Community solar facility is not public utility property

Plain-English summary

A regulated electric utility planned to build, own, and operate a voluntary community solar facility funded through customer subscriptions. The facility's electricity would be charged to all customers at an avoided-fuel amount based on the market price of fuel the utility would not need to purchase, without recovering the facility's capital costs, depreciation, or a rate of return. Subscribers would receive bill credits but would not acquire any right to the electricity generated by the facility. The IRS ruled that the facility would not be public utility property under IRC section 168(i)(10) or former section 46(f)(5). The avoided-fuel charge was not cost-based, rate-of-return ratemaking, and the subscription fee paid for program participation rather than electricity.

Ruling snapshot

• Question: Would the community solar facility be public utility property because of its avoided-fuel charges or customer subscription fees?
• Outcome: approved
• Key authorities: IRC §§ 46(f)(5), 167(l), 168(f)(2), 168(i)(10); Treas. Reg. §§ 1.46-3(g)(2), 1.167(l)-1

Full text (IRS public release)

~~~
Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201718017 Third Party Communication: None
Release Date: 5/5/2017 Date of Communication: Not Applicable
Index Number: 167.22-00, 168.00-00
Person To Contact:
------------------------, ID No. --------------
----------------------------- Telephone Number:
----------------------------- ----------------------
--------------------------------- Refer Reply To:
------------------------------------- CC:PSI:B06
-------------------------------- PLR-125229-16
Date:
January 30, 2017

LEGEND:

Taxpayer = -------------------------------

Parent = ------------------------------

State A = ----------

Commission A = ----------------------------------------------------------

Commission B = ------------------------------------------------------------------

Program = ------------------------------------

$a = --------------

$b = -----------

c = --

$d = -----------
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e = ------------

f = --

g = -------------

$h = ----------

i = ----

Dear --------------:

   This is in response to your request for rulings, submitted by your authorized

representative, concerning the federal income tax consequences of the transaction
described below.

Background and Facts

   Parent is a publicly traded holding company. Taxpayer is a State A corporation

and a wholly-owned subsidiary and a member of Parent’s affiliated group. Taxpayer is
primarily engaged in the business of generating, transmitting, and distributing electrical
energy at retail to its customers in State A as a public utility and, as such, is subject to
the regulatory jurisdiction of the Commission A. Taxpayer’s retail customer base is
located in a service area consisting of eight counties in Northwest State A. Taxpayer is
also subject to the regulation of Commission B with regard to its electric utility
businesses, including the transmission of electricity, the sale of electricity to
municipalities and electric cooperatives, and interchange and other purchases and
sales of electricity involving other utilities. Taxpayer has elected to amortize investment
tax credits using a normalization method of accounting for public utility property
complying with former Code § 46(f)(2).

   Taxpayer’s retail electric rates are cost-based rates approved by Commission A

and are a combination of base rates and several separate cost recovery clauses for
specific categories of costs. These separate cost recovery clauses address such items
as fuel and purchased energy costs, purchased power capacity costs, energy
conservation and demand side management programs, and the costs of compliance
with environmental laws and regulations. Costs not addressed through one of the
specific cost recovery clauses are recovered through Taxpayer’s base rates. Taxpayer
also engages in wholesale electric power sales under the jurisdiction of the Commission
B.
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    Taxpayer’s voluntary community solar pilot program (Program) is designed to

allow Taxpayer customers the choice of participating in and receiving the benefits of a
solar photovoltaic electrical generating facility. The Program is strictly voluntary and is
designed to appeal to those Taxpayer customers who are either unable or do not desire
to install solar generation systems on their residences or businesses. The power plant
for the Program will be an f megawatt solar powered electrical generating facility that will
be built, owned, and operated by Taxpayer (Facility). Taxpayer’s investment in the
Facility will not be included in the determination of revenue requirements for base rates
in any regulatory rate filings before Commission A.

    Any Taxpayer customer - residential, commercial, or industrial - will be eligible to

participate in the Program (a Participant) by paying an annual $b subscription fee, or in
exchange for a c year commitment, a reduced $d subscription fee (Subscription Fee).
