Market-priced renewable facility share was not public utility property

Plain-English summary

A regulated electric utility planned to own renewable generation facilities whose output would serve retail customers in two states and wholesale customers. Public utility property status requires regulated rates that are established or approved on a rate-of-return basis, in addition to use in furnishing electricity. For State A customers, the utility's revenue would be based on market prices from a competitive procurement process rather than the facility's costs, and shareholders would bear any shortfall without a regulatory cost-recovery safety net. The IRS ruled that the State A portion therefore would not be public utility property. The State B portion would use normal cost-based ratemaking with a return on investment, and the wholesale portion would use FERC formula rates that recover asset costs and allow a return on rate base. The IRS ruled that those two portions would be public utility property, making the different portions subject to different normalization treatment.

Ruling snapshot

• Question: Which portions of the renewable facilities would qualify as public utility property under the normalization rules?
• Outcome: Approved: the market-priced State A portion would not qualify, while the State B retail and wholesale portions would qualify.
• Key authorities: IRC §§ 50(d)(2), 167(l), 168(f)(2), and 168(i)(10); former IRC § 46(f); Treas. Reg. §§ 1.46-3(g)(2) and 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201825026                                              [Third Party Communication:
Release Date: 6/22/2018                                        Date of Communication: Month DD, YYYY]
Index Number: 45.00-00
                                                               Person To Contact:
--------------------------------                               ------------------------, ID No. -------------
-----------------------------------                            Telephone Number:
--------------------------------                               ----------------------
----------------------------                                   Refer Reply To:
                                                               CC:PSI:B06
                                                               PLR-135762-17
                                                               Date:
                                                               March 08, 2018

Re: ------------------------------------------------------




LEGEND

Company 1 =                --------------------------------------
Company 2 =                 --------------------------------
---------------------------------------------------
Taxpayer          =         --------------------------------
---------------------------------------------------
State A           =        ---------------------
State B           =        ---------------------
State C           =        --------------
a                 =        ----------
b                 =        ----
c                 =        ----
d                 =        ----
e                 =        ----
f                 =        ------------
g                 =        -------
h                 =        ----
i                 =        ----
j                 =        ----
k                 =        ----
Program           =        ------------------------------------------------------------------------------------------
Certificate =              ------------------------------------------------------------------
Date 1            =        -------------------
Date 2            =        -------------------
PLR-135762-17                                           2

Date 3          =        -----------------------
Date 4          =        ---------------------------
Date 5          =        ----------------------------
Date 6          =        --------------------------
Date 7          =        ---------------------------

Dear -----------------


       This is in response to your request for rulings, submitted by your authorized
representative, concerning the federal income tax consequences of the transaction
described below.

Background and Facts

          Taxpayer is wholly owned by Company 1 a State A corporation. For
 federal income tax purposes, Taxpayer is considered a division of Company 2.
 Company 2 is the common parent of an affiliated group of corporations that file a consolidated
 federal income tax return. Taxpayer is a regulated public utility engaged principally in
 the generation, transmission, distribution and sale of electric energy in portions of
 State A and State B. Taxpayer’s service area covers approximately a square
 miles and supplies electric service to approximately b million residential,
 commercial and industrial customers. Taxpayer is subject to regulation as to rates
 and conditions of service by the State A Utilities Commission, the State B Public
 Service Commission and the Federal Energy Regulatory Commission (FERC)
 (collectively referred to as the ( Commissions). The Commissions generally
 establish rates based on costs including a provision for a return on the capital
 employed by Taxpayer in its regulated business. Approximately c percent of
 Taxpayer’s electricity generation is used to provide electricity to retail customers in
 State A subject to State A’s Utility Commission jurisdiction, approximately d percent
 is used to serve retail customers in State B subject to its utility commission, and
 approximately e percent is used to serve wholesale customers subject to FERC
 jurisdiction.

          On Date 1, the Governor of State A signed a bill into law (Act). The purpose
 of the Act was to reform State A’s approach to integrating renewable electricity
 generation into State A’s energy mix. Though the Act has a number of chapters,
 three chapters establish new programs for renewable energy generation
 resources. Since, under these three programs, Taxpayer is able to own and
 operate renewable generation facilities, the Act raises the issue of whether such
 facilities will qualify as public utility property (PUP), thereby becoming subject to
 the normalization rules of former Code §46(f), Code §167, Code §168(i)(9) and
 the regulations promulgated under each This private letter ruling request
 relates to the Program authorized by the Act.
PLR-135762-17                              3

        The Program requires electric public utilities with f or more State A retail
customers to issue requests for proposals (RFPs) in order to procure
renewable energy and capacity in the aggregate amount of up to g
megawatts. The public utilities will procure this cost-effective renewable
energy resource capacity through one (or, more likely, a combination) of the
three options provided for in State A Act): (1) Acquiring renewable energy
facilities bid into the Program RFP solicitation by third parties for ownership by
the public utility (EPC bids); (2) Self-developed projects bid in by the public
utilities (self-developed bids); or (3) Third-party power purchase agreements
for renewable energy facilities to be dispatched, operated and controlled in the
same manner as the public utility’s own generating resources (PPA bids).

