January 25, 2018 Power and Utility concerns under the TCJA The "Tax Cuts and Jobs Act" (H.R. 1, the Act) was enacted on December 22, 2017, following passage in the House and Senate and signing by the President. This Alert highlights the key aspects of the Act with a focus on the provisions that could affect the Power and Utility (P&U) industry. For a general discussion of the provisions included in the Act, see Tax Alert 2017-2130. Highlights The Act largely adheres to the framework of the Senate version of the bill, but also reflects significant compromises between the House and the Senate. With respect to business taxes, the Act generally adopts the Senate approach to both pass-through and corporate income taxation, with the following rates: — 20% deduction for qualified pass-through business income — 21% top corporate income tax rate, effective beginning in 2018 The Act also limits the deduction for business net interest expense by amending Section 163(j). The revised limitation is on net interest expense that exceeds 30% of adjusted taxable income (ATI). For the first four years, ATI is computed without regard to depreciation, amortization or depletion. Beginning in 2022, ATI is decreased by those items, which could further limit interest deductibility. In addition, unlike the House and the Senate Bills, the Act drops the additional interest expense limitation that would have been imposed through a worldwide debt cap under what would have been Section 163(n). The Act also provides for immediate expensing of qualified investments. Although the Act contains many provisions that have broad applicability to energy sector companies, it is intentionally silent on the disposition of many energy-related tax incentives. Following up on commitments that were made during the tax reform debate, on December 20, 2017, Chairman Orrin Hatch introduced a bill to extend and amend a number of energy and other tax provisions. For details, please see Tax Alert 2017-2165. While proponents of the Hatch tax extender proposal had originally hoped to have it coupled with a congressional Continuing Resolution to be passed in mid-January, it now appears that the package may be held back until at least mid-February. Power and utilities The Act adopted the more favorable power and utility provisions of the House and Senate bills such as the ability to deduct (a portion of) holding company interest, interest on debt of regulated public utilities and not being eligible to immediately expense public utility property. With the Act now law, the challenge begins with interpreting the many provisions, parsing words and their application to companies with regulated and non-regulated trades or businesses as well as organizational structures, which include C corporations, partnerships, publicly traded and master limited partnerships. Compound this with states that automatically follow the Internal Revenue Code (IRC), need legislative action to follow the IRC, or follow selected sections of the IRC (or don't follow the IRC at all) and it becomes quite challenging. The SEC gave filers a reprieve in SAB 118, issued on December 22, 2017. Preparing for year-ends companies and accounting firms alike were concerned on how to apply and accurately reflect the provisions, especially the calculation of the transition tax, by the time financial statements had to be issued. SAB 118 provided relief by permitting companies to record provisional amounts related to the accounting for the Act with a maximum one year true-up period without these amounts automatically being considered errors provided the proper disclosures are made. Tax rates and normalization requirements The Act reduces the corporate tax rate to a flat 21% for tax years beginning after December 31, 2017, and eliminates the AMT (also beginning after December 31, 2017) making the AMT credit available for refund. For tax years before January 1. 2021, the refundable amount of the credit is limited to 50% of the difference between the excess minimum tax credit for the year over the credit allowed against the regular tax liability. In 2021, 100% of the remaining credit is refundable. Under the Act, power and utility companies will generally recognize the tax benefit of the lower US statutory tax rate on non-regulated operations. For regulated entities governed by state public utility commissions, however, the lower tax rate benefits will 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 will need to re-measure deferred tax balances at the 21% rate. For non-regulated entities the reduction in the tax rate provides mixed results. For some, it's a direct income statement benefit (given the preponderance of deferred tax liabilities on the balance sheet due to bonus depreciation related to plant assets); others will experience an income tax expense due to the reduction in deferred tax assets, such as net operating losses, pension and OBEP costs. Lowering the corporate statutory tax rate on regulated entities from 35% to 21% results in excess accumulated deferred tax balances that will need to be passed on to customers in accordance with current normalization rules. The normalization rules apply to public utility property subject to accelerated depreciation under Sections 167 and 168. The Act requires the use of the average rate assumption method (ARAM), and would allow for a simplified alternative method (Reverse South Georgia) if