Power agreements do not create private business use of bond-financed plant

Plain-English summary

A public power issuer financed its interest in an electric generating plant with revenue bonds, and a city held a take-or-pay right to a share of the plant's capacity and energy. The city planned to buy all its electricity from a cooperative, sell its plant power into a regional market, use a financial swap to hedge market price against variable production costs, and sell zonal resource credits to another cooperative corporation. The IRS concluded that the resource credits were not plant output because they conferred no right to energy or capacity and did not affect the plant's nameplate capacity. The credit sale gave the purchaser no control or other special legal entitlement over the plant. The swap and the new electricity supply agreement likewise conveyed no plant output, capacity, or operational control. The three agreements therefore would not create private business use of the bond-financed property under section 141.

Ruling snapshot

• Question: Do the electricity supply, financial swap, and capacity-credit sale agreements create private business use of the bond-financed power plant?
• Outcome: approved
• Key authorities: IRC §§ 103, 141; Treas. Reg. §§ 1.141-3, 1.141-7

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

Number: 201739002                                               Third Party Communication: None
Release Date: 9/29/2017                                         Date of Communication: Not Applicable
Index Number: 141.00-00
                                                                Person To Contact:
------------------------------------------------------------    ------------------------, ID No. ------------------
------------------                                              ----------------------------------------------------
---------------------------------------                         Telephone Number:
------------------------------------                            ----------------------
------------------------------------------                      Refer Reply To:
                                                                CC:FIP:BRANCH 5
                                                                PLR-101521-17
                                                                Date:
                                                                June 28, 2017




Legend

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

Power Plant                =         --------------------------------------------------------------------------------
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City                       =        ------------------------------------

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

Cooperative                =        ------------------------------------------------------

Corporation                =        ----------------------------------------------------------

ISO                        =        -----------------------------------------

Bonds                      =         --------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------
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---------------------------------------------------------------------------------------------------------------
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PLR-101521-17                                 2

Year 1                    =   -------

Year 2                    =   -------

a                         =   ----


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

This is in response to the request submitted on behalf of Issuer for a ruling that the
City’s proposed contracts described below will not result in private business use of the
proceeds of the Bonds under § 141 of the Internal Revenue Code (Code).

FACTS AND REPRESENTATIONS

Issuer was created pursuant to State 1 law for the purpose of permitting political
subdivisions of State 1 that own and operate retail electric utility systems to secure by
joint action an adequate, reliable, and economical supply of electric power. Issuer has
the authority to develop, finance, construct, acquire and operate generation,
transmission and distribution facilities to meet the electricity requirements of its
members. Issuer is authorized to issue bonds for this purpose. Issuer allows certain
rural electric cooperatives and municipalities located outside of State 1 to participate in
Issuer’s power supply programs and projects as non-voting members.

City is a municipality in State 2. City owns and operates an electric distribution system
through which it delivers electricity to its customers within City.

Power Plant is an electric generating station located in City. Issuer has an undivided
ownership interest in Power Plant and financed or refinanced substantially all of the
acquisition and construction costs of its interest in Power Plant with the Bonds. The
Bonds are revenue bonds payable from the revenues of Power Plant, including
payments received under power purchase agreements with municipalities located in
States 1 and 2, including City. City’s power purchase agreement (the PPA) entitles City
to a specified percentage share of the capacity of, and energy generated by, Issuer’s
interest in Power Plant and requires that City pay to Issuer that same percentage share
of Issuer’s costs of acquisition and construction, including the debt service on the
Bonds, (fixed costs) and operation (variable costs) of Power Plant on a take or pay
basis.

ISO is a regional transmission organization that was recognized as such by the Federal
Energy Regulatory Commission in Year 1. In Year 2, ISO’s geographical region
expanded to include the area in which Power Plant is located. ISO also operates as an
energy market (the ISO Market) by buying energy from participating generators and
PLR-101521-17                                3

selling that energy to the load serving entities (LSEs) that sell energy to wholesale and
retail customers.

ISO, along with regulators from states participating in ISO, has the responsibility to
ensure that sufficient electric generating capacity exists within the ISO system (or
elsewhere from which electricity can be delivered into the ISO system) to cover the
anticipated peak demand, plus an appropriate reserve margin, for each LSE within
ISO’s region. The amount of capacity required for an LSE is referred to as its resource
adequacy requirement. The market mechanism that ISO uses to ensure an LSE meets
its resource adequacy requirement is zonal resource credits (ZRCs). All of the
generating capacity within ISO’s region is assigned an amount of ZRCs, with 1 ZRC
equal to 1 megawatt-day of capacity. The number of ZRCs for any generating facility is
determined once per year based upon a variety of factors, including the type of facility
and historical generation at the facility.

