On December 20, 2017, the U.S. House of Representatives and the U.S. Senate passed a tax reform act (formerly known as the Tax Cuts and Jobs Act or the "Act"). President Trump is expected to sign the Act into law. The Act includes several major changes to many areas of the Internal Revenue Code (the Code) impacting taxpayers who are engaged in the energy sector. Because most of the changes are effective January 1, 2018, prompt review of your structure and operations is warranted to understand how the new legislation will impact you and whether restructuring in early 2018 might improve your tax situation.
This update summaries the general changes of the tax law of particular interest to energy companies, as well as specific provisions targeted to particular taxpayers in the energy industry. Topics summarized below include
- General Income Tax Changes
- Reduction of Corporate Income Tax Rate
- Changes to Pass-Through Taxation
- Limitation of Interest Deductibility
- Repeal of Corporate AMT
- New Restrictions on NOL Utilization
- Repeal of Technical Termination of Partnerships
- Changes to Depreciation Rules
- Repeal of Section 199 Deduction
- Changes to International Tax Provisions
- Territorial Corporate Tax System
- Repeal of Active Trade or Business Exception under Section 367(a)
- Loss Recapture on Transfer of a Foreign Branch to a Foreign Corporation
- Deemed Repatriation of Deferred Foreign Earnings of 10%-Owned Foreign Corporations
- Current-Year Taxation for Global Intangible Low-Taxed Income for U.S. Shareholders of CFCs
- Effective 13.125% Tax Rate on Foreign-Derived Intangible Income of a Domestic Corporation
- Other Changes to Subpart F Rules
- Anti-Base Erosion Rules
- Changes to Foreign Tax Credit System
- The Base-Erosion Anti-Abuse Tax (BEAT)
- Shareholders Not Eligible for Preferential Tax Rate on Dividends from Inverted Companies
- Sale of a Partnership Interest by a Foreign Person
- Repeal of Fair Market Value Method of Interest Expense Apportionment
- Impact to MLPs
- Impact to Renewable Energy
- Impact on Power Projects
- Impact on Normalization Rules for Regulated Utilities
- Proposed Energy Tax Changes That Were Not Enacted
Corporate Tax Rate Lowered
One such change is the reduction of the corporate income tax rate. The Act permanently reduces the corporate tax rate to a flat 21% beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
Up to 20% Deduction for Qualified Business Income of Pass-Through Entities
Pass-through entities are also commonly used in the energy sector. Beginning in 2018, the Act provides for up to a 20% deduction for individuals for qualified business income earned through pass-through entities, such as partnerships and limited liability companies taxed as partnerships, S corporations, disregarded entities and trusts. This deduction (when combined with the reduction in individual income tax rates) theoretically would result in an effective maximum marginal tax rate of 29.6% (plus unearned income Medicare tax, where applicable), for taxpayers entitled to the full 20% deduction. However, the deduction is subject to several limitations that are likely to materially limit the deduction for many taxpayers. These limitations include the following:
- Qualified business income does not include IRC Section 707(c) guaranteed payments for services, amounts paid by S corporations that are treated as reasonable compensation of the taxpayer, or, to the extent provided in regulations, amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner.
- Qualified business income does not include income involving the performance of services (i) in the fields of, among others, health, law, accounting consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
- Qualified business income includes (and, thus, the deduction is applicable to) only income that is effectively connected with the conduct of a trade or business within the United States.
- The deduction is limited to 100% of the taxpayer’s combined qualified business income (e.g., if the taxpayer has losses from certain qualified businesses that, in the aggregate, exceed the income generated from other qualified businesses, the taxpayer’s deduction would be $0).
- The deduction is limited to the greater of (i) 50% of the W-2 wages paid with respect to the trade or business or (ii) the sum of 25% of the W-2 wages paid with respect to the trade or business and 2.5% of the unadjusted basis, immediately after acquisition, of all depreciable property used in the qualified trade or business.
This last limitation does not apply to income earned through publicly-traded partnerships (discussed further below) or to taxpayers whose taxable income does not exceed $315,000 (in the case of taxpayers filing a joint return) or $157,500 otherwise. The last limitation may particularly impact real estate private equity funds and real estate ventures that do not have their own employees but, instead, rely on services performed by employees of general partners or managing members or affiliated management companies.
This 20% deduction is scheduled to expire after 2025 under the Act, unless renewed before then.
