Wind facility is not public utility property, but loss question goes unanswered

Plain-English summary

A regulated electric utility and an independent investor planned to form a partnership to buy and operate a wind facility intended to qualify for the section 45 production tax credit. The partnership would sell all output to the utility under an affiliate power-purchase agreement approved by the relevant regulator, but prices would be set on an arm's-length market basis rather than a cost or rate-of-return basis. The IRS ruled that the facility is not public utility property under section 168(i)(10) because it fails the rate-of-return requirement. The utility also asked whether section 707(b) would disallow partnership losses allocated to either owner from electricity sales to the utility. The IRS declined to answer that second question because it could not be readily resolved before regulations or other published guidance.

Ruling snapshot

• Question: Is the wind facility public utility property, and will section 707(b) disallow owner-allocated losses from its power sales?
• Outcome: mixed, the facility is not public utility property, but the IRS declined to rule on the loss issue
• Key authorities: IRC §§ 168(f)(2), 168(i)(10), and 707(b); Treas. Reg. §§ 1.167(l)-1 and 1.46-3(g)(2); Rev. Proc. 2020-1 § 6.09

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202020011 Third Party Communication: None
Release Date: 5/15/2020 Date of Communication: Not Applicable
Index Number: 45.00-00, 167.22-00, 167.22- Person To Contact:
01, 168.00-00 ------------------, ID No. -----------------
Telephone Number:
------------------------- --------------------
------------------------------------ Refer Reply To:
------------------------------ CC:PSI:B06
------------------------ PLR-119259-19
----------------------- Date:
February 13, 2020

In Re: ------------------------------

LEGEND

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

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

Group = ---------------

LLC = ------------------

Facility = ---------------------------------------------------------------------------------
------------------------------------------------------------------------
--------------------------------------

State = ------------

Commission 1 = -------------------------------------------------------------

Commission 2 = ----------------------------------------------------------------

Operator = ---------------------------------------------------------------------------------

Agreement 1 = ------------------------------------------

Agreement 2 = ----------------------------------
PLR-119259-19 2

LLC Agreement = ---------------------------------

Date 1 = -------------------------

Date 2 = --------------------------

a = ---

b = ---

c = ---

d = ---

e = ---

f = ---

g = --

h = ---

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

   This letter responds to your request dated June 10, 2019, for a ruling regarding

the application of §§ 168(i)(10) and 707(b) of Internal Revenue Code to the facts
described below. The relevant facts as represented in your submission are set forth
below.

                                          FACTS

     Parent, a State corporation, is the parent company of a group of corporations

(Group) that includes members that are regulated natural gas and electric utility
companies operating in State. Group files a consolidated federal income tax return on a
calendar year basis using accrual methods of accounting. Taxpayer, a State
corporation that is wholly owned by Parent, operates primarily as a regulated electric
utility in State. Taxpayer is regulated by Commission 1 and is a member of Operator,
an organization created in compliance with Commission 2 regulations. Taxpayer is
governed by the terms and conditions of Operator’s Agreement 1.

   As part of its plan to replace a substantial portion of its existing electric

generating fleet, Taxpayer intends to invest in and purchase electricity from wind
projects. These wind projects are intended to qualify for the production tax credit under
§ 45. On Date 1, Taxpayer entered into Agreement 2 with an independent third party
PLR-119259-19 3

(Developer). Pursuant to Agreement 2, Developer will develop a wind energy facility
(Facility) and sell it to Taxpayer upon completion. The Facility is expected to be
completed before Date 2.

     On or before Date 2, Taxpayer and an independent investor (Investor) will enter

into a joint venture by forming LLC, a limited liability company treated as a partnership
for federal income tax purposes, to purchase and own the Facility. Taxpayer and
Investor will each contribute cash to LLC. Investor will contribute approximately a to b
percent of the capital of LLC, and Taxpayer will contribute approximately c to d percent.
The LLC Agreement will provide that Investor will receive e percent of profits, losses,
and production tax credits, and approximately a to b percent of the cash of LLC for the
first f years. Taxpayer will receive g percent of the profits, losses, and production tax
credits, and the remaining amount of cash. Taxpayer will assign its rights, interests,
and obligations under Agreement 2 to LLC, which will purchase the Facility from
Developer. LLC will file for and received market-based rate authority from Commission
2, allowing it to make any sales of electricity, capacity, and ancillary services at market-
based rates, rather than cost-based rates with a regulated rate of return.

    LLC will use the Facility to generate electricity to sell to Taxpayer under a

wholesale power purchase agreement (PPA). The PPA is subject to separate approval
by Commission 2 because LLC will be an affiliate of Taxpayer. Under the PPA,
Taxpayer will purchase all of the electric output and capacity of the Facility. The PPA
will have a term of at least h years and will constitute a wholesale PPA under the
jurisdiction of Commission 2. Prices under the PPA will be determined on an arm’s
length, market basis pursuant to market-based rate authority granted by Commission 2
and will not be determined on a rate-of-return basis or cost basis.

