In this blog we discuss the potential impact of President Trump’s tax reforms on tax equity projects, outline the incentives available to investors and developers and the extension of incentives. In a later presentation, we will outline the main structures adopted in renewable energy projects financed by tax equity financing.
Tax equity financing is likely to be impacted by President Trump’s proposed tax plan entitled ‘Unified Framework for Fixing Our Broken Tax Code’. The tax plan contains proposals to reduce Federal corporate income tax to 20% and allow eligible capital expenditure to be expensed for a period of at least 5 years. Eligible expenditure is that incurred on depreciable assets after 27 September 2017 apart from on structures.
The plan provides a suggested template to Congressional tax-writing committees for reforming the US federal tax system but delegates to the committees the task of developing specific rules.
The House of Representatives subsequently proposed a ‘Tax Cuts and Jobs Act’ which was introduced in the House on 2nd November 2017. This passed the House of Representatives’ Ways and Means Committee on 9th November 2017. The entire House of Representatives passed a version on 16th November 2017. On the same day, the Senate Finance Committee passed its version.
The main provisions contained in both the House of Representatives and Senate versions that impact corporate entities involved in tax equity projects are:
- A reduction in the corporate income tax rate from 35% to 20%;
- A repeal of the Alternative Minimum Tax (AMT);
- 100% bonus depreciation i.e. expensing of capital expenditure on qualifying property incurred until 2023;
- Net operating losses brought forward can only reduce net taxable income by 90%; and
- Disallowance of interest incurred in excess of 30% of business income to replace the current earnings stripping rules.
There are differences in the above provisions between the Senate version and House of Representatives’ version. Specifically:
- The House of Representatives’ version would cut the corporate income tax rate to 20% immediately whereas the Senate version delays this reduction until 2019;
- For the purposes of the limitation of deductible interest, the Senate version defines ‘business income’ as Earnings Before Interest and Tax (EBIT) whereas the House of Representatives’ version defines ‘business income’ as Earnings Before Interest Tax Depreciation and Amortisation (EBITDA);
- Any unrelieved interest can be carried forward indefinitely under the Senate version whereas it can only be carried forward for up to 5 years under the House of Representatives’ version; and
- There is an exemption from any limitation of interest deductions for businesses with gross receipts of less than $25 million under the House of Representatives’ version and $15 million under the Senate version.
Renewable energy projects in the US currently benefit from a variety of tax credits and accelerated tax depreciation which usually lead to tax losses being incurred in the early periods of projects. Tax equity structures have developed to enable investors who have taxable income from other sources to participate in projects and utilise these tax losses generated.
President Trump’s comprehensive tax reforms
The timing and exact details of President Trump’s tax proposals are still uncertain. However, whilst the exact impact of a reduced 20% corporate income tax rate and expensing of capital expenditure is unclear, it is likely to be the case that the further into the lifespan of a tax equity project that any tax rate reduction occurs, the less of a negative impact it would have and a tax rate reduction could have a positive impact.
This is because the currently applicable yearly 5 year Modified Accelerated Cost Recovery System (MACRS) tax allowance percentages are higher in the early years rather than the latter years. Likewise, if capital expenditure were an allowable deduction in the year incurred, the 100% tax deduction would typically occur in the early years of a project as capital expenditure mostly occurs during the construction phase. As a result, if the tax rate in these early years is the currently applicable 35% rather than the proposed 20%, the additional tax depreciation (possibly equal to 100% of capital expenditure) is realised at a higher tax rate so the benefit of this depreciation is greater. The reason for this is that the tax depreciation reduces the taxable income of investors that will be taxed at this higher tax rate. In addition, if the reduction in tax rate then occurs once taxable income is generated by the tax equity entity, this would be taxed at a lower rate. On the other hand, if the reduction in corporate income tax rate occurs early on in a project, the benefit of the tax depreciation is realised at a lower tax rate.
