Peaking power plant is not public utility property for depreciation rules

Plain-English summary

A taxpayer owned a peaking electric generating facility whose wholesale power rates were negotiated or set through the market. A state authority annually determined a contract-based revenue requirement, and a distribution company or the taxpayer paid the difference between that requirement and the facility's market receipts. The IRS explained that public utility property requires regulated rates established or approved by a qualifying body on a rate-of-return basis. Although the facility furnished electricity, the contractual compensation arrangement did not satisfy the regulatory-rate and rate-of-return factors. The IRS therefore ruled that the facility was not public utility property under IRC § 168(i)(10), making the taxpayer's alternative normalization questions moot.

Ruling snapshot

• Question: Is the peaking electric generation facility public utility property subject to the depreciation normalization rules?
• Outcome: Approved. The IRS ruled that the facility was not public utility property.
• Key authorities: IRC §§ 167(l), 168(f)(2), 168(i)(10); Treas. Reg. §§ 1.167(l)-1, 1.46-3(g)(2)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201722006 Third Party Communication: None
Release Date: 6/2/2017 Date of Communication: Not Applicable
Index Number: 167.22-00
Person To Contact:
------------------------- ------------------------, ID No. -------------
-------------------------------------------------------- Telephone Number:
------------------------------------------------- ----------------------
-------------------- Refer Reply To:
----------------------------- CC:PSI:B06
In Re: Request on consequences under the PLR-125025-16
normalization provisions Date:
March 02, 2017

Legend:

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

-
State A = -----------------
State B = -----------------
Parent = -------------------------------------------------------------------------
--------------------------
Operator = --------------------------
Commission = -------------------------------------------------------
Year = -------
Authority = ----------------------------------------------------------------------------
Contract = ------------------------------------------------------------------------------------------

-
Company = ----------------------------------------------------------------
Director = ------------------------------------------------------------------------------------------

Date 1 = ----------------------
Date 2 = ------------------------
Date 3 = ---------------------
Date 4 = --------------------
a = --
b = --
c = -----------
d = ---------
e = ----
PLR-125025-16 2

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

     This letter responds to the request, dated August 11, 2016, submitted on behalf

of Taxpayer for a ruling on whether Taxpayer’s Facility is not, in whole or in part, public
utility property within the meaning of § 168(i)(10) of the Internal Revenue Code
(“Code”). Depending on the outcome of this request, rulings are also requested on
behalf of Taxpayer on the application of the depreciation normalization rules of
§ 168(i)(9) and § 1.167(l)-1 of the Federal Income Tax Regulations (“Regulations”)
(together, the “Normalization Rules”) to certain State A regulatory procedures.

    The representations set out in your letter follow.

     Taxpayer is a limited liability company. All of Taxpayer’s membership interests

are owned by Parent, a State B corporation, directly or through disregarded entities.
Taxpayer is a disregarded entity for federal income tax purposes and is, therefore,
treated as a division of Parent. Parent is the common parent of a group of corporations
that files a consolidated federal income tax return. The return is under the audit
jurisdiction of the Large Business and International Division of the Internal Revenue
Service. Taxpayer is an accrual basis taxpayer and reports on a calendar year basis.

    Taxpayer owns and operates a peaking electric generating facility located in

State A (“Facility”). Peaking units can rapidly produce electricity and, generally, are only
used during periods of high demand or disruptions to the transmission system. They
improve the reliability of the transmission system to which they are interconnected. The
Facility is interconnected with Operator. As a wholesale power provider, under the
Federal Power Act, Taxpayer is subject to the jurisdiction of Commission. To the extent
Taxpayer's sales are under the jurisdiction of Commission, its rates are established
through negotiation and/or by the wholesale market.

    In Year, State A enacted legislation intended to encourage the planning for and

construction of peaking electric generation plants located in State A in order to benefit
State A electric consumers. Generally, the legislation required State A’s electric
distribution utilities and permitted any other person wanting to build peaking generation
to submit its plan to the Authority between Date 1 and Date 2 for consideration. Any
plan approved by Authority would include a requirement that the owner be compensated
at its cost of service plus a reasonable rate of return on its prudently incurred
investment. The level of compensation was to be established by Authority in annual
contested rate cases with the return on equity reviewed at least every a years.