An LSE can meet its resource adequacy requirement by (1) owning a generation asset
available to produce power within the ISO system (to which ZRCs will be assigned); (2)
having contractual rights equivalent to ownership of such a generation asset, such as,
for example, a “take or pay” contract for the purchase of power; (3) entering into
bilateral contracts to purchase ZRCs; or (4) purchasing ZRCs at the yearly ISO ZRC
auction. If a LSE fails to meet its resource adequacy requirement (that is, has an
insufficient amount of ZRCs for its load), it pays a penalty to ISO.

If an ISO market participant has ZRCs in excess of its resource adequacy requirement,
it must make such ZRCs (above an ISO-determined threshold) available in the yearly
ISO auction to allow the LSEs with inadequate ZRCs to purchase the needed amount of
ZRCs. The market value of ZRCs is largely dependent on the ratio between the
capacity and the load that the ISO serves and the availability of transmission services
for the load served. Under the ISO regulations, the owner of a generating facility that
has sold assigned ZRCs must offer the electric energy produced by that facility in the
ISO Market. A purchase of a ZRC provides no legal entitlement to the energy
corresponding to the ZRC purchased.

City proposes to enter into three agreements. City plans to enter into a long-term
electric service contract with Cooperative, an entity exempt from Federal income tax
under § 501(c)(12) of the Code (the Electric Supply Agreement). Under the Electric
Supply Agreement, Cooperative will supply all of City’s electricity requirements.

As a result of the Electric Supply Agreement, City will no longer need the electricity that
it receives from Power Plant under the PPA. City plans to sell that electricity through
short-term contracts and spot sales in the ISO market. To hedge the difference
between the revenue City collects from selling its PPA power in the ISO market and the
price City must pay to Issuer under the PPA, City will enter into a a-year financial swap
agreement with Corporation (the Swap). Specifically, City will pay Corporation the
PLR-101521-17                                  4

excess of the price for which City sells its electricity under the PPA in the ISO market
over the variable costs it incurs in producing its electricity at Power Plant, and
Corporation will pay City the excess of the variable costs City incurs in such production
over the price at which City sells its PPA electricity in the ISO market. The fixed costs
payable to Issuer under the PPA, including the debt service on the Bonds, are not
factored into the Swap payments.

Corporation is an electric generation and transmission cooperative corporation located
and operating in State 2. It serves its member cooperatives through long-term all
requirements contracts. Cooperative is a member of Corporation, but not a related
party to Corporation under § 1.150-1(b) of the Income Tax Regulations.

As a result of the Electric Supply Agreement and Cooperative’s requirements contract
with Corporation, City’s resource adequacy requirement will be transferred to
Corporation as Cooperative’s supplier. Consequently, the ZRCs assigned to City’s
share of the capacity of Power Plant will be available for City to sell. City will enter into
a a-year contract to sell its ZRCs to Corporation (the ZRC Sales Agreement).
Corporation will use these ZRCs to satisfy its resource adequacy requirement or may
resell them to other LSEs. The ZRC Sales Agreement does not entitle Corporation to
any energy, capacity, or control over the operations of Power Plant.

LAW AND ANALYSIS

Section 103(a) of the Code provides that gross income does not include interest on any
state or local bond. Section 103(b)(1) provides that § 103(a) does not apply to any
private activity bond which is not a qualified bond within the meaning of § 141.

Section 141(a) provides that a private activity bond is any bond issued as part of an
issue that meets either (1) the private business use test of § 141(b)(1) and the private
security or payment test of § 141(b)(2), or (2) the private loan financing test of § 141(c).

Section 141(b)(1) provides that, generally, a bond issue meets the private business use
test if more than 10 percent of the proceeds of the issue are to be used for any private
business use. Section 141(b)(6)(A) provides that the term "private business use"
means use (directly or indirectly) in a trade or business carried on by any person other
than a governmental unit. Section 141(b)(6)(B) provides that, for purposes of
§ 141(b)(6)(A), any activity carried on by a person other than a natural person shall be
treated as a trade or business.

