Clarifications to Output Facilities Regs Suggested

George G. Wolf of Orrick, Herrington & Sutcliffe LLP, San Francisco, has submitted a memorandum of suggested clarifications to the output facilities regs. The suggestions, Wolf says, relate only to matters that are more technical in nature and in need of quick attention.

The memorandum addresses retail requirement contracts, the reserve capacity rule, system allocations, the application of the special reasonable expectations test to a series of current refundings, and the relationship of requirements contract rules to other rules.

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February 25, 1998

Edwin G. Oswald

Re: Output Facilities Regulations

Dear Ed:

[1] Enclosed is our memorandum of suggested clarifications to the recent output facilities regulations. These suggestions relate only to matters that we believe are more technical in nature and in need of quick attention. We expect to submit more detailed comments on this substance of the regulations at a later date.

[2] If you have any questions on this memorandum or other output facilities issues, please feel free to contact me at (415) 773-5988, Richard Chirls at (212) 506-5250, Dean Criddle at (415) 773-5783, Larry Sobel at (213) 612-2421, or Rich Nicholls at (212) 506-5175.

Very truly yours,

George G. Wolf

cc: Internal Revenue Service

Richard Chirls

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MEMORANDUM

TO: TREASURY DEPARTMENT

DATE: FEBRUARY 25, 1998

RETAIL REQUIREMENTS CONTRACTS

[3] Treasury Regulations, section 1.141-7T(c)(4)(iii), provides that a retail requirements contract will not generally be treated as meeting the benefits and burdens test of -7T(c)(1). However, such a contract may be treated as meeting the benefits and burdens test to the extent that the contract "contains contractual terms that obligate the purchaser to make payments that are not contingent on the output requirements of the purchaser (such as significant termination payments). . ." The Regulations state that retail requirements contracts do not meet the benefits and burdens test "because the obligation to make payments on the contract is contingent on the output requirements of a single purchaser." Thus the requisite certainty of payment is missing.

[4] We believe this regulation as written permits retail requirements contracts to contain reasonable damages provisions or reasonable termination provisions without causing treatment as a "bad" output contract, provided such damages or termination provisions are payable only in circumstances of default or termination while the purchaser has requirements within the meaning of the contract. This interpretation should be confirmed.

[5] The essence of a requirements contract is that the purchaser must purchase its requirements from the supplier, if it has any. It seems self-evident that such a contract can provide for damages in the event of a breach. Silence on this point would imply damages at law in any event. An explicit prohibition on damages for breach would imply that the contract must be unenforceable, in which case why have the rule at all. Moreover, if the theory of the rule is that payments under the contract are not sufficiently certain to meet the private payment test -- presumably because a single retail purchaser can fail to have requirements for a variety of reasons -- that logic is as applicable to the defaulting purchaser as to the nondefaulting one. In addition, a reasonable liquidated damages provision should also be permitted; parties should not be forced to litigate their damages. Finally, contracts of this type should be permitted to have termination clauses with reasonable buy out payments; these are no different from liquidated damages provisions without the "default." We emphasize again that this would only be in the context of default or termination by a retail purchaser that otherwise has requirements that would be covered by the contract were no default or termination to occur. In short, the municipal utility should be entitled to the benefit of its bargain.

[6] The Regulations generally do not require amendment to reach this result. A contract provision that obligates the purchaser to make payments when its requirements are reduced or eliminated would "obligate the purchaser to make payments that are not contingent on the output requirements of the purchaser." A contract provision that obligates the purchaser to make payments when it defaults or terminates the contract when it still has requirements does not.

[7] If the Regulation is modified, however, we recommend against trying to write specific damages or termination provisions that would be permitted. There are many formulations of such contract provisions. It should be sufficient for the Treasury's purposes that the damages or termination provision be reasonably related to the purchaser's obligation that is being discharged.

RESERVE CAPACITY RULE

[8] Once it is determined that an output contract results in private business use, Treasury Regulations section 1.141-7T(d) provides that the amount of private business use is the portion of the facility's capacity that must be reserved for the nongovernmental output purchaser under "prudent utility practices." This new rule appears to be technically flawed and might be an overreaction to planning opportunities that existed under prior Regulations but which are adequately addressed elsewhere in the new Regulations.

[9] Section 1.103-7(b)(5) of the prior Regulations generally allowed unutilized capacity to be treated as reserved for use by the governmental owner of the facility even if a nongovernmental person had a contract right to (but in fact did not) call upon the unutilized capacity for its own use. The only impediment was the announced "no rule" position of the Internal Revenue Service ("IRS") in connection with facilities more than 30% of the actual output of which was purchased by nongovernmental persons pursuant to output- type contracts. Section 1.141-7T(b)(iii) makes this a substantive rule, thereby giving the IRS the tool it needs to achieve appropriate results in extreme cases. Thus, the rule of section 1.141-7T(d) is not needed to achieve an appropriate result in the example set forth in that paragraph, where a nongovernmental person has priority rights to the output of a peaking facility, but is entitled to purchase only 10% of the "annual available output (determined by reference to nameplate capacity)". Section 1.141-7T(b)(iii) separately authorizes the Commissioner to treat the reasonably expected annual output of the peaking facility as its "available output" without regard to nameplate capacity.

