Solar facilities are not public utility property under market-based rates

Plain-English summary

A regulated electric utility planned to construct three solar facilities and allocate their output among state-regulated, non-jurisdictional, and wholesale customers. Property is public utility property for the depreciation normalization rules only when it supplies electricity at regulated rates determined on a rate-of-return basis. The state-regulated portion would use an approved market-index rate, the non-jurisdictional portion would use bilaterally negotiated rates, and the wholesale portion would use negotiated or wholesale-market rates. The IRS ruled that none of the three portions was public utility property because the applicable rates were not based on the utility’s rate of return, and some were not regulator-established at all. The ruling did not decide ownership, asset classification, or whether an electricity-sale contract was a service contract.

Ruling snapshot

• Question: Are portions of the solar facilities public utility property subject to the depreciation normalization rules?
• Outcome: Approved
• Key authorities: IRC §§ 168(f)(2) and 168(i)(10); former IRC §§ 46(f) and 167(l)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201619005                                              Third Party Communication: None
Release Date: 5/6/2016                                         Date of Communication: Not Applicable
Index Number: 167.22-01
                                                               Person To Contact:
-----------------------------------------------------          ----------------------, ID No. ----------------
----------------------------------                             Telephone Number:
--------------------------                                     --------------------
----------------------------                                   Refer Reply To:
                                                               CC:PSI:B06
                                                               PLR-136207-15
                                                               Date:
                                                               February 9, 2016




LEGEND:

Taxpayer                   =         --------------------------------------------------
----------------------------------------------------------
Parent                     =        -----------------------------------
-----------------------------------------------------------
State A                    =        ---------
State B                    =        ------------------
Commission A               =        --------------------------------------------------
Commission B               =        ----------------------------------------------
Commission C               =        ----------------------------------------------------
A                          =        ------
B                          =        ------
C                          =        ----
Date A                     =        -----------------------
Year A                     =        ------
X                          =        ---
Y                          =        ---------
Facility A                 =        ---------------------------------------------------------
Facility B                 =        ---------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------
Facility C                 =        ---------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------
Director                   =         --------------------------------------------------------------------------------
                           -----------------------------------------------------------------------------------
---------------------------------------------------

Dear ------------------:
PLR-136207-15                                  2

        This letter responds to your representative’s request dated October 30, 2015, for
a ruling on whether the Facility described below is classified as public utility property
within the meaning of former section 46(f), § 168(i)(10), and the regulations
promulgated thereunder for purposes of the application of the normalization rules to that
Facility.

       The representations set out in your letter follow.

        Taxpayer, a wholly-owned subsidiary of Parent, is a public utility primarily
engaged in the business of generating, transmitting, distributing, and selling electric
power to customers in State A and State B. It is subject to regulation by Commission A,
Commission B, and Commission C with respect to terms and conditions of services,
including the rates it may charge for its services. Commission A and Commission B
generally establish Taxpayer’s rates based on Taxpayer’s costs, including a provision
for a return on the capital employed by Taxpayer in its regulated business. To the
extent Taxpayer’s sales are under the jurisdiction of Commission C, its rates are
established through negotiation and/or by the wholesale market. Finally, approximately
B percent of Taxpayer’s load is used to provide electricity to certain non-jurisdictional
retail customers, generally governmental entities located in State A. The rates for the
non-jurisdictional customers are established by means of bi-lateral negotiations
between Taxpayer and the customer rather than as tariffs established by regulatory
authorities.

        State A law allows a stand-alone ratemaking proceeding for utilities within their
jurisdiction to recover their cost for certain types of facilities, including those generating
electricity through the use of solar energy. Under this provision, the utility may propose
to Commission A the recovery of its costs based on a market index rather than a more
traditional cost of service model. Taxpayer developed a plan to build or acquire several
solar energy facilities, intending to use the stand-alone ratemaking proceeding to
recover its costs. In Year A Taxpayer solicited power purchase agreement proposals to
acquire approximately X megawatts of electricity generated by solar facilities located
within State A. Using the proposals received, Taxpayer developed a market index,
which Taxpayer has proposed to Commission A, providing for a rate of $Y per
megawatt hour for the electricity produced at the solar facilities. The stand-alone
ratemaking will also provide an annual true-up, but such true-up will not include
differences between projected and actual costs, as would be the case if the ratemaking
were based on a traditional cost of service methodology. .

