Law H.R.1, informally known as the Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump on 22 December 2017. The Act contains a number of changes to US Federal corporate income tax legislation. In this blog we discuss the likely impact of these changes on P3 projects. In separate blogs we will discuss the impacts on tax equity financing and the provision to limit a corporation’s ability to deduct interest expenses.
The main provisions included in the TCJA which will impact on P3 projects are:
- Maximum corporate income tax rate is lowered from 35% to 21%;
- Businesses can claim an immediate deduction for the costs of depreciable assets;
- Limits corporations ability to deduct interest expenses;
- Eliminates corporate Alternative Minimum Tax (AMT);
- Amends the rules relating to the use of Net Operating Losses (NOLs);
- Introduces the Base Erosion Anti-Abuse Tax (BEAT);
- Changes sourcing rule for sale, disposition or exchange of partnership interest by foreign partner;
- Allows smaller entities to use completed contract method rather than section 460 accounting; and
- Changes the current worldwide tax system to a territorial tax system.
Reduction in corporate income tax rate
The reduction to 21% applies for tax years beginning after 31 December 2017. Given that this reduction has been accompanied by the ability to immediately deduct capital expenditure, the benefit will be partly offset because the immediate deduction will result in corporate entities paying tax on lower taxable profits.
Entities with a non-calendar year-end, will be subject to a blended rate for the taxable year that includes 1 January 2018.
Section 168(k) Bonus Depreciation – Immediate deduction for capital expenditure
Previously, businesses were allowed a 50% bonus depreciation deduction for qualifying property placed into service before 1 January 2020 (or 1 January 2021 for certain property with longer production periods) with a phasing down of this percentage for property placed into service after 31 December 2017. The TCJA maintains this phase-out for property acquired before 28 September 2017 and placed into service after 27 September 2017.
In addition, the TCJA allows an immediate deduction for costs of qualifying assets incurred after 27 September 2017 and before 1 January 2023. This generally includes tangible property with a recovery period of 20 years or less and certain computer software. It includes previously used property acquired from an unrelated party but does not apply to the costs of structures, shares in corporations, intangibles and property that is leased rather than purchased.
From 1 January 2023, the percentage that can be immediately deducted reduces by 20% each year before being phased-out completely from 1 January 2027 (1 January 2028 for certain property with longer production periods). Deductions for the remaining percentage of capital expenditure revert back to being in accordance with the Modified Accelerated Cost Recovery System (MACRS). For example, in 2023 80% of expenditure is allowable as an immediate expense and 20% is allowable through MACRS. In 2027, 100% of capital expenditure will be allowable via MACRS.
A taxpayer may elect out of expensing on a ‘class of property’ basis each year that such property is placed into service.
Although the ability to immediately deduct qualifying expenditure will not impact on the total corporate income tax payable over the life of a project, it should result in tax being paid later and therefore benefit projects due to the time value of money.
Limitation of deductible interest
The TCJA limits the amount of net interest expense that entities can deduct. The new rules will be discussed in our future blog on the new interest deductibility rules.
The new rules will increase the corporate income tax payable by project entities if any interest expenses are disallowed as a result of these limitations.
Elimination of AMT
Historically, corporate AMT has affected P3 projects in the earlier years. The TCJA repeals corporate AMT for tax years beginning after 31 December 2017.
Where taxpayers have built up AMT credits from paying AMT, in addition to using these credits to fully offset regular tax payable, they can claim a refund of 50% of the remaining credits (after offsetting regular tax payable) in the tax years beginning in 2018, 2019 and 2020. In the tax year beginning in 2021, they can then claim any remaining AMT credits. Financial models relating to existing projects may include AMT credits and therefore need to consider these provisions.
Use of NOLs
NOLs arising in tax years beginning after 31 December 2017, can be used to offset up to 80% of taxable income and can be carried forward indefinitely but cannot be carried back.
Existing NOLs arising in tax years beginning before 1 January 2018 are not affected by these changes. They continue to be utilised under the old NOL rules.
The limitation on the number of years losses could be carried forward under previous legislation did not generally affect projects because any losses generated were typically used within 20 years of being incurred. However, the new NOLs rules will need to be considered in models and for existing projects, two loss pools will need to be modelled. One for losses incurred before 1 January 2018 and one for losses incurred from 1 January 2018 onwards.
