A US utility that had a 10-year tale of woe in what looks like China was told its losses were long-term capital losses — not ordinary losses.

Capital losses are much harder to deduct.

The IRS national office advised its agents in the field who denied deductions the utility claimed that the agents were right to deny them. The case looks headed to court.

The utility invested in a joint venture that was building a power plant to supply electricity to an industrial company. The joint venture received approvals for the project from both the provincial and national governments. The project had to be connected to the regional grid. The industrial company was responsible for handling that effort.

Three years into the project, the rules changed and control over the grid was vested in a new state entity that had commercial responsibility for the grid, but not regulatory authority. When planning for the project started, the region was short on electricity. By year three, the region had too much electricity, and the new grid company had little interest in seeing the project built because it wanted to sell its own excess electricity to the industrial company. For the next three years, the parties argued back and forth. The grid company said that the project could only sell to the grid and then only in limited quantities and at wholesale rates.

Six years into the project, the US utility decided to refocus solely on the US and take a loss on its foreign operations. It filed a claim against its political risk insurance policy for the loss on the project. The insurer rejected the claim because it said there was no government expropriation of the project. After four more years, the utility lost in arbitration. Meanwhile, it sold what remaining interest it had in the project to a foreign investor for what it could get for the project rights.

The utility was clearly entitled to a loss on its taxes, since the loss was not covered by insurance.

The loss is ordinary under section 1231 of the US tax code if it results from an “involuntary conversion.” In a somewhat narrow reading of the law, the IRS said there was no government seizure of the project; the grid company had killed it for its own commercial reasons rather than because it wanted to take the project for public use.

The case is discussed in an internal legal memorandum that the IRS national office made public in mid-January. The memo is CCA 201002035.

Keith Martin