General Comments. The benefits of ownership test provides that the benefits of ownership exist where "the contract gives the purchaser (directly or indirectly) rights to capacity of a facility on a basis that is preferential to the rights of the general public."⁹ The reference in the definition to "rights to capacity" is useful in that it indicates that sales of energy do not pass the benefits of ownership. "Energy" sales have traditionally been non-firm transactions involving the sale of energy if available, with only limited payment for the energy beyond direct costs of production (fuel and other operating costs). Beyond the exclusion of energy sales, however, the definition lacks clarity. The only discussion of what constitutes preferential rights and thus the benefits of ownership is in Example 2 of section 1.141-7T(h) of the Temporary Regulations, which states that a requirements contract must be taken into account because it provides the purchaser with "substantial benefits of ownership (rights to capacity)." The regular general public customers of the city in the example almost certainly have "rights to capacity" that are no more interruptible than that of the investor-owned purchaser. What then are the preferential rights of the purchaser that are a benefit of ownership? There are no facts suggesting that price was the factor. "Preferential rights" may be relevant in cases involving physical possession, but we do not think "preferential rights" is an adequate concept for determining whether substantial benefits of ownership are passed through a service contract. Rights at least somewhat akin to those of a lessee should be required, and, as discussed elsewhere, we think the factors enumerated in section 7701(e) of the Code, if not controlling, are relevant in this regard.

Application to Joint Action Agencies. Section 1.141-7T(c)(2) of the Temporary Regulations 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 Temporary Regulations, because these entities do not sell to the general public, every contract entered into by such an entity, no matter how subordinate to other obligations, would be preferential to the rights of the general public and would meet the benefits and burdens test, whereas a comparable contract entered into by a retail utility might not. If the "preferential rights" concept is retained, it is suggested that this matter be clarified by adding the following language to the end of section 1.141-7T(c)(2):

For the purposes of this section, a contract of a governmental wholesale supplier of electricity gives the purchaser rights to capacity of the facility on a basis that is preferential to the rights of the general public if the right is preferential to the rights of the general public served by governmental purchasers of the governmental wholesale supplier.

General Comments. The burdens of paying debt service test is met under the Temporary Regulations to the extent that the issuer reasonably expects that it is "substantially certain that payments will be made under the terms of the contract."¹⁰ While the test refers only to the "terms of the output contract," it appears from the rules regarding requirements contracts that the surrounding circumstances must be evaluated as well.

As presented, the "burdens" test is reasonably consistent, in keeping with Congressional intent, with prior law. The application of such test under other portions of the Temporary Regulations, however, appears to depart significantly from interpretations under the Subparagraph 5 Regulations. For example, under the Temporary Regulations, payment obligations on a 1-year contract for one percent of the output of a facility may apparently be considered "substantial" burdens of ownership even though such payments represent considerably less than 1% of total debt service on bonds having, for example, a 30-year term. (See discussion below under "Short-Term Contract Safe Harbor".)

Many members of the Committee commented on the need for clarification of the rule that payments be substantially certain. Given that the basic concept is "burden" of debt service, we think that generally the obligation to pay should rise to the level of a take or take or pay contract or guaranteed payment, as under prior law. Lesser levels of obligations should be taken into account only in the rare or exceptional case, such as where the transaction is so clearly beneficial to the purchaser at the time it is made that there is no question that the payments will be made. The basic test should remain whether the burdens of debt service are passed, and the substantial-certainty-of-payment concept should operate more along the lines of the underlying arrangement rule of the prior regulations.

We note in addition that this provision is a part of the IRS reversal of its position on requirements contracts that is discussed in the following section.

Payments on Contract Termination. The Temporary Regulations provide that the burdens of paying debt service are met "for example…if payments must be made upon contract termination." Reg. §1.141-7T(c)(2)(ii). Similarly, the provision regarding retail requirements contracts refers to "payments that are not contingent on the output requirements of the purchaser." Reg. §1.141-7T(c)(4)(iii).

Many contracts for the sale of output involve construction of minor facilities such as substations for the purpose of facilitating the delivery of output. It is not unusual for the purchaser of the output to agree to make payments based on the cost of these improvements if service is terminated before the cost is amortized. In such a case, the benefits and burdens test should be treated as met with respect to the improvement, but that does not mean that the benefits and burdens test is met with respect to the generating facility that supplies the output. Accordingly, we believe the reference to payments in the two above-cited regulatory provisions should be followed by the phrase "properly allocable to the output facility."

In a competitive environment, it seems likely that many retail contracts will contain minimum terms and termination fees for early termination, as is the case with similar services such as cellular phone service. Those types of fees should not be treated as causing the burdens of paying debt service test to be met.

The comments in the preceding two paragraphs are also applicable to retail requirements contracts.

