Firm Seeks to Discuss Public Utility Issues With Treasury

In response to the recently released Department of Treasury (Treasury) 2015-2016 Priority Guidance Plan (Priority Guidance Plan), we are requesting a meeting to discuss Internal Revenue Code § 118 and the safe harbor guidance issued in Notice 88-129,¹ as amended by Notice 2001-82,² (Safe Harbor). Included in the Priority Guidance Plan as Item 19 with respect to General Tax Issues is "Guidance updating Notice 2001-82 addressing the application of § 118 to interconnection upgrade payments." We applaud the willingness of the IRS and Treasury to update the Safe Harbor guidance to better reflect current industry trends with respect to power generation and transmission. In the Priority Guidance Plan, Treasury states that the plan can be fully successful only if it has "the benefit of the insight and experience of taxpayers and practitioners who must apply the rules. Therefore, we invite the public to continue to provide us with their comments and suggestions as we write guidance throughout the plan year." In response to the Treasury's request for comments, we respectfully submit the following thoughts and suggestions for consideration of Code § 118 and the Safe Harbor guidance.

Dependence on the electrical power transmission grid continues to grow, and technology alters the expectations and demands placed on the transmission grid. While demand for a reliable supply of electricity increases, the transmission grid continues to age and becomes more congested. The need to modernize the transmission grid "has been made all the more urgent by the increasing and now pervasive dependence of modem life on a reliable supply of electricity."³ Unless the transmission grid is modernized, America faces unreliability with respect to "navigation; telecommunication; the financial system; healthcare; emergency response; and the Internet, as well as all that depends on it."⁴ Given America's dependence on electricity, the Department of Energy recognized the need to better prepare for threats to the grid, "ranging from geomagnetic storms that can knock out crucial transformers; to terrorist attacks on transmission lines and substations; to more flooding, faster sea-level rise, and increasingly powerful storms from global climate change."⁵

Code § 118 and the accompanying Safe Harbor guidance have greatly facilitated modernization of the transmission grid by providing favorable tax treatment to the contribution of transmission interconnection facilities. These transmission interconnection facilities are needed for new power sources to access the transmission grid.

We are lawyers who represent clients in the public utility industry. Based on our experience in working with our clients, we have identified several issues that we believe should be addressed in any new Safe Harbor guidance. We also recommend certain clarifications we believe should be made to existing rules to reflect recent industry trends.

Section 118 Background

Code § 118(a) excludes from gross income certain contribution to the capital of a corporate taxpayer. Code § 118(b), however, provides that the Code § 118(a) income exclusion docs not apply to any contribution in aid of construction (CIAC) or any other contribution as a customer or potential customer.

Notice 88-129 provides a Safe Harbor for the treatment of certain payments or property transfers to regulated public utilities (utilities) by certain qualifying small power producers and qualifying co-generators (Qualifying Facilities)⁶ to construct interconnection facilities (referred to in the Safe Harbor as an intertie). Under the Safe Harbor, payments and transfers made by a Qualifying Facility to a utility exclusively to sell power to that utility in the future will not be treated as a taxable CIAC under Code § 118(b) (a Qualifying Transfer). In addition to the sale of power by a Qualifying Facility, the intertie can be used to transmit power from the utility to the Qualifying Facility (a dual-use intertie). If the interconnection facility is used by a transferor to purchase power, Notice 88-129 provides that the transfer is a Qualifying Transfer (that is, not a taxable CIAC under Code § 118(b)) if the transferor's projected power purchase through the interconnection facility is limited to five percent or less of the total power sold and purchased by the transferor through the interconnection facility in the first 10 taxable years after tie facility is placed in service (the Five Percent Test).

The IRS extended the Safe Harbor in Notice 2001-82 to include transfers by non-Qualifying Facilities to utilities⁷ and to include transfers of interconnection facilities used (exclusively or in part) to transmit power over a utility's transmission grid for sale to third-party consumers or intermediaries (referred to as wheeling) pursuant to a long-term (10 years or more) interconnection agreement.

Areas of Possible Clarification

With respect to the Safe Harbor under Notices 88-129 and 2001-82, given recent industry trends in electricity generation and transmission, certain issues related to the Safe Harbor have become unclear. As a result, we would like to meet with you to discuss clarification of the following points:

• We believe that the Safe Harbor should be clarified to state that for purposes of determining power flows to and from a generator under the Five Percent Test, the contractual agreements between the purchaser and seller that specify the flow of power that is scheduled over specific transmission lines should be respected. The Safe Harbor is silent regarding contractual agreements over specific transmission lines. When there is more than one transmission line and power can flow over either line, it is not always possible for the purchaser and seller to trace the physical flow of power to match their contractual agreements. For this reason, we believe the Safe Harbor should clarify this reliance on the contractual agreements between a purchaser and seller rather than look to the physical flow of power on a transmission line.

• We believe that the Safe Harbor should be clarified to state that financial derivative transactions that do not involve actual power flows should be ignored and not counted for purposes of calculating compliance with the Safe Harbor. Financial derivative transactions allow the parties to hedge or manage business risks with payments of currency, but do not provide for the physical flow of power. The Safe Harbor is silent regarding such financial derivative transactions. The purpose of the Safe Harbor is to analyze total power flows. Because financial derivative transactions that do not involve the actual flow of physical power would not affect the purpose of the Safe Harbor, we believe a clarification to ignore such financial derivative transactions is appropriate.

• We believe that the Safe Harbor should be clarified to state that the Safe Harbor is met if either a long-term power agreement or a long-term interconnection agreement is used. This clarification is necessary because the language of Notice 2001-82 suggests that a long-term interconnection agreement -- as opposed to a long-term power agreement -- is required in the case of a contribution of a dual-use intertie. There is a growing trend in the industry to use an interconnection agreement of an indefinite duration that can only be terminated after providing a certain number of years of notice of a termination prior to the termination becoming effected. We believe that the Safe Harbor requirement for a long-term interconnection agreement should include indefinite duration interconnection agreements that cannot be terminated unless notice is provided in an agreed to fixed number of years in advance of termination.

• We believe that the Safe Harbor should be clarified to state that it permits a related party of a transferor to make a contribution that qualifies for the Safe Harbor. In certain instances, a related party of a transferor may also make a contribution. To qualify for the Safe Harbor, the Five Percent Test analyzes total power flows to and from the related parties of a transferor. Because the Safe Harbor analyzes power flows to and from related parties, contributions by the same related parties should also be taken into account for purposes of the Safe Harbor, For this reason, we believe this clarification is appropriate because the Five Percent Test takes into account power flows to and from related parties of a transferor.

² 2001-2 C.B. 619.

³ Department of Energy, Quadrennial Energy Review: Energy Transmission, Storage, and Distribution, S-5 (2015), available at http://energy.gov/epsa/downloads/quadrennial-energy-review-full-report.

⁴Id.

⁵Id.

⁶ A Qualifying Facility is defined in Section 3 of the Federal Power Act, as amended by Section 201 of the Public Utilities Regulatory Policies Act of 1978 (PURPA). PURPA and its implementing rules require that a utility interconnect with a Qualifying Facility for the purpose of allowing the sale of power produced by the Qualifying Facility.

⁷ This extension was needed because deregulation of the electric power industry meant that few new stand-alone generators were Qualifying Facilities.