trump and the tax reform blueprint - ernst & young | energy sector implications of the election...

O n Tuesday , N ov ember 8 , 2016, Republican nominee Donald Trump defeated Hillary C linton to w in the P residency of the U nited S tates. A long w ith the election of P resident- elect Trump, Republicans w ere able to retain control of both houses of C ong ress. A fter y ears of discussions of potential for comprehensiv e tax reform, there appears to be a hig h probability of tax reform leg islation being mov ed throug h C ong ress in 2017 . P resident- elect Trump and Republicans from the House of Representativ es ( the House) hav e both produced tax reform outlines that hav e many similarities. These plans w ill impact the energ y sector ( oil and g as, mining and metals, and pow er and utilities) .

O n J une 24 , 2016, the Tax Reform Task F orce, composed of House Republicans and led by House W ay s and M eans C ommittee C hairman K ev in Brady ( R- TX ) , released a report on tax reform, the Tax Reform Task F orce Blueprint ( the Blueprint) . The Blueprint contains a hig h- lev el tax reform proposal that, if enacted, w ould repeal the current U S business income tax reg ime and replace it w ith a q uasi- consumption tax. A s described in more detail below , the Blueprint may serv e as a play book for certain tax reform chang es in a Republican-controlled C ong ress. Below , P resident- elect Trump’ s energ y policy is explored, follow ed by his stated tax policy and energ y tax implications of the Blueprint.

Energy sector Implications of the election of Donald Trump and the 2016 House Republican Tax Reform BlueprintJ anuary 2017

| Energy sector Implications of the election of Donald Trump and the 2016 House Republican Tax Reform Blueprint2

President-elect Trump’s energy policyPresident-elect Trump is widely expected to significantly depart from the priorities of the O bama A dministration by fav oring dev elopment of additional conv entional energ y resources and attempting to put the brak es on new env ironmental initiativ es. The Republican ( G O P ) maj orities in the House and S enate hav e a similar ag enda, and Democrats in C ong ress are expected to mobiliz e in opposition — in particular by lev erag ing their pow er in the S enate to filibuster legislation — and publicly highlight the potential impacts of a Trump A dministration’ s policies. Trump has pledg ed to cancel U S participation in the 2015 P aris C limate ag reement, and opposes implementation of the O bama A dministration’ s C lean P ow er P lan ( C P P ) . His campaig n literature is heav ily salted w ith proposals to prov ide reg ulatory relief to fossil fuel industries and slanted in fav or of new administrativ e initiativ es to foster conv entional energ y development. Specifically, his website calls for the following energy-related initiativ es:

• M ak e A merica energ y independent, create millions of new j obs, and protect clean air and clean w ater; conserv e our natural habitats, reserv es and resources; unleash an energ y rev olution that w ill bring v ast new w ealth to our country

• Declare A merican energ y dominance a strateg ic economic and foreig n policy g oal of the U nited S tates

• U nleash A merica’ s $ 5 0 trillion in untapped shale, oil and natural g as reserv es, plus hundreds of y ears in clean coal reserv es

• Become, and stay , totally independent of any need to import energ y from the O P E C cartel or any nations hostile to our interests

• O pen onshore and offshore leasing on federal lands, eliminate moratorium on coal leasing , and open shale energ y deposits

• E ncourag e the use of natural g as and other A merican energ y resources that w ill both reduce emissions but also reduce the price of energ y and increase our economic output

• Rescind all j ob- destroy ing O bama executiv e actions

Energy sector Implications of the election of Donald Trump and the 2016 House Republican Tax Reform Blueprint | 3

P resident- elect Trump has stated that he w ants to reduce and eliminate all barriers to responsible energ y production, creating at least half a million j obs a y ear, U S $ 3 0 billion in hig her w ag es and cheaper energ y . G iv en the predominance of oil and g as, P resident-elect Trump may try to halt additional env ironmental reg ulatory measures proposed by the O bama A dministration, such as methane emission curbs. It should be noted that it is difficult legally to change or repeal regulations which have been promulgated in final form — such as the C P P — w ithout g oing throug h the A dministrativ e P rocedures A ct process. E nv ironmental law y ers can be expected to litig ate at ev ery step of the w ay if Trump attempts to by pass C ong ress and eliminate the C P P by executiv e order, and the courts may w ell serv e as a brak e on such actions. How ev er, env ironmental adv ocates w ho w ould hav e lik ely tried to push a P resident C linton to administrativ ely expand the scope of the C P P ’ s carbon emission reg ulations bey ond the electric pow er sector, potentially economy -w ide under S ection 115 of the C lean A ir A ct, may now be left to use a litig ation route to try to force the E nv ironmental P rotection A g ency to expand the C P P to achiev e this g oal.

During the campaign, Trump also specifically rejected the idea of using a carbon tax/ carbon pricing as a means of encourag ing mark et-driv en emission reductions. W ith G O P chairmen of the tax- w riting committees in the House and S enate, it is v ery unlik ely they w ill schedule hearing s or mark ups to mov e carbon taxes — other than to schedule v otes in the House or S enate aimed at undermining v ulnerable Democrats up for reelection in 2018 .

