FEDERAL TAX PROVISIONS AFFECTING 

THE ELECTRIC POWER INDUSTRY

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on September 12, 2001

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

September 10, 2001

JCX-67-01
i

CONTENTS

Page

INTRODUCTION ............................................................................................................ 1

I. SUMMARY............................................................................................................... 2

A. Tax Provisions Primarily Affecting Municipal Electric Service Providers:

Tax-Exempt Financing ........................................................................................ 3

B. Tax Provisions Primarily Affecting Investor-Owned Utilities............................ 3

C. Tax Provisions Affecting Electric Cooperatives ................................................. 6

II. FEDERAL TAX PROVISIONS AFFECTING ELECTRIC SERVICE

PROVIDERS ............................................................................................................. 7

A. Tax Provisions Primarily Affecting Municipal Electric Service Providers:

Tax-Exempt Financing ........................................................................................ 7

1. Present law..................................................................................................... 7

2. Examples of private business use issues arising in electric power

industry restructuring..................................................................................... 19

B. Tax Provisions Primarily Affecting Investor-Owned Utilities............................ 21

1. Cost recovery of property used in the production, transmission, and

distribution of electricity................................................................................ 21

2. Other tax provisions of industry concern....................................................... 32

a. Nuclear decommissioning........................................................................ 32

b. Income recognition on the provision of services..................................... 36

c. Conservation payments............................................................................ 36

d. Customer deposits and prepayments........................................................ 37

e. Cost of service adjustments ..................................................................... 38

f. Cancellation of supply contracts.............................................................. 39

g. Contributions in aid of construction ........................................................ 40

h. Involuntary conversions........................................................................... 40

3. Deferred tax accounts: financial, regulatory, and tax accounting.................. 41

4. General corporate restructuring issues........................................................... 42

C. Tax Provisions Affecting Electric Cooperatives ................................................. 44

1. Overview of cooperatives and electricity ...................................................... 44

2. Present law..................................................................................................... 45

3. Tax issues raised by electric power industry restructuring............................ 46
Page

ii

III. OVERVIEW OF SENATE BILLS: ELECTRICITY RESTRUCTURING,

ELECTRIC POWER INDUSTRY, AND CLEAN COAL BILLS ........................... 47
1

INTRODUCTION

This document, 1 prepared by the staff of the Joint Committee on Taxation, provides a 

description of present-law Federal tax provisions relating to the electric power industry. The 

Senate Committee on Finance has scheduled a public hearing on this subject on September 12, 

2001.

This document describes the principal current Federal tax provisions specifically relating 

to the electric power industry, including provisions related to investor-owned, publicly-owned, 

and cooperatively-owned utilities, as well as non-utility generators and other participants in the 

electric power industry.

Part I of the document is a summary. Part II is a description of present-law Federal tax 

provisions affecting electric service providers and issues related to the proposed restructuring of 

the electric power industry. Part III is a summary of tax bills introduced in the Senate relating to 

the electric power industry and incentives for clean coal technology.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Federal Tax 

Provisions Affecting the Electric Power Industry (JCX-67-01), September 10, 2001.
2

I. SUMMARY

In 1999, production and use of electricity comprised 35.8 percent of total energy 

consumption in the United States,2 and in 1999 sales of electricity comprised 2.3 percent of gross 

domestic product. In residential and commercial non-transportation uses, electricity comprised 

69.4 percent of total energy use, while electricity accounted for 31.9 percent of the energy used 

by industry. 3 The residential sector is the largest end-user of electricity, having consumed 34.6 

percent of all electricity consumed in 1999. The industrial sector consumed 32.0 percent of 

electricity, while commercial users consumed 30.3 percent. 4

The electric power industry generally is comprised of three types of electric utilities--

investor-owned utilities ("IOUs"), publicly owned utilities ("public power"), and electric 

cooperatives ("co-ops")--and of certain non-utility ("independent power") producers. 

Independent power producers sell most of their electricity to electric utilities that resell the power 

to final consumers. In 1999, IOUs provided 74.1 percent of final electricity sales, public power 

15.4 percent, and co-ops 8.9 percent. 5 

The provision of electricity involves four distinct functions: generation, transmission, 

distribution, and retail sales. "Generation" involves the creation of electricity. The 

"transmission" of electricity refers to the transportation of electricity from generation sites to 

distribution centers. The "distribution" of electricity refers to the transportation of electricity 

from distribution centers to customers' homes and businesses. The "retailing" function involves 

metering and billing final customers. Retailing also may require the retailer to contract with 

generators and owners of transmission and distribution systems for the provision of electricity. 

Historically, most electricity was provided by vertically integrated suppliers that performed each 

of the four functions of generation, transmission, distribution, and retailing.

Current efforts to restructure the electric power industry by eliminating or reducing both 

its vertical integration and rate regulation aspects raise significant Federal tax and related 

 

2

 Energy Information Administration, U.S. Department of Energy, Annual Energy 

Review 1999 (July 2000). The Department of Energy estimates that in 1999 the United States 

consumed 96.60 quadrillion British thermal units (“Btu”) of energy from all sources and that 

direct consumption of electricity and electrical system energy losses accounted for 34.56 

quadrillion Btu. 

3

 Energy Information Administration, U.S. Department of Energy, Monthly Energy 

Review (February 2001). Electricity comprised 0.2 percent of energy used in transportation. 

4

 Id. at 101.

5

 Energy Information Administration, U.S. Department of Energy, Electric Sales and 

Revenue 1999 (October 2000). These figures are based on millions of kilowatt hours, rather than 

dollars of sales. In 1999, over 3.2 trillion kilowatt hours of electricity were sold by the U.S. 

utilities. Of that total, roughly 2.4 trillion kilowatt hours were sold by IOUs, 499 billion kilowatt 

hours by public power utilities, 288 billion kilowatt hours by co-ops, and 52 billion kilowatt 

hours by direct sales from Federal power authorities to final consumers.
3

economic issues. This pamphlet describes present-law Federal tax provisions applicable to the 

electric power industry and discusses issues raised by these restructuring proposals. 

A. Tax Provisions Primarily Affecting Municipal Electric

Service Providers: Tax-Exempt Financing

Interest on debt incurred by States or local governments is excluded from the income of 

the lender (“bondholder”) if the proceeds of the borrowing are used to carry out governmental 

functions of those entities or the debt is repaid with governmental funds of those entities. 

Interest on bonds that nominally are issued by States or local governments, the proceeds of 

which are used (directly or indirectly) by a private person and payment of which is derived from 

funds of such a private person ("private activity bonds"), is taxable unless the purpose of the 

borrowing is approved specifically in the Internal Revenue Code (the "Code") or in another 

provision of a revenue Act. The term "private person" generally includes the Federal 

Government and all other individuals and entities other than States or local governments. 

The provision of electric service (generation, transmission, distribution, and retailing) is a 

governmental activity eligible for financing with governmental tax-exempt bonds when the 

financed facilities are used by or paid for by a State or local government entity (e.g., by public 

power). As with other governmental activities, public power also is eligible for limited taxexempt financing of working capital costs (e.g., salaries of employees and similar expenses). 

Except as described in Part II, private IOU and co-op electric service providers generally are not 

eligible for tax-exempt financing of their facilities.

If public power entities elect to participate in State open access industry restructuring 

plans where public and private business electric systems are integrated, interest on outstanding 

tax-exempt bonds of the public power entities may become retroactively taxable unless the 

issuers of the bonds qualify for and issuers avail themselves of certain administrative relief 

provided in Treasury Department regulations. In addition, public power facilities that are used in 

a manner violating the Code's restrictions on the issuance of tax-exempt bonds to benefit private 

persons will be ineligible for future tax-exempt financing.

B. Tax Provisions Primarily Affecting Investor-Owned Utilities

Cost recovery of property used in the production, transmission, and distribution of 

electricity

A taxpayer generally must capitalize the cost of property used in a trade or business and 

is allowed to recover the cost over time through allowances for depreciation and amortization. 

Cost recovery rules for ratemaking and Federal income tax purposes are important to electric 

utilities because of the capital-intensive nature of the industry. The methods used by IOUs 

generally recover the cost of public utility property more rapidly for Federal income tax purposes 

than do the methods used for ratemaking or financial accounting purposes.

In order for public utility property to be eligible for the more favorable depreciation 

allowances available for Federal income tax purposes (relative to the depreciation allowances 

used for ratemaking or financial statement purposes), the tax benefits of accelerated depreciation 

must be "normalized" in setting rates charged by utilities to customers and in reflecting operating 
4

results in regulated books of account. The normalization method of accounting generally spreads 

the tax benefits of accelerated depreciation over the regulatory life of the property and results in 

higher utility rates in the early years and lower utility rates in the later years than otherwise 

would have occurred.

Rate regulation typically guarantees the recovery of both the amount invested in property 

to be used in the business as well as a sufficient return on the investment. So long as these 

guarantees exist, electric utilities are able to invest in property without regard to the fair market 

value of such property in an unregulated environment or the amount of income such property 

could earn if used to produce power for sale at competitive rates. In certain instances, utilities, 

with the knowledge of the appropriate regulatory body, may have invested in property whose 

cost could only be justified by the presence of a guaranteed return. 6 

Restructuring of the electric power industry could affect the value of property that was 

placed in service in a regulated environment. If the return on the investment in the property is no 

longer guaranteed through rate regulation, the value of the property will be determined solely by 

the amount of income that the property can earn producing power at competitive rates. 

The extent to which the book or regulatory value of electric utility property exceeds its 

fair market value after restructuring is sometimes referred to as a "stranded cost." These costs 

are considered "stranded," because the electric service provider had anticipated recovering the 

full cost of the property under the ratemaking process when the property was placed in service, 

and such recovery is unlikely in an unregulated environment. Proposals to restructure the 

electric power industry often address the difficult issue of how to allow a utility to recover its 

stranded costs. 

There are no special tax provisions that allow for the immediate recovery of stranded 

costs. In order to recover the adjusted basis of depreciable property, the taxpayer generally must 

dispose of the property, abandon it, or show its obsolescence. In the absence of such an event, 

electric service providers will continue to depreciate the property in the same manner after the 

restructuring of the industry as before the restructuring and will recover any stranded cost over 

the remaining depreciable life of the property. 

The restructuring of the electric power industry also raises several issues with respect to 

the normalization method of accounting. If an entire electric utility is deregulated, IOUs no 

longer will be subject to ratemaking processes, and thus the normalization requirements of the 

Code will no longer apply. If only a portion of the electric utility's services are deregulated (e.g., 

the generation and transmission services but not the distribution services), then a portion of the 

utility's property will remain public utility property subject to the normalization requirements, 

and the remainder will not.

 

6

 A regulated utility may have been obligated to provide electricity to its customers on 

demand. To meet this obligation, the utility’s generating capacity (either owned or contracted) 

must be based on maximum projected demand, which may exceed the capacity the utility would 

have determined to be optimal in an unregulated environment.
5

The method by which the electric power industry is restructured may affect the 

application of the normalization method of accounting. If a public utility commission decides to 

transition into deregulation, the determination of whether or not certain property is public utility 

property may be difficult. For example, if a public utility commission allows an IOU to recover 

a portion of the stranded costs applicable to certain deregulated property, it is unclear the extent 

to which such property is public utility property subject to the normalization method of 

accounting.

Other tax provisions

A number of additional provisions affect IOUs, either because they provide rules 

specifically applicable to utilities, or because they govern the Federal income tax treatment of 

transactions in which IOUs are likely to engage. Some provisions, such as the provision 

allowing for the deduction of certain deposits to nuclear decommissioning funds, assume a 

regulatory framework. If restructuring requires the separation of the businesses of generating 

and distributing electricity, Federal income tax rules applicable to forced sales may apply. 

Provisions governing other transactions may not be affected directly but may become 

significantly more common (such as cancellation of supply contracts) or less common (such as 

conservation payments) as a result of restructuring.

Deferred tax accounts: financial, regulatory, and tax accounting issues

Generally Accepted Accounting Principles require a deferred tax account whenever 

temporary differences exist between the Federal income tax accounting and financial accounting 

treatment of an item. When the difference will result in amounts taxable in the future, a deferred 

tax liability is created. When the difference will result in amounts deductible in the future, as 

well as when there is an anticipated reduction in future tax liability attributable to the 

carryforward of items such as net operating losses and tax credits, a deferred tax asset is created. 

Although it may create numerous indirect effects on the deferred tax accounts, restructuring is 

not expected to affect the balances in these accounts directly.

General corporate restructuring tax issues

Electric power industry restructuring could result in significant reorganization of 

businesses currently owned by IOUs. For example, an IOU that has owned generation, 

transmission, and distribution facilities may dispose of some or all of these facilities. In some 

cases, all the assets and activities of a segment of the business may be disposed of. In other 

cases, businesses and assets might be combined with those of other service providers in new 

ventures. Some ventures also may involve transfers or participation between tax-exempt and 

taxable entities.

The disposition or combination of businesses and assets can be structured in various 

ways, producing various tax results. Assets or businesses may be disposed of for cash or 

otherwise in taxable transactions. If certain continued stock ownership requirements are met, 

transactions also may be structured in a form that is not immediately taxable. Partnerships also 

may be utilized to combine corporate activities or to readjust the future interests of contributing 

partners in those activities. There may be limitations on the future use of existing losses at the 
6

corporate level if more than 50 percent of the corporate stock changes hands. Also, certain 

acquisitions that are part of a plan or series of related transactions may result in corporate level 

tax in connection with certain corporate "spin-off" transactions, in which a corporate business is 

distributed to shareholders as a separate corporation. Some of the corporate restructuring 

described above may be inhibited by the Public Utility Holding Company Act of 1935, which 

restricts combined ownership of IOUs in different States.

Generally, the various corporate reorganization provisions of present law apply to IOUs 

in the same manner as other entities. Special dividends paid and dividends received deduction 

provisions that relate to certain public utility preferred stock issued before October 1, 1942, or 

issued after that date for specified purposes, might be implicated in certain types of 

readjustments.

C. Tax Provisions Affecting Electric Cooperatives

An electric cooperative generally can exclude income that is allocated to patrons pursuant 

to a pre-existing obligation of the cooperative to do so. Under present law, electric cooperatives 

must comply with the fundamental cooperative tax principles that generally apply to 

cooperatives. These principles consist of: (1) subordination of capital to control by the members 

of the cooperative over the cooperative undertaking and the financial benefits of ownership; (2) 

democratic control by the members of the cooperative; (3) vesting in and allocation among the 

members of all excess of operating revenues over the expenses incurred to generate revenues in 

proportion to their participation in the cooperative (patronage); and (4) operation at cost (not 

operating for profit or below cost).

In addition, a rural electric cooperative is exempt from Federal income tax if at least 85 

percent of the cooperative’s income consists of amounts collected from members for the sole 

purpose of meeting losses and expenses of providing service to the members. The Internal 

Revenue Service takes the position that rural electric cooperatives are tax-exempt only if they 

also comply with the fundamental cooperative tax principles described above.

It is not clear whether a rural electric cooperative that participates in restructuring of the 

electric energy industry can be assured that: (1) it will receive at least 85 percent of its income 

from members (in the case of tax-exempt electric cooperatives); or (2) income earned after 

restructuring will be excludible from its taxable income (in the case of non-exempt electric 

cooperatives). For example, fees that a cooperative receives for wheeling electricity through its 

system and sales of surplus electricity to non-members: (1) do not constitute income collected 

from members under the present law 85-percent test for tax exemption; and (2) may not be 

excludible income for non-exempt electric cooperatives under present law.
7

II. FEDERAL TAX PROVISIONS AFFECTING

ELECTRIC SERVICE PROVIDERS

A. Tax Provisions Primarily Affecting Municipal

Electric Service Providers: Tax-Exempt Financing

1. Present law

In general

Interest on debt7 incurred by States or local governments is excluded from income if the 

proceeds of the borrowing are used to carry out governmental functions of those entities or the 

debt is repaid with governmental funds (sec. 103).

