Transmission agreement qualified as a management contract

Plain-English summary

A taxable rural electric cooperative planned to join a regional transmission organization and give it functional control over the cooperative's transmission facilities. The cooperative would retain ownership, physical possession, important operational authority, maintenance responsibility, and the risk of loss. It could also withdraw from the organization and terminate its use of the facilities. The regional organization would collect and remit revenues, keep records, coordinate operations, and recover only its costs and expenses. The IRS concluded that these control and risk-of-loss features made the membership agreement a management contract rather than a lease for federal income tax purposes.

Ruling snapshot

• Question: Was the regional transmission organization's use of the cooperative's facilities a management contract rather than a lease?
• Outcome: Approved, the agreement was treated as a management contract
• Key authorities: IRC § 7701(e); Amerco v. Commissioner; Meagher v. Commissioner

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201525007 Third Party Communication: None
Release Date: 6/19/2015 Date of Communication: Not Applicable
Index Number: 7701.22-01
Person To Contact:
-------------------------------------------------- ----------------------------, ID No. --------------
-------------------------------- -----------------
---------------------------------------------- Telephone Number:
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------------------------------------------ Refer Reply To:
CC:ITA:B05
PLR-140132-14
Date:
March 10, 2015

              TY:-------

Legend

Taxpayer = ------------------------------------------------------------------------------
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RTO = ------------------------------------------------------------------------------
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Membership Agreement = ------------------------------------------------------------------------------
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State A = -------------------
Year 1 = -------
Service Area = ------------------------------------------------------------------------------
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Service Center = ------------------
Y = ------------------------------------------------------------------------------
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Z = -----------------------------------------------------------------------------
Section a = ------------------------------------------------------------------------------
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Section b = ------------------------------------------------------------
Section c = ------------------------------------------------------------
Section d = ------------------------------------------------------------
Section e = ------------------------------------------------------------
Section f = -------------------------------------------------------------
Section g = ------------------------------------------------------------

Dear -----------------:
PLR-140132-14 2

This is in response to your request dated October 24, 2014, as supplemented by a letter
dated December 2, 2014, for a private letter ruling that the proposed transaction
constitutes a management contract for Federal income tax purposes. The facts as
represented are set forth below.

FACTS

Taxpayer is a State A regional, consumer-owned, rural electric power cooperative
corporation incorporated to generate and deliver electric power and other energy at
wholesale to its member systems, many of which are rural electric cooperatives. For
federal income tax purposes, Taxpayer is governed by the rules applicable to
cooperatives that were in effect prior to the enactment of subchapter T of the Internal
Revenue Code of 1986 by the Revenue Code of 1962. Taxpayer is not under
examination.1 Taxpayer uses the accrual method of accounting and employs the
calendar year as its tax year. Taxpayer files its returns with Service Center.

Taxpayer is organized and operated on a not-for-profit basis. However, Taxpayer is
taxable for federal income tax purposes. Taxpayer is a membership organization with
no capital stock. Taxpayer has several classes of membership the qualifications, rights
and obligation of which are set forth in Taxpayer’s corporate bylaws. In accordance
with the laws of State A and its own corporate bylaws, Taxpayer’s margins and reserves
belong to its customer-owners and must be used to improve or maintain operations, set
aside in reserves, or be distributed to the membership. All margins allocated to the
membership are allocated on the basis of business done with Taxpayer in a given year.

Taxpayer operates in Service Area. Taxpayer provides at cost electric service to its
members as part of a three-tier delivery system. It sells wholesale power to certain
members who then sell power to their respective distribution members, who, in turn, sell
power at retail to their respective end-use customers. Taxpayer has certain members
that are themselves distribution cooperatives. Taxpayer also will sell power at
wholesale to unrelated utilities and other entities in the normal course of managing
generation capacity that is temporarily surplus to the needs of its members. Taxpayer
does not make retail sales directly to end-user retail customers.