General Comments. A wholesale requirements contract is taken into account "only to the extent that, based on all the facts and circumstances, the contract meets the benefits and burdens test."¹¹ The Temporary Regulations specify "[s]ignificant factors that tend to establish that the benefits and burdens test is met" under the rule.¹² The factors specified—the significant indicators of stability of the customer base, that the contract covers historical requirements, and that the contract contains an agreement not to acquire other resources—do appear to be factors that provide some indication that the benefits and burdens test is met. However, these factors in and of themselves do not necessarily mean that the purchaser has taken on the burden of ownership and debt service or received a benefit of ownership. Further, the regulation is a substantial shift from prior law, as reflected in the Subparagraph 5 Regulations, which followed PLR 7108270510A, supra, and in PLR 8240049 (July 6, 1982) and PLR 9125007 (Mar. 15, 1991), which have been relied upon by a number of very substantial issuers, particularly with respect to contracts with rural electric cooperatives. There is no suggestion in the legislative history (not even the gratuitous phrase concerning requirements contracts with investor-owned utilities in the Joint Committee Report)¹³ indicating Congress intended to upset these longstanding, very substantial arrangements.

The status of requirements contracts is a difficult policy issue. We are not prepared to say that every requirements contract between municipal and investor-owned utilities must be permitted. We are concerned, however, that the Temporary Regulation tests are not administrable, and that their application will change with the passage of time because of gradually changing facts. In addition, at least one significant factor, the term of the contract, is not specified as a factor.

If the factors are retained in their present form, they will be difficult to apply other than adversely. For example, with respect to the test of whether a contract covers historical or projected requirements, requirements contracts typically cover either all requirements or all requirements above those served from a specific source. The contract thus will normally cover historical requirements. It will also cover projected requirements in that it will cover requirements arising in the future. Accordingly, although the parties may be relying heavily on the projected requirements, this factor would appear to be met in the typical case.

The factor relating to whether the customer base has significant indications of stability "such as large size, diverse composition and a substantial residential base" raises the question "compared to what?" These considerations will be very difficult to apply, either by bond counsel or by the IRS in private rulings or on audit, in the absence of some reference points. Moreover, the size, diversity and residential component may become largely irrelevant in the context of open competition, when such objective factors as efficiency and subjective factors like advertising prowess may be more relevant.

Finally, the factor relating to an agreement not to construct or acquire other resources elsewhere would, in its present form, always point to private use. All requirements contracts by their very nature contain some limitation on the ability of the purchaser to go elsewhere for power. Thus, if retained, this factor needs to be refined. For example, a requirement that the purchaser give reasonable notice, such as five years, before obtaining another source of its requirements is far less significant than a provision that precludes him from doing so for the life of a long term contract.

Similarly, the term of a contract ought to be a material factor in determining whether a contract provides real benefits and burden, as recognized in the T.D.7199 file memorandum cited in note 3. A requirements contract of short term duration, even three or five years, provides no real transfer of benefits and burdens because such short term arrangements provide no protection against market shifts in the context of 30–40 year financings of 40–50 year assets.

Finally, two of the factors specified in the Temporary Regulations, whether the contract covers existing or projected requirements and the stability of the customer base, will likely change over time.

Thus, like many of the other new tests in the Temporary Regulations, these provisions raise issues as to when the tests are to be applied. For the reasons set forth in detail under "Time for Applying Tests—Effect of Involuntary Changes," we believe that, if these tests are retained, the determination as to the status of any contract in existence at the time of a new money financing should be made either at the time the contract is entered into or at the time of issuance of new money bonds to finance a facility, and that subsequent changes in the nature of the customer base or other factor being tested should not adversely affect that determination with respect to any subsequent refinancings of that facility.

Part II | Part IIb | Part IIc | Part IIc2 | Part IId | Part IIe | Part IIf

Transition Rule Regarding Wholesale Requirements Contracts. An extension of the term of a requirements contract should only be considered a new contract starting with the first day of the additional term, not from the date the extension is agreed to. This principle is important since contracts are often extended significantly ahead of the time they expire because of the need for forward planning.

The Temporary Regulations provide that a contract will be treated as a new contract if "other material terms" to the contract besides a change in parties or term are modified.¹⁴ This rule is too broad. A change to a material term of the contract which does not change the concept of the amount of electricity covered, e.g. the purchasers’ requirements, or the length of the contract, should not be considered a new contract. In this era of change in the electric industry, there will likely be many modifications required to material terms of existing contracts which, while significant, do not change the scope of the requirements covered or the term of the agreement. Such modifications should not be treated as creating new agreements. In addition, a change in parties that arises by reason of a merger or acquisition should not give rise to a new contract for this purpose.

Relationship of Requirements Contract Rules to Other Rules. It appears that the requirements contract rules are intended as exclusive rules, but the Temporary 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.