Eligibility questions for new tax exclusions breed uncertainty for US power sector
Determining whether a company qualifies for new exemptions will be a necessity — not just for tax return accuracy, but also in determining the value and viability of pending and future M&A activity.
The following is a viewpoint by Brian Murphy, Partner — National Tax | Americas Power & Utilities, Ernst & Young LLP
The 2017 Tax Cuts and Jobs Act (TCJA) made significant changes to how corporations are taxed. While all corporations are now enjoying the new lower 21% rate, there were other provisions impacting the power and utility industry that are resulting in uncertainty and ambiguity. One of the key revenue raisers in the TCJA was the new limitation on the deductibility of net interest expense. On the other side of the ledger, a more favorable provision for taxpayers allows for the immediate expensing of certain capital expenditures.
These provisions were generally included to spur investment and promote fiscal responsibility, but they would have created unique challenges for regulated public utilities, which generally operate under commission-regulated capital structures that typically require them to rely on significant amounts of debt.
The Edison Electric Institute (EEI), which represents the nation's investor-owned electric companies, argued that limiting the ability of utilities to expense their interest expenditures would almost certainly make power more costly for customers, while the provision allowing for immediate expensing of capital costs would be of limited benefit. Many utilities in the U.S. still have net operating losses as the result of years of bonus depreciation, and they typically plan their capital expenditures several years in advance. It's unlikely that utilities would change or expand their capital investment plans merely to take advantage of any immediate expensing provisions; hence, the industry was more than willing to give up that benefit in order to preserve their ability to deduct all of their net interest expense.
To that end, the TCJA includes two critical carve-outs to these rules that were specifically requested by EEI. However, the complexity of the modern electricity marketplace is sparking a new question with significant consequences. Which companies actually qualify for these new interest and expensing exceptions?
Traditional regulated utilities should clearly meet the definition included in the new law for these exceptions. That said, what about companies like independent power producers with long-term power purchase agreements in place? What about wholesale generators? Or even businesses operating under FERC jurisdiction but utilizing market rates?
In the months ahead, determining whether a particular company qualifies for these exemptions will be a necessity — not just for tax return accuracy, but also in determining the value and viability of pending and future M&A activity.
Companies that qualify for the exceptions
It's important to understand that these two provisions in the TCJA — one, the limitation on the ability to deduct the net interest expense on debt, and two, the ability to immediately expense capital investments — go hand-in-hand. As proposed by EEI, if the exception to the limit on net interest expense applies to a particular company, then they will likewise not qualify for immediate expensing. Congress accomplished this by cross-referencing the immediate expensing provision carve-out to the interest expense limitation carve-out definition of an excluded trade or business.
Although the industry was successful in convincing lawmakers to include these two exceptions, the parameters around exactly which trades or businesses are subject to them is somewhat unclear. That opening has created confusion in the M&A markets, especially where potentially non-qualified businesses are being marketed as a qualified trade or business eligible for these industry carve-outs.
The final definition?
The confusion of whether a particular company qualifies for these exceptions arises from the definition that was included in the new law. Congress didn't use words like "utility" or "public utility," and the law doesn't directly reference existing definitions such as "public utility property." Instead, Congress opted to list trades or businesses that are specifically excluded from the provision.
The TCJA essentially takes the existing definition of a trade or business that uses "public utility property" and includes a few changes, leading many to assume that the definitions are intended to be similar. But it's not entirely clear. Like many other provisions in the TCJA, this confusion is something that requires clarification. The U.S. Treasury Department will likely issue additional guidance, but how long that will take — and what the definition will include — remains to be seen.
In the meantime, EEI has asked the federal government for clarification on a range of TCJA-related issues. In its letter to the U.S. Treasury, EEI offers the term Regulated Public Utility Businesses, providing a fairly narrow description of what constitutes a business that qualifies for the interest expense limitation exception (and exclusion from the immediate expensing provisions).
The definition proposed by EEI would keep with a more traditional definition and would require that rates be established or approved on a cost-of-service basis, including a return on the invested capital. If Treasury adopted the EEI's proposed definition, it would effectively exclude independent power producers, retailers and certain other renewable companies from utilizing these specific industry exclusions.
Obviously, knowing whether a company qualifies for these carve-outs is critical to strategic decision-making in the months ahead. In M&A, for example, private equity firms and other vehicles investing in the electricity market are counting on long-term, predictable cash flows. Understanding the tax consequences of being a qualified trade or business — or not — is vital to determining the value to place on a business.
In addition, companies that take a broad view of what businesses qualify for the interest limitation exception, and file their returns accordingly, could find their positions challenged and overturned if Treasury releases a narrower definition.
Holding company issues
For traditional investor-owned utilities, the final definition is not an issue; their standing is secure. But many utility companies have expressed concern about the interest deduction limitation rule and how it will impact both their unregulated businesses and their holding companies.
While the utility itself may be exempt from the interest deduction limitation, the law did not provide any guidance or methodology on how to allocate holding company interest expense to their regulated and non-regulated subsidiaries.
Since many holding companies incur debt to finance capital expenditures made by both their regulated and unregulated businesses, this adds a layer of uncertainty to the tax law's benefits and could impact cash flow and earnings down the road. EEI attempted to minimize the complexity and need for an allocation by proposing a form of a de minimis rule, where as long as at least 80% of the group is in a qualified trade or business, then the entire group will qualify. It remains to be seen to what extent Treasury will incorporate any of EEI recommendations.
This may be less of an issue in the near term, because for the first four years, the law allows companies to compute their adjusted taxable income (ATI) — the basis for determining how much interest expense can be deducted — without regard to their tax depreciation, amortization or depletion. But beginning in 2022, ATI will be decreased by these items, limiting the threshold for deductions. There are clearly several other uncertainties with the calculation of the interest limitation rules beyond determining whether a company qualifies for the exception.
Best course of action?
Until we have guidance from Treasury, non-utility companies under a traditional definition — independent power producers, private equity firms, certain renewable companies and others — should tread lightly before taking advantage of these TCJA exceptions to the new interest limitation rules.
The views expressed are those of the author and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of the global EY organization.