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Impacts of the tax law change on the wind industry
Written By: Jen Neville
January 17, 2018
Chad Marriott, Partner, STOEL RIVES LLP
Kevin Pearson, Partner, STOEL RIVES LLP
Chad and I are going to talk today about some of the tax law changes that happened at the end of 2017, some that didn’t happen, and basically what impact those changes have already had and will have on the wind industry and in particular tax equity financing for the wind industry and wind projects.
We’re going to start with just a very basic background of the tax benefits that are available for wind projects that will help frame the discussion of the changes. So wind projects qualify for first law for one or of two possible tax credits. The first is the production tax credit it’s a credit against income tax that’s based on the amount of electricity produced and sold to unrelated people during each year of a 10-year credit period. The amount of the credit is adjusted for inflation each year. For 2017 it was 2.4 cents per kilowatt hour and we’ll know what it is for 2018 in the spring. The credit period is 10 years from the date the project was placed in service and this is interesting really only for illustration of one of the tax law change proposals that didn’t happen. The production tax credit can be used against alternative minimum tax for the first four years after a project is placed in service.
The only thing that I would add to that Kevin is for the 10 years from the date a facility is placed in service, when we’re talking about wind projects each of the individual turbines is facility for purposes of the PTC. So the typical PTC period would run from the date that the first turbine is placed in service and till the 10th anniversary of the date that the last one was placed in service.
The other alternative tax credit is the investment tax credit and Congress changed the law several years ago to allow wind project owners to elect to claim the ITC in lieu of the PTC. The ITC, most people are familiar with it in the context of solar projects because those only qualify for the ITC, the ITC is accredited against income tax it’s based on the cost of the qualifying equipment included in a facility. Generally that’s 30 percent of the tax basis. The credit is claimed entirely in the year the project or the facility is placed in service.
The ITC although it’s available in the year property is placed in service its subject to recapture if the property is sold or disposed of or otherwise ceases to be used as energy property during the five year period after it’s placed in service under a declining schedule.
So this is supposed of in the first year there’s 80 percent recapture and the second year 60 percent and so on, so in that regard it’s sort of earned over five years. The basis of property for purposes of determining depreciation and gain on sale is reduced by half the amount of the ITC. So if a facility has a basis of $100 that qualifies for the ITC the ITC would be 30 and the basis of the facility for all other tax purposes would be reduced by half of that to 85. The ITC can be used against AMT without any restriction and property of course can’t qualify for both.
The use against AMT is going to be another discussion point relevant to the new change.
The PTC and the ITC both are scheduled to phase out and and I’m sure everybody who’s paying attention has followed this phase-out schedule which has changed a number of times over the years. The PTC actually expired for ten months in 2004 because they couldn’t get an extension. This is an unfortunate consequence of pay-go rules and Congress. The current schedule is for a project qualify for either the PCC or ITC. Construction has to begin before January 1, 2020 and there’s the phase down of the credit, whether it’s the PCC or the ITC, based on when construction begins. So if construction begins in 2017 you get 80% of the otherwise allowable credit and if it begins this year you get 60% of the otherwise allowable credit.
The thing that I would add to that, because I think most of the folks that are on the phone and listening deal both in the wind and the solar world, this presentation is geared towards wind so this the the phase-out schedule that we’ve got on here is is for wind. The ITC fades out for solar for example is different. You’re going to have a step down from 30% that begins in 2020 and then hits a 10% plateau in 2022. It’s also worth noting that the the PTC isn’t available for technologies other than wind if the construction commenced in 2017 or later. No PTC for 2017 solar projects or geothermal or closed with biomass or anything like that.
The phase down schedule is all based now and when construction begins and anybody who’s involved in development or investment in these kind of projects has dealt with this a lot. The IRS has issued a number of notices regarding what it means for construction to begin.
There are two ways to begin construction you can either start physical work of a significant nature either on-site or off-site or the owner can pay or incur 5% of the total cost of the facility which is the 5% safe harbor. Whichever of those is used to meet the beginning of construction requirement, the taxpayer then has to either show continuous construction or continuous efforts after you begin, which is IRS’s way of trying to prevent people from digging a hole and then just stopping.
