion and development costs, many mining and metals sector companies have been consistently subject to AMT and have large balances of AMT credits representing these prior year AMT payments. The repeal of the AMT would not only be a significant simplification for mining and metals companies, but would also enable them to more completely benefit from tax preferences created to encourage mining activities through the accelerated expensing of development costs and percentage depletion that would be retained under the House Bill. Similarly, the potential refunds of prior period AMT credits in tax years 2019-22 could allow many mining and metals companies to pay down debt or make new capital investments.

The mining and metals sector is particularly capital-intensive, with long payback periods for new capital projects. In this landscape, expanding the asset expensing provisions for 100% of qualified property while extending the term through 2022 to allow for the impact on actual capital decisions would be very beneficial and we would expect this to drive capital investment in the sector. On the other hand, limiting interest deductions to 30% of adjusted taxable income could significantly and adversely affect the after-tax cost of capital for investment decisions that could have been made several years ago. For many mining and metals companies, this limit on interest deductibility would be the largest negative effect of the House Bill.

While all the proposed international provisions would affect the mining and metals sector, no provisions appear to expressly single out the sector. The one provision that appears particularly interesting to mining and metals companies would be the proposed 20% excise tax on payments to foreign affiliate companies that do not elect to have these payments taxed as US ECI. Many global mining companies perform a variety of related-party cross-border technical services, as well as the cross-border transfer of minerals and metal products for either further beneficiation or sale. This would require companies with intercompany transactions of this type to quickly quantify the impact of these proposed rules on these flows, or alternatively consider modifying their procurement and sales to source products and services through unrelated parties.

Oil and gas

Similar to the mining and metals sector, oil and gas companies, on balance, may react somewhat favorably to the House Bill's business provisions. Perhaps most importantly for the oil and gas sector, several of its highest priorities - maintaining the deductibility of intangible drilling costs (IDCs), its eligibility to take percentage depletion, the ability to recovery certain geological and geophysical costs, and the designation of certain natural resource-related activities as generating qualifying income under the publicly traded partnership rules (PTP) were not touched.

As the oil and gas sector is also very capital intensive, and often needs many years to recoup necessary investments, expanding the 100% expensing provisions for five years ought to be effective for the deployment of capital and development of new projects. The oil and gas sector has a history of reinvestment and developing large scale operations that provide both economic growth and employment, and the 100% expensing provisions would appear to further that purpose.

Another potential benefit to oil and gas companies is the proposed repeal of AMT, coupled with the ability to obtain refunds of prior-period AMT credits. Given the nature of drilling programs and capital spending in the sector, many oil and gas companies have been in an AMT position and have carryover AMT credits. Eliminating the economic and administrative burden of the AMT, while allowing prior AMT credits to be potentially refunded, ought to be received positively by affected taxpayers. As previously noted, the oil and gas sector has historically re-deployed capital into new projects, and the repeal of the AMT and the credit provisions appear to further that purpose and ought to allow new, significant investments to be made.

On the other hand, the new provisions related to interest may be detrimental to oil and gas companies. The limitation on the deductibility of interest (which would generally not apply to regulated utilities, certain real property businesses, regulated gas pipelines, and certain other regulated assets) could negatively affect the after-tax cost of capital for investment decisions; those effects, however, ought to be modeled in connection with the 100% expensing, repeal of AMT, and other provisions to appropriately determine the true impact. Similarly, the elimination of the Section 199 deduction for certain domestic production activities may negatively affect certain oil and gas companies, particularly those in the downstream space. Also unfavorable to oil and gas companies, the House Bill would eliminate the carryback of specified liability losses, a provision that has been beneficial to an industry with large NOLs in the bonus depreciation years.

The House Bill's approach to oil and gas sector-specific tax incentives for conventional production is hit or miss: the enhanced oil recovery tax credit (Section 43) and the credit for producing oil and gas from marginal wells (Section 45I) are both proposed to be repealed (as they were previously, in the 2014 Camp bill). However, a number of provisions previously targeted in the 2014 Camp bill, including the Section 179C election to expense certain refineries; the passive activity exception for working interests in oil and gas wells; and the special rules for gain or loss on timber, coal, and domestic iron ore, were not addressed.

