On Nov. 2, House Republicans released their proposed tax reform legislation, providing for massive alterations to tax law. On Nov. 5, Rep. Kevin Brady, R-Texas, formally submitted the bill as H.R.1 to his Committee on the Ways and Means. The proposed legislation would trim tax benefits applicable to the wind and solar industries while broadening the scope of the application of the “orphaned” energy tax credit. The proposed legislation is subject to further amendments and may not be enacted into final legislation.
Continuity of Construction. Pursuant to current law, the production tax credit (PTC) and investment tax credit (ITC) phase out over time, with the level of credit for which a renewable energy project qualifies being based on when the project begins construction relative to various deadlines that determine the level of PTC or ITC. Under the proposed legislation, for any renewable energy project to qualify for a specific level of PTC or ITC, there would need to be continuous construction on such project from the deadline for the specific PTC or ITC level through the date the project is placed in service.
The concept of continuous construction does not exist in the current PTC and ITC provisions of the Tax Code. It was adopted by the U.S. Internal Revenue Service (IRS) as an administrative matter in Notice 2013-29. However, the IRS later, under Notice 2016-31, created a safe harbor to enable projects to avoid application of the IRS’ “continuity” requirement. To qualify for the safe harbor, a project must be placed in service within four calendar years after the end of the calendar year in which construction begins. The proposed House legislation would effectively codify the continuity requirement and eliminate the safe harbor. Further, these changes appear to apply to all projects that have not been placed in service as of the date of enactment of the proposed legislation, regardless of whether construction of such projects began before enactment.
Further, Notice 2013-29 provided a more lenient continuity requirement for projects that started construction by paying or incurring 5% of their total cost. That is, the developers of such projects only have to use “continuous efforts” as opposed to “continuous construction.” “Continuous efforts” includes tasks such as making payments on contracts and obtaining permits. Because the proposed legislation uses the terminology of “continuous program of construction,” it would appear to eliminate the lenient continuous efforts standard for all projects.
Notice 2013-29 excuses from its continuous construction requirement stoppages in construction for events like delays in obtaining permits, financing (for up to six months) or bad weather. We are hopeful that such delays in construction would still be excused in the event the proposed legislation is enacted.
This proposed legislation could put in jeopardy a significant portion of the gigawatts of new capacity from the new wind projects on which developers started construction in 2016 but for which they have not pursued “a continuous program of construction” based upon the expectation that they could pause and finish within the four-calendar-year window provided under Notice 2016-31.
Moreover, the proposed legislation applies the same actual continuous program of construction requirement to ITC-eligible projects, such as solar. The ITC for solar only starts to ratchet down for projects that start construction in 2019 or later. However, it seems unlikely that a developer would start construction on a residential or commercial solar project in 2019 and have a “continuous program of construction” that requires more than a few months to be completed. Therefore, it will be difficult for solar developers to “safe harbor” residential and commercial solar projects in 2019 and then actually finish those projects after 2020. This is in sharp contrast to what happened with respect to start-of-construction grandfathering for residential and commercial solar in the U.S. Treasury cash grant program.
Elimination of Inflation Adjustment. The proposed legislation would repeal the inflation adjustment for PTC calculations for renewable electricity production, thus limiting the PTC to its base statutory rate of 1.5 cents/kWh.
The proposed change would apply to projects that begin construction after the proposed legislation is enacted. The IRS presumably would use the actual continuous construction standard in determining when construction began. Therefore, projects that start construction after the legislation is enacted would be eligible for only 1.5 cents/kWh of renewable electricity production over the entire 10-year PTC period. That is a significantly less than the inflation-adjusted amount, which for 2017 is 2.4 cents/kWh and would be adjusted for inflation each year.
