Two recent tax rulings offer ideas for how to restructure contracts while minimizing the tax consequences. The rulings are private letter rulings. The Internal Revenue Service released both rulings — with the taxpayers’ names deleted — in April.

Contract Buyout

In one, the IRS told a utility planning to issue shares of its own stock to buy out power purchase agreements with “qualifying facility” projects that the utility could immediately deduct the market value of the shares issued. This is equivalent to telling the utility it can issue its own scrip. The independent power producers receiving the shares had to pay taxes on the market value. However, if the stock is publicly-traded, then the shares can be easily converted into cash.

The utility to whom the ruling was issued is almost certainly Niagara Mohawk Power Corporation.

Many utilities complain that the prices they are required to pay for electricity under so-called qualifying facility, or QF, contracts negotiated in the 1980’s are now significantly above market. Utilities have tried to cancel, renegotiate or buy out such contracts. A key issue in negotiations is how to structure the transaction so that the utility gets as large a tax deduction as quickly as possible for its payment to the QF. The larger and the earlier in time the deduction for the utility, the less the buyout will cost after taxes.

The utility in the ruling had a large number of QF contracts. It entered into a master settlement agreement. Under the terms of this settlement, the utility agreed to pay an amount in cash and to convey a block of common shares in the utility to a dispositary, or escrow agent, acting for the QFs. One QF contract was “amended by modifying the price and certain other contract terms.” A number of other QF contracts were “renegotiated and restructured in accordance with certain criteria set out in the [settlement agreement].” The remaining QF contracts were terminated. Each QF received an amount in cash and the rest in shares for renegotiating or terminating its contract.

The IRS said the utility could deduct the fair market value of the shares and amount in cash, but only for payments to QFs whose contracts were terminated.

The agency specifically did not rule on the tax treatment to the utility of payments to QFs whose contracts were merely renegotiated. Ordinarily, such payments must be amortized over the remaining term of the revised contract.

The ruling took an unusually long time to clear the IRS. Private letter rulings usually take three to six months. The utility applied for it in October 1997 and had to send seven more letters with follow up information to the IRS — also unusual — before a ruling was issued finally in late December 1998. (Private rulings are released to the public roughly three months after being put in the mail to the taxpayer.)

The IRS said the utility would not have any income by issuing shares to buy out the contracts. It pointed to a number of cases where corporations issue new shares — for example, as compensation to employees — where the corporation is allowed to deduct the fair market value. The recipient must report the market value of the shares as income.

Involuntary Conversion

In the other ruling, a company that received a payment to cancel a contract did not have to report the payment as income because the IRS said the transaction was an “involuntary conversion.”

Under US tax rules, proceeds from an involuntary conversion do not have to be reported as income as long as the taxpayer finds suitable replacement property within two to three years.

The ruling involved a paper company that had a 50-year contract with the federal government to buy timber from a particular forest. The contract had favorable pricing. Congress passed a law requiring unilateral changes in the contract, including changes in pricing that the company said were essentially a government abrogation of the original contract.

The company filed suit in federal court. The federal government settled. The company planned to replace the original contract with a series of shorter-term timber-cutting contracts with its parent company or third parties. The IRS said there had been an involuntary conversion of the original contract. It said it would apply a “functional use test” to determine whether the new contracts with the parent and third parties were similar enough to the original contract to qualify as replacement property. Although the ruling did not say, presumably the paper company was able to avoid reporting the buyout or settlement payment from the federal government as income by applying the money to the new contracts.

by Keith Martin, in Washington