A utility's negotiated-rate solar array is not "public utility property," so it escapes the depreciation normalization rules

Plain-English summary

A regulated electric utility built a solar photovoltaic array and dedicated part of it (a "dedicated renewable energy facility," or DREF) to serve one municipal-airport customer under a special program its regulator approved. Unlike the utility's normal service, the price the customer pays for the DREF's power is a negotiated, market-based rate set in an arm's-length contract, and any excess power is sold at wholesale market rates. The DREF's costs are assigned directly to that customer and are not folded into the utility's general rates. The utility asked whether the DREF counts as "public utility property" under Section 168(i)(10) (and the old investment-tax-credit rule, former Section 46(f)(5)). That label matters because public utility property must be depreciated using the slower "normalization" method. Property is public utility property only if it meets three tests, including that its rates are set on a cost-of-service, rate-of-return basis. The IRS ruled the DREF fails the third test: because its rates are negotiated and market-based rather than cost-of-service, the DREF is not public utility property and is therefore not subject to the normalization requirement. The IRS expressed no opinion on other issues, including who owns the facility for tax purposes.

Ruling snapshot

• Question: Is a utility's solar facility that sells power at negotiated, market-based rates "public utility property" under § 168(i)(10) and former § 46(f)(5)?
• Outcome: Approved (the DREF is not public utility property)
• Key authorities: IRC § 168(i)(10), (f)(2); former § 46(f)(5); IRC § 50(d)(2); Treas. Reg. §§ 1.46-3(g)(2)(iii), 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202047004 Third Party Communication: None
Release Date: 11/20/2020 Date of Communication: Not Applicable
Index Number: 168.24-00
Person To Contact:
-------------------------- --------------- ID No. ------------
------------------------------------ Telephone Number:
------------------------------------------------ --------------------
-------------------------- Refer Reply To:
-------------------------- CC:PSI:B06
PLR-106179-20
Date:
August 24, 2020

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

LEGEND:

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

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

Commission = ------------------------------------------------------
State = --------------
County = ---------------------------------
Customer = --------------------------------------
Airport = ------------------------------------
Location = ------------------------------------------------------------
Operator = ----------------------------------------------------------
Statute = ----------------------------------------------
Agreement = ------------------------------------------------------------
Program = -----------------------------------
Tariff = -----------------------------------------
a = --------
b = -----
c = --------
d = --
e = ---
Date 1 = ---------------------
Date 2 = ------------------
Director = ---------------------------------------
PLR-106179-20 2

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

This letter responds to your request, dated March 3, 2020, 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 corporation, is a public utility engaged in the generation,
transmission, and distribution of electrical energy to State retail customers. Taxpayer is
a wholly owned subsidiary of Parent, who is a publicly traded holding company. Parent
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. Taxpayer’s retail electric distribution
services are primarily located in County. Taxpayer’s retail electric rates are generally
cost-based rates approved by Commission and are a combination of base rates and
several separate cost recovery clauses for specific categories of costs. These separate
cost recovery clauses address items such as fuel and purchased energy costs,
purchased power capacity costs, energy conservation, 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.

Commission approved the Program giving Taxpayer the ability to negotiate unique
pricing structures with an existing or a new electric service customer. This pricing would
not follow a traditional cost-based utility rate recovery model; instead, the Program
would allow deal specific pricing for renewable energy projects. The participating
customer and shareholders of Parent would bear the full risk of underlying contractual
obligations. Program costs specific to the Program would not be included in the
determination of Taxpayer’s revenue requirements as it would be directly assigned to
the participating customer in any regulatory rate filing before Commission.

Customer is the first customer of Taxpayer to participate in the Program. Customer has
a municipal airport (Airport) located at Location. Customer has agreed to let Taxpayer
utilize a portion of Airport land to build a a kW-AC photovoltaic array (Facility).
Customer has contracted for an undivided interest in b kW-AC of the Facility as a
dedicated renewable energy facility (DREF) to serve a portion of Customer’s electrical
load. The energy generated by the DREF will be delivered to Customer’s metered
locations within Taxpayer’s service territory to offset Customer’s load. Any excess
energy generated by the DREF will be sold to Operator’s energy market. Rates for
PLR-106179-20 3

energy sold to Operator in excess of Customer’s requirements are based on the
wholesale energy market which is market-based.

Pricing of energy coming from the DREF to Customer follows the terms and conditions
of the Agreement, which was negotiated and agreed upon by Taxpayer and Customer
in an arms-length transaction. Generally, a public utility may not enter into an individual
contract to charge one customer a different rate than other customers. However, under
State Statute, a public utility can request approval from Commission for an individual
contract. The Agreement was executed by Taxpayer and Customer on Date 1 and
approved by Commission on Date 2.

The Program’s Tariff specifies that costs attributable to the DREF will be recovered
through a volumetric charge based on actual energy generated by the DREF and
delivered to the Customer. The Program’s Tariff provides for a levelized rate of $c/kWh
in the first year of operation, adjusted for inflation annually at d% for the e-year
agreement term. The Program’s Tariff rate is intended to provide Taxpayer with
sufficient cash flows to meet its required risk adjusted market-based return.

RULING REQUESTED

Taxpayer requested the following ruling:

That the portion of Facility that is the DREF serving Customer shall not be considered
“public utility property” within the meaning of Code § 168(i)(10) and former Code
§ 46(f)(5).

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
PLR-106179-20 4

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
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), contains 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;
PLR-106179-20 5

(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 DREF in the trade or business of the furnishing or
sale of electric energy. Therefore, the DREF will meet the first requirement. In addition,
Taxpayer is a regulated public utility company subject to the jurisdiction of Commission.
Therefore, the DREF will also meet the second requirement.

However, as described above, the rate Taxpayer charges for electricity to be produced
by the DREF will be the negotiated, market-based price that was agreed upon in the
Agreement between Customer and Taxpayer. Any electricity produced in excess of
Customer’s requirements will be sold to Operator at wholesale, market-based rates.
These rates will be the only source of compensation to Taxpayer for electricity produced
from the DREF. The rate established for the sale of electrical energy from the DREF to
Customer under the terms of the Agreement does not include recovery of Taxpayer’s
costs on a cost-of-service, rate-of-return basis. The portion of the costs related to the
DREF will not be included in the determination of Taxpayer’s revenue requirements.
Therefore, the DREF will not meet the third requirement. Accordingly, we conclude that
the portion of Facility that is the DREF serving Customer will not 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 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.
PLR-106179-20 6

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

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