Interest Expense Deductions Generally Limited
Given the capital-intensive nature of the sector, changes to interest deductibility will impact financing costs for the sector. Subject to certain exceptions discussed below, beginning in 2018, the Act generally limits the annual deduction for business interest expense to an amount equal to 30% of the "adjusted taxable income" (as defined in the following paragraph), plus the business interest income, plus the floor plan financing interest (if any), of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely and utilized in future years, subject to this and other applicable interest deductibility limitations and to certain restrictions applicable to partnerships.
"Adjusted taxable income" generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business and by adding back (1) any business interest expense or business interest income, (2) the 20% deduction for pass-through income, (3) the amount of any net operating loss deduction and (4) for taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
There are several exceptions to this new limitation on interest deductibility, including the following:
- At the taxpayer’s election, the limitation does not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business;
- The limitation does not apply to interest incurred by taxpayers in the trade or business of the furnishing (which includes generation, transmission and/or distribution) or sale of (1) electrical energy, water, or sewage disposal services, (2) gas or steam through a local distribution system, or (3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, by a public service or public utility commission or other similar body of any State or political subdivision thereof, or by the governing or ratemaking body of an electric cooperative; and
- The limitation does not apply to taxpayers whose annual gross receipts do not exceed $25 million under the test set forth in IRC Section 448(c).
Special rules apply in the case of partnerships. The limitation on the deduction is determined at the partnership level, and any deduction available after applying such limitation is included in the partners’ nonseparately stated taxable income or loss from the partnership. Any business interest that is not allowed as a deduction to the partnership for the taxable year is not carried forward by the partnership but, instead, is allocated to each partner as "excess business interest" in the same manner as nonseparately stated taxable income or loss of the partnership. The partner may deduct its share of the partnership’s excess business interest in any future year, but only against excess taxable income attributed to the partner by such partnership. The "excess taxable income" with respect to any partnership is the amount which bears the same ratio to the partnership’s adjusted taxable income as (a) the excess of (i) 30% of the adjusted taxable income of the partnership, over (ii) the amount (if any) by which (x) the business interest expense, minus the floor plan financing interest, exceeds (y) the business interest income of the partnership bears to (b) 30% of the adjusted taxable income of the partnership. A partner’s share of excess taxable income is determined in the same manner as nonseparately stated income and loss. Any disallowed interest expense allocated to a partner immediately reduces the unitholder’s basis in its partnership interest, but any amounts that remain unused upon disposition of the interest are restored to basis immediately prior to disposition.
Repeal of the Corporate Alternative Minimum Tax
The Act adopts a corporate tax flat rate of 21% (reduced from the current maximum rate of 35%) and repeals the corporate AMT, effective January 1, 2018. The AMT imposed a minimum tax of 20% on certain corporations and restricted the use of the certain credits (research and development ("R&D") and production tax credits ("PTCs" for renewable energy)) to offset such tax. Repeal of the AMT ensures that these credits will continue to be fully monetizable by most investors under the lower corporate tax rate (unless the taxpayer is subject to the BEAT provisions, as discussed below).
The Senate version of the Act had retained the AMT, raising alarm. Under the lower corporate tax rate, the number of corporations subject to the AMT would have sharply increased, and the value of these credits for such corporations would have been severely curtailed. The Act therefore avoids this undesirable result by repealing the AMT.
Repeal of Technical Terminations of Partnerships
The Act permanently repeals the partnership technical termination rule contained in Section 708(b)(1)(B) of the Code, effective in 2018. This repeal allows partnerships to continue—without resetting depreciation periods and without allowing or requiring new elections—even after the disposition by partners of more than half of the partnership’s outstanding capital and profits interests in a twelve-month period.
New Restrictions on NOL Utilization
The Act generally limits the amount of net operating loss (NOL) that may be utilized in any taxable year to 80% of the taxpayer’s taxable income (determined without regard to the NOL deduction) with respect to losses arising in taxable years beginning after December 31, 2017. Carryovers to other years are adjusted to take account of this limitation, and may be carried forward indefinitely. The bill also generally repeals provisions allowing for the carryback of NOLs effective for losses arising in taxable years after December 31, 2017.
Changes to Depreciation Rules
Depreciable Lives for Real Property Modified
The Act requires any real property trade or business that elects to be excluded from the interest deductibility limitations described above to utilize the alternative depreciation system with respect to its depreciable real property. Under the alternative depreciation system, as modified by the Act, the recovery periods for nonresidential depreciable real property, residential depreciable real property and qualified improvements are 40 years, 30 years and 20 years, respectively.
The Act did not adopt the Senate proposal to reduce the MACRS depreciable lives on residential and nonresidential depreciable property.