8

 Interest on bonds that nominally are issued 

by States or local governments, but the proceeds of which are used (directly or indirectly) by a 

private person and payment of which is derived from funds of such a private person ("private 

activity bonds") is taxable, unless the purpose of the borrowing is approved specifically in the 

Code or in another provision of a revenue Act. The term "private person" generally includes the 

Federal Government and all other individuals and entities other than States or local 

governments.9

The general structure of the rules for determining whether a tax-exempt bond is a 

governmental or a private activity bond was established in 1968. The Tax Reform Act of 1986 

(the "1986 Act") further restricted the amount of private use that may be financed before a State 

or local government bond is classified as a private activity bond, and enacted extensive 

additional restrictions on tax-exempt financing generally.

 

7

 Hereinafter referred to as "State or local government bonds," even though not all taxexempt debt results in the issuance of a formal bond (e.g., installment sales agreements are 

treated as bonds).

8

 Interest on this debt is included in calculating the "adjusted current earnings" 

preference of the corporate alternative minimum tax.

9

 Interest on Federal debt is taxable. However, unlike most State or local government 

debt, Federal debt benefits from the Federal Government's guarantee of repayment. The Code 

includes limited exceptions allowing the combination of these benefits, generally for programs 

that were in existence before enactment of the Tax Reform Act of 1984. 

One such exception allows certain tax-exempt financing of State or local government 

facilities that transmit and distribute electric power supplied by the Bonneville Power 

Administration (the “BPA”), a Federal instrumentality. In addition, section 1316(d) of the Tax 

Reform Act of 1986 codified a prior-law Treasury Department regulation that treated the BPA as 

a State or local government unit rather than as a Federal entity. These exceptions are unique to 

the BPA; other Federal power agencies are treated as Federal entities and are not permitted to 

benefit from tax-exempt financing or to guarantee such financing.
8

The provision of electric service (generation, transmission, distribution, and retailing) is 

an activity eligible for financing with governmental tax-exempt bonds when the financed 

facilities are used by or paid for by a State or local governmental entity (e.g., "public power").10 

As with other governmental activities, public power entities also are eligible for limited taxexempt financing of working capital costs (e.g., salaries of employees and similar expenses). 

Except as described below, IOUs and co-ops generally are not eligible for tax-exempt financing 

of their facilities. With the exception of certain charitable organizations that are described in 

section 501(c)(3), private businesses are not eligible to finance working capital costs with taxexempt bonds (except with proceeds of a permitted five-percent "bad money" portion of a bond 

issue which may be used for any type of expenditure).

Classification of bonds as private activity bonds

Present law provides two tests for determining whether a State or local government bond 

is, in substance, a private activity bond (sec. 141(b) and (c)).

Private business test.--Private business use and private payments result in State or local 

government bonds being private activity bonds if both parts of a two-part private business test 

are violated–

(1) More than 10 percent of the bond proceeds is to be used (directly or indirectly) by 

a private business (the "private business use test"); and

(2) More than 10 percent of the debt service on the bonds directly or indirectly is 

secured by an interest in property to be used for a private business use or is to be 

derived from payments in respect of such property (the "private payment test").

The 10-percent private business use and payment threshold is reduced to five percent for 

private business uses that are unrelated to a governmental purpose also being financed with 

proceeds of the bond issue. For example, a privately operated cafeteria in a government office 

building financed as part of the building's construction could represent a related private business 

use. On the other hand, a separate, private manufacturing facility financed with proceeds of the 

same bond issue would constitute an unrelated private business use of bond proceeds. 

Additionally, as described more fully below, since enactment of the 1986 Act, the 10-percent 

private business use and private payment thresholds are phased-down for larger bond issues for 

the financing of certain "output" facilities. The term output facility includes electric generation, 

transmission, and distribution facilities.

Private business use generally includes any use by a business entity (including the 

Federal Government), which occurs pursuant to terms not generally available to the general 

public. For example, if bond-financed property is leased to a private business (other than 

pursuant to certain short-term leases for which safe harbors are provided under Treasury 

Department regulations), bond proceeds used to finance the property are treated as used in a 

private business use, and rental payments are treated as securing the payment of the bonds. 

 

10 Section 115 also exempts the income that States and local governments derive from 

the operation of public power systems as governmental activities. 
9

Similarly, in the case of public power entities, if output of an electric generating plant or 

transmission or distribution facilities is provided to a private business on terms not generally 

available to other customers of the entity, an allocable portion of bonds financing the facilities is 

treated as used in a private business use and as secured by the payments from the private 

business.11

Private business use also can arise when a governmental entity contracts for the operation 

of a governmental facility by a private business under a management contract that does not 

satisfy Treasury Department regulatory safe harbors regarding the types of payments made to the 

private operator and the length of the contract. 12 These rules require public power entities to 

restrict the period of contracts with private businesses as well as the aggregate amount of electric 

service provided to private businesses on terms that are not generally available to customers of 

the entity, if interest on their bonds is to remain tax-exempt.

Private loan test.--The second standard for determining whether a State or local 

government bond is a private activity bond is whether an amount exceeding the lesser of (1) five 

percent of the bond proceeds or (2) $5 million is used directly or indirectly to finance loans to 

private persons. Private loans include both business and other (e.g., personal) uses and payments 

by private persons; however, in the case of business uses and payments, all private loans also 

constitute private business uses and payments subject to the private business test.

Present law provides that the substance, rather than the form, of a transaction governs in 

determining whether a transaction gives rise to a private loan. In general, any transaction, which 

transfers tax ownership of property to a private person, is treated as a loan. In the context of 

electric facilities, longer-term contracts for the sale of electricity may violate the private loan 

test, because these contracts have the substantive characteristics of a loan.

 

11

 See, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 

1986, (JCS-10-87), May 4, 1987, stating as follows:

The determination of who uses bond proceeds or bond-financed property 

generally is made by reference to the ultimate user of the proceeds or property . . . 

. [B]ond proceeds used to satisfy contractual obligations undertaken in 

connection with general governmental operations, such as payment of government 

salaries, or to pay legal judgments against a governmental unit, are not treated as 

used in the business of the payee. This is to be contrasted with the indirect 

nongovernmental private use of bond proceeds that occurs when a government 

contracts with a nongovernmental person to supply that person’s trade or business 

with a service (e.g., electric energy) on a basis different from that on which the 

service is provided to the public generally or to finance property used in that 

person’s business (e.g., a manufacturing plant). In both of these instances a 

nongovernmental person is considered to use the bond proceeds other than as a 

member of the general public. (p. 1160)

12

 See Treas. Reg. sec. 1.141-3(b)(4) and Revenue Procedure 97-13, 1997-1 C.B. 632.
10

Special legislative rules for tax-exempt financing of governmental "output" facilities

In addition to the general private business use and payment tests, the Code includes three 

specific provisions governing the issuance of governmental tax-exempt bonds to finance electric 

service facilities.

$15 million limit on private business use.--As stated above, the 1986 Act provided an 

additional restriction on private business use of State or local government bonds whose proceeds 

are to be used to finance "output" facilities.13 Output facilities include, inter alia, facilities for 

electric and gas generation, transmission, and distribution. A bond is treated as issued to finance 

an output facility (and subject to this restriction) if five percent or more of the proceeds is to be 

used with respect to any output facility. Under this restriction, the 10-percent private business 

use and private payment tests in substance are phased down for facilities that receive more than 

$15 million in tax-exempt bond financing. Significantly, unlike most tax-exempt bond 

restrictions, which are determined on a bond-issue-by-bond-issue basis, this restriction is 

measured by reference to all outstanding tax-exempt financing from which a facility benefits.

Special rules disregarding certain private business use under the private activity bond 

tests.--The legislative history accompanying the 1986 Act further clarified that certain sales of 

electric power by public power entities to private businesses generally are disregarded in 

applying the private business and private loan tests. For example, the presence of a 

nongovernmental person acting solely as a conduit for exchange of electric output among 

governmentally owned and operated public power entities is to be disregarded. In addition, 

exchange agreements that provide for "swapping" of electricity between governmentally owned 

and operated entities and IOUs do not give rise to private business use when (1) the "swapped" 

amounts are approximately equal over a period of one year or less, (2) the electricity is swapped 

pursuant to an arrangement which does not involve output-type contracts, and (3) the purpose of 

the arrangements is to enable the parties to satisfy differing peak load demands or to 

accommodate temporary outages.14 Finally, the legislative history of the 1986 Act states that 

“spot sales” of excess power capacity for temporary periods not exceeding 30 days are not to be 

treated as violating the private business tests.

Bonds for acquisition of existing output property per se private activity.--In general, any 

bond with respect to which five percent or more ($5 million if less) of the proceeds is to be used, 

directly or indirectly, by a governmental entity to acquire existing output property is per se a 

private activity bond.15 As such, interest on the bond is taxable, unless the use of the acquired 

 

13 Sec. 141(b)(4).

14

 See, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 

1986, (JCS-10-87), May 4, 1987 at 1164.

15 Sec. 141(d). A permanent exception allows the Long Island Power Authority to issue 

governmental tax-exempt bonds for the acquisition of the Long Island Lighting Company 

(“LILCO”) and conversion of that electric utility from a private investor-owned utility to a public 

power entity. Pub. L. No. 100-203, sec. 10631(c)(3) (1987). 
11

facility satisfies the provisions applicable to tax-exempt private activity bonds for the local 

furnishing of electricity, including receipt of an allocation of the applicable State's annual private 

activity bond volume authority (described below). The two-county (or a city and a contiguous 

county) service area requirement that applies to facilities for the local furnishing of electricity 

does not apply in this circumstance. 

There are two exceptions to the rule regarding the acquisition of existing output property. 

First, the rule does not apply to bonds for the acquisition of existing facilities that will provide 

service in a "qualified service area" of the issuer. A qualified service area is defined as an area 

throughout which the acquiring entity has provided electric service for at least the 10-year period 

preceding the date of the acquisition. Second, the rule does not apply to bonds issued to acquire 

existing output property to be used in a "qualified annexed area" of a public power entity. The 

term qualified annexed area includes only areas (1) that are contiguous to existing service areas, 

(2) that are annexed for general governmental purposes, and (3) the size of which does not 

exceed 10 percent of the public power entity's service area before the annexation occurs.

Temporary Treasury regulations

On January 18, 2001, the Treasury Department issued temporary and proposed 

regulations to provide guidance to issuers of governmental bonds for output facilities (“the 

regulations”). The regulations provide special rules for determining whether arrangements for 

the purchase of output from an output facility cause an issue of bonds to meet the private 

business tests. The regulations replace temporary and proposed regulations issued in January of 

1998. The regulations generally apply to bonds sold on or after January 19, 2001. The 

regulations generally allow public power entities to participate in certain electric industry 

restructuring arrangements without endangering tax-exemption for interest on their bonds.

General rule

The regulations provide that purchase by a private person of available output of an output 

facility financed with the proceeds of an issue is taken into account under the private business 

tests if the purchase has the effect of (1) transferring substantial benefits of owning the facility 

and (2) transferring substantial burdens of paying the debt service on bonds used to finance the 

facility (the benefits and burdens test).16 An arrangement transfers substantial benefits if it 

provides the purchaser with rights to bond-financed property that are preferential to the rights of 

the general public. An arrangement transfers substantial burdens of paying debt service to the 

extent the issuer reasonably expects that it is substantially certain that payments will be made 

under the terms of the contract (disregarding default, insolvency, or other similar circumstances). 

Requirements contracts.--The regulations provide that requirements contracts give rise to 

private business use provided the benefits and burden tests are met. 17 Significant factors that 

tend to establish that a wholesale requirements contract results in private business use include, 

but are not limited to: (1) the purchaser’s customer base has significant indicators of stability, 

 

16 Temp. Treas. Reg. sec. 1.141-7T(c)(1) and (c)(2).

17 Temp. Treas. Reg. sec. 1.141-7T(c)(4).
12

(2) the contract covers historical requirements of the purchaser, and (3) the purchaser agrees not 

to construct or acquire other power resources to meet the requirements covered by the contract.

Payments pursuant to pledged contract.--Payments made or to be made under the terms of 

an output contract that is pledged as security for an issue are taken into account under the private 

business tests even if the issuer reasonably expects that it is not substantially certain that 

payments will be made under the contract (disregarding default, insolvency, or other similar 

circumstances).

Measuring available output

Generation facilities.--Under the regulations, the private business use of a generating 

facility is generally measured based on the amount of “output purchased” by the private user 

divided by the available output of the facility. Available output is generally defined as the 

annual nameplate capacity of the generating facility multiplied by the number of years in the 

underlying bond’s measurement period.18 Generally, the regulations provide that nameplate 

capacity is not reduced for reserves, maintenance or unutilized capacity. 19

Transmission facilities.--For transmission facilities, the regulations provide that the 

available output of transmission facilities may be determined in a manner consistent with 

reporting rules and requirements for transmission networks promulgated by the Federal Energy 

Regulatory Commission. 20 

Certain contracts not taken into account under the private business tests

Small purchases of output.--The regulations provide that an output contract is not taken 

into account under the private business tests if the average annual payments under a contract that 

are substantially certain to be made by a private user do not exceed .05 percent of the average 

annual debt service on all outstanding tax-exempt bonds issued to finance the facility determined 

as of the date of the contract.21

Short-term contracts.--Under the regulations, an output contract with a private user is not 

taken into account under the private business tests if: (1) the term of the contract (including 

renewal options) is not longer than one year; (2) the contract is an arm’s length agreement that 

provides for compensation at fair market value, or is based on generally applicable and 

uniformly applied rates; and (3) the output facility was not financed for a principal purpose of 

providing that facility for use by a private person. 22

 

18 Temp. Treas. Reg. sec. 1.141-7T(b)(1) and (b)(1)(i).

19

 Id.

20 Temp. Treas. Reg. sec. 1.141-7T(f)(4).

21 Temp. Treas. Reg. sec. 1.141-7T(f)(1).

22 Temp. Treas. Reg. sec. 1.141-7T(f)(3).
13

Excess generating capacity resulting from participation in open access.--The regulations 

contain an exception to the private business use test for the sale of excess generating capacity 

due to participation in open access.23 Under the regulations, output sales attributable to excess 

generating capacity from participation in open access are not treated as private use if the 

following requirements are satisfied: (1) the term of the contract is not longer than three years 

(including renewal options); (2) the issuer does not make expenditures to increase the generating 

capacity of its system with tax-exempt bonds by more than three percent during the term of the 

contract; (3) the issuer offers open access transmission tariffs under rules promulgated by the 

Federal Energy Regulatory Commission under sections 205 and 206 of the Federal Power Act 

(or comparable provisions of State law); (4) all of the output sold under the contract is 

attributable to excess capacity resulting from open access transmission tariffs; and (5) all 

payments received by the issuer (less operating expenses) are promptly applied to redeem taxexempt bonds that financed the facility.

