November 7, 2017 Power and utility industry affected by House tax reform bill The comprehensive tax reform bill released by the House Ways and Means Committee on November 2, 2017, (Tax Cuts and Jobs Act, the House Bill) includes many provisions that would directly and indirectly affect the power and utility industry. Several provisions lower the general tax rate and could promote infrastructure investment and job creation. For an overview of the House Bill, and its potential application to individuals, accounting methods, international and various other tax implications, please see Tax Alert 2017-1831. The items detailed in this Alert are of particular importance to the power and utility industry. Lower corporate tax rate Welcomed provisions of the House Bill include the reduction of the corporate tax rate to a flat 20% for tax years beginning after December 31, 2017 along with the elimination of the AMT. Power and utility companies generally would recognize the immediate tax benefit of the lower US statutory tax rate on non-regulated operations. However, for regulated entities, governed by FERC or state public utility commissions, the lower tax rate benefits would flow back to customers under current normalization rules and agreed-upon methods with the commissions, including rate mechanisms put in place to recover costs between full rate case proceedings. Power and utility companies would need to re-measure deferred tax balances at the 20% rate. The lower tax rate would result in rate making implications, which would cause regulated utilities to have to model the effects and work closely with commissions on application and transition rules to properly record the lower tax rate benefit for both SEC and regulatory filing. Increased expensing on capital investments The power and utility industry invests billions, annually, in critical infrastructure to provide safe, affordable and reliable energy. Current bonus depreciation rules at 50% immediate expensing (and previous 100% bonus rules) have generated significant current tax savings for the capital intensive industry. The House Bill would require regulated public utilities to rely on the traditional MACRS depreciation rules under Section 168 and would be ineligible for the 100% immediate expensing allowed for other businesses. The 100% expensing and interest limitation provisions set forth in the House bill would not be applicable to businesses that furnish or sell electrical energy, water, or sewage disposal services, gas or steam through a local distribution system, or the transportation of gas or steam by pipeline if the rates for furnishing or selling, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof. This definition of a public utility is consistent with the Section 168(i)(10) definition. Companies not explicitly defined as regulated entities in the House Bill 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). The 100% expensing provision is an expansion of the current provision for bonus depreciation under Section 168(k). Another significant change of note is that property would now be eligible for the additional depreciation if it is the taxpayer's first use of the property and not the property's first use as required under current law in order for a company to apply bonus depreciation. With an effective date of September 27, 2017, companies with property eligible for immediate expensing would need to pay close attention to qualification of assets if this provision is enacted. A transition rule is proposed for a company's first tax year ending after September 27, 2017, where a company can elect to apply Section 168 without regard to the House Bill amendments of this section pertaining to the 100% expensing. Thus, power and utility companies may be able to continue to apply the general rules around Section 168 and 50% bonus for the entire calendar year of 2017. Normalization and transition rules Under current law, tax normalization is a key element in setting customer rates for regulated public utilities that spread the benefit of accelerated depreciation under Sections 167 and 168 to customers over the life of the utility property. Lowering the corporate statutory tax rate from 35% to 20% would result in excess accumulated deferred tax balances that would need to be passed on to customers in accordance with current normalization rules. One issue that is key to the utility industry is keeping the normalization provision similar to that which was applied to the Tax Reform of 1986. This passes the benefit of the lower tax rate and reduction in deferred tax liabilities (i.e., excess tax reserve) to customers over the remaining regulatory life of the fixed assets. The House Bill would retain these normalization rules. The House Bill would require the use of the average rate assumption method (ARAM) and would allow for a simplified alternative method if the utility does not have information available to compute ARAM and is required by their regulatory commission to compute depreciation for public utility property on the basis of an average life or composite rate method. Under ARAM, taxpayers amortize the excess tax reserve over the remaining regulatory lives of the property that gave rise to the reserve for deferred taxes. The amortization is calculated by multiplying the ratio of the aggregate deferred taxes for the property to the aggregate timing difference for the property as of the beginning of the year by the amount of the timing difference that reverses during the period. Under the alternative method, the amortization is calculated by taking the excess tax reserve on all public utility property and ratably amortizing it over the remaining regulatory life of the property using the weighted average life or composite rate used for regulatory book depreciation. One change from prior