Thursday, August 20, 2015

#TBT: Clinton Proposes Tax Changes Affecting Project Finance, March 1999

This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience. This article first appeared in the March 1999 issue of the Project Finance NewsWire and was written by Chadbourne partner Keith Martin.

Clinton Proposes Tax Changes Affecting Project Finance

by Keith Martin, in Washington

The Clinton administration proposed a series of tax law changes in February that, if enacted, would affect project finance. 

Cogenerator Tax Credit 

Clinton wants an energy tax credit to promote investment in new “combined heat and power systems.” These are facilities that produce steam and either electricity or mechanical shaft power. The owner of the project would be able to claim 8% of the cost of the project as a credit against his federal income taxes.

The administration made basically the same proposal last year as part of a plan to reduce greenhouse gas emissions that contribute to global warming, except the credit was 10%.

Projects would qualify only if placed in service during the period 2000 through 2002. At least 20% of the output from the project must be in the form of useful thermal energy. This compares to the 5% threshold to be a “qualifying facility” under the Public Utility Regulatory Policies Act, or PURPA. In addition, the project must have an energy conversion ratio greater than 70%, in the case of projects that exceed 50 megawatts, and 60% in small projects. The energy conversion ratio is the Btu content of the output divided by the Btu content of the fuel that went into the power plant.

Section 45

The US government offers a tax credit of 1.7¢ per kWh for generating electricity from wind or “closed-loop biomass.” The credits can be claimed for 10 years from when the power plant starts commercial operation. Projects must be in service by June 1999 to qualify.

Clinton wants to allow another five years until June 2004 for projects to be put into service. He would also add the following types of biomass to the list of eligible fuels:
“solid, nonhazardous, cellulosic waste material, that is segregated from other waste materials, and that is derived from the following forest-related resources: mill residues, pre-commercial thinnings, slash and brush, but not including old growth timber, waste pallets, crates, and dunnage, and landscape or right-of-way tree trimmings, and biomass derived from agriculture sources, including orchard tree crops, vineyard grain, legumes, sugar, and other crop byproducts or residues.”
Municipal solid waste, or garbage, would not qualify.

Section 45 credits are almost certain to be extended this year by Congress. The only question is the list of fuels that will qualify. Rep. Bill Thomas (R.-Calif.) introduced a bill last month with 16 members of the House tax-writing committee as cosponsors to extend the credit, but only for wind.

Senator Charles Grassley (R.-Iowa) introduced an identical bill in the Senate. The Senate Finance Committee chairman, Bill Roth (R.-Del.), favors adding chicken litter to the list of eligible fuels. There is less support for adding biomass fuels. Companies that produce landfill gas and synthetic fuels from coal hope also to add their fuels to the list, but these fuels currently lack a strong sponsor in Congress.

The Thomas and Grassley bills would deny tax credits for electricity from “qualifying facility” projects where the electricity is sold to a utility under a contract signed before 1987, unless the contract has been amended to reduce the contract price for electricity to avoided cost at time of delivery for any increase in output above a base period.

Aggressive Tax Schemes

There is a growing consensus in Washington that the government must take action against aggressive tax schemes by corporations. Clinton proposes five measures that go beyond what Congress is likely to enact, but some action is expected.

His proposals would take effect from the date of “first committee action” in Congress, which could be sometime this spring.

Clinton would impose a 25% excise tax on fees earned by law and accounting firms and investment
banks for tax advice or for implementing any “tax avoidance transaction.” This is “an entity, plan or arrangement” that reduces or defers a corporation’s taxes and that is expected to generate insignificant profits in relation to the net tax benefits. Michael Graetz, a law professor at Yale, said the definition distills to “a deal done by very smart people that, absent tax considerations, would be very stupid.” Fees paid by a corporation in connection with such a transaction would not be deductible.

The administration’s budget said, “In addition, a tax avoidance transaction would be defined to cover certain transactions involving the improper elimination or significant reduction of tax on economic income.” No one is sure what this means. The government is aware of the problem and is “working furiously” to refine the definition, a Treasury lawyer said on March 4.

There would be a separate 25% excise tax in tax avoidance transactions where there is a right to unwind the transaction, a guarantee of tax benefits or “[an]other arrangement that has the same economic effect.” The tax would be 25% of the maximum amount of money the corporation could get back under the unwind or indemnity. It would be collected at closing.

Tax schemes often involve a transaction between a US taxpayer and a foreign corporation, municipality, Indian tribe or other tax-exempt entity, or a domestic corporation with net operating loss carryfowards. Clinton wants
these “tax-indifferent parties” to pay US income taxes on any income that is shifted to them in the transaction. If the US cannot collect the taxes from the tax-indifferent party, then it will look to the US taxpayer whose tax shelter it is to pay the taxes.

The government already has authority under section 269 of the US tax code to deny tax benefits in transactions where a US taxpayer acquires control of a corporation with the principal purpose of securing a tax benefit. Clinton wants the IRS to have similarly broad authority to deny tax benefits in tax avoidance transactions.

Finally, Clinton would increase the penalty for substantial understatements of tax from 20% to 40% for tax understatements linked to tax avoidance transactions. “Substantial understatement” is defined under current law as a shortfall in total taxes of least 10% or $5,000, whichever is greater. Clinton would change this to a shortfall of at least $10 million. A company could reduce its penalty back to 20% (instead of 40%), but only by submitting documents pertaining to the transaction to the IRS within 30 days after closing and by highlighting any book-tax differences from the transaction on its tax return.

Lease Financing

Clinton wants to prevent lessors in leasing transactions involving “tax-exempt use property” from claiming net losses from the transactions. Any net losses would have to be carried forward and offset against income from the lease transaction in later years. “Tax-exempt use property” is equipment leased to a lessee who is not a US taxpayer. An example would be where a US equity leases a power plant to a Dutch utility. The proposal would apply to leases entered into after enactment, which is expected to be sometime this fall.

A coalition of big-ticket lessors and lease arrangers has retained Ken Kies, until recently chief of staff of the Joint Tax Committee in Congress, and has raised a huge war chest to fight the proposal.

Tracking Stock

Top executives at US utilities sometimes complain that the market undervalues their unregulated businesses. Some utilities have looked at possible direct public offerings of shares in their independent power subsidiaries. Others have considered issuing tracking stock, which is stock in the parent company that tracks economic performance of the
subsidiary. The advantage of tracking stock is it lets the parent continue to file a consolidated tax return with the subsidiary.

The IRS is still unsure when it will treat tracking stock as stock in the subsidiary directly. In the meantime, Clinton wants to treat a company issuing tracking stock as if it had sold part of the subsidiary and collect a tax on any gain. The market has already moved beyond simple tracking stock to “reverse tracking stock.” An example is where a US company wants to acquire a Canadian target. It might have the owners of the target exchange their existing shares for new shares in the target that track economic results in the US parent. This is done to qualify for tax-free reorganization treatment in Canada and to avoid withholding taxes on dividends at the US border, since any dividends on the shares would be paid entirely within Canada.

Fresh Start

Clinton wants companies to “mark to market” all assets and entities when they enter the US tax net. This would have the effect of eliminating any tax attributes in the entity and of resetting the tax basis in assets to market value. For example, a fresh start would be triggered when a foreign corporation becomes a CFC, or “controlled foreign corporation,” because it is suddenly more than 50% US-owned. The US Treasury figures that US taxpayers already plan around situations where bringing entities or assets into the US tax net would trigger a gain. It hopes the proposal will put an end to transactions where losses are imported for use on US tax returns.

Other Proposals

There are at least a dozen more proposals in the Clinton budget that affect different segments of the project finance community. The administration has been criticized for the sheer number of new tax proposals this year. The summary of them issued by the US Treasury is 201 pages.


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