The proposed statutory language would not apply to existing wind projects that have been placed in service. Thus, for projects that are currently operating, the PTC would remain at 2.4 cents/kWh for 2017 and would continue to adjust for inflation for the remaining years in the applicable PTC period. The Section-by-Section Summary from Ways and Means created some confusion with respect to the application of this proposal to operating projects because it provides that “taxpayers’ credit amount would revert to 1.5 cents per kilowatt-hour for the remaining portion of the 10-year period.” For there to be a “remaining portion,” the proposal would have to apply to operating projects. However, the Joint Committee composed of tax professionals that advise Congress on tax matters issued its Description of the “Tax Cuts and Jobs Act” that confirms that the change would not apply to operating projects: the “proposal eliminates the inflation adjustment [for projects] … the construction of which begins after the date of enactment. Such facilities are entitled to a credit of 1.5 cents per kilowatt-hour (i.e., the statutory credit rate unadjusted for inflation). Credits remain subject to the phase-down based on the year construction begins.”
The reduction in the value of the PTC to 1.5 cents/kWh (before application of the phase-out rules) could have the effect of causing owners of new wind projects to elect to claim the ITC (in lieu of the PTC), because the elimination of the inflation adjustment does not impact the ITC. Generally, a stream of PTCs at 2.4 cents/kWh over 10 years (with an inflation adjustment) has been more attractive for land-based wind projects than a 30% ITC. However, a 30% ITC may be more attractive for wind projects if the PTC rate is only 1.5 cents/kWh hour over 10 years (without an inflation adjustment). The start-of-construction phase-out for wind projects affects the PTC or, if elected, the ITC equally, so the phase-out should not change the dynamics of this decision.
Senator Grassley’s Objections. The father of the PTC, Sen. Chuck Grassley, R-Iowa, promptly voiced his objection to these provisions: “The wind energy production tax credit is already being phased out under a compromise brokered in 2015. It shouldn’t be re-opened. I’m working within the Senate Finance Committee to see that the commitment made to a multi-year phase-out remains intact.” The senator is the senior member of the Senate Finance Committee, so he should wield significant influence when the Senate takes up tax reform. Further, his comments have been echoed by two of his Finance Committee colleagues – Sen. John Thune, R-S.D., and Sen. Dean Heller, R-Nev.
We would expect that the senators’ objections, combined with an indemnity for tax change risk from a sponsor with a strong balance sheet, would enable wind projects to continue to be able to raise tax equity.
Further, wind projects in the early stages of development that did not “begin construction” for tax credit purposes in 2016 are likely to still undertake a strategy to begin construction in 2017 (albeit at only 80% of the PTC or ITC due to the 2015 phase-out), viewing it as a bet that either (i) the proposed legislation does not pass (or does not pass with the wind provisions) or (ii) that the project can actually undertake a program of continuous construction through the placed-in-service date.
Repeal of 10 Percent Permanent Solar ITC. The 2015 phase-out left in place the so-called “permanent” 10% solar ITC that applies to solar projects that begin construction after 2021 or are placed in service after 2023. The proposed legislation would repeal the 10% ITC for solar projects that begin construction after 2027.
However, other than a reduction in the corporate tax rate (discussed below), the solar industry until after 2019 would largely be unscathed by this proposed legislation. As the legislation has yet to be enacted and the impact to solar is more than two years away, solar developers may be more focused on their year-end transactions and their 2018 pipelines than war-gaming what the proposed changes to the ITC could mean for them in 2020.
Tax Credit Reinstated for “Orphaned” Technologies. On a positive note, the proposed legislation would reinstate the renewable energy tax credit for qualified fuel cells, geothermal, biomass, combined heat and power, landfill gas, small wind, solar illumination, incremental hydro and ocean energy projects. These technologies were – apparently inadvertently – excluded from the 2015 extension (with phase-out) for wind and solar.
Under the proposed legislation, qualified properties using these resources would be subject to the same requirements and phase-out percentages as qualified solar facilities. For instance, the phase-out rate for qualified fuel cell plants would be 26% if their construction begins after Dec. 31, 2019, and before Jan. 1, 2021. The phase-out rate would become 22% for qualified solar and fuel cell plants that begin construction after Dec. 31, 2020, and before Jan. 1, 2022.
If enacted, the proposed legislation would likely spur tax equity investments in projects using the orphaned technologies. However, it is unlikely that a tax equity investor would commit to an investment prior to reinstatement of tax credits for these orphaned technologies.
20% Corporate Tax Rate. The proposed legislation proposes a 20% corporate tax rate effective next year. The rate cut will reduce the tax appetite of tax equity investors, but the largest tax equity investors are expected to continue to have sufficient tax appetite to merit material levels of tax equity investments.
