Restructuring a Contract

Restructuring a Contract

September 01, 2006

Restructuring a contract led to taxable income for a utility.

A 1978 federal statute called the “Public Utility Regulatory Policies Act,” or “PURPA,” requires US utilities to buy electricity from two types of power plants owned by independent generators. One type is small power plants of up to 80 megawatts in size that use waste or renewable fuels. The other type is cogeneration facilities that generate two useful forms of energy from a single fuel. An example is a coal-fired power plant that makes both steam and electricity. Congress amended PURPA in August 2005 to drop the requirement for utilities to buy electricity from such plants in regions of the country where there is enough of a wholesale market to provide independent generators with other outlets for their electricity.

Many utilities signed long-term contracts to buy electricity from independent generators in the 1980s and early 1990s. PURPA contracts are still used by some windpower developers.

The IRS released an internal memorandum in August that addressed the tax consequences to a utility that agreed to let the independent generator deliver electricity from any source — not just the eligible power plant — in exchange for a reduction in the price of electricity under the contract. The revised contract gave the genera- tor the right to pay the value of the discount in cash in advance to the utility (and then charge normal rates later). The utility took the position that the cash discount was capital gain. An IRS agent disagreed on audit. The utility faced two hurdles in reporting the amount as capital gain. First, it is capital gain only if it represents an increase in value of the underlying contract. Second, there must be a “sale or exchange” of property to trigger capital gain. The IRS reviewer said the cash discount had to be reported as ordinary income. The case is discussed in a “field service memorandum” that the agency made public in August. It is FAA 20062801F.