        On Date A, Taxpayer filed an application with Commission A for a certificate of
public and necessity allowing construction of Facility A, Facility B, and Facility C (the
Facilities), as well as its request for approval of Taxpayer’s proposed market index to
recover the cost of the Facilities. If Commission A approves the applications as filed,
Taxpayer will construct the Facilities. The energy produced by the facilities will be
allocated approximately as follows: A percent to customers within the jurisdiction of
PLR-136207-15                                 3

Commission A, B percent to non-jurisdictional customers, and C percent to customers
under the jurisdiction of Commission C.

       Taxpayer requests that we rule as follows:

       (1) Assuming Commission A adopts Taxpayer’s Market Index rate adjustment
clause proposal, that portion of the three Facilities subject to the jurisdiction of
Commission A will not constitute “public utility property” within the meaning of former
section 46(f), § 168(i)(10), and the regulations promulgated thereunder.

      (2) That portion of the three Facilities that serves the non-jurisdictional retail
customers in State A will not constitute “public utility property” within the meaning of
former section 46(f), § 168(i)(10), and the regulations promulgated thereunder.

        (3) That portion of the three Facilities that serves Commission C wholesale
customers will not constitute “public utility property” within the meaning of former section
46(f), § 168(i)(10), and the regulations promulgated thereunder.

Law and Analysis

       Section 168(f)(2) of the Code provides that the depreciation deduction
determined under § 168 shall not apply to any public utility property (within the meaning
of § 168(i)(10)) if the taxpayer does not use a normalization method of accounting.

        Section 168(i)(10) of the Code defines, in part, public utility property as property
used predominantly in the trade or business of the furnishing or sale of electrical energy
if the rates for such furnishing or sale, as the case may be, have been established or
approved by a State or political subdivision thereof.

        Prior to the Revenue Reconciliation Act of 1990, the definition of public utility
property was contained in § 167(l)(3)(A) and § 168(i)(10), which defined public utility
property by means of a cross reference to § 167(l)(3)(A). The definition of public utility
property is unchanged. Section 1.167(l)-1(b) provides that under § 167(l)(3)(A),
property is public utility property during any period in which it is used predominantly in a
§ 167(l) public utility activity. The term "section 167(l) public utility activity" means, in
part, the trade or business of the furnishing or sale of electrical energy if the rates for
such furnishing or sale, as the case may be, are regulated, i.e., have been established
or approved by a regulatory body described in § 167(l)(3)(A). The term "regulatory body
described in section 167(l)(3)(A)" means a State (including the District of Columbia) or
political subdivision thereof, any agency or instrumentality of the United States, or a
public service or public utility commission or other body of any State or political
subdivision thereof similar to such a commission. The term "established or approved"
includes the filing of a schedule of rates with a regulatory body which has the power to
PLR-136207-15                                  4

approve such rates, though such body has taken no action on the filed schedule or
generally leaves undisturbed rates filed by the taxpayer.

        The definitions of public utility property contained in § 168(i)(10) and former §
46(f)(5) are essentially identical. Section 1.167(l)-1(b) restates the statutory definition
providing that property will be considered public utility property if it is used
predominantly in a public utility activity and the rates are regulated. Section 1.167(l)-
1(b)(1) provides that rates are regulated for such purposes if they are established or
approved by a regulatory body. The terms established or approved are further defined
to include the filing of a schedule of rates with the regulatory body which has the power
to approve such rates even though the body has taken no action on the filed schedule
or generally leaves undisturbed rates filed.

         The regulations under former section 46, specifically § 1.46-3(g)(2), contain an
expanded definition of regulated rates. This expanded definition embodies the notion of
rates established or approved on a rate of return basis. This notion is not specifically
provided for in the regulations under former section 167. Nevertheless, there is an
expressed reference to rate of return in § 1.167(l)-1(h)(6)(i). The operative rules for
normalizing timing differences relating to use of different methods and periods of
depreciation are only logical in the context of rate of return regulation. The normalization
method, which must be used for public utility property to be eligible for the depreciation
allowance available under § 168, is defined in terms of the method the taxpayer uses in
computing its tax expense for purposes of establishing its cost of service for ratemaking
purposes and reflecting operating results in its regulated books of account. Thus, it is
clear that, for purposes of application of the normalization rules, the definition of public
utility property is the same for purposes of the investment tax credit and depreciation.