A dditionally , the P resident- elect has v ow ed to allow energ y infrastructure proj ects, lik e the K ey stone P ipeline and other industrial facilities w hich hav e faced denials or delay s under the current A dministration, to mov e forw ard. Trump has proposed a $ 1 trillion infrastructure plan that w ould rely heav ily on priv ate- public partnerships by prov iding a tax credit to encourag e priv ate inv estors to fund proj ects ov erseen by states and municipalities. A s conceiv ed by Trump’ s adv isors, the tax credit w ould apply to infrastructure proj ects w ith a dedicated source of rev enue, such as toll roads, airports or utilities financed at least in part by fees paid by users. Decisions on w hich proj ects to fund w ould g enerally be left to the states.


President-elect Trump’s tax policyThe results of the presidential election hav e teed up comprehensiv e tax reform as a clear priority for the new Republican P resident and the Republican Congress. A unified Republican government makes the process of achieving significant tax reform much more manageable next y ear, in particular because House S peak er P aul Ry an ( R- W I) during the campaig n pledg ed to mov e such a plan in the form of so- called budg et reconciliation leg islation, w hich w ould mean only a simple maj ority of senators w ould be necessary to pass the plan, rather than the usual 60- v ote maj ority .

A lot of the g roundw ork has been laid throug h proposals and neg otiations ov er the last three or four y ears on v arious k ey aspects of business tax reform, but C ong ressional Republican leaders and the new P resident w ill hav e to decide w hether to push forw ard w ith leg islation that embodies the Blueprint, or the outlines of a tax reform plan that P resident- elect Trump championed during the campaig n. One significant difference is that the Blueprint, according to its authors, is larg ely rev enue neutral using dy namic scoring , w hile the Trump plan w as scored by v arious nong ov ernmental g roups as losing trillions of dollars.

House S peak er Ry an has said on multiple occasions that tax reform is his top priority . A s described in more detail below , the Blueprint, the sixth and final plank of Ryan’s “Better Way” campaign to provide policy alternativ es, proposed a 20% statutory corporate tax rate, a 25 % business tax rate for pass- throug h entities, a mov e tow ard a cash-flow consumption tax through immediate expensing for all businesses and elimination of deductibility of net interest expense, a territorial international tax sy stem, a border tax adj ustment mechanism, and elimination of most business preferences except the research and development tax credit (R&D Credit) and the last-in-first-out (LIFO) method of accounting for inv entories.

Interesting ly , all of these pieces of business tax reform may be fair g ame in discussions w ith Democrats, but the tw o parties differ g reatly ov er w hether to reduce indiv idual tax rates — a k ey component of both the Blueprint and the Trump campaig n ag enda — and ov er important rev enue issues, including w hether reform should be rev enue neutral on a static basis, and w hether timing and one- time rev enue raisers should be used to pay for permanent tax rate reduction. The use of budg et reconciliation, how ev er, could mak e many of these differences irrelev ant as S enate Democrats could hav e little pow er to chang e or block the legislation on the Senate floor.

A long w ith the 20% statutory corporate tax rate, the Blueprint includes a 25 % business tax rate for pass- throug h entities, and indiv idual rates set at 12% , 25 % and 3 3 % , as described in more detail below . The W ay s and M eans Republican tax staff is in the process of receiv ing feedback and building out the Blueprint by drafting detailed statutory lang uag e. The publicly expressed g oal is to hav e that effort completed by the end of 2016. In O ctober 14 remark s at the U niv ersity of W isconsin— M adison, House S peak er Ry an said,

“I really want to get tax reform running as quickly as possible. ” Asked S eptember 29 w hether there is opportunity for prog ress on big -ticket items in 2017, Senate Majority Leader Mitch McConnell (R-KY)l said, “We need to do tax reform — comprehensive tax reform — not piecemeal.”

Trump’ s tax plan differs from the Blueprint in that the corporate tax rate w ould be low er — 15 % — w ith the same rate imposed on pass- throug h entities. The latest statement from the Trump campaig n sug g ests that small business ow ners that do not retain earning s may face double taxation. Indiv idual income tax rates w ould be 12% , 25 % and 3 3 % , the same as the Blueprint. Trump and his staff hav e supported a 10% tax rate on the deemed repatriation of prev iously untaxed foreig n earning s of U S companies, but the campaig n nev er made clear w hether they still support repeal of deferral in a new international tax sy stem g oing forw ard.

Trump has pledg ed to w ork w ith House Republicans on tax issues and, in addition to adopting their proposed indiv idual rates, broug ht his plan closer to theirs by announcing support for immediate expensing of new business inv estments for manufacturers. The House plan proposed expensing in conj unction w ith eliminating the deductibility of net interest expense. In the follow - up to a S eptember 15 speech to the Economic Club of New York, Trump clarified he believes expensing should be limited to manufacturers and those w ho elect expensing w ill lose the deductibility of corporate interest expense. The Trump campaign also clarified in September that they favored repeal of most corporate tax expenditures, except for the R& D C redit. W hile continuing to call for repeal of the estate tax, Trump proposed disallowing a step-up in basis for estates over $10 million: “The Trump plan w ill repeal the death tax, but capital g ains held until death w ill be subject to tax, with the first $10 million tax free as under current law to exempt small businesses and family farms. To prev ent abuse, contributions of appreciated assets into a priv ate charity established by the decedent or the decedent’s relatives will be disallowed.”

Trump additionally proposed capping itemiz ed deductions at $100,000 for single filers and $200,000 for married filers and highlighted the benefits of his proposals for working Americans and the middle class. “By lowering rates, streamlining deductions, and simplify ing the process, w e w ill add millions and millions of new j obs. In addition, because w e hav e strong ly capped deductions for the w ealthy , and closed special interest loopholes, the tax relief w ill be concentrated on the working and middle class taxpayer,” he said. “This is a working and middle class tax relief proposal.” A campaign fact sheet proclaims Trump’ s economic proposals w ould add 25 million j obs ov er a decade, w hich eq uates to 200, 000 new j obs per month.

