PLR 200403037: Generator intertie excluded, upgrade payments left unresolved

Plain-English summary

A utility received payments from a generator to build an intertie connecting a new facility to its transmission grid. The utility expected the agreement to last at least ten years, kept the intertie out of its rate base, and represented that very little power would flow back to the generator. The IRS ruled that the intertie transfer met the published safe harbor and was a nonshareholder capital contribution excluded from the utility's income under section 118(a), rather than a taxable contribution in aid of construction. The IRS declined to rule on whether separate network upgrade payments were debt excluded from income. It also did not verify whether the projected power flow met the safe harbor's five percent limit.

Ruling snapshot

• Question: Is the intertie transfer excluded from the utility's income, and are separate upgrade payments debt?
• Outcome: Mixed: the intertie qualifies under section 118, but the IRS declined the upgrade payment ruling.
• Key authorities: IRC §§ 61, 118; Notices 88-129, 90-60, 2001-82.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200403037
Release Date: 01/16/2004
Index Number: 118.01-02, 118.02-00

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Person To Contact:
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Refer Reply To:
CC:PSI:B05 – PLR-161528-02
Date:
October 07, 2003

LEGEND

Taxpayer = ------------------------------
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Parent = ---------------------------
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Generator = ------------------------------------------
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State A = ------------- State B = ------------- City = --------------------------------------------------- Commission = -------------------------------------------------- Docket Number = ---------------------------------------------------------------
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Date 1 = ------------------ b = ----- c = ----------- Dear -------------:

This letter responds to your letter dated October 28, 2002, and subsequent correspondence, submitted on behalf of Taxpayer, requesting a letter ruling concerning whether the transfer of an intertie by Generator to Taxpayer will be a nonshareholder contribution to capital excludable from income under ' 118(a) of the Internal Revenue Code.

Taxpayer represents that the facts are as follows:

FACTS

Taxpayer is an investor-owned utility organized under the laws of State A that supplies electricity to customers throughout State A. Taxpayer is subject to regulation by the Federal Energy Regulatory Commission (FERC) and the Commission. Taxpayer is a member of the Parent affiliated group of corporations.

Parent is a global energy company that is engaged, through various subsidiaries, in electricity generation, distribution, and trading and related services. Parent owns, manages, or has an interest in power plants in the United States and abroad and serves as a holding company for utilities in various states. Parent files a consolidated federal income tax return for all members of the affiliated group, including Taxpayer. The affiliated group reports its income using a calendar tax year and the accrual method of accounting.

Generator, a State B limited liability company, intends to own and operate a b- MW electric generating facility located in City (Facility). The Facility is located adjacent to Taxpayer=s electric power transmission grid, and will be interconnected with this grid pursuant to Docket Number. The Facility is expected to have a useful economic life of 20 to 50 years.

Taxpayer and Generator entered into an interconnection agreement dated Date 1 (Interconnection Agreement) whereby Taxpayer and Generator agreed to interconnect the Facility to Taxpayer=s transmission system. Taxpayer and Generator intend that the Interconnection Agreement will remain effective for as long as Generator continues its commercial operations, unless both parties mutually agree to an earlier termination date. Taxpayer and Generator intend and expect that the Interconnection Agreement will last at least ten years.

In order to facilitate the interconnection with Taxpayer=s transmission grid, Generator has made substantial cash payments to Taxpayer to cover the costs of equipment required for interconnection, including new connecting and transmission facilities, and modifications, upgrades or relocations of Taxpayer=s existing transmission network. The components of this interconnection that are classified by FERC as ADirect Assignment Facilities@ are the focus of this ruling request (Intertie).

The Intertie will be a dual-use intertie, which will be capable of also transmitting power from Taxpayer to Generator. Meters are in place to track usage and billing. However, Generator will take power from Taxpayer only when the generating plant is down for maintenance or is otherwise off-line. It is projected by Generator that no more than 5 percent of the total projected power flows over the Intertie will flow to the Facility during the ten taxable years of the Taxpayer, beginning with the taxable year in which the interconnection is placed in service.

