SOUTHERN COMPANY COMMENTS ON EMISSION ALLOWANCE PROGRAM.

The Southern Company (Southern) appreciates the opportunity to respond to Notice TR-33-15-92. This notice solicited public comments on the federal income tax consequences of the sulfur dioxide (SO2) emission allowances program of Title IV of the Clean Air Act Amendments of 1990 (the ACT) as administered by the Environmental Protection Agency (EPA).

Southern is a public utility holding company consisting of seventeen companies including Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, Savannah Electric and Power Company, Southern Company Services, Inc., Southern Electric Generating Company, Inc., Southern Nuclear Operating Company, Inc., Southern Electric International, Inc., The Southern Investment Group, Inc., Alabama Property Company, Piedmont-Forrest Corporation, Columbia Fuels, Inc., SEI Hawaiian Cogenerators, Inc., Birchwood Development Corp., and SEI Birchwood, Inc. Together these companies file a consolidated income tax return with the Atlanta district office of the Internal Revenue Service. Because several system subsidiaries will be subject to the Act, and because Southern will be the recipient of one of the largest allocations of allowances in the country, Southern has a vital interest in the tax treatment of emission allowances.

Included below are the company's comments on nine of the proposed questions affecting the Southern Electric System. In addition to such comments, Southern is also concerned with a question not mentioned by the Notice concerning the cost associated with administering the emission allowance program. Our concern arises because the Federal Energy Regulatory Commission (FERC) is currently considering accounting rules for allowances that must be followed for book reporting purposes. Should this guidance be different from the regulations adopted by Treasury, a totally separate record keeping system for allowances would have to be maintained for tax purposes creating an administrative and costly burden for all taxpayers.

Southern believes that this concern can be eliminated by the regulations allowing taxpayers the flexibility to adopt for tax purposes the accounting methods that are specified by FERC and utilized for book reporting purposes. Such a conclusion is supported by Code Section 446(a), which in general states that taxable income should be computed under the method of accounting utilized for book purposes assuming such method clearly reflects income and is consistently followed. Southern believes that FERC will promulgate accounting rules that will properly reflect on a consistent basis the true character of emission allowances and their effect on income. Accordingly, Southern contends that it would be appropriate and desirable for the regulations to allow all taxpayers to adopt such rules for tax reporting purposes. The administrative convenience derived from such a rule would be particularly pleasing at a time when the President has expressed his concern about burdensome government regulations and their debilitating effect on business and the American economy.

1. How are the costs of acquiring emission allowances treated for Federal tax purposes?

The cost of acquiring emission allowances from the government or from the secondary market would be capitalized under Code section 263. GCM 39606 provides a comprehensive analysis regarding taxability of intangible rights and licenses issued by the government at little or no cost to the recipient taxpayer. The General Counsel Memorandum deals with the Federal income tax consequences of the issuance and later sale or exchange of airplane takeoff and landing slots which are initially allocated by grandfathering the slots to existing airline holders and by periodic lotteries granting slots to new airline entrants. The ruling concluded that capitalization under Code Section 263 for the cost of the airline slots was required. Although the GCM was requested by the Federal Aviation Administration prior to the Tax Reform Act of 1986, its conclusions and analysis provide strong precedent and parallels for the tax ramifications of the emission allowance program.

2. What costs, if any, are included in the tax basis of an allowance?

Code section 1012 provides that the tax basis of property shall be the cost of such property. Treasury Reg. Sec. 1.1012-1(a) provides that "cost" is the amount paid for such property in cash or other property.

If an allowance is purchased either through auction or direct sale, the tax basis equals the acquisition price plus costs incurred to effect the purchase. If the allowance is received by allocation from the EPA, the basis of the allowance will generally be zero.

3. Is the cost of acquiring emission allowances an indirect cost of producing property under section 263A?

No, an emission allowance is not properly described in Code section 263A(b) because it is neither property produced by the taxpayer nor would it be property acquired for resale in the case of a public utility. Therefore, the capitalization rules of Code Section 263A(a) does not apply to emission allowances in the hands of public utilities.

4. Can allowances be depreciated under section 167?

No, an emission allowance is not subject to depreciation under section 167. Code section 167(a) allows as a depreciation deduction a reasonable allowance for gradual exhaustion, wear and tear or obsolescence. An emission allowance is either totally consumed within a year or carried over in its entirety to a succeeding year. An allowance, therefore, is not subject to gradual exhaustion, wear and tear or obsolescence, and would therefore not be subject to depreciation.

5. When and how would a taxpayer recover its basis in an emission allowance in each of the following circumstances:

a. a utility uses an emission allowance during a year?