[10] Under section 1.141-7T, the portion of an output facility that is treated as used in the trade or business of a nongovernmental person pursuant to an output contract is determined by reference to the facility's "available output." The portion of private use is equal to a fraction, the denominator of which is "available output" and the numerator of which (according to section 1.141-7T(d)) is the amount of "capacity" reserved for the nongovernmental person. In order to be meaningful, the numerator and denominator must be expressed in the same units of measurement. Under section 1.141- 7T(b)(1), "available output" is expressed in units of kilowatt-hours, a measure of energy. Incongruously, section 1.141-7T(d) would measure a nongovernmental output purchase's use of that "available output" in terms of "capacity," which is expressed in units of kilowatts. The resulting fraction has no meaning.

[11] One interpretation of section 1.141-7T(d) might be to impute to the nongovernmental output purchaser all energy that it would have purchased if all "available output" in fact were produced. While this might produce a sensible result, it appears to be inconsistent with the example set forth in the last sentence of section 1.141-7T(d), which indicates that ALL "available output" might be allocated to a nongovernmental person who is entitled to purchase no more than 10% of that "available output (determined by reference to nameplate capacity)". /1/

[12] Moreover, section 1.141-7T(d) provides that the output purchaser is to be allocated all capacity that must be reserved for it under "prudent reliability standards." In many cases, this standard will be impossible to apply in any meaningful way on a forward-looking basis. Thus, in the example set forth in section 1.141-7T(d), the peaking facility on average might be expected to generate its full nameplate capacity 20% of the time, but to generate no power at other times. If the nongovernmental person were to purchase the maximum amount of energy during January 1 through June 30 of a contract year, then no capacity would need to be reserve[d] to meet that purchaser's requirements from July 1 through December 31, and no more than half of the facility's "available output" for that year would be allocated to the nongovernmental person. But if the nongovernmental person did not actually exhaust its rights under the contract to take delivery of energy until the stroke of midnight on December 31, as much as 100% of "available output" for the year might be allocated to the nongovernmental person. /2/ "Prudent reliability standards" bear only upon how much capacity must be reserved for a power purchaser at a particular moment in time, based upon the peculiar facts existing at that time. In the example set forth in section 1.141-7T(d), as of the date on which bonds are issued "prudent reliability standards" cannot serve as a meaningful basis for determining the amount of capacity reserved for the nongovernmental person.

[13] We suggest that section 1.141-7T(d) be converted to a proposed Regulation with an effective day 30 days after it is finalized.

SYSTEM ALLOCATIONS

[14] While Treasury Regulations, section 1.141-7T(g), contain rules for determining whether output sold under an output contract is allocated to a particular facility or to the entire system of the seller of that output, additional clarification is needed in several respects.

[15] Under the -7T(g) rules, where output sold under an output contract may properly be allocated to the entire system of the seller it is not clear whether such sales must be allocated pro-rata to all units within the system or may still be allocated to particular units. Thus, where a seller has multiple units within its entire system, some of which are bond financed and some of which are not, the Regulations should be clarified to permit the seller to allocate the sales to particular non-bond financed facilities within its system, or to the equity-financed portion of its system. This would be consistent with longstanding practice as well as with the Example in Treasury Regulations, section 1.141-8T(c). On the other hand, there may be an implication in -7T(g) that a "system allocation" requires a pro-rata allocation to all units within the system. Allocations to particular units should be permitted so long as the particular "nexus" rules contained in the Regulations (e.g., physical or operational factors) would not otherwise preclude an allocation to a particular equity-financed facility.

[16] The Regulations also indicate that where facilities have been financed with multiple funding sources, the allocation rules provided in the general private activity bond regulations may be utilized to allocate private use and private payments. Clarification is needed that where private sales are allocated to a particular unit that has been partly financed with bond proceeds and partly financed with equity, the "bad" sales may be allocated to the equity-financed portion of the facility. Such a result is consistent with Congress' intent as reflected in the 1986 Tax Act legislative history which treated the private use and governmental use portions of facilities as "separate facilities" (as reflected in the -8T(c) Example).

[17] Clarification also would be useful with respect to the allocation of private payments from bad contracts. The Regulations refer to the general private activity bond rules where the allocation of payments rule generally requires that where a facility is financed from two or more sources, payments with respect to that facility must be allocated among the sources according to the relative amount of proceeds of each such source. Here again, the 1986 Tax Act legislative history referenced above would allow for allocation of both private use and private payments to the equity-financed portion of facilities.