In exchange for the Subscription Fee, Participants receive a monthly incentive fee
(Incentive Fee) paid by Taxpayer to the Participants, which is intended to compensate
Participants for the energy output of the Facility based on Taxpayer’s Avoided Fuel
Charge (as defined below), as well as the retirement of any Renewable Energy
Certificates or Credits (green tags) associated with the Facility. The Incentive Fee will
be paid to Participants in the form of a line item credit on the Participant’s regular
monthly electric bill.

   Participation in the Program does not entitle a Participant to any energy

generated by the Facility. Rather, Program Participants will continue to be billed for
their energy consumption at Taxpayer’s Commission A approved retail electric rates.
Because the Facility will not be in Taxpayer’s regulated rate base, the Subscription
Fees will be the only way that Taxpayer will earn any revenue from owning and
operating the Facility during the term of the Program.

   Taxpayer’s general body of customers will pay for the electrical energy generated

by the Facility at Taxpayer’s solar-weighted average annual avoided fuel cost
(the Avoided Fuel Charge). Basically, this is the market price of other fuel, such as
natural gas, that the Company will not have to buy when the Facility is producing power
during the daylight hours. The Avoided Fuel Charge will be accounted for and recovered
in a manner similar to purchased power through the Company’s Fuel and Purchased
Power Cost Recovery Clause (the Fuel Clause). For the first year of the Program, the
Avoided Fuel Charge is expected to be g cents per kilowatt hour based upon the sum of
the products of the hourly avoided energy costs and the hourly solar generation, divided
by the annual solar generation from the Facility. This formula is designed to determine
on an average annual basis, the cost per kilowatt hour of fuel that Taxpayer will not need
to purchase to operate its other generating units, but for the operation of the Facility.

   Commission A has previously approved cost recovery clauses for fuel and other

specific categories of costs (for example, for purchased power). The costs addressed
through the Fuel Clause are a mechanism that simply allows Taxpayer to recover its
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actual incurred costs. Unlike a utility’s base rates (rates used to recover capital costs,
depreciation and a rate of return), amounts included in the Fuel Clause simply recover
actual fuel expense and purchase power costs that are incurred to provide service to
the Taxpayer’s customers. Unlike Taxpayer’s base rates, the electrical energy sold to
Taxpayer’s general body of customers from the Facility will be recovered through
Taxpayer’s Fuel Clause, with no Facility rate-of-return associated with those electrical
energy sales.

   The monthly Incentive Fee is determined prior to the beginning of each calendar

year and stated on an average monthly basis. The initial monthly Incentive Fee will be $h
per subscription based upon each subscription’s respective hypothetical portion of the
energy output of the Facility priced at the Avoided Fuel Charge, which initially will be g
cents per kilowatt hour.

   As discussed previously, the aggregate annual Subscription Fees are intended to

cover the full projected annual revenue requirement of the Facility. The projected annual
revenue requirement includes all costs associated with engineering, procurement,
construction, ownership, operation, and maintenance of the Facility, including Program
marketing costs.

    Because depreciation expense causes the net investment in the Facility, and

hence the dollar amount of the equity return, to be naturally higher at the beginning of
the life of a stand-alone generating facility and to gradually decrease over time, for
purposes of determining the number of available subscriptions Taxpayer will “levelize”
the projected annual revenue requirement for the Facility on a net present value basis
over the i year estimated economic useful life of the Facility so that the required annual
number of subscriptions stays the same during the life of the Program.

    The levelized annual revenue requirement for the Facility is expected to be

approximately $a, which includes a return on and of Taxpayer’s investment in the
Facility and all anticipated period costs. The levelized number of annual subscriptions
needed to fully subscribe the Program will be determined by dividing the projected
levelized annual revenue requirement by the established annual Subscription Fee.
Based on marketing surveys, Taxpayer chose an annual Subscription Fee in the
amount of $b and a c year Subscription Fee in the amount of $d, which balanced the
dual objectives of creating a low-cost participation option for those customers interested
in supporting the development of solar energy and minimizing the number of
subscriptions needed to fully subscribe the Program. At an equal mix of $b level
subscriptions and $d level subscriptions, approximately e subscriptions will be needed
annually to fully subscribe the Program on a levelized basis, which is less than one half
of one percent of Taxpayer’s retail customers. Because of this aspect of the Program’s
design, the economic risk of not selling e subscriptions annually throughout the life of the
Program, and therefore not meeting the Facility’s revenue requirement, is borne by
Taxpayer’s shareholders, not its customers. The number of subscriptions needed to fully
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subscribe the Program is dependent on Taxpayer’s total actual investment in the
Facility, which will be determined after a contract to build the Facility is executed.
