US Tax Changes Start to Take Shape: MACRS Depreciation, Pooled Depreciation, Corporate Tax Reform, International Tax Reform, Subpart F, PFICs, Foreign Tax Credits
Project Finance NewsWire
Accelerated depreciation would be eliminated under a draft tax bill the Senate Finance Committee released in November.
The bill is one of three drafts that Senator Max Baucus (D.-Montana) released for public comment after a closed-door meeting of committee members on November 19. Comments are due by January 17.
Another draft dealt with international tax reform for US companies with assets or investments outside the United States.
The drafts are part of a gathering set of corporate tax reform proposals that Baucus intends to package into a major overhaul of the US corporate income tax laws. Baucus chairs the Senate tax-writing committee. Republicans who attended the committee meeting were critical of the decision to release the bill drafts and, in many cases, also of the proposals.
Most lobbyists remain skeptical that the current Congress will be able to reach agreement on corporate tax reform, notwithstanding that both political parties say they want to reduce corporate income tax rates. Republicans want to take the current 35% rate to 25%. Democrats want to go to 28%. This can only be done by stripping the tax code of most deductions and tax credits or by finding new sources of revenue.
Baucus has not set a timetable yet to “mark up” the bill in his committee.
Forward motion also remains stalled in the House where the House tax committee chairman was told by Republican leaders not to move forward on tax reform in late 2013 for fear of diverting the attention of the news media away from the flawed Obamacare rollout.
Under the Baucus bill, all equipment would be put into four asset pools. Each year, a company would deduct a fixed percentage times the aggregate unrecovered cost of assets in the pool. Any new capital spending on equipment during the year would be added to the pool. When assets are sold, the sales price would be deducted from the pool.
This would simplify not only how depreciation is calculated, but also the calculation of gain or loss on asset sales. A company would report gain only to the extent the balance in a pool is driven negative by asset sales in a year. The negative balance would be reported as ordinary income. Asset sales would not trigger losses.
The depreciation percentages are 38% for assets in pool 1, 18% for pool 2, 12% for pool 3 and 5% for pool 4.
Wind and solar projects would be in pool 4. The 5% depreciation percentage for assets in that pool would be applied against a declining balance. Thus, for example, if a wind farm cost $100X, depreciation the first year would be $5X and the second year would be $95X x 5% = $4.75. However, if the company added another $100X wind farm in year 2, depreciation that year would be $195X x 5% = $9.75.
It would not matter when during the year assets are put in service.
Most other power plants and LNG terminals would be considered real property and be depreciated on a straight-line basis over 43 years.
The depreciation on a wind or solar project is currently worth about 23¢ per dollar of capital cost if an investment credit is claimed on the project and 27¢ if production tax credits are claimed (for wind only). That is the present value of the tax savings assuming a 35% tax rate and using a 10% discount rate. The depreciation under the Baucus bill would be worth only 11¢ to 13¢, before any reduction in the corporate tax rate.
Cars, computers and nuclear fuel assemblies would be put in pool 1.
Pool 2 would have trucks, railroad equipment (but not track) and equipment used by construction contractors and timber, trucking and telephone companies (other than poles and lines).
Pool 3 would have in it office furniture, airplanes, ships and equipment used by turbine manufacturers and mining, oil and gas drilling, petroleum refining, paper and chemical companies. It would also have assets like landfill gas facilities to which the Internal Revenue Service has not assigned a “class life.”
Pool 4 would include inside-the-fence power plants and boilers that a company uses to generate electricity or steam for its own use, railroad track, pipelines, transmission and distribution lines, gas mains, gas storage facilities and water utilities, steam boilers and all the equipment through the boiler at small biomass power plants of up to 80 megawatts in size.
The new depreciation percentages would apply starting after 2014.
Congress usually writes transition rules to give companies that already own or have made binding commitments to invest in assets before the tax changes are first approved by one of the Congressional tax-writing committees the chance to see the investments through with the existing tax subsidies. There is no such transition relief in the Baucus bill. The bill says the pools would start with the adjusted bases of a company’s assets at the start of its 2015 tax year. Transition relief could still be added. However, an issue will be whether to let companies keep existing subsidies while also benefiting fully from lower corporate tax rates.
