The Internal Revenue released new guidelines in July that should let some independent power companies get back “tax grossups” that utilities required them to pay in connection with “network upgrades.”

The guidelines also require that certain language be included in interconnection agreements if independent power companies want to avoid paying a tax grossup on the cost of future network upgrades.

“Network upgrades” are improvements that a utility makes to its grid when an independent power company wants to connect a new power plant to the grid. The improvements are needed to accommodate the electricity from the new plant.

Background

Connecting a new power plant to the grid involves construction of a radial line and substation improvements, and it might also require upgrades to the grid itself. Utilities usually do this work and charge the independent power company for the cost. It is current Federal Energy Regulatory Commission policy that the utility can charge the independent power producer for the cost of the “direct” intertie to link his or her power plant to the grid, but the cost of any network upgrades must be collected from all users of the grid through the tariffs the utility charges its customers for wheeling electricity.

This puts utilities in a bind. The grid upgrades must be made immediately, and it takes time to collect the cost from all grid users in rates. Therefore, FERC lets utilities require independent power producers to advance the funds for the grid upgrades. The advances must be repaid over time with interest. FERC released a model interconnection agreement in 2003 and revised it in 2004. Under the model agreement, such advances must be repaid within 20 years. The advances may be repaid in cash or in the form of “transmission credits,” meaning credits that the independent power company can use to offset any future charges it incurs with the utility for wheeling electricity from its plant.

Ordinarily whenever a utility or other corporation receives money from someone else, it must report the amount as income. This normally would apply to the value of any intertie paid for by an independent power producer.

However, the IRS issued two notices in 1988 and 2001 in which it said utilities ordinarily do not have to report interconnection payments from independent generators as income. This is true only in cases where the independent generator is not a customer of the utility. Therefore, independent power companies are careful to sell their electricity to someone else before it reaches the utility grid. That someone else will be a customer of the utility for wheeling the electricity across the grid.

In cases where the independent generator is a customer, then the utility usually insists that a “tax grossup” be paid — on top of the interconnection costs — to compensate the utility for the taxes it must pay. Tax grossups can make interconnection 25% to 40% more expensive.

A handful of utilities have taken the position that amounts independent power companies advance for network upgrades must be reported as income — at least until the IRS says otherwise.

Independent generators insist that the advances are loans. No corporation reports borrowed money as income. They are also startled by the position these utilities take that direct intertie payments the utilities get to keep do not have to be reported as income, but while amounts the utility must give back for network upgrades must be reported.

The IRS balked at addressing the tax treatment of the advances in private letter rulings after receiving eight requests for such rulings quickly from utilities. It was afraid it would be overwhelmed with requests. It promised the industry instead in 2003 that it would issue general guidance on which all utilities can rely. That guidance is what the agency issued in July.

New Rules

The guidelines are in Revenue Procedure 2005-35.

The revenue procedure creates two “safe harbors” under which utilities will not have to report payments from independent generators to cover the cost of network upgrades as income.

A “safe harbor” is a set of facts the IRS has analyzed carefully.

One safe harbor covers interconnection agreements signed on or after December 20, 2004.

Payments from an independent power producer for network upgrades under such an agreement do not have to be reported by a utility as income if the utility is required by the interconnection agreement to return the network upgrade payments to the generator within 20 years with interest.

The interconnection agreement must require that the refunds be made in cash.

It must require that the interest be calculated at the FERC interest rate in Order No. 2003-B. That order refers to Federal Energy Regulatory Commission regulations that explain interest should be paid at the average prime rate for each quarter, calculated to the nearest one hundredth of one percent, as reported in the Federal Reserve Bulletin or the “Selected Interest Rates” (Statistical Release G. 13) published by the Federal Reserve Board. The 20-year period within which the utility must be required to reimburse the generator for the full amount of the network upgrade payments runs from the “commercial operation date,” defined as the date the power plant “commences commercial operation . . . after trial operation . . . has been completed and confirmed in writing as prescribed by FERC.” The model interconnection agreement that FERC adopted in March 2004 has a form of letter that independent generators are supposed to send utilities announcing when their power plants have been put into commercial operation.

The other safe harbor covers older interconnection agreements.

Payments from a generator for network upgrades under such older agreements do not have to be reported by a utility as income as long as the agreement requires the utility to return the full amount of the payments “either in cash, assignable transmission credits, or a combination of both.” The utility must also reasonably expect on July 11, 2005 that full reimbursement will be made within 20 years. There is no need for the utility to return the money with interest. The safe harbor for older agreements appears to have been modeled on the standard interconnection agreement that Entergy was using at the time.

The IRS said that it is a “change in accounting method” for a utility to alter the way it has been reporting network upgrade payments from independent generators, even if the utility is merely following the new guidelines for how to treat such payments. A taxpayer must have approval from the IRS before it can change its accounting method. However, the IRS said approval will be given automatically to any utility that files a form with its tax return. A utility seeking permission for such a change for a tax year ending on or after July 11, 2005 must attach an IRS Form 3115. Utilities will also be given permission automatically to change their treatment of network upgrade payments for all past tax years that remain open to audit. In such cases, the Form 3115 would have to be attached to an amended return.

Amended returns for open tax years must be filed no later than December 31 this year.

Comments

Independent generators may not have seen the last of the controversy in this area.

The new guidelines fail to address all the possible fact patterns.

The model interconnection agreement that many utilities are using talks about returning advances for network upgrades in cash or in transmission credits, at the option of the independent generator. The only fact pattern the IRS addressed in the guidelines — at least for newer agreements meaning interconnection agreements signed since December 20, 2004 — is the case where the agreement talks about a refund solely in cash.

Also, when FERC released its model agreement, it said that regional transmission organizations and independent system operators — like the PJM region in the mid-Atlantic states — are free to adopt their own pricing policies for network upgrades. The guidelines do not address these other cases.

It is not clear whether the IRS will reopen the window for private letter ruling requests to address the other cases.

A “safe harbor” is usually a set of facts that the IRS has taken time to analyze carefully a reach a conclusion. It necessarily does not suggest the IRS has problems with other fact patterns.

Two trade associations — the Electric Power Supply Association and the Edison Electric Institute — have asked senior IRS and Treasury officials for a meeting to discuss the situation. The meeting is expected in late August or September.

In the meantime, the IRS has changed its policy for private letter rulings on electric interties. It will no longer rule in cases where the utility had to take a position on a filed tax return about how to report interconnection payments under an agreement by the time the private letter ruling request relating to that agreement is filed. This new rulings policy is also on the agenda for the meeting with senior IRS and Treasury officials.

Independent generators are exploring other options in the meantime. They include having a utility that reported payments as income test whether the payments had to be reported by filing a refund claim. The other is having the utility apply for a “pre-filing agreement.” The IRS has a program where large companies that are planning to file tax returns in the future can ask the IRS whether it agrees with a position the company plans to take on the return. Interconnection payments are often made over several years. Even if a tax return has already been filed for the year the payments started, there are still additional payments to report — or not to report — on future tax returns.