         The procurement process has the following relevant features with respect
to facilities that will be owned by the public utility, which are the subject of this
ruling request and present the question whether the facilities are PUP: (1)
Electric utilities may satisfy their procurement obligations by acquiring or
constructing (or having affiliates acquire or construct) renewable facilities; (2)
No more than h% of a utility’s procurement obligation can be satisfied through
self-developed or affiliate-developed facilities with the exception of facilities
acquired from third parties through the competitive procurement process; (3) An
electric utility shall be authorized to recover the authorized revenue of any
utility-owned assets outside of base rates; (4) The authorized revenue for any
utility-owned facility may be calculated on a market basis in lieu of cost of service
based recovery using data from the applicable competitive procurement in
accordance with the methodology established by the State A utility commission; (5)
The competitive procurement process, including the pricing, will be administered by
an independ ent third-party entity to be approved by the State A utility commission.
It is with respect to any utility-owned facility for which the authorized revenue is
calculated on a market basis in lieu of cost of service under this procurement
process for which it must be determined whether the facility is PUP.

      On Date 2, State A utility commission issued an order initiating a rulemaking to
adopt and modify the State A utility commission’s rules to implement the Program
in the State A Act. On Date 3, Taxpayer made a filing in the Program rulemaking
proceeding to establish the Program. The Program is for competitive procurement
of energy and capacity from renewable energy facilities with the purpose of adding
renewable energy to the State A generation portfolio in a manner that allows the
Taxpayer to continue to reliably and cost-effectively serve customers’ future energy
needs. This rulemaking addresses: (1) Oversight of the competitive procurement
process; (2) Waiver of regulatory conditions and code of conduct requirements
unreasonably restricting Taxpayer or its affiliates from participating in the Program;
(3) Procedures for expedited review and approval of certificates of public
conven ience and necessity, or the transfer thereof, for renewable energy facilities
owned by Taxpayer and procured under this section ; (4) Methodology to allow
PLR-135762-17                               4

Taxpayer to recover on its investment through market-based rates; and (5) A
procedure for the State A utility commission to modify or delay implementation of
the provisions of the Program section in whole or in part if it is in the public interest
to do so.

        With respect to the methodology to allow Taxpayer to recover on its
investment through market-based rates, Taxpayer will propose to offer programs
that will establish revenues using market prices established in Program
solicitations. Under the proposed methodology, Taxpayer will establish the
market price based upon the evaluation of prices that third parties bid to provide
renewable energy and capacity in the same Program solicitation under
comparable terms. Only winning bids actually procured through the Program
solicitations will be used in deriving the market prices. The authorized revenue
from a facility will be calculated by multiplying the market price by the appropriate
unit procured in terms of energy production made contractually available (e.g.,
MWh), forecasted over the equivalent term of the comparable arrangement.

       Under the Program, the renewable energy (solar produced electricity) will
be charged with other sources of energy on customers’ bills as a single energy
charge. The Program provides a source of electricity from renewable energy,
the cost of which will be taken into account along with other sources of electricity
in calculating the kilowatt per hour charge on the customers’ bills. The
renewable energy provided under the Program will not be identified as a
separate charge on customers’ bills, but the portion of the single energy charge
related to the Program will be based on the market rates applicable to those
renewable energy facilities.

         On Date 4, Taxpayer filed reply comments in that docket further refining the
details of the Program. Taxpayer incorporated three new subsections that: (1)
Further clarify State A utility commission oversight of the Program as it relates to
the process for selecting the independent third- party evaluator (IE); (2) Provide
procedures to be followed by the Taxpayer and the IE in implementing Program
RFP solicitations; and (3) Establish transparency requirements and limits on
affiliate communications between the electric public utility’s “evaluation team”
managing the Program RFP solicitation and any Taxpayer affiliate acting as a
market participant bidding into the Program solicitation. A timeline was also
established identifying critical milestones up to the execution of the first
competitive procurement solicitation.

