Disaster-driven power and gas costs are extraordinary items a city utility can finance with tax-exempt refunding bonds

Plain-English summary

A municipal electric and gas utility got hit with extraordinary power and fuel costs when a disaster caused massive, unprecedented outages and price spikes across its regional grid. The utility is litigating to knock down the excess charges, and the city plans to issue tax-exempt bonds to refinance the disputed amounts it ultimately has to pay. Tax-exempt bond rules generally force issuers to spend their own available cash before bond proceeds when financing working capital (the "proceeds-spent-last" method), which would limit how much the bonds can cover. The city asked the IRS to confirm two points: that these disaster charges are "extraordinary items" exempt from that spend-last rule, and that bonds with the proposed maturity would not be outstanding longer than reasonably necessary (which would otherwise create arbitrage problems under section 148). The IRS agreed on both, finding the charges were extraordinary, nonrecurring expenses not customarily paid from current revenues and not covered by any dedicated reserve, and that the bond term was reasonable given the utility's financial distress. The IRS expressed no opinion on whether interest on the bonds is actually tax-exempt under section 103.

Ruling snapshot

• Question: Are a utility's extraordinary disaster-related power and gas charges exempt from the proceeds-spent-last method, and will refunding bonds financing them not be outstanding longer than reasonably necessary?
• Outcome: Approved (both rulings granted).
• Key authorities: IRC §§ 148, 103; Treas. Reg. §§ 1.148-6(d)(3), 1.148-10(a)(4), 1.148-1(c)(4), 1.148-9.

Full text (IRS public release)

Internal Revenue Service                              Department of the Treasury
                                                      Washington, DC 20224

Number: 202309014                                     Third Party Communication: None
Release Date: 3/3/2023                                Date of Communication: Not Applicable
Index Number: 148.00-00, 148.05-00
                                                      Person To Contact:
                                                      ----------------, ID No.
                                                      Telephone Number:
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                                                      Refer Reply To:
                                                      CC:FIP:B5
                                                      PLR-116814-22
                                                      Date:
                                                      December 09, 2022


LEGEND

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Grid Operator     =      --------------------------------------------------------------

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Dear        :

This letter is in response to a request for a ruling submitted on behalf of City, that (1) the
expenditures for the Charges (as described below) to be financed with Bonds are
extraordinary items pursuant to § 1.148-6(d)(3)(ii)(B) of the Income Tax Regulations
and, therefore, not subject to the proceeds-spent-last method in § 1.148-6(d)(3)(i); and
(2) pursuant to § 1.148-10(a)(4), the Bonds will not be outstanding longer than is
otherwise reasonably necessary.

Facts and Representations

Utility is a provider of electricity and natural gas and a department and component unit
of City. Utility’s operations are independent of any other unit of City. Utility owns
generating and transmission facilities, and it also has purchase agreements for electric
power that it obtains through the grid operated by Grid Operator (the Grid). Grid
Operator serves municipal utilities including Utility, as well as other entities such as
independent power producers and investor-owned utilities. Utility is a wholesale
purchaser of gas for resale to its retail gas customers and to power some of its electric
generation facilities. Utility recovers its electricity and natural gas costs by a direct
pass-through of costs to its customer base and by entering into hedges for a portion of
its forecasted natural gas purchases with third party hedge providers (the “Gas
Hedges”).

Utility does not maintain reserves specifically intended to deal with the fluctuating nature
of the cost of power, although it has reserves for all of its other operational needs
(“Utility’s Operating Reserves”). City maintains reserves for its other standard
operational needs (“City’s Operating Reserves”), which are specifically isolated from the
liabilities of Utility. City’s Operating Reserves are necessary to maintain the operation
of City at the current level, including its ability to fund additional capital improvements as
well as maintain its day-to-day operations. All of the debt issued by City for Utility is
secured by a lien on, and is solely payable from, revenues of Utility, and under State
law cannot be cross collateralized with any of City’s other obligations. With limited
exceptions, State law prohibits City from using any Utility revenues to pay any other
debt, expense, or obligation of City.

In Month, the Occurrence took place and resulted in significant and unprecedented
power loss in State, including in City. The Occurrence caused severe physical damage
to electric power generation and transmission equipment supplying electric power to the
Grid, rendering the equipment unusable. It also caused some gas wellheads, pipelines,
and gas processing plants to be nonoperational. The State and the Federal
Governments issued disaster declarations with respect to the Occurrence.

A direct result of the Occurrence was that spower became extremely scarce and much
more expensive to obtain. Customarily, Utility has budgeted, and managed the Gas
Hedges, for a price to obtain power of approximately $a/Megawatt-hour (“MWh”).
Utility’s average price of power prior to the Occurrence was $b/MWh. During the
Occurrence, Utility’s payments to the Grid Operator to obtain power (the “Power
Charge”) were based on prices averaging approximately $c/MWh, or more than 13
times $a). Because of Utility’s essential service responsibilities coupled with the failure
of its generation facilities for significant durations throughout the Occurrence, Utility was
a net power buyer during this period (meaning it bought more power from the Grid than
it sold into the Grid).

As a result of the size and scope of the Grid’s power charges during the Occurrence,
some utilities divested their interests in transmission operations and some utilities
sought bankruptcy or other remedies, including non-payment. Under the Grid’s pricing
mechanism, in the event of bankruptcy or defaulting counter parties within the Grid, the
Grid Operator may impose fees on the remaining utilities to cover the charges of such
other defaulting counter parties (“uplift charges”). Utility’s average uplift charge in the
previous five years had been $d. The fee imposed on Utility in the aftermath of the
Occurrence (the “Uplift Charge”) was significantly greater.

Utility ensures delivery of natural gas to its customers by executing contracts with
various natural gas suppliers (the “Gas Providers”). The average price of natural gas
purchased by Utility prior to the Occurrence had been approximately $e per million
British thermal units (“MMBtu”), and Utility budgets for approximately $f/MMBtu. The
highest price for natural gas ever paid by Utility prior to the occurrence was $g/MMBtu,
or eight times $f. Due to the scarcity of available natural gas during the Occurrence, the
cost of natural gas to Utility as charged by the Gas Providers during the Occurrence
increased to more than $h per MMBtu (which is 60 times $f/MMBtu), plus related
transmission charges predicated on the increased gas price. Although Utility withdrew
natural gas from its storage facilities and received payments on the Gas Hedges, which
together reduced its costs for natural gas by approximately 25 percent, Utility’s costs for
natural gas during the Occurrence equaled approximately $i million (the “Gas Charge,”
and together with the Power Charge and the Uplift Charge, the “Charges”).

Utility has challenged the amounts of the Charges by initiating various litigation
proceedings against the Grid Operator and the Gas Providers. In its litigation, Utility
has challenged the portion of the Charges in excess of what the Charges would have
been if calculated at the prices determined by its experts to be reasonable. Utility’s
experts determined that a reasonable price for power during the Occurrence would have
been $j/MWh and a reasonable price for gas would have been $k/MMBtu. Litigation
with most, but not all, of the Gas Providers has been resolved. The outcome of these
litigation proceedings will establish the final amounts of the Charges that Utility will
finance (or refinance). Any amount still in dispute that is determined by the litigation
proceedings to be owed by Utility (the “Legal Judgment”) will be paid by Utility at that
time. City expects that the overall amount it will end up paying to settle these cases will
be approximately $l million for the Gas Charge and approximately $m million for the
Power Charge and Uplift Charge.

