Stranded cost recoveries by utilities are taxable income, the IRS said in an audit.

A state allowed consumers to bypass the local utility and contract directly with independent suppliers for electricity.  As part of this deregulation plan, the utility moved its power plants into an unregulated affiliate owned by its parent company.  That left the utility owning only transmission and distribution lines.  The state deregulation law authorized the utility to collect a “transition charge” from all of its distribution customers until it recovered its “stranded costs,” or its unrecovered investment in the power plants.  The utility borrowed against the transition charges it expected to collect in the future — so that it would have the cash value today — and then used the transition charges as they came in over time to repay the lenders.

The utility took the position the transition charges it eventually collected did not have to be reported as taxable income. (It is not clear whether the utility took the potential tax cost into account when it borrowed against the transition charges.  Since the cash it collects goes to repay the lenders, it has little cash left over to pay any taxes.)

An IRS agent flagged the issue on audit.  The agent and the utility sent the question to the IRS national office for resolution.  The national office said in a private ruling called a “technical advice memorandum” that the charges are income.

The ruling is TAM 200411008.  The IRS released the text in late March.

Keith Martin