Market-priced solar sales are not public utility property

Plain-English summary

A regulated utility planned to invest with a tax-equity investor in a partnership that would acquire a solar facility and sell its power to the utility. A federal regulator would approve the affiliate power contract, but the contract price would be negotiated at arm's length under market-based rate authority rather than set through cost-of-service or rate-of-return regulation. The utility's state regulator would allow the purchase costs to pass through to retail customers and include the utility's partnership interest in rate base, but it would not control the wholesale contract price. The IRS explained that public utility property must involve regulated rates determined on a rate-of-return basis. It ruled that, to the extent the facility sold power under the market-based service agreement, the facility was not public utility property under Section 168(i)(10), so the related depreciation deductions and investment tax credits were not subject to the public-utility normalization rules.

Ruling snapshot

• Question: Was the solar facility public utility property when its wholesale power price was market-based rather than rate-of-return based?
• Outcome: Approved.
• Key authorities: IRC §§ 46(f), 50(d)(2), 167, and 168; Treas. Reg. §§ 1.46-3 and 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202131004 Third Party Communication: None
Release Date: 8/6/2021 Date of Communication: Not Applicable
Index Number: 168.24-00
Person To Contact:
---------------------- ------------------, ID No. -----------------
-------------------------------------- Telephone Number:
------------------ --------------------
------------------------------ Refer Reply To:
------------------------------- CC:PSI:B06
PLR-110019-20
Date:
May 04, 2021
Re: -------------------

LEGEND

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

Company = --------------------------------------------------------------

Partnership = -----------

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

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

State B = ----------

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

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

Statute = -------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
Clause = -------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
Month = ---------

Year = -------

a = --

PLR-110019-20 2

b = ---

c = -----

d = -----

Director = ---------------------------------------

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

  This letter responds to your request dated April 15, 2020, for a ruling regarding

the application of Internal Revenue Code (Code) § 168(i)(10) and former § 46(f) to the
facts described below. The relevant facts as represented in your submission are set
forth below.

FACTS

    Taxpayer, a State A corporation, is the parent company of a group of

corporations (Group), the members of which include regulated natural gas and electric
utility companies operating in a states. The Group files a consolidated federal income
tax return on a calendar year basis using accrual methods of accounting. Company is a
State B limited liability company wholly owned by Taxpayer and treated as a
disregarded entity for federal income tax purposes. Company primarily operates as a
natural gas and electric utility in State B and is regulated by Commission 1.

  As part of its plan to replace a substantial portion of its coal-fueled electric

generating fleet, Company intends to invest in and purchase electricity from solar
projects. These projects are intended to qualify for investment tax credits with respect
to energy property under § 48.

 As of the date of this ruling request, Company expected to enter into a Build

Transfer Agreement with an independent third party (Developer) in Month Year. Under
the Build Transfer Agreement, Developer will develop the Facility.

  Company and an independent investor (Tax Equity Investor) will enter into a joint

venture by forming Partnership, a limited liability company, that will be treated as a
partnership for federal income tax purposes. Company and Tax Equity Investor will
each contribute cash to Partnership. Company will assign its rights, interests, and
obligations under the Build Transfer Agreement to Partnership. Partnership will
purchase the Facility from Developer.

 The Facility will sell the energy generated directly to Company under either a

wholesale power purchase agreement with a per megawatt hour charge or a fixed

PLR-110019-20 3

monthly price charge (Service Agreement). The Service Agreement will have a term of
at least b years and will constitute a wholesale contract under the jurisdiction of
Commission 2. The Service Agreement will be subject to separate approval by
Commission 2 because Partnership will be making wholesale sales of energy to
Company. The Service Agreement will have to be separately approved under
Commission 2’s process (under Statute 1) for assessing the justness and
reasonableness of an affiliate contract.

