Tax-rate adjustment does not make a solar facility public utility property

Plain-English summary

A regulated electric utility agreed to sell power from a new solar facility
at a fixed rate negotiated from comparable market prices rather than through
traditional cost-of-service, rate-of-return ratemaking. The approved rate
could change if federal or state income tax rates changed, using a model that
would alter only the tax input. The utility asked whether that tax-rate
adjuster would make the facility public utility property under IRC
§ 168(i)(10) and former § 46(f)(5). The IRS explained that public utility
property requires regulated rates determined on a rate-of-return basis. Because
the facility's costs remain excluded from base rates and the fixed rate,
including any tax adjustment, does not recover costs on that basis, the IRS
ruled that the facility is not public utility property.

Ruling snapshot

• Question: Does recalculating a market-based fixed electricity rate after
  a tax-rate change make the solar facility public utility property?
• Outcome: Approved, the tax-rate adjustment does not create public utility
  property status
• Key authorities: IRC §§ 168(f)(2), 168(i)(10), and 50(d)(2); former IRC
  §§ 46(f)(5) and 167(l)(3)(A); Treas. Reg. §§ 1.46-3(g)(2)(iii) and
  1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202042005 Third Party Communication: None
Release Date: 10/16/2020 Date of Communication: Not Applicable
Index Number: 168.24-00
Person To Contact:
-------------------- --------------- ID No. ------------
-------------------------- Telephone Number:
--------------------------------- --------------------
----------------------------- Refer Reply To:
------------------------------ CC:PSI:B06
PLR-102330-20
Date:
July 17, 2020

Re: ---------------------------------

LEGEND:

Taxpayer = ------------------------------------------------------------------------
--------------------------
Parent = ----------------------------------------------------------
Commission A = ---------------------------------------------------
Commission B = -----------------------------------------------------
State A = ----------
State B = --------
Organization A = -----------------------------------------------------------
Organization B = ----------------------------------------------
Facility = ------------------------------------------------------------------------
---------------------------------------------
Contractor = --------------------------------
Company = --------------------
Order A = ------------------------------------------------------------
Order B = ------------------------------------------------------------------------
------------------------------------------------------------------------------------------
--------------------
a = ---
b = ------------
c = ---------------
d = ---
e = -----
f = ---
Date 1 = ----------------
Date 2 = -----------------
Date 3 = ----------------------
Date 4 = -----------------------
Date 5 = ---------------------
Date 6 = -----------------------
Date 7 = -------------------
PLR-102330-20 2

Date 8 = ------------------
Date 9 = -----------------
Date 10 = -------------------
Director = ---------------------------------------

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

This letter responds to your request, dated December 5, 2019, for a ruling regarding
certain federal income tax consequences under § 168(i)(10) and former § 46(f)(5) of the
Internal Revenue Code of the proposed transaction described below. The relevant facts
as represented in your submission are set forth below.

FACTS

Taxpayer, a State A corporation, is a public utility engaged in the generation,
transmission, and sale of electrical energy to State A retail customers. Taxpayer is an
indirectly wholly owned subsidiary of Parent. Parent, a State B corporation, and its
affiliated group of corporations, including Taxpayer, file a consolidated federal income
tax return on a calendar year basis using the accrual method of accounting.

Taxpayer is subject to regulation by Commission A and Commission B. Commission A
generally establishes Taxpayer’s retail electric rates on a cost-based, rate-of-return
basis, and such rates are generally a combination of base rates and several separate
cost recovery clauses for specific categories of costs. Taxpayer also has approved
capital investment mechanisms, such as the ---------------------------------------------------------
mechanism, which capture, outside of base rates, the recovery of certain utility
investments related to transmission, distribution, and generation resources. The
combination of Taxpayer’s base rates, cost recovery clauses, and capital investment
mechanisms comprise the total rates and charges applied to State A customers.

On Date 1, Taxpayer filed a Verified Petition with Commission A seeking an order (1)
authorizing Taxpayer to construct, own, and operate the Facility and finding that the
Facility is a clean energy project under State A law; (2) issuing a Certificate of Public
Convenience and Necessity (CPCN) for the Facility under State A law; and (3)
authorizing Taxpayer to timely recover costs incurred in the construction and operation
of the Facility using traditional cost-of service, rate-of-return ratemaking. The Facility is
a a megawatt AC solar energy facility. Within Date 2 and Date 3, several organizations
filed Petitions to Intervene in the regulatory proceedings, including Organization A and
Organization B.

