The proposed regulations under section 168(k) issued by Treasury and the Internal Revenue Service (IRS) on August 3, 2018, not only presented utilities with some surprises, but also raised concerns as a result of unaddressed uncertainties.
The amendments to section 168(k) of the Internal Revenue Code (Code), created by the Tax Cuts and Jobs Act of 2017 (TCJA), allow immediate expensing for certain business assets, which was intended to lower the cost of certain investments and increase the liquidity of investing companies by reducing overall tax liability. However, many utilities had accumulated significant net operating losses as a result of prior iterations of bonus depreciation. Rather than continuing to add to those accumulated net operating loss balances through expensing, utilities essentially opted to forgo expensing and instead receive relief from the interest limitations of new section 163(j). The two provisions are inextricably tied – trades or businesses described in section 163(j)(7) are excluded from the application of the interest limitations and are ineligible for expensing.1
Specifically, under the proposed section 168(k) regulations, utilities were likely surprised by the following:
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The treatment of utility property not subject to a binding contract as of September 27, 2017, construction of which commenced after that date, and placed in service prior to December 31, 2017, as assets eligible for expensing under section 168(k); and
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Property constructed under a binding contract that would have been self-constructed property if constructed by the utility taxpayer under prior regulations would be treated as binding contract property, not self-constructed property, under the proposed regulations.
Utilities also may be perplexed by the failure of the regulations to define the scope of the term, “trade or business of the furnishing or sale of electrical energy, water,…gas or steam through a local distribution system, or transportation of gas or steam by pipeline,” which defines the class of taxpayers ineligible for expensing and exempt from the interest expense limitations under section 163(j). Had the proposed regulations deemed those businesses to be entirely ineligible for expensing, rather than treating them as eligible for certain property they placed in service before January 1, 2018, the failure to address this issue until guidance under section 163(j) was issued would not be nearly as problematic.
Each of these issues is discussed below.
Surprise No. 1 – Utility property eligible for expensing in 2017
As noted above, utility property was intended to be excluded from expensing in exchange for granting the industry an exemption from the interest limitations. New section 163(j)(7), which lists trades or businesses exempt from the interest limitations, has an effective date of January 1, 2018. The incorporation in section 168(k)(9) of ineligible trades or businesses listed in section 163(j)(7), without taking into account the expensing effective date of September 27, 2017, was apparently a drafting error. As a result of this error, and notwithstanding Congressional intent and utility expectations to the contrary, Treasury and the IRS concluded that utility property acquired after September 27, 2017, construction of which commenced after that date, and placed in service before the calendar year end, was indeed eligible for expensing.2
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Eversheds Sutherland Observation: Utilities that do not desire additional deductions that might lead to greater accumulated net operating losses will need to file an election out of the expensing provisions for 2017. For example, a utility suffering from a major storm between September and December 2017 likely will have incurred significant capital expenditures that would be eligible for expensing under the proposed regulations. To avoid the additional net operating losses expensing would create, a utility should consider electing out of expensing under section 168(k). A further (and contrary) consideration is that net operating losses incurred in 2017 are entitled to more beneficial utilization than net operating losses incurred in later years.3 |
Surprise No. 2 – The proposed regulations changed the interplay between the binding contract rule and the self-constructed property rule
Historically, if a taxpayer contracted with another party to construct property on its behalf that would have been self-constructed property if constructed by the taxpayer, the property was treated as self-constructed property for purposes of the prior bonus depreciation rules.4 Under the proposed rules, all property constructed under a binding contract for the taxpayer is treated as binding contract property even if it would have been self-constructed property if constructed by the taxpayer. This change is significant because property subject to a binding contract entered into prior to September 27, 2017, is ineligible for expensing under section 168(k), and property is considered to be “acquired” as of the date the contract becomes binding, regardless of when the property is actually delivered to the taxpayer.5
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Eversheds Sutherland Observation: Had the historical position been retained, so long as construction of self-constructed property produced under a binding contract commenced after September 27, 2017, such property placed in service prior to January 1, 2018, would have been eligible for expensing. By converting such property to binding contract property, so long as the contract execution date is prior to September 27, 2017, the property is ineligible for expensing regardless of when construction began. For those seeking to minimize additional deductions that generate net operating losses, this rule creating unexpected ineligibility might prove beneficial. |
Uncertainties unaddressed – The scope of trades or businesses ineligible for expensing and excluded from the interest limitations
As noted above, the proposed regulations did not address the scope of the exclusion for the provision of regulated electric and gas service under new section 163(j)(7)(A) and incorporated by reference in section 168(k)(9)(A). Thus, many questions are left unanswered, including the following:
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Is it clear that independent power producers, i.e., generators that provide service not subject to rate regulation by federal or state bodies, are excluded?
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Is property used for wholesale sales at market rates ineligible for expensing?
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If property is not subject to a cost of service/rate of return rate setting, is that property ineligible? For example, rates are often freely negotiated, priced at avoided costs, priced with reference to an external market index, or are established in response to a solicitation of bids.
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Will the regulations adopt a predominant use test so that all property is considered ineligible if more than a stated percentage is used to provide regulated service? If so, what percentage will be adopted?
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Alternatively, will the regulations adopt a de minimis rule whereby if less than a stated percentage of property is used for unregulated purposes, all property will be deemed to be used in regulated service?
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If neither a predominant use nor a de minimis use test is adopted, what method or methods will be permissible to determine eligible and ineligible property (e.g., relative fair market value, relative adjusted basis, modified adjusted basis to eliminate bonus depreciation, gross receipts, direct tracing, etc.)?
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Eversheds Sutherland Observation: The failure to address the scope of the term “trade or business” might not have been problematic had the proposed regulations not allowed eligibility for certain property placed in service in late 2017. In making such property eligible for expensing, however, these questions are critically important. Unless the section 163(j) proposed regulations are issued expeditiously, the failure to address this issue is clearly problematic unless utilities elect out of expensing for 2017 and defer the need to address this issue for interest limitation purposes until tax year 2018. |
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1 Section 168(k)(9) excludes any property which is primarily used in a trade or business described in clause (iv) of section 163(j)(7)(A), which includes the trade or business of the furnishing or sale of electrical energy.
2 Specifically, the Preamble to the Proposed Regulations states: “[s]ection 163(j) applies to taxable years beginning after December 31, 2017. Accordingly the exclusion of property described in section 168(k)(9) from the additional first year depreciation deduction applies to property placed in service in any taxable year beginning after December 31, 2017.”
3 Pre-2018 net operating losses can be used to offset full taxable income (limited to 90% under the AMT) whereas post-2017 net operating losses can only offset 80% of taxable income. Compare I.R.C. §§ 56(a)(4), (d) and 172(a)(2).
4 Treas. Reg. § 1.168(k)-1(b)(4)(iii).
5 Prop. Treas. Reg. § 1.168(k)-2(b)(5)(ii).
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