APPLICATION OF SPECIAL REASONABLE EXPECTATIONS TEST TO SERIES OF

[18] Treasury Regulations, section 1.1411-7T(f)(5)(i) and (ii), generally provide that certain contracts for the use of transmission facilities relating to mandated wheeling and open access will not be treated as a deliberate action under Treasury Regulations, section 141-2(d). Section 1.141.7T(f)(5)(iii) provides that such contracts will not be taken into account under the reasonable expectations test of section 1.141-2(d) with respect to transmission facilities that are refinanced by an issue if (A) the bonds of the issue are current refunding bonds that, directly or indirectly, refund bonds issued before July 9, 1996 and (B) the weighted average maturity of the refunding bonds is not greater than the remaining weighted average maturity of those prior bonds.

[19] We believe that the exception from the reasonable expectations test applies to a series of current refunding bonds where the original bonds were issued before July 9, 1996 and the weighted average maturity is not extended. The phrase "directly or indirectly" clearly covers a series of refunding bonds. If there is any doubt that this is the meaning of this provision, the phrase "series of refundings" should be inserted into section 1.141- 7T(f)(5)(iii)(B) to clarify the application of this rule.

[20] The following examples show how this rule works.

[21] EXAMPLE 1. Series A bonds issued in 1995 to finance transmission facilities. Series B bonds issued in September 1996 to current refund Series A bonds, with no extension of weighted average maturity. Exception to reasonable expectations test applies to Series B.

[22] EXAMPLE 2. Same as example 1, except Series B bonds issued in June 1996 and Series C bonds issued in September 1996 to current refund Series B bonds (purpose is to replace variable rate bonds with fixed rate bonds), with no extension of maturity. Exception to reasonable expectations test applies to Series C.

[23] EXAMPLE 3. Same as example 2, except Series B bonds issued in September 1996 and Series C bonds issued in March 1998. Exception to reasonable expectations test applies to both Series B and Series C bonds.

[24] EXAMPLE 4. Same as example 3, except Series B bonds had a greater weighted average maturity than Series A bonds. At time of issue of Series B bonds, issuer did not reasonably expect to engage in any actions described in paragraphs (f)(5)(i) or (ii) of section 1.141-7T. At time of issue of Series C bonds, issuer did reasonably expect to take such actions. However, the weighted average maturity of the Series C bonds was shorter than that of the Series B bonds and did not exceed the remaining weighted average maturity for the Series A bonds. The exception from the reasonable expectations test does not apply to the Series B bonds -- however, no such expectations of the issuer existed with respect to the relevant actions. The exception from the reasonable expectations test applies to the Series C bonds.

[25] In each example the intent of the regulation is satisfied by permitting current refundings of bonds issued prior to July 9, 1996 as long as there is no extension of maturity. In particular, it should make no difference whether bonds are converted from a variable rate mode to a fixed rate mode without constituting a reissuance or whether the rate change is achieved through a current refunding.

AVAILABLE TO THE GENERAL PUBLIC -- APPLICATION TO JOINT ACTION

[26] Regulations section 1.141-T(c)(2) provides that an output contract transfers substantial benefits of owning a facility if the contract "gives the purchaser (directly or indirectly) rights to capacity of the facility on a basis that is preferential to the rights of the general public." Many joint action agencies and other similar governmental entities with municipal members sell only at wholesale. Often this limitation on their scope of operation is imposed by state law. Under the regulations, every contract entered into by such an entity, no matter how subordinate to other obligations, would meet the benefits and burdens test, whereas a comparable contract entered into by a retail utility might well not. It is suggested that this matter be clarified by adding the following to the end of -7T(c)(2).

For the purposes of this section, a contract of a

RELATIONSHIP OF REQUIREMENTS CONTRACT RULES TO OTHER RULES

[27] The requirements contract rules appear to be intended as exclusive rules, but the regulations do not make this clear. For example, a requirements contract that is grandfathered under the rule of section 1.141-15T(f)(2), protecting contracts entered into before February 23, 1998, literally could run afoul of the rule of section 1.141-7T(c)(2)(iii), relating to pledged contracts. Accordingly, the regulations should be amended to make clear that the requirements contract rule is an exclusive rule, or to specify those rules, if any, that might override it.

FOOTNOTES

/1/ Perhaps this example was intended merely to illustrate the operation of section 1.141-7T(b)(iii). Under that rule, the Commissioner is authorized to set "available output" of the peaking facility by reference to expected actual output of the facility. As concluded in the example, this in fact could result in all "available output" being allocated to the nongovernmental output purchaser. However, the placement of this example in section 1.141-7T(d), and the language referring to "prudent reliability standards" seems to indicate an intent to describe the application of a rule different from section 1.141-7T(b)(iii).

/2/ Most such "firm capacity" contracts require the purchaser to schedule power some specified period of time (e.g., 7 days; 24 hours; 60 minutes; 10 minutes) in advance. If the purchaser fails to make such advance scheduling, then at the moment of potential generation, capacity in fact is not held in reserve for the purchaser and the operator of the facility is free to generate power for its own use or for sale to a third party. In the example given in section 1.141- 7T(d), the nongovernmental person would have a contract right to schedule power only 10% of the time, so that at least 90% of the time power actually would not be held in reserve for the nongovernmental person.

END OF FOOTNOTES