the utility did not have information available to compute the ARAM and was required by its Regulatory Commission to compute depreciation for public utility property on the basis of an average life or composite rate method. An important note is that the normalization provisions apply to public utility property, which is defined as property used predominately in the trade or business of the furnishing or sale of electric energy, water or sewage disposal services, and gas or steam through a local distribution system if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by an agency or instrumentality of the US, or by a public service or public utility commission or other similar body of the of any State or political subdivision thereof. Some utilities are debating whether certain FERC-regulated entities are subject to ARAM or the alternative normalization rules of the Act. The question is whether or not the tariff provisions of FERC-regulated entities established or approved by a State or political subdivision thereof, by an agency or instrumentality of the US, or by a public service or public utility commission or other similar body of the of any State or political subdivision thereof. If so, the excess deferred tax is subject to ARAM or the alternative method. We believe that companies will be looking to the former Section 46 regulations for the expanded definition of regulated rates, which embodies the notion of rates established or approved on a rate-of-return basis. ARAM requires amortization of the excess tax reserve over the remaining regulatory lives of the property at a rate that follows reversal of the deferred taxes, while the alternative method takes the excess tax reserve on all public utility property and ratably amortizes it over the remaining regulatory life of the property using the weighted average life or composite rate used for regulatory book depreciation. Another significant regulatory concern is the treatment 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, NOLs, repairs and derivatives, among other items. Should the excess deferred tax balance associated with NOLs be netted against plant assets or treated separately as a non-protected balance? We believe there is a support for netting with the net balance subject to ARAM or the alternative method. Over what period of time should the excess deferred tax associated with repairs, deferred compensation, bad debts and other temporary items be amortized? Utilities will need to determine which items were included in rates and the tax benefit or costs recovered from rate payers. This alone can be a challenging task and will require most companies to work closely with the regulatory group. It is a first step in understanding which balances needs to be amortized in to income over time as opposed to reflected directly in the income statement. Utilities without immediate rate cases may need to determine how to handle the reduction in tax rates for the years before the next rate case. Many are deferring the excess deferred tax on the balance sheet until further guidance is received from their state public service commission (PSC). Many PSC's are proactively reaching out to power and utility companies to come in and have a discussion on the impact of tax reform on current and future rates. Immediate capital expensing for qualified property The Act adopts the Senate bill's 100% bonus depreciation approach and provides full expensing for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% bonus deprecation for qualified property is phased down after 2022 as follows: — 80% for property placed in service during calendar year 2023 — 60% for property placed in service during calendar year 2024 — 40% for property placed in service during calendar year 2025 — 20% for property placed in service during calendar year 2026 The Act follows the Senate amendment but also includes the provision in the House bill permitting immediate expensing for both new and used (i.e., first use) qualified property. This is important for asset deals or deemed asset deals in which capital property is acquired from a third party. No provision in the Act permits the immediate expensing of amortizable intangible assets, including goodwill and other Section 197 assets. The Act followed the House bill in the phase-down of bonus depreciation to property acquired before September 28, 2017 and placed in service after September 27, 2017 with a phase-down as follows: — 50% for property placed in service post-September 27, 2017 — 40% for property placed in service during calendar year 2018 — 30% for property placed in service during calendar year 2019 The Act includes an exception to the definition of qualified property for property used in the trade or business of furnishing or selling electrical energy, water, or sewage disposal services, gas or steam through a local distribution systems, 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 or by the governing or ratemaking body of an electric cooperative. The reference to an electric cooperative was added to the Act. One would expect parity with the normalization rules in the construct of "rates established or approved." We believe that companies will look to the former Section 46 regulations for the expanded definition of regulated rates which embodies the notion of rates established or approved on a rate-of-return basis. Utilities will need to be conscious of