In a ruling obtained by professionals at EY (PLR 202519002), the IRS ruled that two renewable energy projects would not by classified as public utility property (PUP) because their rates are fixed and not determined on a cost-of-service, rate-of-return basis.

Facts

Taxpayer is owned by its parent corporation in State A and operates as a division of that parent. Taxpayer is a regulated public utility subject to the ratemaking jurisdiction of multiple Commissions.

Taxpayer entered into a Renewable Energy Procurement and Service Agreement (Enabling Agreement) with Manufacturer to provide renewable energy to Manufacturer's facility. The Enabling Agreement allows Taxpayer to serve Manufacturer under a special retail arrangement whereby they will negotiate project-specific power purchase agreements (PPAs).

The Enabling Agreement establishes a framework for these special arrangements, which are separate from the existing Commission-approved tariffs and rate schedules. The two projects under the Enabling Agreement are Project A and Project B.

In both projects, Taxpayer will own, operate and maintain the renewable facility, with the final agreement, including negotiated pricing, filed with the applicable Commission as a special contract. The solar asset will not be included in Taxpayer's rate-base with Commission.

In Project A, the proposed structure is a utility-scale virtual PPA. Taxpayer will charge Manufacturer a rate per megawatt-hour (MWh), which will be negotiated between the parties and subject to approval by Commission. All energy and associated credits to Manufacturer will be sold under the terms of the PPA. The transaction will be exclusively financial, meaning no energy will be physically delivered to the manufacturer; instead, it will be directed to the grid at the point of interconnection. Taxpayer and Manufacturer will negotiate the valuation formula for the energy delivered to the grid. No incremental costs associated with Project A will be included in Taxpayer's rate base or cost of service used to calculate rates for its customers.

Project B is a rooftop solar system that will go on the manufacturing facility and will not deliver any energy back to the grid.

Law and analysis

Under IRC Section 168(f)(2), the depreciation deduction determined under IRC Section 168 does not apply to any PUP if the taxpayer does not use a normalization method of accounting.

IRC Section 168(i)(10) defines PUP as property used predominantly in the trade or business of furnishing or selling electrical energy if the rates for furnishing or selling have been established or approved by a state or political subdivision.

Treas. Reg. Section 1.46-3(g)(2) defines the regulated rates as those established or approved on a rate-of-return basis.

Depreciation under IRC Section 168 will not apply if the utility does not use the normalization method of accounting. The operative rules for normalizing timing differences from use of different methods and periods of depreciation are only logical in the context of rate-of-return regulation.

The IRS said a facility must have three characteristics to qualify as PUP:

• It must be predominantly used in the trade or business of furnishing or selling electricity
• The rates for the sale must be established or approved by one of the listed agencies or instrumentalities
• The rates must be established on a rate-of-return basis

The IRS ruled that neither Project A nor Project B would be classified as PUP under former IRC Section 46(f) and IRC Section 168(i)(10). While Taxpayer meets the first two criteria for PUP — predominant use in the trade or business of furnishing electrical energy and rates established or approved by a regulatory body — the rates for electricity produced by these projects will be negotiated between the utility and the manufacturer. This arrangement does not conform to the requirement to determine rates on a rate-of-return basis.

Implications

By structuring arrangements so that the normalization rules do not apply, utilities can price PPAs competitively. Commissions and utilities have worked together to help provide an attractive environment for businesses to locate in their jurisdictions by offering affordable energy.