Late last year, Congress enacted the Tax Cuts and Jobs Act (“the Act”), making significant changes to the Internal Revenue Code. The centerpiece of the Act was the lowering of the corporate income tax rate from 35 percent to 21 percent. However, the rate reduction was not the only mechanism that Congress placed into the Act to bolster the economy. The Act includes several other provisions to incentivize growth and investment in the economy, including provisions that will provide significant benefits to taxpayers in infrastructure and regulated industries. This article will discuss some of the pertinent changes that will impact businesses in these industries and how these changes might affect opportunities for growth and expansion.
February 28, 2019 Feature
The Impact of the New Tax Law on Infrastructure Industries
By B. Benjamin Haas and Martha Groves Pugh
Bonus Depreciation
Prior to the Act, taxpayers generally recovered their capital investment expenses over a period of time through depreciation deductions. If a taxpaying entity purchased new equipment and placed that equipment into service, it could generally claim a depreciation deduction over the useful life of the asset, which was normally anywhere between three to twenty years. In some circumstances, the taxpayer could fully deduct the cost of some types of property placed into service in the current year, but that amount was limited to a certain amount ($500,000 for property placed in 2010 through 2016), and the taxpayer lost the ability to take advantage of this benefit if the property placed into service during the year exceeded a certain threshold value ($2,500,000 for property placed in 2010 through 2015).1
The Act changed the depreciation rules significantly and gave taxpayers investing heavily in infrastructure and equipment a substantial benefit. If a taxpayer places qualified property into service between September 27, 2017, and December 31, 2023, the taxpayer can claim a depreciation deduction of 100 percent of the property’s basis in the year the taxpayer places the property into service (i.e., the taxpayer can fully expense the property). The depreciation deduction does phase down for later years (80% for property placed in service in 2023, 60% for 2024, 40% for 2025, and 20% for 2026). Qualified property eligible for bonus depreciation generally means tangible personal property with a class life of twenty years or less. The notable exception is real property and improvements to commercial buildings.
The other significant change is that taxpayers can now claim bonus depreciation on used property. Prior to the Act, taxpayers could take advantage of the bonus depreciation rules only if that taxpayer was the first to use the property. Now, any qualified property the taxpayer acquires (both used and new) qualifies for bonus depreciation unless the taxpayer previously held a depreciable interest in that same property, acquired the property from a related party (e.g., family member, majority shareholder, members of the same controlled group, etc.), or obtained the property in a carry-over basis transaction (e.g., gift, capital contribution, etc.).
Many taxpayers can take advantage of the new bonus depreciation rules. However, there are a few taxpayers who cannot use these new rules, namely, regulated utilities;2 businesses that have floor plan financing debt; real property businesses that elect out of the interest limitation provisions (discussed below); and taxpayers who choose to elect out of bonus depreciation for certain classes of assets. While public utilities cannot utilize the bonus depreciation provisions, banks and other infrastructure funding entities may benefit from these new provisions by acquiring assets and leasing them to public utilities. Although further clarification from Treasury and the IRS is needed, banks and other infrastructure funding entities benefit from the ability to immediately expense the acquired assets. At the same time, public utilities benefit from the ability to fully deduct the interest payments because they are generally excluded from the limitations on deductibility of business interest, as discussed below.3
In some cases, a taxpayer may choose to elect out of bonus depreciation. One reason for doing so may involve certain state and local tax incentives. Some state and local tax incentives require businesses to maintain a certain level of assets to be in use in a particular region in order to qualify. Often the requirements are tied to the assets’ bases for federal tax purposes. If a taxpaying entity fully expensed its assets for federal tax purposes, it could lose the state and local tax incentives. The ability to opt out of bonus depreciation allows taxpayers some flexibility to choose certain classes of assets to fully depreciate in the current year while still allowing the taxpayer to deploy local, high-basis assets to maximize state and local tax incentives. Additionally, certain tax credits are based on the amount of basis in certain assets. Therefore, in some cases, the ability to maximize credits may outweigh the benefits of 100-percent bonus depreciation, especially if the accelerated depreciation generates a net operating loss (as explained further below).
Limitation on Interest Expense Deductions
Prior to the Act, taxpayers could generally deduct the full amount of business-related interest. However, Congress and the IRS became increasingly concerned that business entities were eroding their taxable base by paying interest to their debt holders. To mitigate this base erosion, Congress enacted I.R.C. § 163(j) to limit the amount of business-related interest a taxpayer can deduct. Under this new provision, a taxpayer can only deduct business interest up to the sum of (1) its business interest income for the year; (2) 30 percent of adjusted taxable income; plus (3) any floor plan financing interest. In calculating adjusted taxable income, the taxpayer only includes those items attributable to operating a trade or business and adds back any net operating loss deduction, and for tax years 2018 through 2021, the taxpayer adds back its depreciation, amortization, and depletion deductions. Any excess interest disallowed in the current year is carried forward indefinitely. In the case of partnerships and S corporations, the limitation is computed at the entity level. The interest limitation does not apply to certain taxpayers. The limitations do not apply to regulated utilities and real estate businesses that elect out of these provisions. The trade-off is that these taxpayers cannot utilize the bonus depreciation provisions described above.