Taxpayer is owned by the cooperative members and consumers it serves so end-user
customers have substantial input with respect to control and direction of the conduct of
Taxpayer’s business activities. Taxpayer is governed by a Board of Directors elected
by its membership, none of whom is a “related party” with respect to each other
pursuant § 318 of the Code. The Board of Directors sets policies that Taxpayer’s
management implements. With several exceptions, each director has been elected to
the board of his or her respective intermediate generation and transmission system.

1
Taxpayer does have issues before Appeals on a separate matter. The Appeals Officer was contacted in
connection with this ruling request and confirmed that Appeals has no objection to ruling in this case.
PLR-140132-14 3

Taxpayer participates in the federal loan program established by the Rural
Electrification Act of 1936, which is administered by the Rural Utilities Service (“RUS”).
As a consumer-owned, RUS borrower, Taxpayer is not a public utility subject to
comprehensive regulation by the Federal Energy Regulatory Commission (“FERC”) or
subject to regulation by state utilities commissions. As a RUS borrower, Taxpayer has
planned and constructed all its facilities for the sole purpose of serving the current and
projected power requirements of its members. It is precluded by the terms and
conditions associated with its RUS borrowing from constructing facilities that would
support merchant functions (i.e., those functions that attempt to profit from the sales of
power to unrelated third parties), although Taxpayer does sell power to unrelated third
parties from time-to-time, but only if such power is from temporary surplus to the power
needs of its membership and only under very limited circumstances.

Taxpayer’s Board of Directors set the rates with respect to its sales of electric capacity,
power and energy in accordance with Taxpayer’s bylaws and in compliance with its loan
covenants, power sales contracts and general cooperative principles. At the end of
each calendar year, the Board of Directors reviews Taxpayer’s financial position and
allocates to its members revenues in excess of operating expenses. The allocations
are made on a pro-rata basis, based upon electric energy purchased by each member
during the preceding year, and are redeemed in cash to the patrons at times when the
Board determines that it is appropriate given Taxpayer’s financial needs. As the power
requirements of its member systems have grown, Taxpayer has taken steps to ensure
the availability of power supply sufficient to meet the needs of its members.

Y and Z are two entities separate and independent from Taxpayer. Taxpayer, Y and Z
(collectively, “IS owners”), each own transmission facilities that they operate on a
coordinated basis known as an “integrated system” (“IS”). The IS owners operate under
a non-jurisdictional Open Access Transmission Tariff that has been filed with the FERC.
Y and Z are not members of Taxpayer and are not parties to this ruling request.

The IS owners have decided to transition from the current IS transmission arrangement
to a Regional Transmission Organization by becoming members of RTO. Each IS
owners has executed a separate membership agreement with RTO. RTO is a not-for-
profit § 501(c)(6) organization. RTO has numerous members including investor-owned
utilities, municipal systems, cooperatives, wholesale generators, power marketers and
independent transmission companies. RTO’s primary purposes include facilitating joint
planning and coordination of the generation and transmission systems of its members;
facilitating maintenance of coordinated operations and service reliability of its member
systems; providing a method for member dispute resolution; and preserving or
enhancing interconnected system reliability. RTO is mandated by FERC to ensure
reliable supplies of power, adequate transmission infrastructure, and competitive
wholesale prices of electricity.
PLR-140132-14 4

RTO’s members, not RTO, own the transmission facilities comprising the grid or the
generation resources comprising the energy markets. Pursuant to its FERC approved
Tariff and the terms of membership agreement with its members, RTO coordinates and
directs the real time operations of the members’ facilities comprising RTO transmission
system (“Transmission System”) to ensure that power reaches customers efficiently and
timely. RTO provides the following services to its members: (i) Tariff administration to
ensure that transmission services are offered over the Transmission System on a
nondiscriminatory basis; (ii) Reliability coordination to ensure the Transmission
System’s reliability; (iii) Monitoring compliance with applicable reliability guidelines,
standards, policies, rules, regulations, orders, etc.; (iv) Records management with
respect to maintaining and providing access to RTO’s books, records, business
practices, and control procedures as necessary to assist members in complying with
statutory and regulatory requirements including provision of quarterly and annual
reports; (v) Joint planning of activities, scheduling and overseeing the maintenance of
the Transmission System; (vi) Market operations to control the dispatch and curtailment
of the Transmission System; (vii) Expansion coordination of the Transmission System;
(viii) Monitoring the Transmission System in real time; and (ix) Revenue management
using its best efforts to maximize revenue derived from the use of individual member
transmission facilities (“Tariff Facilities”) that comprise Transmission System including
collecting and distribution revenue to its members.