Further, Participants can choose to purchase more than one subscription, so that the
number of subscriptions and the number of Participants can differ.

   Taxpayer sought and received approval for the Community Solar Program from

Commission A. It did so for two reasons. One, Taxpayer planned to limit participation in
the Program to its customers and to use its customers’ regular monthly electric bills as a
cost effective way of collecting the Subscription Fees from and paying Incentive Fees to
those customers who choose to participate in the Program. Two, Taxpayer sought
approval of the Program from Commission A because it wanted to be certain that the
Program did not run afoul of any possible Commission A rules or regulations for the
ownership and operation of the Facility. Commission A approved the Program based in
part upon the assurance that the costs of owning and operating the Facility would not be
passed through to Taxpayer’s customers, i.e., the costs would be borne by Participants
or the Company’s shareholders.

Rulings Requested:

Taxpayer seeks a ruling that the Facility will not be “public utility property” within the
meaning of Code section 168(i)(10) and Former Code section 46(f)(5) because:

   (1) none of the payments for the electrical energy produced by the Facility at the
   Avoided Fuel Charge (market rate) constitutes a payment for the furnishing or
   sale of electrical energy at a price that reflects cost-based, rate-of-return
   ratemaking, and

   (2) the Subscription Fee is not for the furnishing or sale of electrical energy from
   the Facility.

Law and Analysis:

  Section 168(f)(2) of the Internal Revenue Code (Code) provides that the

depreciation deduction determined under § 168 shall not apply to any public utility
property (within the meaning of § 168(i)(10)) if the taxpayer does not use a
normalization method of accounting.

    Section 168(i)(10) of the Code defines, in part, public utility property as property

used predominantly in the trade or business of the furnishing or sale of electrical energy
if the rates for such furnishing or sale, as the case may be, have been established or
approved by a State or political subdivision thereof.

   Prior to the Revenue Reconciliation Act of 1990, the definition of public utility

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property was contained in § 167(l)(3)(A) and § 168(i)(10), which defined public utility
property by means of a cross reference to § 167(l)(3)(A). The definition of public utility
property is unchanged. Section 1.167(l)-1(b) provides that under § 167(l)(3)(A), property
is public utility property during any period in which it is used predominantly in a § 167(l)
public utility activity. The term “section 167(l) public utility activity” means, in part, the
trade or business of the furnishing or sale of electrical energy if the rates for such
furnishing or sale, as the case may be, are regulated, i.e., have been established or
approved by a regulatory body described in § 167(l)(3)(A). The term “regulatory body
described in section 167(l)(3)(A)” means a State (including the District of Columbia) or
political subdivision thereof, any agency or instrumentality of the United States, or a
public service or public utility commission or other body of any State or political
subdivision thereof similar to such a commission. The term ““established or approved”
includes the filing of a schedule of rates with a regulatory body which has the power to
approve such rates, though such body has taken no action on the filed schedule or
generally leaves undisturbed rates filed by the taxpayer.

    The definitions of public utility property contained in § 168(i)(10) and former §

46(f)(5) are essentially identical. Section 1.167(l)-1(b) restates the statutory definition
providing that property will be considered public utility property if it is used
predominantly in a public utility activity and the rates are regulated. Section 1.167(l)-
1(b)(1) provides that rates are regulated for such purposes if they are established or
approved by a regulatory body. The terms established or approved are further defined
to include the filing of a schedule of rates with the regulatory body which has the power
to approve such rates even though the body has taken no action on the filed schedule
or generally leaves undisturbed rates filed.