    Under State A law, merchant generators (such as the Facility) are not electric

distribution companies or any other type of public service company subject to regulation
by Authority, and consequently, Authority does not have the statutory basis to subject
PLR-125025-16 3

any such generator to cost of service regulation. However, Authority concluded in Year
that merchant generators could agree contractually to submit to rate determinations.
On Date 3, Taxpayer’s predecessor in interest entered into a Contract with Company, a
public service electric distribution company over which Authority exercises ratemaking
jurisdiction. The provisions of the Contract describe the rules that govern the
relationship between Taxpayer and Company.

  Some of the pertinent provisions include:

1. Taxpayer agreed to construct, own, operate and maintain the Facility;
2. Taxpayer agreed that Authority will determine a revenue requirement, including a
  review of its cost of service, in annual contested proceedings. In these cases,
  the allowed return on equity will be indexed to an average of the returns
  approved for b unrelated State A electric distribution companies (rather than
  being based on a return on equity determination involving Taxpayer), plus c
  except that such return shall never go below d. In addition, limited portions of
  rate base and expense are reconciled to actual expenses in subsequent cases in
  a process known as a “True-Up”;
3. Taxpayer agreed that, during the term of the Contract, any premium above book
  value received upon the sale of the Facility shall be paid to Company and
  returned to ratepayers. However, once the Contract term ends, ratepayers have
  no further claim and any proceeds from the sale of the Facility are solely for the
  Taxpayer’s benefit.
4. The term of the Contract is e years.
5. Each year, Authority will establish a revenue requirement for Taxpayer based on
  the costs Taxpayer projects it will incur during the forthcoming contract year, a
  cost of equity as described in provision 2 above, and using certain other
  conventions. During that year, Taxpayer will receive monthly payments from
  Operator for capacity, power and ancillary services. Each month during the
  forthcoming contract year, Taxpayer computes the difference between 1/12 of
  the revenue requirement Authority established for Taxpayer and the amount of
  monthly payment Taxpayer received from the Operator. If the difference is
  positive, Company is obligated to make a payment to Taxpayer in the amount of
  the difference. If the amount is negative, Taxpayer is obligated to make a
  payment to Company in the amount of the difference. Outside of the Contract,
  Authority announced that any payments made by Company (and companies
  similarly situated) pursuant to the Contract will be recoverable by it from its
  ratepayers. Any Contract payments received by Company (and companies
  similarly situated) will be credited to its ratepayers.

The following ruling is requested on behalf of Taxpayer:
PLR-125025-16 4

 Taxpayer’s Facility is not, in whole or in part, public utility property within the

meaning of § 168(i)(10) of the Code.1

                                     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) of the Code, 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) of the Regulations 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 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) of the Code are essentially identical. Section 1.167(l)-1(b) of the Regulations
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.

1
Other rulings were requested on behalf of Taxpayer in the event that the Service reached an adverse
conclusion to that requested by Taxpayer. Because, as set forth below, we have reached a favorable
conclusion, the other rulings are moot and will not be discussed in this letter.
PLR-125025-16 5

    The regulations under former section § 46 of the Code, specifically § 1.46-3(g)(2)

of the Regulations, 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 § 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.

   The Facility is used primarily in the trade or business of furnishing electrical

energy, satisfying the first factor. The determination of amounts to be received by
Taxpayer under the Contract, while containing some elements in common with the
determination of rates for the furnishing or sale of electrical energy established or
approved by a State or political subdivision thereof, such rates being determined on a
rate-of-return basis, does not, under these facts, satisfy the second and third factor.
Accordingly, we rule as follows:

   Taxpayer’s Facility is not public utility property within the meaning of § 168(i)(10)

of the Code. Because we rule that the Facility is not public utility property, Taxpayer’s
additional ruling requests are moot and will not be addressed.

     This ruling is based on the representations submitted by Taxpayer and is only

valid if those representations are accurate. The accuracy of these representations is
subject to verification on audit.

  Except as specifically determined above, no opinion is expressed or implied

concerning the Federal income tax consequences of the matters described above.
PLR-125025-16 6

   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,



                                 Patrick S. Kirwan
                                 Chief, Branch 6
                                 Office of Associate Chief Counsel
                                 (Passthroughs & Special Industries)