A utility's market-rate solar project is not "public utility property," so normalization rules do not apply

Plain-English summary

A regulated electric utility planned to develop a solar facility and hold it through a partnership with an unrelated investor. The partnership would sell the solar power into the wholesale market at market-based rates set by the federal regulator, not at traditional cost-plus rates that guarantee a regulated rate of return. The utility asked the IRS whether the solar facility counts as "public utility property," which would force the depreciation and old investment tax credit "normalization" rules to apply. Those rules limit how fast a regulated utility can pass tax benefits from accelerated depreciation and credits through to ratepayers. The IRS ruled the facility is not public utility property, because it fails the requirement that its rates be set on a rate-of-return basis. As a result, neither the utility nor its partner is subject to the normalization rules of section 168(i)(9) or former section 46(f) for this project. This matters because it confirms that when a utility sells power at market rates through a partnership, rather than under regulated cost-of-service rates, the normalization constraints that govern classic rate-base assets do not attach.

Ruling snapshot

• Question: Is a partnership-owned solar facility that sells power at market-based rates "public utility property" subject to the section 168 and former section 46(f) normalization rules?
• Outcome: Approved (ruled not public utility property; normalization rules do not apply)
• Key authorities: IRC § 168(i)(10), § 168(i)(9), § 168(f)(2); former § 46(f); § 50(d)(2); Treas. Reg. § 1.167(l)-1, § 1.46-3(g)(2)(iii)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202205002 Third Party Communication: None
Release Date: 2/4/2022 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
----------------------------------------------------- ------------------------, ID No. -----------------
---------------------------- Telephone Number:
------------------------- --------------------
------------------------------- Refer Reply To:
CC:PSI:B06
---------------------------- PLR-109384-21
In Re: --------------------------------------- Date:
October 20, 2021

LEGEND:

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

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

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

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

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

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

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

RTO = ----------------------------------------------------------

LLC1 = ------------------------------------------------

LLC2 = ------------------------

ProjectCo = ---------------------------------------

Facility = --------------------------------
PLR-109384-21 2

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

   This letter responds to your request dated April, 20, 2021, for a ruling regarding

the application of § 168(i)(10) and the normalization rules of § 168 and former § 46(f) of
the Internal Revenue Code with regards to the facts described below.

FACTS:

  Taxpayer is a utility located and incorporated in State A. Taxpayer is wholly

owned by Parent. Taxpayer is included in Parent’s consolidated tax return, filed on a
calendar year basis. Taxpayer uses the accrual method of accounting. Parent is
incorporated in State B.

   Taxpayer is an integrated utility that is primarily engaged in generating,

transmitting, distributing and selling electric energy to retail customers in State A.
Taxpayer is subject to the jurisdiction of Commission A and Commission B. Taxpayer is
one of many transmission system owner-members in RTO, a regional transmission
organization. RTO operates on a merit order dispatch, considering transmission
constraints and other reliability issues to meet the total demand in the RTO region.
Taxpayer offers electricity in the RTO day-ahead and real-time markets.

   Taxpayer created LLC1, a wholly-owned limited liability company treated as a

corporation for federal income tax purposes, with a capital contribution of cash. LLC1
and an unrelated power generation development company (Developer) executed a
membership interest purchase, project development, and construction management
agreement to acquire ProjectCo, the owner of Facility, a solar electric production facility
currently being developed. The Facility is expected to qualify for the Investment Tax
Credit (ITC).

    Upon obtaining Commission A approval, LLC1 will acquire all of ProjectCo from

Developer. After acquisition, ProjectCo will be a disregarded entity for tax purposes and
treated as part of Taxpayer. Taxpayer will then create a subsidiary and join with that
subsidiary to form LLC2. LLC2 will join with one or more unrelated parties (Partner) to
form Partnership. Partnership will be treated as a partnership for federal income tax
purposes. LLC1 will sell its membership interest in ProjectCo to Partnership. ProjectCo
will be disregarded for tax purposes and be treated as a part of Partnership for federal
tax purposes. After Partner achieves its targeted after-tax yield (expected to occur
seven or eight years after the commercial operations begin), Taxpayer will have the
option to buy out Partner's interest in Partnership at a mutually agreed-upon price (fair
market value) determined at that time.