In the international tax section of the bill, the House Bill includes several oil-and-gas-specific provisions, including the proposed repeal of the foreign base company oil-related income rules. This proposal, which was not previously proposed in the Camp bill, would be effective for tax years of foreign corps beginning after 2017, and for tax years of US shareholders in which or with which such tax years of foreign subsidiaries end. Additionally, in the calculation of multinationals' one-time repatriation tax bill, recapture of foreign oil and gas losses was treated similarly to overall foreign losses, thus ensuring that the rules do not inadvertently discriminate against the oil and gas sector. Additionally, and as noted in the mining and metals sector implications section, the 20% excise tax, as well as the anti-deferral provisions and the one-time transition tax, could adversely affect certain oil and gas companies. Multinational oil and gas companies ought to quickly quantify the effects of these proposed rules on global operations and global payments and potentially consider modifying their procurement and sales to source products and services through unrelated parties. Finally, to the dismay of certain non-US investors, the Foreign Investment in Real Property Tax Rules do not appear to be altered under the House Bill.

Lastly, the House Bill appears to retain the working interest exception to the passive activity rules, and also appears to retain qualifying like-kind exchange treatment for certain investments in oil and gas reserves. The House Bill also contains a number of provisions related to pass-through activities, including the repeal of the technical termination rules under Section 708(b)(1)(B), which could affect joint venture relationships of oil and gas companies.

Power and utilities

The House Bill contains a number of provisions directly addressing power and utility companies. As capital-intensive businesses, power and utility companies are very interested in the immediate expensing provisions and the treatment of interest. With hundreds of millions of dollars invested in assets each year by the power and utilities industry, the treatment of the cost of capital is an economic factor on the minds of Treasurers and Chief Executive Officers. Unlike companies in most other industries, the debt-to-equity mix of regulated power and utility companies is already established and monitored at the state level.

The House Bill provides an exemption from the definition of qualified property for regulated power and utility companies, thereby forcing the use of the modified accelerated cost recovery system or an elective straight-line depreciation (under the alternative depreciation system). Most utility companies have historically used bonus depreciation and have amassed a large number of federal NOLs. The House Bill would permit these companies to start using their stockpile of NOL carryforwards. Conversely, the House Bill would eliminate the carryback of specified liability losses, a provision that has benefited an industry with large NOLs in the bonus depreciation years.

With large annual capital investments, an important issue to the power and utilities industry is the deductibility of net interest expense. Those regulated utilities ineligible for the proposed full expensing rules would be exempted from the net interest expense limitation rules. The House Bill defines business interest to exclude the interest paid or accrued on debt allocated to entities with rate-regulated revenue from electrical energy, water, sewage disposal, gas or steam through local distribution systems and gas or steam transported through pipelines. The House Bill does not provide a method of allocating interest to a rate-regulated entity, leaving a question as to whether a Section 861-type allocation method or perhaps a net book assets allocation method applies. Should this provision survive, further guidance would be needed.

Another provision included in the House Bill directly affecting power and utilities companies is the effect of the reduction in the overall tax rate on deferred taxes. The reduction in the tax rate would result in power and utility companies having excess accumulated deferred tax balances that would need to be passed on to customers in accordance with current normalization rules. The House Bill sets forth the average rate assumption method (ARAM) to pass the benefit of the lower tax rate and reduction in deferred tax liabilities to customers over the remaining regulatory life of the utility property. The House Bill does permit a simplified alternative method if information is not available to compute the ARAM method.

Few power and utility companies have international operations, but those with CFCs with non-previously taxed unremitted earnings and profits would incur the one-time tax on tax-deferred earnings. For those companies with previous foreign-source income limitations due to Section 861 allocations, the ability to use foreign tax credit carryforwards against this tax is a benefit. Finally, the repeal of Section 956, requiring immediate income recognition for loans or other investment in US property, such as stock of the US entity, is well-received among power and utility companies with foreign operations, as is the 100% exemption of foreign-source dividends paid by a CFC.

Renewable and alternative energy

The House Bill contains a number of provisions related to renewable and alternative energy, many of which could affect companies either currently investing and operating in the space or currently considering making such investments.

The House Bill proposes major retroactive changes to the Section 45 production tax credit (PTC) for electricity produced from renewable resources. The inflation adjustment, under which the base credit amount of 1.5 cents per kilowatt hour has risen with inflation to 2.4 cents, would be repealed, effective for electricity and refined coal produced at a facility whose construction begins after the House Bill's enactment date. The statutory language provides that the reduction in the credit rate would apply only to facilities that begin construction after the date of enactment, but the section-by-section analysis accompanying the House Bill indicates that a "taxpayers' credit amount would revert to 1.5 cents per kilowatt hour for the remaining portion of the 10-year period," which implies that the change would also apply to electricity produced at existing facilities. Subsequent signals from the committee confirm that the termination of the inflation adjustment is intended to apply to qualified facilities whose construction begins after the House Bill's enactment date.