A special rule would apply to assets sold in sale-leasebacks, to related parties or in tax shelter transactions. Such sales would be more likely to trigger taxable income. The pool balance would be reduced by the “recomputed basis” or the gross sales proceeds, whichever is less. However, any shortfall between the amount subtracted from the pool and the fair market value of the asset at time of sale would be taxed as ordinary income. The “recomputed basis” is the basis that the seller would have had in the asset if it had been in the pool all by itself.
Geothermal (and oil and gas) companies would no longer be able to deduct intangible drilling costs. The costs would have to be amortized ratably over five years.
Percentage depletion would be repealed. All taxpayers would have to use cost depletion to recover their investments in minerals and natural resources.
Intangible assets would be amortized ratably over 20 years rather than 15 years as under current law.
The Senate Finance Committee staff asked for comments on a number of issues by January 17, including on “whether and how tax incentives . . . such as tax credits for clean energy . . . should be adjusted in light of” the cutbacks in depreciation. The staff also asked for comments on whether the alternative minimum tax should be repealed and on what transition rules ought to be included.
Baucus may still release a specific tax reform proposal related to energy, but nothing firm has been decided.
The Obama administration also called for scaling back depreciation in a white paper on corporate tax reform in 2012. House Republicans have not taken a public position.
Transition rules are potentially a huge issue. The last time Congress did a major overhaul of the US tax code in 1986, the tax committee chairmen included generous transition relief, also handing out so-called “rifle shot” transition rules that covered just a few situations at a time in order to win votes for the bill. The committee staff expects people to come in and tell it where the bill drafts cause problems.
In partnership flip transactions in the tax equity market, the tax equity investor’s interest in a wind or solar project flips down to a smaller interest once the investor reaches a target return. Depreciation is taken into account in calculating when the target return is reached. The depreciation periods and methods are usually a “fixed tax assumption,” meaning the tax equity investor will flip down on the original timetable notwithstanding a change in law for calculating depreciation. In a sale-leaseback, a change in law is not usually grounds for the lessor to be entitled to a tax indemnity payment from the lessee.
The existing “normalization” rules for regulated utilities do not work for depreciation under the new regime. Utilities are not able to claim accelerated depreciation under current law if their regulators require the benefits be passed through too quickly to ratepayers. The staff asked for comments about whether normalization rules will still be needed and, if so, how they should work.
A technical correction in the bill would make clear that section 1603 payments on renewable energy projects do not have to be reported as income for purposes of calculating corporate minimum taxes.
Turning to the international tax reforms, the United States taxes US companies on their worldwide earnings. It is one of the few countries to do so, and US companies complain that it puts them at a competitive disadvantage.
The US taxes foreign corporations only on income from US sources. Therefore, US companies with projects in other countries set up offshore holding corporations to hold the projects. This blocks the earnings from being taxed in the US until the earnings are repatriated. However, the US looks through offshore holding corporations that are majority owned by US shareholders and taxes the US shareholders on any interest, dividends or other passive income it sees earned by the offshore company. The theory is that there is no need to defer taxing passive income since the US owners of this income could just as easily have invested directly from the United States. US taxes are deferred until repatriation only on active income from real business operations overseas; that is the only kind of income that, were it taxed currently without waiting for repatriation, would put US companies at a competitive disadvantage.
Baucus would simplify these rules to a degree. All foreign income would either be taxed when earned or treated as exempted from US taxes.
He is concerned about the “lock-out” effect of the current rules. US companies have an incentive to keep reinvesting their income from active business operations outside the US to keep it outside the US tax net as long as possible.
Under the Baucus bill, passive and highly-mobile income would be taxed annually at full US rates. Income from selling products and providing services to US customers would be taxed annually at the full US rate with limited exemptions.
He is proposing two options for taxing income from products and services sold into foreign markets. One is a minimum tax of 80% of the maximum US corporate income tax rate — 28% if the rate remained at 35% — with full foreign tax credits for taxes already paid on the income to foreign countries.
The other option is a minimum tax of 60% of the maximum US corporate income tax rate — 21% if the rate remained at 35% — if the income is from an active business outside the US, but at the full US rate if it is not.
Earnings of foreign subsidiaries for periods before 2015 that have not already been taxed in the US would be subject to a one-time tax at a reduced rate of, for example, 20%, payable over eight years.
(House Republicans are also proposing to tax that income, but only 5% of it at a 5.25% rate.)
The international tax reforms were not well received by Republicans and business and labor groups or several former international tax counsels at Treasury. The AFL-CIO said it leaves too many loopholes intact that lead US companies to shift jobs overseas.