Involuntary Conversions

“Involuntary Conversions”

September 01, 2006 | By Keith Martin in Washington, DC

“Involuntary conversions” are not easy to achieve.

The IRS told a utility that was ordered by its public utility commission to divest at least half of its power plants that it could not delay reporting the gain from the sale as taxable income on grounds that the plants were “involuntarily converted” into cash. The IRS reported its conclusions in “technical advice memorandum.” A “technical advice memorandum” is a ruling by the national office to settle a dispute arising in an audit.

A company does not have to report gain on assets that it is forced by government action to convert into cash as long as the company reinvests the sales proceeds within two years in replacement property that is “similar or related in service or use” to the property that was converted. The IRS said the utility in this case failed to prove that its assets were involuntarily converted.

The IRS said it will rarely accept that assets were involuntarily converted unless they were taken directly by the government The government sometimes orders companies to divest assets due to anti-trust concerns or to limit the use of property because of health, safety or zoning concerns. These are normal uses of government police powers and are not a “taking” of property by the government, the IRS said. It said there would be a “taking” in such cases only if a company is denied “all economically beneficial uses”of the assets, adding,“One who does business in a regulated field cannot reason- ably rely on the status quo because there is the foreseeable potential for regulatory change.”

The IRS said that even if the assets had been involuntarily converted, the utility failed to show that it reinvested the cash in replacement property.

The utility filed amended tax returns reporting after the fact that its assets were involuntarily converted. It argued that the sales proceeds were reinvested in normal spending on upkeep of other assets and other investments the utility made within the two years in its business. The IRS said the replacement property must be acquired with the specific intention to replace the assets converted. Therefore, one cannot designate an asset as replacement property after it has already been purchased.

The ruling also addressed whether utilities that turn operational control of their electricity grids over to a regional trans- mission organization under government orders suffer an involuntarily conversion of their grids. The IRS said no. It said that the government has merely changed the form of regulation over the grid. The utility has always been required to use its grid to serve customers. Now federal regulators have expanded the customer base to include competitors, like independent generators, who want to move power over the grid.

Finally, the agency also rejected the claim that stranded-cost rate recovery orders are compensation for an involuntary taking of property.

Utilities have historically had a monopoly right to supply electricity in a designated service territory. Many states have moved to deregulate their electricity markets. The retail supply of electricity remains regulated, but some states offer consumers the right to choose among competing electricity suppliers. The wholesale market for electricity is usually fully deregulated. Utilities that built new power plants with the expectation that they would be able to recover the cost in rates over time were caught with declining customer bases to whom they could charge the last of these power plants. States often let utilities recover these “stranded costs” over a fixed number of years by assessing surcharges on electricity or wheeling rates. Many utilities have borrowed against the stranded cost orders, thereby converting the additional revenue they expect to collect over time into immediate cash.

The IRS refused to accept the characterization of the stranded cost recoveries as compensation for an involuntary taking of property (the monopoly franchise over a service territory). It said they are simply a speeding up of what the utility would have collected anyway through rates.“The ratepayers did not view the payments of [stranded cost surcharges] as compensation for a government taking because the charge had always been a part of the ratepayer’s rate.”

The ruling is Technical Advice Memorandum 200627024. The IRS made it public in early August.

Keith Martin