On Date 4, Taxpayer, Organization A, and Organization B jointly submitted to
Commission A a Stipulation and Settlement Agreement (Settlement Agreement)
resolving all matters raised in the proceeding between the parties. Under the
Settlement Agreement, Taxpayer agreed to forego traditional ratemaking for the Facility
and agreed to a fixed rate of $b per KWh for electrical energy generated and sold from
PLR-102330-20 3

the Facility (before a gross-up for State A utility receipts tax). The fixed rate was (1) the
result of negotiations between Taxpayer, Organization A, and Organization B, (2)
derived from market rates for solar energy sold pursuant to long-term power purchase
agreements from comparable facilities, and (3) based upon an estimated capital cost of
the Facility of $c, which the parties to the Settlement Agreement agreed was a
reasonable estimate of the construction costs of the Facility. Actual costs of the Facility,
whether higher or lower, would not change the fixed rate. Furthermore, future changes
in anticipated costs of owning and operating the Facility would not change the fixed rate.
Finally, the Settlement Agreement specified that the Facility and its associated costs
would be excluded from Taxpayer’s Commission A-approved base rates throughout the
life of the project.

During negotiations and prior to entering into the Settlement Agreement, Taxpayer used
a revenue requirement model to determine whether the negotiated market-based rate
met Taxpayer’s economic return requirements for a capital investment. The model
initially used traditional cost-of-service, rate-of-return ratemaking, and, as such, the
model includes all costs associated with engineering, procurement, construction,
ownership, operation, and maintenance of the Facility. After developing the model,
Taxpayer then levelized the resulting annual revenue requirement using Taxpayer’s
weighted average cost of capital. The levelized rate ensured that the costs to
customers would be relatively fixed over the life of the project, as opposed to the
traditional cost-of-service, rate-of-return ratemaking. The levelized annual revenue
requirement was then divided by the expected production from the Facility to determine
a levelized revenue requirement per kWh of electrical energy expected to be generated
by the Facility. Taxpayer then compared this amount to the negotiated, market-based
fixed rate discussed above to determine the economic viability of the Facility using the
alternative ratemaking procedure proposed under the Settlement Agreement.

While the rate determined under the Settlement Agreement is generally fixed over the
life of the Facility, the parties agreed that the rate could be adjusted in three distinct
circumstances: (1) a change in Taxpayer’s approved rate of return on equity as
determined by a final order of Commission A in a future base rate proceeding (ROE
Adjuster); (2) a change in the federal or State A income tax rate that resulted in a
change to Taxpayer’s other Commission A approved tariff rates (Tax Rate Adjuster);
and (3) the receipt of any liquidated damages from the engineering procurement, and
construction contractor for the Facility as a result of the failure of the Facility to meet its
designed output capacity (LD Adjuster). If any of these events were to occur, Taxpayer
agreed to use the model discussed above to calculate a new levelized price per kWh to
be used for pricing the electrical energy from the Facility on a going forward basis.
However, in calculating the new fixed rate, only the agreed upon input related to the
particular adjuster would change. The formulas built into the model would then
automatically calculate the new fixed rate. No other cost-of-service inputs are changed,
regardless of whether the actual costs of providing electric service from the Facility have
increased or decreased. Furthermore, any adjustment to the rate would not impact the
PLR-102330-20 4

exclusion of the Facility’s investment and operating costs from the Taxpayer’s
Commission A-approved standard base rates.

Under the Settlement Agreement, the fixed rate was based upon an assumed annual
level of production in kWh (Production Baseline) from the Facility under a d-year
declining schedule. For each year, the fixed rate would be multiplied by the Production
Baseline and that amount would be added as a recoverable cost within Taxpayer’s ------
-------- mechanism. If the rolling three year average of actual production from the
Facility is more or less than e% or f% of the Production Baseline, respectively, the
excess or shortfall amount would be multiplied by the fixed rate and added or subtracted
from the Production Baseline amount for true-up within the -------- mechanism in future
periods.

On Date 5, Commission A issued Order A, which approved the Settlement Agreement
without change, granted the CPCN, and approved the Facility as a clean energy project
under State A law.