The motiv ating factors for tax reform w ill remain the same as they were in the current Congress, but unified government should make enacting tax reform much easier. The statutory corporate income tax rate is seen as too hig h and the international tax sy stem compels profit shifting to low-tax jurisdictions and erodes the US tax base.


That phenomenon escalated this y ear w ith the E uropean C ommission’ s latest state aid decision, w hich w as seen as demonstrating a tension betw een the U nited S tates and E urope ov er w ho should tax the foreig n income of U S multinationals.

The passag e of the E uropean U nion’ s ( E U ) harmful tax competition directiv e w ill lead to enactment in all E U countries of a v ariety of measures that could increase taxes on U S companies operating in E urope, w hile implementation of innov ation box reg imes in many countries, follow ing the O rg anisation for E conomic C o- operation and Development’s Base Erosion and Profit Shifting project outline, w ill mak e it more attractiv e for U S companies to mov e intellectual property and exploit that intellectual property into those j urisdictions. The Administration took significant steps this year to try to prevent further erosion of the U S tax base throug h reg ulatory action to deter inv ersions and earning s stripping , but all inv olv ed said these w ere Band- A id approaches that w ere no substitute for U S tax reform.

A s has been the case for the last few y ears, there is broad ag reement on the design elements of business tax reform, and more specifically, international tax reform, but the dev il is in the details. F or example, the Blueprint calls for an 8 . 7 5 % tax rate on prev iously untaxed accumulated foreig n earning s held in cash or cash eq uiv alents, and a 3 . 5 % tax rate on all other accumulated earning s, w ith tax liability pay able ov er an eig ht- y ear period. This is the same tax treatment of accumulated foreig n earning s called for under former W ay s and M eans C ommittee C hairman Dav e C amp’ s ( R- M I) Tax Reform A ct of 2014 .

But in a departure from the C amp bill, the Blueprint also calls for a mov e to a destination- basis tax sy stem, under w hich border adj ustments exempt exports from tax w hile taxing imports, mak ing the tax j urisdiction the location of consumption rather than production. E xempting exports from U S tax and taxing imports reg ardless of w here they are produced w ill eliminate incentiv es for U S businesses to mov e or locate operations outside of the U nited S tates under a territorial tax sy stem, according to the Blueprint. By reliev ing exports from U S tax w hile imposing U S tax on imports, the Blueprint w ould eliminate the need for any new exemption or territorial tax sy stem to be accompanied by a minimum tax or any other more conv entional anti- base erosion measure, thereby sidestepping one of the more intractable and div isiv e debates among the business community ov er the past sev eral y ears of tax reform discussions.

Dev eloping a w ork able border adj ustability mechanism that is not actually a component of a value-added tax presents some significant policy and technical hurdles. U S companies that are net exporters could end up in a perpetual tax loss position, and handing out refunds to some of the larg est U S companies may not w ork from a political standpoint, particularly as the domestic income of U S companies ( including the suppliers for exporting companies) is subj ect to tax. How to apply the border adjustability concept to cross-border flows of capital, or whether to exempt financial transactions, must also be considered.

W hile mov ing to a form of exemption sy stem has some lev el of bipartisan support, certain Democrats may insist on a more pure w orldw ide sy stem that includes repeal of deferral. S enate F inance C ommittee Rank ing M ember Ron W y den ( D- O R) ( intermittently ) and S enator E liz abeth W arren ( D- M A ) ( consistently ) hav e both back ed the latter approach, and S peak er Ry an noted the differing v iew points in S eptember g iv en that Democrats increasing ly call for a w orldw ide system and repeal of deferral. “There is a big gulf between our two v iew s. . . . W e believ e that w e should hav e a pure territorial sy stem. … And so I do believe that this issue is coming,” Ryan said. “I don’t think you can stand against a territorial system much longer.” Ryan also remarked, “The experience I had when I was Ways and Means chair w ith [ Democrats] w as not a pleasant one, and I don’ t k now if that’ s going to change.”

In a S eptember 8 New York Times op- ed, S enator W arren said foreig n dev elopments are increasing pressure on C ong ress to cut corporations “a new sweetheart deal” in tax reform, but lawmakers should instead tak e the opportunity to collect more rev enue from corporations. “Preferential tax treatment, either through special rates or deferred due dates, creates a huge financial incentive for American companies to build businesses and create j obs abroad rather than in the U nited S tates. O ur tax code should fav or j obs and businesses at home — period,” Warren said.

A long w ith these political and mechanical q uestions, there is the q uestion of w hether such a sy stem, embedded in an income tax rather than a v alue added tax or other true consumption tax, is leg al from an international trade perspectiv e.

There may also be tension among House Republicans g iv en the Blueprint has not had a full airing among members — it w as released soon before C ong ress left for its summer recess — and the drafting of leg islativ e lang uag e may mak e apparent w hat is necessary to achiev e the stated g oals, particularly the reduced rates: a 20% statutory corporate tax rate; a 25 % business tax rate for pass- throug h entities; and indiv idual rates set at 12% , 25 % and 3 3 % . O nce the details are hashed out, the Blueprint could present j ust as many trade- offs as prev ious serious tax reform proposals. W hile the mix of w inners and losers may be different than under other proposals, the ultimate fate of the Blueprint w ill still be determined by the same fundamental political dy namics that w ould face any tax reform proposal.

