One of the most important items on President Trump’s first-year agenda was the implementation of tax reform in the U.S. Republican lawmakers worked tirelessly as the calendar year drew to an end to get a new tax law through Congress. In the end, some of the measures passed will help the energy industry, while others could hurt. The devil is in the details.
The 2017 tax act, Public Law No. 115-97, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” was signed by President Trump on December 22, 2017. Americans had been hearing about it for months, and now that it’s here, industries across the nation are scrambling to assess the act’s impact on their bottom line.
While the full, technical, effects of the act are next to impossible to ascertain at this early stage, there are standout provisions that send a clear message. For example, players in the energy and mining industry can breathe a sigh of relief after having narrowly avoided the loss of several key credits. Amid the energy and mining industry’s other wins in this fight are increased section 179 expensing limitations, temporary full expensing for certain business assets, and of course, the sharply cut corporate tax rate that’s been greeted with open arms by corporate leaders across all industries.
The act does pose some risk to the industry though, as a few provisions could nearly halt conventional financing practices, particularly those frequently employed in the oil and gas sector of the industry. But, do the act’s drawbacks undermine its allure? Reviewing the details may help answer that question.
Lower Rates, Higher Limits, and Extended Phaseout Periods
First, the good news: While initially slated for repeal by the House, the industry will see continued benefits from the enhanced oil recovery production credit, which permits taxpayers to claim a credit equal to 15% of their enhanced oil recovery costs. Oil producers may also be entitled to a credit for the production of crude oil and natural gas from marginal wells. While the credit has phased out for oil production, the House bill would have repealed it altogether.
Additionally, the previously proposed extension and phaseout of the energy investment tax credit was likely to remove at least some of the incentive to invest in energy efficient equipment and property, but fortunately for the industry, the provision didn’t make its way into the act. As a result, taxpayers will see continued tax benefits for expenditures made in placing energy property in service: there is a 30% credit for solar energy property and fiber-optic property, and a 10% credit for geothermal energy property, among others. The final version of the act allowed portions of the energy investment tax credit to expire, although the issue may come up again in extender legislation in 2018.
The House’s initial plan had also included a modification to the current credit for electricity produced from certain renewable resources: The credit per kilowatt-hour of electricity is currently adjusted annually for inflation, but the plan would have eliminated the inflation adjustment, potentially rendering future wind facilities economically unfeasible (Figure 1).
|1. Wind power projects get a reprieve. Although the original House bill would have eliminated previously passed tax credits, the final version left the credits alone. Source: POWER|
There is cause for more optimism. The act boasts large across-the-board corporate tax cuts, not only for the energy and mining industry, but also for corporate taxpayers nationally. Though analysts initially warned that lowering corporate tax rates may discourage tax-equity deals because companies with lower tax bills would have less interest in buying tax credits from renewable-energy developers, the permanently reduced 21% tax rate is nevertheless expected to spur investment and stimulate job growth. The new rate combined with the repeal of the corporate alternative minimum tax means that taxpayers will be able to take full advantage of available credits to realize a truly lower effective tax rate. Smaller entities operating as pass-throughs will see similar benefits, as the act generally allows a 20% deduction from a taxpayer’s domestic qualified business income.
The act additionally permits taxpayers to immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for property with longer production periods). This is a significant increase from the previously permitted bonus depreciation.
Before reform, the amount of bonus depreciation was 50% of the cost of qualified property placed in service during 2017, and that number was set to phase down to 40% this year and 30% by 2019. While full expensing is only temporary under the act, phaseout is strikingly less severe: The act incrementally phases out the full expensing over a five-year period, beginning in 2023 (2024 for property with longer production periods). Still, taxpayers might consider the purchase of new machinery and equipment sooner rather than later. The act even removes the original use requirement for qualified property, allowing the 100% expensing for used machinery and equipment.