     The regulations under former § 46, specifically § 1.46-3(g)(2), contain an

expanded definition of regulated rates. This expanded definition embodies the notion of
rates established or approved on a rate of return basis. In addition, there is an
expressed reference to rate of return in § 1.167(l)-1(h)(6)(i). The operative rules for
normalizing timing differences relating to use of different methods and periods of
depreciation are only logical in the context of rate of return regulation. The normalization
method, which must be used for public utility property to be eligible for the depreciation
allowance available under § 168, is defined in terms of the method the taxpayer uses in
computing its tax expense for purposes of establishing its cost of service for ratemaking
purposes and reflecting operating results in its regulated books of account. Thus, it is
clear that, for purposes of application of the normalization rules, the definition of public
utility property is the same for purposes of the investment tax credit and depreciation.

   Accordingly, the key factors in determining whether property is public utility

property are that (1) the property must be used predominantly in the trade or business
of the furnishing or sale of, inter alia, electrical energy; (2) the rates for such furnishing
or sale must be established or approved by a State or political subdivision thereof, any
agency or instrumentality of the United States, or by a public service or public utility
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commission or similar body of any State or political subdivision thereof; and (3) the rates
so established or approved must be determined on a rate-of-return basis.

   With respect to the first issue, as previously discussed, all energy generated by

the Facility will be included in Taxpayer’s electric rates at an initial Avoided Fuel Charge
of g cents per kilowatt hour and collected through the Fuel Clause. This price will be
paid by all of Taxpayer’s customers, including Participants, as part of their regular
monthly electric bills based upon their individual consumption. This Avoided Fuel
Charge cannot cause the Facility to be treated as public utility property under Code §
168(i)(10) or Former Code § 46(f)(5) because it is market driven by the average price of
fuel that Taxpayer will not have to purchase because of the operation of the Facility.
Accordingly, the price paid for the electrical energy generated by the Facility is not
determined based upon cost-based, rate-of-return rate regulation. The market derived
Avoided Fuel Charge of g cents per kilowatt hour, which is also the basis for the amount
of the Incentive Fee, cannot cause the Facility to be public utility property within the
meaning of Code section 168(i)(10) or Former Code section 46(f)(5).

    With respect to the second issue, The Subscription Fee is paid for the right to

participate in the Program, which does not include the right to a single megawatt hour of
electrical energy from the Facility or any other generating unit owned by Taxpayer. The
price paid by a Participant to Taxpayer for electricity as a customer of Taxpayer is not
changed in any way by their participation in the Program. Because the Subscription Fee
does not involve the sale or furnishing of electrical energy from the Facility, it cannot
cause the Facility to be treated as public utility property under Code § 168(i)(10) or
Former Code § 46(f)(5) regardless of how the required number of subscriptions under
the Program is calculated.

   Accordingly, we conclude that:

   1. the Facility will not be “public utility property” within the meaning of Code §
      168(i)(10) and Former Code § 46(f)(5) because none of the payments for the
      electrical energy produced by the Facility at the Avoided Fuel Charge (market
      rate) constitutes a payment for the furnishing or sale of electrical energy at a
      price that reflects cost-based, rate-of-return ratemaking, and

   2. the Facility will not be “public utility property” within the meaning of Code §
      168(i)(10) and Former Code § 46(f)(5) because the Subscription Fee is not for
      the furnishing or sale of electrical energy from the Facility.


   Except as specifically determined above, no opinion is expressed or implied

concerning the Federal income tax consequences of the matters described above under
any other provisions of the Code (including other subsections of § 168). Specifically, no
opinion is expressed concerning whether the contract to sell electricity constitutes a
service contract under § 7701(e). In addition, no opinion is expressed concerning
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whether the Taxpayer is the owner of the Facility generating electricity for federal
income tax purposes. Further, no opinion is expressed or implied on the classification of
the property under § 168(e). Except as provided in § 168(e)(3), section 5.03 of Rev.
Proc. 87-56, 1987-2 C.B. 674, provides, however, that asset classes in Rev. Proc. 87-
56 include property described in such asset classes without regard to whether a
taxpayer is a regulated public utility or an unregulated company.

   This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of

the Code provides it may not be used or cited as precedent. In accordance with the
power of attorney on file with this office, a copy of this letter is being sent to your
authorized representative. We are also sending a copy of this letter ruling to the Industry
Director.

                                  Sincerely,



                                  Peter C. Friedman
                                  Senior Technician Reviewer, Branch 6
                                  Office of Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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