       On Date 5, Taxpayer filed additional reply comments in that docket further
refining the details of the Program. The filing further addressed the assurance of
fairness and integrity of the RFP process by which market rates will be established
in the Program by State A utility commission oversight and independent third-party
evaluation, including the role and selection of the third- party evaluator.
PLR-135762-17                               5

         On Date 6, State A utility commission issued an order adopting and amending
the rules under which Taxpayer will present the Program guidelines on the design of
the RFP process used to establish market pricing. More specifically, by Date 7,
Taxpayer expects to make a filing to establish the Program guidelines for
competitive solicitations. As described above, the market price for electricity would
be set based on prices at which Taxpayer or third parties competitively bid and offer
to sell electricity to Taxpayer at comparable terms in response to an RFP issued by
Taxpayer. The market price shall not exceed the electric public utility’s “Avoided
Cost Rates” established for the same Program RFP Solicitation. Taxpayer’s
Avoided Cost Rates will be used for purposes of determining the cost effectiveness
of renewable energy resources procured through a Program RFP Solicitation. The
State A utility commission will issue an order to approve, modify, or deny the
program no later than i days after the submission of the program by Taxpayer. The
authorized revenue of any utility-owned asset selected in the Program RFP
Solicitation will be approved through an annual rider cost recovery mechanism
based on the market price in lieu of a cost-of-service based recovery upon a finding
by the State A utility commission that market-based recovery is in the public
interest. Renewable energy facilities eligible to participate in the competitive
procurement will be limited to facilities with a nameplate capacity rating of j
megawatts or less that are placed in service after the date of the electric public
utility’s initial Program RFP Solicitation.

          “Avoided Cost Rates” are Taxpayer’s calculation of its long-term , levelized
 avoided costs utilizing the methodology most recently approved or established by
 the State A utility commission as of h days prior to the date of the electric public
 utility’s upcoming Program RFP Solicitation for purchases of electricity from
 qualifying facilities. For each Program RFP Solicitation, the electric public utility’s
 avoided costs shall be calcu lated over the time period of the utility’s pro formal
 contract(s) approved by the State A utility commission. For example, where
 Taxpayer solicits a pro forma Program contract offering a term of k years, the
 Avoided Cost Rate applicable to that contract would be a k-year, levelized long-
 term rate calculated based upon the State A utility’s commission approved avoided
 cost methodology in effect at the time the solicitation is held. The Avoided Cost
 Rate is not based on either the cost or the investment in the facility from which the
 energy being priced is produced nor is the cost of the facility included in
 Taxpayer’s rate base for State A retail ratemaking purposes.

        The above described methodology of market pricing is for State A retail
customers only. While the portion of the facility allocable to State A retail customers
will be recovered through market pricing as described above, the recovery of the
cost of Taxpayer owned renewable energy facilities allocable to State B retail
customers and wholesale customers will be recovered through normal State B and
wholesale rate making procedures. Wholesale recovery will be determin ed under
the FERC filed formula rates.
PLR-135762-17                                 6

                     RULINGS REQUESTED


        The Taxpayer h a s requested the following rulings:


         1.     That portion of any facility owned and operated by Taxpayer, the
 electric output from which is charged to State A customers based on rates
 established under the Program, as such program is described above on a market
 basis in lieu of cost of service based recovery using data from the applicable
 competitive procurement, will not constitute PUP.
       2.    That portion of the same facilities that will be charged to State B retail
 customers will constitute PUP.
        3.    That portion of the same facility that will be charged to wholesale
 customers will constitute PUP.

LAW AND ANALYSIS

      Section 168(f)(2) of the Internal Revenue Code (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
approve such rates, though such body has taken no action on the filed schedule or
PLR-135762-17                                 7

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 § 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. In addition, 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. Therefore,
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.

       Accordingly, 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.

        Pursuant to Code §50(d)(2), rules similar to the rules of former Code §46(f)
 as in effect on November 5, 1990, continue to determine whether or not an asset
 is PUP for purposes of the investment tax credit normalization rules. As in effect
 at that time, former Code §46(f)(5) defined PUP by reference to former Code
 §46(c)(3)(B) . Section 168(i)(l0) sets out the current definition of PUP for purposes
 of the depreciation normalization rules.

        Under both the depreciation and investment tax credit normalization rule
definitions, the property mu st be predominately used in one of a number of
enumerated activities. Aside from the description of certain telecommunications
services (which has no relevance to Taxpayer’s situation), the list of activities in the
PLR-135762-17                                  8

two definitions are virtually identical. One of these activities is the furnishing or
sale of electric energy.

        Under both definitions, in order to be classified as PUP, the rates for the
electricity produced by the property must be “established or approved” by:

        1.     A State or political subdivi sion thereof;
        2.     Any agency or instrumentality of the United States; or
       3.     A public service or public utility commission or other similar body of
 any State or political subdivision thereof.

        Finally, Treas. Reg. §1.46-3(g)(2)(ii) further requires that property used in
 one of the enumerated activities and subject to the jurisdiction of a governmental
 regulator must be furnished or sold at regulated rates. Treas. Reg. §1.46-
 3(g)(2)(iii) provides that rates are regulated if they are established or approved on
 a rate-of-return basis.