this construct, as we believe it affects both the depreciation rules and the interest limitation rules discussed next. Interest expense limitation The Act limits the deduction for business net interest expense that exceeds 30% of ATI. For the first four years, ATI is taxable income computed without regard to depreciation, amortization or depletion. Beginning in 2022, ATI is decreased by these items, which could further limit interest deductibility. Business interest is interest properly allocable to a trade or business. An exception to the definition of a trade or business is furnishing or selling electrical energy, water, or sewage disposal services, or gas or steam through a local distribution systems, or transporting gas or steam by pipeline if the rates for furnishing or selling are established or approved by a government agency, a public utility commission, an electric cooperative or other similar ratemaking body. Thus, interest on debt of a regulated entity meeting this definition is not business interest and is therefore not subject to the limitation. The Act did not define properly allocable to a trade or business, which leaves open a question as to how to properly allocate debt at a holding company level to that of its regulated an non-regulated subsidiaries. Many times debt is incurred at the holding company level in order to finance certain capital expenditures of the power and utility company and/or acquisitions of power and utility companies. Many power and utility companies are limited in their debt/equity ratio by the particular State Public Service Commission regulating them. Not defined by the Act is how to properly allocate interest at the holding company level to power and utility business, thus not subjecting this interest to the limitation. Various methods have been discussed among tax professionals with an agreement that it depends on the particular facts and circumstances. Net operating losses (NOLs) The Act limits the use of NOLs generated post-December 31. 2017 to 80% of a C corporation's taxable income for tax years beginning after December 31, 2017. These NOLs have an unlimited carryforward period. The carryback provisions are generally repealed, except for certain farming and property and casualty losses. NOLs arising in tax years beginning before December 31, 2017, would be allowed to offset 100% of a C corporation's taxable income with the historical 20-year carried forward period still applying to these NOLs. As a capital-intensive industry, power and utility companies often have NOLs due to bonus depreciation, as well as other expenses such as environmental, workmen's compensation and tort claims. Section 172(f) allowed them to carry such expenses back to profitable years and obtain a refund of taxes previously paid. NOLs generated post-December 31, 2017 are no longer eligible for Section 172(f). Contributions in aid of construction The Act modifies the definition of tax contributions in aid of construction under Section 118(b) and repeals the exclusion from gross income under Section 118(c) for water utility companies. The modification to the definition of a taxable contribution in aid of construction includes contributions from customers as well as any payment received from a governmental or civic entity. This will result in many more contributions being considered taxable, thus likely resulting in the utilities requiring a gross-up payment to cover the increased tax cost. Current nontaxable contributions for generation interconnections do not appear to be affected by the change in Section 118. Renewables and alternative energy Overall, the renewables industry was very satisfied with the Act. Most notably, the Act does not adopt the House proposals to eliminate the renewable electricity production tax credit (PTC) inflation adjustment factor, revisit the rules defining "beginning of construction" of renewable energy facilities or terminate the permanent 10% investment tax credit (ITC) available for geothermal and solar technologies. Beyond these specific items, what's most notable is what the Act does "not" address. Congress chose not to extend the incentives for certain renewable electricity technologies (fiber-optic solar property, fuel cells, microturbines, combined heat and power systems, thermal energy property and small wind systems). It also chose not to repeal the tax credit for new four-wheeled, battery-powered electric vehicles (repealed in the House bill for vehicles placed in service in tax years beginning after December 31, 2017). Likewise, the Act does not address credits for residential energy-efficiency property (qualified geothermal heat pump property, qualified small wind property and qualified fuel cell power plants). Also notable, the Act did not extend a number of other temporary tax incentives for renewable electricity, including expired credits for production of hydropower, biomass and waste to energy. Similarly, the Act did not extend expired fuel tax incentives for biodiesel, renewable diesel, second generation biofuels, alternative fuels, and alternative fuels mixtures. Additionally the nuclear production tax incentives modification, featured in the House bill, was not included in the Act. The renewable and alternative energy industry is somewhat concerned as to how the BEAT and other provisions of the Act may affect the value and/or the ability to efficiently utilize the tax