Immediate Expensing of Qualified Depreciable Personal Property
The Act extends and modifies the additional first-year depreciation deduction for qualified depreciable personal property by increasing the 50% allowance to 100% for property placed in service after September 27, 2017, and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. The bill removes the requirement in current law that the original use of qualified property must commence with the taxpayer. Thus, immediate expensing applies to purchases of used as well as new items.
Qualified property does not include generation, transmission, distribution or transportation assets of a public utility.
Repeal of Section 199 Deduction
The deduction for domestic production activities under section 199 is repealed for tax years beginning after December 31, 2017. The general reduction in the corporate tax rate is meant to encompass the key policy justifications that were the original motivations for the adoption of section 199.
Changes to International Tax Provisions
The energy sector is international in scope and the changes, and the changes to the U.S. international tax system will have a profound impact on the energy industry.
Territorial Corporate Tax System
The Act changes the taxation of domestic corporations from a worldwide tax system to a hybrid territorial tax system by establishing a limited participation exemption system. Such participation exemption will allow a domestic corporation to claim a 100% deduction for the foreign-source portion of a dividend (including deemed dividends arising under Section 1248 of the Code from the sale or exchange of stock) received by such domestic corporation from a "specified 10%-owned foreign corporation" in which such domestic corporation is a "United State shareholder." For this purpose, a "specified 10%-owned foreign corporation" is any foreign corporation (other than a passive foreign investment company (PFIC) that is not a controlled foreign corporation (CFC)) with respect to which any domestic corporation is a United States shareholder. As discussed below, the Act expands the current definition of United States shareholder to include not only United States persons that own (directly or constructively) stock of the foreign corporation representing 10% of the combined voting power of a foreign corporation but also United States persons that own (directly or constructively) stock of the foreign corporation representing 10% of the value of the foreign corporation. The deduction is allowed only to a C corporation that is not a regulated investment company or a real estate investment trust.A domestic corporation may claim the deduction only if the dividend is paid on a share of stock that the domestic corporation has held for 366 days or more during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to such dividend. The holding period requirement will be satisfied only if the specified 10%-owned foreign corporation is a specified 10%-owned foreign corporation at all times during this period and the domestic corporation is a United States Shareholder with respect to such foreign corporation at all times during such period.
The deduction is not available if the dividend received from the specified 10%-owned foreign corporation is a "hybrid dividend," which is generally defined as any dividend for which the specified 10%-owned foreign corporation received a deduction in a foreign country.
No credit or deduction is allowed for any foreign income taxes paid or accrued with respect to any portion of a dividend that qualifies for the deduction.
This provision applies to distributions made after December 31, 2017.
Repeal of Active Trade or Business Exception Under Section 367(a)
The Act provides that, if a U.S. person transfers to a foreign corporation property that is used in the active conduct of a foreign trade or business, then such foreign corporation shall not be treated as a corporation for purposes of determining the extent to which gain is recognized on such transfer. The Act thus repeals the active trade or business exception under current law. This provision applies to transfers after December 31, 2017.
Loss Recapture on Transfer of a Foreign Branch to a Foreign Corporation
Under the Act, if a domestic corporation transfers substantially all of the assets of a foreign branch to a specified 10%-owned foreign corporation with respect to which it is a United States shareholder after the transfer, then the domestic corporation must recapture, as U.S. source income, any net branch losses incurred after December 31, 2017, and before the transfer and with respect to which the domestic corporation was allowed a deduction. This provision applies to transfers after December 31, 2017.
Deemed Repatriation of Deferred Foreign Earnings of 10%-Owned Foreign Corporations
The Act amends Section 965 to require a United States shareholder (which for this purpose includes domestic corporations, partnerships, trusts, estates, and U.S. individuals that own 10% of the voting power) of CFCs and other specified foreign corporations to include in income, for the last taxable year of such foreign corporation beginning before January 1, 2018, such shareholder’s pro rata share of the deemed repatriation amount. Other specified foreign corporations are non-CFC, non-PFIC foreign corporations with a corporate United States shareholder (which for this purpose includes domestic corporations that own 10% of the voting power of such foreign corporation). The deemed repatriation amount is the greater of such foreign corporation’s post-1986 deferred foreign income as of (i) November 2, 2017 or (ii) December 31, 2017 and that was not previously subject to U.S. tax (but excluding earnings and profits that were accumulated prior to the foreign corporation becoming a CFC or having a 10% U.S. shareholder). The deemed repatriation amount generally is unreduced by distributions made by the foreign corporation during the taxable year.This deemed repatriation generally will be taxed at a 15.5% rate to the extent the underlying foreign earnings are attributable to the U.S. shareholder’s cash position and an 8% rate for all other amounts. The "cash position" is defined to include cash, net accounts receivable, and the fair market value of similarly liquid assets.