F or example, the Blueprint w ould permit companies to fully and immediately deduct the cost of all tang ible and intang ible property , w ith the exception of land. How ev er, the Blueprint also w ould corresponding ly deny deductions for net interest expense. C ompanies must therefore w eig h w hether losing interest deductions is a cost they are w illing to incur in exchang e for full expensing ( and a 20% corporate rate) .

The purpose of deny ing deductions for net interest expense is to prevent a presumed double benefit from fully expensing leveraged purchases of property . How ev er, the exclusion of land from full expensing under the Blueprint w ould be particularly sev ere for debt-


financed purchases of land because the land would not be eligible for full expensing ( or apparently ev en depreciation as under current law ) , w hile deductions for interest expense on the debt w ould not be permitted. M oreov er, the persistent issues under current law inv olv ing the allocation of purchase price betw een nondeductible land and immediately deductible improv ements on the land w ould be intensified under the Blueprint. Other aspects of paying for a reduced corporate rate w ill not come easier in the new C ong ress. The allure of reducing business tax rates did not draw members to support the bill presented to them by former W ay s and M eans C hairman Dav e C amp.

In the S enate, F inance C ommittee C hairman O rrin Hatch ( R- U T) continues to g o his ow n direction on tax reform, touting a corporate integ ration plan that could be a substitute for or be complementary to a rate reduction effort that includes international tax reform. Hatch say s he is still aiming to release a corporate integ ration discussion draft. C hairman Hatch has said the proposal could accomplish the international tax reform w idely seen as necessary , and the reception to the draft could dictate how strong ly he tries to adv ance the proposal next y ear. The draft is expected to pair a div idends- paid deduction w ith a mandatory 3 5 % w ithholding tax for div idends and interest. O ther senators and third parties hav e raised concerns about a corporate integ ration plan, including :

• That the proposed 3 5 % w ithholding tax expected w ould penaliz e tax- exempt entities lik e retirement plans and deter foreig n inv estment in the U nited S tates

• That a div idends paid deduction w ould, by reducing corporate tax liability , diminish the effectiv eness of current tax incentiv es lik e the R& D C redit and accelerated depreciation, and disadv antag e start- up companies more lik ely to retain their earning s rather than pay div idends

Tax treaties. A ction on the eig ht F oreig n Relations C ommittee-approved tax treaties Senator Rand Paul (R-KY) wants renegotiated ov er information- sharing concerns is seen as ov erdue. The treaties include: new protocols amending U S tax treaties w ith S w itz erland, Luxembourg, Spain and Japan; new tax treaties with Hungary, Chile and P oland; and a multilateral conv ention on tax administration. There hav e been no plans announced for try ing to mov e the treaties during the lame- duck session, thoug h such an effort is possible.

State tax issues. In A ug ust, House J udiciary C ommittee C hairman Bob G oodlatte ( R- V A ) released a second discussion draft related to remote sales tax that w ould apply tax at the destination state of the g oods, rather than on the location of the seller, w hich w as his prev ious approach. The tax w ould be imposed at a sing le rate determined by the state of the purchaser, but using the tax base of the state of orig in. C hairman G oodlatte w anted a v ote this y ear on the proposal, w hich had the support of S peak er Ry an, but this v ote is not lik ely to occur during the lame duck session. W hen C ong ress approv ed a customs reauthoriz ation measure that made permanent the Internet Tax Freedom Act in February, Senate Majority Leader McConnell said he had prov ided assurances to supporters of the M ark etplace F airness Act “that we’ll have an opportunity to consider that sometime this year.” Since that is not likely to occur during the lame-duck session, the issue is sure to resurface in 2017 .

In S eptember, the House approv ed by v oice v ote the M obile Workforce State Income Tax Simplification Act (H.R. 2315), to prohibit w ag es earned by an employ ee w ho performs employ ment duties in more than one state from being subj ect to income tax in any state other than: ( 1) the state of the employ ee’ s residence, and ( 2) the state w ithin w hich the employ ee is present and performing employ ment duties for more than 3 0 day s during the calendar y ear.


S enate F inance C ommittee member J ohn Thune ( R- S D) sponsors a S enate v ersion of the bill ( S . 3 8 6) , thoug h the outlook for the issue is unclear.

House Republican BlueprintA s described in some detail here, the Blueprint proposes a 20% statutory corporate tax rate, a 25 % business tax rate for pass-through entities, a move toward a cash-flow consumption tax through immediate expensing of plant and eq uipment for all businesses and elimination of deductibility of net interest expense, a territorial international tax sy stem, a border adj ustment mechanism and the elimination of most business tax preferences ( except the R& D C redit and the LIFO method of accounting). If enacted, the Blueprint would lik ely impact both the economics and tax burden of a taxpay er in the energ y sector ( oil and g as, pow er and utilities, and mining and metals industries) .

The Blueprint contains three primary elements: a tax on w ag es, a tax on investment income and a cash-flow tax. The tax on wages and the tax on inv estment income are lev ied upon the indiv idual, w hereas the cash-flow tax is levied upon businesses, including sole proprietorships, pass- throug h entities and corporations. Tak en tog ether, these three elements result in a q uasi- consumption tax. The commentary below primarily explores how the cash-flow tax element may affect a taxpay er in the energ y sector.