To cover its costs, RTO collects nominal, annual membership fees from each member
as well as administrative charges that are applied to all transmission service on the
Transmission System. RTO’s Board of Directors establishes the administrative rate
applied to the transmission service. RTO retains only that portion of the amounts
collected that represent its administrative charges. It distributes the balance of the
revenues collected to its member systems based upon the revenue distribution
provisions of the Tariff. RTO does not earn a profit. Members are entitled to recover all
costs and expenses associated with ownership, maintenance, operation, repair and
replacement of their respective transmission facilities included in the RTO Transmission
System, which generally includes a FERC approved rate of return on their respective
investments in those facilities.

To become a member of RTO, Taxpayer has executed and delivered to RTO the
Membership Agreement, which describes the respective rights and obligations of the
members to each other and to RTO, as well as RTO’s commitments and obligations to
its members. Under Membership Agreement, RTO’s responsibilities include certain
operational and planning activities in administering transmission service over the
Transmission System and ensuring reliability of facilities subject to RTO. Membership
Agreement is fully effective in accordance with its terms subject to final FERC approval.

Pursuant to Section a of the Membership Agreement, Taxpayer will transfer “functional
control” of its Tariff Facilities to RTO, which, according to Taxpayer, means that RTO
will direct operation of Taxpayer’s Tariff Facilities in administering transmission service
PLR-140132-14 5

under RTO’s Tariff. However, under Section b, while RTO directs operations pursuant
to its Tariff, Taxpayer retains physical control and operational control of the Tariff
Facilities as discussed below. Further, under Section a, Taxpayer retains all rights of
ownership including legal and equitable title in its Tariff Facilities. In addition, Section c
sets forth RTO’s fiduciary obligations with respect to Taxpayer’s Tariff Facilities, which
include collecting and distributing revenue on behalf of Taxpayer and using its best
efforts to maximize that revenue. RTO is required to use its best efforts to administer
Taxpayer’s Tariff Facilities in the most efficient manner possible consistent with FERC
approved RTO Tariff. In addition, RTO is required to collect and remit to Taxpayer all
revenue collected by RTO for use of those facilities less only RTO’s administrative costs
and fees, which will not include any profit for RTO.

Sections a and b further provide that Taxpayer will retain certain operational authority
over its Tariff Facilities in order to protect the public safety and the safety of its workers,
or control as necessary to preserve its rights and obligations in serving its customers in
accordance with state law. RTO must to coordinate operational control with Taxpayer
whenever processing requests for transmission service over Taxpayer’s Tariff Facilities.

Under Section d of Membership Agreement, RTO is required to maintain adequate
books and records in order to comply with applicable federal and state regulatory
requirements and to permit inspection of its books, records, business practices, control
procedures, required audit test results, and related financial transactions and settlement
activities. Accordingly, RTO must collect and remit monthly to Taxpayer the revenue
received by it from third parties attributable to the use of Taxpayer’s Tariff Facilities and
to provide quarterly and annual written reports to Taxpayer.

Pursuant to Section e of Membership Agreement, Taxpayer will have the unilateral right
to terminate RTO’s right to use and possess Taxpayer’s Tariff Facilities. Taxpayer thus
may unilaterally withdraw from Membership Agreement subject only to advance notice
and withdrawal fee requirements set forth in Membership Agreement.

Pursuant to Section f, Taxpayer agrees to become subject to RTO’s bylaws and have
certain voting rights. Taxpayer expects to participate in the election of RTO directors
and work with other RTO members in various operational groups, which focus upon
specific topics relating to RTO’s operations and activities. Taxpayer will be represented
on those committees officially by elected representatives and unofficially by such
employers and other representatives as it chooses.

