The ATR Act may have avoided the recession that the Federal Reserve and others predicted would have resulted from going over the fiscal cliff, but the new legislation is still likely to have a negative impact on the country’s short-term economic growth due to a reduction in disposable income. Left largely unresolved are both the country’s underfunded existing entitlement programs and broader income tax reform.
This article provides a summary of the provisions of the ATR Act most likely to have an impact on corporations operating in a regulated environment and other infrastructure businesses. We also review the impact of the ATR Act on the ensuing reform of entitlement expenditures and comprehensive tax reform over the course of 2013.
Individual Income Tax Changes
One of the most significant aspects of the ATR Act was the omission of an extension of the 2 percent reduction to federal payroll taxes used to fund Social Security benefits. Thus, all individuals earning wages or self-employment income up to the Social Security wage base ($113,000 for 2013) will again be subject to the full 6.2 percent wage tax, decreasing disposable income for the entire spectrum of this country’s wage earners. Most of the press headlines have been devoted to the income level at which the Clinton-era tax rates would be allowed to reemerge. For joint return taxpayers with adjusted taxable income in excess of $450,000 per year, tax rates will revert to 39.6 percent.7 Other provisions of the ATR Act, however, may affect a much broader segment of middle income taxpayers. Among these are the limitations on itemized deductions and personal exemptions for joint returns earning in excess of $300,000 per year of adjusted taxable income, which are very likely to affect middle income individuals in high tax states.8 The 2011 health-care surcharge applicable to net investment income (including capital gains, dividend, interest, rents, and royalties) earned after 2012 applies a 3.8 percent tax to joint returns earning in excess of $250,000.9 In addition to these changes, Congress enacted a permanent cost-of-living adjustment to the alternative minimum tax (AMT) exemption amount, which will reduce the impact of the AMT from broadly affecting many middle income taxpayers.10
A significant question the fiscal cliff negotiations considered was the appropriateness of taxing dividend income at the same rates applicable to capital gains. Without the changes enacted by the ATR Act, capital gains rates would have reverted to 20 percent, while dividend income would have reverted to ordinary income tax rates depending on the taxpayer’s bracket, but up to the marginal rate of 39.6 percent. The Edison Electric Institute, among other industry associations, lobbied extensively for keeping the dividend rates at the same level applicable to capital gains. Among its arguments were that issuance of dividend paying preferred and common stock is a conventional means of capitalizing regulated and other infrastructure businesses and a decrease in the after-tax yield on such instruments would likely increase the cost of capital and the resulting cost of the services such corporations charge to rate payers. Moreover, bankers had regularly noted that imposing a high income tax rate on dividends would merely shift corporate cash distributions from pro rata dividends into stock buyback programs, allowing liquidity seeking investors identical access to cash through stock sales taxed at capital gains rates. At some point in the December negotiations, the administration dropped its suggestion that dividends revert to taxation at ordinary rates. Accordingly, the final legislation imposes the 20 percent rate on both capital gains and dividends.11 Still, because of the rise to the 20 percent rate and the health-are surcharge of 3.8 percent, the aggregate tax on dividend income earned by high income taxpayers increased more than 58 percent—from 15 percent to 23.8 percent.
The fiscal cliff negotiations devoted little, if any, time to corporate tax reforms. A large number of expiring or recently expired corporate tax benefit provisions exist, fundamental to the way US corporations conduct their business, and these are normally extended at year end under past legislative practice. Fortunately, Congress included many of the most important of these extenders in the ATR Act, retroactively to 2012 in some cases, as well as extensions for 2013. Most significant of these was the retroactive extension of the research and experimentation credit, which had expired for 2012 but will now apply to 2012 and to 2013. Certain accounting issues have resulted as to whether this tax benefit, enacted on January 2, 2013 may be taken into account for calculating a corporation’s year-end financial statements. Other broadly applicable extenders included the extension of 50 percent bonus depreciation to 2013 as well as the higher threshold for first-year expensing of new plant and equipment available under section 179 of the code.12 With respect to regulated utilities, the legislation clarifies that the normalization rules for bonus depreciation are violated if a utility regulator, for ratemaking purposes, assumes a bonus depreciation benefit when the utility has not elected to take bonus depreciation.13
A number of other credits that some consider to be more politically oriented were also extended under the legislation, many of which have been utilized by large corporation through programs that syndicate tax benefits to high-taxpaying corporations. Thus, for example, the New Market Tax Credit designed to induce investment in low income communities, and the Low Income Housing Credit, were both extended.14 Among the less visible extensions of corporate tax benefits was the extension of the active financing exemption to sub-part F of the code. Under this exemption, controlled foreign affiliates of major US corporations involved in active financing and leasing operations are permitted to treat their interest and rental income from such activities as active income, the US taxation of which is deferred until such income is repatriated to the United States.15 This exemption, sometimes referred to as the “GE exemption,” was extended in the final legislation along with the section 954(c)(6) (foreign affiliate “look through” rule).16 The repeated extension of the active finance exemption suggests that it has effectively become a permanent part of the US sub-part F regime not likely to be eliminated so long as the sub-part F regime continues.