normalization proposals is that the penalty for failure to comply with this normalization provision would be the imposition of a tax equal to the amount of benefit that has been improperly passed through to customers. It should be noted that the normalization provision applies to accelerated depreciation under Sections 167 and168. Because there are major aspects of federal tax reform measures subject to the discretion of the FERC and state public commissioners for regulatory treatment, after modeling the effects of the House Bill, utilities may want to approach commissions in advance to gain agreement on the rate making implications and transition rules. Modeling the effects of the potential outcomes of tax reform is suggested so companies may prepare their regulatory commission for the impact on rates. Another key regulatory consideration is the flow back or immediate recognition of changes in deferred tax balances other than accelerated depreciation under Sections 167 and 168 that have no mandated treatment, such as benefit plans, bad debts, net operating losses, repairs and derivatives, amongst other items. Utilities may want to negotiate alternative flow-through or normalization treatment for certain temporary differences for rate making purposes in the context of tax reform. As with most things, planning and communication will be key to getting the most favorable outcome and to reaching agreement to properly report the regulatory tax reform effect in the period of enactment. For regulated utilities, the lower corporate tax rate from 35% to 20% would require changes to the gross-up formula of 1/(1-tax rate) on regulatory accounts, such as AFUDC-equity, contributions in aid of construction (CIAC) arrangements, and state deferred balances. The tax rate used in the gross-up calculation could be the statutory federal and state rate, the state rate only, or the statutory rate modified by permanent items such as AFUDC-equity, depending on the item, purpose, or the situation requiring the gross-up. Companies should take note which accounts currently require gross-up calculations so they can efficiently capture the effects of tax reform in the books and records in a timely manner. Also any pending CIAC agreements should be monitored or adapted to include "make whole" payments in the event the interconnect payments would become taxable, thus requiring a gross up calculation. Interest limitation A victory for the power and utility industry is the exception to the net interest limitation rules. Under the House Bill, regulated public utilities and regulated pipelines ineligible for the full investment expensing rules would not be subject to the limitation of net interest expense deduction. The House Bill, however, does not explicitly address affiliated entities of the regulated business exempted from the interest limitation. This is where additional guidance would likely be needed for consolidated filings and debt arrangements between affiliated entities. Under current law, Section 163(j) limits interest paid or accrued by certain corporations (with interest paid to foreign related parties) whose debt-to-equity ratio exceeds the safe harbor ratio of 1.5 to 1.0, and where net interest expense exceeds 50% of its adjusted taxable income. Also under current law, purely domestic companies not subject to the provisions of Section 163(j) encounter no such limitation (other than certain capitalization provisions, such as Section 263) on the current deductibility of interest expense and certainly no requirements of net interest expense. The House Bill would set forth multiple limitations through revisions to current Section 163(j) and a new Section 163(n): — Section 163(j) would be "revised" and expanded to limit the deduction for net interest expense of all businesses including pure domestic businesses. The limitation would apply to net interest expense that exceeds 30% of adjusted taxable income defined similar to current Section 163(j). — New Section 163(n) would limit the deduction for net interest expense of domestic corporations that are part of a multinational group. The limitation would be based on a comparison of the domestic corporation's EBITDA to the worldwide EBITDA of the group (referred to as an international financial reporting group). The interest expense of the domestic corporation would be grossed up by 110%, but then limited to a percentage (referred to as the allowable percentage) that takes into account the domestic corporation's share of worldwide EBITDA. — When both interest limitations apply, the limitation that results in the greater disallowance of interest deductions would take precedence, and the disallowed interest would be available as a carry over for five years. The disallowance of net interest is determined at the level of the entity filing the tax return. Thus, for flow through entities, this is at the partnership level. For consolidated groups, this is the parent corporation. Unanswered for power and utility companies is the treatment of interest expense on debt at the holding company level incurred for the capital needs or acquisition of a regulated entity, which is exempt from this provision of the House Bill. Executive compensation Under current law, Section 162(m) imposes a $1 million annual limit on deductions for executive compensation other than "performance-based compensation" for the top five highest compensated executives. The House bill would expand the $1 million deduction limit that applies to compensation paid to top executives of publicly-traded companies. The bill would eliminate the performance-based compensation and commissions exceptions to Section 162(m) and expand the definition of covered employee to specifically include the CFO. In addition, it would limit the ongoing deductibility of deferred compensation