Ownership of all electricity wheeled by Generator will pass prior to its transmission on Taxpayer=s transmission grid, either to a power consumer or an intermediary, including an affiliated intermediary. In order to accomplish this transfer, title to wheeled electricity will pass at the busbar on the Generator=s side of the Intertie with Taxpayer.

Although Taxpayer has yet to determine a final cost estimate, the costs charged to Generator for completion of the Intertie are estimated to be $c. Taxpayer will not include the cost of the Intertie in its rate base.

Generator represents that the costs of the Intertie contributed to Taxpayer by Generator will be capitalized by Generator as an intangible asset and recovered using a straight line method over a useful life of 20 years.

RULINGS REQUESTED

Taxpayer requests the Service to rule that the transfer of the Intertie by Generator to Taxpayer is not a contribution in aid of construction (CIAC) under ' 118(b), and is excludable from Taxpayer=s gross income as a nonshareholder contribution to capital under ' 118(a).

In addition, Taxpayer also requests a ruling that payments made, or to be made, by Generator to Taxpayer pursuant to the Interconnection Agreement for Network Upgrades, which include those items identified in the Interconnection Agreement as Optional System Upgrades, represent indebtedness for Federal income tax purposes, and are not includable in Taxpayer’s gross income under §61 upon receipt of such payments. As discussed with you on September 29, 2003, the Service is declining to issue a ruling on this request.

LAW AND ANALYSIS

Section 61(a) and ' 1.61-1 of the Income Tax Regulations provide that gross income means all income from whatever source derived, unless excluded by law. Section 118(a) provides that in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer. Section 118(b), as amended by ' 824(a) of the Tax Reform Act of 1986 (the 1986 Act) and ' 1613(a) of the Small Business Job Protection Act of 1996, provides that for purposes of subsection (a), except as provided in subsection (c), the term Acontribution to the capital of the taxpayer@ does not include any CIAC or any other contribution as a customer or potential customer.

Section 1.118-1 of the Income Tax Regulations provides, in part, that ' 118 also applies to contributions to capital made by persons other than shareholders. For example, the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of enabling the corporation to expand its operating facilities. However, the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid to induce the taxpayer to limit production.

The legislative history to ' 118 indicates that the exclusion from gross income for nonshareholder contributions to capital of a corporation was intended to apply to those contributions that are neither gifts, because the contributor expects to derive indirect benefits, nor payments for future services, because the anticipated future benefits are too intangible. The legislative history also indicates that the provision was intended to codify the existing law that had developed through administrative and court decisions on the subject. H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 17 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 18-19 (1954).

Notice 88-129, 1988-2 C.B. 541, as modified and amended by Notice 90-60, 1990-2 C.B. 345, and Notice 2001-82, 2001-52 I.R.B. 619, provides specific guidance with respect to the treatment of transfers of property to regulated public utilities by qualifying small power producers and qualifying cogenerators (collectively, Qualifying Facilities), as defined in section 3 of the Federal Power Act, as amended by section 201 of the Public Utilities Regulatory Policies Act of 1978 (PURPA).

The amendment of ' 118(b) by the 1986 Act was intended to require utilities to include in income the value of any CIACs made to encourage the provision of services by a utility to a customer. See H.R. Rep. No. 841, 99th Cong., 2d Sess. 324 (1986) (Conference Report). In a CIAC transaction, the purpose of the contribution of property to the utility is to facilitate the sale of power by the utility to a customer. In contrast, the purpose of the contribution by a Qualifying Facility to a utility is to permit the sale of power by the Qualifying Facility to the utility. Accordingly, the fact that the 1986 amendments to ' 118(b) render CIAC transactions taxable to the utility does not require a similar conclusion with respect to transfers from Qualifying Facilities to utilities.

