In PLR 201722006, the IRS has ruled that a peaking electric generating facility is not a public utility property under Section 168(i)(10).

Facts

State A enacted legislation that required the state's electric distribution utilities, and allowed any other person wanting to build peaking generation plants, to submit a plan to the Authority. A plan approved by the Authority would require the owner to be compensated at its cost of service, plus a reasonable rate of return on its investment.

State A law does not treat merchant generators as electric distribution companies or as any other type of public service company subject to regulation by the Authority, which means the Authority cannot subject a generator to the cost of service regulation. The Authority concluded, however, "that merchant generators could agree contractually to submit to rate determinations."

Taxpayer is a limited liability company and a wholesale power provider under the jurisdiction of a commission and its rates are determined through negotiation or by the wholesale market. Taxpayer's predecessor in interest entered into a contract with a public service distribution company over which the Authority had ratemaking jurisdiction. Under the contract, Taxpayer agreed to construct, own, operate and maintain the peaking electric generating facility (Facility). Taxpayer also agreed that the Authority will determine the revenue requirement, including a review of Taxpayer's cost of service, in annual contested proceedings. In a process called a "True-Up," the Authority may reconcile certain portions of the rate base to actual expenses.

Additionally, Taxpayer agreed that any premium above book value received on the Facility's sale would be paid to the public service distribution company and returned to ratepayers during the contract period. At the end of the contract term, ratepayers would have no further claim and proceeds from the Facility's sale would be only for the Taxpayer's benefit.

Each year, the Authority will establish a revenue requirement for Taxpayer based on the costs Taxpayer believes it will incur in the forthcoming contract year. Operator will pay Taxpayer monthly for capacity, power and ancillary services during the year. During the year, Taxpayer also will calculate the difference between 1/12 of the revenue requirement established by the Authority and the monthly payment amount received from the Operator. If the difference is positive, the public service distribution company will be required to pay Taxpayer the amount of the difference. If the difference is negative, Taxpayer will be required to pay the public service distribution company the amount of the difference. Payments received by the public service distribution company under the contract will be credited to the ratepayers.

Analysis

Section 168(i)(10) defines "public utility property" as property used primarily in the trade or business of providing or selling electrical energy if the rates for providing or selling the energy have been established or approved by a state or political subdivision.

The regulations under former Section 46 contain an expanded definition of regulated rates under which rates are established or approved on a rate-of-return basis.

Based on the definition in Section 168(i)(10) and the regulations under former Section 46, the IRS determined that the following factors should be considered in determining whether property is public utility property:

1. The property must be used primarily in the trade or business of providing or selling electrical energy

2. The rates for the provision or sale of energy must be established or approved by a state or political subdivision

3. The established or approved rates must be determined on a rate-of-return basis

The IRS concluded that the Facility is used predominantly in the trade or business of providing electrical energy, but the calculation of rates under the contract does not satisfy the last two factors. Accordingly, the IRS ruled that the Facility is not a public utility property under Section 168(i)(10). Because the IRS ruled that the Facility is not a public utility property, the IRS did not rule on the application of the depreciation normalization rules of Section 168(i)(9) and Reg. Section 1.167(l)-1 to State A regulatory procedures.

Implications

Being public utility property requires compliance with the normalization rules under Sections 167 and 168 for depreciation and Section 46 for investment tax credits, which limit how a company can account for such items and their effect on rate setting. If classified as public utility property, failure to comply with the normalization rules would result in disallowance of accelerated depreciation or recapture of investment tax credits. Because the penalty is so severe for failure to comply with the normalization rules, this ruling gives the taxpayer certainty over the fact that the merchant facility was not public utility property even though the contract for electricity was set using cost-of-service and rate-of-return principles. The merchant generator itself was not subject to regulation by the Authority, but rather entered into a contract that set the rates in such manner and, therefore, was not subject to the normalization rules.

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