Have you really started if you then immediately stopped? These IRS notices create a presumption of continuous construction or continuous efforts if the project is finished and placed in service by the end of the fourth year after the year in which construction began. And that four year safe harbor or presumption has been very important in the industry because everybody almost always relies on that for actually qualifying for the credit.
That’s for qualifying for the credit that was in place in the year that they started construction?
So if a project began construction in 2017 it’s going to be placed in service and as long as it’s placed in service by that same date four years later in 2021 then it would qualify for the 2017 PTC rate.
So those are the credits. The other major tax benefits for which wind projects may qualify is accelerated depreciation deductions which create valuable tax losses, that investors may be able to use to offset income from other sources. MACRS stands for modified accelerated cost recovery system, which is the modern form of accelerated depreciation. For wind projects most generation property qualifies for five-year double declining balance depreciation deductions, which is very front-loaded, it creates very large deductions in early years. In addition Congress has over the years allowed bonus depreciation for the year in which property is placed in service in varying amounts at various different times. Prior to the tax cuts and Jobs Act which was enacted at the end of 2017, 50% was bonus depreciation which was allowed for projects that were in service in 2017 then it was phased down after that it would have been 40% in 2018 and so on.
If a project qualifies for bonus depreciation any amount that is not depreciated in the first year under bonus is then depreciated under the normal MACRS schedule.
Starting in the first year.
Now we’re going to talk about the tax law changes that did and did not happen at the end of the year. Keep in mind we’re talking particularly about how tax equity investment document terms evolved. President Trump was in his campaign promising broad sweeping tax reform. I think a number of people didn’t think that would happen and then he was elected to the surprise of many and tax reform didn’t happen for a very long time, we didn’t even have anything in writing for a very long time, other than very very vague tweaks, basically whatever a white paper is, and then it all happened very very quickly at the end of the year. I think the Senate voted on its version of the bill maybe before they saw it, but if not very shortly thereafter, so a lot of this is all very recent and everybody is still working through a lot of these changes.
Some of the proposals that didn’t happen that got a lot of press particularly in the wind industry and thankfully didn’t end up in the final bill. The first one: the House version of the tax reform bill would have eliminated the inflation adjustment for the PTC. So the PTC would have been 1.5c, that would have been flat for everybody. It was very unclear from the proposed legislative language how that applied with respect to existing facilities. Nobody really knew to what extent it was retroactive. That didn’t make it thankfully. A huge change that was in the House version of the bill it didn’t make it was a provision that would have appeared to eliminate the four-year presumption for continuous construction. Again that presumption was created by a series of IRS notices. The legislative language would have appeared to just invalidate those and would have appeared to require that you actually have a continuous program of construction and would have applied a facts and circumstance regardless of when the project is placed in service.
That really worried a lot of people who had begun construction in 2016 or 2015, who had taken a break and then we’re diligently working and maybe even were close to being finished and might not have qualified if that change had gone through. So thankfully that also didn’t make it into the final version. Finally this one I think caused a lot of confusion among people. One version of the bill would have reduced the corporate tax rate to 20% and would have retained the corporate AMT which is 20%. And so the result of that would have been every corporation would just be subject to the AMT. That means that unless you can use the tax credit to offset AMT it would have been wiped out, and so this didn’t impact the ITC because the ITC can be used against the AMT, but it would have caused the PTC to be unavailable after the fourth year following placed in service for every project retroactively. So obviously that caused a lot of panic in the industry and thankfully didn’t make it into the final bill because because the corporate AMT was eliminated from the final bill.
Next we can talk about what did happen. The the final act which was un-creatively titled the Tax Cuts and Jobs Act, the corporate tax rate is reduced to a flat 21% starting with 2018.
The big impact that this has on the wind industry and all industries, is that the value of the losses created by accelerated depreciation deductions is reduced because those losses are offsetting. There’s always some confusion over the difference between a tax credit and the tax loss. A credit is a credit against your tax liability, a loss is a deduction. The impact of reducing the rates of 21% is that the value of those losses, which are deductions, is now offsetting income that would have been taxed at 21% rather than 35% and so they’re less valuable.