The Act provides that a United States shareholder that is required to include an amount in income under Section 965 is allowed a credit for approximately 44.3% of the foreign income taxes paid that are attributable to the cash position portion of the inclusion and approximately 22.9% of the foreign income taxes paid that are attributable to the remainder of the inclusion.
The Act provides that, in the case of a corporation that becomes an expatriated entity (within the meaning of Section 7874(a)(2)) at any point within the 10-year period following the enactment of the Act, a United States shareholder of such corporation is subject to U.S. tax at a 35% rate (with no reduction for foreign tax credits) on the entire amount of the deemed repatriation with respect to such corporation.
Current-Year Taxation for Global Intangible Low-Taxed Income (GILTI) for U.S. Shareholders of CFCs
The Act adds to the Code new Section 951A, which requires a United States shareholder of a CFC to include in income, as a deemed dividend, the global intangible low-taxed income (GILTI) of the CFC. After factoring in a deduction that a domestic corporation will be entitled to claim with respect to such income inclusion, a domestic corporation will be subject to U.S. tax on GILTI at an effective rate of 10.5% (that is, 50% of the U.S. corporate tax rate of 21%).For purposes of this rule, "GILTI" is defined as the excess of the U.S. shareholder’s net CFC tested income over a net deemed tangible income return. "Net CFC tested income" generally means a CFC’s gross income, other than income that is subject to U.S. tax as effectively connected income, Subpart F income (including income that would be Subpart F income but for the application of certain exceptions), and foreign oil and gas extraction income, less allocable deductions. The "net deemed tangible income return" generally is an amount equal to (i) 10% of the aggregate of the United States shareholder’s pro rata share of a CFC’s qualified business asset investment (generally, a quarterly average of the CFC’s tax basis in depreciable property used in its trade or business) over (ii) the amount of interest expense taken into account to determine such U.S. shareholder’s net CFC tested income.
Under the Act, a domestic corporation is entitled to a credit for 80% of its pro rata share of the foreign income taxes attributable to the income of the CFC that is taken into account in computing its net CFC tested income. The foreign tax credit limitation rules apply separately to such taxes, and any taxes that are deemed paid under these rules may not be carried back or forward to other tax years.
This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Effective 13.125% Tax Rate on Foreign-Derived Intangible Income of a Domestic Corporation
The Act adds to the Code new Section 250, which allows a domestic corporation to claim a deduction (for tax years from 2018 through 2025) for an amount equal to 37.5% of its foreign-derived intangible income (reduced to 21.875% for tax years beginning after December 31, 2025). Thus, a domestic corporation is subject to U.S. tax on foreign-derived intangible income at a rate of 13.125%.
In general, a domestic corporation’s "foreign-derived intangible income" is calculated by applying a complex series of formulas and definitions that ultimately measure the extent to which the domestic corporation’s income in excess of a 10% return on its U.S. depreciable assets (increased to 15.625% for tax years beginning after December 31, 2025) is attributable to (i) the sale of property to foreign persons for use outside the United States or (ii) the performance of services for foreign persons, or with respect to property located, outside the United States. Income of the domestic corporation is not taken into account for this purpose to the extent it is Subpart F income, GILTI, financial services income, a dividend received from a CFC in which the domestic corporation is a United States shareholder, domestic oil and gas extraction income, and foreign branch income. Special rules apply to transactions involving intermediaries and related parties.
This provision is effective for taxable years beginning after December 31, 2017.
Other Changes to Subpart F Rules
Expansion of Stock Attribution Rules for Determining CFC Status
The Act repeals Section 954(b)(4), which provides that stock in a foreign corporation is not attributed "downward" from a foreign person to a related U.S. person for purposes of determining whether such U.S. person is a United States shareholder of such foreign corporation (and, thus, whether such foreign corporation is a CFC). This provision apparently is intended to render ineffective "de-control transactions" in which a foreign parent acquires a greater than 50% interest in a CFC of its U.S. subsidiary and, thus, causes the CFC to be a non-CFC.This provision is effective for the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations and for the taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Expansion of Definition of United States Shareholder
Under current law, a United States shareholder is defined as any U.S. person that owns 10% of the voting stock in a foreign corporation. The Act expands this definition to also include any U.S. person that owns 10% of the value of the stock in a foreign corporation. This change accordingly expands the circumstances in which a foreign corporation will be treated as a CFC (including in situations where a U.S. person owns "low vote" stock that represents at least 10% of the value of the foreign corporation).