Tax equity – Incentives available
Some of the available incentives expired before the beginning of 2015. However, under the Consolidations Appropriation Act 2016, the expiry dates of a number of the incentives available to renewable energy projects in the US were retrospectively extended. This has given a boost to tax equity financing.
Production Tax Credit (PTC) – This was 2.3 (now 1.5 cents per kWh) or 1.1 cents per kilowatt-hour (kWh) for the first 10 years of production depending on the energy type. Wind along with closed-loop biomass and geothermal energy qualified for 2.3 cents per kWh.
The PTC expired on 31 December 2014 but was retrospectively extended, see Extension section below.
Investment Tax Credit (ITC) – From 2006, this replaced the PTC for solar projects. The ITC is equal to 30% of the total solar energy property cost. If claimed, the tax base of the asset for MACRS tax depreciation purposes decreases by 50% of the ITC claimed.
From 2009, qualifying facilities could claim the ITC or equivalent cash grant (whilst it was available) in lieu of the PTC.
There is a recapture of the ITC should the facility stop operations within 5 tax years of the claim. The percentage recaptured is 100% in the first year and then reduces by 20% per annum thereafter.
ITC was due to reduce to a maximum of 10% for solar facilities brought into service from 1 January 2017 onwards but was retrospectively extended as discussed in the Extension section below.
Bonus Depreciation – This is a percentage of the total cost of the facility claimed upfront. However, unlike the ITC, the tax base of the asset reduces by the percentage bonus depreciation claimed (rather than 50% of the percentage claimed).
The applicable percentage was 100% until 31 December 2011 and then 50% until 31 December 2014. As with the PTC, it was retrospectively extended as discussed in the Extension section below.
Where both bonus depreciation and the ITC are claimed, the ITC is claimed first. Bonus depreciation is then claimed on the remaining tax value.
MACRS – Renewable energy assets currently qualify as 5 year 200% declining balance assets. However, under President Trump’s tax plan, renewable energy assets may qualify for an immediate tax deduction in the tax year incurred.
Tax equity – Extension of incentives
The Consolidations Appropriations Act 2016 was signed into law by Barack Obama in December 2015.This Act:
Extended the expiry of the 30% ITC to 31 December 2019
- Commercial ITC then reduces to 26% in 2020, 22% in 2021 and 10% after 31 December 2021.
- Commercial and utility projects commencing construction before 31 December 2021 can still claim either 30%, 26% or 22% (depending on when construction commenced) providing the facility is brought into service by 31 December 2023.
Retrospectively extended the PTC for wind energy to 31 December 2019
- For other energy, the PTC was extended until 31 December 2016.
- The PTC for facilities that started construction in 2016 was 1.5 cents per kWH (compared to 2.3 cents before the end of 2015).
- Introduced a phased reduction in the PTC for wind since 31 December 2016, with a 20% reduction if construction commences in 2017, 40% if it commences in 2018 and 60% if it commences in 2019.
- It is possible to claim ITC in lieu of the PTC for wind projects until 31 December 2019. The ITC percentage available to wind projects each year reduces by same percentage as PTC i.e. 24% in 2017 (reduces by 20% of 30%), 18% in 2018 and 12% in 2019.
Retrospectively extended bonus depreciation
- Qualified property placed into service on or before 31 December 2017 can claim 50% bonus depreciation.
- For qualifying properties placed into service in 2018, 50% reduces to 40% and in 2019 reduces to 30%.
Given the extension of the incentives, tax equity financing is likely to continue until at least the end of 2019. The need to track returns of the parties involved and the impact of any potential corporate income tax rate reduction that President Trump announces, lend themselves to financial modelling. Operis has experience in building models to optimise tax equity structures and auditing models relating to tax equity financing to ensure that they correctly reflect the tax benefits and project cashflows to the parties involved.
If you have any questions regarding the above or would like to speak to someone at Operis about potential issues relating to tax equity structures, please don’t hesitate to get in touch.