Comments on §141 Related to Output Facilities

Section of Taxation
Committee Comment: Tax Exempt Financing

COMMENTS ON REGULATIONS UNDER SECTION 141
OF THE CODE AS THEY RELATE TO OUTPUT FACILITIES

COMMENTS AFFECTING GENERATION AND TRANSMISSION

The general rule relating to output contracts under § 1.141-7T(c)(1) should be amended by inserting the phrase "pursuant to a contract" in the first sentence after "The purchase." As it is, the defined term "output contract" has no antecedent.

Contracts With Specific Performance Rights

Section 1.141-7T(c)(5) of the Temporary Regulations provides that an output contract that provides the purchaser with specific rights to control the output of a facility or with other specific performance rights to the use of output of a facility is generally taken into account even if the issuer does not reasonably expect that it is substantially certain that payments will be made under the contract; however, a customer’s normal entitlement to receive utility service (for example, an entitlement to reasonable protection against blackouts in times of high demand through rotating the effect of blackouts) is not treated as a specific performance right for this purpose.

We do not understand what specific performance rights are. If they are intended to cover preferential rights to output, that concept is already covered in the benefits portion of the benefits and burdens test, making the specific performance rights rule redundant.

Former IRS personnel have explained that this rule reflects the notion that contracts resembling leases should be subject to a more restrictive standard than simple contracts for service. We agree with this notion. We suggest, however, that the specific performance standard alone is not reflective of the nature of a contract as a lease, as well as being uncertain as to its meaning. If the theory is to treat contracts resembling leases as leases, the Code already provides section 7701(e) for that purpose. Concepts from that section should be used, rather than a vague and novel specific performance standard.

In many plants with joint ownership, the operator of the plant is also a purchaser of some of a municipal participant’s output from the facility. Typically such purchases would be under take or take or pay contracts and would be counted in any event. In some instances, however, the operator may purchase surplus energy from the municipal participant to the extent it is available. If the effect of this provision is to require that those purchases be taken into account because of the de facto control of the operator, it would be a radical departure from existing law that would preclude a party from such a contract from opting into the Temporary Regulations. If this test is retained, it should be modified to clarify that it does not apply by reason of an agreement to manage or dispatch a plant owned by multiple participants in accordance with prudent utility practice.

Short-Term Contract Safe Harbor

Under the Temporary Regulations, the time limitation on sales that are treated as "uses" of the facility are the same as they would be if the purchaser of the output actually leased the plant, used its employees to operate it and sold the output, even if in fact the purchaser of the output pays a market price, has no involvement in the operation or financing of the plant, has no participation in the profits or cost savings from its operation and has no risk of loss with respect to the plant. There is no other area of tax law in which it could even be imagined that a purchase of service on such terms for a period of 31, 91 or 181 days might be treated as a use of the facility or the funds that financed it, and there is nothing in the 1986 Act that supports reaching that result simply because property is governmentally owned. By contrast, an investor-owned utility has been allowed to purchase 41 percent of the output of a facility owned by a cooperative for a term of 15 years under a "take" contract without any portion of the facility becoming public utility property.²⁹ PLR 8521163 (Feb. 28, 1985).

It is sometimes suggested that any purchase of output from an output facility is a use because the output is the only value produced by the facility. That reasoning is fallacious. As previously noted, the provisions of the Code denying investment credits and limiting depreciation deductions for property used by tax-exempt entities (including governmental entities) stem from policy concerns that are comparable to the limitations on private use in the tax-exempt financing area. Yet no one has suggested that a government contractor that uses its plant to produce widgets for the government, or a manufacturer that sells to a tax-exempt entity under a 61-day contract, should lose tax benefits associated with the plant, even if the contract is a cost plus contract. Ford does not lose tax benefits just because half its Crown Victorias are sold to the police pursuant to contracts. A payroll service does not lose a portion of the tax benefits associated with its computers because it has contracts with governments or 501(c)(3) organizations. The mere purchase of output from a plant is not the use of the plant.

We think a common sense approach should be applied to the short-term use of output facilities. In particular, without specifying the exact outlines of what constitutes use, we believe a contract that (1) is of a relatively short term duration, such as 3-5 years, (2) is at an arm’s length market or tariff price rather than direct cost pass-through price, (3) was not a material factor in the financing of a facility and (4) gives the purchaser of the output no possessory interest or ability to control the manner of operation of a facility cannot be considered to give rise to use of the facility on any reasonable basis and that a safe harbor should be established along those lines.