During and after the Occurrence, Utility has financed (and refinanced) a portion of the
cost of the Charges with proceeds of taxable commercial paper (the “Short-term
Taxable Debt”). City determined that, for financial accounting purposes, the Charges
are a regulatory asset under Generally Accepted Financial Principles, allowing Utility to
capitalize and recover these costs on its books over a n-year period. Under this
determination, Utility is authorized to refinance these costs with fixed long-term debt.
Prior to the filing of the request for this private letter ruling with the Internal Revenue
Service (the “Service”), Utility refinanced a portion of the Short-term Taxable Debt with
long-term taxable debt that has a final maturity of n years and a weighted average
maturity of o years (the “Taxable Bonds”).

Upon obtaining a favorable response from the Service to its private letter ruling request,
City will issue the Bonds and use the proceeds to refund the portion of outstanding
Short-term Taxable Debt representing any Legal Judgment not refinanced with the
Taxable Bonds. The Bonds will be secured solely by, and will be repaid solely with,
Utility’s revenues comprised of generally applicable rates and charges. The Bonds will
have a final maturity date that is n years from the date of issue and a weighted average
maturity of o years. Utility will not apply the safe harbor for longer-term working capital
financings under § 1.148-1(c)(4)(ii).

City represents that issuing the Bonds with a term of n years and a weighted average
maturity of not more than o years provides Utility with a reasonable debt service
expense over the term of the issue which considers the economic impact of the
Occurrence and the Charges without causing further downgrades in its credit rating
while preserving customer affordability. By providing a debt service payment that is
expected to be manageable, the term and weighted average maturity of the Bonds will
also assist Utility in meeting its budgetary requirements.

Law and Analysis

Section 103(a) of the Internal Revenue Code provides that, except as provided in
§ 103(b), gross income does not include interest on any state or local bond. Section
103(b) provides, in part, that § 103(a) shall not apply to any arbitrage bond (within the
meaning of § 148).

Section 148(a) defines an arbitrage bond as any bond issued as part of an issue any
portion of the proceeds of which are reasonably expected (at the time of issuance of the
bond) to be used directly or indirectly (1) to acquire higher yielding investments, or (2) to
replace funds which were used directly or indirectly to acquire higher yielding
investments. Section 148(a) further provides that a bond is an arbitrage bond if the
issuer intentionally uses any portion of the proceeds of the issue of which such bond is
a part in a manner described in (1) or (2).

Section 1.148-1(b) defines proceeds, in part, to mean any sale proceeds, investment
proceeds, and transferred proceeds of an issue. Transferred proceeds are defined in
§ 1.148-9. Section 1.148-9(b) provides, in part, that when proceeds of the refunding
issue discharge any of the outstanding principal amount of the prior issue, proceeds of
the prior issue become transferred proceeds of the refunding issue and cease to be
proceeds of the prior issue.

Section 1.148-6(d)(3)(i) provides that, except as otherwise provided in § 1.148-6(d)(3)
or (d)(4), proceeds of an issue may only be allocated to working capital expenditures as
of any date to the extent that those working capital expenditures exceed available
amounts (as defined in § 1.148-6(d)(3)(iii)) as of that date (i.e., a “proceeds-spent-last”
method). For this purpose, proceeds include replacement proceeds described in
§ 1.148-1(c)(4).

Section 1.148-6(d)(3)(ii)(B) provides that § 1.148-6(d)(3)(i) does not apply to
expenditures for extraordinary, nonrecurring items that are not customarily payable from
current revenues, such as casualty losses or extraordinary legal judgments in amounts
in excess of reasonable insurance coverage. If, however, an issuer or a related party
maintains a reserve for such items (e.g., a self-insurance fund) or has set aside other
available amounts for such expenses, gross proceeds within that reserve must be
allocated to expenditures only after all other available amounts in that reserve are
expended.

Section1.148-6(d)(3)(ii)(C) provides that § 1.148-6(d)(3)(i) does not apply to
expenditures for payment of principal, interest, or redemption prices on a prior issue
and, for a crossover refunding issue, interest on that issue.
Section 1.148-6(d)(3)(iii)(A) defines available amount, in general, as any amount that is
available to an issuer for working capital expenditure purposes of the type financed by
an issue. Except as otherwise provided, available amount excludes proceeds of any
issue but includes cash, investments, and other amounts held in accounts or otherwise
by the issuer or a related party if those amounts may be used by the issuer for working
capital expenditures of the type being financed by an issue without legislative or judicial
action and without a legislative, judicial, or contractual requirement that those amounts
be reimbursed.

