SERVICE EXPLAINS NONRECOGNITION TREATMENT OF CIAC TRANSFERS BETWEEN 'QUALIFYING FACILITIES' AND UTILITIES UNDER PURPA.

Notice 88-129

This notice provides guidance with respect to certain payments or transfers of property to regulated public utilities ("utilities") by qualifying small power producers and qualifying cogenerators (collectively "Qualifying Facilities"), as defined in section 3 of the Federal Power Act, as amended by section 201 of the Public Utilities Regulatory Policies Act of 1978 ("PURPA").

BACKGROUND

Notice 87-82, 1987-51 I.R.B. 10 (Dec. 21, 1987), addressed the Federal tax treatment of contributions in aid of construction ("CIACS") in light of the amendments made to section 118 of the Internal Revenue Code ("Code") by section 824 of the Tax Reform Act of 1986 (the "1986 Act"). Notice 87-82 reserved for separate guidance the treatment of payments or transfers of property made by Qualifying Facilities to utilities in connection with sales of power under PURPA. The Internal Revenue Service has received many inquiries concerning whether, as a result of the 1986 Act, such transfers result in income to utilities. This notice provides guidance with respect to certain types of transfers from Qualifying Facilities to utilities. No inference is intended with respect to other types of transfers.

1. TRANSFERS EXCLUSIVELY IN CONNECTION WITH THE SALE OF ELECTRICITY BY A QUALIFYING FACILITY.

PURPA and its implementing rules and regulations require that a utility interconnect with a Qualifying Facility for the purpose of allowing the sale of power produced by the Qualifying Facility. A Qualifying Facility must bear the cost of the purchase and installation of any equipment required for the interconnection. This equipment, referred to herein as an "intertie", may include new connecting and transmission facilities, or modifications, upgrades or relocations of a utility's existing transmission network. Generally, the utility takes legal title to the intertie, which becomes part of the utility's transmission network. Under standard cost-based rate regulation, utilities may neither earn a profit on sales of power purchased from Qualifying Facilities nor include the cost of interties in rate base.

The amendment of Code section 118(b) by the 1986 Act was intended to require utilities to include in income the value of any contribution in aid of construction made to encourage the provision of services by a utility to a customer. See H.R. Rep. No. 841, 99th Cong., 2d Sess. 324 (1986) (Conference Report). In a CIAC transaction the purpose of the contribution of property to the utility is to facilitate the sale of power by the utility to a customer. In contrast, the purpose of the contribution by a Qualifying Facility to a utility is to permit the sale of power by the Qualifying Facility to the utility. Accordingly, the fact that the 1986 amendments to Code section 118(b) render CIAC transactions taxable to the utility does not require a similar conclusion with respect to transfers from Qualifying Facilities to utilities.

Qualifying Facilities generally sell electricity to utilities pursuant to long-term power purchase contracts. Some contracts require the Qualifying Facility to construct and install the intertie, and subsequently transfer the intertie to the utility. With respect to transfers of property made by a Qualifying Facility to a utility exclusively in connection with the sale of electricity by the Qualifying Facility to the utility, a utility will not realize income upon transfer of an intertie by a Qualifying Facility. These nontaxable transfers are referred to herein as "QF transfers". The possibility that an intertie may be used to transmit power to a utility that will in turn transmit the power across its transmission network for sale by the Qualifying Facility to another utility (i.e., "wheeling") shall not cause the contribution to be treated as a CIAC. A utility takes no basis in property transferred in a QF transfer, thus, for example, a utility shall not be allowed any depreciation (or amortization) deductions with respect to the property transferred in a QF transfer.

Under some power purchase contracts, the utility agrees to construct and install the intertie on behalf of the Qualifying Facility, with the Qualifying Facility agreeing to reimburse or finance the construction and installation costs. A utility that constructs an intertie in exchange for a cash payment from a Qualifying Facility pursuant to a PURPA contract will be deemed to construct the property for the Qualifying Facility under contract and will recognize income from the construction in the same manner as any other taxpayer constructing similar property under contract. See, e.g., Code section 460. Subsequent to the construction of the property, the Qualifying Facility will be deemed to transfer the property to the utility in a QF transfer that will be treated in exactly the same manner as an in-kind QF transfer.