Notice 88-129 provides, in part, that with respect to transfers made by a Qualifying Facility to a utility exclusively in connection with the sale of electricity by the Qualifying Facility to the utility, a utility will not realize income upon transfer of an intertie by a Qualifying Facility. An intertie may include new connecting and transmission facilities, or modifications, upgrades or relocations of a utility=s existing transmission network. The possibility that an intertie may be used to transmit power to a utility that will in turn transmit the power across its transmission network for sale by the Qualifying Facility to another utility (wheeling) will not cause the contribution to be treated as a CIAC.

Further, the notice provides, in part, that a transfer from a Qualifying Facility to a utility will not be treated as a Qualifying Facility transfer (QF transfer) under this notice to the extent the intertie is included in the utility=s rate base. Moreover, a transfer of an intertie to a utility will not be treated as a QF transfer under this notice if the term of the power purchase contract is less than ten years.

Notice 88-129 also provides, in part, that a utility that constructs an intertie in exchange for a cash payment from a Qualifying Facility pursuant to a PURPA contract will be deemed to construct the property under contract and will recognize income from the construction in the same manner as any other taxpayer constructing similar property under contract. Subsequent to the construction of the property, the Qualifying Facility will be deemed to transfer the property to the utility in a QF transfer that will be treated in exactly the same manner as an in-kind QF transfer.

Notice 2001-82 amplifies and modifies Notice 88-129. Notice 2001-82 extends the safe harbor provisions of Notice 88-129 to include transfers of interties from non- Qualifying Facilities, and transfers of interties used exclusively or in part to transmit power over the utility=s transmission grid for sale to consumers or intermediaries (wheeling). The notice requires that ownership of the electricity wheeled passes to the purchaser prior to its transmission on the utility=s transmission grid. This ownership requirement is deemed satisfied if title passes at the busbar on the generator=s end of the intertie. Further, Notice 2001-82 provides that a long-term interconnection agreement in lieu of a long-term power purchase contract may be used to satisfy the safe harbor provisions of Notice 88-129 in wheeling transactions. Finally, Notice 2001- 82 requires that the generator must capitalize the cost of the property transferred as an intangible asset and recovered using the straight-line method over a useful life of 20 years.

In the instant case, the transfer of the Intertie is subject to the guidance set forth in Notice 88-129, Notice 90-60, and Notice 2001-82 for the following reasons: (1) the Facility is a stand-alone generator as contemplated under Notice 2001-82; (2) Generator and Taxpayer have entered into a long-term interconnection agreement; (3) the Intertie will be used in connection with the transmission of electricity for sale to third parties (wheeling); (4) the cost of the Intertie will not be included in Taxpayer=s rate base; (5) the Intertie is a dual-use intertie; however, it is projected that during the first ten taxable years of the Facility, no more than 5 percent of the projected total power flows over the Intertie will flow to Generator; (6) it is represented that Generator will not own the electricity prior to its transmission on Taxpayer=s transmission grid; and (7) the cost of the Intertie will be capitalized by Generator as an intangible asset and recovered using the straight-line method over a useful life of 20 years. Thus, we conclude that the transfer of the Intertie by Generator to Taxpayer meets the safe harbor requirements of Notice 88-129, as amended and modified by Notice 90-60 and Notice 2001-82.

Next, we must decide whether the contribution qualifies as a contribution to capital under ' 118(a).

The legislative history of ' 118 provides, in part, as follows:

This [' 118] in effect places in the Code the court decisions on the subject. It deals with cases where a contribution is made to a corporation by a governmental unit, chamber of commerce, or other association of individuals having no proprietary interest in the corporation. In many such cases because the contributor expects to derive indirect benefits, the contribution cannot be called a gift; yet the anticipated future benefits may also be so intangible as to not warrant treating the treating the contribution as a payment for future services.