subsidies, in particular the tax equity market. Also we note that the immediate expensing provisions may be less beneficial to renewable energy projects held in partnership structures, which comprises a significant share of the market. Partnership terminations Under Section 708(b)(1)(B), a sale or exchange of 50% or more of interests in partnership capital and profits within 12 months causes a "technical termination" of the partnership. The Act repeals Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017. Executive compensation limits (Section 162(m)) The Act expands the $1 million deduction limit that applies to compensation paid to top executives of publicly traded companies. Once an individual is named as a covered employee, the $1 million deduction limitation applies to compensation (including performance-based compensation) paid to that individual at any point in the future. Once executives are designated as a covered person, they remain so designated as long as they (or their beneficiaries) receive any compensation from the company. In addition, the Act expands the definition of covered employee to include the CFO. Business credits The Act preserves the research tax credit without modification and requires the capitalization and five-year amortization of domestic qualified research and experimental (R&E) expenditures (15 years for R&E conducted outside the US), but only for such expenditures incurred in tax years after 2021. The Act repeals the Section 199 domestic production activities deduction for tax years beginning after 2017. The Act retains current law with respect to the Work Opportunity Tax Credit, which expires after 2019. In addition, the Act does not adopt the Senate bill's changes to the Low-Income Housing Credit, nor is the deduction for certain unused business credits repealed under the Act. US international tax The Act significantly modifies the current US international tax system, including by: (1) implementing a territorial tax system for business income; (2) imposing a one-time transition tax on accumulated foreign earnings; and (3) introducing new anti-base erosion rules. 100% exemption for foreign-source dividends The Act provides a 100% exemption for foreign-source dividends received by a US corporation from a 10%-or-greater-owned foreign corporation. The deduction is not available for "hybrid dividends," and a one-year holding period in the stock of the foreign corporation is required. The Act allows an exemption for a US corporation's distributive share of a dividend received by a partnership in which the US corporation is a partner if the dividend would have been eligible for the exemption had the US corporation directly owned stock in the foreign corporation. Deemed repatriation tax The Act imposes a one-time transition tax on a US shareholder's pro rata share of the undistributed, non-previously taxed post-1986 earnings of a CFC or other "specified foreign corporation," at an effective rate of either 15.5% (to the extent of cash or other liquid assets) or 8% (for illiquid assets) by applying a new participation exemption deduction provided in Section 965(c). A US shareholder can elect to pay the tax over eight years or less, with larger payments due in the last three years. The Act contains some clarifications for specified foreign corporations held through partnerships. First, the Act explains that, for a foreign corporation that is not a CFC, there must be at least one US shareholder that is a domestic corporation for the foreign corporation to be a specified foreign corporation whose earnings are subject to the transition tax. Second, the Act clarifies that appropriate basis adjustments will be made to increase a partner or S corporation shareholder's outside basis in her partnership or S corporation interest respectively to reflect the full inclusion amount. Worldwide interest limitation The worldwide interest limitation provision was struck in conference negotiations, thereby removing a potential impediment to accessing foreign debt financing for certain multinational companies. Anti-base erosion — intangible assets The Act follows the Senate Bill and imposes a tax on a US shareholder's aggregate net CFC income that is treated as global intangible low-taxed income (GILTI). GILTI is gross income in excess of extraordinary returns from tangible depreciable assets excluding effectively connected income (ECI), subpart F income, high-taxed income, dividends from related parties, and foreign oil and gas extraction income. The extraordinary return base equals 10% of the CFCs' aggregate adjusted basis in depreciable tangible property. Only 80% of the foreign taxes paid on the income are allowed as a foreign tax credit. All CFCs are aggregated for purposes of the computation. For tax years beginning after December 31, 2017, and before January 1, 2026, the highest effective tax rate on GILTI is 10.5%. For tax years beginning after December 31, 2025, the effective tax rate on GILTI is 13.125%. The Act allows US companies to earn intangible income from US intangibles abroad. Income from foreign-derived intangible income (FDII) for tax years beginning after December 31, 2017, and before January 1, 2026, is provided an effective tax rate of 13.125%. For tax years beginning after December 31, 2025, the effective tax rate on FDII is 16.406%. Eligible income does not include, among other items, financial services