The Bracewell Tax Report is a periodic publication focused on developments in federal income tax law, including the recently enacted Tax Cuts and Jobs Act, with emphasis on how such developments impact the energy, technology and finance industries. The publication provides summaries of changes in tax law and its interpretation, as well as related practical guidance critical to making strategic business decisions and negotiating transactions.
By Liz McGinley and Steven Lorch
On August 3, 2018, the IRS and Treasury Department released proposed regulations (the Proposed Regulations) that interpret and clarify the new bonus depreciation regime under the Tax Cuts and Jobs Act (TCJA). As discussed here in greater detail, the TCJA provides businesses the opportunity to take a special depreciation deduction (Bonus Depreciation) equal to 100% of the cost of any qualified property. Qualified property generally includes depreciable property subject to the modified accelerated cost recovery system (MACRS) with a recovery period of 20 years or less that is placed in service after September 27, 2017, in the case of new property, or acquired in an arm’s length transaction after September 27, 2017, in the case of used property. The available deduction is phased out, in 20% increments, from 2023 to 2026.
The Proposed Regulations generally have been well-received by taxpayers. Aside from being favorable to taxpayers in several respects, the Proposed Regulations provide clarity to certain aspects of the Bonus Depreciation regime, and such clarity should permit taxpayers, including those in the energy industry, to plan projects and structure transactions with greater certainty.
First, the Proposed Regulations provide rules regarding when new property is treated as placed in service and when used property is treated as acquired. The TCJA did not provide clear guidance on these topics and, as a result, many sponsors and investors in the energy industry questioned whether they could claim Bonus Depreciation for projects that were underway when the TCJA was enacted. In the case of self-constructed property, the Proposed Regulations provide that property is eligible for Bonus Depreciation if the taxpayer began construction activities after September 27, 2017, but the property will not be eligible if such activities began before such date. Construction activities are deemed to begin when the taxpayer commences physical work of a significant nature with respect to the property, which requires a facts-and-circumstances analysis. Taxpayers, however, can take comfort that certain preliminary planning activities, such as designing, researching and securing financing, and certain preliminary physical work, such as clearing the site and test drilling, will not be viewed as construction activities under the Proposed Regulations. As a result, even if a taxpayer conducted these activities with respect to a property on or before September 27, 2017, the property still should be eligible for Bonus Depreciation when completed. Taxpayers seeking greater certainty can rely on a safe harbor providing that physical work of a significant nature does not begin until the taxpayer incurs more than 10% of the total cost of the property, not including the cost of land and the cost of any preliminary activities described above.
In the case of property acquired by the taxpayer from an unrelated party, property acquired after September 27, 2017 generally will be eligible for Bonus Depreciation, but only if the taxpayer did not enter into a binding written contract to acquire the property before this date. This limitation applies both to property that the taxpayer engages a third party to construct on its behalf and used property that the taxpayer acquires from a third party. For purposes of this rule, a contract is binding if it is enforceable under State law against the taxpayer, or its predecessor, and does not limit damages for failure to perform to a specified amount (for example, by means of a liquidated damages provision).
The Proposed Regulations provide additional guidance regarding when Bonus Depreciation is available for used property. Many taxpayers in the energy industry have been eager to avail themselves of Bonus Depreciation in this context, which provides a new opportunity for tax savings in the year of an asset acquisition. For this purpose, eligible acquisitions of used property include direct asset acquisitions and other transactions that are treated as asset acquisitions for tax purposes (including, for example, the acquisition of all of the outstanding equity of a partnership or disregarded entity). Some taxpayers have been deterred from taking Bonus Depreciation due to a vague prohibition in the TCJA against the deduction for property “used by the taxpayer at any time prior to such acquisition.” The Proposed Regulations clarify that property is deemed to have been used by a taxpayer if the taxpayer previously owned a depreciable interest in the property. For example, a taxpayer that owns an item of depreciable equipment, sells it, and later reacquires it for cash would not be eligible for Bonus Depreciation on the reacquired equipment. By contrast, a taxpayer that leases an item of depreciable equipment, but takes no depreciation deductions, and later acquires it for cash would be eligible for Bonus Depreciation upon the acquisition.