Special exceptions for transmission facilities

The regulations include two exceptions for transmission and distribution facilities under 

which mandated wheeling, and actions taken to implement nondiscriminatory open access, will 

not be treated as deliberate actions resulting in private business use. The first exception is for 

contracts entered into in response to (or in anticipation of) an order under sections 211 or 212 of 

the Federal Power Act (or comparable State laws). The terms of the contract must be bona fide 

and arm's length and the consideration paid must be consistent with the provisions of section 

212(a) of the Federal Power Act. The second exception is for other actions taken by public 

power entities to implement the offering of non-discriminatory, open-access tariffs for the use of 

transmission facilities financed by an issue in a manner consistent with rules promulgated by the

Federal Energy Regulatory Commission under sections 205 and 206 of the Federal Power Act 

(or comparable provisions of State law). The exceptions, however, do not apply to the sale, 

exchange, or other disposition of facilities to a private person.24

Issuance of tax-exempt bonds for private activities

As stated above, interest on State or local government bonds to finance activities of 

private persons (both business and personal activities) is taxable unless a specific exception is 

contained in the Code (or a non-Code provision of a revenue Act). The Code includes 

exceptions permitting States or local governments to act as conduits providing tax-exempt 

financing for certain private activities. In most cases, the aggregate volume of these tax-exempt 

private activity bonds is restricted by annual aggregate volume limits imposed on bonds issued 

by issuers within each State. The Code further imposes several additional restrictions on taxexempt private activity bonds that do not apply to bonds for governmental activities.

 

23 Temp. Treas. Reg. sec. 1.141-7T(f)(4).

24 Temp. Treas. Reg. sec. 1.141-7T(f)(5)(ii).
14

Eligible activities

In general.--States and local governments may issue tax-exempt exempt-facility bonds to 

finance facilities for certain private businesses.25 Business uses eligible for this financing 

generally include transportation (airports, ports, local mass commuting, and high speed intercity 

rail facilities); privately owned and/or privately operated public works facilities (sewage, solid 

waste disposal, local district heating or cooling, and hazardous waste disposal facilities); 

privately-owned and/or operated low-income rental housing; and, certain private facilities for the 

local furnishing of electricity or gas. A further provision allows tax-exempt financing for 

"environmental enhancements of hydro-electric generating facilities." This provision was 

enacted to permit tax-exempt financing of certain renovations to the dams and accompanying 

hydroelectric electric generating facilities along the Columbia River that are a part of the 

Bonneville Power Administration system. 26

Tax-exempt financing is authorized for capital expenditures for certain manufacturing 

facilities and land and equipment for first-time farmers ("qualified small-issue bonds"), certain 

local redevelopment activities ("qualified redevelopment bonds"), and eligible empowerment 

zone and enterprise community businesses. Further, certain non-business private purposes may 

be financed with proceeds of these bonds: certain student loans, mortgage loans for first-time 

home buyers satisfying moderate income and home purchase price requirements, and mortgage 

loans generally for certain pre-1977 veterans who purchase homes in any of the five States that 

historically authorized issuance of these bonds.27 Finally, both capital expenditures and limited 

working capital expenditures of charitable organizations described in section 501(c)(3) of the 

Code may be financed with tax-exempt bonds ("qualified 501(c)(3) bonds").

Private activity bonds for the local furnishing of electricity.--Tax-exempt private activity 

bonds may be issued by States or local governments acting as conduits to finance generation, 

transmission, and distribution facilities for private businesses engaged in the local furnishing of 

electricity ("local furnishers"). A business is treated as engaged in local furnishing of electricity 

if the service territory in which the electricity is provided does not exceed (1) two contiguous 

counties, or (2) a city and a contiguous county. Historically, local furnishers eligible for this tax-

 

25

 A separate non-Code exception allows the State of Iowa to issue tax-exempt private 

activity bonds to finance an industrial new jobs program.

26

 Two additional non-Code provisions allow tax-exempt financing for certain electric 

generating facilities located in the State of Alaska. The first of these treats the Bradley Lake 

hydro-electric generating plant as a facility for the local furnishing of electricity. The second 

authorized issue of tax-exempt private activity bonds to finance the sale by the Federal 

Government of the Snettisham electric generating facility, also in Alaska, without satisfaction of 

the general rehabilitation requirement applicable to private activity bonds, because after the sale 

the facility's output is sold to an IOU in Juneau, Alaska.

27

 The five States are Alaska, California, Oregon, Texas, and Wisconsin. A non-Code 

exception allows the State of Texas to issue tax-exempt private activity bonds to finance limited 

amounts of land for veterans (in addition to any veterans mortgage bonds that Texas may issue).
15

exempt financing have included both IOUs and independent power ventures. These bonds may 

be issued for the benefit of only those persons that were engaged in local furnishing of electricity 

in the service territory in which the new facilities will be used as of January 1, 1997, or in 

qualified expansions of those service territories. A “qualified expansion” is limited to service 

territory that is a part of a county in which the local furnisher was providing electric service on 

that date. For example, if a local furnisher was providing electric service to one county and a 

portion of a contiguous county on January 1, 1997, bonds may be issued for the continued 

provision of service both within that area and also for service to be provided in the remaining 

portion of the contiguous county in the future. In addition to persons actually engaged in local 

furnishing activities on January 1, 1997, the Code allows certain successors in interest to persons 

that qualified as local furnishers on that date to "step into the shoes" of the predecessor local 

furnishers provided that the service territories served otherwise satisfy the requirements for local 

furnishing.

Notwithstanding the general limits on service territories of local furnishers, the Code 

includes special rules allowing these electric service providers to transmit ("wheel") electricity 

through their systems, if ordered by the Federal Energy Regulatory Commission to do so under 

sections 211 or 213 of the Federal Power Act, provided that the size of the transmission lines or 

other facilities used in these wheeling activities does not exceed the capacity required to serve 

their otherwise qualified two county or city and a county service area.

In general, if a local furnisher ceases to qualify as such, interest on outstanding taxexempt bonds issued for its benefit becomes taxable, and interest payments by the local furnisher 

on loans securing the bonds becomes nondeductible. A special election allows local furnishers 

to avoid these penalties if the local furnishers do not benefit from any tax-exempt bonds issued 

after August 19, 1996. If that election is made, in lieu of loss of tax-exemption on outstanding 

bonds and loss of interest deductions on underlying loans, all outstanding bonds from which the 

local furnisher benefits must be redeemed no later than six months after the earliest date on 

which redemption is permitted under the bond covenants (or the date of the election, if later). 

This election must be made for all local furnishing facilities of the local furnisher rather than on 

a facility-by-facility or bond-issue-by-bond-issue basis.

Additional restrictions imposed on private activity tax-exempt bonds

State volume limitations.--Issuance of most tax-exempt private activity bonds is subject 

to an annual volume limitation that each State receives. Each State (including local governments 

within the State) is allowed to issue an annual amount of these bonds not exceeding the greater 

of $62.50 per resident of the State or $187.5 million in calendar year 2001. These volume limits 

are scheduled to increase to $75 per resident of the State or $225 million beginning in calendar 

year 2002. Beginning in calendar year 2003, the volume limit will be adjusted annually for 

inflation. States may elect to carryover their unused private activity bond volume authority for 

designated activities for a period of up to three years. Bond authority that is not used within the 

carryforward period lapses.

This limit also applies to the private business portion of certain larger governmental bond 

issues; such private business use in excess of $15 million (and up to the permitted 10 percent of 

the issue) must receive an allocation of State volume limitation for interest on the overall bond 
16

issue to be tax-exempt. 28 Exceptions to the volume limitation are provided for bonds to finance 

airports, ports, solid waste disposal facilities (if governmentally owned), qualified 501(c)(3) 

bonds, and high speed intercity rail facility bonds (if governmentally owned), and bonds for 

environmental enhancements of hydro-electric generating facilities. Additionally, bonds for 

privately owned high-speed intercity rail facilities are required to receive a State volume 

limitation allocation only for 25 percent of the amount of the bonds.

Miscellaneous other restrictions.--Tax-exempt private activity bonds are subject to 

several other restrictions that do not apply to governmental bonds. These restrictions include the 

requirement of a public hearing and approval of their issuance by an appropriate elected 

governmental official, a prohibition on advance refundings,29 a restriction on the term to maturity 

of the bonds measured by reference to the economic lives of the property to be financed, 

minimum rehabilitation requirements for bonds used to finance acquisition of existing property, 

and, in general, slightly more restrictive limits on arbitrage profits that may be earned.30

 

28

 Unlike this general provision for larger governmental bond issues, the $15 million 

limit on private business use of output facility bonds, described above, is an absolute limit which 

may not be waived by an allocation of State private activity bond volume limitation.

29

 The prohibition does not apply to qualified 501(c)(3) bonds. Governmental bonds and 

qualified 501(c)(3) bonds may be advance refunded one time. An advance refunding occurs 

when the refunded bonds remain outstanding for a period greater than 90 days after issuance of 

the refunding bonds. Advance refundings typically are undertaken because an issuer includes 

provisions in its original bond documents agreeing not to redeem the bonds before expiration of 

a minimum period. Advance refundings are used to restructure debt service generally, to 

eliminate restrictive covenants contained in outstanding bond documents, or to hedge against 

anticipated future interest rate increases by locking in for the future what is believed to be a more 

favorable rate than that of the refunded bonds. In an advance refunding both the refunded and 

the refunding bonds remain outstanding until the refunded bonds may be redeemed under their 

contractual terms. Proceeds of the refunding bonds are deposited in a yield-restricted escrow 

account until that time.

30

 The Code in general limits the amount of arbitrage profits that may be earned on 

tax-exemp t bonds and requires that most such profits be rebated to the Federal Government. 

These provisions are designed to preclude issuance of tax-exempt bonds earlier than necessary 

for the governmental or approved private activity which is the stated purpose of the borrowing or 

in larger amounts than required for the purpose. Absent such restrictions, State or local 

governments as tax-exempt entities could borrow at tax-exempt rates and invest in, for example, 

taxable Federal Government debt, as an income production undertaking. Such an undertaking 

would reduce Federal revenues by substituting tax-exempt debt for taxable debt in the hands of 

taxable bond investors.
17

Penalties for violation of tax-exempt bond restrictions after issuance

General change in use penalties and administrative alternatives

In general, the determination of whether interest on State or local government bonds is 

tax-exempt is made when the bonds are issued. That is, the determination is made by reference 

to how the bond proceeds are "to be used” (sec. 141). Intentional acts after the date of issuance 

to use bond-financed property (indirectly a use of bond proceeds) in a manner not qualifying for 

tax exemption may render interest on the bonds taxable, retroactive to the date of issuance (the 

"change in use rules"). Such a prohibited change in use may be illustrated by the subsequent 

sale of public power electric output to private businesses in a manner not qualifying for tax 

exemption after the bond-financed property is placed in service. Other privatization programs 

transferring the operation of State or local government programs to private businesses similarly 

can give rise to a prohibited change in use as can the sale or lease of bond-financed State or local 

government facilities to private businesses.

Treasury Department regulations and an accompanying Revenue Procedure, provide 

alternative remedies to loss of tax-exemption for certain changes in use of governmental bonds.31 

The alternative remedies are available only if five conditions are satisfied:

(1) The issuer of the bonds must have reasonably expected on the date of the 

borrowing that the bonds would not meet the private business and private loan 

tests (i.e., would not become private activity bonds) for their entire term;32

(2) The term of the bonds must not be longer than is reasonably necessary for the 

governmental purposes of the borrowing;

(3) The change in use must result from a bona fide, arm's length transaction for fair 

market value;33

(4) Any disposition proceeds must be treated as "gross proceeds" of the bond issue, 

subject to the Code arbitrage rules; and

 

31 Treas. Reg. sec. 1.141-12; Rev. Proc. 97-15, 1997-1 C.B. 635.

32

 Absent satisfaction of this reasonable expectations test, bonds are eligible for the 

alternative remedies only if the issuer (1) on the issue date, reasonably expected to use the 

bond-financed property in a qualified use for a substantial period, (2) redeems all nonqualified 

bonds within six months of any action changing that use to a nonqualified one, (3) has no 

arrangement with a private business as of the issue date regarding a nonqualified change in use, 

and (4) otherwise meets the regulatory remedial actions. The requirement that all nonqualified 

bonds be redeemed includes redemption in cases where bond-financed property is disposed of 

for less than the unpaid bond amount. In such cases, the issuer must make up any shortfall in the 

disposition proceeds from other sources to avoid bond interest being rendered taxable.

33

 The determination of fair market value may take into account restrictions on the use of 

the bond-financed property that serve "a bona fide government purpose."
18

(5) The bond proceeds must have been spent for the purpose of the borrowing before 

the change in use occurs (unless the bonds are redeemed) (Treas. Reg. sec. 1.141-

12(a)).

If the five conditions are satisfied, four possible alternative remedies to loss of taxexemption are available for post-bond-issuance actions violating the private business tests. First, 

all currently callable bonds may be redeemed within 90 days after the change in use and all other 

bonds may be defeased with a yield-restricted escrow and called on the first date when that 

action is permitted under the bond terms (Treas. Reg. sec. 1.141-12(d)).34 Second, in the case of 

dispositions entirely for cash where the bond issuer expects to spend the disposition proceeds 

within two years after the change in use, the disposition proceeds may be treated as bond 

proceeds and used accordingly, subject to all of the Code's tax-exempt bond provisions (Treas. 

Reg. sec. 1.141-12(e)). To the extent the disposition proceeds are not used for a qualifying use 

within the two-year period, bonds must be redeemed.

A third remedy provides that loss of tax-exemption will not occur if bond-financed 

property is transferred in a transaction constituting a change in use from a governmental use to a 

use that is eligible for financing with tax-exempt private activity bonds provided that the issuer 

treats the bonds as reissued on the date the change in use occurs and satisfies rules applicable to 

the revised use of the bonds (including where applicable, allocation of State private activity bond 

volume limitation) (Treas. Reg. sec. 1.141-12(f)).35 The final alternative remedy to loss of taxexemption allows the issuer to pay the Federal Government an amount equal to lost tax revenues 

from allowing nonqualified tax-exempt bonds to remain outstanding as tax-exempt (Rev. Proc. 

97-15).

Additional change in use penalties for private activity tax-exempt bonds

In addition to loss of tax-exemption on bond interest, conduit borrowers receiving taxexempt private activity bond financing lose interest deductions on their underlying loans if the 

use of the bond-financed property changes to a non-qualified use after issuance (the "additional 

change-in-use rules"). For example, if the output of an IOU facility for the local furnishing of 

electric service is used to provide service beyond the permitted two county or city and a county 

area, interest paid by the IOU on loans underlying the tax-exempt bonds is nondeductible (sec. 

150(b)(4)).36

 

34

 The maximum period of the escrow account may not exceed 10-1/2 years.

35

 Because the original tax-exempt bonds remain outstanding, a purchaser of property 

financed with tax-exempt bonds qualifying for this remedy is not permitted to finance any 

acquisition costs with additional tax-exempt bonds (e.g., tax-exempt exempt-facility bonds could 

not be issued to finance the transfer of a governmental solid waste disposal system to a private 

business).

