Utilities Seek Meeting With Treasury on Unrelated Person Requirement Under Credit for Electricity Produced From Renewable Resources

From: Askey, Elizabeth P. [mailto:elizabeth.askey@pillsburylaw.com]

Attached per your request is an electronic version of the letter we discussed last week addressing the unrelated person requirement of Section 45. Members of our coalition will be in Washington March 4-7 should that present a convenient time for a meeting. Of course, we will accommodate your schedule and can be available to meet before then as well.

Thank you again for considering the attached. Please do not hesitate to call me if you have further questions.

Gentlemen:

On behalf of a coalition of regulated utilities, I thank you in advance for your consideration of the following proposal for guidance clarifying the unrelated person requirement of sections 45(a)(2)(B) and (e)(4) of the Internal Revenue Code with respect to the credit for electricity produced from certain renewable resources (the "REPTC").¹

I. Background

During the last several years, the generation of cost-effective renewable energy has become increasingly important to utilities all across the United States. With Congress and many of the states considering or adopting new laws requiring the acquisition of renewable resources, utilities are seeking new methods for acquiring projects and structuring ownership agreements that will maximize the benefit of the REPTC for their customers and minimize energy supply costs. An important public policy goal for many regulated utilities is to be able to structure renewable projects in a variety of ways without running afoul of certain restrictions associated with the REPTC. One such impediment is section 45(a)(2)(B), which requires electricity generated by a renewable project be sold to an unrelated person in order to qualify for the credit. In practice, this has limited the ability of regulated utilities to enter into business partnerships with other investors to develop renewable sources of energy. To address this problem, 13 investor-owned utilities representing over 20 million customers throughout the United States joined together in 2007 to seek a clarification of the unrelated person requirement that would allow regulated utilities to enjoy the full benefit of the REPTC. The utilities in this coalition are AEP, Alliant Energy, Avista Corporation, MDU Resources Group, MidAmerican Energy Holdings Company, Minnesota Power, PG&E Corporation, Pinnacle West, PNM Resources, Portland General Electric, Puget Sound Energy, Wisconsin Energy, and Xcel Energy.

II. Overview of Issue

The REPTC provided by section 45(a) is a component of the general business credit in section 38. In order to qualify for the credit, the electricity must be sold by the taxpayer to an unrelated person.² Section 45(a)(2)(B). This restriction effectively prevents regulated utilities that develop renewable energy facilities in partnership with third parties from qualifying for the credit. This is because any electricity produced by such partnerships must first be sold back to the regulated utility, i.e., a related person (assuming the utility has a greater than 50% ownership interest in the partnership), before being sold to utility customers.

It is important that regulated utilities have flexibility in structuring their ownership of renewable resource facilities for a number of reasons. First, as alluded to above, regulated utilities are now subject to renewable portfolio standard ("RPS") requirements in nearly half the states, with more states, and possibly the Federal Government, likely to follow suit. Utilities need access to the REPTC to help offset the cost of more expensive renewable energy, and the ability to develop renewable energy facilities through related entities would allow utilities access to important equity capital sources to help in development of those facilities.

Second, providing utilities with the flexibility to partner with third parties will ensure that utilities realize the full benefit of the credit, a benefit that will be passed through to utility customers. Load-serving utilities have a regulated rate of return and taxable income that grows slowly from year to year, and, as a result, the ability of such utilities to utilize the REPTC cannot keep pace with their satisfaction of RPS requirements. Such utilities must either carry such credits forward (resulting in higher power costs to utility customers today), or purchase renewable energy through long-term power purchase agreements, which can be more expensive and do not provide utility customers the benefits associated with full or partial asset ownership.

Third, providing such flexibility to regulated utilities achieves parity with independent developers, most of whom currently utilize partnerships to develop renewable resource facilities and then sell the electricity to utilities at a price that reflects the REPTC.

III. Discussion

It is clear from the above that Congress intended for the REPTC to be available to utilities who own or co-own (as opposed to lease) qualified facilities as long as the utilities ultimately sell the electricity to unrelated parties rather than, for example, using the electricity themselves.

In situations where a utility co-owns a qualified facility with another party, such as through a partnership, the electricity that is produced must go through a preliminary step of being sold back to the utility before it can be sold to customers. However, the electricity "ultimately" is sold to unrelated parties as intended by Congress. Thus, the intermediate "related person" sale should not disqualify the energy produced from qualifying for the REPTC, and the requested clarification merely reflects Congressional intent.

The proposed clarification would extend the reasoning of Notice 2006-40 in an analogous context to the REPTC. There are a number of reasons this is appropriate. First, as noted above, the language of section 45 and section 45J are nearly identical. Section 45J explicitly defines related person by cross-reference to section 45(e)(4). Thus, it is reasonable to apply the same interpretation of section 45(e)(4) in the context of the REPTC as that which has been applied in the context of the advanced nuclear power facility production credit.