Limitation on Net Operating Losses
Another limitation that may have significant impact on the industry are the changes to net operating losses. Under prior law, a taxpayer with excess net operating losses could carry those losses back two years (and potentially get a refund for prior-year taxes paid) or carry forward those losses for up to twenty years (and offset future income). The new tax law has changed the use of net operating losses. Now, taxpayers can no longer carry the losses back two years (and obtain a refund), though taxpayers can carry the losses forward indefinitely. Additionally, taxpayers can only offset up to 80 percent of taxable income with a prior year’s net operating losses.
These changes will greatly affect how taxpayers approach opportunities for growth, whether through mergers and acquisitions or organic capital investment. For example, taxpayers may be more willing to pursue an asset acquisition, rather than an equity acquisition, to take advantage of the new bonus depreciation provisions. Alternatively, taxpayers may wish to accelerate capital improvements or other investment in production assets to fully utilize bonus depreciation. However, these benefits may be limited if the depreciation deductions (along with the taxpayer’s other business deductions) create a net operating loss, since the losses can only offset up to 80 percent of taxable income in future years. Additionally, taxpayers may find it more difficult to fund these acquisitions and growth opportunities through debt because the of the limited deduction for business-related interest.
Qualified Opportunity Zones
Consistent with the Act’s overall theme of incentivizing business activity within U.S. borders, Congress created two new provisions that provide long-term tax benefits for taxpayers who reinvest in economically depressed areas.4 Like other tax incentive programs such as the Washington, D.C. Empowerment Zone and the New Markets Tax Credit program, the newly created Qualified Opportunity Zone (QOZ) incentive program is designed to spur economic activity in specially designated communities across the United States.5 However, unlike other empowerment zone and enterprise zone programs, most types of businesses qualify as QOZ businesses except for “sin businesses” (e.g., massage parlors, hot tub facilities, suntan facilities, racetracks or other gambling facilities, and liquor stores).
Pursuant to the new legislation, states, the District of Columbia, and U.S. possessions could nominate a limited number of low-income communities (LICs) and non-LICs for purposes of obtaining QOZ designations from the U.S. Department of Treasury.6 To date, approximately 4,800 census tracts have received QOZ designations.7
Investors in QOZs receive three layers of tax benefits: (1) temporary deferral of reinvested gains; (2) partial exclusion from tax on deferred gains; and (3) permanent exclusion from tax on any appreciation on the investment. Investors may, upon making an election, temporarily defer gain from the sale or exchange to an unrelated person of any property, including stock, partnership interests, real estate, or personal property. Investors must also reinvest all or part of that gain in a certified QOZ fund within 180 days of the sale or exchange. If the investor holds a QOZ investment for at least five years, 10 percent of the deferred gain is permanently excluded. If the investor holds the QOZ investment for at least seven years, 15 percent of the deferred gain will be permanently excluded.8 While a portion of the deferred gain receives permanent exclusion from tax, investors will ultimately be subjected to income tax on the deferred gain no later than December 31, 2026. However, only 85 percent of the deferred gain will be subject to federal income tax if the investor held on to the investment for at least seven years.9 Consider the following example.
- November 1, 2018: Investor has $100 of capital gain (from a sale that occurred within 180 days prior to the reinvestment date) that it contributes to a QOZ fund. Investor’s initial tax basis in its QOZ fund investment is $0.
- November 1, 2023: Investor’s tax basis in its QOZ investment increases from $0 to $10.
- November 1, 2025: Investor’s tax basis in its QOZ investment increases from $10 to $15.
- December 31, 2026: $85 of the $100 deferred capital gain is taxed, and Investor’s basis in its QOZ investment increases to $100.
If the QOZ investment is held for at least 10 years, all the gain attributable to appreciation in the value of the initial QOZ investment is permanently excluded from tax. In the example above, if Investor sells his or her QOZ investment for $200 on November 2, 2028, Investor’s tax basis in the QOZ investment is increased to $200, which results in $0 taxable gain upon the disposition. Assuming the QOZ investment appreciates in value over a 10-year period, investors can potentially capture the upside to their investments in these QOZs on a tax-free basis.
As previously mentioned, an investor must reinvest proceeds from capital gains into a QOZ fund to benefit from these tax incentives. The QOZ fund must satisfy certain asset requirements and timing requirements and must also self-certify that it has met all such requirements to be designated as a QOZ fund. Although the IRS has indicated that there will be no formal approval or certification process, investors in QOZ funds should be aware that a failure to comply with all the requirements will result in assessed penalties to the fund.