In that connection, we note that the economic beneficiary of any contract of the nature described would not be the purchaser under the contract, who would be paying an arm’s length price. Rather, the benefit would go to the other customers of the MOU, whose rates would otherwise be increased to pay the fixed costs of unused capacity.

Short-Term Contract Limits Should Treat All Months Equally. The 30 day, 90 day and 180 day safe harbors should be changed to one month, three months and six months. It is impossible to explain to clients that they can make sales for some months, but not others.

Other Transactions. Other transactions that should not give rise to private use include seasonal sales, typically for one or more 6-month periods that do not take the form of swaps and thus do not qualify for the swapped output exception, and sales of excess energy, including sales of so-called financially firm energy³⁰ at arm’s-length rates for limited periods. These transactions in no sense pass to the purchaser the benefits of ownership or burdens of paying debt service, substantial or otherwise.

De Minimis Contracts

The rule of the 1994 Proposed Regulations was a reasonable approach. It scaled down the 3 percent rule in proportion to the reduction in permissible private use from 25 percent to 10 percent. In addition, it explicitly recognized what was implicit in the term "annually" in the Subparagraph 5 Regulations: that the average annual guaranteed payment during the contract term should be compared to the average annual debt service.

By reducing the limit to half of one percent, making it a comparison between the payment in any one year and the average annual debt service, by (perhaps inadvertently) suggesting that it be compared to debt service on any bond issue or at best leaving this issue vague, and by requiring that these miniscule payments be evaluated to determine if they are substantially certain, the Service has created a nullity.

The rule of the 1994 Proposed Regulations should be adopted, but should be limited to "guaranteed minimum payments."

Relationship to Payments Test. Given the reliance placed by the Temporary Regulations on Reg. § 1.141-4 (see § 1.141-7T(e)), the de minimis rule should explicitly state that Reg. § 1.141-4(c) is to be applied before application of the de minimis rule. Thus, payments should be allocated to O&M as well as sources of funding before determining whether the payments allocable to particular bonds meets the de minimis threshold.

Rules Regarding Measurement Period

The Temporary Regulations provide that "the rules of 1.141-3(g)" are used to determine the measurement period, thus replacing the "contract term" concept of the Subparagraph 5 Regulations. It appears that the reference should be to section 1.141-3(g)(2), since most of the other portions of section 1.141-3(g) deal with subjects other than the "measurement period" or deal with subjects that are covered by the concept of available output. Moreover, the provisions of section 1.141-3(g)(7) should not apply to output facilities. Under that provision, if an issuer enters into an arrangement for private use of a facility a substantial period (10 percent of the measurement period) before the right to actual private use commences, and "the arrangement is an arrangement for ...long term use," the measurement period begins on the date the arrangement is entered into. Under this rule, an issuer issuing 30 year bonds to finance a facility with a three year construction period and having an agreement from the beginning to sell 20 percent of the output of the facility for 13.5 years (10 percent of the available output over the term of the bonds) in a transaction giving rise to private use would apparently exceed the permissible limit because the construction period would count as private use. That result is inappropriate. We note that Example 1 of section 1.141-7T(h) of the Temporary Regulations, where 25 year bonds are issued to finance a facility with a four year construction period, correctly ignores the application of section 1.141–3(g)(7).

Under section 1.141-3(g)(2)(i), the measurement period ends on the earlier of the maturity date of the latest maturity date of any bond of the issue that financed the facility or the reasonably expected economic life of the facility. Output facilities are often financed with more than one issue, each of which has a different final maturity. As a result, there may be different private activity limits for the same facility for each issue.³¹ This complexity could be avoided if the last maturity of any issue financing the facility were used for all issues financing that facility. The anti-abuse rule of section 1.141-3(g)(2)(v) should protect against manipulation through multiple issues.

"The reasonably expected economic life" of the facility is to be determined "as of the issue date." This should be the issue date of the first substantial issue of obligations issued to finance the facility. It should not be retested in the event of a refunding of one or more of the issues. See "Time for Applying Rules – Involuntary Charges," above.

The special rule of section 1.141-(g)(2)(iii) for reasonably expected mandatory redemptions is discussed below under "COMMENTS REGARDING REMEDIAL ACTION."