36

 An exception to this rule, enacted in 1996 and described above, provided that this 

penalty and loss of tax-exemption on bonds not apply to bonds issued before August 20, 1996, in 

the case of service territory expansions by local furnishers of electricity or gas that elect to 
19

2. Examples of private business use issues arising in electric power industry restructuring

"Open access" proposals for restructuring the electric power industry assume greater 

integration of facilities of the participating electric service providers. Under these proposals, 

electric service providers are expected to compete for customers, both within their current 

service territories and within areas currently served by other providers as well. To foster this 

competition, providers may be required to transmit or distribute ("wheel") electricity over their 

facilities to customers of other providers. Additionally, certain plans have called for public 

power, IOUs, and co-ops to surrender at least some of their facilities (notably transmission lines) 

to third party control and/or ownership. Each of these circumstances may limit the ability of 

public power entities and local furnishers of electricity to finance future facilities with taxexempt bonds, and may render interest on outstanding bonds retroactively taxable unless the 

issuers qualify for and avail themselves of certain administrative relief provided in Treasury 

Department regulations. The following examples illustrate arrangements which could affect taxexempt status of outstanding bonds or the ability of public power entities and local furnishers of 

electricity to issue new tax-exempt debt if those providers participate in open access plans.

Example (1).--Assume that XYZ Manufacturing Company is located in the service 

territory of Public Power Agency A which traditionally has supplied electricity to the company. 

A has elected to participate in the open access plan of the state where A is located. Independent 

Power Producer B offers to supply the electricity requirements of XYZ at rates set under contract 

and which are lower than those offered by A to its other customers. XYZ uses 5 percent of the 

electricity supplied by A, but that electricity comprises more than $15 million of the output of 

A's electric facilities. A enters into a long-term contract with XYZ which matches the prices 

offered by B and does not offer the same rates as generally available to its other customers. 

Assume further that the payments under the contract are equal to the amount of private business 

use involved. A has taken a deliberate action causing its bonds to violate the Code private 

business tests. Unless A qualifies for (1) one of the general remedial actions for correcting 

prohibited changes in use of tax-exempt-bond-financed property prescribed in Treasury 

Department regulations or (2) temporary relief provided under the 2001 Temporary Regulations, 

interest on A’s bonds would become taxable retroactive to the date of their issuance.

Example (2).--Under facts similar to those of Example (1), neighboring IOU C contracts 

with Big Box Retailer in Public Power Agency A's service territory. As a result, A has surplus 

electricity generating capacity exceeding 10 percent of its generating capacity. A wants to sell 

that capacity to Electricity Broker D for re-sell pursuant to a firm price long-term contract having 

different rates than A's tariff prices to its regular customers. Assume further that the contract 

price would exceed 10 percent of the debt service on A's bonds. The firm price contract between 

A and D would be treated as a deliberate action giving rise to private business use under the 

Code tax-exempt bond rules. Interest on A's outstanding bonds would become retroactively 

taxable unless A qualified for one of the general remedial actions for correcting prohibited 

changes in use of tax-exempt bond-financed property or temporary relief provided under the 

2001 Temporary Regulations.

 

forego additional tax-exempt financing from bonds issued after August 19, 1996, and satisfy 

certain other conditions.
20

Example (3).--Under the facts of Example (2), A decides that it prudently must improve 

its generating plant. A may not issue tax-exempt bonds to finance the improvements because an 

amount exceeding the lesser of 10 percent or $15 million of the output of the facility is used in a 

private business use and a like amount of the debt service on its bonds is secured by such 

payments. 

Example (4).--As part of its agreement to participate in State E's open access plan, Public 

Power Agency F must agree to allow Investor-Owned Utilities G and H to use its transmission 

and distribution facilities. G and H use those facilities to provide electric service to F's former 

customers T Manufacturing Company and Big Box Retailer that have elected to purchase 

electricity from G and H under a firm price contract. G and H's use of the facilities (and the 

payments therefore) exceed $15 million and occurs under fixed contractual terms that enable G 

and H to enter the fixed price contract with F's former customers. Assume that F makes no 

offsetting use of G or H's transmission and distribution facilities. When F permits G and H to 

use its transmission facilities, it has taken a deliberate action that violates the Code's private 

business use and payment limits. Interest on its bonds will become retroactively taxable unless F 

qualifies for and satisfies one of the general remedial actions prescribed in Treasury regulations.

Example (5).--Under State I's open access plan, control of all transmission facilities 

(including public power, IOU, and co-op facilities) would be transferred to a regional 

transmission organization (an "RTO"). The RTO would be created as a private business entity to 

operate State I's electric transmission grid as a single system without regard to whether 

electricity transmitted over any given facilities constituted private business use. Public Power 

Agency A financed its transmission facilities with tax-exempt bonds. If A elects to participate in 

the open access plan, interest on A's bonds could become retroactively taxable unless A is 

eligible for and satisfies one of the general remedial actions prescribed in Treasury regulations or 

otherwise qualifies under the 2001 Temporary Regulations.

Example (6).--Under facts similar to those of Example (4), Local Furnisher J allows other 

IOUs to use its transmission and distribution facilities. Assume further that the use is not 

pursuant to a FERC order or the other circumstances described in section 142(f)(2). Interest on 

J's bonds financing these facilities would become retroactively taxable (and interest deductions 

on loans to J underlying the bonds would be disallowed prospectively) unless J qualifies for and 

makes the special election of section 142(f)(3) terminating its status as a local furnisher.

Example (7).--Under facts similar to those of Example (2), Local Furnisher K has excess 

capacity which it wishes to sell to customers located outside local furnishing service area. The 

provision of service to customers located outside of a qualified local furnishing service area will 

render interest on K's bonds retroactively taxable (and K's interest payments on loans underlying 

the bonds prospectively nondeductible) unless K qualifies for and makes the special election of 

section 142(f)(3) terminating its status as a local furnisher.
21

B. Tax Provisions Primarily Affecting Investor-Owned Utilities

1. Cost recovery of property used in the production, transmission, and distribution of 

electricity

Tax depreciation generally

A taxpayer generally must capitalize the cost of property used in a trade or business and 

is allowed to recover such cost over time through allowances for depreciation or amortization. 

Code section 167 allows annual depreciation deductions for the reasonable allowance for the 

exhaustion, wear and tear, or obsolescence of the capitalized cost of property. Theoretically, the 

exhaustion, wear and tear, or obsolescence of depreciable property would be determined most 

accurately by "economic depreciation." Under economic depreciation, property is valued and 

"marked to market" on an annual basis and any decrease in value from one year to the next is 

allowed as a depreciation deduction. Economic depreciation generally is conceded to be 

difficult to administer due to the case-by-case, annual valuations of each property that would be 

required.

Prior to 1981, taxpayers were allowed to depreciate the cost of property (net of salvage 

value) over the useful life of the property (i.e., the period over which the property is reasonably 

expected to be useful to the taxpayer in its trade or business). This depreciation method, known 

as "facts and circumstances" depreciation, allows the taxpayer to estimate (and re-estimate) the 

useful life and salvage value of property, often resulting in disputes between taxpayers and the 

Internal Revenue Service ("IRS"). Under facts and circumstances depreciation, reasonable 

allowances for depreciation could be computed using a straight-line or an accelerated method 

(such as a declining balance method or a sum of the years-digits method).

In order to minimize some of these controversies, the IRS published depreciation 

guidelines in 1962.37 These guidelines assigned useful lives to a few common types of assets, 

and grouped other assets based on the activity in which they were used. The useful lives 

provided by these guidelines formed the basis of the asset depreciation range ("ADR") system 

that could be elected by taxpayers for property placed in service after 1970 and before 1981.

Facts and circumstances depreciation was repealed by the enactment of the Accelerated 

Cost Recovery System ("ACRS") in 1981. For property placed in service after 1980 and before 

1987, ACRS generally provides that depreciation is computed by applying specific recovery 

allowances over specified periods for various types of depreciable property. ACRS provided 

accelerated methods and 10- and 15-year recovery periods for "public utility property;" most 

other tangible personal property had a 5-year recovery period. Depreciation under ACRS 

generally recovered the cost more quickly than under either economic or facts and circumstances 

depreciation.

 

37

 Rev. Proc. 62-21, 1962-2 C.B. 418.
22

For property placed in service after 1986, depreciation allowances for tangible property 

generally are determined under the modified Accelerated Cost Recovery System ("MACRS") of 

Code section 168. MACRS is similar to ACRS, but generally provides less generous 

depreciation allowances.38 Under MACRS, property is assigned a recovery period that generally 

is based on the class life of the property under the asset depreciation range ("ADR") system in 

effect before 1981. The MACRS recovery periods range from 3 to 50 years. The recovery 

periods for some types of property (such as alternative energy and biomass property described in 

the Table 1 below) are prescribed by statute. The depreciation method generally applicable to 

property with a recovery period of less than 15 years is the 200-percent declining balance 

method (switching to the straight-line method in the year that maximizes the depreciation 

deduction). The 150-percent declining balance method (switching to the straight-line method in 

the year that maximizes the depreciation deduction) applies to property with recovery periods of 

15 or 20 years, and the straight-line method applies to property with a recovery period over 20 

years (generally, real property). In addition, MACRS removed the distinction between public 

utility property and any other property used to provide similar services. 

Tax depreciation rules applicable to utility property

The MACRS recovery periods and depreciation methods for property used in the 

production, transmission, and distribution of electricity are described in Table 1 below.39

 

38

 The depreciation deductions computed under section 168 for regular tax purposes may 

be adjusted under the alternative minimum tax ("AMT"). The AMT generally is a separate 

system that imposes tax at a lower rate upon a broader base of income than does the regular tax. 

For property placed in service after December 31, 1998, AMT depreciation deductions are to be 

computed using the recovery periods prescribed by section 168 and the 150-percent declining 

balance method (or the straight-line method for property subject to such method for regular tax 

purposes). For property placed in service before January 1, 1999, AMT depreciation deductions 

generally are computed using recovery periods longer than those prescribed for regular tax.

39

 Rev. Proc. 87-56, 1987-2 C.B. 674.
23

Table 1.--Recovery Periods and Depreciation Methods Applicable to

Electric Utility Property Under MACRS

Asset

Class

Description

of Asset

Recovery 

Period (years)

Depreciation 

Method

49.11

Electric Utility Hydraulic Production 

Plant (includes assets used in hydraulic 

power production of electricity for sale, 

including related land improvements, used 

as dams, flumes, canals and waterways) 20

150%

declining balance

49.12

Electric Utility Nuclear Production Plant 

(includes assets used in nuclear power 

production and electricity for sale and 

related land improvements; does not 

include nuclear fuel assemblies) 15

150%

declining balance

49.121

Electric Utility Nuclear Fuel Assemblies 

(includes initial core and replacement core 

nuclear fuel assemblies (i.e., the 

composites of fabricated nuclear fuel and 

container) when used in boiling water, 

pressurized water, or high temperature gas 

reactor used in the production of 

electricity; does not include nuclear fuel 

assemblies used in breeder reactors)

5

200%

declining balance

49.13

Electric Utility Steam Production Plant 

(includes assets used in the steam power 

production of electricity for sale, 

combustion turbines operated in a 

combined cycle, with a conventional 

steam unit and related land improvements; 

also includes package boilers, electric 

generators and related assets such as 

electricity and steam distribution systems 

as used by a waste reduction and resource 

recovery plant if the steam or electricity is 

normally for sale to others) 20

150%

declining balance

49.14

Electric Utility Transmission and 

Distribution Plant (includes assets used in 

the transmission and distribution of 

electricity for sale and related land 

improvements; generally excludes 

clearing initial grading land 

improvements) 20

150%

declining balance
24

Asset

Class

Description

of Asset

Recovery 

Period (years)

Depreciation 

Method

49.15

Electric Utility Combustion Turbine 

Production Plant (includes assets used in 

the production of electricity for sale by the 

use of such prime movers as jet engines, 

combustion turbines, diesel engines, 

gasoline engines, and other internal 

combustion engines, their associated 

power turbines, and/or generators, and 

related land improvements; does not 

include combustion engines operated in a 

combined cycle with a conventional steam 

unit)

15

150%

declining balance

-------

Alternative Energy Property (sec. 

168(e)(3)(B)(vi)(I) and (III)) (generally, 

equipment that uses solar or wind energy 

to generate electricity; equipment used to 

produce, distribute, or use energy derived 

from a geothermal deposit up to the point 

of the electrical distribution stage; or 

equipment that converts ocean thermal 

energy into usable energy at one of two 

locations designated by the Secretary 

Treasury) 15

200%

declining balance

-------

Biomass Property (sec. 

168(e)(3)(B)(vi)(II)) (assets described in 

section 48(l)(15) (as in effect on 

November 5, 1990), and is a qualifying 

small production facility within the 

meaning of section 3(17)(c) of the Federal 

Power Act, (16 U.S. C. 796(17)(C) (as in 

effect on September 1, 1986)) 5

200%

declining balance
25

In addition, under present law, a taxpayer may elect to amortize (over 60 months) the 

amortizable basis of any certified pollution control facility (sec. 169). A certified pollution 

control facility is a facility (1) to abate or control water or air pollution, (2) that is State- or 

Federally-certified for such purposes, (3) that is used in connection with a plant or other property 

placed in service before 1976, and (4) that does not extend the useful life, reduce the operating 

cost, or alter the manufacturing or production process of the plant or other property. The 

amortizable basis is the cost of such facility. However, if the facility has a useful life greater 

than 15 years, the amount amortizable over 60 months is equal to the cost of the property 

multiplied by a fraction equal to 15 divided by the useful life. 40 Any cost not amortizable under 

section 169 may be depreciated as tangible property under sections 167 and 168.

Pollution control facilities often are placed in service with respect to public utility 

property (e.g., coal scrubbers used in connection with coal-fired electric generating facilities). 

Such facilities generally have useful lives greater than 15 years. Thus, under present law, only a 

portion of the cost of such facilities may be amortized over 60 months, with the remainder 

determined under MACRS (generally, using the 150-percent declining balance method over 15 

or 20 years).

Normalization of tax benefits derived from accelerated tax depreciation

In order for public utility property to be eligible for the more favorable depreciation 

allowances available for tax purposes (relative to the depreciation allowances used for 

ratemaking or financial statement purposes), the tax benefits of accelerated depreciation must be 

normalized in setting rates charged by utilities to customers and in reflecting operating results in 

regulated books of account. 41

Under present law, the tax benefits of accelerated depreciation are considered to be 

normalized only if three requirements are satisfied (sec. 168(i)(9)(A)). First, the tax expense of 

the public utility for ratemaking purposes must be computed by using the same depreciation 

method that is used in determining depreciation for ratemaking purposes and by using a recovery 

period that is no shorter than the useful life used in determining depreciation for ratemaking 

purposes (which generally results in depreciation being determined over a relatively long useful 

life and using the straight-line method). Second, the difference between the actual tax expense 

computed using tax depreciation and the tax expense determined for ratemaking purposes must 

be reflected in a deferred tax reserve. Third, in determining the rate of return of a public utility, 

the public utility commission may not exclude from the rate base an amount that exceeds the 

addition to the deferred tax reserve for the period used in determining the tax expense for 

ratemaking purposes. In addition, any ratemaking procedure or adjustment with respect to a 

 

40 In addition, section 291(a)(5) requires corporate taxpayers to reduce the amount 

amortizable under section 169 by twenty percent of the otherwise permitted amount. 

41

 Similar rules are provided for certain public utility property placed in service prior to 

1986 (the first year that MACRS was applicable).
26

utility's tax expense, depreciation expense, or reserve for deferred taxes must also be consistently 

used with respect to the other two items and rate base (sec. 168(i)(9)(B)).