Section 1.148-1(c)(4)(i)(A) provides that replacement proceeds arise to the extent that
the issuer reasonably expects as of the issue date that: (1) the term of an issue will be
longer than is reasonably necessary for the governmental purposes of the issue; and
(2) there will be available amounts during the period that the issue remains outstanding
longer than necessary. Whether an issue is outstanding longer than necessary is
determined under § 1.148-10. Replacement proceeds are created under § 1.148-
1(c)(4)(i)(A) at the beginning of each fiscal year during which an issue remains
outstanding longer than necessary in an amount equal to available amounts of the
issuer as of that date.

Section 1.148-1(c)(4)(i)(B)(1) provides, as a safe harbor, that replacement proceeds do
not arise under § 1.148-1(c)(4)(i)(A) for the portion of an issue that is to be used to
finance restricted working capital expenditures, if that portion is not outstanding longer
than 2 years. For the portion of an issue that is a refunding issue, § 1.148-
1(c)(4)(i)(B)(3) provides that replacement proceeds do not arise if that portion has a
weighted average maturity that does not exceed the remaining weighted average
maturity of the prior issue, and the issue of which the prior issue is a part satisfies
§ 1.148-1(c)(4)(i)(B)(1) or (2). Section 1.148-1(c)(4)(ii) provides a safe harbor against
the creation of replacement proceeds for longer-term working capital financings. This
safe harbor requires annual testing for available amounts and application of the
available amounts to reduce the burden on the tax-exempt bond market.

Section 1.148-10(a)(4) provides that an action overburdens the tax-exempt bond market
if it results in issuing more bonds, issuing bonds earlier, or allowing bonds to remain
outstanding longer than is otherwise reasonably necessary to accomplish the
governmental purposes of the bonds, based on all the facts and circumstances.
Whether an action is reasonably necessary to accomplish the governmental purposes
of the bonds depends on whether the primary purpose of the transaction is a bona fide
governmental purpose (e.g., an issue of refunding bonds to achieve a debt service
restructuring that would be issued independent of any arbitrage benefit). An important
factor bearing on this determination is whether the action would reasonably be taken to
accomplish the governmental purpose of the issue if the interest on the issue were not
excludable from gross income under § 103(a) (assuming that the hypothetical taxable
interest rate would be the same as the actual tax-exempt interest rate). Factors
evidencing an overissuance include the issuance of an issue the proceeds of which are
reasonably expected to exceed by more than a minor portion the amount necessary to
accomplish the governmental purposes of the issue, or an issue the proceeds of which
are, in fact, substantially in excess of the amount of sale proceeds allocated to
expenditures for the governmental purposes of the issue. One factor evidencing an
early issuance is the issuance of bonds that do not qualify for a temporary period under
§ 1.148-2(e)(2), (e)(3), or (e)(4). One factor evidencing that bonds may remain
outstanding longer than necessary is a term that exceeds the safe harbors against the
creation of replacement proceeds under § 1.148-1(c)(4)(i)(B). These factors may be
outweighed by other factors, however, such as bona fide cost underruns, an issuer’s
bona fide need to finance extraordinary working capital items, or an issuer’s long-term
financial distress. Section 1.148-10(b) imposes limitations on an issue that overburdens
the tax-exempt market, including the mandatory application of the proceeds-spent-last
rule under § 1.148-6(d)(3)(i).

The Bonds are refunding bonds. Under § 1.148-6(d)(3)(ii)(C), the proceeds-spent-last-
method does not apply to expenditures for payment of principal, interest, or redemptions
prices on a prior issue. However, proceeds of the Bonds will include any transferred
proceeds from the Short-term Taxable Debt to be refunded with the Bonds. The answer
to the question of whether the Charges are subject to the proceeds-spent-last method
will determine the amount of the proceeds of the refunded bonds, or of any transferred
proceeds of the Bonds, that Utility can allocate to the Charges.