In addition, the Proposed Regulations provide clear guidance and examples concerning partial acquisitions of depreciable property. Under these rules, if a taxpayer owns a partial interest in depreciable property, either directly or indirectly through a partnership, and then acquires an additional interest in the same property for cash, the additional interest would be eligible for Bonus Depreciation even though the taxpayer owned, and continues to own, the first partial interest. If, however, the taxpayer owns a partial interest in a property, sells it, and later acquires a new partial interest in the same property for cash, the taxpayer would be treated as previously owning a partial depreciable interest in the property up to the amount of the initial interest, and therefore would not be eligible to take Bonus Depreciation on such portion of the interest.
Many taxpayers were anticipating that the Proposed Regulations would apply an outer limit to the number of years a taxpayer must look back to determine whether the taxpayer, or its predecessor, would be treated as owning a depreciable interest in property. Without such a limit, a taxpayer could be required to engage in burdensome due diligence to determine whether Bonus Depreciation is available, or accept the risk that it previously owned a depreciable interest in such property. The Proposed Regulations, however, request comments on whether a limited look-back period should be included in the final regulations and, if so, how long the period should be, which has given taxpayers reason to be optimistic that the IRS and Treasury Department will consider adding this feature to the final regulations.
Finally, the Proposed Regulations provide guidance on the availability of Bonus Depreciation in connection with various partnership transactions. As expected, the Proposed Regulations confirm that a step-up in the basis of partnership property in connection with a taxpayer’s acquisition of a partnership interest, when an election under section 754 of the Code is in effect, is eligible for Bonus Depreciation, provided that the acquirer did not previously own a depreciable interest in the partnership property. This guidance confirms most practitioners’ view that Bonus Depreciation should be available regardless of whether used property is acquired directly, by means of a taxpayer’s acquisition of an undivided interest in the property, or indirectly, by means of a taxpayer’s acquisition of an interest in a partnership owning the property.
Bonus Depreciation, however, is not available when a partnership distributes cash or property to its partners and, as a result, there is an increase in the basis of the partnership’s remaining property. The preamble to the Proposed Regulations explains that the partnership would be treated as previously owning a depreciable interest in the property, and such property neither would be original use property nor newly-acquired property for purposes of the TCJA and the Proposed Regulations. Some taxpayers also were optimistic that remedial allocations of depreciation and amortization would be eligible for Bonus Depreciation. The preamble to the Proposed Regulations, however, provides that remedial allocations are not eligible for Bonus Depreciation because the underlying partnership property would have been received by the partnership in a nontaxable transaction described in section 721 of the Code, and therefore the partnership would have a carryover basis in such property that is not eligible for Bonus Depreciation, and also because the partnership would be treated as previously owning a depreciable interest in such property.
Per the preamble to the Proposed Regulations, the Proposed Regulations may be relied upon by taxpayers until the IRS and Treasury Department issue final regulations concerning Bonus Depreciation. Comments to the Proposed Regulations or requests for a public hearing must be submitted by October 9, 2018.
Focus on Finance: Tax Reform and the Banking Industry Revisited
By Michele Alexander and Ryan Davis
The Tax Cuts and Jobs Act (TCJA) has far-reaching implications for the banking and finance industry. In our very first Bracewell Tax Report (click here for more), we noted certain issues that companies might consider when evaluating their financing options, namely whether to (i) exchange equity for outstanding debt or seek equity rather than debt financing or (ii) pursue financing in a foreign jurisdiction, in each case due to the new Interest Deduction Limitation (as detailed below). Now, more than eight months after passage of the TCJA, we may be seeing the manifestation of the concerns raised in that article, particularly insofar as it relates to debt versus equity considerations.
As we predicted, it appears that the TCJA’s new limit on the deductibility of interest (the Interest Deduction Limitation) is indeed causing companies in need of financing to rethink using debt and instead consider turning to equity (click here for more). Although the fact that borrowers may be considering preferred equity investment, both by private equity firms and otherwise, is not unexpected, it will be interesting to see if this trend will continue or if it is more reactionary to the change in law.
