The Internal Revenue Service said on December 6 that utilities do not have to report interconnection payments from independent generators in most cases as taxable income.

The decision is important because some utilities had been insisting that independent generators pay not only the cost to connect their power plants to the grid, but also a “tax grossup” that added in some cases millions of dollars to the cost.

The IRS announcement came in the form of a “notice” on which all taxpayers can rely. The notice will be published in the Internal Revenue Bulletin on December 24.

The IRS said it has decided to extend its existing policy of not taxing interties at qualifying facility, or QF, projects to interties at merchant plants. The problem had been that merchant plant interties failed certain tests that the IRS set up in 1988 for QF interties to escape tax. The IRS said it is relaxing those tests.

Background

Power plants must be connected to utility grids in order to deliver their electricity to market. It is market practice for the owner of the power plant to pay the cost not only of any radial lines and substations needed to connect to the grid, but also the cost of any upgrades to the grid itself to accommodate the extra power.

The utility insists on owning those parts of the intertie that come in contact with the grid.

The generator usually either constructs the intertie and conveys title to the utility or reimburses the utility for the cost.

Ordinarily, when one company pays money or transfers property to another, the recipient must report the value as taxable income.

Interties paid for by generators have historically never been reported by utilities as taxable income. However, in 1986, Congress changed the law to say that property supplied to a utility by a “customer or potential customer” must be reported.

QF Interties

At the urging of the independent power industry, the IRS issued a notice in 1988 to make clear that QF interties do not have to be reported by utilities, but there were conditions. First, the QF had to have a power purchase agreement with a term of at least 10 years to sell electricity either to the interconnecting utility or to another utility to which the electricity would be wheeled. Second, the utility could not put the intertie into rate base. QFs argued that utilities had no income in the sense of an accession to wealth because the utility lacked unfettered use of the property, at least during the period of the power contract with the QF, and the utility could not earn a profit from its use because the intertie was not put in rate base. These rules are in Notice 88-129.

The 1988 notice said that if the utility retains title to the intertie after the power contract with the qualifying facility ends, then it would have income to report at that time. The utility would have income equal to the then-fair market value of the intertie less any “basis” the utility has in the intertie on account of having paid the QF something for it. In 1990, the IRS said in a second notice that it would determine the value at contract termination based on “all facts and circumstances, including the age and condition of the property and whether the property is needed to serve the utility’s customers.”  Thus, if the utility has no further use for the intertie, the intertie would have no value. The agency also said it will ordinarily accept whatever value the local public utility commission attaches to the intertie for purposes of setting compensatory payments.

Equipment that is required solely for the utility to sell power to the QF did not qualify for tax-free treatment. “Dual-use interties” were subject to special rules. A dual-use intertie is one that is used both to carry power to the grid and supply it back to the generator. An example is where an intertie is equipped to carry backup power to a power plant for purposes of startup. The utility must show that it expects that no more than 5% of the total power flowing in both directions over a dual-use intertie will be power flowing back to the generator during the first 10 years after the intertie is put into service. If in fact this proves untrue, then it can lead to a “disqualification event” where the utility would have to report the portion of the intertie used to supply power to the QF as income.

In the early 1990’s, the IRS issued a large number of private letter rulings extending the policy in Notice 88-129 to non-QF interties, gas pipelines and interconnections between utility grids. However, some IRS officials began to question by the late 1990’s whether the policy ought to apply to merchant plant interties. At issue was whether merchant plants are “customers” of the utilities with whom they interconnect and, if so, whether this meant that the change in the tax code in 1986 that utilities had to report contributions from “customers or potential customers” as income meant they must report the value of merchant plant interties.

Notice 2001-82

The new notice makes clear that most merchant plant interties do not have to be reported as income. Merchant plant interties will be treated the same as QF interties. Some of the tests in the 1988 notice are being changed to fit the new fact patterns found in the merchant power industry.

The new notice creates essentially a “safe harbor.” Interties that fall within the safe harbor will not have to be reported as income. Parties to transactions that are outside the safe harbor must apply for private letter rulings.

The tests for tax-free treatment remain the same as in the 1988 notice for QF interties, with the following changes. First, the generator does not have to be a QF. Second, it does not need a contract to sell electricity to a utility; a long-term interconnection agreement will suffice. The IRS said that an interconnection agreement that has no fixed term but is tied to the period the generator will remain in commercial operation is considered long term. Third, ownership of the electricity must pass from the generator “to the purchaser prior to its transmission on the utility’s transmission grid.” The IRS said this requirement is satisfied if title to the electricity passes from the generator to the purchaser at the busbar for the power plant. The industry urged Treasury before the new notice was issued to allow transfers at other points along the intertie before the power goes on to the grid. The final notice allows such downstream transfers. It also makes clear that the transfer can be to a power marketer who is affiliated with the generator.

The generator must recover his interconnection payments for tax purposes over 20 years using the straight-line method. The IRS insisted on this as a tradeoff for concluding that interties are not income to utilities.

The notice is prospective. It applies to interconnection payments made pursuant to interconnection agreements signed after December 24, 2001. Projects that already signed interconnection agreements will have to apply for private rulings. The IRS said it will waive its usual policy of not ruling in cases where the issue already appears on the utility’s tax return in order to deal with past cases.

by Keith Martin, in Washington