This doesn’t change the value of the tax credit because a dollar of tax credit is offsetting a dollar of tax liability either way. As I said the corporate AMT was repealed which thankfully eliminated the four year limit on PTC’s that would have been caused by the Senate proposal. It also simplifies corporate taxes which is good.
The new bill also creates a limitation on interest deductions and the details of these are beyond the scope of this presentation but at a very basic level, it limits interest deductions to 30% of the sum of adjusted taxable income plus business interest income. This is going to impact projects with debt. There’s just no way around it. I think a lot of people who prepare financial models for projects are scrambling to make sure that their models incorporate this limitation appropriately for projects with debt and going forward everyone should make sure that they’re properly accounting for this limitation. That’s an interest expense deduction limitation so that applies to all projects with debt.
One of the other major changes that the bill created was 100% expensing which is really a 100% bonus depreciation deduction for certain qualifying projects. Nothing in this bill is simple.
The 100% expensing applies to any property that is placed into service after September 27, 2017 but only if it was acquired after December 27, 2017. We’ll talk about what that may mean. Then there’s a phase down for bonus depreciation thereafter and the percentage is shown and those percentages are the percent of bonus allowables. So in 2023 you get 80% bonus depreciation and so on and that’s all based on when property is placed in service. As I mentioned the 100% bonus depreciation does not apply to property that is acquired before September 27, 2017. The reason for that date is that’s the date that the House version of the bill was released. The bill doesn’t say what it means for property to be acquired. The effective date doesn’t even say acquired by whom, but it does say that property will not under any circumstances be treated as acquired after a binding written contract was entered into. So there’s a lot of uncertainty over this provision in tax equity structures because, you know for example in some partnerships with structures, the partnership doesn’t exist until funding. Before then the LLC that owns the project is a disregarded entity and an argument could be made that the partnership doesn’t acquire the facility until the partnership is formed and there’s a dean transferred to a partnership.
I think also in the context of the portfolio structure where the structure is set up so that the sponsor is contributing the project company to the partnership. Whether the contribution of the project company to the partnership would be whether it’s acquired at that time as well.
I think the more likely answer is that especially given the reference to binding written contracts, I think that when the project company agreed to buy the components. But more more to come on that one. In addition and this is maybe not as interesting for financing of new projects but in all prior iterations of bonus depreciation one of the requirements is that the person claiming the bonus depreciation be the original user of the property. Which prevented recycling of bonus depreciation for used property. That provision has been eliminated and this may be of great interest to people buying and selling projects that are may be out of the credit period. Subject to these phase down days you can now fully depreciate in year one a used project that is purchased by a different person.
Some of the other relevant provisions of the new bill is it eliminates the technical termination of a partnership rule. This rule used to be that if 50% or more of the interests in partnership profits and capital were sold in any 12-month period, the partnership was deemed to terminate and a new partnership was deemed to be formed. The only downside of that was depreciation periods for property owned by the partnership would restart and that rule has now been eliminated. What this does is it makes it more difficult for developers to get bonus depreciation to investors.
Many investors who wanted bonus depreciation would often take advantage of the partnership termination rules and structure to cause of termination for the purpose of getting the investor the bonus depreciation after the deemed termination and that’s no longer available because that rules just been eliminated. One of the big international provisions in the bill was repatriation tax for certain foreign assets and the details of this are well beyond the scope of this presentation, but essentially certain taxpayers are going to have to pay US tax on assets that they have parked in foreign subsidiaries. That tax can be spread over eight years and there’s a lot of detail but the one impact of this provision is that some investors appetite for tax credits will be reduced and we’ve seen in the marketplace some investors backing away from these kind of investments as a result of that provision.
A similar provision is what’s been called the BEAT tax.(base erosion and anti abuse tax) This is a tax that is intended to prevent or discourage US companies from exporting their tax liability by shifting what would be US income offshore. Many companies for example park their intellectual property in Ireland in a subsidiary there and then the US company will pay royalties to the Irish subsidiary for the use of that intellectual property. The result of that is what would have been US taxed income is now taxed only in Ireland. The BEAT tax is intended to discourage that. What it does essentially is it imposes a minimum tax on companies that do a lot of that kind of planning. That minimum tax means that there’s a possibility that the tax credits that are otherwise available with respect to renewable energy projects, could be unavailable, and in an early version of the language it could have entirely eliminated tax credits because they can’t be used to offset that minimum tax liability.
