PLR 1341029: IRS allows a utility to deduct renewable-energy incentive payments

Plain-English summary

The IRS ruled that an electric utility may currently deduct payments it makes to customers to encourage them to install eligible renewable-energy systems. The payments help the utility comply with state renewable-energy requirements and are ordinary and necessary business expenses under section 162(a). The IRS also ruled that the payments do not have to be capitalized under section 263(a), because the associated renewable-energy credits had no market value and the contracts did not create a separate and distinct intangible asset. The ruling is useful for understanding the treatment of regulated utility incentive payments on the specific facts presented.

Ruling snapshot

• Question: Could the utility deduct its annual upfront incentive payments, rather than capitalize them?
• Outcome: Approved
• Key authorities: IRC §§ 162(a), 161, 263(a), and 6110(k)(3); Treas. Reg. §§ 1.162-1(a) and 1.263(a)-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201341029 Third Party Communication: None
Release Date: 10/11/2013 Date of Communication: Not Applicable
Index Number: 162.00-00, 263.00-00
Person To Contact:
------------------------------------------ -----------------------, ID No. -------------------
------------------- ---------------------------------------------------
-------------------------- Telephone Number:
----------------------
Attn: --------------------------- Refer Reply To:
------------------------------------------ CC:ITA:B01
----------------------------------- PLR-135992-12
Date:
February 15, 2013

Legend

Sub = ----------------------------------------------------------------------
Parent = -------------------------------------------------------------------
City = -----------
State = -----------
Rules = ---------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
Commission = ----------------------------------------------
D1 = ----------------------------
x = --
y = --

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

This responds to your letter dated July 25, 2012, requesting rulings on behalf of
Sub. Parent requests rulings on the federal income tax consequences of certain “Up
Front Incentive” payments (“UFIs”) made by Sub.

                                         RULINGS REQUESTED

(1) The annual amount of UFIs made by Sub is currently deductible under § 162(a) of
the Internal Revenue Code.

(2) The annual amount of UFIs made by Sub is not capitalized under § 263(a).
PLR-135992-12 2

                                              FACTS

Parent is the parent corporation of a group of affiliated corporations that file a
consolidated return for U.S. federal income tax purposes. Sub, a member of the
consolidated group, provides electric service to a diverse group of residential,
commercial, industrial, and public sector customers in the city and suburbs of City,
State.

As an electric utility operating in State, Sub is subject to the regulatory authority of the
Commission. On D1, the Commission adopted the Rules requiring electric utility
companies operating in State to produce a certain amount of renewable energy each
year. Compliance with the renewable energy requirements in the Rules is measured by
“renewable energy credits” (“RECs”). A single REC represents x kWh of renewable
energy generated by an renewable energy resource. A utility in State meets its
renewable energy requirements by retiring a sufficient amount of RECs to satisfy the
renewable energy requirements. Under the Rules, at least a certain percentage of the
renewable energy must come from “distributed energy”—that is, energy created by
equipment owned by the particular utility’s customer and located on that customer’s
premises. As a result, Sub was required to implement a plan to comply with the Rules,
and to allocate specific funding for each segment of the plan, including the distributed
energy requirement.

To meet its distributed energy requirement, Sub makes UFIs to incentivize customers
(both residential and commercial) to purchase and install certain -------------------------------
---------- systems. UFIs are one-time, up-front payments based on potential energy
production and made to a customer who agrees to purchase, install, and maintain an
eligible system. The amount of UFI payments is regulated by the Commission and is
subject to change year to year and also mid-year. UFI rates are not based on the value
of the renewable energy or the RECs actually produced.

Under the Rules, a REC is defined as the unit created to track kWh derived from ---------
------------------------------------------------ or kWh equivalent of conventional energy
resources displaced by ------------------------------------------------------. The Rules also
provide that a REC is the “property” of the owner of the -------------------------------------------
--------------------------------------------------------------------------------------------------------------.
RECs derived from distributed energy (“distributed energy RECs”) must be assigned to
the Utility under the UFI contracts. The customer does not agree to produce any certain
minimum number of RECs, and no refund or partial refund of the UFI is required as long
as the System is maintained and not removed.

Parent represents on behalf of Sub that RECs are merely used as a scorekeeping
mechanism for measuring a utility’s compliance with the Rules. The distributed energy
RECs are retired by Sub to satisfy its distributed energy requirements under the Rules.
There is no market for distributed energy RECs in State or elsewhere. No other utility
PLR-135992-12 3

would want the customer’s distributed energy RECs because they would not be
distributed energy RECs as to the other utility (i.e. they would not have been produced
by a customer of that other utility). To date, neither Sub nor any other subsidiary of
Parent has ever sold, transferred, or traded a distributed energy REC. The assignment
of the RECs provides no long-term benefit to Sub other than allowing Sub to comply
with state law.
LAW AND ANALYSIS

Ruling Request 1

Section 162(a) provides generally that taxpayers may deduct all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business. See also § 1.162-1(a) of the Income Tax Regulations. In order to be
deductible under § 162, an expenditure must be (1) paid or incurred during the taxable
year, (2) related to carrying on a trade or business, and (3) ordinary and necessary for
the trade or business. Commissioner v. Lincoln Savings and Loan Ass’n, 403 U.S. 345,
352 (1971).