2. OTHER QF TRANSFERS.

In some situations the transfer of property by a Qualifying Facility to a utility may not be exclusively in connection with the sale of power from the Qualifying Facility to the utility. In addition to transmitting power from the Qualifying Facility to the utility, the intertie may be used to transmit power from the utility for sale to the Qualifying Facility (a "dual-use intertie"). A dual- use intertie may be employed where a Qualifying Facility relies on the utility as a "backup" or supplemental power source, either sporadically or on a regular basis. The transfer of a dual-use intertie may be treated as a QF transfer, as provided in the following paragraph; however, the transfer of an asset necessary only for sale of power by the utility to the Qualifying Facility is not a QF transfer and constitutes a CIAC, even if the asset is used in part in connection with the transmission of power to the utility. Thus, for example, if at the time of a QF transfer a Qualifying Facility transfers an asset necessary only for the sale of power to the Qualifying Facility, the transfer of that asset is not a QF transfer.

The contribution of a dual-use intertie to a utility will be treated as a QF transfer (and, therefore, nontaxable) if, in light of all information available to the utility at the time of transfer, it is reasonably projected that during the first ten taxable years of the utility, beginning with the year in which the transferred property is placed in service, no more than 5% of the projected total power flows over the intertie will flow to the Qualifying Facility (the "5% test"). Such a projection shall, if practicable, be supported by a report from an independent engineer. Total power flows means power flows to or from the Qualifying Facility over the intertie. For purposes of this notice, power flows to a Qualifying Facility include power flows to a related party of the Qualifying Facility, if the transmission of power to the related party has been facilitated by the transfer of the intertie. Thus, for example, in the case of a modification or relocation of a utility's existing transmission line, power flows to an unrelated third party are ignored. For purposes of the 5% test, power flows in the taxable year in which the transferred property is placed in service may, at the option of the utility, be ignored. For example, suppose a utility and a Qualifying Facility enter into a power purchase contract with a term of twenty years, and power flow from the utility to the Qualifying Facility is expected to comprise 10% of total power flows in the first year (the taxable year in which the facility is placed in service), 1% in the second and third years, and 0.5% in each of the fourth through tenth years. Total power flows are projected to be 100 megawatt hours ("MWH") in the first and second years, and 200 MWH in the third through tenth years. Assume that the taxpayer excludes the first year of the contract from the projection. Thus, the taxpayer reasonably projects that power flow to the Qualifying Facility will be 0.59% of total power flows over the intertie for the applicable nine-year period ((1% x 100 MWH + 1% x 200 MWH + 7 x (0.5% x 200 MWH))/(100 MWH + 8 + 200 MWH)). Under the 5% test provided in this notice, the contribution of the intertie to the utility by the Qualifying Facility will be treated as a QF transfer and, therefore, shall be nontaxable.

3. EXCLUDED TRANSFERS.

Certain transfers that would otherwise qualify as QF transfers are excluded from the definition of QF transfers if such transfers are described in this section 3 of this notice. A transfer from a Qualifying Facility to a utility will not be treated as a QF transfer under this notice to the extent the intertie is included in the utility's rate base. Moreover, a transfer of an intertie to a utility will not be treated as a QF transfer under this notice if the term of the power purchase contract is less than ten years.

4. TERMINATION OF SAFE HARBOR.

The fact that a transfer constitutes a QF transfer under this notice does not establish that a utility will never recognize income attributable to receipt of the transferred property. The occurrence of an event specified below in section 4(A) or 4(B) shall terminate the safe harbor and require the utility to recognize income as a consequence of the QF transfer.