Its not that the credits would be unavailable it’s that the value of that credit couldn’t be used by those investors.
Right. Thankfully in the final version of the bill there was some language in it that it doesn’t completely eliminate this problem but it means that the worst it can get is that the ITC and PTC value could be reduced by 20%.
Again it’s important that not all investors are impacted by this rule because not all investors do the degree of international tax planning and the kind of international tax planning that would put them in the soup in the BEAT tax. Finally there’s a provision in the bill that relates to accrual accounting and accounting for prepaid contracts. That could impact the usefulness of prepaid PPAs in renewable energy financing. Which maybe isn’t as important to wind as it is to other kinds of facilities but one of the other changes that’s relevant.
So that’s a summary of the tax law changes that were proposed and the ones that actually made it at a very high level. Now we’re going to talk about what this means in terms of tax equity financing and in particular both new and existing tax equity financing documents.
Back in the late 90s it was very common for tax equity investors to bear the risk of tax law changes. The way these tax equity financing agreements often work in a very high level is that there’s a set of agreements signed on day one that say, okay if you’re going to build a project developer and if you meet all of the conditions set forth in the agreement on the date it’s done, tax equity investor will put in money, and if it’s a tax flip partnership structure for example, they’ll put in their money and become a partner for purposes of being allocated the credits and losses and you’re off. Many years ago Senator Grassley said I’m going to eliminate MACRS because it is a giveaway to corporate America and we’re not going to do it anymore. A lot of the investment community began to get worried about that so we started negotiating stronger and stronger tax law change provisions and agreements. For example around that time investors started getting worried about well what if I sign the agreement on day one and the law changes before the funding date and now I can’t take advantage of these tax benefits anymore who bears that risk? Of course any time investors start asking that question the answer is that developers should bear that risk. So we began negotiating provisions that shift the risk of changes to developers. We would also sometimes negotiate provisions for how the risk of tax law changes after funding is allocated between the parties.
Beginning in late 2016 when Trump was elected. Investors suddenly became very concerned about the now seemingly real possibility that the corporate tax rate would be reduced thereby reducing the value of the tax losses that flow through from these investments. So we had another round of negotiating more investor favorable provisions regarding tax law changes and proposed tax law changes. The trend every time one of these happens, it’s kind of a ratchet effect, is more and more risk gets shifted to the developer and away from the investor.
Tax Equity Trends: The provisions regarding tax law changes and proposed tax law changes in transaction documents vary greatly depending on the structure of the transaction. Whether it’s a sale lease back or a lease pass-through or inverted lease (mostly solar). What we typically deal with in wind is partnership flips and even there these provisions vary greatly depending on the specific terms of the flip. For example whether it’s a sign and close, immediately that obviously eliminates the risk of tax, a lot changes between signing and funding, so it’s important when you’re thinking through these issues to keep in mind the very specific structure of the transaction at issue.
These are proposed tax law changes and they’re increasingly investor friendly.
The least investor friendly would be to negotiate what happens if and when a proposed tax law change occurs . Second is you update the base case model if and when it’s passed and then the protection for the investor is a cash sweep or an indemnity in favor of the investor to make up for any amounts that they may have over funded based on the assumed tax rate at funding. The third which is probably the most investor friendly and this is whether it’s an actual proposal or an assumed rate for purposes of the sizing in the base case model is you incorporate it in the base case model with a supplemental funding if it’s not agreed.
We’ll talk a little bit later about if you’re building in the potential for a proposed tax law change and you’re assuming a rate that is lower than the actual rated time assignment.
