Prepaid power contracts

Prepaid power contracts

October 07, 2019 | By Keith Martin in Washington, DC

Prepaid power contracts may have gotten a new lease on life in proposed regulations the IRS issued in September.

In a prepaid contract, the customer pays the electricity supplier in advance for electricity to be delivered over time. Such arrangements are also used for gas supply agreements. The structure had been used mainly where electricity or gas is supplied to a municipal utility or cooperative that has a lower cost of capital than the supplier. (For more detail, see “Prepaid Power Contracts” in the September 2012 NewsWire.)

The 2017 tax reforms appeared to shut down such arrangements by requiring the electricity or gas supplier to report the full prepayment as income immediately upon receipt or at best partly upon receipt and the balance the next year. The structure had appeal only if the supplier could stretch out the income over the period the electricity or gas is delivered. (For more detail, see “Final US Tax Bill: Effect on Project Finance Market” in the December 2017 NewsWire and “Prepaid Power Contracts” in the December 2018 NewsWire.)

The proposed IRS regulations to implement the 2017 tax reforms make a number of exceptions.

One was in the 2017 law when it passed Congress and applies to advance payments received under “financial instruments (for example . . . forward contracts . . . ).” The scope and consequences of this exception remain unclear.

The other exception is new. It covers advance payments received at least two tax years before the tax year when the prepaid electricity or gas is delivered. For example, it would apply to an advance payment received by a calendar-year electricity or gas supplier in 2020 for electricity or gas that will not be delivered until 2022 or later.   

This is a so-called specified-goods exception, and there are two other conditions to fit in it. First, the supplier cannot have “on hand (or available to it in [the year the advance payment is received] through its normal source of supply) goods of a substantially similar kind and in a sufficient quantity to satisfy” the contract. Second, the supplier must wait to report the prepayment as book income as the electricity or gas is delivered.

If prepayments for electricity or gas sold under long-term contracts do not have to be reported immediately as income or at best deferred for only a year, then this begs the question how such payments should be reported.

The proposed regulations suggest they should be reported over the same period they accrue for tax purposes, but no later than when they are reported on audited financial statements or other financial statements filed with the US Securities and Exchange Commission, other government agencies or regulators or industry self-regulatory bodies.

The proposed regulations implement sections 451(b) and (c) of the US tax code as those sections were amended in late 2017.

The specified-goods exception appears to have been adopted at the request of Boeing and other aerospace manufacturers.

The IRS is collecting comments through November 8.

The IRS disappointed companies by not allowing the future projected costs to produce prepaid goods to be subtracted as an offset in cases where advance payments must be reported as income at inception, but said it is still considering limited exceptions for companies that use the percentage-of-completion method for calculating book income. In such cases, costs could be accelerated as an offset against the amount that must be reported as income.

The 2017 tax law requires companies to report income to the US tax authorities no later than they report it on financial statements. This applies solely to companies that use accrual accounting.

The proposed regulations say there was no intention to apply a book label to a transaction where the transaction is characterized differently for tax purposes. For example, a transaction that is a lease for tax purposes and an installment sale for book purposes does not turn into a sale for tax purposes. Income would continue to be reported for tax purposes as a lease.

Also, just because income reporting is accelerated for book purposes does not accelerate it for tax if there has not yet been a “realization event” to trigger a tax. An example of a realization event is when an investment is sold.

A mismatch in the proposed regulations may play a role in how some contracts should be written in the future.

The IRS proposes to treat contingent income — for example, where the amount is contingent on a future event — and contingent liabilities differently. Contingent income does not have to be reported for tax purposes, even if the book income has been reported, while contingent liabilities cannot be used immediately as an offset. For example, if an electricity supplier offers a volume discount, the discount may be a contingent liability since the supplier might have to give money back. The contingent liability is ignored. Therefore, it may be better from a tax standpoint to write the contract to charge the discounted price from the start with an add-on in case too little electricity is delivered to qualify for the discount.

The mismatch may also play a role in the drafting of project sale agreements.

Proposed regulations normally do not apply until they are republished in final form. However, companies have the option not to wait in this case as long as they do not cherry pick among the new proposed rules.