The House Bill would also alter the current IRS guidance for qualification of when construction begins on a qualified facility. There are currently two methods by which a taxpayer can establish that construction has begun — a physical work test and a 5% safe harbor. The methods require the taxpayer to satisfy a continuous construction or continuous efforts requirement, respectively. Under guidance issued by the Internal Revenue Service in 2016 (Notice 2016-31), if a taxpayer places a facility in service during a calendar year that is no more than four calendar years after the calendar year during which construction of the facility began, the facility will be deemed to have satisfied the continuous construction requirements.

The House Bill would overturn that guidance and provides instead that the construction of any facility, modification, improvement, addition or other property may not be treated as beginning before any date unless there is a continuous program of construction beginning before such date and ending on the date that such property is placed in service. This clarification would apply to tax years beginning before, on or after the date that the House Bill is enacted into law.

The House Bill leaves largely intact the investment tax credit (ITC) provisions for both residential and commercial solar property that were enacted in 2015, preserving the 30% ITC for solar energy property whose construction begins before 2020, phasing down to 26% for solar property whose construction begins before 2021 and to 22% for projects beginning construction before 2022. For the residential solar credit under Section 25D, the credit would expire at the end of 2021. For the commercial ITC under Section 48, a permanent 10% ITC would be available for solar property whose construction begins after 2021. In a noticeable departure from the 2015 agreement, the House Bill would eliminate the 10% ITC for property whose construction begins after 2027.

The House Bill would also extend the Section 48 investment tax credit to technologies that were left out of the 2015 PATH Act, namely fiber-optic solar property, geothermal energy, fuel cells, microturbines, combined heat and power systems, and small wind systems. The expiration dates and phase-out schedules for these technologies would be harmonized with the solar ITC. Accordingly, fiber-optic solar energy, qualified fuel cell, and qualified small wind energy property would receive a 30% ITC for property whose construction begins before 2020, 26% for property whose construction begins before 2021, and 22% for property whose construction begins before 2022. No ITC would be available for property whose construction begins after 2021. Additionally, the 10% ITC for qualified microturbine, combined heat and power system, and thermal energy property would be available for property whose construction begins before 2022.

The Section 25D residential energy efficiency credit likewise would be extended and phased out for other technologies that were omitted from the 2015 PATH Act, including qualified geothermal heat pump property, qualified small wind property and qualified fuel cell power plants. These particular amendments would apply to property placed in service after 2016.

Finally, the House Bill would clarify that the construction of any solar facility, modification, improvement, addition, or other property may not be treated as beginning before any date 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 clarification would apply to tax years beginning before, on, or after the date of the House Bill's enactment.

The House Bill fails to extend a number of other temporary tax incentives for renewable energy. On December 31, 2016, provisions aimed at stimulating both renewable baseload electricity facility development, and advanced biofuel production, expired. Technologies affected by the electricity credit expiration include hydropower; biomass and waste to energy. Biofuel companies still hoping for an extension of their expired incentives include biodiesel; renewable diesel; alternative fuels and second generation biofuels.

Conclusion

While the potential effects of the Tax Cuts and Jobs Act will vary across the domestic energy sector on a company-by-company basis, at first glance, we think the bill could drive economic growth and foster energy development. The energy sector is very capital-intensive, and has a history of re-deploying capital and earnings into new projects, driving economic activity and employment. Chairman Brady's proposal appears to support and encourage companies to continue to make significant investments in the United States. That being said, a number of provisions, including those related to interest expense limitations, those affecting inbound energy investments, and those related to the taxation of foreign income and foreign persons, will require further analysis.

Next steps

The House Bill will be the subject of Committee consideration, kicking off formal tax committee action on the first such overhaul of the US federal tax system in over 30 years. Separately, Senate Finance Committee Chairman Orrin Hatch (R-UT) announced that he plans to release a Senate Republican version of a tax reform bill after the Ways and Means Committee completes its work.

———————————————

———————————————
ENDNOTES

¹ Subsequently, on November 3, 2017, Chairman Brady released an Amendment in the Nature of a Substitute to H.R. 1 (collectively with the original version of H.R. 1, the House Bill). The same day, the staff of the Joint Committee on Taxation released a "Description of H.R. 1, The 'Tax Cuts and Jobs Act,'" which provides for additional commentary around the House Bill.