SALE OF A POWER CONTRACT can yield capital gain, provided the transaction is properly structured

SALE OF A POWER CONTRACT can yield capital gain, provided the transaction is properly structured

February 01, 2001
SALE OF A POWER CONTRACT can yield capital gain, provided the transaction is properly structured.

Before the huge runup in electricity prices in California, utilities across the country had been looking for ways to cancel long-term contracts to buy electricity from “qualifying facility” projects. Utilities offered large buyout payments to QFs to get out from under the contracts. Some QFs reported the payments as capital gain (rather than ordinary income). The IRS has challenged this treatment on audit. Individuals prefer capital gains because they are taxed at a lower tax rate. Corporations are indifferent, unless they have capital losses to use as an offset.

A recent “technical advice memorandum” sheds new light on the issue. This is a ruling by the IRS national office to settle a dispute on audit between a taxpayer and an IRS. The IRS made the ruling public in December.

In it, a QF sold its contract to a power marketer rather than accept a payment from the utility directly to cancel the contract. The power marketer then renegotiated the contract with the utility.

The IRS let the QF treat the payment from the power marketer as capital gain. One must make a “sale or exchange” of “property” to qualify for capital gain. The IRS conceded that a power contract is “property” because it has an independent value that fluctuates with the market. A transfer of the contract back to the utility would not have qualified as a “sale or exchange.” That’s because when contract rights are extinguished, they simply disappear. The key in this case was the contract survived the sale to the power marketer.

It did not matter that the power marketer traded the contract immediately to the utility for a new contract.

Keith Martin