IRS Says Power Contracts Were “Involuntarily Converted”

IRS Says Power Contracts Were “Involuntarily Converted”

December 01, 1999 | By Keith Martin in Washington, DC

The Internal Revenue Service said in seven private letter rulings recently that independent power projects that accepted buyout payments from a utility had their power contracts “involuntarily converted.”

This is important because it means the projects do not have to pay income taxes on the buyout payments, provided the money is reinvested within two years in property that is “similar or related in service or use.”

The IRS also said the buyout payments will be long-term capital gain to the extent they are taxed.

The rulings do not identify the utility, but it is almost certainly Niagara Mohawk.

The utility had 175 contracts to buy electricity from independent power facilities at prices that were above market. It managed to buy out 20 of the 175 contracts and then entered into a five-year struggle that led to buyouts or buy-downs of contracts with another 44 projects. During this period, the utility threatened to apply to the state public service commission for permission to seize independent power facilities by eminent domain and sell them at public auction. Also during the period, an administrative law judge recommended that utilities in the state be allowed to curtail purchases from independent power facilities, and the public service commission approved a curtailment order affecting certain projects, but the order was never formally issued.

The IRS said it is an “involuntary conversion” when a taxpayer has reasonable grounds to believe that steps will be taken to condemn his property if he does not agree to a voluntary sale.

Even though the eminent domain threat was against the power plant, the IRS said this would also be considered against the power contract since the two assets are so closely linked that they are an “economic unit.” It cited a US tax court case where a taxpayer was forced by condemnation of parking lots he owned across the street from his freight elevator also to sell the freight elevator.

According to the rulings, “The actions of the State PSC and [the utility]...provide . . . a reasonable basis for Taxpayer to conclude that [the utility] would pursue its threat to condemn Taxpayer’s facility if Taxpayer did not renegotiate its PPA. Further, it is clear that [the utility] had the authority under [state law] to commence eminent domain proceedings against Taxpayer’s facility.”

In five of the rulings, the independent power company later sold the power plant to a third party or abandoned it. The IRS said these power plants were also involuntarily converted.

The independent power companies reportedly asked the IRS to rule that the payments to buy out contracts will be considered reinvested in like property if the money is applied toward a greenfield power project in a different location. The rulings are silent on this issue, suggesting the IRS either would not rule or was “adverse.” A taxpayer will usually withdraw part of his ruling request rather than receive an unfavorable ruling.

The seven projects received buyout payments in the form of cash or shares in the utility.

In two cases, the projects entered into new “swap” and “put” agreements with the utility to replace their power contracts. Under the swap contracts, the parties agreed that in months when the market price for electricity is below an agreed contract price, the utility will pay the difference times a notional quantity of electricity to the independent power producer. The independent power company will make differences payments to the utility in months when the market price is above the contract price. These payments will continue for 10 years.

Under the “put,” the independent power producer has a right to sell the same quantity of electricity covered by the swap to the utility at the market price. The put has the same 10year term. The market price is determined by a formula tied to the utility’s short-term avoided energy and fixed costs in its tariff on file with the public service commission. However, once a power exchange starts functioning, then the actual market price quoted by the power exchange will be used in place of this formula.

The IRS said the swap and put are “similar or related in service or use” to the power contract so that replacing one with the other in an involuntary conversion does not trigger income taxes.

by Keith Martin, in Washington