On September 13, 2019, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) issued final and reproposed regulations under § 168(k) of the Internal Revenue Code (Code), the provision of the Tax Cuts and Jobs Act (TCJA) providing for an additional first-year depreciation deduction equal to 100% of the cost of qualified property.1 The final and proposed regulations, together with their respective preambles, generally demonstrate thoughtful consideration of comments submitted by utilities and their representatives. Among the most significant clarifications impacting regulated public utilities (RPUs)2 were:
- clarification of the treatment of self-constructed property constructed on the taxpayer’s behalf under a binding contract with third parties
- clarification of the eligibility of utilities to claim the additional 100% first-year depreciation deduction for property subject to a binding contract entered into after September 27, 2017, or for self-constructed property construction that commenced after that date, if placed in service before January 1, 2018
- clarification that § 168(k) does not include a basis allocation rule such that the entire basis qualifies for the additional first-year depreciation or is ineligible for such treatment3
- clarification that the “primary use” of an asset in a public utility activity is determined under the traditional rules of the § 167 regulations
- clarification of the test for determining the eligibility of property subject to a binding contract that fails the 5% liquidated damages safe harbor
- clarification of the eligibility of property leased to a regulated public utility by a taxpayer other than a utility, e.g., a financial institution
Interplay Between the Self-Constructed Property (“SCP”) Rule and the Binding Contract (“BC”) Rule
To the surprise of many, both within and without the utility industry, the original proposed § 168(k) regulations reversed the long-standing interplay between the BC and SCP rules where third parties constructed property under a binding contract that would have been self-constructed property if constructed by the taxpayer itself.4 Under the original proposed regulations, such property was treated as BC property such that the “acquisition date” of the property was deemed to be the date the contract became binding, a date that almost certainly would precede the date when construction commenced, otherwise triggering the application of the SCP rule. Treasury and the IRS believed that this result was mandated by the somewhat differing language of the TCJA than that employed in prior iterations of bonus depreciation legislation.
Responding to comments from numerous commentators, including Eversheds Sutherland, the IRS and Treasury concluded that notwithstanding the use of somewhat different language, Congress intended the continuation of traditional treatment of property constructed by a third party under a binding contract. The final regulations, therefore, provide that property that is manufactured, constructed or produced for the taxpayer by another person under a binding contract that is entered into before the manufacture, construction or production of the property for use by the taxpayer is SCP, not BC property.5
Eversheds Sutherland Observation: As Treasury and the IRS acknowledged, the adoption of the rule with which all taxpayers were familiar will ease their administrative burden. For utilities, of course, the rule will have limited application after December 31, 2017.
Treasury and the IRS Declined to Accept the Argument That Utilities Should Not Be Eligible for the Additional First-Year Depreciation for Certain Property Placed in Service After September 27, 2017, and Before January 1, 2018.
Most utilities believed that in light of years of net operating losses largely attributable to prior iterations of bonus depreciation, they would be expected to forgo the new additional first-year depreciation in exchange for not being subject to the interest expense deduction limitations under § 163(j) as amended by the TCJA. Notwithstanding our contention that § 163(j)(7)(A)(iv)—which defines the trades or businesses whose property is ineligible for the additional first-year depreciation deduction—is simply definitional, not substantive or operational, and is consistent with the definition of regulated public utility trades or businesses under prior law, Treasury and the IRS concluded that it was bound by the inconsistent effective dates of the additional first-year depreciation rules (September 27, 2017) and the interest limitation rules (January 1, 2018). Accordingly, qualified property placed in service by utilities after September 27, 2017, and before January 1, 2018, is eligible for the additional first-year deduction.
