On November 9, 2017, Senate Finance Committee Chairman Orrin Hatch released his Chairman's Mark of the Tax Cuts and Jobs Act (the Chairman's Mark or Senate proposal) which, similar to the House Ways and Means Committee (Ways and Means) bill, includes many provisions that would directly and indirectly affect the power and utility industry.

For an overview of the Chairman's Mark, please see Tax Alert 2017-1907 and for an overview of the Ways and Means bill, 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 Chairman's Mark include the reduction of the corporate tax rate to a flat 20% (similar to the Ways and Means bill). The Senate proposal would apply the lower rate for tax years beginning after December 31, 2018 (the Ways and Means bill provides after December 31, 2017) along with the elimination of the AMT beginning after December 31, 2017 (both provisions are similar), although the Chairman's Mark would accelerate the period to recoup certain AMT credits by one year, as compared to the Ways and Means bill.

Under both proposals, power and utility companies generally would recognize the tax benefit of the lower US statutory tax rate on non-regulated operations. However, for regulated entities governed by the Federal Energy Regulatory Commission (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 challenge will be determining the effect of the lower tax rate on deferred liabilities at the date of enactment, which likely will be in advance of the effective date of the tax rate change. The lower tax rate would result in rate making implications, which would require regulated utilities to model the effects and work closely with commissions on application and transition rules to properly record the lower tax rate benefit for both the Security and Exchange Commission (SEC) and regulatory filing.

Net operating losses

The Chairman's Mark would follow the Ways and Means bill by limiting the deduction of a NOL's carryforward to 90% of a C-corporation's taxable income for tax years commencing after December 31, 2017. The carryback provisions would generally be repealed, except for a special two-year carryback for certain losses (one year carryback in the Ways and Means bill). The Chairman's Mark provides that NOLs arising in tax years beginning after 2017 would be allowed to be carried forward indefinitely (same for the Ways and Means bill); however, the Chairman's Mark makes no provision for an interest factor to preserve the NOL carryforward value as in the Ways and Means Bill.

With significant specified liability losses, such as environmental expenses, power and utility companies have utilized the current law 10-year carryback provisions to carryback current year expenses and recoup taxes paid in past tax years. Both proposals would prohibit this type of carryback and require these losses be carried forward in the pool of NOL carryforwards.

Increased expensing on capital investments

The Chairman's Mark, similar to the Ways and Means bill, would require regulated public utilities to rely on the traditional modified accelerated cost recovery system depreciation rules under Section 168 and would provide that such entities are ineligible for the 100% immediate expensing allowed for other businesses. Power and utility companies may always elect the alternative depreciation system, which provides for longer depreciation life under a straight-line method.

The 100% expensing provisions in the Chairman's Mark would exclude from the definition of qualified property certain public utility property, i.e., property used predominantly in the trade or business of furnishing or sale of 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.

The Ways and Means bill does not use the terms property predominantly used in a regulated public utility trade or business, but rather references property of trades or business not subject to the limitation on interest expense rules. It is unclear whether the addition of the term "predominantly" was meant as a clarifying term or rather to broaden the set of inclusive assets. Careful review of legislative language would be required if finalized.

Companies not explicitly defined as regulated entities in the Chairman's Mark 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).

Unlike the Ways and Means bill, the Chairman's Mark does not modify the original use test. The Ways and Means bill provided that property would be eligible for the additional depreciation if it was the taxpayer's first use of the property as opposed to the property's first use as required under current law in order for a company to apply bonus depreciation.

A transition rule is proposed for a company's first tax year ending after September 27, 2017, where a company may elect to apply 50% bonus depreciation without regard to the Ways and Means bill amendments pertaining to the 100% expensing. Thus, under the Ways and Means bill, power and utility companies may be able to continue to apply the currently enacted general rules around Section 168 and 50% bonus for the entire calendar year of 2017. Under the Chairman's Mark, this is not entirely clear and would depend on how the specific wording of the bill is ultimately crafted.

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 inclusion of a normalization provision similar to that which was applied to the Internal Revenue Code of 1986, as amended. 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 Chairman's Mark, similar to the Ways and Means bill, retains these normalization rules. The Chairman's Mark did not specifically articulate the manner in which a company should comply with the normalization rules, unlike the specificity in the Ways and Means bill.

The Ways and Means bill would require the use of the average rate assumption method (ARAM) and allows for a simplified alternative method, but only 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.

Under the Ways and Means bill, 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 and 168.

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 both proposals, 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 are in a position to 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, which have no mandated treatment, such as benefit plans, bad debts, net operating losses, repairs and derivatives, amongst other items. Power and utility companies will be working closely with state public utility commissions to determine the excess deferred tax balances attributable to re-measurement at the lower US statutory tax rate on protected and unprotected classes for rate making, which ultimately will result in a refund or charge to customers. 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 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, 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.

Limitation on deduction for interest

One of the more striking differences between the Chairman's Mark and the Ways and Means bill is in the area of interest limitation for both pure domestic companies, as well as companies with worldwide operations. Both proposals would provide an exemption for interest on debt of regulated public utilities. Both would define business interest subject to limitation as interest paid or accrued on debt properly allocable to a trade or business. The Ways and Means bill would limit net interest expense to 30% of adjusted taxable income (ATI) computed without business interest income and expense, amortization, depletion, depreciation and NOL deduction. Disallowed net interest under the Ways and Means bill could be carried forward for five years. The Chairman's Mark also provides for a 30% ATI limitation, but defines ATI much more conservatively. Under the Chairman's Mark, ATI would be taxable income that includes depreciation, amortization and depletion and excludes NOL deductions and certain other items. Business interest subject to the limitation may be carried forward indefinitely under the Chairman's Mark. This item is subject to Section 382 limitation and is taken into account in transactions subject to Section 381.

