PLR 1024036: IRS approved a like-kind exchange of emission credits

Plain-English summary

The IRS ruled that nitrogen oxide emission credits and volatile organic compound emission credits were like-kind intangible personal property for purposes of a proposed section 1031 exchange. A parent corporation planned to receive nitrogen oxide credits from its wholly owned subsidiary and exchange them for credits held by unrelated parties, then use the replacement credits in its business. The IRS concluded that the credits had the same nature and character because they were government-granted rights under the same pollution-control program with identical terms and conditions, even though the underlying pollutants differed. It also addressed the consolidated-group consequences of the distribution and concluded that the exchange could qualify for nonrecognition if the other requirements of § 1031 were satisfied.

Ruling snapshot

• Question: Are nitrogen oxide and volatile organic compound emission credits like-kind property for a proposed section 1031 exchange?
• Outcome: Approved
• Key authorities: IRC §§ 1031, 1502, 197, and 311; Rev. Proc. 92-91

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201024036 Third Party Communication: None
Release Date: 6/18/2010 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1031.01-00, 1031.02-00 --------------------------- , ID No.----------------
----------------------
Telephone Number:

                                                       ---------------------

------------------------- Refer Reply To:
---------------------------- CC:ITA:B04
--------------------------- PLR-149323-09
Date:
TY:------- February 23, 2010

LEGEND:

Taxpayer (hereafter “Parent”) = -------------------------------------------------
Sub = -----------------------------
Region = -------------------------------------------

Dear ----------- -

This responds to your request for a private letter ruling dated November 3, 2009, on
whether gain from the exchange of certain emission credits may be deferred under
§ 1031 of the Internal Revenue Code.

FACTS

Parent is a ------------------------------------headquartered in Region. Parent is also the
common parent of a consolidated group. Sub is a wholly owned subsidiary of Parent
and a member of Parent’s consolidated group.

The concentration of ground level ozone (commonly known as smog) in Region often
exceeds permissible air quality standards established by the Environmental Protection
Agency (EPA). Ground-level ozone is principally created by two types of pollutants:
nitrogen oxide (“NOx”) and volatile organic compounds (“VOCs”). NOx is produced
during combustion of natural gas. VOCs are organic chemical compounds that
evaporate under specific conditions. Parent and its subsidiaries create NOx primarily
during the process of -----------------------------------------------------------and create VOCs
primarily during the process of ----------------------------------------------------------------------------
---------------------------.

The ------------------------------------------------------------- - was created to develop and
implement air pollution control measures in Region. In an effort to improve the Region’s
air quality and bring the area into compliance with state and federal law, the --------- has
PLR-149323-09 2

established a program to review and control emissions in Region. Under this
program, businesses that take measures to reduce their emissions of pollutants, for
example by installing emission reduction equipment, may apply for and receive
emission reduction credits (“Credits”). Credits are used by the holder to “offset”
emissions that would otherwise exceed permitted levels. Each Credit is a grant to the
holder of the right to emit a specified amount of the pollutant per year for an indefinite
period of time. Credits may be transferred temporarily or permanently.

Credits for the purpose of reducing ozone are designated by the ----------as either NOx
Credits or VOCs Credits. Apart from the underlying pollutant, the terms and conditions
of the two types of Credits are identical. NOx Credits may be used to offset VOCs
emissions and VOCs Credits may be used to offset NOx emissions, as long as the
holder of the Credits demonstrates that such use of the Credits will not cause or
contribute to a violation of state or federal air quality standards.

Sub holds NOx Credits that were granted by the ----------when Sub installed air emission
reduction equipment on its -------------------. Sub holds these Credits for productive use
in a trade or business or for investment.

Parent anticipates the future need for VOCs Credits in order to meet emission
standards related to ---- ---------------------------------------------------------------. Although NOx
reductions are far more desirable to the --------- than VOCs reductions in achieving the
air quality objectives, the ----------has historically granted permission to use NOx Credits
to offset VOCs emissions. However, this interpollutant use of the Credits is not
economically optimal for Parent because the NOx Credits are more valuable due to their
relative scarcity. From a business perspective Parent would prefer to exchange NOx
Credits for VOCs Credits held by unrelated third parties. This would generally allow
Parent to emit a greater amount of VOCs than if Parent obtains authorization by the -----
--------- to use its NOx Credits to offset its VOCs emissions.

Sub possesses NOx Credits in excess of its needs. To satisfy Parent’s need for VOCs
Credits, Parent proposes to cause Sub to make a distribution of its NOx Credits to
Parent. Thereafter, Parent proposes to exchange the NOx Credits it acquired from Sub
for VOCs Credits held by unrelated third parties. Parent would then use the VOCs
Credits to offset emissions from its trade or business.

Parent’s basis in its Sub’s stock exceeds the fair market value of the NOx Credits to be
distributed by Sub to Parent.