This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Elimination of 30-Day Requirement for Subpart F Inclusions
Under current law, a United States shareholder of a foreign corporation is required to include amounts in income under Subpart F for a particular tax year only if such foreign corporation has been a CFC for at least 30 consecutive days for such year. The Act eliminates this 30-day requirement. This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
Repeal of Treatment of Foreign Base Company Oil-Related Income as Subpart F Income
The Act repeals Section 954(g), which includes foreign base company oil-related income as one of the categories of foreign base company income. This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Repeal of Inclusion Based on Withdrawal of Previously Excluded Subpart F Income from Investment in Qualified Shipping Operations
The Act repeals Section 955, which requires a United States shareholder of a CFC to include in income any previously excluded Subpart F income that such CFC withdraws from investment in certain qualified shipping operations. This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
Anti-Base Erosion Rules
Expansion of the Definition of Intangible Property for Outbound Transfers
The Act expands the definition of "intangible property" under Section 936(h)(3)(B) to include goodwill, going concern value, workforce in place and any other item the value or potential value of which is not attributable to tangible property or the services of an individual. This provision legislatively overturns several recent Tax Court cases holding that assets such as workforce in place and goodwill are beyond the scope of the statutory definition of "intangible property." In addition, the Act removes the qualification that intangible property under Section 936(h)(3)(B) must have substantial value independent of the services of an individual. As a result, certain transfers of such assets by a U.S. person to a foreign corporation will be subject to Section 367(d) or 482.The Act also requires Treasury to issue regulations that would, for purposes of applying the outbound transfer rules under Section 367(d) or the transfer pricing rules under Section 482, require the valuation of intangible properties on an aggregate basis or on the basis of realistic alternatives to such transfers, in each case, if Treasury determines that such a basis is the most reliable means of valuation.
These provisions apply to transfers in taxable years beginning after December 31, 2017. However, the Act expressly provides that the changes to Section 936(h)(3)(B) are not to be construed as creating an inference as to the application of the prior version of the section.
Certain Related Party Amounts Paid or Accrued in Hybrid Transactions or with Respect to Hybrid Entities
The Act adds new Section 267A, which disallows a deduction for interest or royalties paid or accrued to a related party pursuant to a "hybrid transaction" or by or to a "hybrid entity" if such amount is not included in the income of such party under the local tax laws of the country of which such related party is a resident or if such party is entitled to a deduction with respect to such payments under the local tax laws of such country.
For purposes of this rule, a "hybrid transaction" is any transaction, series of transactions, or instrument one or more payments with respect to which are treated as interest or royalties for U.S. tax purposes but not so treated under the local tax laws of the country of which the recipient is a resident. A "hybrid entity" is an entity that is treated as fiscally transparent under U.S. tax law but not so treated under the local tax laws of the country of which the recipient is a resident, or vice versa.
This provision is effective for taxable years beginning after December 31, 2017.
Changes to Foreign Tax Credit System
Changes to Indirect Foreign Tax Credit Rules
The Act repeals Section 902, which allows a domestic corporation to claim an indirect foreign tax credit with respect to dividends it receives from a foreign corporation in which it owns 10% of the voting stock.The Act modifies Section 960, which allows a domestic corporation to claim an indirect foreign tax credit with respect to Subpart F inclusions. Under the Act, the foreign tax credit is calculated based on current-year foreign taxes paid (rather than a cumulative foreign tax pool) with respect to the relevant item of Subpart F income. The Act also includes provisions addressing distributions of previously taxed income by a CFC to a domestic corporation (or by a lower-tier CFC to an upper-tier CFC).
These provisions apply to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Separate Foreign Tax Credit Limitation Basket for Foreign Branch Income
In general, under Section 904, a taxpayer is permitted to claim a foreign tax credit in an amount equal to the U.S. tax imposed on such taxpayer’s foreign source income. This limitation applies separately to the taxpayer’s "general basket" and "passive basket" income.
The Act adds as a new basket "foreign branch income," which is defined as the business profits of a U.S. person that are attributable to one or more qualified business units in one or more foreign countries. However, foreign branch income does not include any income that is otherwise treated as passive basket income.
This provision is effective for taxable years beginning after December 31, 2017.