   Taxpayer will immediately sell all of the electricity purchased from LLC under the

PPA into Operator’s wholesale electric markets. Concurrently with the sale to Operator,
Taxpayer will purchase electricity from Operator’s wholesale market to satisfy its
obligations to its retail customers. The quantity of electricity it purchases from
Operator’s markets may differ from the quantity it sells into Operator’s markets. The
sales to and from the Operator’s markets will be at market rates set by Operator, which
may differ from each other based on timing and locational differences. As with all
PPAs, Taxpayer will pass the cost of electricity directly to its customers without any
additional markup through a Commission 1 rate adjustment mechanism.

   Taxpayer’s sale of electricity to its retail customers is subject to regulation by

Commission 1. The LLC structure and related transactions, including the ownership in
LLC by Taxpayer and Investor, and the PPA, must be approved by Commission 1. All
of the power purchased under the PPA ultimately will be sold to persons that are
unrelated to Parent, Taxpayer, LLC, Investor or any of their affiliates.
PLR-119259-19 4

                              RULINGS REQUESTED

   Taxpayer requests the following rulings:

1. The Facility is not public utility property under § 168(i)(10).

2. Any tax losses of LLC allocated to Investor or Taxpayer resulting from the sale of
   electricity by LLC to Taxpayer under the PPA will not be disallowed under § 707(b).

                               LAW AND ANALYSIS
   

   Section 168(f)(2) 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) 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, by any agency or instrumentality of
   the United States, or by a public utility service or public utility commission or other
   similar body of any State or public subdivision thereof.

    Prior to the Revenue Reconciliation Act of 1990, § 168(i)(10) defined public utility
   

   property by means of a cross reference to § 167(l)(3)(A). Section 167(l)(3)(A) as then in
   effect contained the same definition of public utility property that is currently in
   § 168(i)(10). 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 the same. Pursuant to § 50(d)(2), rules similar to the rules of
   former § 46(f) as in effect on November 5, 1990, continue to determine whether or not
   an asset is public utility property for purposes of the investment tax credit normalization
   rules. As in effect at that time, former § 46(f)(5) defined public utility property by
   reference to former § 46(c)(3)(B). The definition of regulated rates contained in § 1.46-
   PLR-119259-19 5

3(g)(2) adds an additional element to that contained in § 1.167(l)-1(b)(1). Under § 1.46-
3(g)(2), a taxpayer’s rates are “regulated” if they are established or approved on a rate-
of-return basis. Rates regulated on a rate-of-return basis are an authorization to collect
revenues that cover the taxpayer’s cost of providing goods or services, including a fair
return on the taxpayer’s investment in providing such goods or services, where the
taxpayer’s costs and investment are determined by use of a uniform system of accounts
prescribed by the regulatory body. There is also 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. Therefore, 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.

    Thus, under both the depreciation and investment tax credit normalization rule

definitions, a facility must meet three requirements to be considered public utility
property:

1. It must be used predominately in the trade or business of the furnishing or sale
  of, inter alia, electric 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 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.

    The Facility will meet the first requirement as it will be used predominately in the

trade or business of the furnishing or sale of electric energy. The Facility will meet the
second requirement as it will be subject to the jurisdiction of Commission 2. The Facility
will not meet the third requirement because the electricity it will generate will not be sold
at rates determined on a rate-of-return basis. Under the PPA, all of the Facility’s electric
output and capacity will be sold by LLC to Taxpayer. Taxpayer will sell all of the
electricity purchased from LLC under the PPA immediately into Operator’s wholesale
electric markets. Prices under the PPA will be determined on an arm’s length, market
basis pursuant to market-based rate authority granted by Commission 2 and will not be
determined on a rate-of-return basis or cost basis. Moreover, Commission 1 will not
have any jurisdiction over the Facility or LLC, and as a result, cannot influence the rates
PLR-119259-19 6

Taxpayer will pay for electricity from the Facility. Therefore, we conclude that the
Facility is not public utility property under § 168(i)(10).

    Regarding the second issue, section 6.09 of Rev. Proc. 2020-1, 2020-1 I.R.B. 1,

provides that generally, the Service will not issue a letter ruling or a determination letter
if the request presents an issue that cannot be readily resolved before a regulation or
any other published guidance is issued. Accordingly, we decline to rule on the second
issue based on § 6.09 of Rev. Proc. 2020-1.

  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).

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

provides that it may not be used or cited as precedent. This ruling is based upon
information and representations submitted by Taxpayer and accompanied by penalty of
perjury statements executed by an appropriate party. While this office has not verified
any of the material submitted in support of the request for a ruling, it is subject to
verification on examination.

     In accordance with the power of attorney on file with this office, a copy of this

letter ruling is being sent to your authorized representatives. We are also sending a
copy of this letter ruling to the appropriate director. A copy of this letter ruling must be
attached to any federal income tax return to which it is relevant. Alternatively, taxpayers
filing their returns electronically may satisfy this requirement by attaching a statement to
their return that provides the date and control number of the letter ruling.

                                Sincerely,

                                David Selig
                                Senior Counsel, Branch 6
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)

cc: