PREPAID ELECTRICITY DEALS got a green light from the Internal Revenue Service on August 1.

The IRS issued new regulations that will allow owners of some power plants that supply electricity to municipal utilities to benefit indirectly from tax-exempt financing for their projects.

Gas suppliers are already able to enter into such arrangements. Roughly 20 prepayment deals have been done to date, mostly for gas. In gas transactions, a gas supplier enters into a long-term contract to supply gas to a municipal utility. The utility is given a discount in exchange for prepaying for the gas. It borrows the funds to cover the prepayment in the tax-exempt bond market. The effect is to give the gas supplier access indirectly to money at tax-exempt borrowing rates. IRS regulations allow a supplier who is prepaid for “goods” to report the prepayment over the same period the goods are delivered as long as this is how the income is reported for financial purposes.

These deals run afoul potentially of rules that bar a municipality from borrowing at tax-exempt rates and then reinvesting the proceeds in a commodity or other “investment-type property” that earns it a higher return than its cost to borrow. The discount off the gas price might be viewed as such an arbitrage profit.

In April 2002, the IRS proposed an exception to the arbitrage rules to allow prepaid gas deals. On August 1, the IRS modified the gas exception and also broadened it to cover electricity.

Under the new rules, no arbitrage profit will be found where a municipal utility prepays for electricity as long as the municipal utility uses at least 90% of the electricity to supply retail customers in its historic service territory or to make wholesale sales to other municipal utilities that use the power to supply their own retail loads. A utility’s historic service territory is the area it served at all times during the five years leading up to when the tax-exempt bonds were issued.

In prepaid gas deals, at least 90% of the gas must be used by the municipal utility to supply retail gas customers in its historic service territory or to generate electricity for customers whom it is required by federal or state law to serve.

The parties to long-term contracts usually also enter into a swap at the same time. Under the IRS regulations, such swaps are okay as long as they are with third parties and the swaps stand as independent contracts.