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Company Seeks Relief When Computing Domestic Production Activities Deduction for Utilities

SEP. 1, 2010

Company Seeks Relief When Computing Domestic Production Activities Deduction for Utilities

DATED SEP. 1, 2010
DOCUMENT ATTRIBUTES
  • Authors
    Terry, Thomas D., Jr.
  • Institutional Authors
    Exelon Corp.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2010-20105
  • Tax Analysts Electronic Citation
    2010 TNT 179-20

 

September 1, 2010

 

 

Mr. Jeffrey Van Hove

 

Acting Tax Legislative Counsel,

 

Office of Tax Policy,

 

US Treasury Department

 

 

Office of Tax Policy

 

US Treasury Department

 

1500 Pennsylvania Avenue, NW

 

Washington, DC 20220

 

 

Re: Exelon Comments on Treasury Regulation Section 1.199-3(i)(3)

Dear Mr. Van Hove:

Please find the enclosed comment letter submitted by Exelon Corporation and Subsidiaries regarding Treasury Regulation Section 1.199-3(i)(3) and the related rules surrounding hedging gains and losses with respect to computing the domestic production activities deduction. We hope that you find our comments helpful and appreciate your attention to this matter. If you require any additional information or would like to discuss this matter further, please do not hesitate to contact me at (312) 394-4321.

Sincerely,

 

 

Thomas D. Terry, Jr.

 

Vice President and

 

General Tax Officer

 

Exelon

 

Chicago, IL

 

* * * * *

 

 

September 1, 2010

 

 

Mr. Paul Handleman

 

Branch 5, Office of the Associate Chief Counsel

 

(Passthroughs and Special Industries), CC:PSI:5

 

1111 Constitution Ave., NW., Room 5111

 

Washington, DC 20224

 

 

Mr. Jeffrey Van Hove

 

Acting Tax Legislative Counsel,

 

Office of Tax Policy,

 

US Treasury Department

 

 

Office of Tax Policy

 

US Treasury Department

 

1500 Pennsylvania Avenue, NW

 

Washington, DC 20220

 

 

Re: Exelon Comments on Treasury Regulation Section 1.199-3(i)(3)

Dear Mr. Handleman and Mr. Van Hove:

Exelon Corporation and Subsidiaries ("Exelon" or the "Company") respectfully submit this comment letter to address a clear inconsistency that currently exists within the Domestic Production Activities Deduction ("DPAD") regulations under Section 199 (the "regulations") and request consideration of the suggestions set forth herein.1

Exelon is one of the nation's largest electric utilities and is engaged, through its principal subsidiaries, in the generation and energy delivery businesses. Through Exelon's wholly-owned subsidiary, Exelon Generation Company, LLC ("ExGen"), the Company's generation business consists of electric generating facilities, wholesale energy marketing operations and competitive retail supply operations.2 Exelon's other principal subsidiaries, Commonwealth Edison Company ("ComEd") and PECO Energy Company ("PECO"), distribute electricity to approximately 5.4 million customers in northern Illinois and southeastern Pennsylvania and natural gas to approximately 486,000 customers in the Philadelphia area.

 

I. Background

 

A. General
Electricity generated from ExGen's owned or contracted generation facilities that exceed ExGen's obligations to customers, including ComEd's and PECO's retail load, is sold into the wholesale markets. This exposes the Company to market fluctuation in the prices of electricity, fossil fuels, and other commodities. To reduce price risk caused by market fluctuations, ExGen enters into physical contracts as well as financial derivative contracts, including forwards, futures, swaps, and options with approved counter parties to hedge anticipated exposures.

From year to year, ExGen has historically realized both gains and losses with respect to its hedging program. ExGen properly identifies these financial derivative contracts within its books and records as qualified federal income tax hedges pursuant to Section 1221(b)(2)(B) and Treasury Regulation Section 1.1221-2(f), and has accounted for these transactions as such on its federal income tax returns.

B. DPAD Impact from Hedging Transactions
Section 199 provides for a permanent tax deduction that is in part based on a taxpayer's taxable income derived from qualifying manufacturing activities. Among the types of property to which the DPAD applies are qualified production property ("QPP"), any qualified film, electricity, natural gas, and potable water (collectively "qualified property"). Section 199(c)(5) defines QPP as either tangible personal property ("TPP"), any computer software, or any property described in Section 168(f)(4) (i.e., sound recordings).