Any violation of these requirements results in the loss of the application of accelerated 

tax depreciation for the applicable public utility property and the depreciation allowances for 

such property must be determined for Federal income tax purposes under the method used for 

regulatory purposes (secs. 168(f)(2) and (i)(9)(C)). Under present law, public utility property is 

defined as property used predominantly in the trade or business of the furnishing or sale of: (1) 

electrical energy, water, or sewage disposal services; (2) gas or steam through a local distribution 

system; (3) telephone services; (4) other communications services if furnished or sold by the 

Communications Satellite Corporation for purposes authorized by the Communications Satellite 

Act of 1962 (47 U.S.C. 701); or (5) transportation of gas or steam by pipeline, if the rates for 

such furnishing or sale are established or approved by a State or political subdivision thereof, by 

any agency or instrumentality of the United States, or by a public service or public utility 

commission or other similar body of a State or political subdivision thereof (sec. 168(i)(10)).

Example of normalization method of accounting

In order to understand the effect of the Federal income tax normalization requirement on 

the determination of rates charged for utility services, an understanding of the ratemaking 

process and an alternative method of accounting for accelerated tax depreciation benefits (the 

"flow-through" method) is helpful.

The ratemaking process–in general

The ratemaking process is a means by which the revenue requirements of a utility are 

determined. In setting utility rates, public utility commissions generally attempt to allow the 

utility to collect enough charges from utility customers to (1) recover operating expenses (the 

cost of service element), and (2) provide a fair rate of return to investors (the rate of return 

element).

Expenses taken into account in determining the cost of service element include labor, 

fuel, materials, depreciation on utility plant and equipment, and income tax expense. The rate of 

return element typically is computed by multiplying (1) an allowable rate of return (as 

determined by the public utility commission) by (2) the rate base. The allowable rate of return 

generally is determined with reference to the utility's weighted cost of borrowing plus an 

appropriate return on equity capital. Rate base is usually computed as the working capital of the 

utility, plus the original cost of utility plant and equipment, less accumulated regulatory 

depreciation, and less the deferred tax reserve (as described below). The deferred tax reserve is 

deducted from rate base for purposes of computing the rate of return element because the reserve 

is considered to be a no-cost source of capital. Thus, Federal income taxes are an important 

factor in determining the rates a utility may charge its customer because (1) income tax expense 

is considered a recoverable cost of service, and (2) deferred income taxes reduce the rate base 

upon which an allowable rate of return is applied.
27

Methods of accounting for tax depreciation: flow-through vs. normalization

Flow-through accounting.--The determination of the amount of Federal income taxes 

reflected in cost of service and rate base depends on the treatment of depreciation of utility 

property. The use of an accelerated depreciation method for Federal income tax purposes results 

in an actual Federal income tax liability that differs from the Federal income tax liability that 

would have been incurred if the typically slower depreciation methods used for regulatory 

purposes had been used for tax purposes. In general, in the first few years after property has 

been placed in service, the Federal income tax liability will be lower than if the regulatory 

depreciation schedule had been used. The Federal income tax liability will be greater in later 

years when the tax depreciation allowances are less than the regulatory depreciation allowances.

Flow-through accounting treats the actual Federal income tax liability of the regulated 

utility as reported on its tax return as the utility's tax expense in determining appropriate utility 

rates. Under flow-through accounting, the tax benefits of accelerated depreciation are taken into 

account as they are claimed in determining utility rates. Thus, under flow-through accounting, 

utility rates are lower for those consumers who are charged for service in the earlier years of the 

useful life of the utility property (relative to those consumers who are charged for service in later 

years).

Normalization accounting.--In contrast, under normalization accounting, the utility's tax 

expense for ratemaking purposes is determined by using regulatory depreciation allowances. 

The use of regulatory depreciation allowances generally results in the spreading of the tax 

benefits of accelerated tax depreciation over the regulatory life of the property. The 

normalization method for accelerated depreciation requires adjustments to actual Federal income 

tax liability to arrive at the regulatory tax expense and adjustments to rate base. The 

accumulation of the differences between regulatory tax expense and actual Federal tax liability 

creates a deferred tax reserve that represents both accumulated Federal income tax savings and 

expected future Federal tax liabilities. Normalization accounting is consistent with generally 

accepted accounting principles used to prepare financial accounting statements.

Example.--Assume a calendar year regulated utility placed property costing $100 million 

in service in 1997. For regulatory (book) purposes, the property is depreciated over 10 years on 

a straight-line basis with a full year's allowance in the first year. For tax purposes, the property 

is 5-year property and is recovered using the straight-line method, with a full year's deduction 

allowed in 1997.42 Assuming a tax rate of 35 percent for all years, deferred taxes (the tax rate 

times the difference between tax and book depreciation) would be computed as shown in Table 

2. 

 

42

 The 5-year tax and 10-year book lives, the straight-line tax method and the full 

depreciation allowance for the first year are used for illustration purposes only. In general, public 

utility property is 5-, 15-, or 20-year property under MACRS, is depreciated using an accelerated 

depreciation method, and is subject to a half-year placed-in service convention. For regulatory 

purposes, public utility property may have a life of 30 years or more.
28

Table 2.--Deferred Tax Reserve Assuming Constant Tax Rates

(Millions of Dollars)

1997 1998 1999 2000 2001 2002 2003-06 1997-06

Tax 

depreciation 20 20 20 20 20 0 0 100

Book 

depreciation 10 10 10 10 10 10 40 100

Timing 

difference 10 10 10 10 10 [10] [40] ----

Tax rate .35 .35 .35 .35 .35 .35 .35 ----

Annual 

adjustments 

to reserve 3.5 3.5 3.5 3.5 3.5 [3.5] [14.0]1

Deferred 

tax reserve 3.5 7.0 10.5 14.0 17.5 14.0 ---- ----

1

 The deferred tax reserve is reduced by $3.5 million a year for 2003 through 2006 so that no reserve 

exists as of December 31, 2006.

Under flow-through accounting, Federal tax expense is determined with reference to 

accelerated tax depreciation and no deferred tax reserve is created. Under normalization 

accounting, Federal tax expense is determined with reference to book depreciation and a deferred 

tax reserve is created to account for the accumulated tax benefits arising from the differences 

between tax and book depreciation. In Table 2, above, the use of accelerated tax depreciation in 

the first five years of the property's life results in a deferred tax reserve of $17.5 million at the 

end of 2001 which, under normalization accounting, is then reduced over the remaining 

regulatory life of the property.

Generally, if normalization accounting is followed in the ratemaking process, the $17.5 

million deferred tax reserve at December 31, 2001, would have been included as a portion of 

income tax expense in computing cost of service for years 1997 through 2001. The $17.5 

million deferred tax reserve generally would have also reduced the rate base over that same 

period. In that case, rate base with respect to this property, as of December 31, 2001, would be 

$32.5 million ($100 million original cost, less $50 million accumulated book depreciation, less 

the $17.5 million deferred tax reserve).

Normalization accounting methods adjust for various timing differences between tax and 

regulatory accounting of utilities. The benefit of the interest-free loan created by accelerated 

cost recovery for tax purposes could be distributed to consumers in a variety of ways. However, 

normalization as applied to accelerated depreciation for Federal income tax purposes attempts to 

distribute to consumers the benefit of the interest-free loan made to the utility over the entire 

useful life of the asset. Because accelerated tax benefits are front-end loaded, utility rates under 

the normalization method are higher in the early years of the life of the property than the rates 

would be under the flow-through method. However, as these tax benefits reverse (i.e., as 

ratemaking depreciation exceeds tax depreciation), utility rates under the normalization method 

become lower than the rates computed under the flow-through method. Theoretically, because 
29

the normalization method results in decreases to a utility's rate base that are not present under the 

flow-through method, the present value of utility rates over the life of the property under the 

normalization and flow-through methods should be equal, when discounted at the rate of return 

that is applied to rate base for ratemaking purposes.

It has been argued that a purpose of normalization is to ensure that the capital subsidy of 

accelerated tax depreciation provides an investment incentive for regulated utilities. Some 

reason that if tax benefits were flowed through to ratepayers immediately, the utility would have 

no incentive to invest in property to which such benefits accrue. Proponents of normalization 

accounting claim that even if the normalization and flow-through methods theoretically should 

equalize rates over time on a present-value basis, practical aspects of the ratemaking process may 

distort such results.

Tax issues raised by electric power industry restructuring

Treatment of stranded costs

Regulated public utilities (“IOUs”) have traditionally provided generation, transmission, 

distribution, and retailing services to the ratepayers in their service territories on a monopolistic 

basis. The rates charged by electric utilities for these services are regulated by public utility 

commissions based on the premise that, absent such regulation, IOUs may take advantage of 

their position as sole providers of utility services to earn excessive profits at the expense of 

consumers. One of the goals of the proposals to restructure the electric utility industry is to 

eliminate this rate regulation and to introduce competition in the provision of generation and 

perhaps in transmission and retailing services. 

Rate regulation typically guaranteed the recovery of both the amount invested in property 

to be used in the business, as well as a sufficient return on the investment. So long as this 

guarantee existed, IOUs were able to invest in property without regard to the fair market value of 

such property in a unregulated environment, or the amount of income such property could earn if 

used to produce power for sale at competitive rates. In certain instances, IOUs, with the 

knowledge of the appropriate regulatory body, may have invested in property whose cost could 

only be justified by the presence of a guaranteed return. 43 

Restructuring of the electric power industry could affect the value of property that was 

placed in service in a regulated environment. If the return on the investment in the property is no 

longer guaranteed through rate regulation, the value of the property will be determined solely by 

the amount of income the property can earn producing power at competitive rates. 

The extent to which the book or regulatory value of electric utility property exceeds its 

fair market value after restructuring is sometimes referred to as a "stranded cost." These costs 

 

43 An IOU may have been obligated to provide electricity to its customers on demand. 

To meet this obligation, the IOU’s generating capacity (either owned or contracted) must be 

based on maximum projected demand, which may exceed the capacity the IOU would have 

determined to be optimal in an unregulated environment.
30

are considered "stranded" because the electric service provider had anticipated recovering the 

full cost of the property under the ratemaking process when the property was placed in service 

and such recovery is unlikely in an unregulated environment. Proposals to restructure the 

electric power industry often address the issue of how to allow an IOU to recover its stranded 

costs. Frequently, some or all of the stranded costs are allowed to be recovered through rates 

during a transition period.

Because of the accelerated depreciation allowances, the adjusted tax basis of electric 

utility property generally is lower than its book or regulatory value. In some instances, the fair 

market value of this property after deregulation may equal or exceed its adjusted tax basis, 

resulting in no stranded costs for tax purposes. However, in other instances, the adjusted tax 

basis of property will exceed its fair market value after the deregulation of the industry resulting 

in stranded costs for tax as well as book purposes. 

There are no special tax provisions that allow for the immediate recovery of stranded 

costs. In order to recover the adjusted basis of depreciable property, the taxpayer generally must 

dispose of the property, abandon it, or show its obsolescence. In the absence of such an event, 

electric service providers will continue to depreciate the property in the same manner after the 

restructuring of the industry as before the restructuring and will recover any stranded cost over 

the remaining depreciable life of the property. 

Length of capital recovery period

Property placed in service by a public utility after 1980 and before 1987 generally is 

subject to ACRS, which provided 10-year and 15-year recovery periods for "public utility 

property" (as defined in former Code section 167(l)). To the extent that such property is no 

longer subject to rate regulation under the restructuring of the industry, it would appear that such 

property would no longer be considered to be public utility property subject to the 10-year and 

15-year recovery periods, and instead may be classified as 5-year ACRS property. Proposed 

Treasury regulation sec. 1.168-2(j)(3) provides that if the use of ACRS property changes, and 

such change in use results in the property having a shorter recovery period, the taxpayer may 

treat the lesser of (1) the adjusted basis or (2) the fair market value of the property as placed in 

service in the year of the change and subject to the shorter cost recovery schedule. It is unclear 

whether the proposed regulation applies in this case. In the event it does, any impact to 

taxpayer’s will be limited because most ACRS property is fully recovered.44 This issue does not 

arise with respect to MACRS property because MACRS does not provide recovery periods that 

are specific to public utility property.

 

44 The issue will generally only apply to property which is subject to the ACRS transition 

rules of the Tax Reform Act of 1986.
31

Depreciation allowances for property subject to facts and circumstances depreciation,45

may be adjusted to take into account changes in useful life or salvage value. However, 

demonstrations of decreases in earning power or increases in competition often are insufficient to 

justify shortening the useful life or decreasing the salvage value of property, particularly where 

the taxpayer continues to use the property in the same manner.46 

Effect on the normalization method of accounting

The normalization method of accounting only applies to public utility property subject to 

rate regulation. Electric power industry restructuring that deregulates public utility property 

raises several issues. First, as described above with respect to ACRS depreciation, the 

deregulation of the generation segment of the industry likely would cause the related property to 

no longer meet the definition of public utility property. If an entire IOU is deregulated, the IOU 

will not be subject to ratemaking processes and thus the normalization requirements will no 

longer apply.

If only a portion of an IOU's services are deregulated (e.g., the generation services, but 

not the distribution services) then a portion of the IOU’s property will remain public utility 

property subject to the normalization requirements and the remainder will not. In such instances, 

it appears that for purposes of the normalization requirements, the public utility commission with 

regulatory authority over the remaining regulated services cannot reduce rates for these services 

by any current or deferred tax benefits related to the deregulated property. 47 Such treatment 

raises certain policy issues. Opponents of this result note that the normalization method of 

accounting generally results in higher utility rates in the earlier years after the property was 

 

45 Facts and circumstances depreciation applies to property placed in service before 

1981. Public utilities may still have a significant amount of such property given the relatively 

long useful life of public utility property

46

 See, Treas. Reg. secs. 1.167(a)-1(c) (relating to salvage value), 1.167(a)-8 (relating to 

abandonment), and 1.167(a)-9 (relating to obsolescence). See also, Detroit and Windsor 

Ferryboat Co. v. Woodworth, 115 F2d 795 (6th Cir 1940), George Weidman Brewing Co. et al, 9 

BTA 792 (1927); Farmers Feed Co. of NY, 17 BTA 507 (1929) (relating to useful life and 

obsolescence).

47

 See, e.g., Private Letter Ruling ("PLR") 8920025 (February 15, 1989), where the IRS 

ruled that where property is removed from a regulated use to a nonregulated use, the related 

deferred tax reserves also must be removed in order to meet the consistency rules of the 

normalization requirements. See also PLR's 9613004 (December 19, 1995), 9552007 

(September 22, 1995), 9547008 (August 23, 1995), and 9312007 (December 21, 1992) where the 

public utility commissions disallowed (i.e., denied recovery for) a portion of the cost of plant and 

equipment placed in service by public utilities. In these rulings the IRS held that the 

commissions could not reduce rates for any Federal income tax benefits related to the disallowed 

costs. Private letter rulings are only applicable to the taxpayer to whom issued and may not be 

used or cited as precedent. However, they are an indication of the IRS's ruling policy.
32

placed in service, relative to the flow-through method. Under this view, the existing deferred tax 

reserves represent excessive earlier rates that should be returned to the ratepayers.48 Proponents 

of the normalization rulings claim that it would be unfair for ratepayers to receive any tax 

benefits for any property the cost for which the ratepayers are no longer responsible. Proponents 

also would point out that although the normalization method of accounting results in higher 

utility rates in the early years after the property is placed in service, the method results in lower 

rates in the later years, and that the deregulation of the electric power industry should also 

provide such lower rates--giving ratepayers the same lower rates that they would have enjoyed 

under the normalization method.