Code section 162(a) allows as a current deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. An emission allowance, by statutory definition, represents the right to emit one ton of SO2 on or after a specified date. Accordingly, an allowance does not have a useful life extending beyond the taxable year in which it is used. Treasury Reg. Sec. 1.162-3 provides for expensing of items that are actually consumed and used in operation during the taxable year, provided that the costs of such items have not been deducted in determining the net income or loss or taxable income for any previous year. Therefore, a deduction would be allowable for the basis of the allowance in the year during which it is used.

Although emission allowances are not inventory or stock in trade, regulatory commissions may prescribe the use of differing inventory methods including average cost or specific identification to account for emission allowances similar to the accounting treatment now accorded materials or fuel supplies. Code section 471 provides that where the use of inventories is necessary to clearly reflect income, then inventories shall be taken on a basis that conforms as nearly as possible to the best accounting practice in the trade or business and as most clearly reflects income. Regulation section 1.471-2(b) provides that inventory practice must be consistent from year to year in order to clearly reflect income. As a result of the potential for the use of different inventory practices based upon the requirements of the various regulatory commissions in the industry, alternative inventory methods including specific identification, average cost, FIFO, LIFO, etc., should be allowed to be used as acceptable methods of determining the cost of allowances used and allowances on hand for tax purposes provided such method is used consistently from year to year and would clearly reflect income.

b. a utility sells or exchanges an emission allowance;

Code section 1001(a) provides that gain from the sale or other disposition of property equals the excess of the amount realized over its adjusted basis. Therefore a taxpayer that sells or otherwise disposes of an allowance will recover its basis in the allowance as a reduction to the amount realized on the disposition in computing the net gain or loss from the disposition. The particular allowance disposed of should be determined by the same acceptable inventory method as is used for determining which allowances are used during a year as described in a. above.

c. a purchaser of an emission allowance which is not a utility sells or exchanges the allowance; and

There should be no distinction in terms of basis recovery between a purchaser of an emission allowance which is not a utility versus a purchaser which is a utility. Any distinction between users and dealers of allowances will be discussed in the characterization of the income under 6. below.

d. an emission allowance becomes worthless?

Code section 165(a) provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated by insurance or otherwise. Regulation section 1.165-1(b) provides that to be allowable as a deduction, a loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained during the taxable year.

Regulation section 1.165-2(a) provides that a loss incurred in a business or in a transaction entered into for profit and arising from the sudden termination of usefulness in such business or transaction of any nondepreciable property, in a case where such business or transaction is discontinued or when such property is permanently discarded from use therein, shall be allowed as a deduction under Code section 165(a) for the tax year in which the loss is actually sustained.

The Act provides that it shall not be construed to limit the authority of the United States to terminate or limit emission allowances allocated under the program. The termination of an emission allowance by the government would be an identifiable event evidenced by a closed and completed transaction. Therefore, a loss deduction would be allowed under Code section 165(a) in the year in which the allowance is terminated.

If the allowances are not needed and simply expire or otherwise become completely worthless, a loss deduction would be available under Code section 165(a). A reversion of an allowance to the EPA as a result of termination, expiration or worthlessness of the allowance would result in a loss deduction to the extent of the basis in the allowance.

6. What is the character of any gain or loss realized in situations (b)-(d) set forth in paragraph 5 above?

(b) a utility sells or exchanges an emission allowance;

The characterization of the gain or loss on the sale or disposition of an emission allowance is dependent upon whether the emission allowance is a capital asset under Code section 1221. Code section 1221 defines a "capital asset" as "property held by the taxpayer (whether or not connected with his trade or business)" with specified exceptions. Code section 1221(1) excludes from "capital asset" treatment stock in trade, inventory, and property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. As discussed in 3. above, the primary purpose for a public utility to have an emission allowance is for use in the utility's operations, and not for resale. Therefore, an allowance is not excluded from "capital asset" under Code section 1221(1) for a public utility.

Code section 1221(2) excludes from the definition of a capital asset a taxpayer's property that is "used in his trade or business, of a character which is subject to the allowance for depreciation provided in Code section 167, or real property used in his trade or business." Emission allowances are clearly not real property. Further, they are not subject to depreciation, as discussed in 4. above. Therefore, the allowance is not excluded from "capital asset" under Code section 1221(2).

The additional exceptions to capital asset treatment under Code section 1221(3), (4), and (5) are clearly not applicable to emission allowances. Therefore, provided the allowances are not held for resale, as discussed above, they would be treated as capital assets under Code section 1221. As such, gain or loss recognized on the sale of an allowance will be capital gain or loss.

