Non-Renewables See Net Gain From Tax Law

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By Lydia O'Neal

The new GOP tax law left non-renewable energy sectors with significant gains, such as temporary full expensing, but also with potential strains on project finance, including lower caps on interest and loss deductions. Except in the case of regulated utilities, however, industry observers don’t expect product prices to reflect the companies’ new windfalls.

Much of the private sector, traditional energy companies included, welcomed the drop in the corporate tax rate to 21 percent from 35 percent, as well as the repeal of the corporate alternative minimum tax (AMT), a tool meant to keep corporations from whittling down their effective rates with the help of tax credits and deductions.

But the benefits come with a few snags that are set to become more severe a few years down the road.

Oil and Gas Financing

Oil and gas companies, like many players in the capital-intensive energy industry, are set to benefit from the new tax law’s provision on retroactive temporary 100 percent expensing, which allows companies to write off both new and used equipment purchased and put into service after Sept. 27, 2017. The benefit comes with a catch and a trade-off: The amount companies can expense winds down by 20 percentage points each year starting Jan. 1, 2023, limiting the benefit for corporations like Exxon Mobil Corp. and Chevron Corp. as they carry out long-term projects.

Worse for those capital-heavy businesses, Congress lowered the cap on the deduction for corporations’ interest payments to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA); at the start of 2022, that deduction will fall to 30 percent of a smaller measure of income—earnings before interest and taxes (EBIT).

“Many oil and gas companies, particularly in the upstream sector, which often have significant leverage, may be impacted by the interest expense limitations,” said Mike Terracina, a partner and national tax leader for oil and gas at KPMG LLP. While the positive effects of the expensing provision will vary from company to company, he said, “many of the smaller, independent producers—highly leveraged—we would expect to be impacted significantly in the near term and going forward.”

Companies can still carry forward their interest deductions indefinitely, and can do the same with deductions of net operating losses (NOLs), although the limit on the latter falls to 80 percent under the new tax law. But the new tax act ( Pub. L. No. 115-97) also eliminated companies’ ability to carry back those losses—a troubling change for a sector that must invest significantly in capital while bearing the volatility of its product’s price, Terracina said.

One provision that would have hit multinational oil and gas firms hard—the base erosion and anti-abuse tax (BEAT)—included a sort of loophole for those producers. The base erosion payments, made to a foreign affiliate to “strip” a company’s taxable income, don’t include the cost of goods sold, a factor that “mitigates the impact on many related party transactions for many oil and gas companies,” Terracina said.

“There’s quite a bit of complexity and unanswered questions in this area, but companies and their tax advisers are analyzing the law and modeling it to try and understand the impact in these related-party business transactions,” he said. “This is an area that will likely see a lot of guidance” from the Internal Revenue Service and Treasury Department in coming years.

No Quick Changes

The law’s opening of the Arctic National Wildlife Refuge (ANWR) to drilling won’t have an impact on the market for at least several years, according to industry analysts.

“First they have to lease. The drilling season up there is short, because you’ve got the permafrost, you’ve got rocks. It’s going to be a three- to four-year thing,” said Philip K. Verleger, an energy consultant and retired economics professor. Compared with the revenue stemming from U.S. shale production, he said, ANWR “won’t even be a factor.”

The oil and gas sector should enjoy substantial gains from the lower corporate rate and the repealed AMT. But because of the high degree of competition within the industry, consumers and downmarket businesses shouldn’t expect much price change, said Verleger, the owner and president of PKVerleger LLC.

“What we have right now in the energy market is an extremely competitive market,” he said. “Competitive market prices are set by supply and demand. Does the tax law change supply? No, it doesn’t.”

Utilities and Expensing

The law’s provision limiting the interest expense deduction exempted regulated utilities. But those companies were also left out of a major perk for the generally capital-heavy power sector: temporary full expensing of new and used capital purchases.

“The industry basically lobbied to have the provisions for interest disallowance, to have them exempted for that. As part of that arrangement, then also exempted themselves, if you will, from the 100 percent expensing,” Rodney L. Anderson, a partner and national tax leader at KPMG LLP, said. The result was essentially a “trade-off of those two provisions,” he said.

For some large regulated utilities with one or more subsidiaries that don’t fall under the exemption, filing may get tricky, Anderson said.

“If you have a consolidated group that has more than just rate-regulated activity, there needs to be an allocation of the interest between those components,” he said. “We’re going to need some guidance from the IRS as far as how that’s going to take place.”

Most industries are likely to channel their new gains from a lower corporate rate toward their shareholders, employee salaries and benefits, and investment. Regulated utilities, however, will pass the benefits to their customers in the form of lower prices in accordance with “normalization” accounting rules, which regulate how utilities transfer their tax benefits to consumers. Exactly when customers can see the results of these tax-related price changes will depend on the public utility commission and its jurisdiction, Anderson said.

Nothing for Coal

Observers agree that the coal industry was largely left out of the tax law. Although Verleger said the limits on deductions for interest expenses and NOLs could “be a death knell” for capital-intensive coal companies, the head of one coal startup appears more optimistic.

The modifications that benefit most businesses—the lower corporate rate and repeal of the AMT—will also shrink coal mining companies’ tax liabilities, as will the temporary full expensing provision, which should “more than offset” the limits on interest deductions, said Grant Quasha, CEO and managing director of Indiana-based Paringa Resources Ltd.

Still, Quasha said, he would have been happier to see the House proposal’s limits on certain renewable tax credits appear in the law. Those credits represented a “huge distortion” swaying the market toward solar, wind, and other similarly renewable-friendly energy sources, he said.

As for whether the benefit of what he expected to be a significantly lower effective tax rate would translate to lower prices, Quasha demurred. “What it’ll translate to is better returns for the equity holders,” he said. “I think it’ll allow folks to improve wages and benefits for employees.”

With assistance from Alex Nussbaum and Kevin Crowley (Bloomberg).

To contact the reporter on this story: Lydia O'Neal in Washington at loneal@bloombergtax.com

To contact the editors responsible for this story: Meg Shreve at mshreve@bloombergtax.com (Bloomberg Tax), Reg Gale at rgale5@bloomberg.net (Bloomberg)

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