Of course, the Interest Deduction Limitation replaced the old “earnings stripping” rules, which limited the ability of U.S. corporations to borrow from foreign parents or affiliates. While the overall deduction is limited (i.e. the limit does not just apply to corporations with foreign related lenders), the limitation may not be as strong a barrier to a foreign shareholder loan as were the old rules (though we note that a U.S. corporation could avoid the old earnings stripping rules if it was able to manage its debt/equity ratio below 1.5:1). We might then expect to see an uptick in cross-border financing in situations where the borrower has strong business reasons for using debt to finance its operations namely in jurisdictions without similar deduction limitations. However, the TCJA certainly did not otherwise encourage foreign inbound lending. Consistent with its overall chill on inbound activity (click here for more), the TCJA introduced hybrid rules that further limit the ability to create more sophisticated structures that rely on competing treatment of both payments (e.g., as interest in one jurisdiction but return of capital in the other) and entities (fiscally transparent in one jurisdiction but not the other). Still, it left open "plain vanilla" shareholder loans, provided of course the loan is respected as debt and the rate is consistent with third party terms. Market terms not only are required for debt treatment for tax purposes, but to protect against a transfer pricing challenge. While a full discussion of transfer pricing is outside the scope of this article, generally transfer pricing rules operate to ensure that related parties do not artificially inflate payments (or undercharge each other) in intercompany transactions to maximize a tax benefit or reduce taxable income. As a practical matter, transfer pricing rules generally require the parties to interact as unrelated third parties in order for the IRS to respect, for example, deductions made by a U.S. borrower to a related foreign lender. Thus, even if loans from foreign parents now are more accessible, the rest of the rules have not changed, and may limit, trends towards cross border lending transactions.
Moreover, certain constraints on foreign corporations still remain, thus mitigating their advantage over domestic lenders. For instance, a foreign lender that is lending through a so-called “blocker” corporation instead of a domestic branch or subsidiary must file U.C. Form 5472 (click here for more). This form is meant to disclose the amount of related party and reportable transactions a company entered into over the course of a taxable period in order to help the IRS ensure the legitimacy of pricing with respect to intercompany transfers. Thus, these payments still are subject to additional scrutiny, and not only with respect to the interest rate charged by the lending company and transfer pricing concerns.
And still, there are several reasons why the Interest Deduction Limitation will not act as a death blow to the banking industry or debt financing. Firstly, the new lower tax rates, may make the limited deductibility of interest an easier cost to bear as (i) companies may find themselves with more cash on hand and (ii) the lower corporate tax rate means the deduction itself is less valuable. Banks also offer a good source of cash to borrowers but without any desire to control the decisions of the company (as opposed to their equity investor counterparts). Further, although the TCJA does limit the borrower’s ability to deduct interest on debt, there is no corresponding deduction when using equity financing at all; a partial benefit in many circumstances is better than no benefit at all. These factors may mean that, although certain businesses may indeed opt for equity financing in situations where they would have used debt financing before the passage of the TCJA, it certainly should not result in a complete move away from debt and towards equity investment.
Indeed, given how the Act disproportionately impacts foreign inbound investment, we may not be likely to see significant non-U.S. equity investment, especially in pass-through form. As we have previously discussed (click here for more), the TCJA codified Revenue Ruling 91-32 (the Ruling), which held that a foreign partner has “effectively connected income” (or ECI, which generally is taxable in the same manner as if the partner were a U.S. person) to the extent the gain is attributable to ECI-producing assets, defined as those assets belonging to a partnership that is carrying on a trade or business in the United States through a fixed place of business. This controversial ruling, which many challenged, now is codified in new Code Section 864(c), which states that ECI is to be treated in the same manner as if the partnership had sold the assets generating ECI and allocated the gain to the partner. Moreover, in calculating the taxable gain of a foreign partner of a partnership that is engaged in a U.S. trade or business, the new provision states that any gain on the disposition of a partnership interest will be presumed to be U.S. source ECI gain and any loss will be presumed to be foreign source non-ECI, unless the partner is able to produce evidence demonstrating otherwise.
While the impact of this holding certainly is more far-reaching than its impact on financing alternatives, the implications with respect to equity financing for passthrough entities – a particularly common structure in certain industries, such as energy – must be considered as companies consider alternate financing sources post tax reform. Thus, even if the equity markets rise on the new laws, new Code Section 864(c) may act to limit the uptick primarily on cross border equity financing options.