In general, the proposed cash-flow tax base would equal a business’s sales to customers in the U nited S tates plus interest income less purchases from other businesses, interest expense ( limited to the amount of interest income) , w ag es paid and capital expenditures ( excluding land) . A taxpay er could carry forw ard interest expense that exceeds interest income and deduct the amount carried forw ard ag ainst interest income in future y ears. U nder the Blueprint, a taxpay er w ould not be permitted to carry back an excess net operating loss (NOL) but would be permitted to carry the excess NOL forward indefinitely for use in future years. The maximum NOL carry forw ard deduction in any y ear, how ev er, w ould be limited to 9 0% of taxable cash flow and would be increased by an interest factor. As described above, the cash-flow tax would be imposed at a flat 20% rate on corporations and at a 25 % rate for sole proprietorships and pass- throug h entities.

The Blueprint would preserve the LIFO method of accounting for inv entory and w ould retain the R& D C redit. The Blueprint, how ev er, appears to eliminate all other deductions and credits ( for example, the S ection 19 9 domestic production deduction) . In addition, the Blueprint w ould eliminate the alternativ e minimum tax ( the A M T) .

W ith respect to international taxation, the Blueprint proposes the use of a destination- based territorial tax sy stem, under w hich sales to customers located in the U nited S tates w ould be included in the tax base and sales to customers located outside the U nited S tates may be excluded from the tax base. The Blueprint also prov ides a 100% exemption for div idends receiv ed from foreig n subsidiaries.

In addition, accumulated foreig n earning s w ould be subj ect to an 8 . 7 5 % tax, to the extent held in cash or cash eq uiv alents, or a 3 . 5 % tax, to the extent not held in cash or cash eq uiv alents, w hich w ould be pay able ov er an eig ht- y ear period. ( P resident- elect Trump’ s plan has called for a 10% tax on accumulated foreig n earning s. ) F inally , the Blueprint w ould eliminate the subpart F rules, w ith the exception of the foreig n personal holding company rules.

W ith the destination- based territorial tax sy stem, the Blueprint business tax contains a border adj ustability element, pursuant to which business income taxes would be “border adjusted.” While this concept has not been fully articulated by House Republicans, it appears that the border adj ustment w ould disallow the deduction for cost of imported products, and businesses w ould not hav e to include rev enues from sales outside of the U nited S tates.

The House Republicans intend the Blueprint to be rev enue neutral. F or a v ariety of reasons bey ond the scope of this article, it is not clear w hether the Blueprint is in fact rev enue neutral. N ev ertheless, it is clear the Blueprint, if enacted in its current form, w ould shift the tax burden across business sectors, thereby chang ing the economics of those business sectors.

Oil and gas sectorIntangible drilling and development costsIntang ible drilling and dev elopment costs ( IDC s) are expenses that are incident to and necessary for the drilling of w ells and the preparation of w ells for the production of oil and g as that hav e no salv ag e v alue. IDC s g enerally include the cost of surv ey w ork , g round clearing , drainag e, w ag es, fuel, repairs, supplies and related costs incurred before w ell completion. U nder current law , an independent oil and g as producer may deduct 100% of IDC s in the y ear the independent producer incurs the cost. A n integ rated oil and g as producer, how ev er, may deduct 7 0% of the IDC s in the y ear it incurs the cost and may amortiz e the remaining 3 0% ov er a 60- month period beg inning w ith the month in w hich the costs are paid or incurred.

The Blueprint appears to allow both an independent producer and an integ rated producer to deduct 100% of IDC s in the y ear such costs are paid or incurred. Because an independent producer is currently allow ed to deduct 100% of IDC s in the y ear paid or incurred, it does not appear the Blueprint w ould directly alter the economics associated w ith oil and g as w ells for an independent producer. In contrast, the Blueprint appears to permit an integ rated oil and g as company to also deduct 100% of IDC s in the y ear paid or incurred. Thus, it appears the Blueprint could increase the discounted cash flow and the rate of return on oil and g as w ells drilled by an integ rated oil and g as company . By potentially eq ualiz ing the tax treatment w ith respect to IDC s, an independent producer may lose an economic adv antag e v is- à - v is an integ rated oil and g as company . This chang e may ultimately mak e an independent producer less competitiv e w ith an integ rated oil and g as company because an integ rated oil and g as company may hav e a low er borrow ing cost than a small independent producer.


Dual capacity for international earningsA dual capacity taxpay er is subj ect to a lev y from a foreig n jurisdiction and also receives an economic benefit (e.g., the right to use, acq uire or extract a natural resource) from the j urisdiction. U nder current law , a dual capacity taxpay er can only claim a foreig n tax credit for a payment made to a foreign jurisdiction that qualifies as an income tax as defined by US tax law. The dual capacity taxpay er bears the burden of proof that the foreig n lev y it paid w as an income tax, as opposed to a roy alty or other ty pe of fee. If the dual capacity taxpay er cannot satisfy the burden of proof, the taxpay er may not receiv e a credit for the portion of the pay ment that does not q ualify as an income tax. The Blueprint w ould replace the U S corporate income tax on w orldw ide earning s w ith a territorial cash-flow tax. Thus, a domestic oil and gas producer would only pay tax upon its sales of oil and g as to a customer in the U nited S tates. Therefore, under the Blueprint, it appears a domestic oil and g as producer that also pay s a lev y to a foreig n j urisdiction w ould no long er be at risk of double taxation upon its foreig n earning s, w hich should benefit a domestic oil and gas producer doing business in a foreig n j urisdiction.