It’s important to keep in mind what this relates to proposed changes is, and this gained importance when Trump was elected, so what happens if it’s time for closing and there’s a bill in Congress to reduce the tax rate. What are we going to do about that? Are we going to ignore it? No. We were closing some deals right around the election and in some of those there wasn’t enough time to actually deal with these in detail and so we just put in we’ll deal with it if and when the bill passes and we will agree to just negotiate to make the economics the same with the new tax rate. I’d say the ratchet was in full effect in proposed tax law changes and I think where things ended up in the market is before the bill passed, pretty much everybody was saying all right well we’re going to run the base case model to determine the investors funding amount based on the assumption that the rate is going to go down. And if it doesn’t go down by whatever date the parties agree on they’ll put in more money. But we’re going to size the initial funding based on that assumption. Many of those assumed 20% and it actually went down to 21% so even if you think your documents dealt with this it’s important to look at everything because some investors may owe a little more money just because the rate didn’t go all the way down to 20%.
As of right now there is not a proposed tax law change I think under any definition that would take it to 20%. I think one theme that Chad and I discovered going through this is that even though tax law change became a big issue last year in particular in documents and even though the bill has now passed the fun is really just starting. The tax law changes issue hasn’t gone away and I think it’s in fact going to ramp up which we’ll get into some of the details of that.
The Tax Cuts and Jobs Act is the biggest Christmas present for tax lawyers and tax accountants for the next several years to come.
So that’s how documents dealt with proposed tax law changes. They also deal with actual tax law changes. Typically one of the conditions to funding is that any tax law change that happens before funding is incorporated into the base case model for purposes of determining the investors investment. That’s been fairly typical for a long time. I would say the documents vary pretty greatly regarding who bears the risk of tax law changes after funding. One issue that has been also addressed in transaction documents over the years is it’s typically a condition to funding that the investor get a bring down of a tax opinion. Typically a tax opinion on the signing date, that’s a condition to signing. Then there’s a condition to funding which is a bring down of that tax opinion. In some documents that bring down is limited to changes in law, so in other words, developers have said you don’t just get to change your mind. That condition is deemed satisfied if nothing has changed but if there is a change then you can get a new tax opinion. Change in tax laws often addressed in that language.
So with that kind of very general overview of what the import of these terms is, we’ll talk a little bit about how they’re defined. The definition of proposed tax law change in tax law change are super important for reasons that will become apparent. In proposed tax law change the things that we frequently negotiate include what kinds of proposals are taken into account. So some documents say it’s a bill that’s reported out of the subcommittee. Others say it’s a bill reported out of the ways and means committee or the finance committee only. Some say it’s any bill that’s introduced. The range of language is very very broad.
I think it’s fair to say that earlier on the process immediately post Trump election the definitions tended to be a little bit broader in the proposed tax law change no matter how hard sponsors were fighting back against it.
We think it’s important if you’re a developer to try to think what really is the purpose of this. If there’s a serious proposal to change the law then we should deal with it in our agreement. Some of these things you just can’t argue. The way we dealt with that issue in many agreements is adding a qualifier that basically says, whatever among that list we’re talking about it’s only things that are reasonably likely to be enacted that you’ve taken account of. Everybody recognizes that’s very loose language.
I think if there’s a theme to this it’s for sponsors and investors alike and I would say sponsors especially, is make sure that when you’re looking at these provisions that you take a little bit of time to get smart on the legislative process. Really understand that Congress has two sessions and when you’re talking about the first or the second session you’re talking about two completely different dates and how these potential changes or how these proposals actually come to be and how they could die. Both are important to look at.
The other thing that will be important in tax law change also is what scope of changes get included. Is it any change that would impact the financial results to the investor or is it just changes to the PTC and tax losses. The ratchet was in effect there too and everyone can guess which way it ratcheted.
It’s important to think for what purpose is this term being defined. That relates to how the risk is being born between the parties and the agreements. I’d say on the developer side what you want to be thoughtful of is this should include actual changes to the law. The things we negotiate are similar to proposed tax law change. It always includes legislation that’s passed and signed. Some people tried to get it to include legislation that’s passed and likely to be signed. Regulations are often listed here. Just like Chad said about the legislative process it’s important to understand the Treasury Department regulatory process because proposed regulations may not actually be the law. Sometimes we see definitions proposed where it just says that any release by the IRS and again it’s been important to understand that process because revenue procedures may have general applicability but private letter rulings are issued to a taxpayer and are not generally applicable and also are heavily redacted. So often you have to guess what’s even going on in the ruling.