Source of Income from Sales of Inventory Produced by the Taxpayer
Under current law, the source of a taxpayer’s income from the sale or exchange of inventory property produced (in whole or in part) by the taxpayer in the United States and sold outside the United States (or vice versa) is generally sourced 50% to the place of production and 50% to the place of sale (based on title passage rule).
The Act modifies these rules and provides that the source of such income is determined solely based on the location of production with respect to such inventory property.
This provision is effective for taxable years beginning after December 31, 2017.
Election to Increase Percentage of ODL Recapture as Foreign Source Income
Under current law, Section 904(g) allows a taxpayer with an overall domestic loss (ODL) to recapture such ODL by recharacterizing U.S. source income earned in succeeding taxable years as foreign source to the extent of the lesser of the ODL or 50% of the taxpayer’s U.S. source income in such year.
The Act amends Section 904(g) to allow a taxpayer to elect a percentage between 50% and 100% with respect to ODLs that arose prior to January 1, 2018 in determining the amount of U.S. source income earned in a succeeding year that it may recharacterize as foreign source income.
This provision is effective for ODLs in existence prior to January 1, 2018, and the election may only be made during taxable years beginning after December 31, 2017, and before January 1, 2028.
The Base Erosion Anti-Abuse Tax (BEAT)
BEAT is a minimum tax on multinational corporations that have at least $500 million of annual domestic gross receipts (averaged over a 3-year period) and a "base erosion percentage" of 3% or higher (2% or higher for certain banks and registered security dealers) for the taxable year. BEAT generally is the excess of
- 10% (5% for taxable years beginning during 2018) of the taxpayer’s modified taxable income (generally, its taxable income plus the base erosion tax benefit amount (including the base erosion percentage of an NOL deduction)) over
- an amount equal to the taxpayer’s regular tax liability reduced by certain credits, except for certain business tax credits, including up to 80% of the value of production tax credits under Section 45 of the Code and investment tax credits under Section 48 of the Code.
For taxable years beginning after 2025, the 10% limit is increased to 12.5% and certain credits are treated differently for purposes of determining a taxpayer’s regular tax liability. For example, after 2025, production tax credits and investment tax credits will no longer offset any portion of the BEAT.
For this purpose, a corporation’s "base erosion percentage" generally equals the aggregate amount of "base erosion tax benefits" of the corporation for the taxable year, divided by the aggregate amount of deductions allowable to the corporation for the taxable year. A "base erosion tax benefit" generally means (i) any deduction allowed with respect to a base erosion payment, (ii) in the case of a base erosion payment with respect to the purchase of depreciable property, any deduction allowed for depreciation (or amortization in lieu of depreciation) with respect to the property acquired with such payment, or (iii) any reduction in gross receipts with respect to a payment described above made to a related foreign corporation that became a surrogate foreign corporation after November 9, 2017 or made to a member of an expanded affiliated group that includes such surrogate foreign corporation. A "base erosion payment" generally is a deductible payment by the corporation to a foreign related party (subject to certain exceptions).
This provision is effective for payments paid or accrued in taxable years beginning after December 31, 2017.
Shareholders Not Eligible for Preferential Tax Rate on Dividends from Inverted Companies
Certain dividends from "qualified foreign corporations" are subject to a reduced rate of tax. Such qualified foreign corporations include corporations incorporated in a U.S. possession and certain corporations that are eligible for benefits of an income tax treaty with the United States and is approved by Treasury as satisfactorily providing for an exchange of information.
The Act provides that dividends from a surrogate foreign corporation (as defined under Section 7874) are not eligible for reduced tax rates unless such corporation is deemed to be a domestic corporation under Section 7874.
This provision is effective for dividends paid after the date of enactment of the Act and will apply only to dividends from foreign corporations that became surrogate foreign corporations after the date of enactment of the Act.
Sale of a Partnership Interest by a Foreign Person
Under the Act, gain or loss realized by a foreign corporation or a foreign individual from the sale or exchange of an interest in a partnership engaged in a U.S. trade or business is treated as effectively connected with a U.S. trade or business to the extent that the sale of all the partnership assets would have produced effectively connected gain or loss. This provision applies to sales, exchanges, and dispositions occurring on or after November 27, 2017. This provision repeals the result in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), where the Tax Court held that a foreign partner was not subject to U.S. tax on sale of a partnership interest, rejecting the holding of Rev. Rul. 91-32 to the contrary.
The Act also amends Section 1446 to require the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that it is not a nonresident alien individual or foreign corporation. This provision is effective for transfers occurring after December 31, 2017.
