US corporate tax reform has been a key plank in the Republican platform for several years and has recently become a key focus of the Trump administration. In June 2016, the House Ways and Means Committee Republicans led an effort to unveil a blueprint toward a “Better Way for Tax Reform.” This proposal, backed by House Leader Paul Ryan, would (among other things) reduce the corporate income tax rate from 35% to 20%, allow capital investments to be fully and immediately deductible, and dramatically reduce tax rates on funds repatriated to the United States. The downside of the proposal is that it would eliminate the deductibility of interest expense on future loans. It would also introduce a so-called border adjustment, which would disallow deductions for import purchases while exempting export profits from taxation. Treasury Secretary Steven Mnuchin says the Trump administration is working with House and Senate Republicans with the aim of passing major tax reform legislation before Congress leaves for its August recess.
It’s too early to tell if real tax reform will be achieved by Congress during this administration. The border tax adjustment is being protested by many industries that rely heavily on imports, such as retailers and oil refiners, and opposition from Democratic congressmen and senators may derail the effort. Nevertheless, it’s useful to analyze how such reform (or portions of it) could affect business in the electric power industry, including utilities, independent power producers, equipment manufacturers, and constructors.
Renewable resource owners and investors in particular would be affected by the proposed tax reform due to most renewable plants’ heavy reliance on Federal Tax Credits and the accelerated depreciation of tax benefits in the capital structure. Currently, an entity with significant income tax exposure will often participate in a renewable project as a tax-equity investor to absorb these tax benefits in lieu of cash. With a reduction of the income tax rate to 20%, the value of investing in renewables for these tax-equity investors is significantly depressed. This could lead to a reduction in tax-equity supply and therefore an increase in tax-equity cost and cost of capital. This is somewhat offset by the full deductibility of capital investment (e.g., 100% depreciation in year 1), but again, that value is discounted by the reduction in the tax rate.
Due to the border adjustment, costs for renewable and conventional resources may increase to the extent that key components (e.g., combustion turbines, wind turbines, solar panels, inverters) are imported. Those costs cannot be deducted from income and are therefore taxed. This would not be offset by the exemption for exports, since electric power generated in the United States is generally consumed in-country. As a result, power producers are disproportionately affected by the border adjustment, compared with other business that can export their product to foreign buyers.
The timing and duration of the adjustment presents another important impact, as utilities and investors may stop negotiating contracts for new resources until tax rates and rules are clarified. This could cause delay in plant construction and achievement of Renewable Portfolio Standards or carbon reduction goals. For renewables, this works against the need to start construction and secure the federal wind Production Tax Credit before it disappears in 2022 and the solar Investment Tax Credit before it drops to 10% (from 30%) in 2022. Duration also becomes a factor since the new tax regime may only last 10 years. Senate reconciliation rules require changes passed by a simple majority (in this case, 51 Republicans) must sunset after 10 years if they cause an increase in the deficit. Planning a 20- to 30-year asset under a 10-year temporary tax regime raises the risk of future cost increases.
Strategies to mitigate these impacts are varied. It’s likely that debt issued before a certain date in advance of the new tax regime will be grandfathered in, with the interest deductible over its term. Therefore, issuing debt now to fund resources in the future may be prudent to reducing costs. Procurement of major equipment from US-based manufacturing plants is also a viable strategy to avoid the taxation of imports under the border adjustment mechanism. Manufacturers should consider shifting production to US facilities to support this demand. Finally, the export of excess power to Canada or Mexico is also a viable strategy for mitigation, as these sales would be excluded from taxable income under the border adjustment. Utilities and/or independent power producers should consider border sites and transmission corridors that allow for these exports.
Each of these strategies will likely be constrained by specific eligibility rules and limits baked into the new tax law. Nevertheless, the momentum behind tax reform is significant, and advanced planning and actions around these strategies before the stampede will be time well spent.