Matching power contracts are not “section 197 intangibles” but rather a financial play, the IRS said.

The IRS made the statement in a private letter ruling that it made public in April.

The significance is a company that bought a pair of matching long-term contracts — one a contract to buy a quantity of electricity and the other a contract to resell the same electricity at a higher price — was able to amortize its investment in the power contracts over a faster period than if the contracts had been “section 197 intangibles.” An investment in such intangibles must ordinarily be amortized over 15 years. The ruling is PLR 200614001.

During the 1980’s, many utilities in the United States signed long-term contracts to buy electricity from owners of so-called independent power plants. The utilities were required to do so by federal law.

By the 1990’s, electricity prices had fallen to such an extent that these contracts were no longer economic. Utilities sometimes paid large sums of money to cancel the contracts. However, rather than sell their contracts back to the utilities, some independent generators agreed to reduce the price of electricity somewhat in exchange for being released from the obligation to supply the electricity from a specific power plant. They then locked in a long-term supply of electricity to match what they had to deliver to the utility, but at the lower prices that were then prevailing in the market. This had the effect of locking in a profit margin over time. Both contracts were put in a special-purpose company. The specialpurpose company borrowed against the profit margin to turn it immediately into cash.

An investor planning to buy such a specialpurpose company went to the IRS last year to ask for a ruling. The transaction to purchase the special-purpose company was treated for tax purposes as a direct purchase of the matching power contracts. The special-purpose company did not exist for tax purposes.

The IRS ruled that the investor bought something closer to a “futures contract, foreign currency contract, notional principal contract, or other similar financial contract” rather than a pair of power contracts. The former are not “section 197 intangibles.” Power contracts may be such intangibles. The problem with intangibles is the investor would have had to write off his investment over 15 years. The ruling let him write it off more quickly.

Special-purpose companies in this situation are usually saddled with debt. The ruling does not explain what happened to the debt.

The ruling has implications for anyone trying to avoid characterizing revenue from electricity sales outside the United States as “subpart F income.”

The United States taxes US companies on any subpart F income earned by their offshore subsidiaries without waiting for the income to be repatriated to the United States. Nonsubpart F income would not ordinarily be taxed until it is repatriated. The ruling says, “[T]he contracts at issue require the sale or purchase of electricity, a commodity with respect to which futures contracts are regularly traded on established markets.” Gain or loss from the sale of commodities is subpart F income.

By Keith Martin