IRS updates tax treatment of interconnection payments

IRS updates tax treatment of interconnection payments

August 11, 2016 | By Keith Martin in Washington, DC

The Internal Revenue Service reaffirmed in June that utilities do not have to report most payments from independent generators to reimburse for the cost of grid improvements as taxable income.

The IRS action is important because the agency had been taking a narrow view of when such payments can be received tax free by utilities. As a consequence, some utilities had begun collecting “tax gross ups” that run in some cases into the millions of dollars on top of the cost reimbursements.

IRS policy since 1988 has been not to tax utilities in most cases when independent generators connect to the grid and reimburse the utility for the cost of substation improvements and network upgrades to accommodate the additional power on the grid.

The independent generator must be careful to transfer its electricity to someone else before the electricity reaches the grid so that the generator is not considered a customer of the utility or grid for transmission. Utilities must report payments from customers as income.

The IRS published a “safe harbor,” or list of conditions, that must be met by utilities to avoid reporting cost reimbursements from independent generators as income in 1988, and then updated it in 1990 and 2001.

One of the conditions is that the cost reimbursement must be required by a long-term power purchase agreement or interconnection agreement with the utility receiving the payment.

The IRS dropped this requirement in Notice 2016-36 in June.

It no longer matters what agreement requires the cost reimbursement. The issue had come to a head recently because grid congestion is leading generators to enter into transmission upgrade agreements with neighboring utilities whose congested grids are forcing generators to curtail, or cut back, the electricity from their projects. Some wind farms on the PJM grid have been forced recently to curtail electricity output by as much as 97% due to congestion on parts of the neighboring MISO grid. The owners of the wind farms reimbursed the utilities on the MISO grid for the cost of improvements to relieve the congestion. The IRS notice makes clear that these cost reimbursements do not have to be reported by the MISO utilities as income.

The IRS also made it easy for utilities that reported payments as income to get the money back. The utilities will be able to reduce the taxes they owe on their current-year tax returns rather than having to file amended returns for past tax years.

Some independent generators may be entitled to refunds of tax gross ups they paid utilities in the past.

The IRS also broadened the policy of not taxing utilities on cost reimbursements to cover interconnection and network upgrade payments from standalone energy storage facilities that connect to the grid.

Background

Independent power plants must be connected to the grid in order to deliver electricity to market. It is market practice for the owner of the power plant to pay the cost not only of any radial lines and substations needed to connect to the grid, but also the cost of any upgrades to the grid itself to accommodate the extra power.

The utility insists on owning those parts of the intertie that come in contact with the grid.

The independent generator usually either constructs the intertie and conveys title to the utility or reimburses the utility for the cost.

Ordinarily, when one company pays money or transfers property to another, the recipient must report the value as taxable income.

Interties paid for by generators have historically never been reported by utilities as taxable income. However, in 1986, Congress changed the law to say that property supplied to a utility by a “customer or potential customer” must be reported.

At the urging of the independent power industry, the IRS issued a notice in 1988 to make clear that interties paid for by “qualifying facility” projects — independent power plants from which utilities are required by federal law to buy electricity — do not have to be reported by utilities as income. That was Notice 88-129. In 2001, the IRS extended the same policy, in Notice 2001-82, to cost reimbursements from other independent power projects that do not qualify as qualifying facilities. There was also a notice in between in 1990 when negotiations between independent power companies and the three investor-owned utilities in California over getting back tax gross ups that had been collected by the California utilities after 1986 became stalled.

The latest notice replaces all the earlier notices.

Five tests

Stating June 20, 2016, utilities do not have to report payments from owners of independent power plants and energy storage facilities as income that satisfy five tests.

Utilities can apply the new rules retroactively to past payments.

First, the generator or storage facility must not be expected to buy more than a small amount of electricity from the utility over the first 10 years after the project is first connected to the grid.

No more than 5% of the total power flows in both directions over the intertie can be electricity flowing to the project from the grid. Power moving over the intertie to affiliates of the generator is taken into account. The utility must project power flows in both directions over the first 10 years. The projection must be supported by an independent engineer’s report or other “appropriate documentation.” However, power flows in the first utility tax year that the intertie is in service can be ignored.

Second, if electricity from the project will be wheeled over the grid to a distant customer, then someone other than the generator must take ownership of the electricity before it reaches the grid. Thus, either the customer for the electricity should take delivery of the electricity or else title should be transferred to a power marketing affiliate on the project side of the grid.

Make sure that any affiliate taking title to the electricity is a different entity for tax purposes. For example, if the affiliate and the project company that owns the power plant are both single-member limited liability companies with a common parent, then they may be considered the same entity for tax purposes.

The key is that the generator should not be a customer of the utility receiving the interconnection payment. It is a customer if it has to pay for transmission.

Third, the utility must not put the intertie or other improvements paid for by the generator into rate base.

Fourth, the intertie must be used for “transmitting electricity.” Some distributed solar facilities connect to distribution lines rather than transmission lines. The IRS said it intends the policy of not taxing utilities on cost reimbursements will apply equally to them. The suggestion the intertie must be used for transmission left the new notice less clear on this point than was intended.

Finally, the generator must recover the cost reimbursements for tax purposes on a straight-line basis over 20 years.

Income

It is possible that the utility might have to report income in the future, although the likelihood is small.

The IRS identified two situations.

The IRS wanted a check in the event the intertie is in fact used “for the purpose of selling power to the generator” despite the earlier expectation that the amount of power flowing back to the generator over the intertie would be minimal.

If electricity sold to the generator is more than 5% of total power flows in both directions over the intertie in any three of five consecutive years, then the utility must report a fraction of the fair market value of the intertie at the end of the three years as income. This need to monitor power flows is not limited to the first 10 years. The fraction is supposed to represent the percentage of actual and anticipated future use of the intertie to sell power to the generator, not just during the three years when power flowing back to the generator triggered a tax. The fair market value for this purpose is the depreciated replacement cost, meaning the utility calculates what a new intertie would cost and then reduces the value for the fact the intertie has been in use for a number of years.

The other situation where the utility might have to report income is where the generator has a power contract to sell electricity to the utility and the utility keeps the intertie after the power contract terminates.

In that case, the utility must report the fair market value of the intertie, less any amount it pays the generator for it.

However, the IRS said it will not require the generator to report income after a power contract terminates unless circumstances “indicate an intention by the parties to characterize the contribution of the intertie as a transaction that in substance constitutes a [contribution in aid of construction]” to the utility and, even then, if the utility pays anything to the generator for the intertie “under a procedure or method established or used by the relevant utility commission,” then that payment will ordinarily be presumed to be the full value so that there is no income for the utility to report.

An example in the notice makes clear that if the utility does not need the intertie, then the value should ordinarily be nil.

Other

The IRS will no longer issue private letter rulings about whether payments are covered by the new notice. Congress has forced a 19% reduction in manpower on the IRS in the last six years. The IRS issued the notice in the hope that this would cut down on the time it has to spend answering questions in this area.

Some payments by generators to cover the cost of network upgrades to the grid are treated as loans to utilities and are not income to the utilities for that reason. A borrower does not report borrowed money as income. This is true in cases where the utility is required by the interconnection agreement with the independent generator 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 Federal Energy Regulatory Commission rate in Order No. 2003-B. The order refers to FERC 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 of the generator’s power plant. 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 IRS guidelines for interconnection payments treated as loans are in Revenue Procedure 2005-35.