Application of the Payments and Security Tests

The Temporary Regulations provide that the measurement of payments made or to be made by nongovernmental persons under output contracts as a percentage of debt service is determined under the rules provided in section 1.141-4. Section 1.141-4(c)(2) provides that payments for a use of property include payments (whether or not to the issuer) in respect of property financed directly or indirectly with those proceeds "even if not made by a private business user." This rule is sensible in the context of a bond financed facility subject to a "bad" management contract; in such a case, since the manager in effect has the benefits and burdens of ownership, it is as if the payments by the general public are the manager’s payments. This rule, however, should not be applied where, for example, a private user is taking 20 percent of the output of a bond financed facility but is only making payments equal to 10 percent of debt service, to treat an additional 10 percent paid by the general public as private payments. To interpret the rule in that fashion would render the payments test a nullity. In the past, the regulations have never articulated a basis for different treatment of general public payments in the management contract context as opposed to the output context. The reason for the difference is that in the management contract situation the particular facility is entirely privately used by reason of the management contract, and the general public is making payments for its use of the very property that is privately used. By contrast, in the output context, where the general public makes payments with respect to output, it is only with respect to the output of the portion of the facility that is not being used by a private user. Thus, such payments should not be considered private payments. The regulations should articulate this difference.

Allocation of Payments to Debt Service

There are several different rules regarding the amount of payments that must be taken into account. Under section 1.141-4(c)(2)(i)(B), payments are not taken into account to the extent that the present value of those payments exceeds the present value of debt service on the proceeds being used. Thus, if a purchaser is using 10 percent of the output of a facility for the first 10 percent of the life of the facility, the payments taken into account would not exceed an amount equal to 10 percent of debt service during that period. Under section 1.141-4(c)(2)(i)(C), payments by a person for a use of proceeds do not include the portion of any payment that is properly allocable to the operation and maintenance of the financed property used by that person, but operation and maintenance do not include general overhead and administrative expenses. Accordingly, if the contract referred to above required the purchaser to pay for 10 percent of all costs, including general overhead and administrative, the overhead and administrative payments would not be excluded under section 1.141-4(c)(2)(i)(C), but they would be excluded under section 1.141-4(c)(2)(i)(B). If, on the other hand, the contract required the purchaser to pay 80 percent of 10 percent of all costs, and 20 percent of the costs were overhead and administrative, the payments allocable to debt service would include the full amount of debt service even though that was not the agreement of the parties. In other words, even though the parties had agreed that the purchaser would only pay 80 percent of the actual costs, including debt service, the regulation would allocate payments to debt service in the full amount of debt service.

In addition, output contracts frequently call for separate charges for energy and capacity. Since capacity charges are fixed and energy charges vary with the energy taken, the allocations can generally be relied on to determine the payments that should be counted under the payment test.

There are well established rules for accounting for costs in the electric industry. We think an issuer should be able to use those rules in determining the amount of payments allocable to debt service.

Under section 1.141-4(c)(3)(iv), payments made under an arrangement entered into in connection with the issuance of bonds are generally allocable to that issue. Presumably, this rule does not change the amounts of payments that are taken into account, as described above.

Allocation to Equity Financed Portion of a Facility

The Temporary Regulations also indicate that where facilities have been financed with multiple funding sources, the allocation rules provided in the 1997 Final Regulations may be utilized to allocate private use and private payments. These rules generally provide for pro rata allocations to sources. We are concerned that these rules foreshadow a rule that private sales might have to be allocated pro rata to the equity and debt financed portions of facilities. 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 effectively treated the private use and governmental use portions of facilities as separate facilities. Thus, the Conference Report states that, where 10% of the output of a $500,000,000 facility is to be sold to an IOU, $465,000,000 of tax-exempt debt can be issued to finance the facility. If the private sales had to be allocated pro-rata to tax-exempt debt and equity, only $150,000,000 of bonds could have been issued without exceeding the $15,000,000 limit. The example only works where the private sales are allocated first to equity. The example is properly reflected in the example in section 1.141-8T(c) of the Temporary Regulations. Thus, both Congress and the IRS have recognized that private sales can be allocated first to equity.

Clarification also would be useful with respect to the allocation of private payments from bad contracts. The Temporary Regulations refer to the rules of the 1997 Final Regulations relating to the allocation of payments which generally require 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.

Transmission facilities are often financed in part with equity and in part with debt. In addition, in anticipation of contracts for transmission, a MOU may redeem part of its debt with equity or taxable bonds. The regulations should recognize that private use is permitted with respect to facilities to the extent financed with other than tax-exempt bonds. For example, if a particular transmission line is financed 75 percent with tax-exempt bonds and 25 percent with taxable bonds or equity, subsequent private use of 25 percent of the capacity on such line should not result in any of the bonds having to be redeemed. If the facility had been 100 percent tax-exempt financed and subsequently 25 percent of it is privately used, then only 25 percent of the bonds would have to be redeemed. 75 percent of the facilities could continue to be financed with tax-exempt bonds. The order in which the equity or taxable bonds are applied to finance the facilities should not change the percentage that can be tax-exempt bond financed.