Sections a and g of Membership Agreement require Taxpayer to maintain its Tariff
Facilities in accordance with Good Utility Practice. Taxpayer is obligated to coordinate
and obtain RTO approval for maintenance on its Tariff Facilities. Where Taxpayer owns
or controls generation facilities within RTO’s region affecting Electric Transmission
System capability or reliability, Taxpayer agrees to coordinate maintenance of such
facilities with RTO in accordance with this agreement. Taxpayer asserts that pursuant
PLR-140132-14 6

to these provisions, it will remain fully responsible for all operating, maintenance, repair
and replacement costs, and all losses relating to the Tariff Facilities.

The Membership Agreement does not contain any provisions that transfer risk of loss
for Taxpayer’s Tariff Facilities to RTO. Consequently, Taxpayer asserts that it will retain
the full risk of any loss, physical or economic, with respect to Taxpayer’s Tariff Facilities.

Under Membership Agreement, Taxpayer is subject to the provisions for coordinated
dispatch, maintenance, and planning. Taxpayer also must subject its Tariff Facilities to
RTO administration relating to rates, terms and conditions of the RTO Tariff. Thus,
while RTO will have the authority to direct day-to-day operations of the Tariff Facilities,
Taxpayer will retain physical and operational control of its Tariff Facilities.

Taxpayer makes the following additional representations concerning becoming a
member of RTO pursuant to signing Membership Agreement:

1. The remaining useful lives of the owned and leased Tariff Facilities which
   Taxpayer expects to include in the RTO Transmission System as its Tariff
   Facilities are reasonably expected to be in excess of 25 years.
2. Taxpayer’s Tariff Facilities are, and will continue to be, located on land owned by
   Taxpayer or on land with respect to which Taxpayer has rights of possession.
3. After the transfer date, Taxpayer’s Tariff Facilities will be used to transmit its own
   energy and the energy of unrelated third parties. Taxpayer will be compensated
   for the use of its facilities by third-party customers of the Transmission System in
   accordance with the terms and conditions of the RTO Tariff.
4. Taxpayer will maintain full physical possession, financial responsibility for and
   operational control over its Tariff Facilities, subject only to the administrative
   oversight and operational authority granted RTO by the Membership Agreement.
5. Taxpayer will be compensated for third-party use of its Tariff Facilities as
   described above.
6. RTO will not acquire or be subject to any risk of loss with respect to Taxpayer’s
   Tariff Facilities, and likewise will not be entitled to earn any profit or otherwise to
   benefit economically from the use of Taxpayer’s Tariff Facilities – other than to
   recover its costs and expenses associated with performing functions and
   responsibilities set forth in the Membership Agreement and described above.

Taxpayer has requested a ruling that the Membership Agreement executed by and
between Taxpayer and RTO will treated as a management contract for Federal income
tax purposes.

LAW AND ANALYSIS

Courts have long held that the substance of an agreement rather than its form
determines its true character as a management contract, lease, or other arrangement.
PLR-140132-14 7

Amerco v. Commissioner, 82 T.C. 654 (1984); Kingsbury v. Commissioner, 65 T.C.
1068 (1976). According to the Tax Court, the two primary factors that indicate the
existence of a management contract are (1) control of the venture by the property owner
and (2) risk of loss on the property owner. Amerco, 82 T.C. at 670; Freesen v.
Commissioner, 84 T.C. 920 (1985), rev'd on other grounds, 798 F.2d 195 (7th Cir.
1986); Nigh v. Commissioner, T.C. Memo 1990-349; Meagher v. Commissioner, T.C.
Memo 1977-270.

Section 7701(e)(1) of the Code provides that a contract which purports to be a service
contract shall be treated as a lease of property if such contract is properly treated as a
lease, taking into account all relevant factors including whether or not -- (A) the service
recipient is in physical possession of the property; (B) the service recipient controls the
property; (C) the service recipient has a significant economic or possessory interest in
the property; (D) the service provider does not bear any risk of substantially diminished
receipts or substantially increased expenditures if there is nonperformance under the
contract; (E) the service provider does not use the property concurrently to provide
significant services to entities unrelated to the service recipient; and (F) the total
contract price does not substantially exceed the rental value of the property for the
contract period.