Repeal of Fair Market Value Method of Interest Expense Apportionment
Under current law, members of a U.S. affiliated group may elect to allocate and apportion their interest expense among U.S. source income and foreign source income based on either the adjusted tax basis or fair market value of their assets.
The Act now provides that interest expense must be allocated and apportioned based on the adjusted tax basis of their assets. This provision is effective for taxable years beginning after December 31, 2017.
Impact on Master Limited Partnerships
MLP Tax Rate vs. Corporate Tax Rate
A significant benefit of MLPs over C corporations is the lower effective tax rate that applies to MLP income. The Act preserves that benefit through 2025. As discussed above, the Act permanently reduces the corporate tax rate to a flat 21%, beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
The Act reduces the maximum individual tax rate to 37%, beginning in 2018. In addition, the Act provides a deduction to individual MLP unitholders generally equal to 20% of the MLP’s domestic income and 20% of any recapture income of an MLP unitholder on the sale of an MLP unit. The wage-based limitation on the 20% deduction that applies to other pass-through entities does not apply to MLPs or REITS. The combination of the reduced individual tax rate and the 20% deduction lowers the effective tax rate on income of an MLP to 29.6% (or 33.4% after the 3.8% Medicare tax). Both the reduced 37% tax rate and the 20% deduction sunset after 2025.
Table of Effective Tax Rates Before and After the Act
The reduced maximum individual 37% rate and the 20% deduction for MLP income, but not the reduced 21% rate on income of a C corporation, are scheduled to expire after 2025. Thus, after 2025, the effective tax rate on MLP income will be slightly higher than the effective tax rate on C corporation income (39.6% for MLPs and 36.8% for C corporations, in both cases before the 3.8% Medicare tax), unless the individual reduced rates and the 20% deduction are extended before then. Because many other favorable provisions of the Act sunset after 2025, it is possible that future legislation will extend the MLP effective tax rate benefit beyond 2025.
Interest Deduction Limitation
As discussed above, the Act imposes a new limitation on interest expense deductions of large business taxpayers, including MLPs, beginning in 2018. The limitation is calculated and applied separately for each entity, in a manner that is intended to avoid double-counting. For example, in calculating the limitation on an MLP’s ability to deduct its own interest expense, the MLP would take into account net income allocated to it from a subsidiary partnership only if the subsidiary partnership’s interest expense fell short of 30% of the subsidiary partnership’s adjusted taxable income, and in proportion to that shortfall. Similarly, an MLP unitholder would take into account net income allocated to it from the MLP in calculating the limitation on the unitholder’s interest expense only if the MLP’s interest expense fell short of 30% of the MLP’s adjusted taxable income, and in proportion to that shortfall.
Disallowed interest expense allocated to an MLP unitholder can be carried forward indefinitely, to a year in which the unitholder’s share of the MLP’s interest expense does not exceed 30% of the unitholder’s share of the MLP’s adjusted taxable income. The disallowed interest expense immediately reduces the unitholder’s basis in its MLP interest, but any amounts that remain unused upon disposition of the interest are restored to basis immediately prior to disposition.
As discussed above, under the Act, the bonus depreciation percentage is generally increased to 100% (from its current level of 50%) for property placed in service after September 27, 2017 and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. The Act expands the availability of bonus depreciation to non-original use property, as long as it is the taxpayer’s first use. The Act does not provide any express rules for how this expanded availability applies to purchasers of MLP units or other partnership interests. Bonus depreciation is not available for property of a regulated public utility.
As discussed above, the Act permanently repeals the partnership technical termination rule contained in Section 708(b)(1)(B) of the Code, effective in 2018. This repeal allows an MLP or other partnership to continue—without resetting depreciation periods and without allowing or requiring new elections—even after the disposition by partners of more than half of the partnership’s outstanding capital and profits interests in a twelve-month period.
Sale of Foreign Partner’s Partnership Interest
As discussed above, under the Act, gain or loss realized by a foreign corporation or a foreign individual from the sale or exchange of an interest in a partnership engaged in a U.S. trade or business is treated as effectively connected with a U.S. trade or business to the extent that the sale of all the partnership assets would have produced effectively connected gain or loss. This provision applies to sales, exchanges, and dispositions occurring on or after November 27, 2017. This provision repeals the result in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), where the Tax Court held that a foreign partner was not subject to U.S. tax on sale of a partnership interest, rejecting the holding of Rev. Rul. 91-32 to the contrary.