The Occurrence caused Utility to incur the Charges. The damage caused by the
Occurrence resulted in unprecedented power losses, which in turn resulted in
substantial and unprecedented increases in Utility’s cost of electric power and natural
gas. Utility is refinancing with the Bonds only the portion of the Legal Judgment not
refinanced with the Taxable Bonds. The amount of the Charges that Utility challenged
in its litigation with the Grid Operator and the Gas Providers, and therefore the Legal
Judgment, includes only amounts beyond what Utility’s experts have determined to be
reasonable charges. The amounts determined to be reasonable charges are
significantly greater than the charges for which Utility ordinarily budgets. Utility could
not reasonably have expected or budgeted to pay out of current revenues the amounts
included in the Legal Judgment. We conclude that the Charges being refinanced with
the proceeds of the Bonds are extraordinary, nonrecurring expenses that are not
customarily payable from current revenues and that the exception in § 1.148-
6(d)(3)(ii)(B) applies to these Charges (the “Extraordinary Charges”).

Utility does not maintain specific reserves for expenses such as the Extraordinary
Charges. Utility’s and City’s Operating Reserves are not for such expenses within the
meaning of § 1.148-6(d)(3)(ii)(B). Accordingly, City need not allocate amounts in those
reserves prior to allocating proceeds of the prior bonds or of the Bonds to the
Extraordinary Charges.

Whether the Bonds will remain outstanding longer than is otherwise reasonably
necessary to accomplish the governmental purpose of the Bonds is determined based
on all the facts and circumstances. In determining whether the term of an issue used to
finance extraordinary working capital items is reasonable, considerations include the
nature of the event giving rise to the expenditures, the size of the expenditures relative
to the size of a borrower’s budget, and the impact of the expenditure on a borrower’s
operating budget over the term of the issue that will finance the expenditures.


First, we conclude that Utility has a bona fide need to finance the Extraordinary Charges
as an extraordinary working capital item. Utility did not budget or reserve for the
Extraordinary Charges and the amount of the Extraordinary Charges is substantial. In
addition, Utility already has financed (and refinanced) a portion of the Charges with the
Short-term Taxable Debt and the Taxable Bonds.

Further, City has represented that issuing the Bonds with a term of n years and a
weighted average maturity of not more than o years provides Utility with a reasonable
debt service expense over the term of the issue which considers the economic impact of
the Occurrence and the Charges without causing further downgrades in its credit rating
while preserving customer affordability. Utility’s costs, including its debt, can only be
paid with revenues from its ratepayers. By providing a debt service payment that is
expected to be manageable, the term and weighted average maturity of the Bonds will
also assist Utility in meeting its budgetary requirements. Accordingly, we conclude that
under § 1.148-10(a)(4), the Bonds will not be outstanding longer than reasonably
necessary.

Conclusion

Based solely on the information submitted and representations made, we conclude that
(1) the expenditures for the Extraordinary Charges are extraordinary items pursuant to
§ 1.148-6(d)(3)(ii)(B) and, therefore, not subject to the proceeds-spent-last method in
§ 1.148-6(d)(3)(i); and (2) pursuant to § 1.148-10(a)(4), the Bonds will not be
outstanding longer than is otherwise reasonably necessary.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any transaction or item discussed or referenced in this letter,
including whether the interest on the Bonds is excludable from gross income under
§ 103(a).

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. Because this office has not verified any of the material
submitted in support of the request for rulings, such material is subject to verification on
examination.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                    Sincerely,


                                             Associate Chief Counsel
                                             (Financial Institutions and Products)



                                             By:      ________________________
                                                      Johanna Som de Cerff
                                                      Senior Technician Reviewer
                                                      Branch 5



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