Tax costs plague grid interconnections

By Patrick M. Kowis Jr., Entergy

The Federal Energy Regulatory Commission (FERC) generally provides that all power generators must have equal and unfettered access to the transmission grid. However, this access comes at a cost in that generators are required to build the interconnection facilities or alternatively, reimburse the grid owner for its costs to build such interconnections, including applicable income taxes. The property transfer to the grid owner or reimbursement for the grid owner’s interconnection costs is commonly referred to as a contribution in aid of construction (CIAC).

In 1986, the Tax Code was expanded to include a revenue-raising provision that taxes the grid owner for any CIAC it receives from a customer or potential customer for the purpose of encouraging the grid owner to provide new or additional services. In 1988, IRS made a distinction between CIAC received from a qualifying facility (QF) and CIAC received from all other generators by giving notice that certain property transfers or cost reimbursements received from a QF were tax-free to the grid owner. Since that time, IRS has issued several private letter rulings that extended the 1988 notice to apply to merchant plants as well as QFs based upon the reason that such plants are analogous to QFs. However, the law became unclear in 2000 when IRS backed away from its earlier position that grid owners could receive tax-free CIAC from merchant plants and also refused to issue further rulings involving merchant plants until more detailed study could be completed.

FERC has ruled in at least one case that the appropriate method for calculating the income tax cost to be allocated to interconnecting independent power producers (IPPs) is as follows:

Federal and state income tax + tax on tax effect (the reimbursement of taxes is also taxed as income) – present value of future tax depreciation on interconnection property = tax gross-up rate

The effect of income tax on CIAC can be critical to cost-conscious IPPs in that the cost of income taxes under the above gross-up formula can add roughly 35 percent to the construction cost of an interconnection facility and transmission system upgrades. Once more, if the IPP decides to build the interconnection facility, it must contribute the property and 35 percent of the fair market value of its property to cover the tax costs. Such significant front-end tax costs can often mean the difference between a feasible IPP project and one that must be reconsidered or scrapped all together.

By taxing CIAC, significant administrative burdens or financial risk are unfairly placed upon grid owners. In fact, grid owners must incur the administrative burden of collecting taxes from the various interconnecting IPPs and promptly submit the taxes to IRS and state taxing authorities without any compensation for their administrative costs. In effect, the grid owner is forced to assume the role of an IRS collection agent without being paid for such work. In lieu of collecting and paying taxes on the CIAC it receives, some grid owners have chosen to take an aggressive tax position that the CIAC they receive from an interconnecting IPP is not taxable. To protect themselves against future tax liability, the grid owners will typically require that all interconnecting IPPs execute an indemnity agreement that provides for reimbursement in the event that IRS later assesses income tax on the CIAC. However, this approach carries an inherent risk that the IPPs, many of which may be small or risky business enterprises, will still be in business and have the financial ability to pay said taxes at the time IRS audits the grid owner’s tax returns. Because of FERC rules that require grid owners to treat all interconnecting IPPs equally, it may not be prudent for the grid owner to accept indemnity agreements in lieu of taxes from large, stable IPPs while refusing to accept an indemnity from smaller or more risky IPPs. Accordingly, many grid owners are unwilling to assume such financial risk and instead have wisely chosen, as the lessor of two evils, to accept the administrative burden of collecting and paying the income tax on CIAC.

In August, IRS issued a private letter ruling, which provided that a CIAC received from a QF may be tax-free even if the QF wheels part of its power to wholesale buyers. This ruling appears to provide IPPs with the option of building a QF so the interconnection costs will not be subject to income tax. To satisfy IRS requirements, the QF should enter into a non-exclusive, long-term power purchase agreement with the grid owner to sell the majority of its capacity at avoided cost. The remaining portion of its capacity would then be available to sell during the summer or other peak hours to wholesale buyers at potentially much higher rates.

Last April, the Edison Electric Institute, American Public Power Association and Large Public Power Council jointly supported proposed legislation (Electric Power Industry Tax Modernization Act) that contained a provision aimed at eliminating income tax on CIAC as it pertains to interconnections to distribution and transmission grids. However, the CIAC provision was not part of the energy legislation passed by the House of Representatives in July (H.R. 2511) possibly because such provision may have a high revenue cost. Unfortunately, any tax relief legislation has little promise of being passed by Congress in the immediate future due to the current pressure on Congress to avoid using social security reserves to offset tax relief legislation.

Pursuant to the Treasury’s 2001 Business Plan, IRS began drafting guidance on the taxation of CIAC in June. All indications are that IRS is expected to publish guidance by the end of this year. While it is difficult to predict what position the IRS may ultimately take, the sooner that IRS issues guidance one way or the other, the sooner that IPPs and investor-owned utilities can begin to make plans accordingly.

Until the law is clarified by IRS or Congress, the recently issued IRS ruling is the most favorable opportunity for IPPs to interconnect without income tax costs. Accordingly, IPPs should seriously consider opportunities using QFs to wheel their power to wholesale buyers. To seek relief from the administrative burdens and financial risk inherent with the tax on CIAC, grid owners should undertake serious lobbying efforts to persuade Congress that the revenue cost of eliminating the income tax on CIAC is worthwhile in light of the benefits to the entire electric generation, distribution and transmission industry. This is especially true when considering that the added tax cost is ultimately passed on to consumers in the form of higher electricity prices.

The burdens caused by the taxation of CIAC have become a financial and administrative obstacle for the development of new generation, distribution and transmission facilities. To avoid the type of crisis felt by California, Congress and IRS need to seriously consider eliminating the tax on CIAC received from IPPs for use in building interconnection facilities or system upgrades.

Patrick M. Kowis Jr., tax counsel for Entergy, may be contacted at pkowis@entergy.com.

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