The regulations provide that gains and losses from certain qualified federal income tax hedges of inventory and of supplies consumed in activities giving rise to domestic production gross receipts ("DPGR") must be included in determining the DPAD. Specifically, provided that the risk being hedged relates to QPP described in Section 1221(a)(1) (i.e., inventory), or relates to property described in Section 1221(a)(8) (i.e., supplies regularly consumed in the ordinary course of the taxpayer's trade or business) consumed in an activity giving rise to DPGR, and provided that the transaction is, and is properly identified as, a hedging transaction, then:

  • In the case of a hedge of purchases of property described in Section 1221(a)(1), gain or loss on the hedging transaction must be taken into account in determining cost of goods sold ("CGS");

  • In the case of a hedge of sales of property described in Section 1221(a)(1), gain or loss on the hedging transaction must be taken into account in determining DPGR; and

  • In the case of a hedge of purchases of property described in Section 1221(a)(8), gain or loss on the hedging transaction must be taken into account in determining DPGR.3

 

In other words, gain or loss on a hedging transaction must be taken into account in computing the DPAD if the transaction hedges a sale of QPP and that property is Section 1221(a)(1) property, or the transaction hedges a purchase of property that is Section 1221(a)(8) property.

Section 199(c)(5) defines QPP as either TPP, any computer software, or any property described in Section 168(f)(4) (i.e., sound recordings). The Code does not define TPP.

However, Treasury Regulation Section 1199-3(j)(2) describes TPP as any tangible property other than land, real property described under Treasury Regulation Section 1.199-3(m)(3) (i.e., buildings, inherently permanent structures other than machinery, inherently permanent land improvements, oil and gas wells, and infrastructure), and any property described under Treasury Regulation Sections 1.199-30(4) (i.e., sound recordings), -3(k)(1) (i.e., qualified film), or -3(l) (i.e., electricity, natural gas, and potable water).

Because electricity is specifically excluded from the definition of TPP, it does not qualify as QPP. Therefore, under the current construction of the regulations, realized gains and losses from qualified tax hedges as described under Section 1221(a)(1) related to the production of electricity are not includible in DPGR.

In guidance published by the Internal Revenue Service ("Service"), the generation of electricity is considered production of TPP. For example, the Service has taken the position that the generation of electricity constitutes production of TPP and is therefore subject to Section 263A, requiring the capitalization of both direct and indirect production costs.4 Section 263A only applies to real property and TPP and the tax law clearly applies Section 263A to the production of electricity. Therefore, under Section 263A and the regulations thereunder, electricity is characterized as TPP. However, the Section 199 Treasury Regulations inexplicably exclude electricity from the definition of TPP in determining QPP.

 

II. Issue

 

Because the regulations specifically exclude electricity from the definition of TPP, electricity does not qualify as QPP. By omitting electricity from the definition of QPP, the current Treasury Regulations create an inconsistency: qualified tax hedges related to one qualified production activity are included in DPGR, while similar qualified tax hedges related to another qualified production activity are not included in DPGR.5 We believe this to be an inadvertent omission that creates an inconsistent treatment of hedging activities related to electricity, natural gas, and potable water relative to other qualified production activities. For example, a company that produces both oil and natural gas, and hedges the production of each in precisely the same manner, would include hedging gains and losses derived from its qualified oil producing activities in its DPGR, but would exclude from DPGR hedging gains and losses derived from its otherwise qualifying natural gas production activities. This differentiation is not reasonable and may favor one energy commodity over another.

 

III. Discussion

 

Similar to other taxpayers that manufacture QPP, utilities not only hedge the "front-end" raw material inputs (such as coal, gas, and uranium) used in the production of electricity, but also hedge their "back-end" (sales) output of electricity. If a utility hedges a raw material input to make electricity, then the realized gains and losses from those supply hedges would be includible in DPGR.6 However, under the current regulations, qualified hedges on the sale of that electricity would be excluded from the computation of DPGR because electricity is excluded from the definition of QPP. This is inconsistent with all other qualified production activities where both the output and supply hedges on property described under Sections 1221(a)(1) and (a)(8), respectively, would be characterized as DPGR.

To exclude hedging gains and losses related to the production and sale of electricity would cause an inaccurate determination of DPGR in calculating the qualified production activities income. ExGen's financial derivative contracts entered into in order to hedge the price at which electricity is sold by it accomplish the same goal of price risk reduction as physically settled forward sales contracts, which qualify as gross receipts from the sale of produced electricity and are not designated as hedges. These forward sales contracts are physically settled and reduce risk by fixing the sales price of electricity that will be produced and sold in the future. Similar to forward sales agreements, the derivative contracts designated as hedges essentially fix the price of electricity that ExGen produces and sells into the open spot market. These hedges directly relate to the sale of electricity and seek to reduce the volatility surrounding market fluctuations by fixing the price of electricity to be sold in the future.