The reduced tax rate would reduce the value of depreciation deductions but would not affect the value of tax credits. Based on the current pricing of power purchase agreements (PPAs), the reduced tax rate would have more pronounced negative impact on wind projects relative to solar projects due to the fact that wind projects tend to have lower-priced PPAs and, thus, generate less pre-tax income to benefit from a reduced tax rate.
For operating projects that no longer have material tax depreciation remaining, the reduced tax rate would be beneficial. Thus, enactment may mean that owners of interests in operating projects may be able to demand a higher price when they sell.
Expensing of Project Costs. The proposed legislation provides for “expensing” of all personal property (i.e., not real estate) through the end of 2022 to incentivize domestic investments, with an additional year for certain long-lived assets, including transmission.
The immediate expensing may incentivize sponsors looking to monetize investment tax credits to use sale-leasebacks, rather than partnership flip transactions.
Taxpayers would be able to opt out of “expensing” and into current MACRS (e.g., five-year double-declining balance depreciation) or straight-line depreciation. However, expensing would supersede the current bonus depreciation rules, but there is a “transition rule” that would allow taxpayers to elect use of the “current” bonus deprecation rules (e.g., 50% bonus depreciation for wind and solar projects in 2017) on their first tax return filed for a tax year ending after Sept. 27, 2017. This rule is not limited to new taxpayers, but an existing taxpayer can only use it on its 2017 tax return. In contrast, a taxpayer formed in 2018 (such as a new tax equity partnership) could also use the election to avoid “expensing” (and opt for bonus depreciation but at phased-down 40% level) on its 2018 tax return, which would be its first return filed after Sept. 27, 2017.
Of particular note, the expensing appears to apply to “used” equipment that is “new” to the taxpayer. For instance, if a business purchases a truck manufactured in 2015 from a used car dealer, that truck would be eligible for expensing. This could incentivize owners of wind projects (including repowered projects) to sell them to an investor that could immediately expense the full cost of the project (other than real estate).
Prospects for Enactment. Rep. Brady, House Speaker Paul Ryan, R-Wis., and the Trump administration may be able to push the proposed legislation through the House. However, the Senate is expected to be more challenging. Currently, the Senate has 52 Republicans, 46 Democrats and two Independents who caucus with the Democrats. The Republicans also have the advantage of Vice President Mike Pence casting tie-breaking votes. Therefore, the proposed legislation will not be enacted if three Republican senators oppose it (assuming the Democratic caucus holds the line).
As of press time, there may be three Republican senators who would oppose the proposed legislation. Sen. Susan Collins, R-Maine, has stated she will not support any bill that fully repeals the estate tax as this proposed legislation would. Sen. Bob Corker, R-Tenn., has stated he will not support any tax bill that increases the deficit, which this proposed legislation would. Sen. John McCain, R-Ariz., has stated he will not vote for any bill that uses the budget reconciliation process to avoid filibusters as is the strategy for this proposed legislation.
Nonetheless, the pendulum could swing toward passage if a moderate Democratic senator up for re-election in a state that President Donald Trump won could be persuaded to support the proposed legislation. For instance, Sen. Joe Manchin, D-W.Va., is being courted in that regard, and Sens. Joe Donnelly, D-Ind.; Claire McCaskill, D-Mo.; Heidi Heitkamp, D-N.D.; Jon Tester, D-Mont.; and Bob Casey Jr., D-Pa., are also in that situation. Further, if McCain leaves office, his replacement would be selected by the Republican governor of Arizona, Doug Ducey. One could imagine the governor would likely pick a replacement that is willing to vote for the Republican version of tax reform under the budget reconciliation process.
However, those gains could be offset by other Republicans opposing the proposed legislation. As of press time, candidates for that role include Sen. Rand Paul, R-Ky., who is rumored to be likely to vote against tax reform on fiscal grounds, or Grassley, Thune or Heller, who each could, in theory, withhold his vote over the treatment of wind power.
All three co-authors are from law firm Mayer Brown LLP, where David Burton and Jeff Davis are partners and Anne Levin-Nussbaum is a counsel.