The term “ordinary” refers to an expenditure that is normal, usual, or customary. Deputy
v. du Pont, 308 U.S. 488, 495 (1940). An expenditure may be ordinary if it is commonly
and frequently incurred in the type of business involved. Id. (citing Welch v. Helvering,
290 U.S. 111, 114 (1933)).

The term “necessary” means appropriate and helpful to the development of the
taxpayer’s business. Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (quoting
Welch, 290 U.S. at 113); Commissioner v. Heininger, 320 U.S. 467, 471 (1943). A
payment may be appropriate and helpful to the development of a taxpayer’s business if
that payment is mandated by a state governmental entity which confers upon the
taxpayer the right to conduct its business in that state. See Rothner v. Commissioner,
T.C. Memo. 1996-442.

The UFIs that Sub pays to its customers are currently deductible as ordinary and
necessary business expenses. Sub provides electric service in State, and is subject to
the regulatory authority of the Commission. Sub makes UFIs to customers in order to
comply with the Rules implemented by the Commission. The Commission’s imposition
and oversight of the Rules generally and, in particular, the UFI requirements show that
the UFIs are ordinary expenses of Sub. Moreover, as an electric utility operating in
State, Sub is subject to the regulatory authority of the Commission, and must comply
with the renewable energy requirements in the Rules imposed by the Commission. The
UFIs are paid in order to comply with rules of the governmental entity regulating Sub’s
right to conduct its business operations in State, and failure to make those UFIs could
jeopardize Sub’s continued business operations in State. The UFIs are appropriate and
helpful to Sub’s business, and therefore, the UFIs are necessary expenses.
PLR-135992-12 4

Accordingly, we conclude that the UFIs are ordinary and necessary business expenses,
and are currently deductible under § 162.

Ruling Request 2

Under § 161, if a cost is a capital expenditure, the capitalization rules of § 263 take
precedence over the deduction rules of § 162. Commissioner v. Idaho Power Co., 418
U.S. 1, 17 (1974). Therefore, a capital expenditure cannot be deducted under § 162,
regardless of whether the expenditure is ordinary and necessary in carrying on a trade
or business.

Section 263(a) provides generally that no deduction is allowed for any amount paid out
for new buildings or for permanent improvements or betterments made to increase the
value of any property or estate or any amount expended in restoring property or in
making good the exhaustion thereof for which an allowance is or has been made.

Section 1.263(a)-4 provides the rules for applying § 263(a) to amounts paid to acquire
or create intangibles. In relevant part, § 1.263(a)-4(b)(1) provides that a taxpayer must
capitalize an amount paid to acquire or create an intangible, or to create or enhance a
separate and distinct intangible asset.

First, we address whether Sub's payments to customers under the UFI contracts are
required to be capitalized as costs to acquire an intangible. Under § 1.263(a)-4(c), a
taxpayer must capitalize amounts paid to another party to acquire any intangible from
that party in a purchase or similar transaction. Sub is not acquiring an intangible within
the scope of § 1.263(a)-4(c).

Though the Rules provide that a REC is the “property” of the owner of the renewable
energy resource, the Rules also provide that RECs were created to track kWh derived
from ----------------------------------------------------. In this case, the distributed energy RECs
have no value and are used only to track the amount of renewable energy produced
during the year. Therefore, UFIs are not required to be capitalized under § 1.263(a)-
4(c).

Second, we address whether Sub's payments to customers under the UFI contracts are
required to be capitalized as costs to create an intangible. Section 1.263(a)-4(b)(1)(ii)
provides that a taxpayer must capitalize an amount paid to create an intangible
described in § 1.263(a)-4(d). Sub is not creating an intangible described under
§ 1.263(a)-4(d).

Finally, we address whether Sub's payments to customers under the UFI contracts are
required to be capitalized as costs to create or enhance a separate and distinct
intangible asset. The term “separate and distinct intangible asset” is defined as a
property interest of ascertainable and measurable value in money's worth that is subject
PLR-135992-12 5

to protection under applicable state, federal or foreign law and the possession and
control of which is intrinsically capable of being sold, transferred or pledged (ignoring
any restrictions imposed on assignability) separate and apart from a trade or business.
Section 1.263(a)-4(b)(3)(i).

Section 1.263(a)-4(b)(3)(ii) provides that amounts paid to another party to create,
originate, enter into, renew or renegotiate an agreement with that party that produces
rights or benefits for the taxpayer are treated as amounts that do not create a separate
and distinct intangible asset. The UFI contracts are agreements that produce rights or
benefits for the taxpayer and, therefore, cannot be separate and distinct intangible
assets as defined by § 1.263(a)-4(b)(3).

Accordingly, the UFIs that Sub pays to its customers are not required to be capitalized
as costs to create or enhance a separate and distinct intangible asset under § 1.263(a)-
4(b)(1)(iii).

                                  CONCLUSIONS

(1) The annual amount of UFIs made by Sub is currently deductible under § 162(a).

(2) The annual amount of UFIs made by Sub is not capitalized under § 263(a).

Except as expressly provided herein, no opinion is expressed or implied 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 representatives.

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.
PLR-135992-12 6

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,



                                 Lewis K Brickates
                                 Branch Chief, Branch 1
                                 Office of Associate Chief Counsel
                                 (Income Tax & Accounting)