The method by which the electric power industry is restructured may change the analysis 

above. If a public utility commission decides to transition IOUs into deregulation, the 

determination of whether or not certain property is public utility property subject to the 

normalization method of accounting may be difficult. For example, assume a State continues to 

regulate the rates charged to customers for the distribution of electricity, but to deregulate the 

rates applicable to electricity generation and transmission services. If in setting distribution 

rates, the State's public utility commission allows IOUs to recover a portion of the stranded costs 

applicable to generation or transmission property, it is unclear the extent to which such property 

is public utility property subject to the normalization method of accounting.

2. Other tax provisions of industry concern

(a) Nuclear decommissioning

Special rules dealing with nuclear decommissioning reserve funds were adopted by 

Congress in the Deficit Reduction Act of 1984 (“1984 Act”), when tax issues regarding the time 

value of money were addressed generally. Under general tax accounting rules, a deduction for 

accrual basis taxpayers generally is deferred until there is economic performance for the item for 

which the deduction is claimed. However, the 1984 Act contains an exception to those rules 

under which a taxpayer responsible for nuclear power plant decommissioning may elect to 

deduct contributions made to a qualified nuclear decommissioning fund for future payment costs. 

Taxpayers who do not elect this provision are subject to the general rules in the 1984 Act.

A qualified nuclear decommissioning fund is a segregated fund established by the 

taxpayer that is used exclusively for the payment of decommissioning costs, taxes on fund 

 

48 Proponents of flow-through accounting further would argue that such treatment is 

particularly appropriate for the "excess tax reserves" related to the deregulated property. The 

excess tax reserve is that portion of the reserve that was established prior the corporate income 

rate reduction provided by the Tax Reform Act of 1986 (which reduced the rate from 46 to 34 

percent). Section 203(e) of the Tax Reform Act of 1986 provided that the excess tax reserves 

should be taken into account ratably over the remaining life of the utility's property. For a 

detailed discussion of section 203(e), see Joint Committee on Taxation, Description of H.R. 1150 

(The Utility Ratepayer Refund Act of 1987) and H.R. 2493 (The Utility Customer Refund Act of 

1989) (JCX-55-89), September 29, 1989.
33

income, and management costs of the fund, and for making investments. The qualified fund is 

prohibited from dealing with the taxpayer that established the fund. The income of the fund is 

taxed at a reduced rate of 20 percent for taxable years beginning after December 31, 1995.49

Contributions to a qualified fund are deductible in the year made to the extent that these 

amounts were collected as part of the cost of service to ratepayers. Funds withdrawn by the 

taxpayer to pay for decommissioning expenses are included in the taxpayer’s income and the 

taxpayer is entitled to a deduction for decommissioning expenses as economic performance of 

those costs occurs.

A taxpayer's contributions to the qualified fund may not exceed the amount of nuclear 

decommissioning costs included in the taxpayer's cost of service for ratemaking purposes for the 

taxable year. Additionally, in order to prevent accumulations of funds over the remaining life of 

a nuclear power plant in excess of those required to pay future decommissioning costs and to 

ensure that contributions to the funds are not deducted more rapidly than level funding (taking 

into account an appropriate discount rate), taxpayers must obtain a ruling from the IRS to 

establish the maximum contribution that may be made to the qualified fund in any year. The 

ruling amount may not exceed the amount necessary to fund a percentage of decommissioning 

costs equal to the percentage of the useful life of the nuclear power plant for which the qualified 

fund is in effect. 50 A taxpayer is required to include in gross income the amount of nuclear 

decommissioning costs included in cost of service for ratemaking purposes (sec. 88).

If the decommissioning fund fails to comply with the qualification requirements or when 

the decommissioning is substantially completed, the fund's qualification may be terminated. The 

amounts in the fund must then be included in income of the taxpayer upon termination.

A qualified decommissioning fund may be transferred in connection with the sale, 

exchange or other transfer of the nuclear power plant to which it relates. If the transferee is a 

regulated public utility and meets certain other requirements, the transfer will be treated as a 

nontaxable transaction. No gain or loss will be recognized on the transfer of the qualified 

decommissioning fund and the transferee will take the transferor’s basis in the fund.51 The 

 

49

 As originally enacted in 1984, the fund paid tax on its earnings at the top corporate 

rate and, as a result, there would be no present-value tax benefit of making deductible 

contributions to the fund. Also, as originally enacted, the funds in the trust could be invested 

only in certain low risk investments. Subsequent amendments to the provision have reduced the 

rate of tax on the fund to 20 percent and removed the restrictions on the types of permitted 

investments that the fund can make.

50

 For example, in 1979 ElectriCo places in service a nuclear power plant with an 

estimated useful life of 20 years. In 1984, when the estimated remaining useful life is 15 years, 

ElectriCo establishes a qualified nuclear decommissioning fund with respect to the plant. 

ElectriCo’s contribution to the fund will be limited to the amount necessary to fund 75% (15/20) 

of the cost of decommissioning.

51

 Treas. Reg. sec. 1.468A-6.
34

transferee is required to obtain a new ruling amount from the IRS, or accept a discretionary 

determination by the IRS.52

Federal and State regulators may require utilities to set aside funds for nuclear 

decommissioning purposes in excess of the amount allowed as a deductible contribution to a 

qualified decommissioning fund. In addition, the taxpayer may have set aside funds prior to the 

effective date of the qualified decommissioning fund rules. The treatment of these pre-1984 

amounts varies. Some taxpayers may have received no tax benefit while others may have 

deducted such amounts or excluded such amounts from gross income.53 These nonqualified 

funds are not eligible for the special rules that apply to qualified decommissioning funds. Since 

1984, no deduction has been allowed with respect to the contribution or segregation of 

nonqualified funds, and the income on nonqualified funds is taxed to the taxpayer at the 

taxpayer’s marginal rate.

Tax issues raised by electric power industry restructuring

Amount of deductible contributions

As indicated above, one of the rules applicable to qualified nuclear decommissioning 

funds is that deductible contributions cannot exceed the amount of nuclear decommissioning 

costs that are included in the utility's cost of service for rate making purposes (sec. 468A(b)(1)). 

When a restructuring plan includes the deregulation of electric rates, there may not be a cost of

service for ratemaking purposes. If no nuclear decommissioning costs are included in cost of 

service, no deductions would be permitted for contributions to a nuclear decommissioning 

reserve fund.

Disposition of nuclear power plants

As discussed above, the restructuring of the electric power industry is expected to result 

in the disposition of generating facilities, including the potential disposition of nuclear power 

plants. The special rules applicable to qualified nuclear decommissioning funds raise Federal 

income tax issues when a nuclear plant is sold.

Treasury regulations provide that if a nuclear power plant is transferred from one eligible 

taxpayer to another eligible taxpayer, the concurrent transfer of the qualified nuclear 

decommissioning fund associated with the plant will not be a taxable event. For this purpose, an 

eligible taxpayer is an owner of a nuclear power plant that is eligible to contribute to a qualified 

 

52

 Treas. Reg. sec. 1.468A-6(f).

53

 Prior to July 17, 1984 (the date of enactment of the Deficit Reduction Act of 1984), 

accrual basis taxpayers could deduct items without regard to the time they were economically 

performed. Some taxpayers may have taken the position that amounts irrevocably set aside for 

nuclear decommissioning purposes prior to July 17, 1984, were deductible. In addition, other 

taxpayers may have taken the position, prior to the enactment of section 88 on July 18, 1984, that 

customer charges for nuclear decommissioning costs were not includable in taxable income. 
35

nuclear decommissioning fund. A transferor may not be considered an eligible taxpayer if it is 

unable to contribute to a qualified fund because its rates are not regulated and it has no cost of 

service. No gain, loss, income, or deduction is recognized by the transferor, transferee, or 

qualified fund on account of the transfer of the qualified fund, and the qualified fund’s basis in 

its assets is not changed.54 The IRS may treat any transfer, whether or not between eligible 

taxpayers, in a similar manner if it determines that such treatment is necessary or appropriate to 

carry out the purposes of section 468A.55 

The transfer of other assets, including nonqualified decommissioning funds, in 

connection with the transfer of a nuclear power plant is not accorded special treatment. The 

transferor is required to allocate the amount realized among the assets transferred pursuant to 

section 1060. The amount realized will include cash and other consideration received by the 

transferor, plus the amount of liabilities (including decommissioning liabilities) assumed by the 

transferee. If the transferor is determined to have a fixed and quantifiable liability56 then a 

deduction may be available for the amount of nonqualified funds it transfers in satisfaction of an 

obligation to prefund the expected costs of decommissioning. Although the general economic 

performance rules would normally prevent the deduction of nuclear decommissioning costs prior 

to the expenditure of funds for decommissioning, the exception in Treas. Reg. sec. 1.461-4(d)(5) 

may allow deduction if the liability is assumed by the transferee and an equivalent amount is 

included in the income of the transferor as a result of the transferee’s assumption of the 

liability.57 

The transfer of the plant normally will not result in income to the purchaser. However, if 

the amount of cash and cash-equivalents (other than cash and cash-equivalents held in a qualified 

fund) that is received by the seller to offset future decommissioning costs exceeds the amount 

paid for the nuclear power plant, the purchaser may be required to recognize such excess as 

income at the time of sale.

The purchaser’s basis in the assets it acquires will be equal to the consideration paid to 

the seller, plus liabilities that are considered incurred by the purchaser for Federal income tax 

purposes. Because the cost of decommissioning normally will not be considered incurred under 

 

54 Treas. Reg. sec. 1.468A-6.

55 Treas. Reg. sec. 1.468A-6(g).

56 The operator of a nuclear power plant is required to determine the cost of 

decommissioning and to insure that sufficient funds will be available for decommissioning. 

Under present law, some consider the determination of the liability for regulatory purposes to be 

a fixed and quantifiable liability for this purpose.

57 The IRS has applied this approach in recent private letter rulings. These rulings held 

that the seller had both proceeds and a deduction in an amount equal to the fair market value of 

the nonqualified funds that were transferred to purchaser to prefund the anticipated nuclear 

decommissioning liability.
36

the economic performance rules until decommissioning takes place, the anticipated costs of 

decommissioning assumed by the purchaser will not increase the purchaser’s basis.

(b) Income recognition on the provision of services

Income attributable to the sale or furnishing of utility services to customers by an accrual 

basis taxpayer must be recognized no later that the taxable year in which such services are 

provided (sec. 451(f)). The taxable year in which services are provided may not be determined 

by reference to either (1) the period in which the customers' meters are read or (2) the period in 

which the customer is billed. The provision of electricity is considered a utility service whose 

sale is subject to this rule. The IRS has previously taken the position that providers of electricity 

generally are required to use the accrual method of accounting. 58

The rule requiring recognition of utility income in the taxable year in which the service is 

provided was enacted as part of the 1986 Act, to ensure a better matching of income and 

expense, and to eliminate a source of controversy between utilities and the IRS.59 Before 

enactment of this rule, an electric utility typically did not recognize income until the customer's 

meter was read or the customer was billed. As the cost of generating the electricity was typically 

deducted at the time of generation, a deferral of income was believed to result. This deferral was 

understood to be unique to the utility industry, and not generally available to other providers of 

goods and services.

Tax issues raised by electric power industry restructuring 

Restructuring and any accompanying deregulation of rates for electric services is not 

expected to have a material effect on the rule requiring recognition of utility income in the 

taxable year in which the service is provided. Regulation by a public utility commission or 

similar body is not a prerequisite to the application of the rule. The concept supporting the rule, 

the matching of items of income and expense, applies equally in a regulated and unregulated 

setting.

(c) Conservation payments

Residential utility customers are not required to include in taxable income any subsidy 

provided by public utilities to their customers for the purchase or installation of energy 

conservation measures that are designed to reduce the consumption of electricity or natural gas, 

or to improve the management of energy demand, with respect to a dwelling unit (sec. 136)). 

Before 1997, a partial exclusion for energy conservation payments for nonresidential purposes 

also was available. In the absence of the statutory rule allowing exclusion, customers that 

receive such subsidies generally would be required to include them in income. Examples of 

energy conservation measures included under this rule could include energy efficient heating and 

 

58

 Technical Advice Memorandum ("TAM") 9527003 (February 15, 1995).

59

 See, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 

1986, (JCS-10-87), May 4, 1987, at 542.
37

air conditioning systems, special thermostats designed to reduce the consumption of energy, and 

devices for the capture and use of waste heat.

Tax issues raised by electric power industry restructuring

Restructuring of the electric power industry could reduce significantly the availability of 

energy conservation subsidies, and could change the tax treatment of those subsidies that 

continue to be available. In the past, energy conservation subsidies typically have been provided 

as part of a demand side management program by electric utilities seeking to avoid or delay the 

cost of constructing additional generation capacity and/or in response to pressure from the public 

utility commission to make such subsidies available. Restructuring may eliminate those 

programs that were undertaken primarily as a result of public utility commission pressure. 

Conservation subsidies that do remain available are likely to be limited to programs initiated by 

local distribution companies, which are expected to remain as regulated utilities.

The effect of restructuring on those subsidies that continue to be available is uncertain. 

Although the Code does not explicitly require that the public utility providing the subsidy be a 

regulated utility for the subsidy to be excluded from income, the legislative history 

accompanying enactment of the provision suggests that the exclusion may have been intended to 

apply to subsidies provided by regulated public utilities, rural electric cooperatives, and utilities 

that are owned or operated by a governmental entity, instrumentality or subdivision.60 

(d) Customer deposits and prepayments

A taxpayer generally is required to include in income any prepayments for goods or 

services it receives from its customers in the year of receipt. A security deposit, on the other 

hand, need not be included in income on receipt. Whether an amount received from a customer is 

a prepayment or a deposit depends upon whether the taxpayer has complete dominion over the 

funds.61 A taxpayer is not considered to have complete dominion over funds if it has an 

obligation to repay the funds, whether or not the purpose of the transfer of the funds is to 

guarantee the customer's payment for goods or services received. These rules apply to both IOUs 

and other taxpayers.

Tax issues raised by electric power industry restructuring

Restructuring of the electric power industry is not expected to affect the application of 

these rules. A distributor of electric energy, whether or not regulated, may continue to require 

deposits from some or all of its customers in the same manner as a regulated provider does 

currently.

 

60

 See, S. Rep. No. 102-95, Technical Explanation of the Amendment to Title XIX of H.R. 

776 (Comprehensive National Energy Act) (1992).

61

 Indianapolis Power v. Commissioner, 493 U.S. 203 (1990).
38

(e) Cost of service adjustments

As described above (Part II.B.l.), rates charged by IOUs are typically established at a 

level that allows the utilities to recover their costs, including the cost of fuel, and to earn a return 

on their investment. Because rates are established before the costs of generating the electricity 

are known with certainty, an estimate of those costs must be used. Where the estimate overstates 

an IOU's costs, allowing the IOU to over-recover its costs, the amount of the over-recovery 

generally is required to be returned to the ratepayers through a cost of service adjustment, either 

as a refund or through lower rates for future service.

The Federal income tax treatment of cost of service adjustments depends upon the 

method in which the IOU is required to restore the amount of the over-recovery to its ratepayers. 

Where the cost of service adjustment is accomplished through the reduction of rates on future 

sales, the taxable income of the IOU is determined by the amount it charges for the electric 

service, without adjustment for the over-recovery or its refund.62 On the other hand, if the 

repayment of the over-recovery is an enforceable obligation of the IOU, and must be returned to 

the ratepayers with interest, the courts have held that the utility derives no benefit from the 

overpayments and is not required to include them in income in the period the overpayments are 

charged to customers.63 If the overpayments are not included in income in the period they are 

originally charged, no deduction is allowed in the later period in which they are refunded.