Percentage depletionP ercentag e depletion is a tax deduction throug h w hich an independent producer or a roy alty ow ner that ow ns an economic interest in an oil and g as property may recov er its capital inv estment in the property ov er time. U nder current law , an independent producer can claim a percentag e depletion deduction using a rate of 15 % of the g ross income from the property based on the independent producer’ s av erag e daily production of domestic crude oil or domestic natural g as up to its depletable oil or natural g as q uantity . Because percentag e depletion is measured by g ross income, a taxpay er that uses percentag e depletion need not q uantify the costs associated w ith the deduction. In addition, there is no dollar limit on the percentag e depletion deduction. Therefore, the cumulativ e percentag e depletion deduction may exceed the cost of acq uiring the w ell. A n integ rated oil and g as company may not claim a percentag e depletion deduction.

U nder the Blueprint, it appears both an independent producer and an integ rated oil and g as company may deduct any costs associated w ith acq uiring an oil or g as property in the y ear incurred. A s a result, under the Blueprint, if enacted in its current form, an independent producer may no long er hav e a competitiv e adv antag e ov er an integ rated oil and g as company created by percentag e depletion. The accelerated deduction may increase a property ’ s rate of return but an independent producer w ill no long er be permitted to claim deductions that exceed the cost of acq uiring the property . Thus, the economic impact of the loss of percentag e depletion for an independent producer coupled w ith the ability to deduct all costs associated w ith the oil or g as property for both an independent and an integ rated oil and g as company depends upon each taxpay er’ s facts and circumstances.

Border adjustabilityThe Blueprint does not prov ide full details on the border adj ustability concept; how ev er, the concept, if enacted in its current form, could have significant impacts for upstream and downstream taxpayers. The border adj ustment w ould disallow deductions for imported products. This would have immediate impacts on gulf coast refiners that rely on imported crude oil to produce refined products. However, the concept appears to provide a benefit for taxpayers who export crude oil or refined products. Revenues from exports w ould not be included in the U S tax base. It is uncertain how these changes would impact the global commodities markets for refined products and crude oil.

Repatriation of foreign earningsFor oil and gas taxpayers with significant foreign operations and un- repatriated foreig n accumulated earning s, both the Blueprint and P resident- elect Trump’ s tax framew ork include deemed repatriation elements. The Blueprint allow s for tw o separate rates on accumulated foreig n earning s, an 8 . 7 5 % rate on earning s held in cash or cash eq uiv alents, and a 3 . 5 % rate for earning s not held in cash or cash eq uiv alents. The P resident- elect’ s proposal has called for a 10% tax on accumulated foreig n earning s. W ith the intention of mov ing tow ard a territorial tax reg ime, any tax reform leg islation broug ht to a v ote may include a repatriation tax.

AMT tax preferencesThe A M T is a separate and parallel sy stem from the reg ular U S federal income tax. U nder current law , if a taxpay er’ s A M T liability exceeds the amount of U S federal income tax the taxpay er would otherwise owe, a taxpayer must pay a flat-rate 20% AMT. A taxpay er’ s A M T base is determined w ith reference to the taxpay er’ s income tax base, w hich is increased or decreased by A M T “adjustments” and increased by AMT “preferences.” For the oil and g as industry , A M T adj ustments and preferences include IDC s, excess percentage depletion, the LIFO method of computing costs of goods sold, depreciation and adj usted current earning s. If a taxpay er pay s A M T, the taxpay er receiv es an A M T credit, eq ual to the amount of A M T paid, w hich it may use to offset its reg ular income tax liability in future y ears.

The Blueprint does not discuss specific transition rules. Rather, it states that any proposed leg islation w ill contain clear transition rules that w ill be drafted w ith the input of stak eholders. Thus, it is not clear w hether the leg islation that w ould implement the Blueprint w ould contain a transition rule that allow s a taxpay er to monetiz e or otherw ise utiliz e existing A M T credits the taxpay er may hav e at the time the transition w ould occur. A n oil and g as sector taxpay er with significant AMT credits should carefully monitor any proposed leg islation associated w ith the Blueprint to determine w hether the leg islation contains appropriate transition rules.


Power and utilities sectorInterest expense deductionC urrently , a taxpay er may deduct the interest expense it paid or accrued on its indebtedness. A reg ulated public utility recov ers its interest expense as part of its ov erall return on inv ested capital. The use of debt in a reg ulated utility ’ s capital structure decreases the utility ’ s rates because the utility may deduct its interest expense for U S federal income tax purposes. The eq uity portion of a utility ’ s capital structure g enerally results in hig her rates because the after-tax return on eq uity has no corresponding tax deduction.

Under the Blueprint’s proposed cash-flow tax, a taxpayer may only deduct interest expense to the extent of the taxpay er’ s interest income. In response, it is lik ely that a reg ulator w ould g ross- up a reg ulated utility ’ s return on rate base for both the debt and the eq uity portions of the utility ’ s capital structure. S uch a g ross- up w ould increase the utility ’ s rates. M oreov er, the chang ing cost of debt that results from the loss of the interest deduction may cause a reg ulator to reconsider w hat constitutes an appropriate capital structure for a utility . Tak en tog ether, these reg ulatory actions w ould lik ely increase the rate a utility charg es its customers and may accelerate the arriv al of “grid parity,” which occurs when a customer’s cost of generating its ow n electricity eq uals the rates it pay s for electricity , and ultimately reduce the utility ’ s customer base. Thus, this element of the proposed cash-flow tax may have a significant effect upon a regulated utility and its ratepay ers.