  Facility will be self-certified as an exempt wholesale generator under guidelines

administered by Commission B. Partnership also expects to obtain permission from
Commission B for market-based rate authority, that is, the authority to sell Facility’s
PLR-109384-21 3

electricity at market-based wholesale rates, rather than at cost-based rates with a
regulated rate of return. Partnership will sell electricity directly to the wholesale
electricity markets administered by regional transmission organization (RTO).
Partnership will not sell energy to Taxpayer and there will be no power purchase
agreement between Partnership and Taxpayer. Rather, Taxpayer will purchase
electricity, as needed, on the wholesale markets at prices administered by RTO for its
customers.

   The economic value of electricity produced by Facility is greater than the mere

value of the energy itself since Facility’s production of solar energy will also yield
renewable energy certificates (REC) and RTO zonal resource credits (ZRC).

   Taxpayer will enter into an agreement with Partnership under which Taxpayer will

pay to Partnership a fixed price tied to a notional amount of power (corresponding to
actual power generated by Facility) and the expected values of the RECs’ and the
ZRCs’ resulting from operation of Facility. The RECs and ZRCs generated by Facility
are assigned to Taxpayer under the agreement. In return, Partnership will pay to
Taxpayer a market-based amount related to the same amount of power. To the extent
the amount of these payments differ, the agreement provides for a net settlement
payment to equalize the cash flows between Taxpayer and Partnership. The net
settlement payment (if any) is not determined by or related to, any aspect of cost of
service, rate of return ratemaking, but operates as a hedge for both parties against
energy price fluctuations, volumetric fluctuations, and other market-related risks.

    The facts above are contingent on Taxpayer and Partnership obtaining approval

for the various parts of the transaction from Commission A and Commission B.

RULINGS REQUESTED:

1. Whether the Facility owned by Partnership is public utility property under §
   168(i)(10) and former § 46(f)(5) and therefore subject to the normalization rules
   of § 168(i)(9) or former § 46(f)?

2. Whether Taxpayer or Partner are subject to the deferred tax normalization rules
   of § 168(i)(9) as a result of their investments in Partnership or the transactions
   between Taxpayer and Partnership?

3. Whether Taxpayer or Partner are subject to the ITC tax normalization rules of
   former § 46(f) as a result of their investments in Partnership or the transactions
   between Taxpayer and Partnership?
   PLR-109384-21 4

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-
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
PLR-109384-21 5

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 B.

    The Facility will not meet the third requirement because Partnership will use the
   

   Facility to sell the energy the Facility generates at rates established on a market basis
   (and not on a rate-of-return or cost basis), under market-based rate authority from
   Commission B. Nor will the agreement between Taxpayer and Partnership involve the
   sale of electricity at rates established at a rate-of-return or cost basis. Thus, to the
   extent power is sold from the Facility under the 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).

   Based on the forgoing we conclude that:

4. Facility owned by Partnership is not public utility property and therefore is not
   subject to the normalization rules of § 168(i)(9) or former § 46(f).
   PLR-109384-21 6

   2. Neither Taxpayer nor Partner are subject to the deferred tax normalization rules
      of § 168(i)(9) as a result of their investments in Partnership or the related
      transactions between Taxpayer and Partnership described herein.

   3. Neither Taxpayer nor Partner are subject to the ITC tax normalization rules of
      former § 46(f) as a result of their investments in Partnership or the related
      transactions between Taxpayer and Partnership described herein.

      Except as specifically set forth above, no opinion is expressed or implied
      concerning the federal income tax consequences of the above-described facts under
      any other provision of the Code or regulations. Specifically, nothing in this letter should
      be construed as endorsing that the Partnership will be respected for federal tax
      purposes. In addition, no opinion is expressed concerning whether Partnership is
      eligible to elect out of partnership treatment under § 761. Finally, the conclusions
      reached above are dependent on approvals of various parts of the described
      transactions by Commission A and Commission B.

   This ruling is directed only to the taxpayer requesting it. We note that, while we
   have concluded that “Partner” is not subject to either the deferred tax or ITC
   normalization rules under the facts described above, no person may legally rely on a
   ruling not issued to that person. Section 6110(k)(3) of the Code 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 rulings, 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 representatives.

                                                 Sincerely,
   
                                                     /s/
                                                 Patrick S. Kirwan
                                                 Chief, Branch 6
                                                 Office of Associate Chief Counsel
                                                 (Passthroughs & Special Industries)
   

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