paid to individuals who previously held a covered employee position, even after they no longer hold that position. Thus, once an individual is named as a covered employee, the $1 million deduction limitation would apply to compensation paid to that individual at any point in the future, including after the cessation of services. Business-related exclusions and deductions Net operating losses Under current law, net operating losses (NOLs) generally have a carryback period of two years and a carryforward period of 20 years. The House Bill would limit the deduction of a NOL carryforward to 90% of a C-corporation's taxable income for tax years beginning after December 31, 2017. The carryback provisions would generally be repealed for losses in tax years beginning after December 31, 2017, except for a special one-year carryback for certain taxpayers (among other provisions for other industries). NOLs arising in tax years beginning after 2017 would be allowed to be carried forward indefinitely with an interest factor to preserve its value. With significant specified liability losses such as environmental expenses, power and utility companies have utilized the current law 10-year carryback provisions to carry back current year expenses to recoup taxes paid in past tax years. The House Bill would prohibit this type of carryback and require these losses be carried forward in the pool of NOL carryforwards. Like kind exchanges Under current law, an exchange of property, like a sale, generally is a taxable transaction; however, an exception exists such that no gain or loss is recognized to the extent that property held for productive use, or property held for investment purposes, is exchanged for property of a like-kind that is also held for productive use or for investment. Under current law, the like-kind exchange provisions apply to a wide range of property from real estate to tangible property. Under the House Bill, the like-kind exchange rules would be modified to allow for like-kind exchanges only with respect to real property. The provision would be effective for transfers after 2017; however, a special transition rule would apply to permit like-kind exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before December 31, 2017. Lobbying expenses Under current law, lobbying and political expenses with respect to legislation and candidates for office are disallowed deductions, except for lobbying expenses with respect to legislation before local government bodies as provided in Sections 162(e)(2) and (7). Current law disallows a deduction for amounts paid or incurred to influence legislation through a lobbying communication, participation or intervention in a political campaign for public office, attempts to influence the general public with respect to legislation and/or elections and direct communication with a specified top-level federal executive branch official in an attempt to influence actions or positions of such official. Despite the described disallowance, a deduction is allowed for ordinary and necessary expenses incurred in connection with any legislation of any local council or similar governing body (local legislation). With respect to local legislation, the exception permits a deduction for amounts paid or incurred in carrying on any trade or business: (1) In direct connection with appearances before, submission of statements to, or sending communications to the committees or individual members of such council or body with respect to legislation or proposed legislation of direct interest to the taxpayer or (2) In direct connection with communication of information between the taxpayer and an organization of which the taxpayer is a member with respect to any such legislation or proposed legislation, which is of direct interest to the taxpayer and such organization, and (3) That portion of the dues paid or incurred with respect to any organization of which the taxpayer is a member, which is attributable to the expenses of the activities described in (1) or (2) carried on by such organization. The House Bill would repeal the exception for amounts paid or incurred related to lobbying local councils or similar governing bodies. Thus the general disallowance rules applicable to lobbying and political expenditures would apply to costs incurred related to local legislation. Contributions in aid of construction Under current law, corporations exclude contributions to capital from gross income under Section 118 and to the extent stock is issued by the transferee corporation, no gain or loss is recognized under Section 1032(a). Certain non-shareholder contributions to capital are also excluded from income and include industry specific items such as generation interconnection payments and government relocation payments common to the industry. Other contributions in aid of construction are generally taxable with an exception provided to water utilities under Section 118(c). The House Bill would repeal the exclusion from gross income under Section 118 for contributions to the capital of a company unless in exchange for cash or property. An exception is provided to the extent that the transferee corporation issues stock in an amount equal to the amount of money or the fair market value of the property transferred. This would result in all non-shareholder contributions received by utilities, including those by water utilities, to be treated as taxable, thus likely resulting in the utilities requiring a gross-up payment to cover the increased tax cost. Manufacturing deduction Under current law, power and utility companies with generation operations meeting certain income and wage requirements with taxable income at the consolidated filer level may avail themselves of a deduction for income attributable to domestic production activities equal to 9% (6% in case of certain oil and gas activities) of the lesser of the qualified production activities income or taxable income for the tax year. The effect is a reduction in a company's effective tax rate. The House bill would repeal the deduction for domestic production activities under Section 199, effective for tax years beginning after 2017. Technical terminations Under current law, a partnership technically terminates if within a 12-month period there is a sale or exchange of 50% or more of the partnership capital and profits. This technical termination of the partnership results in a deemed contribution of all the partnership's assets and liabilities to a new partnership in exchange for an interest in the new partnership, followed by a deemed distribution of interests in the new partnership to the purchasing partners and the other remaining partners. The technical termination is a continuation of the earlier partnership with the termination of some tax attributes. Upon a technical termination, the partnership's tax year closes, potentially resulting in short tax years. Partnership-level elections generally cease to apply following a technical termination. A technical termination generally results in the restart of partnership depreciation recovery periods. The House Bill would repeal the technical termination rule. Thus, the partnership would continue even if more than 50% of the capital or profits interests are sold or exchanged within a 12-month period and the partnership continues in business. Production tax credit Section 45 allows a production tax credit (PTC) for electricity produced from qualified energy resources (wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy) and sold to an unrelated person. The PTC is 1.5 cents (indexed annually for inflation) per kilowatt-hour of electricity produced and is currently at 2.4 cents for 2017. The House Bill contains two significant changes to the production tax credits. The first change is the lowering of the credit level by repealing the inflation adjustment factor, effectively reducing the PTC amount by 35% back to the statutory 1.5 cents. We note that the summary of the House Bill indicates that the repeal of the inflation adjustment factor may apply to all projects, even those that are already in service. That said, the language of the House Bill does not indicate that the repeal of the inflation adjustment factor would apply to all projects, but only those which begin construction after November 2, 2017. Subsequent signals from the committee confirm that the termination of the inflation adjustment is intended to apply to qualified facilities the construction of which is begun after date of enactment. It is worth noting that wind facilities eligible for the PTC would appear to continue to be eligible for a 30% investment tax credit in lieu of the PTC, which would not be reduced under the House Bill. Given the reduction to the PTC, it is likely more important that taxpayers model their project to determine whether the PTC or the ITC is the most advantageous tax credit for their project. The second significant change is around the qualification for beginning of construction. This is an important qualification as under Section 45(b)(5), the PTC steps down 20% per year starting for projects "the construction of which begins" before January 1, 2018. Effectively, projects that begin construction in 2017 will receive only 80% of the PTC, projects that begin construction in 2018 will only receive 60% of the PTC, and projects that begin construction in 2019 will receive 40% of the PTC. Under IRS Notice 2016-31 (see Tax Alert 2016-848), wind farms were provided two different ways to meet the "begun construction" requirement; 1) a continuous program of physical construction test (i.e. physical work of a significant nature), or 2) incurring 5% of total project costs and making continuous efforts to advance towards completion of the facility. The Notice also provided a "Continuity Safe Harbor," which stated that a taxpayer satisfies the continuous efforts portion of the 5% test (and the continuous program of construction test) if the project was placed in service by December 31, 2020. Under the provision of the House Bill, it appears PTC projects could no longer begin construction by incurring 5% of project costs and could no longer avail themselves of the Continuity Safe Harbor. This would have a significant impact for taxpayers who are planning wind as PTC projects. For example, a project that began construction in 2016 by incurring 5% of project costs (but did not maintain a program of continuous construction) expected that they had qualified their project for 100% of the PTC. Under the proposed law, many of those projects would now need to start physical construction by the end of the year and continue physical construction until the project is complete in order to lock in only 80% of the PTC (which under the first significant change was also lowered from 2.4 cents per kilowatt hour to 1.5 cents). Similar to the first change, it is important that affected taxpayers pay close attention to how the bill progresses. Investment tax credit Section 48(a) provides an investment tax credit (ITC) that is equal to 30% of the cost basis of qualifying energy property (eligible energy property consists of solar energy, fiber-optic solar energy, geothermal energy, qualified fuel cell, qualified microturbine, combined heat and power system, qualified small wind energy and thermal energy properties) for both residential and commercial property placed in service before January 1, 2017. The House Bill would generally harmonize the expiration dates and phase-out schedules for different types of qualifying energy property. The ITC would remain at 30% ITC for property where construction begins before 2020, phasing down to 26% for property with construction beginning before 2021, to 22% for projects beginning construction before 2022. Under the House Bill, the residential solar credit under Section 25D would expire at the end of 2021. The House Bill would terminate the 10% ITC for property with construction beginning after 2027. The House bill would also extend the ITC for residential energy efficient property, subject to the same phase-out schedule. The House Bill would also apply the same continuous program of construction requirement for beginning of construction to the ITC as previously proposed for the PTC. This provision would harmonize the various ITC technologies. While solar is the most well-known ITC technology, Section 48 also includes qualified fuel cell property, qualified microturbine property, combined heat and power systems, and qualified small wind property. The ITC for these other technologies previously lapsed at the end of 2016. Under this provision, those technologies would be extended and the phase-out timing would now be the same as that for solar. This provision would also end the previously permanent 10% ITC for solar after 2027. It's worth noting that the solar industry has not yet received their "begun construction" guidance that would have presumably allowed for a 5% incurred and continuity safe harbor similar to what was provided to the wind industry under IRS Notice 2016-31. However, the fact that the ITC credit phase-out for solar does not start until 2020 leaves the solar industry with time to adjust their plans and qualify for the full 30% ITC, unlike the wind industry where that ship appears to have sailed under this guidance. State and local income tax considerations In addition to the federal tax consequences, the House Bill would have a trickle-down effect on state and local income taxes. The specific impact at the state level would depend upon the extent and the manner in which the jurisdiction has adopted its conformity to the Internal Revenue Code. States with "rolling date conformity" will see the federal changes automatically take effect, while states with either "fixed date conformity" or "selective conformity" may need to take specific action to adopt the changes. If the federal (and therefore state) tax base expands, but the state tax rates don't proportionately follow federal rate reductions, the states could enjoy huge windfalls of tax revenues without taking any action. On the other hand, many states have already decoupled from prior federal tax legislation that either (a) accelerated temporary or (b) created permanent deductions (i.e. bonus depreciation or Section 199 deductions). Thus, it is possible that the House Bill could have limited impact on state taxable income. For example, because many states have already decoupled from Sections 168(k) and 199, the disallowance of those deductions to "regulated utilities" may have limited state tax impact. The limitation on interest expense deductions, however, to the extent applicable to any non-regulated entities could have a significant adverse state income tax impact. Regulated utilities may need to consider reorganizing their legal structure or debt agreements to mitigate the impact of this provision on state income tax liabilities. In summary, utilities should evaluate whether the specific provisions of the House Bill will cause an increase in state income tax liabilities. If so, the utility will also need to evaluate whether it can recover that potential tax increase from its ratepayers, the answer to which will depend upon the agreement that the utility has with its commission. On one hand, the utility may have negotiated to incorporate a state tax adjustment surcharge (STAS) in its tariff. In these cases, the utility may be able to assert that federal tax reform has effectively triggered a change in its effective state income tax rate, the impact of which is encompassed within its STAS. This mechanism, if accepted, may permit the utility to incorporate the increased state income tax liabilities in a more immediate method. On the other hand, a utility may not have the flexibility of a STAS, but may have the authority to record a regulatory asset reflecting the probable future revenue impact of recovering the increased state income taxes. While this mechanism would not allow for the immediate recovery of the impact, it would permit the utility to calculate and immediately offset any negative impacts from a financial statement perspective. If neither of those mechanisms is available, a utility could be faced with simply shouldering a higher state income burden until the effect is incorporated into its next rate case. Consequently, utilities should focus on three potential efforts in the coming months: (1) utilizing a SALT-specific model to quantify the potential impacts of federal tax reform, and to identify any mitigation strategies; (2) educating their governmental affairs group as to the potential impact of federal tax reform from a state income tax perspective, so that the appropriate message can be conveyed to state legislatures; and (3) planning proactively with their public utility commissions to identify the mechanism to recover the any additional state income taxes. For a more comprehensive summary of the state tax implications of the House Bill, please read EY State Tax Alert 2017-1850. Conclusion The House Ways and Means Committee will begin deliberation on the bill this week. Separately, a Senate Finance Committee version of a tax reform bill will be released. Potential effects of the House tax reform bill will vary and power and utility companies should pay close attention to the mark-up of the House Bill, the Senate version of tax reform and the ultimate progression of these bills. ———————————————
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