Anyone who has tried to do a deal with a municipal utility knows that the municipal utility must be careful not to allow too much private use of its assets or it can lose the tax exemption on bonds issued to finance the assets.

The Internal Revenue Service issued guidelines in January showing how far such deals can go before they cross the line.

The new rules will affect anyone trying to wheel his electricity across municipal transmission lines or buy electricity from a municipal power plant. They will also affect schemes to finance merchant power plants in the tax-exempt bond market by making a municipal utility nominally the owner. However, they do not address what terms are allowed for someone seeking to operate a municipal facility. The IRS discussed operator or management contracts in a separate “revenue procedure” in 1997.

One can view the new rules as limits. Alternatively, they can be seen as a road map for creative thinking.

The new guidelines are in “temporary and proposed” regulations. The IRS wants comments on them by July 12. Temporary regulations — unlike regulations that are merely proposed — have legal effect in the meantime.

They leave municipal utilities somewhat in limbo. All utilities are under pressure from the Federal Energy Regulatory Commission to transfer at least operating control over their transmission lines to regional transmission organizations, or RTOs. The IRS said it is still studying what effect such transfers will have on municipal utilities.

Background

Municipalities can finance schools, roads, hospitals and other public facilities in the tax-exempt bond market. This gives municipal utilities an edge over private power companies because they can borrow at lower interest rates. They are also not subject to income taxes on their earnings.

Privilege comes at a cost. The municipality must be careful not to allow more than 10% “private business use” of its assets or the bonds issued to finance the assets will lose their tax exemption. Private business use ordinarily means use in a capacity other than as a member of the general public. Thus, for example, a municipality cannot agree to a special deal to sell power from one of its power plants to an industrial customer or a power marketer on terms that are not available to the general public.

The utility must also be careful not to permit more than $15 million in bond proceeds spent on an “output facility” from being put effectively to private use. Output facilities are not only power plants, but also transmission and distribution lines.

Line Drawing

A deal with a municipal utility goes too far if it has the effect of transferring “substantial benefits of owning the facility and substantial burdens of paying the debt service on the bonds” used to finance the facility. The deal must do both before it is considered private use.

Some situations where a private party has ownership benefits are obvious. An example is where a facility is leased to a private party.

The new rules the IRS issued in January address what one can say in “output contracts” — or contracts to buy power or use transmission lines — without crossing the line.

Ownership Benefit

The IRS said that a contract giving the holder a preferential right to capacity — ahead of the general public — transfers the benefits of owning the facility.

The amount of private use in that case is the percentage of capacity reserved. For example, if a power plant has a capacity of 800 megawatts, a contract to sell 40 megawatts to a private party is 5% private use.

The percentage for a power plant is determined by multiplying the annual nameplate capacity by the number of years to maturity of the bonds. However, if the bonds are issued before the project goes into service, then one counts only the years from the in-service date to when the bonds mature. Thus, if the bonds for the project will mature in 12 years, the project has a nameplate capacity of 800 megawatts, and 40 megawatts have been contracted for three years, the percentage of private use is only 40 x 3 = 120 divided by 800 x 12 = 9,600. In other words, the amount of private business use is only 1.25%. The way this formula works leaves room for planning.

The nameplate capacity must be adjusted for physical constraints – like the fact that a river has too little water to run a hydroelectric project at full capacity – but not for economic constraints. An economic constraint is the fact that a plant loses money because fuel prices are too high in relation to what the plant can get for its power. The IRS said it will calculate private use as a percentage of the expected average actualoutput — rather than nameplate capacity — in cases where there would be less than 10% private use using nameplate capacity but more than 20% such use by looking at actual output.

Debt Service Burden

The burden of paying debt service is borne by a private party to the extent of any payments under a contract that the private party is “substantially certain” to have to make. Payments that are forecast to be made are considered “substantially certain”; they do not have to be legally required.

All payments under an “output contract” — for example, a power purchase agreement or wheeling contract — count as going toward debt service if the contract is pledged as security for the bonds. It does not matter in that case how likely the payments are to be made. However, this is true only if the contract cannot be substantially amended without consent of the bondholders.

The percentage of the debt service that a private party will bear is determined by comparing the present value of the payments under the contract to the present value of the debt service. The discount rate for this calculation is the yield on the bonds.

What happens if there is a 10% transfer of ownership but only 5% support of debt service? The contract is okay because one needs more than 10% private use on both counts to have crossed the line.

$15 Million Limit

Municipal utilities must also be careful not to allow more than $15 million in bond proceeds to be put effectively to private use. If a power plant is considered put 15% to private use, then 15% of the bonds used to finance the power plant are considered put to private use. Thus, for example, if the plant was financed with a $600 million bond issue, 15% of the bond issue is $90 million.

One must take into account all outstanding bonds for the same “project.” Generating units placed in service more than three years apart are not part of the same project. Transmission lines are not part of the same project if placed in service more than two years apart. Improvements are not part of the same project if they were not contemplated in the original design and work on them commences — and the bonds to finance them are issued — more than three years after the original project went into service.

Take or Pay

A contract to “take” or to “take or pay” for output is a lost cause. The IRS will treat the facility as put to private use to the full extent of this contract. IRS regulations define a contract to “take” as one where the purchaser agrees to pay for output if the facility is capable of producing it.

Requirements Contracts

Requirements contracts — where someone commits to buy his requirements for electricity or transmission — may or may not be private use depending on the facts. It is a bad fact where the customer commits not to cease business operations (so that he would still have to make payments under the contract for breach of a covenant after a business shutdown).

Opportunities

The following kinds of contracts are ignored; they are not considered private use.

Some merchant plant developers have tried to give a municipal utility nominal ownership of a facility, but to operate the facility and to stitch together a number of output contracts from the following list in order remain below the radar screen on private use.

• Small volume contracts — The payments each year under the contract must not be expected, when the contract is signed, to exceed 0.5% of average annual debt service on the bonds used to finance the facility.
• Swaps and pooling agreements — The purpose of the swap must be to “enable each of the parties to satisfy peak load demands, to accommodate temporary outages, to diversify supply, or to enhance reliability.” The swapped output must be expected to be approximately equal in value from year to year.
• Short-term contracts — The contract, including renewal options, must not last more than a year. It must either be a negotiated deal at arm’s length or be based on generally applicable and uniformly applied rates.
• Excess capacity — Excess capacity at a power plant or on a transmission grid can be offered under contract for a term of up to three years. Renewal options are counted as part of the term. The municipal utility must apply any payments received from such sales to pay down the bonds issued to finance the power plant or grid. It cannot borrow in the tax-exempt market in the meantime to add capacity.
• Power marketers — Output can be sold to a power marketer without being considered private use as long as the power marketer acts solely as a conduit. The contract would probably have to be structured so that the power marketer acts as an agent for the municipal utility in placing the power.