I think the next one is important too when you’re talking about Court opinions. There’s a difference between a legislative change in the law or a change in the regulations that’s very easy to see but if you’ve got a case that’s coming up for a taxpayer in the fifth circuit and your project is located in the ninth circuit and really there’s no precedential value for a decision in Chicago on a project in California or somewhere else in the west. One of the things to be thinking about is whether you want to push hard enough to ensure that only courts whose decisions are binding on your project should be included in the scope of tax law change.
There’s often references to executive orders and other executive releases that you just have to think about what they really mean. As with proposed tax law change definitions a couple of other things to keep in mind are whether the definition is limited to changes that directly impact the project or the tax credits or depreciation or whether it’s anything that might impact the economic benefit to the investor. A really great example of this is the BEAT tax because obviously has nothing to do with anything in the US much less an investor’s investment in wind farms. It may cause that investor to get less value out of the tax credits and if your definition of tax law change or proposed tax law change was very broad to include anything that might limit the value of these benefits to this investor, the change or proposed changes to the BEAT tax could have given the investor and out to funding arguably, even though it had nothing to do with any of this.
That investor may have a bunch of other investments in tax credits like rehab credits and new market tax credits or other US tax credits, query which credits are less valuable if your aggregate use of credits is reduced they’re going to argue it’s the ones they haven’t paid for yet. These issues also come up and have a term called fixed tax assumptions and these are assumptions that are made for purposes of calculating the investors investment that are assumed to be true unless they’re untrue because of something the developer did wrong. They’re often things like the partnership will be respected if it’s a flip partnership structure, investor will be treated as a partner, the allocations will be respected, the company project will be treated as the owner, and it’s very important to look at these documents and ask what happens here if the law changes.
So what’s the status of all of this after the tax reform bill is passed? As we alluded to earlier this is not going to end the consternation over tax law changes or proposed tax law changes I think if anything is going to heat up.
First of all there’s a lot about the tax reform bill that remains unclear, for example we talked about how it’s not really clear what acquired means for purposes of bonus depreciation. There is going to need to be some additional guidance on that topic which may include “proposed” guidance and it may include somebody asking for a private letter ruling and the question will become more important of whether a private letter ruling can be tax law change or proposed change. Another open question is how bonus depreciation is going to impact DRO issues. If an investor wants it is, is something that has to be modeled? There’s a lot that’s uncertain about exactly how it works. I think a lot of people who have to put these things into models without knowing exactly what the rules are, are scrambling to try to figure all this out. It’s just something that’s going to need to be worked out over the next coming years. Another is how the BEAT tax will impact investors. I think a lot of the big investors are still working out internally how much risk they have of the BEAT tax applying. Different investors have different sorts of offshore tax planning profiles and these provisions are going to apply differently to them. So there’s there’s going to be years of regulations, technical corrections, IRS rulings and cases. I would say that the provisions and agreements may not change much, the war between developers and investors to allocate this risk will continue and the ratchet doesn’t usually work the other direction, so there’s a lot that’s unknown and all of these issues and provisions are still very very relevant.
Q & A
Q: Do the rules on PPAs also apply to 467 rents?
A: So prepaid lease agreements yes, they might very well apply to those. You also have to look at the changes to 451 that were created by the the bill. Those rules apply to any transaction where the tax treatment differs from the book treatment.
Q: How do you treat bonus if a portion of the system is placed in service in 2017 and a portion in 2018?
A: There is a whole 50 years of authority for what constitutes “property for depreciation purposes” and it the question is first you have to figure out what the property in question is. Then you have to figure out when it was placed in service. There are cases having to do with aircraft maintenance for example where if you replaced the engines on an airplane is it now a new airplane that could be newly placed in service or not? It’s fairly clear with wind that each turbine, together with its pad, tower and blades is a property that is separately placed in service from all the other turbines in the wind farm. So any turbine that’s done and capable of operating and placed in service in a particular year is eligible for whatever bonus is available for property placed in service that year.