Section 7701(e) thus sets forth rules for determining whether an entity is properly
characterized as a lessor or a service provider with respect to its property. In the instant
case, however, Taxpayer is a service recipient with respect to its transmission system.
Therefore, § 7701(e) has limited applicability. Nevertheless, the legislative history to
§ 7701(e) and case law are helpful for determining the proper characterization of the
agreement between Taxpayer and RTO.

Section 7701(e)(1) was added to the Code by § 31(e) of the Tax Reform Act of 1984,
Pub. L. No. 98-369. The legislative history indicates that although each factor must be
considered, some factors may be more significant than others in the context of the
entire transaction. See S. Rpt. No. 169, 98th Cong., 2d Sess. 137-138 (1984); H. R.
Rep. No. 432 (Part 2), 98th Cong., 2nd Sess. 1152-1156 (1984). For instance, Example
(3) in the House Report, specifically references the control and risk of loss tests for
determining if a transaction structured as a management contract is, in fact, a lease. In
Example (3), E, a tax-exempt entity, owned Section-8-assisted low-income housing
projects. E sold the property to T, a partnership of taxable persons. In order to ensure
that the purposes of the Section 8 housing program are fulfilled, T retained E to manage
the property under a long-term management contract pursuant to which E continued to
perform many of the same managerial and administrative functions that it performed
before the sale. T, however, exercised a degree of control over E's activities because
the management contract required E to keep records of operations, use its best efforts
to lease the property and to pay net earnings to T within a reasonable period. E was
compensated by a fee determined on an arm's length basis. T bore the risk that the
PLR-140132-14 8

property would decline in value and that the property would be lost or destroyed. E
does not have an option to repurchase the property.

Example (3) states that the mere fact that E, a tax-exempt entity, continues to control
the maintenance and operation of the property under a management contract does not
provide a basis for treating the arrangement as a lease. However, Example (3) also
notes that the bill leaves open the possibility that an arrangement structured as a
management contract could be treated as a lease (under which the tax-exempt entity
provides services to third parties for its own benefit) under present law. Example (3)
specifically cites to McNabb v. Commissioner, 81-1 USTC paragraph 9143 (W.D. Wash.
1980); Meagher v. Commissioner, supra. H. R. Rep. No. 432, supra., at 156. See also
S. Prt. 169 (Senate Print), 98th Cong., 2d Sess. 140, Example (3) (1984).

In Meagher v. Commissioner, T.C. Memo 1977-270, the taxpayers owned a railroad
tank car and entered into a "management contract" with Relco Tank Lines pursuant to
which Relco agreed to perform all administrative functions necessary to operate the car
(including collecting the mileage or per diem earnings); to repair and maintain the car; to
keep records of the car's operation; to insure the car; and to use its "best efforts" to
lease the car to shippers, railroads, or others. The taxpayers agreed to pay Relco a
quarterly fee equal to 35 percent of the gross operating profit earned by the car and to
defend and hold Relco harmless from any loss or damage to the car.

In order to determine whether the "management contract" was in fact a lease, the Tax
Court examined whether the owners of the railroad tank car retained control over the
venture and had the risk of loss with respect to the property. Concerning the control
factor, the Tax Court in Meagher found that although the taxpayers did not directly
control the leasing activities of Relco, they did insert provisions in the agreement
requiring Relco to keep adequate records of the car's operation; to use its best efforts to
lease the car; to obtain insurance coverage for the car naming taxpayers as co-
beneficiaries; and to pay the net earnings of the car to taxpayers within ninety days after
the end of the calendar quarter. The court found that such provisions provided the
taxpayers with sufficient control over the venture to support a conclusion that the
agreement was a management contract. Concerning the risk of loss factor, the court
acknowledged that the taxpayers agreed to reimburse Relco upon demand for any
expenses incurred by the tank car in excess of a $ 200.00 reserve and to defend,
indemnify, and hold Relco harmless from and against all risk of loss or damage to the
tank car as well as all claims, damage, expenses or liabilities incurred by, or asserted
against Relco, as a result of the operation, possession, control or use of the tank car.
Consequently, the court also found that the taxpayers' risk of loss was sufficient to
support a finding that the transaction was a management contract.