income under Section 904(d)(2)(D). Base erosion and anti-abuse tax The Act creates the new base erosion anti-abuse tax (BEAT). The BEAT applies to corporations (other than RICs, REITs, or S-corporations) that are subject to US net income tax with average annual gross receipts of at least $500 million and that have made related-party deductible payments totaling 3% (2% for banks and certain security dealers) or more of the corporation's total deductions for the year. A corporation subject to the tax generally determines the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate (base erosion payments) for the year (the modified taxable income). Base erosion payments do not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. The excess of 10% (5% for one tax year for base erosion payments paid or accrued in tax years beginning after December 31, 2017) of the corporation's modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) is the base erosion minimum tax amount that is owed. For tax years beginning after December 31, 2025, the rate increases from 10% to 12.5%. Intangible property The Act did not include a Senate proposal to permit a CFC to distribute on a tax-free basis certain eligible intangible property to any corporate US shareholder. The Act adopts the House proposal to no longer treat certain self-created assets — including patents, inventions or processes — as a capital asset, effective for dispositions after December 31, 2017. As such, gain or loss from the disposition of the property is ordinary in character. Those items of property also are excluded from the definition of property used in the trade or business under Section 1231. Ownership and attribution rules for CFC status The Act repeals Section 958(b)(4), effective for the 2017 tax year. In addition, beginning in 2018, the definition of "US shareholder" is extended to US persons that owned 10% or more of the voting power or value of a CFC. These expanded ownership and attribution rules could cause significant changes for many investment structures, particularly when the current-law rules prevent CFC status for foreign subsidiaries owned through foreign vehicles. Managers should consider any potential impact on the one-time transition tax determination, on fund reporting, and whether certain portfolio companies could become subject to anti-deferral or anti-base erosion measures. Employment taxes Although the effect of the Act on employers is far less than was proposed by the House, the compliance effort will nonetheless be substantial, the implementation window tight and the timing less than ideal given the January 31 deadline for meeting Form W-2 and other 2017 filing deadlines. As with any substantial legislation, there are areas of uncertainty that will require resolution through IRS regulations and other guidance. We can also expect future technical corrections to address inadvertent errors or unintended consequences. Realistically, the process for analyzing the law and coordinating regulations across various IRS departments could stretch well into the future. In the meantime, businesses will need to identify provisions where clarity is needed, acting prudently in the absence of IRS guidance. Attached to this Alert you will find an analysis of TCJA's employer provisions with a focus on actions that employers need to take now and areas where IRS guidance will be needed. A summary chart of employer considerations begins on page 25 of the guide attached to Tax Alert 2017-2216. Background The House and Senate conferees for H.R 1 were able to reconcile the earlier House and Senate bills and reach agreement on the legislative language in the Act less than a month after the House of Representatives passed its version of the Tax Cuts and Jobs Act on November 16 (the House bill), and less than two weeks after the Senate passed its tax reform bill on December 2 (the Senate bill). A Joint Explanatory Statement of the Conference Committee was issued along with the Conference Agreement. For a detailed discussion of the House and Senate Bill provisions relevant for the PE and alternative asset management industry, see Tax Alerts 2017-1868 and 2017-1927, respectively. Tax Alert 2017-2216 includes: — Federal income tax withholding, supplemental wages and backup tax — Fig. 1: Change in individual income tax rates: 2017 compared to 2018 — Federal tax levies (suspension of personal exemption) — Bicycle commuting benefits (repeal of payroll tax exclusion) — Eating facilities and de minimis meals (business deduction rules) — Employee achievement awards (clarification) — Equity compensation-stock and RSU (election to defer income tax) — Entertainment expenses (business deduction rules) — Family and Medical Leave — paid leave (business tax credit) — Length-of-service awards for public safety volunteers (IRC Section 457 plans) — Moving expenses (repeal of payroll tax exclusion) — Settlements — sexual harassment (business deduction rules) — Transportation fringe benefits (business deduction rules) — Wage advances and repayments (individual deduction rules) — Tax Cuts and Jobs Act: Employer considerations Conclusion Power and utility companies ought to carefully analyze the provisions of the Act and evaluate the potential effects on current operations, short- and long-range planning, and financial statement and accounting. ———————————————
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