For example, assume two equivalent utilities have received rate orders from the 

respective public utility commissions based on the same estimate of fuel costs. Assume further 

that actual fuel costs are 10 percent less than estimated, resulting in an over-recovery of costs in 

the amount of $1,000,000 for the year for each IOU. Both utilities are required to refund the 

over-recovery of costs to their ratepayers. Utility A will refund the over-recovery by reducing 

future rates so that estimated fuel costs are under-recovered in the following year. Utility A is 

required to include the $1,000,000 in over-recoveries in income in the first year, but will report 

income of $1,000,000 less than it would otherwise expect to in year 2 when the over-recovery is 

refunded through the lower rates.

The law in Utility B's State requires it to segregate its over-recovery of costs and to 

refund that amount, plus interest, to its ratepayers when ordered to do so by its public utility 

commission. The PUC orders the refund to be made as a credit on the customers' bills in the 

following year. Utility B is not required to include the amount of the overpayment in income in 

the first year, but may not deduct any overpayment in subsequent years.

If a utility originally included the overpayment in income because it appeared that it had 

an unrestricted right to the funds, and it is later established that the utility did not have such an 

unrestricted right and is obligated to refund these amounts, section 1341 may apply. If 

applicable, section 1341 allows tax in the year of repayment of the overcharge to equal the lesser 

 

62

 Roanoke Gas Co. v. United States, 977 F. 2d 131 (4th Cir., 1992).

63

 Houston Industries v. United States, 125 F. 3d 1442 (Fed. Cir. 1997).
39

of: (1) the amount due if the restoration of the overcharge were treated as a deduction in the year 

of its restoration; or (2) the amount due if the overcharge were not allowed as a deduction, less 

the decrease in Federal income tax that would result if the over-recovery had been excluded from 

income in the prior year.

Tax issues raised by electric power industry restructuring

Regulatory cost of service adjustments would not be expected in a completely rate 

deregulated environment. The Federal income tax treatment of any cost of service adjustments 

that may be ordered as part of the transition to a restructured, unregulated industry would be 

expected to follow present law, absent a provision specifically addressing the tax consequences 

of such adjustments.

Following deregulation, contracts for the sale of electricity may include fuel adjustments 

similar to those included under the current regulatory environment. It is expected that similar 

rules would apply to adjustments made pursuant to private contracts as apply to regulatory 

adjustments.

(f) Cancellation of supply contracts

IOUs frequently enter into long-term, fixed price contracts in order to guarantee supplies 

of fuel. In addition, utilities may have been required to enter into long-term contracts to 

purchase the output of cogeneration and other small power producers under the Public Utility 

Regulatory Policies Act of 1978 ("PURPA"). If the payments required by these contracts require 

the payment of above-market rates, or require the purchase of electricity at the time the utility 

has excess generating capacity, the utility may seek to cancel the contract through the payment of 

a settlement or damages to the other party.

The IRS has allowed taxpayers to deduct amounts paid to buy out and terminate supply 

contracts as ordinary and necessary business expenses in the year they are paid.64 However, the 

IRS also has ruled that, where the utility enters into a revised contract with the same supplier as 

part of the transaction canceling the first contract, the cost of canceling the first contract should 

be capitalized and recovered over the length of the new contract. 65

Tax issues raised by electric power industry restructuring

A significant number of supply contracts with suppliers have been canceled in 

anticipation of, or in response to, the restructuring of the electric power industry. Restructuring 

through deregulation of rates may prevent IOUs from passing through the costs of 

disadvantageous supply contracts to their customers, increasing the likelihood that the utilities 

will seek their cancellation. Finally, the ability to recover at least a portion of stranded costs 

through temporary rate provisions may encourage utilities to make payments to cancel 

 

64

 PLR 9615028 (January 3, 1996) and PLR 199913032 (December 21, 1998).

65

 TAM 9334005 (May 14, 1993).
40

disadvantageous contracts, so that the amount of stranded cost attributable to such contracts can 

be measured and, to the extent allowed, recovered.

(g) Contributions in aid of construction

In the case of a corporation, gross income does not include any contribution to the capital 

of the taxpayer. For this purpose, contributions to the capital of a corporation do not include any 

contribution in aid of construction or any other contribution as a customer or potential customer, 

except in the case of water and sewerage disposal utilities (sec. 118)). The basis of any property 

that is acquired as a nontaxable contribution to capital, or with the proceeds of a nontaxable 

contribution to capital, is zero (sec. 362)).

For example, if an IOU requires new customers to pay the cost of extending the existing 

wires to the customer's premises, the IOU is required to include such amount in income and may 

depreciate the cost of the additional wires. The contribution is denied tax free treatment (under 

Code section 118) because the contribution was made by a customer in that role. On the other 

hand, a contribution received by an IOU from an independent power producer as reimbursement 

for construction of interconnection facilities would not be disqualified automatically from 

nontaxable contribution treatment, since the contribution is being made by a supplier in its 

capacity as a supplier, and not by a customer.66

Tax issues raised by electric power industry restructuring

The contribution to capital rules are not affected by whether an electric service provider 

is regulated. Accordingly, the rules would continue to apply as under present law in a 

deregulated environment.

(h) Involuntary conversions

Under section 1033, gain realized by a taxpayer from certain involuntary conversions of 

property is deferred to the extent the taxpayer purchases property similar to, or related in service 

or use to, the converted property. To qualify, the replacement property must be acquired within 

a specified period of time, generally two years. The taxpayer’s basis in the replacement property 

generally is the same as taxpayer’s basis in the converted property, decreased by the amount of 

any money or loss recognized on the conversion, and increased by the amount of any gain 

recognized on the conversion. Involuntary conversions include the loss of property as a result of 

its destruction, theft, seizure, requisition or condemnation. Involuntary conversions also include 

sales of property under the threat or imminence of requisition or condemnation (sec. 1033(a)). 

Sales of property to a private party in order to comply with a government order, such as an order 

of divestiture in an antitrust case, generally have not been considered involuntary conversions for 

this purpose.

 

66

 PLR 9327019 (April 6, 1993); Notice 88-129, 1988-2 C.B. 541.
41

Tax issues raised by electric power industry restructuring

Certain jurisdictions have adopted, or are considering, rules that would require the 

separate ownership of generation and distribution assets. A sale of assets under such 

circumstances may not be eligible for involuntary conversion treatment under section 1033. 

Even if the sale were eligible for involuntary conversion treatment, gain deferral would be 

available only if the proceeds of the sale were invested in replacement property within the 

specified period of time. If the rule requiring separate ownership prevents reinvestment in assets 

that are similar or related in service or use to the converted property, gain deferral would not be 

available.

3. Deferred tax accounts: financial, regulatory, and tax accounting

Financial accounting

A deferred tax account67 is required whenever temporary differences exist between 

Federal income tax accounting and the financial accounting treatment of an item. Where the 

difference will result in taxable amounts in the future, a deferred tax liability is created. For 

example, if accelerated depreciation deductions are allowed for Federal income tax purposes, but 

not for financial accounting purposes, additional taxes will have to be paid in the future when the 

depreciation deductions that were accelerated into the current period are not available. These 

taxes, measured using current income tax rules and rates, are recognized as a deferred tax 

liability. The financial accounting expense attributable to these additional taxes is recognized 

currently, making financial accounting tax expense for the period in which the accelerated 

depreciation is available for Federal income tax purposes greater than the amount actually paid.

A deferred tax asset is recorded for temporary differences that will result in deductible 

amounts in the future, as well as the anticipated reduction in future tax liability attributable to the 

carryforward of such items as net operating losses and tax credits. If it is more likely than not 

that the benefit of some or all of the deferred tax asset will not be realized, a valuation allowance 

is required to reduce the balance in the account to the amount that is likely to be realized.

Deferred tax assets in the public utility industry are frequently associated with the 

unamortized portion of investment tax credits that were claimed for Federal income tax purposes 

in earlier years. IOUs generally are allowed to elect to include the benefit attributable to the 

investment tax credit in the year it is claimed for Federal income tax purposes, or to amortize the 

benefit over the useful life of the asset on which the credit was claimed. Financial accounting 

typically will use amortization of the benefit from the investment tax credit where that method is 

used for regulatory accounting purposes. 

 

67

 Financial accounting for income taxes is governed by Financial Accounting Statement 

109 (FAS 109), published by the Financial Accounting Standards Board. The rules herein stated 

are derived from FAS 109.
42

Regulatory accounting

Deferred tax accounts also are established for regulatory accounting purposes to reflect 

temporary differences between Federal income tax accounting and regulatory accounting. Such 

accounts are described in Part II.B.1. of this pamphlet, with respect to the normalization method 

of accounting

4. General corporate restructuring issues

In general

Proposals to restructure the electric power industry could result in a significant 

reorganization of the businesses currently owned by IOUs. For example, an IOU that has owned 

generation, transmission, and distribution facilities may dispose of some or all of these activities. 

In some cases, the IOU may dispose of all the assets and activities of a segment of its business. 

In other cases, businesses and assets may be combined with those of other providers in new 

ventures. Some ventures also may involve transfers or participation between tax-exempt and 

taxable entities.

The disposition or combination of businesses and assets can be structured in various 

ways, producing different Federal income tax results. Assets or businesses can be disposed of 

for cash, or through other transactions that are fully taxable. In a fully taxable transaction, gain 

or loss is recognized in full on the transfer of assets or corporate stock interests. Assets or stock 

purchased in a taxable transaction obtain a fair market value basis. Depreciable assets then can 

be depreciated by the purchaser over the appropriate recovery period, or resold for their 

acquisition basis without further gain or loss. Goodwill, customer base, and most other 

intangible assets generally are depreciable over a 15-year period; however assets such as 

interests in land and stock are not depreciable.

Dispositions or combinations also can often be structured in a form that is not 

immediately taxable. For example, assets or stock generally may be transferred to a partnership 

in exchange for a partnership interest without incurring tax on the transfer. The partners often 

can achieve a significant amount of flexibility in the division of their interests in the ongoing 

venture through different classes of partnership interests. There are certain restrictions on 

transactions that result in the transfer of appreciated property from one partner to another within 

specified periods, and also certain restrictions on the nature of certain allocations. However, the 

partnership form of venture often is considered a fairly flexible form for combination and 

restructuring of interests.

Corporate combinations and restructurings also can often be structured in a tax-free 

manner. Generally, contributors can form new ventures or provide for a change in the nature of 

ownership in an old venture through the various corporate reorganization provisions, or through 

provisions permitting the transfers of stock or assets tax-free to a corporation controlled by the 

transferors, in exchange for certain consideration. Generally, stock can be received tax free in 

such situations (and, in limited cases, securities to the extent of certain securities transferred). 

Under the Taxpayer Relief Act of 1997 (the "1997 Act"), a limited type of preferred stock that 
43

does not participate to any significant extent in corporate growth and that is likely to be (or can 

be at the option of the holder) redeemed within 20 years could be taxable. In general, however, 

stock consideration, including stock representing varying interests in the underlying business or 

businesses, can be received tax free if the requisite continuity or ownership requirements are met.

A corporation also can separate existing businesses through the tax-free "spin off" of a 5-

year active trade or business to its shareholders. However, under the 1997 Act, certain planned 

or related changes of 50 percent or more of the ownership of the distributed or distributing 

corporation can result in corporate-level tax being imposed on a spin-off if there is gain at the 

corporate level.

In some cases involving electric power industry restructuring, it is possible that assets 

still may have a fairly high basis from costs of investment, but may produce less income in a 

competitive market than originally expected in a regulated market that assured cost recovery. To 

the extent such assets can generate losses, it could be desirable to structure the transaction in a 

manner intended to make the greatest use of losses. Taxable sales could generate losses, though 

use of such losses could be limited if there are not gains or other income against which they can 

be applied. Certain limitations also apply to the future use of existing (or certain "built-in") 

losses at the corporate level, if a sufficient amount of corporate stock is transferred (rather than 

the underlying corporate assets) whether in a taxable or nontaxable transaction. Generally, if 

more than 50 percent of the ownership of a corporation changes hands within a 3-year period, 

limitations on the use of losses after such ownership change may apply (sec. 382). These 

limitations are significantly relaxed if the transfer occurs in the context of certain bankruptcy 

proceedings.

Some situations may involve new ventures between tax-exempt and taxable entities. 

Tax-exempt entities holding equity interests in certain business activities conducted in 

partnership form may be subject to unrelated business taxable income. However, tax-exempt 

entities generally can sell existing tax-exempt assets without tax to taxable entities that then 

obtain a fair market value basis. Tax-exempt entities also can hold corporate stock, and 

generally can hold debt interests in any form of venture, without tax, subject to certain rules such 

as those relating to debt-financed activities.

Special rules relating to IOUs

IOUs that are corporations are allowed a dividends paid deduction on certain preferred 

stock issued before October 1, 1942, or issued after that date to the extent the preferred stock 

refunded or replaced certain debentures issued before that date (sec. 247). A special dividends 

received deduction computation applies to corporate holders of such stock (sec. 244). Whether 

or not a proposed restructuring could affect the benefits available under this provision may be a 

consideration. 
44

C. Tax Provisions Affecting Electric Cooperatives

1. Overview of cooperatives and electricity

Brief description of cooperatives

Generally, cooperatives are formed under State “cooperative statutes.” Federal tax rules 

require any entity that is formed as a cooperative to operate on a cooperative basis. Although not 

defined by statute or regulation, the two principal criteria for determining whether an entity is 

operating on a cooperative basis are: (1) ownership of the cooperative by persons who patronize 

the cooperative; and (2) return of earnings to patrons in proportion to their patronage. The 

Internal Revenue Service requires that cooperatives must operate under the following principles: 

(1) subordination of capital to control by the members of the cooperative over the cooperative 

undertaking and the financial benefits of ownership; (2) democratic control by the members of 

the cooperative; (3) vesting in and allocation among the members of all excess of operating 

revenues over the expenses incurred to generate revenues in proportion to their participation in 

the cooperative (patronage); and (4) operation at cost (not operating for profit or below cost).68

Although cooperatives may have several types of members, cooperative members 

generally are comprised of participants in the management of the cooperative who share in 

patronage capital.69 Income from the sale of electric energy by an electric cooperative may be 

member or non-member income to the cooperative, depending on the membership status of the 

purchaser. A municipal corporation may be a member or non-member of a cooperative.

Structure of electric cooperatives

Cooperatives are involved in all four primary functions of the electricity industry: 

generation, transmission, distribution and retailing. Generation and transmission cooperatives 

(“G&Ts”) construct and operate power plants (alone or in arrangements with other utilities) and 

sell electricity at wholesale prices to their distribution cooperatives, which in turn sell electricity 

to consumers at retail. Each cooperative may, in turn, be a member of other cooperatives, 

including cooperative subsidiaries. G&Ts often join with other utilities to build and operate 

power generating stations. The joint venture participants may own the station as tenants in 

common, operating the station and sharing its capacity and energy according to various operating 

agreements, station agreements and load management agreements. As of 1996, State public 

utility commissions in approximately 21 States regulated rates charged by electric cooperatives.70

 

68

 Announcement 96-24, Proposed Examination Guidelines Regarding Rural Electric 

Cooperatives, 1996-16 I.R.B. 35.

69

 Id.