An analysis of the above factors indicates that under the Membership Agreement,
Taxpayer retains sufficient control and risk of loss over its Tariff Facilities for the
PLR-140132-14 9

Membership Agreement to be treated as a management contract.2 Concerning the
control factor, several provisions of the Membership Agreement indicate that Taxpayer
retains control over its Tariff Facilities. As outlined in the facts, these provisions require
RTO to: (i) maintain adequate records in order to comply with applicable federal and
state regulatory requirements, and to permit inspection of those records by Taxpayer;
and (ii) exercise its fiduciary duty to use best efforts to maximize revenue to Taxpayer
with regard to Taxpayer’s Tariff Facilities, to collect and remit net revenues to Taxpayer,
and to provide quarterly and annual reports to Taxpayer. Further, Taxpayer retains
greater operational control over the Tariff Facilities than did the taxpayers in Meagher,
supra. In the instant case, Taxpayer retains operational control over the Tariff Facilities
when necessary to serve its customers or to ensure that it will meet its regulatory
requirements, and RTO must coordinate with Taxpayer when scheduling transmission
service over Taxpayer’s Tariff Facilities.

Further, the ability of a property owner to terminate the user's right to use and possess
the property is indicative of a management contract. See Nigh v. Commissioner, T.C.
Memo 1990-349. In the instant case, Taxpayer has the unilateral right to withdraw from
membership in RTO and thus to terminate RTO’s use of Taxpayer’s Tariff Facilities. In
addition, the ability of an owner to sell or assign property without the user's consent is
also indicative of a management contract. See Amerco, 82 T.C. at 682. Taxpayer here
represents that it can sell any of its Tariff Facilities subject only to advance notice and
withdrawal fee requirements set forth in Membership Agreement. Such withdrawal and
sale are consistent with a management contract.

Concerning the risk of loss factor, there is no provision in the Membership Agreement
that shifts the risk of loss with respect to the Taxpayer's Tariff Facilities to RTO. As
owner of these properties and facilities, Taxpayer remains ultimately responsible for all
operating and maintenance costs. Any losses incurred in operating the Tariff Facilities
System are solely for the account of Taxpayer. As represented by Taxpayer, RTO will
not acquire or be subject to any risk of loss with respect to Taxpayer’s Tariff Facilities,
and likewise will not be entitled to earn any profit or otherwise to benefit economically
from the use of Taxpayer’s Tariff Facilities, other than to recover its costs and expenses
associated with performing functions and responsibilities set forth in the Membership
Agreement. Lastly, RTO’s compensation depends upon gross revenue for transmission
service. It is unable to profit from that service. Consequently, RTO has no interest in,
and therefore has no risk from the net operating profits of Taxpayer’s Tariff Facilities.

In our view, the relationship of the parties under the Management Agreement is
consistent with the control and risk of loss analysis in Example (3) and the cases cited
above for concluding that this transaction is, in fact, a management contract.

HOLDING
2
PLR 199940040 (July 13, 1999) contains an excellent discussion of the law in this area and how it
applies to facts very similar to the facts in the instant case.
PLR-140132-14 10

We therefore conclude that the Membership Agreement between Taxpayer and RTO
concerning the use and operation of Taxpayer's Tariff Facilities will be considered a
management contract for Federal income tax purposes.

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. It has no force or effect with
respect to Y and Z, the other IS Owners, who may also become involved as members of
RTO. Section 6110(k)(3) of the Code provides that it may not be used or cited as
precedent.

A copy of this letter must be attached to the Federal income tax return of Taxpayer for
the taxable year in which the transaction covered by this ruling letter occurs.
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 Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. No opinion is expressed or implied by this office concerning the
correctness of the representations made by Taxpayer. 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,



                                   William A. Jackson
                                   Branch Chief, Branch 5
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)