Losses in the pool relating to losses incurred before 1 January 2018 would need to be utilised under the old rules i.e. carried forward for up to 20 years and used to fully offset taxable income. Losses incurred from 1 January 2018 onwards would then be utilised under the new rules.
Given that P3 projects were generally not impacted by the 20 year limitation in respect of carrying forward losses, the ability to only offset up to 80% of taxable income is likely to have a negative impact on projects by bringing forward corporate income tax payments.
BEAT
BEAT is a new tax designed to prevent large multinational companies from reducing their US tax liabilities by claiming deductions for payments made to foreign affiliates such as interest and royalty payments. A taxpayer will have to pay BEAT in any year it exceeds the taxpayer’s regular tax liability otherwise owed in that year.
BEAT only applies to: a) large corporations with average annual gross receipts over the past three years of at least US$500 million, and b) corporations that take deductions for cross-border payments that are equal to at least 3% of the corporation’s total deductions for that year (2% for banks).
BEAT is calculated as a percentage of a modified, higher tax base, determined by disallowing all deductions that are generated by payments to foreign affiliates unless the payments are subject to US withholding tax or come within certain exceptions for cross-border derivative payments and cost-based service payments. The BEAT rate is 5% in 2018, 10% in 2019 through 2025, and 12.5% in 2026 and thereafter. The rates are 1% higher in each year for banks.
Whilst individual project entities are unlikely to have average turnover over the past three years in excess of US$500 million, they may be part of a wider group that does.
Change to sourcing rules
Previously, foreign entities did not pay capital gains tax on the sale of an interest in an LLC. However, the TCJA introduced a rule that the sale, disposition or exchange of a partnership interest by a foreign partner will be US sourced income for transactions on or after 27 November 2017. The acquirer of the interest must withhold 10% of the consideration paid as a withholding tax.
This change could lead to more project entities being set up as C Corps rather than LLCs as no capital gain would be payable by a C Corp on the sale, disposition or exchange of a partnership interest. However, for existing projects, the rules around whether a capital gain is payable if a LLC becomes a C Corp are unclear and there has been no announcement as to whether this new rule overrides existing tax treaties.
Furthermore, there are more restrictive rules in respect of how much can be distributed from a C Corp compared to an LCC. Therefore, existing LLCs with foreign owners may tick the box to be treated as a C Corp for tax purposes if the foreign owners are considering disposing of their interest to avoid a capital gain being payable.
Section 460 accounting
The TCJA introduced a provision stating that where a corporation has average annual gross receipts of less than $25 million for the preceding 3 year period (this amount will increase by indexation in future years), it is not required to use section 460 (long term contract accounting) but instead can use the complete contract method.
Given that the $25 million is based on group receipts, this provision might not be applicable to a number of parties involved in P3 projects as the ultimate owners of interests in the project entity may have gross annual receipts of more than $25 million. However, if applicable, this is likely to impact on the timing of revenue recognition from P3 projects and hence the timing of tax payments.
Worldwide vs Territorial tax system
Under the ‘worldwide’ system, US multinational corporations are taxed on foreign income earned but do not pay tax on this foreign income until they bring the profits back to the USA. Under a ‘territorial’ system, effective from 1 January 2018, these multinational corporations would not be taxed on foreign income and therefore may reinvest profits in America.
A one-time transition tax will be imposed on the earnings of foreign subsidiaries at rates of 8% (for illiquid assets like tangible assets e.g. equipment) and 15.5% (for liquid assets like cash) for corporate shareholders. Taxpayers can generally elect to pay the tax over 8 years. Going forward, dividends received by a US corporation from its 10%-or-greater-owned foreign subsidiaries will generally be exempt from tax (if attributable to foreign sourced income).
Whilst this will not directly impact on US P3 projects, it might impact on US corporations undertaking projects in other tax jurisdictions. If these corporations decide to bring profits from overseas projects back to the US, capital available to invest in P3 projects could increase.
The Tax Cuts and Jobs Act included a number of provisions that are likely to impact on P3 projects. Financial modelling enables these impacts to be analysed individually or on an overall basis to assess the extent to which these changes will have a positive or negative impact on the parties involved in the project.
If you have any questions regarding the above or would like to speak to someone at Operis about potential issues relating to the impact of provisions within the Tax Cuts and Jobs Act, please don’t hesitate to get in touch.