Renewable Energy Credits
The ATR Act extended the production tax credit (PTC) for wind facilities that otherwise would have expired at the end of 2012. Most of the other renewable technologies that are eligible for the production tax credit were set to expire at the end of 2013.17 These credits for production of energy from wind facilities were extended for one additional calendar year, but with an important change. Under the ATR Act, to be eligible for the PTC, a facility must only “begin construction” by the expiration date rather than be put in service by the expiration date, which was the previous requirement. This change also applies to other renewable energy technologies, including closed-loop biomass facilities, open-loop biomass facilities, geothermal energy facilities, landfill gas facilities, trash facilities, hydropower facilities, and marine and hydrokinetic renewable energy facilities.18
The change to a “begin construction” requirement rather than a “placed in service” requirement extends the impact of the PTC beyond 2013 and provides additional time to complete construction of new wind energy projects and other qualifying renewable energy projects. Some reporters have described this one-year extension as being equivalent to a two-and-a-half year extension of the prior credit. However, it should be noted that the PTC will not be generated until the property is placed in service despite the fact that the project has begun construction and remains eligible. The legislation also allows for a 30 percent investment tax credit (ITC) in lieu of the PTC for wind and other qualifying facilities that begin construction before January 1, 2014.19 The extension of the renewable energy incentives for wind facilities is expected to help preserve the 37,000 jobs provided by the wind industry in the United States; however, all renewable energy incentives will likely continue to face challenges as to their propriety as long the technologies are perceived to be uneconomic without such incentives.
Future Budgetary Considerations
While the ATR Act successfully prevented governmental inaction from forcing the economy back into a recession during 2013, some economists have noted that the restoration of the 6.2 percent payroll tax combined with the increased taxes to investment income and to high income taxpayers could reduce the growth of the gross domestic product in 2013. More significantly, the legislation did not even attempt to address entitlement spending, leaving much uncertainty about future government deficits. The legislation deferred for two months the sequestration of defense funding otherwise required in the Budget Control Act, which raised the federal government’s legal debt authority limit (“debt ceiling”) by $400 billion.
Secretary of the Treasury, Timothy Geithner, stated that as of the end of 2012, the federal government had reached its debt ceiling and would be able to continue operations for only a limited period of time (two to three months) utilizing extraordinary procedures before incurring a “hard” ceiling triggering a default on federal debt. Accordingly, during the first two months of 2013, we are likely to witness yet another budgetary battle as our leaders seek to impose some restraints on spending to balance an increase in the authorized level of the national debt.20 As suggested by the National Commission on Fiscal Responsibility and Reform21 in its 2010 report (the “Simpson Bowles Report”),22 a substantial change in the projected entitlement spending cost could be achieved by measures such as chain-linked CPI adjustments to social security benefits and by delaying the eligibility age of Medicare benefits to 67, the same age for receiving full Social Security retirement benefits. Also on the table are medical service provider reimbursement rates to doctors and other Medicare service providers. All of these entitlement obligations represent politically charged issues likely to result in further acrimonious political dialogue.
The Simpson Bowles Report also suggested that income taxes be reformed generally by eliminating tax benefits, broadening the tax base, and permitting the rate of taxation to be reduced. The report argued such changes would increase the competitiveness of US businesses and build a better base for employment of American workers. It has been widely projected that fundamental tax reform negotiations would begin in earnest during the first half of 2013 with the new Congress. Such changes could include the elimination of many long-standing tax benefits including potentially limiting mortgage interest deductibility, full exclusion of employer provided health care, eliminating domestic manufacturing deduction, “last-in first-out” inventory method, limiting intangible drilling expense deductions, and shifting to a territorial method of taxation for the taxations of profits earned by foreign affiliates of US groups outside the United States. Any such initiative to substantially and meaningfully change the method of taxing corporate and individual income could be delayed by the legislative exhaustion resulting from the fiscal cliff, debt ceiling increase, and other budgetary battles.
Regulated corporations may not be as directly affected by income tax expense, if they are permitted to pass such costs on to rate payers as a cost of service. Such industries are nonetheless affected by the resulting change in economic activity generally, which such tax changes might affect. Moreover, the broader budgetary issues described here can affect interest rates and the cost of capital such companies incur. Changes in tax provisions and tax rates can also affect the carrying values of deferred or contingent tax assets and liabilities disclosed on the financial statements of such companies.
1. T.S. Eliot, The Hollow Men (1925).
2. The Budget Control Act of 2011, P.L. No. 112-25 (August 2, 2011) (hereinafter, the “Budget Control Act”) was enacted to raise the federal debt ceiling. Under the Budget Control Act, without superseding legislation, reversion of tax rates to higher rates along with defense and domestic budget sequestration and health expenditure reduction would all have gone into effect on January 1, 2013.
3. Hereinafter, referred to as the “Code.”
4. Section 41 of the Code.
5. Section 168(k) of the Code.
6. Section 954(h) of the Code.
7. Section 101(b)(1) of the ATR Act.
8. Section 101(b)(2) of the ATR Act.
9. See § 1411, which was added to the Code by § 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, P.L. No. 111-152 (March 30, 2010).
10. Section 104 of the ATR Act.
11. Section 102 of the ATR Act.
12. Section 315 of the ATR Act.
13. Section 331(d) of the ATR Act, amending Section 168(i)(9)(A) of the Code.
14. Section 305 of the ATR Act.
15. Section 953(h) of the Code.
16. Sections 322 & 323 of the ATR Act.
17. Solar facilities are generally eligible for the investment tax credit rather than the production tax credit if the property is placed in service before January 1, 2017. The rules applicable to solar facilities were generally not changed by the ATR Act.
18. Section 407(a)(3) of the ATR Act.
19. Section 407(b) of the ATR Act.
20. As of this writing, the House has passed a bill that would “suspend” the debt ceiling until May 18, and then allow the debt ceiling to rise to the level of actual debt then incurred. The stated intent is to allow negotiations to continue deeper into the spring, and to occur in conjunction with negotiation of a budget resolution that could pass both House and Senate and bind the appropriations committees. The Senate leadership has indicated the Senate will agree to the suspension, and the White House has indicated the president will sign it. That bill does not affect the “sequestration” of expenditures, which will take effect March 1, unless other action is taken.
21. The commission was cochaired by Alan Simpson and Erskine Bowles.
22. The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform (December 2010).