LAW AND ANALYSIS

Section 1031(a)(1) of the Code provides that no gain or loss shall be recognized on the
exchange of property held for productive use in a trade or business or for investment if
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such property is exchanged solely for property of like kind which is to be held either for
productive use in a trade or business or for investment.

Section 1.1031(a)-1(b) of the regulations provides, in part, that as used in § 1031(a), the
words “like kind” have reference to the nature or character of the property and not to its
grade or quality. One kind or class of property may not be exchanged for property of a
different kind or class.

Under § 1.1031(a)-2(c), intangible personal property is of like kind to other intangible
personal property only if (1) the nature or character of the rights involved are of like kind
(e.g., a patent is of like kind to a patent and a copyright is of like kind to a copyright) and
(2) the nature or character of the underlying property to which the intangible personal
property relates is of like kind. For example, an exchange of a copyright on a novel for
a copyright on a different novel is a like-kind exchange, but an exchange of a copyright
on a novel for a copyright on a song is not.

Rev. Proc. 92-91, 1992-2 C.B. 503, section 3, Q&A 5, provides that emission
allowances are treated as like-kind property for purposes of § 1031 of the Code.
Therefore, an exchange of emission allowances that would otherwise result in the
recognition of gain or loss under § 1001 is an exchange of like-kind property that
qualifies for nonrecognition treatment under § 1031, provided the other requirements of
§ 1031 are satisfied.1

Effectively, NOx Credits and VOCs Credits are government licenses or permits and
constitute intangible personal property for federal income tax purposes. See
§ 197(d)(1)(D). Accordingly, the NOx Credits and VOCs Credits will be of like kind if the
nature or character of the rights involved and the nature or character of the underlying
property to which the intangible personal property relates are of like kind.

Both the NOx Credits and the VOCs Credits are rights granted by the --------- as part of
its program to control air pollution in Region. The Credits are distributed by the -----------
to businesses operating in Region, and enable the holder to emit a certain quantity of
pollutant each year without penalty. The terms and conditions of the Credits are
identical. Thus the nature and character of the rights involved are the same.

Although NOx and VOCs are different chemical compounds, they are both ozone-
causing pollutants, and controlling ozone is the primary purpose of the Credits. As

1
Rev. Proc. 92-91 provides guidance in a question and answer (Q&A) format on certain federal income
tax consequences of the air emission allowance program (the “program”) established pursuant to Title IV
of the Clean Air Act Amendments of 1990, Pub. L. No. 101-549, 104 Stat. 2584 (1990), 42 U.S.C. section
7651 et seq. (the “Act”), with respect to utilities, non-utilities that elect to participate in the program, and
other persons that acquire, hold, or transfer sulfur dioxide emission allowances.
PLR-149323-09 4

such, the differences between the two chemical compounds, insofar as they relate to
the Credits and the purposes for issuing the Credits, should be regarded as differences
in grade or quality, not nature or character. As evidence that they are of the same
nature or character, the --------- rules make NOx and VOCs Credits interchangeable
when certain conditions are met. Furthermore, both NOx and VOCs are emitted in the
process of -------------------------------------------------. That NOx Credits are more valuable
than VOCs Credits because of their relative scarcity indicates a difference in grade or
quality between the two types of Credits but not of their nature or character.
Accordingly, the VOCs Credits and NOx Credits are of like kind.

CONCLUSIONS

1. Parent does not include the amount of the distribution of the NOx Credits received
   from Sub in its gross income. See §1.1502-13(f)(2)(ii). Parent shall reduce its basis in
   the stock of Sub by the amount of the distribution. See §1.1502-32(b)(2).

2. Sub’s gain under §311(b) with respect to the excess of the fair market value of the
   NOx Credits over Sub’s basis in the Credits shall not be taken into account upon the
   distribution of the NOx Credits to Parent or upon Parent’s exchange of those Credits
   with a third party in an exchange qualifying under §1031(a). Sub shall take the gain
   under § 311(b) into account by reference to the VOCs Credits received in the §1031(a)
   exchange rather than the NOx Credits distributed to Parent. See §§ 1.1502-13(c) and
   1.1502-13(j)(1).

3. The NOx Credits and VOCs Credits are like-kind property for purposes of § 1031(a)
   of the Code. Further, Parent is considered to have, prior to the exchange, held the NOx
   Credits for productive use in its trade or business. Thus, neither Parent nor Sub will
   recognize gain or loss as a result of Parent’s exchange of NOx Credits for VOCs Credits
   immediately following the distribution of such NOx Credits from Sub, provided all other
   requirements for deferral under § 1031, not discussed herein, are satisfied.

CAVEATS:

Except as expressly provided herein, we express or imply no opinion concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter.

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

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative(s).
PLR-149323-09 5

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement 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.

                                   Sincerely,




                                   Michael J. Montemurro
                                   Branch Chief, Branch 4
                                   (Income Tax & Accounting)

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