Moreover, there is no discernible policy reason for treating renewable energy production facilities differently from advanced nuclear power facilities. The policy underlying section 45 was explained by the Senate Finance Committee as follows: "The committee believes that the development and utilization of certain renewable energy resources should be encouraged through the tax laws.... The credit is intended to enhance the development of technology to utilize the specified renewable energy sources and to promote competition between renewable energy sources and conventional energy sources." Technical Explanation of the Senate Finance Committee Amendment to Title XIX of H.R. 776 (Comprehensive National Energy Act), 138 Cong. Rec. S8486 (1992). When the credit for electricity produced from an advanced nuclear facility (section 45J) was enacted in 2005, it similarly was intended to provide an incentive for the production of nuclear power as an alternative to fossil fuels, and the legislative history suggested it was specifically patterned after the REPTC in section 45. See, e.g., Description and Technical Explanation of the Conference Agreement of H.R. 6, Title XIII, The "Energy Tax Incentives Act of 2005" (JCX-60-05, July 28, 2005). The proposed clarification would simply afford utilities the same flexibility in structuring renewable energy sales that is available for sales of energy produced by advanced nuclear facilities, thus maximizing the credit available under section 45. As the underlying policy of sections 45 and 45J is the same, parity of treatment is appropriate.

Indeed, there is perhaps an even stronger case to be made for the proposed clarification of the related person rule in the case of the REPTC in light of the explicit language of the legislative history quoted above -- requiring that the renewable electricity "ultimately" be sold to unrelated parties -- language very similar to that used in the Notice 2006-40 with respect to the unrelated persons requirement for advanced nuclear facilities but which does not appear in the legislative history for section 45J.

The requested change would also be consistent with section 45(e)(4)'s current treatment of sales within a consolidated group as unrelated party sales. The sale by the development partnership to the utility is analogous to the intermediate intragroup sale that may take place in the consolidated group context and should be treated similarly.

IV. Requested Guidance

We believe that the above presents a compelling case for issuing guidance clarifying section 45(e)(4) in a manner that both furthers Congressional intent and is consistent with the similar provision of Notice 2006-40. We would like to work with Treasury to achieve such a clarification in the most efficient manner possible. The ability of some members of this coalition to meet their RPS requirements and fully utilize the REPTC for taxable year 2008 will depend on their ability to structure joint ventures with third parties for the development of renewable resource projects this year.

As you know, Treasury and the Service recently issued Rev. Proc. 2007-65, 2007-45 I.R.B. 1, dealing with the allocation of section 45 wind energy production tax credits by partnerships in accordance with section 704(b). We respectfully suggest that a simple and efficient vehicle to address this issue would be to issue an Announcement modifying Rev. Proc. 2007-65. (There has already been one previous modification of Rev. Proc. 2007-65, Announcement, 2007-112, 2007-50 I.R.B. 1175 (Dec. 6, 2007).) Specifically:

• Section 1 would be modified by adding the following sentence: "This revenue procedure also clarifies the definition of "related persons" in section 45(e)(4)."

• Section 4.10 would be modified to read as follow: "For purposes of the revenue procedure and section 45(e)(4) in general as it applies to renewable energy sources including wind, electricity will be treated as sold to an unrelated person if the ultimate purchaser of the electricity is not related to the person that produces the electricity. The requirement of a sale to an unrelated person will be treated as satisfied in these circumstances even if the producer sells the electricity to a related person for resale by the related person to a person that is not related to the producer."

V. Support for Legislative Solution

Although we believe that an administrative clarification is both appropriate and the simplest way to address this issue, a proposal to resolve this legislatively is under active consideration on the Hill. We respectfully request that Treasury communicate its support for such a proposal to the tax-writing committees and their staffs. Obviously it is also important that the proposed extension of section 45, which is currently scheduled to expire at the end of this year, also be swiftly enacted to afford the industry greater certainty in its planning for upcoming renewable energy projects.

Because of both the uncertainty of the timing of an appropriate vehicle for a legislative clarification of the unrelated person requirement and the importance of obtaining such clarification as soon as possible, we respectfully request that Treasury issue the guidance requested herein at its earliest convenience. The clarification of the unrelated party requirement we seek will enable companies in our coalition to invest millions of dollars in new renewable energy projects, thus advancing the policy of the REPTC while also promoting robust economic growth over the coming year.

² As discussed below, the phrase "related persons" is defined in section 45(e)(4).

³ The text of section 45(a) is as follows:

45(a) GENERAL RULE. -- For purposes of section 38, the renewable electricity production credit for any taxable year is an amount equal to the product of --

45J(a) GENERAL RULE. -- For purposes of section 38, the advanced nuclear power facility production credit of any taxpayer for any taxable year is equal to the product of --