Capital expenditure deductionC urrently , the tax law allow s a utility to claim accelerated depreciation. To prev ent accelerated depreciation from becoming a federal subsidy to the utility ’ s ratepay ers, for ratemak ing purposes, C ong ress req uires a utility to use the normaliz ation method of accounting . U nder the normaliz ation method of accounting , a utility computes the U S federal income tax expense included in its costs of serv ice as if the utility used the same depreciation method for US federal income tax purposes that the utility uses for financial accounting purposes. The normaliz ation method of accounting also allow s a utility to include the deferred tax liability associated w ith accelerated depreciation as a decrease to the utility ’ s rate base. In addition to accelerated depreciation, the current tax law permits a taxpay er to elect to claim a special depreciation allow ance — bonus depreciation on certain property .

U nder the Blueprint, a utility w ould be req uired to deduct 100% of its capital expenditures in the y ear incurred. The Blueprint does not discuss w hether it env isions req uiring a utility to compute the U S federal income tax expense included in its costs of serv ice using the normaliz ation method of accounting . If C ong ress does not enact a normalization rule as part of the cash-flow tax, Congress will effectively create a significant federal subsidy for a utility’s current customers by allowing a regulator to pass through the tax benefit associated w ith a utility ’ s capital inv estments to the utility ’ s ratepay ers

in the year the assets are placed in service, as opposed to flowing the benefit through to the utility’s current and future ratepayers over the life of the asset.

For the past several years, many utilities have incurred NOLs for US federal income tax purposes as a result of the bonus depreciation. The normaliz ation method of accounting req uires a utility to include the portion of an NOL associated with accelerated depreciation as an increase to the rate base. U nder the Blueprint, it is lik ely that the 100% capital expenditure deduction w ould cause many utilities to be in an NOL position. If Congress enacts a normalization rule as part of the cash-flow tax, the deferred tax assets associated those NOLs and the deferred tax liability associated w ith the capital expenditure deduction w ould offset each other in the utility ’ s rate base. A bsent this rule, a regulator could ignore the economic effects of an NOL and effectiv ely reduce a utility ’ s earning s.

Research and development creditsU ntil December 2015 , the R& D C redit contained in Internal Rev enue C ode S ection 4 1 w as not permanent and there w as no certainty w hether the credit w ould be av ailable in future y ears. O n December 18 , 2015 , H. R. 2029 , the P rotecting A mericans from Tax Hik es A ct of 2015 made the S ection 4 1 credit permanent, thereby g iv ing a utility certainty that a research and dev elopment credit built into the utility ’ s rates w ill be av ailable in the y ears betw een rate cases.

The Blueprint proposes retaining the permanent R& D C redit. Thus, a utility may plan a long - term research proj ect w ith the certainty that the benefit related to the R&D Credit will be available. This certainty may also allow a utility to build the R& D C redit into its rates because the credit w ill be av ailable in y ears betw een rate cases.

Excess deferred taxes and transition rulesA s noted abov e, the Blueprint does not contain details on the contents of any proposed transition rules. Rather, it states that any proposed leg islation w ill contain clear transition rules that w ill be drafted w ith the input of stak eholders. W hen a reduction in tax rate occurs, a taxpay er must recalculate its deferred tax reserv es. A reduction in tax rate results in excess deferred tax reserv es. A normal subchapter C corporation is req uired to recog niz e the excess deferred tax reserv e in income, but a utility g enerally must refund the excess deferred tax reserv es related to accelerated depreciation to its customers.

F or a utility , the issue related to refunding the excess deferred tax reserv es is the timing of the pay ments to its customers. A n immediate refund of the entire amount may significantly reduce the utility’s cash flow. In 1986, when Congress last enacted a comprehensive tax reform package, Congress enacted legislation that spread the benefit of the refund to utility customers ov er the remaining useful liv es of the assets. To av oid the neg ativ e conseq uences associated w ith an immediate refund of excess deferred taxes, a utility should monitor the draft of tax reform leg islation associated w ith the Blueprint and ensure that leg islation contains an appropriate transition rule.


Mining and metals sectorPercentage depletion and AMTBecause the percentag e depletion limitations imposed upon a taxpay er in the oil and g as industry are not applicable to a taxpay er in the mining industry, percentage depletion is more significant to the mining industry . U nder the current U S federal income tax law , a taxpay er in the mining industry may claim percentag e depletion to recov er its capital inv estment in a mineral property eq ual to the lessor of a stated percentage of “gross income from mining” or 50% of “net income from mining.” Because percentage depletion is based upon the taxpay er’ s net income and not the cost of the mineral property , ov er time a taxpay er may claim a cumulativ e percentag e depletion deduction that exceeds the cost of the mineral property , i. e. , excess percentag e depletion. This excess percentag e depletion results in req uired adj ustments in calculating A M T, and, conseq uently , a taxpay er in the mining industry ty pically pay s A M T in excess of its reg ular U S federal income tax liability . U nder the Blueprint’ s proposed cash-flow tax, percentage depletion would no longer be av ailable. A s a result, the unav ailability of the excess percentag e depletion deduction could reduce the rate of return and the cash flow of a mineral property . The economic conseq uences related to the lack of percentag e depletion may be offset by the increased rate of return and the reduced cost of capital that result from the immediate deduction of capital expenditures associated w ith acq uiring and operating the mineral property .