In another boost for the industry, the act increases the section 179 expensing limitation and phaseout amount for smaller companies, and it expands the types of property subject to the election. Businesses are able to expense up to $1 million (double the previously allowed amount), subject to a $2.5 million phaseout (prior law began to phase out expensing at $2 million). Both of these amounts are indexed for inflation. The act also extends section 179 property to income qualified improvement property as well as many improvements to non-residential real property. Those include items like roofs, heating, ventilation, and air-conditioning property, fire protection and alarm systems, and security systems.
Foreign-Derived Income and Tax Equity Deals Take a Hit
The news is not all good, however. The act limits the deduction for net interest expenses incurred by a business to the sum of business interest income, 30% of the business’s adjusted taxable income, and floor plan financing interest. Businesses with average annual gross receipts of $25 million or less are exempt from the limit. Still, small, highly leveraged independent operations are likely to be significantly negatively impacted by the provision in the near future.
Another provision of the act threatens a crucial, albeit obscure and highly technical, source of wind and solar finance: tax equity. In tax-equity deals, renewable-energy developers sell portions of their projects’ tax credits to corporations—often banks and some insurance companies—that can apply the credits to their own tax bills. If a taxpayer is subject to the new taxes, but business credits can’t be claimed against the taxes, then business credits become less valuable for an affected taxpayer.
Generally, foreign income earned by a foreign subsidiary of a U.S. corporation is not subject to U.S. tax until it is distributed to the U.S. parent corporation as a dividend. Such dividends, minus credits for foreign income taxes paid, are considered taxable income for the U.S. corporation. The main exception to deferral of U.S. tax is what is commonly called Subpart F income (certain foreign insurance income, certain passive investment income, and specified kinds of business income, as well as certain investments in U.S. property). A U.S. parent is generally subject to current U.S. tax on Subpart F income earned by its foreign subsidiaries, less any foreign income taxes paid on such income.
The act, however, includes new base erosion provisions meant to prevent companies from shifting profits to other lower, or no tax, international jurisdictions. It requires a U.S. shareholder of a controlled foreign corporation (CFC) to currently include in income its global intangible low-taxed income in a manner similar to how it currently includes Subpart F income.
First, the act expands the definition of intangible property to include goodwill, going concern value, workforce in place, or any other item the value of which is not attributable to tangible property or the services of an individual. Then, the act imposes tax on “global intangible low-taxed income” (GILTI) of U.S. shareholders of CFCs, with a deduction of 37.5% for foreign-derived intangible income plus 50% of the GILTI, and the amount treated as a dividend under section 78. Deductions are reduced for tax years beginning after December 31, 2025. The act also imposes a minimum base erosion anti-abuse tax for certain taxpayers. The calculation of the tax is based on the excess of 10% of the modified taxable income over the amount of regular tax liability, which is reduced by certain credits. The 10% rate is 5% for tax years beginning in calendar year 2018, and 12.5% for tax years beginning after December 31, 2025. This is the provision getting significant attention because it has the potential to discourage interest in tax-equity deals, and could even conflict with existing tax treaties because it, in practice, restricts tax benefits based on nationality.
In a massive blow to environmental groups interested in protecting Alaska’s Arctic National Wildlife Refuge (Figure 2)—despite their strenuous efforts to stop it—the act opens a portion of the region to oil and natural gas drilling. The move is one that lawmakers estimate could yield $1 billion in revenue, but drilling seasons are short, and it will likely take the better part of a decade for the government to see that result.
Good Times Ahead?
The message for the energy and mining industry seems mostly positive, and the energy and mining industry should remain optimistic, if even cautiously so. Whether the energy and mining industry comes out a major winner of tax reform is tough to quantify, and it’s even tougher to garner the full effects of each new provision this early.
Many provisions, most notably, new base erosion provisions, necessitate the need for the U.S. Treasury to release guidance, and industry insiders should brace themselves for a long wait while experts work out some highly technical aspects of the act. Time will be the true test. ■
—Amber Gorski ([email protected]) is tax law editor for Bloomberg Tax.