(c) a purchaser of an emission allowance which is not a utility sells or exchanges the allowance; and

Classification of an allowance as a "capital asset" will depend on the holder's business and the way in which the allowance is used. For example, if a particular holder is an investor in allowances, the allowances would be capital assets and any gain from their sale would be capital gain. If, on the other hand, the holder is a dealer in allowances, the allowances would be excluded from capital asset treatment under Code section 1221(1).

(d) an emission allowance becomes worthless?

Code section 165(f) states that losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in Code sections 1211 and 1212. Section 1211(a), which applies only to corporations, limits a deduction for losses resulting from the sale or exchange of capital assets only to the extent of gains from the sale or exchange of capital assets. Section 1212 provides for capital loss carrybacks and carryforwards.

As discussed above, there may be circumstances in which an allowance will be an ordinary asset in a non-utility taxpayer's hands. Since Code section 165(f) only applies to capital assets, the general rule of Code section 165(a) would call for a deduction against ordinary income in the year of the loss if the allowance is characterized as an ordinary asset.

Moreover, even if an allowance qualified as a Code section 1221 capital asset, a loss stemming from reversion would be ordinary in nature because the sale or exchange requirement in Code section 165(f) would not be met.

7. Is an exchange of emission allowances a taxable event? If so, are allowances issued in different years like-kind property under section 1031?

An exchange of emission allowances qualifies for nonrecognition of income under the "like-kind exchange" provisions of Code section 1031. Under Code section 1031(a)(1), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of like-kind to be held either for productive use in a trade or business or for investment. Unless the particular allowance constitutes "stock in trade or other property held primarily for sale" (such as if held by non-utility purchasers who were investors or brokers), it would not be excluded from nonrecognition treatment by exceptions in Code section 1031(a)(2).

Allowances which are issued in different years are sufficiently similar to be characterized as like-kind property and to receive like-kind property treatment on exchanges under Code section 1031. Regulation section 1.1031(a)-1(b) provides that the term "like-kind" refers to the nature or character of the property and not to its grade or quality. Such differences as the type of emission, SO2 or NOX, the time period to which the allowance applies or the number of allowances would not affect the basic nature of the allowances to the extent recognition would be required. Therefore, emission allowances would constitute properties of like-kind, the exchange of which qualifies for nonrecognition treatment.

8. Is a penalty paid to the EPA for emissions in excess of allowances deductible under Code section 162(a)?

A payment to the EPA for emissions in excess of allowances would be deductible under Code section 162(a). Code section 162(a) provides as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Code section 162(f), however, provides that no deduction shall be allowed under Code section 162(a) for any fine or similar penalty paid to a government for the violation of any law. The Service has previously ruled that if a taxpayer pays a nonconformance penalty for excessive emissions, that such a payment would be deductible under Code section 162(a) as a business expense and not as a disallowed deduction under Code section 162(f). Rev. Rul. 88-46.

In Rev. Rul. 88-46, the taxpayer, a manufacturer of heavy-duty trucks and truck engines, failed to conform to emissions standards imposed under the Act. The Act required the EPA to issue a Certificate of Conformity for any trucks sold which exceeded the set emission standard if the manufacturer paid a nonconformance penalty of not more than $10,000. The Service ruled that the emissions nonconformance penalty was primarily designed as a permissive and equalizing formula to eliminate the competitive economic advantage that a nonconforming producer might otherwise have over a conforming producer. The ruling also noted that the payment of the nonconformance penalty merely constituted one lawful alternative method for staying in compliance with the Act.

Title IV of the Act contains the compliance, control provisions. Section 411 of the Act in the compliance provisions, provides for a $2,000 per ton penalty for excess emissions. This penalty is in the nature of a nonconformance penalty and does not seem to be punitive in nature. The EPA recognized this distinction in the preamble to the proposed rules issued under Title IV of the Act by stating that imposition of the penalty would eliminate any financial benefit of exceeding the emissions limitation. This penalty would, therefore, be similar to the penalty discussed in Rev. Rul. 88-46, and, therefore, a deductible under Code Section 162(a).

We recognize that there is existing authority which holds that penalties under the Clean Air Act are not deductible. See Colt Industries, 880 F.2nd 1311. However, we at Southern believe that the best conclusion is the position outlined above.

9. What is the likely accounting treatment of emission allowances? For example, will separate accounts be established for allowances held for use in electricity production and for allowances held for investment?

The Federal Energy Regulatory Commission has published a Notice of Proposed Rulemaking, Docket No. RM91-1-1-000, to revise the Uniform System of Accounts to account for allowances under the Clean Air Act Amendments of 1990. The Southern Company is preparing a response to the proposal. Under both existing and proposed rules, allowances held for production and those held for investment would be maintained in separate accounts.

Once again, we appreciate the opportunity to provide you with our comments. Should you have any questions concerning our thoughts, please do not hesitate to contact me directly.

Respectfully submitted,