On Date 6, Commission A issued Order B approving an amendment to the Settlement
Agreement (the Amended Settlement Agreement) to remove the ROE Adjuster as one
of the three ways that the fixed rate for sale of electricity from the Facility could be
adjusted.

Despite good faith efforts, Taxpayer and Contractor were unable to reach an agreement
for the construction of the Facility. On Date 8, Taxpayer and Contractor, a subsidiary of
Company, entered into a Termination Agreement, whereby the Engineering
Procurement and Construction (EPC) Agreement entered into on Date 7 and a
Transformer and Invertor Purchase order were terminated. Also on Date 8, Taxpayer
and Company entered into a new agreement, the Module Sale Agreement, whereby
Taxpayer agreed to purchase photovoltaic solar modules for the Facility. Company also
assigned all its rights, title, interests, obligations, duties in, to, and under an OEM
Transformer Purchase Order to Taxpayer.

Because of the termination of the EPC Agreement, the LD Adjuster will not be used to
modify the fixed rate charged by Taxpayer for electrical energy generated by the Facility
that was agreed to in the Settlement Agreement and approved by Commission A.
Furthermore, the termination of the EPC Agreement will not change Commission A’s
approval of the Settlement Agreement.

Taxpayer planned to begin receiving materials and installing the stormwater pollution
prevention facilities at Facility on Date 9. Facility is expected to be placed in service by
Date 10.
PLR-102330-20 5

RULING REQUESTED

Taxpayer requested the following ruling:

The Tax Rate Adjuster will not cause the Facility to be “public utility property” within the
meaning of § 168(i)(10) and former § 46(f)(5) because the use of the model to
recalculate the fixed rate in the event of a Tax Rate Adjuster does not cause the fixed
rate to be treated as having been derived from cost-of-service, rate-of-return
ratemaking.

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 service or public utility commission or other similar body of any State or political
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 identical. 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 an asset is
public utility property for purposes of the investment tax credit normalization rules. As in
PLR-102330-20 6

effect at that time, former § 46(f)(5) defined public utility property by reference to former
§ 46(c)(3)(B).

The regulations under former § 46 (of continuing applicability by virtue of § 50(d)(2)),
specifically § 1.46-3(g)(2)(iii), contain an expanded definition of regulated rates. This
expanded definition embodies the notion of rates established or approved on a rate-of-
return basis, where rate of return includes a fair return on the taxpayer’s investment in
providing such goods and services. Furthermore, rates are not “regulated” if they are
established or approved on the basis of maintaining competition within an industry,
insuring adequate service to customers of an industry, or charging “reasonable” rates
within an industry. In addition to the definition in the § 46 regulations, 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. 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 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 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.

Taxpayer will predominantly use the Facility in the trade or business of the furnishing or
sale of electric energy. Therefore, the Facility will meet the first requirement. In
addition, Taxpayer is a regulated public utility company subject to the jurisdiction of
federal and state law, including the ratemaking jurisdiction of Commission A. Therefore,
the Facility will also meet the second requirement.
PLR-102330-20 7

However, as described above, the rate Taxpayer charges for electricity to be produced
by the Facility will be the rate determined by reference to comparable, competitive
market prices and agreed upon in the Settlement Agreement (as modified by the
Amended Settlement Agreement). This rate will be the only source of compensation to
Taxpayer for electricity produced by the Facility. The fixed rate established for the sale
of electrical energy from the Facility under the terms of the Settlement Agreement (as
modified by the Amended Settlement Agreement), including adjustments to the fixed
rate under the Tax Rate Adjuster, does not include recovery of Taxpayer’s costs on a
cost-of-service, rate-of-return basis, and all costs of the Facility will be permanently
excluded from Taxpayer’s base rates. The ROE Adjuster and LD Adjuster will have no
effect following the Amended Settlement Agreement and termination of the EPC
Agreement. Therefore, the Facility will not meet the third requirement. Accordingly, we
conclude that the Tax Rate Adjuster will not cause the Facility to be public utility
property within the meaning of § 168(i)(10) and former § 46(f)(5).

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). In addition, no opinion is
expressed concerning whether Taxpayer is the owner of the Facility generating
electricity for federal income tax purposes.

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 on behalf of 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 is
being sent to your authorized representative. We are also sending a copy of this letter
to the Director.

                                   Sincerely,


                                   Jennifer A. Records
                                   Senior Technician Reviewer, Branch 6
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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