A worldwide limitation on interest deductibility would be targeted at US interest deductions that are viewed as eroding the US tax base. The limitation would be based on a comparison of debt that could be incurred if the US group has a debt-equity ratio in proportion to the worldwide group's debt to equity ratio. The resulting amount of debt that "should" be in the US, based on proportionate ratios, is grossed-up by 110% to determine the amount of the US debt that is in excess of the "proper" amount. This excess would be the "excess domestic indebtedness" which would be divided by all actual domestic debt and multiplied by the net interest expense. In essence, the more that actual US debt exceeds the debt that "should" be in the US group, the more allowable percentage of interest deductions decreases.

Although interest of a regulated utility is exempt from the interest limitation rules, the Chairman's Mark has not excluded the debt of regulated utilities from the base erosion ratios already described. Thus, consolidated groups with holding company debt and worldwide operations need to be concerned about the potential effect of the disallowance of interest of holding company debt.

When both interest limitations apply, the limitation that results in the greater disallowance of interest deductions would take precedence.

Executive compensation

The Chairman's Mark would expand the $1 million deduction limit that applies to compensation paid to top executives of publicly-traded companies. The proposal would eliminate the performance-based compensation and commissions exceptions to Section 162(m) and expand the definition of a covered employee to specifically include the CEO and CFO (similarly for the Ways and Means bill). Both proposals would realign the definition of covered employee with current SEC disclosure rules. In addition, both proposals 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, for as long as the corporation pays remuneration to the person. 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. Both proposals would provide that a person is measured as a covered employee at any time during the year rather than at the end of the year.

Like-kind exchanges

Under the both the Chairman's Mark and the Ways and Means bill, the like-kind exchange rules would be modified to allow for like-kind exchanges only with respect to real property. This 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

The Ways and Means bill would repeal the exception for amounts paid or incurred related to lobbying local councils or similar governing bodies, while the Chairman's Mark does not address this provision.

Contributions in aid of construction

The Chairman's Mark does not contain any modifications to contributions to capital under Section 118, whereas the Ways and Means 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.

Manufacturing deduction

Both the Chairman's Mark and the Ways and Means bill would repeal the deduction for domestic production activities under Section 199, with different effective dates - the Chairman's Mark provides for tax years beginning after December 31, 2018, while the Ways and Means bill provides for tax years beginning after December 31, 2017.

Partnership provisions

The Ways and Means bill proposes to repeal the partnership technical termination rule whereas the Chairman's Mark does not address this provision. Alternatively, the Chairman's Mark looks to reverse by statute the ruling in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Comm'r, 149 TC No. 3 (Jul. 13, 2017), where the Tax Court declined to follow Revenue Ruling 91-32 (1991-1 C.B. 107) and held that the gain recognized by a foreign person on its redemption from a partnership engaged in a US trade or business did not result in effectively connected income. Additionally, the Chairman's Mark provides for an expansion of the mandatory downward basis adjustments on transfers of partnership interests by taking into account gain and loss allocations to the transferee. The Chairman's Mark would require a partnership to adjust the basis of its assets upon the sale of partnership interest if the partnership has a built-in loss of more than $250,000 in its assets or if the partner selling the partnership interest would be allocated more than $250,000 of a loss in a hypothetical sale of all the assets of the partnership. The Ways and Means bill did not address either of these provisions.

Alternative energy and credits

The Chairman's Mark did not contain any changes to the current investment tax credit or production tax credit rules. The Chairman's Mark is expected to receive mixed reviews from renewable and alternative energy companies, as compared to the extensive, largely negative changes included in the Ways and Means bill (see Tax Alert 2017-1848). Although the Chairman's Mark was silent on these key provisions, it is of continued importance for interested parties to closely monitor this legislation as it progresses and through a potential reconciliation process. To that end, we are hearing that there may be a separate renewable energy bill introduced in December, the contents of which are uncertain at this time.

State and local income tax considerations

Utilities should evaluate whether the specific provisions of the Chairman's Mark and the Ways and Means bill will cause an increase in state income tax liabilities. If so, the utility would also need to evaluate whether it can recover that potential tax increase from its customers, the answer to which would 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 tax burden until the result is incorporated into its next rate case.

Conclusion

While the Chairman's Mark is similar in many respects to the Ways and Means bill, certain key differences are significant, including the international tax regime, the effective dates of certain key provisions and others. While the potential effects of the Tax Cuts and Jobs Act will vary on a company-by-company basis, similar to the Ways and Means bill, the Chairman's Mark could drive economic growth and foster development. Power and utility companies collectively represent one of the largest US capital intensive industries, investing billions of dollars annually in critical infrastructure projects, driving economic activity and employment. The Chairman's Mark appears to support and encourage power and utility companies to continue to make significant investments in the US. That being said, a number of provisions, including those related to interest expense limitations and those affecting inbound energy investments will require further analysis and guidance.

Next steps

The Senate Finance Committee began mark-up of its plan on November 13, 2017 and Chairman Hatch said he hopes to report the legislation by the end of that week. A list of filed amendments and a Chairman's Modification may be issued prior to that time. Changes are likewise possible during the Committee Process.

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