(A) PROPORTIONATE DISQUALIFICATION. If, for each of any three taxable years within any period of five consecutive taxable years, more than 5% of the total power flows over the intertie flow from the utility to the Qualifying Facility (a "disqualification event"), then the Qualifying Facility will be deemed to have made a transfer to the utility which constitutes a CIAC under section 118(b) as of the last day of the third such year. At the option of the utility, the taxable year in which the property is placed in service shall not be taken into account in determining whether there has been a disqualification event. The amount of the CIAC shall be that percentage of the fair market value of the intertie as of the date of the deemed transfer which is reflective of the use of the intertie for the purpose of selling power to the Qualifying Facility, determined by the Internal Revenue Service by taking into account all facts and circumstances. Relevant factors include (1) the use of the intertie during the period immediately preceding the disqualification event; (2) the use of the intertie since the date it was placed in service; (3) the reasonably anticipated use of the intertie during the remaining term of the power purchase contract. See section 111 of Notice 87-82 for guidance as to the fair market value of a CIAC. For example, suppose a Qualifying Facility contributes an intertie to a utility that is a calendar year taxpayer. The utility places the intertie in service in 1990, and reasonably projects that over the ten taxable years beginning in 1990 power flows over the intertie to the Qualifying Facility will be less than 5% of total power flows over the intertie. Power flows over the intertie to the Qualifying Facility constitute the following percentages of total flows over the intertie: 10% in 1990; 7% in 1991; 6% in 1992; 3% in 1993, 1% in 1994; and 6% in 1995. The utility excludes 1990 (the year in which the intertie is placed in service) from the determination of whether a disqualification event has occurred. A disqualification event occurs due to power flows in 1995, the third year within the five year period from 1991 to 1995 in which more than 5% of power flows over the intertie flow to the Qualifying Facility. Therefore, the Qualifying Facility is deemed to have made a CIAC transfer to the utility as of December 31, 1995.

Proportionate disqualification does not apply to any property necessary for, and used solely to facilitate, the transmission of power by the Qualifying Facility to the utility. For example, suppose the contract between a Qualifying Facility and a utility requires the utility to relocate a major transmission line and to construct an intertie to the Qualifying Facility including protective devices which are necessary and used solely for the delivery of power to the utility. Several years into the contract, the use of the intertie by the utility for delivery of power results in a disqualification event. Payments made for the construction of the protective devices are not subject to proportionate disqualification, while payments made for the relocation of the transmission lines are subject to proportionate disqualification (because the transmission line is used for the delivery of power over the intertie by the utility to the Qualifying Facility).

(B) TERMINATION OF POWER PURCHASE CONTRACT. Upon the termination of the power purchase contract between a Qualifying Facility and a utility, if the utility obtains or retains ownership (for tax purposes) of property transferred in a QF transfer, the Qualified Facility will be deemed to have made a transfer to the utility which constitutes a CIAC under section 118(b) as of the first day of such termination. The amount of the CIAC shall be the fair market value of the intertie, less the amount, if any, paid by the utility to obtain or retain ownership of the property for tax purposes. Therefore, if the amount paid by the utility is fair market value, the Qualified Facility will not be deemed to have made a CIAC transfer. See Section 111 of Notice 87-82 for guidance as to the fair market value of a CIAC.

5. NOTIFICATION REQUIREMENTS.

If for any taxable year power flows to the Qualifying Facility exceed 5% of total power flows over the intertie, then the utility must attach a statement to this effect to its return for such taxable year. If a power supply contract subject to the provisions of this notice terminates, the utility must attach a statement to this effect to its return for the year in which the termination occurs. The notification requirements of this section 5 apply to taxable years ending more than 180 days after [THE DATE THIS NOTICE IS PUBLISHED IN THE FEDERAL REGISTER].

6. COST RECOVERY OF QF TRANSFER PROPERTY.

Sections 1.461-1(a)(1) and (2) of the Income Tax Regulations provide that taxpayers using the cash and accrual methods of accounting, respectively, may not currently deduct the total amount of an expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year. Instead, such taxpayers are required to capitalize such expenditures as assets and recover the cost of the expenditures over the useful life of the asset in question. See, e.g., Rev. Rul. 70-413, 1970-2 C.B. 103. The cost of property transferred in a QF transfer must be capitalized by the Qualified Facility as an intangible asset and recovered as appropriate. Cf. Section VII of Notice 87-82 (amortization of the cost of a CIAC by the contributor).

A utility may not take depreciation (or amortization) deductions with respect to property transferred in a QF transfer. This rule applies regardless of whether the Qualifying Facility initially transfers intertie property to the utility or whether the Qualifying Facility initially transfers cash followed by a deemed QF transfer to the utility. However, if property which is the subject of a QF transfer is subsequently transferred or deemed transferred to the utility as a CIAC, the utility may be allowed to take depreciation deductions with respect to the property.

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure.

DRAFTING INFORMATION

The principal author of this notice is Glenn Bodgonoff, of the Office of Assistant Chief Counsel (Passthroughs and Special Industries) Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing this notice both on matters of substance and style. For further information on matters regarding this notice contact Glenn Bodgonoff at (202) 566-6423 (not a toll-free call).