Capital expenditure deductionThe mining and metals industry is a capital- intensiv e industry . Thus, the immediate expensing of capital eq uipment w ould be a significant benefit. Historically, a mining industry taxpayer eligible for accelerated or bonus depreciation had to weigh the benefits of accelerated or bonus depreciation ag ainst the potential loss of percentag e depletion. W ith the elimination of percentag e depletion, the immediate expensing of capital equipment would be a significant benefit. The immediate expensing of capital investment expenditures may put many taxpayers in the mining and metals industry in an NOL position, at least initially . N ev ertheless, it is also important to note that the Blueprint, if enacted, w ould only permit a taxpay er to offset 90% of the cash-flow tax base by an NOL generated in an earlier year, which could result in a mining and metals taxpayer owing a cash-flow liability even though it has a remaining NOL carryfoward.

S imilar to current depreciation rules, the Blueprint w ould not permit a taxpay er to deduct the cost of land. In contrast to the current U S federal income tax reg ime, the Blueprint appears to allow a taxpay er to immediately deduct the cost of purchasing intang ible property . In the mining and metals industry , in many instances the purchase of land includes the intang ible mineral rig hts associated w ith the land. The Blueprint does not mak e clear w hether a taxpay er that purchases land and the associated mineral rig hts in a sing le transaction may seg reg ate and deduct the cost of the mineral rig hts included in the purchase price of the land. If the Blueprint does not seg reg ate and

deduct the cost of the mineral rig hts included in the purchase price of land, a taxpay er in the mining and metals sector w ould realiz e a decreased rate of return and cash flow on the mineral property due to its inability to claim a percentag e depletion deduction under the proposed cash-flow tax.

R&D CreditHistorically , taxpay ers in the mining and metals industry hav e often paid A M T and may not hav e alw ay s been in a position to recog niz e the benefits of research and development credits, since these credits w ere not creditable ag ainst the A M T. The combination of the elimination of percentag e depletion and the elimination of A M T could create an opportunity for a mining and metals taxpay er to rev iew its activ ities that may q ualify for the R& D C redit.

AMT credits and transition rulesAs explained above, the Blueprint does not mention specific transition rules. Rather, it states that any proposed leg islation w ill contain clear transition rules that w ill be drafted w ith the input of stak eholders. Thus, it is not clear w hether the leg islation that w ould implement the Blueprint w ould contain a transition rule that allow s a taxpay er to monetiz e or otherw ise utiliz e existing A M T credits the taxpay er may hav e at the time the transition w ould occur. A mining and metals sector taxpayer with significant AMT credits should carefully monitor any proposed leg islation associated w ith the Blueprint to determine w hether the leg islation contains appropriate transition rules.

ConclusionW ith the election of Donald Trump, the Republicans retaining control of C ong ress, House S peak er P aul Ry an’ s ( R- W I) commitment to bring ing tax reform to v ote in 2017 , and the dev elopment of the Blueprint, there finally appears to be a legislative path forward for tax reform. The House W ay s and M eans C ommittee w ill now shift its attention to w ork ing w ith the income A dministration to produce tax reform leg islation. During the drafting process, the C ommittee w ill continue to seek feedback from stak eholders. The C ommittee has indicated that any transition rules w ill be drafted w ith the input of stak eholders.

P resident- elect Trump’ s tax reform plans g enerally adhere to the precepts of the House Republican Tax Reform Blueprint, but his plans differ from that outline in some important respects. A s described abov e, the Blueprint proposes, among other thing s, to allow 100% expensing of qualified business investments and to deny the deductibility of net business interest expenses. It w ould also eliminate most fossil-fuel-specific tax incentives such as deductions for IDCs and percentag e depletion, but its proposal to allow expensing of all business investment would mitigate the loss of many of the specific deductions. Trump offered qualified support for the Blueprint’s proposal to allow 100% expensing — but w ould limit the prov ision to manufacturers — and those w ho elect expensing w ould lose the deductibility of business interest expenses.


W hile P resident- elect Trump has spent much of his time discussing federal policy issues surrounding conv entional energ y resources, he has expressed opposition to continued federal support for the dev elopment of w ind and solar energ y and has said he w ill eliminate all federal spending for clean energ y research. How he proceeds in the new Congress may be heavily influenced by both electoral politics ( e. g . , ethanol- rich Iow a larg ely supported his candidacy ) and the pre- existing dy namics in C ong ress. M any C ong ressional Republicans hav e opposed ev en temporary extensions of renew able energ y incentiv es and the fate of these prov isions may w ell be link ed to the effectiv eness of the Democratic minority .

A s demonstrated by the examples abov e, tax reform could hav e significant impact on the economics of a taxpayer in the energy sector, and, as a result, an energ y sector taxpay er should attempt to q uantify the potential tax and economic effects of potential tax reform on their business and activ ely eng ag e in the leg islativ e process.

T o l ea rn m ore, conta ct:

Deborah ByersUS Energy LeaderErnst & Young LLP+ 1 7 13 7 5 0 8 13 8deborah. by ers@ ey . com

Steve LandryEY Americas Oil and Gas Tax Leader+ 1 7 13 7 5 0 8 4 25stephen. landry @ ey . com

Greg MatlockEY Americas EnergyTax Leader+ 1 7 13 7 5 0 8 13 3g reg . matlock @ ey . com

Thomas MinorEY Americas Mining andMetals Tax Leader+ 1 205 226 7 4 07thomas. minor@ ey . com

Ginny NortonEY Americas Power andUtilities Tax Leader+ 1 212 7 7 3 625 6g inny . norton@ ey . com

Tim UrbanW ashing ton C ouncil+ 1 202 4 67 4 3 19timothy . urban@ w c. ey . com

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