The 2017 tax reform reconciliation act, commonly referred to as the Tax Cuts and Jobs Act (TCJA), contained sweeping changes to the federal tax code that significantly impacted the renewable energy sector. Two provisions in particular, interest expense limitations and the base-erosion anti-abuse tax (BEAT), now appear to have broader implications than originally anticipated due to the classification of electricity and renewable energy projects.
Interest Expense Limitations
In private letter rulings, the IRS has generally held that electricity is a good that can be inventoried and is therefore governed by the uniform capitalization rules of Section 263A. As a result, renewable energy projects that generate and sell electricity are treated as manufacturers.
One controversial provision of TCJA is the manner in which new interest expense limitation provisions of Section 163(j) apply to manufacturers. Under the new rules, the deduction for net interest expense is limited to 30% of adjusted taxable income (ATI). Through 2021, ATI is computed as taxable income before depreciation, amortization, and depletion, generally making ATI equivalent to earnings before interest, taxes, depreciation, and amortization (EBITDA).
By adding back depreciation expense, ATI increases and the amount of interest expense that’s subject to limitation decreases. In November 2018, the IRS issued proposed regulations under Section 163(j) that hold that to the extent depreciation is subject to capitalization under Section 263A, depreciation becomes a cost of sale (COS). As such, it’s not added back to taxable income as a depreciation deduction in determining ATI.
This provision affects all manufacturers, including renewable energy projects, that are required to capitalize productions costs, including depreciation, under Section 263A. Manufacturers accurately argue that the proposed regulations significantly raise their cost of capital in relation to other businesses that aren’t subject to Section 263A. This view, as reflected in the proposed regulations, is particularly harsh for renewable energy projects. Most renewable energy projects are capital intensive with few nonproduction-related costs, such as selling or policy costs, so nearly all costs are production costs.
Moreover, although the IRS views electricity as a good that can be inventoried, it can’t be stored on hand and must be immediately sold. Depreciation expense subject to Section 263A would be immediately capitalized and deducted as COS. In this context, it seems particularly severe that the IRS would conclude that capitalized depreciation expense is no longer a deduction but instead a reduction of sales as part of COS. This happens simply because the producer is subject to Section 263A and depreciation is technically capitalized to electricity, even though it’s immediately deducted and doesn’t end up in an inventory item on the balance sheet.
The current trend to use back-leverage for financing renewable energy projects lessens the direct impact from Section 163(j) at the partnership level. However, factors involved in the limitation calculation must be segregated and reported out to the respective partners, so the calculations and reporting must still be done at the partnership level.
Most practitioners believe the proposed regulations are punitive to the manufacturing industry and don’t reflect the intent of Congress. Fortunately, negative feedback to the proposed regulations is gaining traction and there are indications that the IRS is reconsidering its position.
The other TCJA provision that affects renewable energy projects in the manufacturing context is BEAT, which applies to base-erosion payments paid or accrued by an applicable taxpayer to a related foreign person.
An applicable taxpayer is a corporate taxpayer with average annual gross receipts over the prior three years of at least $500 million and who’s made related-party base-erosion payments totaling 3% or more of the corporation’s total deductions for the year.
BEAT is calculated in the following manner. A US corporation first calculates its regular US tax at a rate of 21%. It then recalculates its taxable income for BEAT purposes by adding back base-erosion payments to foreign affiliates. This recalculated taxable income is then multiplied by the BEAT rate, which is 5% for 2018, 10% for 2019 through 2025, and 12.5% for 2026 and beyond. If the regular tax is lower than the BEAT, then the corporation must pay the regular tax plus the amount by which the BEAT exceeds the regular tax.
The base-erosion percentage is determined by dividing the aggregate amount of base-erosion payments by the aggregate amount of the corporation’s aggregate deductions including the base-erosion tax payments for which a deduction is allowed. In determining a taxpayer’s base-erosion payments, items capitalized to COS generally aren’t subject to base erosion because, as previously noted, the IRS views COS as a reduction of sales and not as a deduction.
In the case of a renewable energy project, it may seem that the BEAT provisions would be largely inapplicable because nearly all deductions are part of COS. However, as many renewable energy projects are owned by large institutional investors, the attributes of the project need to roll-up to the investors who can make a corporate-level determination of the BEAT.
The geography of the deduction or contra sale on the tax return wasn’t as crucial prior to TCJA when electricity wasn’t stored and all deductions were immediately expensed—either directly or as part of COS—upon the sale of the electricity. For purposes of BEAT, the geography of the deduction—either below or above the line—is more important and requires preparers to be more conscientious in determining the nature and reporting of the costs.
BEAT for Partnerships
To determine the base-erosion percentage for corporate partners in renewable energy projects, partners should carefully review their capitalized costs including those costs incurred at the partnership level. As noted above, to the extent costs can be appropriately capitalized under Section 263A, they’re not subject to BEAT and should be excluded from both the numerator and the denominator in determining the base-erosion payment.
It’s especially important to exclude all costs that are properly capitalized under Section 263A from the numerator and to include all costs that aren’t required to be capitalized in the denominator. This means the more costs that can be treated as non-Section 263A costs and included in the denominator, the lower the base-erosion percentage. Further, to the extent base-erosion payments are determined to be subject to Section 263A, they don’t need to be added back to taxable income in determining the corporate partner’s BEAT.
We’re Here to Help
To learn more about how tax reform may affect your renewable energy projects, contact your Moss Adams professional.