        Thus, the key factors in determining whether property is public utility property are
that (1) the property must be used predominantly in the trade or business of the
furnishing or sale of, inter alia, electrical energy; (2) the rates for such furnishing or sale
must be established or approved by a State or political subdivision thereof, any agency
or instrumentality of the United States, or by a public service or public utility commission
or similar body of any State or political subdivision thereof; and (3) the rates so
established or approved must be determined on a rate-of-return basis. As a preliminary
matter, the Facilities are all used primarily in the trade or business of furnishing
electrical energy, satisfying the first factor. Here, Taxpayer will construct the Facilities
and it’s costs will be recovered, to the extent relevant here, under three different
methodologies.

        First, for electricity produced by the Facilities and allocated to customers within
the jurisdiction of Commission A, Taxpayer’s rates will be determined under a market
index approved by Commission A. Those rates are therefore established or approved
by a public utility commission, satisfying the second factor. However, because the rates
are determined under a market index and not on a rate-of-return basis, the Facilities are
PLR-136207-15                                 5

not public utility property to the extent that the energy produced by the Facilities is
allocated to customers within the jurisdiction of Commission A.

        Second, for electricity produced by the Facilities and allocated to non-
jurisdictional customers located within State A, Taxpayer’s rates are established by
means of bi-lateral negotiations between Taxpayer and the customer rather than as
tariffs established by regulatory authorities. Thus, these rates are not established or
approved by a public utility commission and are not determined on a rate-of-return
basis. Therefore, the Facilities are not public utility property to the extent that the
energy produced by the Facilities is allocated to the non-jurisdictional customers within
State A.

        Third, for electricity produced by the Facilities and allocated to customers within
the jurisdiction of Commission C, Taxpayer’s rates are established or approved by a
public utility commission, satisfying the second factor. However, because the rates are
determined through negotiation and/or by the wholesale market index and not on a rate-
of-return basis, the Facilities are not public utility property to the extent that the energy
produced by the Facilities is allocated to customers within the jurisdiction of
Commission C.

Conclusions:

       (1) Assuming Commission A adopts Taxpayer’s Market Index rate adjustment
clause proposal, that portion of the three Facilities subject to the jurisdiction of
Commission A will not constitute “public utility property” within the meaning of former
section 46(f), § 168(i)(10), and the regulations promulgated thereunder.

      (2) That portion of the three Facilities that serves the non-jurisdictional retail
customers in State A will not constitute “public utility property” within the meaning of
former section 46(f), § 168(i)(10), and the regulations promulgated thereunder.

        (3) That portion of the three Facilities that serves Commission C wholesale
customers will not constitute “public utility property” within the meaning of former section
46(f), § 168(i)(10), and the regulations promulgated thereunder.

       Except as specifically determined above, no opinion is expressed or implied
concerning the Federal income tax consequences of the matters described above under
any other provisions of the Code (including other subsections of § 168). Specifically, no
opinion is expressed concerning whether the contract to sell electricity constitutes a
service contract under § 7701(e). In addition, no opinion is expressed concerning
whether the Taxpayer is the owner of the Facility generating electricity for federal
income tax purposes. Further, no opinion is expressed or implied on the classification
of the property under § 168(e). Except as provided in § 168(e)(3), section 5.03 of Rev.
Proc. 87-56, 1987-2 C.B. 674, provides, however, that asset classes in Rev. Proc. 87-
PLR-136207-15                               6

56 include property described in such asset classes without regard to whether a
taxpayer is a regulated public utility or an unregulated company.   .

       This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
of the Code provides 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. We are also sending a copy of this letter ruling to the
Director.




                                      Sincerely,



                                      Peter C. Friedman
                                      Senior Technician Reviewer, Branch 6
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)