S. Rep. No. 1622, 83d Cong., 2d Sess. 18-19 (1954).

In Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), the Court held that payments by prospective customers to an electric utility company to cover the cost of extending the utility=s facilities to their homes, were part of the price of service rather than contributions to capital. The case concerned customers= payments to a utility company for the estimated cost of constructing service facilities (primary power lines) that the utility company otherwise was not obligated to provide. The customers intended no contribution to the company=s capital.

Later, in Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), the Court held that money and property contributions by community groups to induce a shoe company to locate or expand its factory operations in the contributing communities were nonshareholder contributions to capital. The Court reasoned that when the motivation of the contributors is to benefit the community at large and the contributors do not anticipate any direct benefit from their contributions, the contributions are nonshareholder contributions to capital. Id. at 591.

Finally, in United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S.
401 (1973), the Court, in determining whether a taxpayer was entitled to depreciate the cost of certain facilities that had been funded by the federal government, held that the governmental subsidies were not contributions to the taxpayer=s capital. The court recognized that the holding in Detroit Edison Co. had been qualified by its decision in Brown Shoe Co. The Court in Chicago, Burlington & Quincy Railroad Co. found that the distinguishing characteristic between those two cases was the differing purpose motivating the respective transfers. In Brown Shoe Co., the only expectation of the contributors was that such contributions might prove advantageous to the community at large. Thus, in Brown Shoe Co., since the transfers were made with the purpose, not of receiving direct services or recompense, but only of obtaining advantage for the general community, the result was a contribution to capital.

The Court in Chicago, Burlington & Quincy Railroad Co. also stated that there were other characteristics of a nonshareholder contribution to capital implicit in Detroit Edison Co. and Brown Shoe Co. From these two cases, the Court distilled some of the characteristics of a nonshareholder contribution to capital under both the 1939 and 1954 Codes. First, the payment must become a permanent part of the transferee=s working capital structure. Second, it may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee. Third, it must be bargained for. Fourth, the asset transferred foreseeably must benefit the transferee in an amount commensurate with its value. Fifth, the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect. Chicago, Burlington & Quincy Railroad Co., 412 U.S. at 413.

The transfer of the Intertie by Generator to Taxpayer possesses the characteristics of a nonshareholder contribution to capital as described in Chicago, Burlington & Quincy Railroad Co. First, the Intertie will become a permanent part of Taxpayer=s working capital structure. Second, the Intertie is not compensation for a specific, quantifiable service provided by Taxpayer. Third, the proposed transfer of the Intertie was subject to negotiations between Generator and Taxpayer, consequently, it was bargained for. Fourth, the Intertie will foreseeably benefit Taxpayer in an amount commensurate with its value for the reasons stated above regarding the benefits that Taxpayer will derive from the more efficient operation of the grid in this area. Fifth, the Intertie will be employed in or contribute to the production of additional income to Taxpayer and consequently, the value of the Intertie will be assured in that respect. Therefore, Taxpayer=s receipt from Generator of the Intertie is a contribution to capital under ' 118(a).

Accordingly, based solely on the foregoing analysis and the representations made by Taxpayer and Transferor, we rule that the transfer of the Intertie by Generator to Taxpayer is not a CIAC under ' 118(b) and is excludable from the gross income of Taxpayer as a nonshareholder contribution to capital under ' 118(a).

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, no opinion is expressed or implied as to whether Taxpayer=s representation that less than 5 percent of the total projected power flows over the Intertie from Taxpayer to Generator is a reasonable projection for purposes of the 5 percent test in Notice 88-129. In addition, no opinion is
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expressed or implied as to whether payments by Generator to Taxpayer represent indebtedness of Taxpayer for Federal income tax purposes.

In accordance with the power of attorney on file with this request, we are sending a copy of this letter ruling to Taxpayer.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

Sincerely,

Walter H. Woo
Senior Technician Reviewer
Branch 5
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosure: 6110 copy