Eversheds Sutherland Observation: Most utilities, or at least those with significant NOL carryforwards that could expire under the pre-TCJA statutory regime, would have preferred to forgo the additional first-year depreciation for certain property placed in service between September 28, 2017, and December 31, 2017. For property subject to a binding contract entered into after September 27, 2017, taxpayers can avoid the additional 100% first-year depreciation if the property was placed in service after December 31, 2017. For SCP, taxpayers not wanting the 100% additional allowance can reexamine whether physical construction commenced before September 28, 2017, even if the 10% safe harbor was not satisfied until after September 27, 2017.6
In fairness to Treasury and the IRS, which felt constrained by the statutory language, they also adopted the same approach with respect to the acknowledged legislative glitch eliminating the eligibility of property of certain restaurant and retail businesses as well as qualified leasehold improvements. They applied what they concluded was an unambiguous statute as written, indicating that relief could only be provided by Congress through curative legislation.
The Final Regulations Clarify That There Is No Basis Allocation Rule for SCP, the Construction of Which Begins After September 27, 2017, That Is Placed in Service After December 31, 2017.
Unlike prior iterations of the bonus depreciation rules, the TCJA version of the 100% additional first-year depreciation regime incorporated a basis allocation rule neither for property construction that commenced under the pre-TCJA bonus depreciation rules but placed in service after the effective date of § 168(k) nor for property construction that commenced before the expiration of the TCJA additional first-year depreciation rules but placed in service after their expiration in 2027. Under such circumstances, no portion of the basis of the property is eligible for the 100% additional first-year depreciation deduction. See Treas. Reg. § 1.168(k)-2(b)(5)(viii)(K), Example 11. RPUs will welcome this clarification and the elimination of uncertainty.
Rather Than Adopt a New Test for Whether Property Is Primarily Used in a RPU Trade or Business, the Proposed Regulations Adopt a Familiar Standard.
Another helpful clarification was the proposed regulations’ adoption of the existing “primary use” test under the depreciation regulations. See Treas. Reg. §§ 1.167(a)-11(b)(4)(ii)(b) and (e)(3)(iii). The adoption of a standard with which utilities are already familiar minimizes compliance burdens.
The Final Regulations Clarify the Governing Rules for Property That “Fails” the 5% Liquidated Damages Safe Harbor.
The final regulations clarify that if a contract has a contractual provision that limits damages for a breach to an amount equal to at least 5% of the total contract price, the contract will not be treated as limiting damages to a specified amount, and thus is “binding” on the later of: (1) its date of execution; (2) the date it becomes enforceable under state law; (3) the date on which the last of multiple cancellation periods lapse; or (4) the date on which the last of multiple contingencies is satisfied. Perhaps more importantly, the final regulations clarify that if the 5% safe harbor is not satisfied, the eligibility of such property is determined under the self-constructed property rule. In other words, the acquisition date of such property is the date on which substantial construction begins under either the 10% safe harbor or the commencement of physical construction test.
Surprisingly, the Proposed Regulations Treat Property Leased by a Non-RPU for Use in the Latter’s Regulated Trade or Business as Eligible Property.
The preamble to the proposed regulations recognizes that the normalization rules generally apply to property used by an RPU in its regulated business. Nevertheless, Treasury and the IRS concluded that incentivizing the acquisition of such property will allow businesses to share some of the benefits of § 168(k) without regard to the application of the normalization rules. The ability for non-utility lessors such as financial institutions to acquire and lease property to RPUs and to share the benefits of the additional first-year depreciation deduction with utilities notwithstanding the normalization rules will certainly incentivize such transactions, particularly if utilities are permitted by their public utility commissions to include the leased property in rate base.
Eversheds Sutherland Observation: The inclusion of property leased to RPUs by non-RPUs for use in the trade or business of the RPUs represents a policy decision by Treasury and the IRS given that the TCJA did not directly address leased property. Nevertheless, it is surprising that neither the proposed regulations nor the preamble addressed Treas. Reg. § 1.46-3(g)(3), which expressly provides that property leased by a lessor, where the leasing is not part of a public utility activity, to a lessee who uses such property predominantly in a public utility activity is public utility property.
In general, the clarifications provided by the final and proposed regulations will be welcomed by utilities who prefer certainty in a regulated environment. Although there were a few surprises, and a few disappointments, Treasury and the IRS are to be commended for the timely release of generally helpful guidance for utilities and other taxpayers.