   Prior to commencing sales pursuant to the Service Agreement, Partnership will

obtain market-based rate authority from Commission 2, allowing it to make sales of
electricity, capacity, and ancillary services at market-based rates, rather than cost-
based rates with a regulated rate of return. Under the Service Agreement, Company
will purchase c% of the electric output, capacity, and other marketable products or
capabilities of the Facility. Prices under the Service Agreement will be determined on
an arm’s-length negotiated basis pursuant to market-based rate authority granted to
Partnership by Commission 2 and will not be determined on a cost-of-service basis.

   The Service Agreement will also be submitted to Commission 1 for approval

because the costs associated with Company’s contractual purchases will be passed
through to Company’s retail customers. The costs associated with the purchase of
electricity from Partnership will be included in Commission 1 Clause as a pass through
to Company customers. Company’s sale of electricity to its retail customers will be
subject to regulation by Commission 1, and Company’s equity interest in Partnership
will be included in its rate base. Commission 1 will not have jurisdiction over sales of
electricity between Partnership and Company, however.

  As it will purchase c% of the Facility’s electrical power through the term of the

Service Agreement, Company will make ongoing, periodic payments to Partnership
pursuant to the Service Agreement. Partnership’s profits, losses, cash, and investment
tax credits will be allocated to Company and Tax Equity Investor in accordance with the
LLC Agreement.

  At a future date, Company will have an option to purchase all of Tax Equity

Investor’s interests in Partnership for fair market value in accordance with the terms of
the LLC Agreement. If the option is exercised, Company will then own d% of
Partnership.

  The transactions described herein are contingent on Partnership receiving from

Commission 2 both market-based authority for all of its sales of electricity, capacity, and
ancillary services, as well as separate approval of the Service Agreement.

RULING REQUESTED

  Taxpayer requests the following ruling:

PLR-110019-20 4

  To the extent power is sold from the Facility under the Service Agreement,
  the Facility will not be public utility property under § 168(i)(10), and
  therefore, related depreciation deductions and investment tax credits will
  not be subject to the normalization rules of § 168 or former § 46(f).

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, even 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 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)) contain an expanded definition of regulated rates in § 1.46-3(g)(2)(iii). This
expanded definition embodies the notion of rates established or approved on a rate-of-

PLR-110019-20 5

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 the 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 the 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.

   The Facility will meet the first requirement as it will be used predominantly in the
   trade or business of the furnishing or sale of electrical energy. The Facility will also
   meet the second requirement as it will be subject to the jurisdiction of Commission 2.

   The Facility will not meet the third requirement because Partnership will use the
   Facility to sell the power the Facility generates at rates established on a market basis
   (and not on a rate-of-return or cost basis) under the wholesale Service Agreement.
   Such sales will be regulated by Commission 2 under market-based rates. Commission
   1 will not be able to influence the contractual rates that Company will pay for electricity
   from the Facility as sales between Partnership and Company will not be subject to its
   jurisdiction.

   Accordingly, we conclude that:

PLR-110019-20 6

 To the extent power is sold from the Facility under the Service Agreement,
 the Facility will not be public utility property under § 168(i)(10), and
 therefore, related depreciation deductions and investment tax credits will
 not be subject to the normalization rules of § 168 or former § 46(f).

  Except as explicitly 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,
Taxpayer has not requested a ruling regarding whether Partnership will be respected as
a partnership for federal income tax purposes nor provided a final partnership
agreement for Partnership. Accordingly, nothing in this letter should be construed as
providing a ruling or other determination that Partnership will be respected as a
partnership or that any purported owner will be respected as a partner of Partnership for
federal income tax purposes. In addition, no opinion is expressed concerning whether
Partnership is eligible to elect out of partnership treatment under § 761 or whether the
Service Agreement constitutes a service contract under § 7701(e).

  This ruling is directed only to the taxpayer that 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
penalties 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 upon examination.

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

letter are being sent to your authorized representatives. We are also sending a copy of
this letter to Director.

                                    Sincerely,



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

cc: