Transmission-upgrade reimbursements are not capital contributions

Plain-English summary

An electric and gas utility had to upgrade its transmission system to accommodate a new transmission project linking two regional grids. A municipal power entity ultimately paid the upgrade costs because it had contracted for a share of the project's transmission capacity and expected to use the connection to serve its metropolitan-area customers. The utility argued that the reimbursements were nonshareholder contributions to capital under § 118 because the project also improved reliability, safety, and access to cleaner generation for the broader public. The IRS focused on the payer's motivation. It concluded that the municipal entity paid for the direct benefit of its own customers, even though the public also benefited. The reimbursements therefore were not excludable capital contributions under § 118(a).

Ruling snapshot

• Question: Were payments reimbursing the utility for transmission-system upgrades nonshareholder contributions to capital under § 118(a)?
• Outcome: Denied, the reimbursements were not capital contributions
• Key authorities: IRC §§ 61 and 118; Detroit Edison Co. v. Commissioner; Brown Shoe Co. v. Commissioner; United States v. Chicago, Burlington & Quincy Railroad Co.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201451007 Third Party Communication: None
Release Date: 12/19/2014 Date of Communication: Not Applicable
Index Number: 118.01-04
Person To Contact:
------------------------- ----------------, ID No. ------------------
------------------------------------------------- Telephone Number:
--------------------------- ----------------------
-------------------------- Refer Reply To:
CC:PSI:B05
In Re: PLR-109652-14
------------------------------------- Date:
----------------------- September 05, 2014

Legend

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

Corp 1 = ------------------------------------

Corp 2 = -------------------------------------------------

Corp 3 = -----------------------------------

Corp 4 = ------------------------------------------------------------------

Administrator 1 = ------------------------------------

Administrator 2 = --------------------------------------------------------------

State 1 = --------------

State 2 = -----------------

City 1 = --------------------

City 2 = -------------------------------

Agreement 1 = ------------------------------------------------

Agreement 2 = -------------------------------------------------------------------

Agreement 3 = --------------------------------------------------------------------
PLR-109652-14 2

Right 1 = ------------------------------------------------

Right 2 = ---------------------------------------

System 2 = --------------------------------------------------------------------------------

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

Year 1 = -------

Year 2 = -------

Date 1 = ------------------

Date 2 = --------------

Date 3 = ---------------

b = -----

c = ----

d = -----

e = ----

f = -----

g = ----------------

h = ----------------

i = ----------------

j = ----------------

k = ----

l = -----

m = ----

n = ----
PLR-109652-14 3

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

   This letter responds to a request for a ruling dated March 7, 2014, and

subsequent correspondence, submitted on behalf of Taxpayer by your authorized
representatives. Taxpayer requested a ruling that certain payments Taxpayer receives
from Corp 1 are contributions to the capital of Taxpayer under § 118(a) of the Internal
Revenue Code. The relevant facts as represented in your submission are set forth
below.

    Taxpayer is an electric and gas utility primarily engaged in the transmission and

distribution of electric energy and gas service in State 2. Taxpayer owns and maintains
an electric transmission system in State 2 (Taxpayer’s System) and is a transmission
owning member of Administrator 1. Taxpayer is wholly owned by Corp 4. Both
Taxpayer and Corp 4 are State 2 corporations. Taxpayer is included in a consolidated
federal income tax return of which Corp 4 is the common parent.

    Corp 1 is a corporate municipal instrumentality and political subdivision of State 1

that owns, maintains, and operates electric energy generation and transmission facilities
in State 1. Corp 1’s mission is to provide clean, low-cost and reliable energy for its
customers and all residents of State 1. Corp 1 generates, transmits, purchases, and
sells electricity to provide electric service to its numerous customers throughout State 1.
In Year 2, approximately e of Corp 1’s customer sales were to its City 1 ---------------------
customers.

    In Year 1, Corp 1 authorized contract negotiations with Corp 2 to meet the

growing electric needs of electricity consumers in the City 1 metropolitan area. As a
result, Corp 1 entered into an agreement with Corp 2 for the development of a b
megawatt transmission line connecting the electric transmission grids of ------------ State
2 and City 2 (the Project), which Corp 2 agreed to build, own, and operate. Corp 1 also
agreed to pay for and received the rights to c percent of the transmission capacity of the
Project (or d megawatts). The Project also establishes a connection between the
regional transmission grids administered by Administrator 1 and Administrator 2. The
State 2 connection interties to and is owned and operated by Taxpayer. The City 2
connection interties to and is owned and operated by Corp 3, a transmission-owning
member of Administrator 2.

   In order for the regional transmission grid to accommodate the expected

increased electric energy flows on Taxpayer’s System created by the Project,
Administrator 1 required Taxpayer to complete a number of upgrades to Taxpayer’s
System (the Upgrades). Pursuant to an agreement among Administrator 1, Taxpayer,
and Corp 2, Corp 2 is liable for reimbursing Taxpayer for the costs of the Upgrades.
PLR-109652-14 4

    Specifically, Taxpayer entered into Agreement 1 with Administrator 1 and Corp 2,

under which Corp 2 agreed, among other things, to reimburse Administrator 1 for the
cost of the Upgrades. Agreement 1 also enables Administrator 1 to award Corp 2
certain transmission rights (Right 1 and Right 2). Corp 2 assigned a portion of these
rights to Corp 1.

  As required by the Administrator 1 rules, Corp 2 entered into Agreement 2 with

Administrator 1 and Taxpayer for Taxpayer to construct the Upgrades. Pursuant to
Agreement 2, Taxpayer agreed to construct the Upgrades on Taxpayer’s System at
Corp 2’s cost. Agreement 2 also requires Corp 2 to indemnify Taxpayer for any taxes
associated with the Upgrades.

    As of Date 1, only a portion of the Upgrades were completed, and Administrator

1 had only awarded k megawatts of Right 1. However, Corp 1 is able to schedule
electric energy deliveries from Administrator 1 into City 1 over the Project up to the
maximum electric transmission capability available, but may schedule only k megawatts
on a firm basis. Once all Upgrades have been completed, Corp 1 will be able to
schedule electric energy deliveries of up to f megawatts of electric energy on a firm
basis at all times, and the remainder of its d megawatt entitlement on a non-firm basis.

   In order to effectuate the development of the Project, Corp 1 and Corp 2 entered

into a n-year Agreement 3 under which Corp 2 agreed to build, own, and operate the
Project, and Corp 1 agreed to pay for, and received the rights to, c percent or d
megawatts of the total transmission capacity of the Project. Corp 1 agreed to make
monthly contract payments to Corp 2 for the transmission capacity share of the Project
and to reimburse Corp 2 for the full cost of the Upgrades.

    Although Corp 1 is ultimately responsible for the full cost of all Upgrades on

Taxpayer’s System, Corp 1 only has the rights to c percent of the Project’s transmission
capacity. Corp 1 is obligated to make the monthly payments regardless of whether or
not it uses its full share of the transmission capacity. Since the Project’s Date 3
commencement of operations, Corp 1 has only used an average of l megawatts per
month.

    Agreement 3 also provides that when Administrator 1 awards Right 1 for the

Project, Corp 2 will assign the first f megawatts of Right 1 and c percent of Right 2 to
Corp 1. Corp 2 retained m percent of the Project transmission capacity for its own use
as a merchant transmission operator. Corp 1 has not yet received and does not
anticipate receiving Right 2 in connection with the Project.

   Although in Year 1, Corp 1 expected to earn revenues from economic electric

sales using its portion of the transmission capacity of the Project, and Administrator 1
will award Right 2, Corp 1 does not anticipate earning sufficient revenue to recover its
payments for the Upgrades or monthly capacity payments to Corp 2 under Agreement
PLR-109652-14 5

3. In Year 1, Corp 1 estimated that the under-recovery of its costs would range
   between $g and $h. However, Corp 1 acknowledges that Agreement 3 includes
   provisions designed to provide more long-term value for, and help prevent losses to
   Corp 1.

    Corp 1 acknowledges that the estimated under-recovery amount does not take
   

   into consideration yet-to-be negotiated customer agreements with Corp 1’s -----------------
   ------------------- customers. In Year 1, Corp 1 contemplated entering into customer
   agreements to collect fixed monthly payments from the City 1 -------------------- customers
   to help defray but not eliminate Corp 1’s under-recovery. However, those negotiations
   to date have not resulted in any recovery mechanism for the Project costs.

   Agreement 3 requires Corp 1 to reimburse Corp 2 for the cost of the Upgrades
   and any associated tax costs. Corp 1 began that process on Date 2, shortly after the
   commercial operation of the Project, when it reimbursed Corp 2 $j for the cost of the
   Upgrades to Taxpayer’s System and System 2 (excluding associated tax costs). Corp 2
   and Corp 1 subsequently arranged for Corp 1 to remit such payments directly to
   Administrator 1 in the future. Also on Date 2, Corp 1 posted security with Administrator
   1 for an additional $i of remaining Upgrade costs and posted security for the associated
   tax costs. Meanwhile Corp 1 has paid Administrator 1 for the costs of the continued
   Upgrade work. Corp 2 remains contractually liable to Taxpayer in the event Corp 1
   were to fail to reimburse the cost of the Upgrades.

    Taxpayer represents that the Project benefits the public at large in State 1
   

   because the Project provides enhanced transmission reliability and security, significant
   economic benefits to electricity consumers, increased public safety, and increased
   access to cleaner generation. Also, the Project indirectly benefits the general public in
   State 1 through improvements to the essential public services provided by the City 1 ----
   -------------------- customers. In addition, the Project enhances the performance of Corp
   3’s entire delivery system. Therefore, all electricity consumers in the metropolitan area
   of City 1, the vast majority which are not power customers of Corp 1, will receive direct
   benefits from the Project. Additionally, because Corp 1 is the sole electric supplier to its
   City 1 ------------------- customers, numerous essential public services depend on Corp 1
   for electricity. Taxpayer represents that City 1’s -------------------- customers will only
   receive benefits of the Project in their capacity as members of the public at large, and
   they will not receive any benefits of the Project beyond those received by all electricity
   consumers in State 1 who are not customers of Corp 1.

   Taxpayer requests a ruling that the payments Taxpayer receives from Corp 1as
   reimbursement for the Upgrades are contributions to the capital of Taxpayer under
   § 118(a).

   Section 61 and § 1.61-1 of the Income Tax Regulations provide that gross
   income means all income from whatever source derived, unless excluded by law.
   PLR-109652-14 6

   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) provides that the term “contribution to the capital of the taxpayer”
   does not include any contribution in aid of construction or any other contribution as a
   customer or potential customer.

   Section 1.118-1 of the Income Tax Regulations provides that in the case of a
   

   corporation, § 118 provides an exclusion from gross income with respect to any
   contribution of money or property to the capital of the taxpayer. Thus, if a corporation
   requires additional funds for conducting its business and obtains such funds through
   voluntary pro rata payments by its shareholders, the amounts so received being
   credited to its surplus account or to a special account, such amounts do not constitute
   income, although there is no increase in the outstanding shares of stock of the
   corporation. In such a case the payments are in the nature of assessments upon, and
   represent an additional price paid for, the shares of stock held by the individual
   shareholders, and will be treated as an addition to and as a part of the operating capital
   of the company. Section 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 inducing the corporation to locate its business in a particular community,
   or for the purpose of enabling the corporation to expand its operating facilities.

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

   This [section 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 contribution as a
   payment for future services.

   S. Rep. No. 1622, 83rd 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 customer’s 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.
   PLR-109652-14 7

   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, 413 (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.

   Therefore, to determine whether or not Corp 1’s payments for the Upgrades are
   contributions to capital under § 118, we must examine Corp 1’s motivation for making
   the payments. While we recognize that the Upgrades will benefit the general public, we
   believe, based on the facts submitted, that Corp 1 was motivated to pay for the
   Upgrades for the direct benefit of its own customers.

   Therefore, we rule that the payments Taxpayer receives from Corp 1 as
   reimbursement for the Upgrades are not contributions to the capital of Taxpayer under
   § 118(a).
   PLR-109652-14 8

   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.

   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.

   This ruling is 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.

    In accordance with the Power of Attorney on file with this office, a copy of this
   

   letter is being sent to your authorized representative.

                                            Sincerely,
   
                                            Nicole Cimino
                                            Senior Technician Reviewer, Branch 5
                                            Office of Associate Chief Counsel
                                            (Passthroughs and Special Industries)
   

Enclosure: 6110 copy

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