Similarly, recognizing the ability to have 10 percent private use, if 60 percent of the facility is to be used by the MOU and 40 percent is used by private persons, then approximately 66 percent of the facility can be bond financed and 34 percent would have to be financed with taxable debt or equity. Consistently, if 100 percent of the facilities is bond financed and 40 percent becomes privately used, the issuer should only be required to retire 34 percent of its debt, not 40 percent. Again, the order in which the private use arises, particularly in a changing industry, should not change the amount of facilities which can be tax-exempt bond financed.

Examples 5 and 6 of Section 1.141-14(b) Should Be Modified

Example 5 concludes that where 30 percent of the output of a facility is taken by a private utility and 70 percent by a governmental utility and each party pays its proportionate share of the costs, the allocation of the 30 percent private use portion to the taxable financing having a weighted average life of 15 years does not reflect economic substance where the tax-exempt financing has an average life of 26 years.

The example misconstrues the intent of the private activity limitations, which is to limit the amount of tax-exempt financing rather than to specify the type of financing arrangements that may be entered into. This is clear from the example in the legislative history, incorporated into the Temporary Regulations, of the $500,000,000 plant. The example concludes that only $465,000,000 of bonds may be issued on a tax-exempt basis. It says nothing about how the remaining 35 million is to be financed. Reg. §1.141-8T(c).

Example 5 does not state what would have happened if the issuer had financed the transaction with 30 percent equity and a tax-exempt financing having an average life of 26 years. However, based on the $500,000,000 example in the legislative history, it must be possible to finance the facility in that manner. If an issuer finances 30 percent with equity and 70 percent with debt, there is no rule that the equity cannot be "amortized" faster than the debt; that is, that the debt could be interest only for some period of time or involve slower amortization than level debt service in the early years so as to allow a return of all or some part of the equity. There is no reason taxable debt should be treated less favorably than equity.

Example 6 indicates the peril of attempting to dictate how parties acting at arms-length should negotiate their deals. In that example, the allocation is upheld where the private utility pays all the taxable debt service and the MOU pays all the tax-exempt debt service. This ignores the fact that, depending on the term of the taxable debt and the relationship of taxable to tax-exempt rates, the private utility might pay less than it would have had it paid 30 percent of all debt service, because the taxable debt service is shorter than the tax-exempt. The regulations should leave these matters to arm’s length negotiation.

Financial Contracts

The Preamble to the Temporary Regulations requested comment upon the proper treatment of options. There are also other emerging financial transactions that may have relevance. We are not in a position to deal exhaustively with these matters, but we offer the following comments.

Purely Financial Transactions. In general we believe that financial transactions that hedge positions but do not involve the actual use of output of facilities should be disregarded. One example of this type of transaction is a swap from a fixed price to a variable price based on notional amounts of energy. In such transactions, no actual energy changes hands nor even need be generated. We believe such transactions should be disregarded.

Transmission Congestion Charges. Another example of a financial contract that should be disregarded as not involving the use of facilities to which they seemingly relate is the Transmission Congestion Charge ("TCC").

At least under some models, TCCs are not charges for transmission service at all. Rather, they are increased costs of power over and above the cost of generation and transmission that are caused by reason of the unavailability of transmission and that are collected from purchasers of electricity and paid to the holders of the TCCs. Because the TCCs do not involve actual transmission, they can be held by persons other than transmission owners and, in fact, synthetic TCCs can be traded.

One place where TCCs are being used is New York. We have enclosed a description of the New York TCCs as Appendix C because we believe it is similar to what is being, or will be, done elsewhere. This description indicates that these types of arrangements are purely financial and are not tied to any provision of transmission service.

Options. Options where the MOU agrees to purchase power or energy when put to it generally do not involve the use of the MOU’s facilities and should not give rise to private activity bond concerns. Options where the MOU agrees to sell power or energy pursuant to an option to purchase may, however, give rise to such concerns. If the option, when entered into, is at a bargain price such that there is economic compulsion that it be exercised, the option may be analyzed under the underlying arrangement rubric of the Subparagraph 5 Regulations or the substantial certainty of payment rule consistent with the interpretation we have suggested in these comments. Authorities distinguishing options from disguised sales are also relevant. Where the option price is such that there is no substantial certainty of exercise, however, it is hard to see how the option in and of itself could pass the benefits and burdens of ownership to the option holder.

A second level of analysis may, however, be required depending on the effect of the exercise of the option. If the exercise of the option itself creates a long term obligation that would itself be taken into account, the fact that it arose from an option should be immaterial.