Based upon the statutory language of Section 199 that characterizes both QPP and electricity as types of qualified property from which the sale or disposition gives rise to DPGR, we believe that the treatment of hedging gains and losses with respect to both types of qualified property should be treated similarly in determining DPGR. Depending on market factors, generators of electricity experience both net gains and losses associated with their hedging activities. Regardless of whether such hedging activities give rise to net gains or net losses, we believe that it is appropriate to characterize both hedging gains and losses as DPGR to the extent the qualified tax hedging activities relate to property described under Section 1221(a)(1) and (a)(8) and that are connected to qualified production activities. Accordingly, we believe that the regulations should be modified to provide for the treatment of hedging gains and losses related to both QPP and electricity in determining DPGR.

 

IV. Recommendations

 

Exelon recommends that Treasury Regulation Section 1.199-3(i)(3)(i) be revised to characterize all qualified tax hedges related to property described under Section 1221(a)(1) and (a)(8) as DPGR to the extent they are connected to qualified production activities. Hedging both the production and sale of electricity is a common practice among utilities.7

Proposed Modification to Treasury Regulation Section 1.199-3(i)(3)(i):

 

(3) Hedging transactions.

 

(i) In general. For purposes of this section, provided that the risk being hedged relates to QPPproperty described in section 1221(a)(1) connected to an activity giving rise to DPGR or relates to property described in section 1221(a)(8) consumed in an activity giving rise to DPGR, and provided that the transaction is a hedging transaction within the meaning of section 1221(b)(2)(A) and §1.1221-2(b) and is properly identified as a hedging transaction in accordance with § 1.1221-2(f), then --
Effective Date

We believe that the inconsistency in the regulations concerning the treatment of certain electricity-related hedges was an unintentional oversight. Accordingly, we request that our aforementioned recommended modification to Treasury Regulation Section 1.199-3(i)(3)(i) be retroactively elective to taxpayers for all open tax years for which the DPAD is available. In addition, to ensure consistent application of the modified regulation for both taxpayers and the Service, taxpayers who elect to apply this modified regulation section should be required to apply the revised rule to all open tax years to which the DPAD is available to promote consistency in the tax positions across multiple reporting periods.

Interim Guidance

Hedging of property described under Section 1221(a) is common across the utility industry and is not specific to Exelon To ensure taxpayers properly comply with their federal income tax return reporting requirements, we recommend that in advance of promulgating revised regulations addressing the issues discussed herein, the Service issue interim guidance on this matter, whether through a Revenue Procedure, Notice, or other form of guidance that taxpayers can rely on in advance of such revised regulations.

 

V. Conclusion

 

We believe the exclusion from DPGR of qualified federal income tax hedges described under Section 1221(a)(1) related to the production of electricity was an unintended result under the Section 199 Treasury Regulations. Exelon respectfully requests that the Service and Treasury Department consider our concerns and suggestions. We hope that you find the foregoing comments helpful in your continued efforts to provide clear, useful and administrable guidance with respect to Section 199.

If you have any questions or if there is any additional information that you would find useful, please do not hesitate to contact me at (312) 394-4321.

Sincerely,

 

 

Thomas D. Terry, Jr.

 

Vice President and General Tax

 

Officer

 

Exelon

 

Chicago, IL

 

cc:

 

Brandon Carlton

 

Attorney-Advisor,

 

Office of Tax Policy,

 

US Treasury Department

 

 

Curt Wilson

 

Associate Chief Counsel,

 

Passthroughs and Special Industries,

 

Internal Revenue Service

 

 

Sandra Frost

 

Domestic Production Deduction Technical Advisor,

 

Large Business & International Division,

 

Internal Revenue Service

 

FOOTNOTES

 

 

1 Unless otherwise stated, all Section references are to the internal Revenue Code of 1986, as amended (the "Code").

2 ExGen is a limited liability company wholly-owned by Exelon that is disregarded for federal income tax purposes.

3 Treas. Reg. § 1.199-3(i)(3).

4See CCA 200152012; PLR 200152014; TAM 200626044; PLR 200916004.

5 Another interpretation is that the regulations only address hedging gains and losses with respect to QPP and are silent on the treatment of hedging gains and losses with respect to electricity and other activities that give rise to DPGR

6 Raw material inputs such as coal, natural gas, and uranium are interpreted to be "supplies" as described under Section 1221(a)(8). See, e.g., Preamble to Proposed Treasury Regulations under Section 199, Fed. Reg. Vol. 70, No. 213, p. 67219, Nov. 4, 2005 (stating that utilities may hedge to manage the risk of change in prices of ordinary inputs into the production process).

7 While we have focused exclusively on generators of electricity within this comment letter, we would expect producers of natural gas, potable water, etc. to also participate in similar hedging transactions.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Terry, Thomas D., Jr.
  • Institutional Authors
    Exelon Corp.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2010-20105
  • Tax Analysts Electronic Citation
    2010 TNT 179-20
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