       There are, therefore, three characteristics all of which a facility must
 possess in order to be characterized as PUP:

        1.     It must be predominately used in the trade or business of the
 furnishing or sale of electric energy;
        2.     The rates for such sale must be established or approved by one of
 the enumerated agencies or instrumentalities; and
        3.     The rates set by that agency or instrumentality must be established or
 approved on a rate-of-return basis.

           Any facility in the Program, described above, will be predominantly used in
 the trade or business of the furnishing or sale of electric energy and therefore, it
 will possess the first of the three characteristics. Moreover, as a regulated public
 utility subject to the jurisdiction of federal or state law, including the ratemaking
 jurisdiction of the State A utility commission, the State B commission and FERC, a
 P r o g r a m f a c i l i t y will possess the second of the three characteristics. However,
 as will be discussed below, the portion of any Program facility owned and
 operated by Taxpayer the price for the electric output which i s charged to
 customers based on rates established under the Program, as such program is
 described above, on a market basis in lieu of cost of service based recovery using
 data from the applicable competitive procurement, will not possess the third
 characteristic. The following is an analysis of the third characteristic of PUP with
 respect to each customer base: (1) State A retail customers; (2) State B retail
 customers; and (3) Wholesale customers.
PLR-135762-17                                9

                         STATE A C U S T O M E R


       Treas. Reg. §1.46-3(g)(2)(iii) provides that rates regulated on a rate-of-return
basis are an authorization to collect revenues that cover the taxpayer’s cost of
providing goods or services, including a fair return on the taxpayer’s investment in
providing such goods or services. It specifically states:

               A taxpayer’s rates are not “regulated” if they are
               established or approved on the basis of...charging
               “reasonable” rates within an industry since the taxpayer is
               not authorized to collect revenues based on the taxpayer’s
               cost of providing goods and services.

        As described above, the rate charged State A retail customers under the
 Program will be determined by the Program RFP process, which is a market
 mechanism administered by a non-regulatory third-party entity. These rates are the
 only source of compensation to Taxpayer from State A retail customers. The only
 cash flow that actually involves Taxpayer’s sale of electricity to State A retail
 customers is not computed by reference to the costs of the facility. The process by
 which the Taxpayer’s rates are determined for State A retail customers has nothing
 whatsoever to do with the facility’s costs and, therefore, cannot be characterized as
 rate-of-return based. Moreover, any difference between Taxpayer’s revenue from
 this charge and its facility cost will be borne entirely by Taxpayer’s shareholders.
 There will be no “safety net” by which the State A utility commission will ensure or
 support Taxpayer’s recovery of its costs.

         Although the projected costs of a facility will be an element of the information
 submitted to the State A utility commission in the process of procuring a Certificate,
 the State A utility commission will not have the authority under the Program to
 establish rates based on those costs. This mere availability of cost data is not
 dispositive. Instead, the portion of any facility owned and operated by Taxpayer,
 the electric output from which is charged to State A customers based on rates
 established under the Program, which as described above is on a market basis in
 lieu of cost of service based recovery using data from the applicable competitive
 procurement, will not constitute PUP.

                             STATE B CUSTOMERS


        The recovery of the cost of Taxpayer owned renewable energy facilities
 allocable to State B retail customers will be recovered through normal State B rate
 making procedures. Taxpayer will recover the portion of the facility allocable to
 State B retail customers through normal cost recovery rate making principles
 (including a return on investment). Thus, the portion of a facility owned and
PLR-135762-17                              10

 operated by Taxpayer the electric output from which is charged to retail customers
 in State B will be PUP.

                          WHOLESALE CUSTOMERS


       Taxpayer has applied for and received Market Based Ratemaking Authority
(MBRA) from FERC for wholesale power sales outside of the areas in which
Corporation has been determined to have market power. Pursuant to this authority,
it makes sales through the wholesale market at rates established by the market.
However, the recovery of the cost of Taxpayer owned renewable energy facilities
allocable to wholesale customers will be recovered through normal wholesale rate
making procedures. Wholesale recovery will be determined under the FERC filed
formula rates, which currently recover an assets cost through depreciation and
allow a return on rate base. As a result, that portion of the same facility that will
be charged to wholesale customers will constitute PUP.



      Accordingly, we conclude that:


       1. That portion of any facility owned and operated by Taxpayer, the electric
          output from which is charged to State A customers based on rates
          established under the Program, as such program is described above on
          a market basis in lieu of cost of service based recovery using data from
          the applicable competitive procurement, will not constitute PUP.

       2. That portion of the same facilities that will be charged to State B retail
          customers will constitute PUP.

       3. That portion of the same facility that will be charged to wholesale
          customers will constitute PUP.
PLR-135762-17                                  11

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


                                  Sincerely,



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




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