While the tax incentives of QOZ investments may benefit investors with capital gains proceeds available for redeployment, the ambiguity of many aspects of the QOZ statute leaves many fundamental questions unanswered. The resulting uncertainty has neither prevented activity within these communities nor stalled the formation of QOZ funds. However, additional guidance from the IRS will likely generate more actionable interest from potential investors. The IRS is expected to release proposed regulations on QOZ investments outlining in further detail the requirements a QOZ fund must satisfy to maintain QOZ designation, as well as administrative processes (e.g., forms, elections, etc.) that investors must follow.
“Beginning of Construction” Guidelines for Energy Property
In addition to tax reform, taxpayers involved in certain renewable energy development projects received further good news when the IRS issued long-awaited guidance to address concerns about the timeframe in which construction must begin on energy property to be eligible for the investment tax credit (ITC).
The enactment of the Consolidated Appropriations Act of 2016 modified the ITC to provide a phasedown of the ITC for certain energy property where construction begins after December 31, 2019, but before January 1, 2022. It also limits the amount of the ITC available for energy property not placed into service before January 1, 2024. For example, a solar development project that begins construction prior to January 1, 2020, and is placed into service prior to January 1, 2024, is eligible for a 30-percent ITC. However, if construction occurs after January 1, 2022, the ITC-eligible percentage is 10 percent regardless of when the project is placed into service.
While it was clear that the ITC would begin to phase down for projects beginning in 2020, the question of when construction was deemed to have begun remained unanswered. This uncertainty remained within the industry for nearly two years until the IRS issued a notice detailing the procedures for determining when construction is deemed to begin for ITC purposes. Although the guidance broadly defines the term “energy property,” the guidance appeared to have the most significant impact on the solar industry.
Like earlier guidance relating to utility-scale wind projects, IRS Notice 2018-59 (“the Notice”) provides two methods to establish the beginning of construction: (1) the physical work test, and (2) the five-percent safe harbor. A taxpayer will satisfy the beginning of construction requirement by starting physical work of a significant nature (physical work test) or by having paid or incurred five percent or more of the total cost of the energy property (five-percent safe harbor). Construction is deemed to have begun on the date the taxpayer first meets either method. Under either method, the taxpayer must make continuous progress towards completion once construction has begun.
The Notice contained language nearly identical to that of the utility-scale wind project guidance, including the “continuous improvement” requirement for both the physical work test and the five-percent safe harbor, as well as the safe harbor for retrofitted energy property. However, the most notable similarity between the two notices is the effective four-year window that a developer has to complete a project and to subsequently place it into service. Solar developers were not expecting the IRS to grant the four-year window applicable to wind projects to solar projects because the general timeframe to build and complete solar projects is significantly shorter than it is for wind projects. Nevertheless, many developers see this extended timeframe as an opportunity to begin work on projects that have not yet received full funding commitments.
Conclusion
The Act provides numerous incentives to spur growth in the infrastructure industry. Tax incentives such as 100-percent bonus depreciation, the inapplicability of the limit on deductible business interest to public utilities, and the opportunity to defer gain through investments in qualified opportunity zones, coupled with lower tax rates (for corporations and qualifying pass-through businesses) can provide opportunities to reduce costs and increase returns on infrastructure projects.
Endnotes
1. The Act changed these thresholds to $1,000,000 and $3,500,000, respectively.
2. Regulated utilities are permitted to claim 100-percent bonus depreciation for assets placed in service between September 27, 2017, and December 31, 2017.
3. The Joint Committee on Taxation (“JCT”) commented that the bonus depreciation exception only applies to regulated public utility businesses excluded from the interest limitation rules of I.R.C. § 163(j). The JCT also stated that property leased by a leasing trade or business to a regulated public utility can be eligible for bonus depreciation because the leasing trade or business is not exempt from the interest limitation rules. See Staff of the Joint Comm’n. on Taxation, General Explanation of Public Law 115-97, at 126 n. 551 (Joint Comm. Print, Dec. 2018), https://www.jct.gov/publications.html?func=startdown&id=5152.
4. I.R.C. §§ 1400Z-1, 1400Z-2.
5. QOZ-eligible tracts are also located in Puerto Rico, the U.S. Virgin Islands, the Northern Mariana Islands, and American Samoa.
6. The deadline to submit all nominations was June 18, 2018.
7. Pending IRS publication of the official QOZ designation list in the Internal Revenue Bulletin. Unofficial information can be found on Treasury’s Community Development Financial Institutions (CDFI) Fund’s website at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
8. The language of the statute suggests that an investor must reinvest proceeds into a QOZ investment by December 31, 2019, in order to receive the seven-year, 15-percent exclusion.
9. If the QOZ fund investment is held for less than seven years, 90 percent of the deferred gain will be subject to federal income tax. Any QOZ fund investment held for less than five years will not be entitled to gain deferral, thus making the entire amount of the reinvestment taxable upon disposition.