Section 1.141-3(a)(1) of the Income Tax Regulations provides that the private business
use test relates to the use of the proceeds of an issue, and, for this purpose, the use of
financed property is treated as the direct use of proceeds.
PLR-101521-17                                 5

Section 1.141-3(b)(1) provides that both actual and beneficial use by a
nongovernmental person may be treated as private business use. In most cases, the
private business use test is met only if a nongovernmental person has special legal
entitlements to use the financed property under an arrangement with the issuer. In
general, a nongovernmental person is treated as a private business user of proceeds
and financed property as a result of ownership; actual or beneficial use of property
pursuant to a lease, or a management or incentive payment contract; or certain other
arrangements such as a take or pay or other output-type contract.

Section 1.141-3(b)(7)(i) provides that any other arrangement that conveys special legal
entitlements for beneficial use of bond proceeds or of financed property that are
comparable to special legal entitlements such as ownership, leases, or output contracts
(or other arrangements not relevant for this purpose) results in private business use.
For example, an arrangement that conveys priority rights to the use or capacity of a
facility generally results in private business use.

Section 1.141-7 provides special rules to determine whether arrangements for the
purchase of output from an output facility cause an issue of bonds to meet the private
business tests. Section 1.141-3 applies to determine whether other types of
arrangements for use of an output facility cause an issue to meet the private business
tests. Section 1.141-1(b) provides that an “output facility” means electric and gas
generation, transmission, distribution, and related facilities, and water collection,
storage, and distribution facilities.

Section 1.141-7(b)(1) provides that the available output of a facility financed by an issue
is determined by multiplying the number of units produced or to be produced by the
facility in one year by the number of years in the measurement period of that facility for
that issue. Section 1.141-7(b)(1)(i) provides that the number of units produced or to be
produced by a generating facility in one year is determined by reference to its
nameplate capacity or the equivalent (or where there is no nameplate capacity or the
equivalent, its maximum capacity), which is not reduced for reserves, maintenance or
other unutilized capacity. Section 1.141-7(c)(1) provides that the purchase pursuant to
a contract by a nongovernmental person of available output of an output facility (output
contract) financed with proceeds of an issue is taken into account under the private
business test if the purchase has the effect of transferring the benefits of owning the
facility and the burdens of paying the debt service on the bonds used (directly or
indirectly) to finance the facility (the burdens and benefits test).

Issuer is requesting a ruling that the three agreements described above, specifically, the
Electric Supply Agreement, the Swap, and the ZRCs Sale Agreement (collectively, the
Agreements) will not result in private business use under § 141 of the Code.

Proceeds of the Bonds were spent on the costs of acquiring, constructing, and
refinancing Issuer’s interest in Power Plant, an output facility as defined in § 1.141-1(b).
PLR-101521-17                                 6

Although ZRCs are assigned to Power Plant based on its capacity, ZRCs do not
increase or otherwise impact the nameplate capacity of Power Plant, and the sale of
ZRCs does not affect the units of electricity that may be sold nor entitle Corporation, the
ZRC purchaser, to any energy or capacity of Power Plant. We thus conclude that ZRCs
are not output for purposes of § 141 and the rules in § 1.141-7 do not apply to the ZRC
Sales Agreement.

The rules under § 1.141-3 must also be examined to determine whether there is private
business use. Under the Agreements, Corporation, the purchaser of City’s ZRCs, will
receive no legal entitlements to the energy or capacity of Power Plant. The ZRCs are a
market mechanism to meet the LSE resource adequacy requirements and do not
themselves constitute capacity or use of Power Plant. Under the ZRC Sales
Agreement, City will have no obligation to Corporation to produce any electricity, and
Corporation will have no control over Power Plant and its operations. Thus, Corporation
has no direct or indirect control of the operation of, or any other special legal entitlement
with respect to, Power Plant under § 1.141-3.

Similarly, the Swap is not an output contract and does not grant any special legal
entitlements to Corporation, the Swap counterparty, regarding the energy, capacity, or
control over the operations of Power Plant. Finally, the Electricity Supply Agreement is
not an agreement with respect to the output of Power Plant, nor does it grant
Cooperative any special legal entitlements relating to the energy, capacity, or control
over the operations of Power Plant.

CONCLUSION

Based on the foregoing, we conclude that the Agreements will not result in private
business use of the Bonds.

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(s) requesting it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

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
PLR-101521-17                                7



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,

                                      Associate Chief Counsel
                                      (Financial Institutions & Products)


                                                      /S/
                                      By: ______________________
                                      Johanna Som de Cerff
                                      Senior Technician Reviewer
                                      Branch 5