The transferee of a partnership interest is required to withhold 10% of the amount realized by the transferor unless the transferor certifies that it is not a foreign person. The partnership is required to deduct and withhold from the transferee amounts that should have been withheld by transferee. The explanation to the Act indicates that the IRS may under regulatory authority granted to it provide guidance permitting brokers to handle the withholding of the 10% tax in cases where foreign partners sell MLP units through a broker. The withholding requirement is effective for sales, exchanges, and dispositions after December 31, 2017.
Impact on Renewable Energy
Renewable Tax Credits Unchanged
The House version of the Act included a number of proposed changes to renewable tax credits. It eliminated inflation indexing for the PTC and eliminated the ITC for solar energy projects for which construction commences after 2027. The final version of the Act does not adopt these proposals, leaving the PTC and the ITC unchanged.Additionally, the House version of the Act would have codified the "continuous construction" requirement for determining when construction of a project commences. This requirement is currently established in IRS guidance, but such guidance also provides a safe harbor for projects placed in service within a certain time frame after construction commences. The House bill omitted, and thus would have invalided, the safe harbor. The final version of the Act did not include this proposal, so taxpayers may continue to rely on the safe harbor.
Under current law, the PTC and ITC are phased out based on when construction begins. The PTC and ITC for wind facilities are scheduled to phase-down for projects commencing through 2019, after which the credits expire. The ITC for solar properties phases-down through 2021, bottoming out at 10% for projects that commence after 2021. During the drafting process of the Act, several members of Congress indicated interest in extending these credits, but no extensions were included in any version of the Act. Any extensions of renewable tax credits will need to be part of a future extender package.
Impact on Power Projects
Prepaid Power Purchase Agreements
Under current law, prepaid power purchase agreements are often used in renewable projects (notably, in rooftop solar projects). This is because, in part, they permitted the electricity provider to include the advance payments in income over the entire period in which the electricity will be delivered. However, the Act will require these prepayments to be reported immediately as income (or, at best, partly in the year of the prepayment and partly in the following year, depending on the circumstances).
Contributions to Capital No Longer Tax-Free
The Act provides that Section 118 of the Code, which generally provides that a corporation is not taxed on property contributed to it, will not apply to contributions in aid of construction, to contributions as a customer or potential customer or to contributions by any governmental entity or civic group. Thus, for example a contribution of land by a City to a developer corporation would be taxed to the corporation at the land’s fair market value. The explanation to the bill further provides that "[t]he conferees intend that section 118, as modified, continue to apply only to corporations." This may be read to imply that a partnership (or any other type of entity other than a corporation) also would be taxed on such a contribution, as well as any contribution that might otherwise qualify for nonrecognition treatment under section 118 if made to a corporation.
Impact on Normalization Rules for Regulated Utilities
Because the Act adopts a corporate tax rate of 21% (reduced from the current maximum rate of 35%), many companies’ accumulated deferred income tax ("ADIT") balances will be reduced. For regulated utilities making large capital investments and utilizing accelerated tax depreciation, the ADIT balances derive in large part from the differences between that accelerated tax depreciation, on the one hand, and the straight-line book depreciation that is required for rate making purposes, on the other hand. To encourage these capital investments, the Code requires the use of a normalized method of accounting, which effectively prevents regulators from flowing through the accelerated depreciation benefits to ratepayers too quickly.Generally, in computing ADIT, the book/tax differences in depreciation are multiplied by the applicable tax rate. The tax rate reduction in the Act creates "excess ADIT" because the ADIT balance previously computed using the 35% rate will be reduced when the book/tax differences are multiplied by the new 21% rate.
To address normalization issues, the Act adopts a similar approach to that taken in the Tax Reform Act of 1986, which also substantially reduced the corporate tax rate. Namely, the Act provides that if excess ADIT is reduced more rapidly, or to a greater extent than, it would be reduced under the "average rate assumption method," the taxpayer will not be treated as using a normalized method of accounting. The Act further provides that normalization violations for any taxable year result in (1) the taxpayer’s tax for that year being increased by the amount by which excess ADIT is reduced more rapidly than permitted under a normalized method of accounting and (2) the taxpayer no longer being able to claim accelerated depreciation.
Proposed Energy Tax Changes That Were Not Enacted
Several energy tax provisions that were proposed at one point to be amended were not amended in the final bill. The deduction for intangible drilling costs and depletion were not affected, but several tax credits were not extended. Credits for fuel cells, geothermal heat pumps, fiber-optic solar panels, combined heat and power projects, and nuclear power plants were not extended. The placed-in-service deadline for new nuclear plants was not waived, as had been proposed.
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