70

 Id.
45

2. Present law

Taxation of cooperatives and their patrons generally

In general, cooperatives (including tax-exempt farmers' cooperatives) and their members 

are subject to special tax rules under subchapter T of the Code (secs. 1381 through 1388).71 The 

provisions of subchapter T generally operate to treat the cooperative more like a conduit than a 

separate taxable business enterprise. At the same time, these provisions also ensure that the 

income of a cooperative is taxed either to the cooperative or its patrons.

For Federal income tax purposes, a cooperative generally computes its income as if it 

were a taxable corporation, with one exception--the cooperative may deduct from its taxable 

income distributions of patronage dividends. In general, patronage dividends constitute the 

profits of a cooperative that are rebated to its patrons pursuant to a pre-existing obligation of the 

cooperative to do so. The rebate must be made in some equitable fashion on the basis of the 

quantity or value of business done with the cooperative. Except for tax-exempt farmers' 

cooperatives, cooperatives are permitted to deduct patronage dividends only to the extent of net 

income derived from transactions with its members. The availability of these deductions for the 

cooperative has the effect of allowing the cooperative to be treated like a conduit with respect to 

profits derived from transactions with members.

Although the general rules under subchapter T broadly apply to cooperatives, section 

1381(a)(2)(C) provides that subchapter T does not apply to any cooperative "which is engaged in 

furnishing electric energy, or providing telephone service, to persons in rural areas".

Taxation of electric cooperatives

Because subchapter T does not apply to rural electric cooperatives, electric cooperatives 

generally are taxed under the cooperative tax rules that predated the enactment of subchapter T 

in 1962. Under these rules, electric cooperatives generally can exclude income that is allocated 

to patrons pursuant to a pre-existing obligation of the cooperative to do so.72

In addition, section 501(c)(12) provides an income tax exemption for rural electric 

cooperatives if at least 85 percent of the cooperative's income consists of amounts collected from 

members for the sole purpose of meeting losses and expenses of providing service to its 

members. The Internal Revenue Service takes the position that rural electric cooperatives that 

satisfy the 85-percent test also must comply with the fundamental cooperative tax principles 

described above in order to qualify for tax exemption under section 501(c)(12).73 The 85-percent 

test is determined without taking into account any income from qualified pole rentals and 

cancellation of indebtedness income from prepayment of a loan under sections 306A, 306B, or 

 

71 Sec. 1381, et seq.

72

 See Rev. Rul. 83-135, 1983-2 C.B. 149.

73 Rev. Rul. 72-36, 1972-1 C.B. 151.
46

311 of the Rural Electrification Act of 1936 (as on effect on January 1, 1987). Rural electric 

cooperatives that are tax-exempt under section 501(c)(12) are subject to tax on any unrelated 

trade or business taxable income.

Taxation of electric cooperative patrons

Regardless of whether an electric cooperative is tax-exempt under section 501(c)(12), 

amounts allocated to patrons with respect to purchases of electric energy that are deductible by 

patrons under section 162 as trade or business expenditures or under section 212 as incurred in 

the production of income generally are includable by patrons as ordinary income to the extent the 

allocations are paid in: (1) cash; (2) the fair market value of any merchandise received; or (3) the 

fair market value of any revolving fund certificate, retain certificate, certificate of indebtedness, 

letter of advice, capital stock, etc. (except that any allocations paid under conditions beyond the 

control of the patron are not considered to have any value).74 Other amounts allocated by a 

cooperative to patrons (i.e., with respect to purchases of electric energy that are not deductible by 

patrons) are not includable in the income of patrons.75

3. Tax issues raised by electric power industry restructuring

It is not clear whether a rural electric cooperative that participates in restructuring of the 

electric power industry can be assured that: (1) it will receive at least 85 percent of its income 

from members (in the case of tax-exempt electric cooperatives); or (2) income earned after 

restructuring will be excludible from its taxable income (in the case of non-exempt electric 

cooperatives). For example, fees that a cooperative receives for wheeling electricity through its 

system and sales of surplus electricity to non-members: (1) do not constitute income collected 

from members under the present law 85-percent test for tax exemption; and (2) may not be 

excludible income for non-exempt electric cooperatives under present law.

 

74

 See Treas. Reg. sec. 1.61-5(a) and (b).

75

 See Treas. Reg. sec. 1.61-5(b).
47

III. OVERVIEW OF SENATE BILLS: ELECTRICITY RESTRUCTURING,

ELECTRIC POWER INDUSTRY, AND CLEAN COAL BILLS76

A. S. 60, the “National Electricity and Environmental Technology Act” 

On January 22, 2001, Senator Byrd77 introduced S. 60, the “National Electricity and 

Environmental Technology Act.” The bill’s tax provisions include production and investment 

tax credits for existing clean coal technology, production and investment tax credits for advanced 

clean coal technology and provisions relating to the treatment of such credits for electric 

cooperatives and the Tennessee Valley Authority.

Existing clean coal technology

The bill would provide a ten percent investment tax credit for pollution control 

investments that serve, are added to, or retrofit an existing coal-based electricity generating unit 

and remove or reduce one or more pollutants regulated under title I of the Clean Air Act. The 

credit is limited to the first $100 million of qualifying investment for any one existing coal-based 

electricity generating unit.

The bill would also provide a production tax credit for electricity produced from an 

existing coal-based electricity generating steam generator turbine unit that has a nameplate 

capacity rating of not more than 300,000 kilowatts and has been retrofitted, repowered, or 

replaced with a clean coal technology within ten years of the effective date of the bill (a 

“qualifying clean coal technology unit”).78 The credit would be equal to an applicable amount of 

clean coal technology production credit ($0.0034) multiplied by the kilowatt hours of electricity 

produced by the taxpayer during such taxable year at a qualifying clean coal technology unit 

during the ten-year period beginning on the date the unit was returned to service after retrofit, 

repowering, or replacement. 

 

76 The “Securing America’s Future Energy Act of 2001” (H.R. 4) has been passed by the 

House, received in the Senate, and placed on the Senate Legislative Calendar. The bill, of which 

the Energy Tax Policy Act of 2001 is a part (secs. 3001-3310), amends the Internal Revenue 

Code with respect to specified energy credit and deductions, including provisions related to 

electric power.

77 The bill is co-sponsored by Senators Rockefeller, Thomas, Bingaman, Conrad, 

Thompson, and others.

78 “Clean coal technology” is defined as technology which: (1) uses coal to produce 50 

percent or more of its thermal output as electricity; (2) has a design rate not less than 500 

Btu/kWh below that of the existing unit before it is retrofit, repowered, or replaced with the 

qualifying clean coal technology; (3) has a maximum design heat rate of not more than 9,000 

Btu/kWh when the design coal has a heat content of more than 8,000 Btu per pound; and (4) has 

a maximum design heat rate of not more than 10,500 Btu/kWh when the design coal has a heat 

content of 8,000 Btu per pound or less.
48

Advanced clean coal technology

The bill would provide a ten percent investment tax credit for certain investments in a 

qualifying advanced clean coal technology facility that meet specified efficiency and other 

requirements.79 The bill also would provide a production tax credit equal to the applicable 

amount of advanced clean coal technology production credit (ranging from $0.0005 to $0.0120), 

multiplied by the sum of (1) the kilowatt hours of electricity, plus (2) each 3,413 Btu of fuels or 

chemicals, produced by the taxpayer during the taxable year at a qualifying advanced clean coal 

technology facility during the ten-year period beginning on the date the facility was originally 

placed in service.

Other provisions related to clean coal

S. 60 also would require the Secretary of the Treasury to establish a financial risk pool to 

offset the modification costs resulting from the failure of qualifying advanced clean coal 

technology to achieve its design performance. The bill would permit excess credits for emission 

reductions and efficiency improvements in existing coal-based generating facilities to be treated 

as an overpayment for certain electric cooperatives and publicly owned electric utilities. Under 

the bill, the Tennessee Valley Authority would be permitted to aggregate certain clean coal 

technology credits and have them applied as a credit against payments required to be made in 

such fiscal year as an annual return on the appropriations investment and an annual repayment 

sum.

B. S. 173, the “Consumer Utilities Turnback (CUT) Trust Fund Act of 2001” 

On January 24, 2001, Senator Boxer introduced S. 173, the “Consumer Utilities Turnback 

(CUT) Trust Fund Act of 2001.” The bill would impose an excise tax on the “windfall profit” 

from the sale of electricity produced from a facility located in the United States. The tax would 

be equal to 100 percent of such windfall profit. The bill would allocate the revenues from the 

windfall profit adjustment on electricity production to individual and business consumers 

through the establishment of the Consumer Utilities Turnback Trust Fund.

C. S. 389, the “National Energy Security Act of 2001” 

On February 26, 2001, Senator Murkowski 80 introduced S. 389, the “National Energy 

Security Act of 2001.” The bill contains many tax and non-tax provisions. The provisions 

relating to clean coal technology and electric power are highlighted below. 

 

79 A “qualifying advanced clean coal technology facility” is a facility which: (1) replaces 

a conventional technology facility, the original use of which commences with the taxpayer, is a 

retrofitted or repowered conventional facility, the retrofitting or repowering of which is 

completed by the taxpayer, or is acquired by purchase; (2) is depreciable under section 167; (3) 

has a useful life of not less than four years; (4) is located in the United States; and (5) uses 

qualifying advanced clean coal technology, as specifically defined in the bill.

80 The bill is co-sponsored by Senators Thomas, Breaux, Lott, and others.
49

Existing clean coal technology

The bill would provide a ten percent investment tax credit for pollution control 

investments that serve, are added to, or retrofit an existing coal-based electricity generating unit 

and remove or reduce one or more pollutants regulated by title I of the Clean Air Act. The credit 

is limited to the first $100 million of qualifying investment for any one existing coal-based 

electricity generating unit. 

The bill would also provide a production tax credit for electricity produced from an 

existing coal-based electricity generating steam generator turbine unit that has a nameplate 

capacity rating of not more than 300,000 kilowatts and has been retrofitted, repowered, or 

replaced with a clean coal technology within ten years of the effective date of the bill (a 

“qualifying clean coal technology unit”).81 The credit would be equal to an applicable amount of 

clean coal technology production credit ($0.0034) multiplied by the kilowatt hours of electricity 

produced by the taxpayer during such taxable year at a qualifying clean coal technology unit 

during the ten-year period beginning on the date the unit was returned to service after retrofit, 

repowering, or replacement. 

Advanced clean coal technology

The bill would provide a ten percent investment tax credit for certain investments in a 

qualifying advanced clean coal technology facility that meet specified efficiency and other 

requirements.82 The bill also would provide a production tax credit equal to the applicable 

amount of advanced clean coal technology production credit (ranging from $0.0005 to $0.0120), 

multiplied by the sum of (1) the kilowatt hours of electricity, plus (2) each 3,413 Btu of fuels or 

chemicals, produced by the taxpayer during the taxable year at a qualifying advanced clean coal 

technology facility during the ten-year period beginning on the date the facility was originally 

placed in service.

 

81 “Clean coal technology” is defined as technology which: (1) uses coal to produce 50 

percent or more of its thermal output as electricity; (2) has a design rate not less than 500 

Btu/kWh below that of the existing unit before it is retrofit, repowered, or replaced with the 

qualifying clean coal technology; (3) has a maximum design heat rate of not more than 9,000 

Btu/kWh when the design coal has a heat content of more than 8,000 Btu per pound; and (4) has 

a maximum design heat rate of not more than 10,500 Btu/kWh when the design coal has a heat 

content of 8,000 Btu per pound or less.

82 A “qualifying advanced clean coal technology facility” is a facility which: (1) replaces 

a conventional technology facility, the original use of which commences with the taxpayer, is a 

retrofitted or repowered conventional facility, the retrofitting or repowering of which is 

completed by the taxpayer, or is acquired by purchase; (2) is depreciable under section 167; (3) 

has a useful life of not less than four years; (4) is located in the United States; and (5) uses 

qualifying advanced clean coal technology, as specifically defined in the bill.
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Electric power

The bill would classify property used in the generation or transmission of electricity as 

seven-year depreciable property, with a ten-year life for alternative depreciation purposes. The 

bill would provide special, liberalized private business use rules for bonds issued by public 

power entities to finance electric output facilities when the entities participate in qualifying 

electric industry restructuring arrangements. These rules would apply both to facilities financed 

with currently outstanding bonds and to certain facilities financed with bonds issued in the 

future. The bill would further allow public power entities that engage in activities beyond those 

allowed under the liberalized private business use rules to elect to forego certain future issuances 

of tax-exempt bonds while preserving the tax-exempt status of their previously issued bonds. 

(This portion of the bill would primarily affect electric generation facilities.) The bill would 

modify current rules regarding issuance of tax-exempt bonds for the acquisition of existing 

electric output faculties. The provision would apply only to governmental bonds issued by 

public power entities. Thus, bond-financed facilities would have to be governmentally owned, 

determined under generally applicable tax rules. 

The bill would allow a taxpayer to elect to treat qualifying electric transmission 

transactions83 as involuntary conversions if the proceeds from the transaction are invested in 

exempt utility property within four years. The bill would also provide that stock distributed in a 

qualifying electric transmission transaction84 shall be treated as qualifying property for purposes 

of section 355(c)(2) and section 361(c)(2) (relating to distributions of appreciated property). 

The bill would also allow certain amounts received by electric energy, natural gas, or 

steam utilities to be excluded from gross income as contributions to capital. 

The bill would allow taxpayers to elect to deduct any amount paid or incurred for the 

temporary storage or isolation of spent nuclear fuel. The bill would also revise the special rules 

concerning the tax treatment of nuclear decommissioning costs to: permit the full cost of nuclear 

decommissioning to be ratably contributed to a Nuclear Decommissioning Reserve Fund; permit 

funding in excess of the ratable amount in two cases, (1) where a taxpayer is permitted to charge 

customers an amount greater than such amount for decommissioning costs, and (2) on certain 

transfers of nuclear powerplants; repeal the requirement to obtain a ruling amount from the IRS; 

and clarify that nuclear decommissioning costs are deductible when paid or incurred. 

 

83 A “qualifying electric transmission transaction” is defined as any sale or other 

disposition of property used in the trade or business of electric transmission, or an ownership 

interest in a person whose primary trade or business consists of providing electric transmission 

services, to another person that is an independent transmission company. 

84 For this provision, a “qualifying electric transmission transaction” is defined as any 

distribution of stock in a corporation whose primary trade or business consists of providing 

electric transmission services, where such stock is later acquired (or where the assets of such 

corporation are later acquired) by another person that is an independent transmission company.
51

D. S. 596, the “Energy Security and Tax Incentive Policy Act of 2001”

On March 22, 2001, Senator Bingaman85 introduced S. 596, the “Energy Security and 

Tax Incentive Policy Act of 2001.” The bill contains many tax and non-tax provisions. The 

provisions relating to electric power and advanced clean coal technology are highlighted below. 

Electric power 

The bill would classify property used in the transmission of electricity as seven-year 

depreciable property, with a ten-year life for alternative depreciation purposes. 

Advanced clean coal technology

The bill would allow a ten percent investment tax credit for certain investments in a 

qualifying advanced clean coal technology facility that meet specified efficiency and other 

requirements.86 The bill would also provide a production tax credit equal to the applicable 

amount of advanced clean coal technology production credit (ranging from $0.0005 to $0.0120), 

multiplied by the sum of (1) the kilowatt hours of electricity, plus (2) each 3,413 Btu of fuels or 

chemicals, produced by the taxpayer during such taxable year at a qualifying advanced clean 

coal technology facility during the ten-year period beginning on the date the facility was 

originally placed in service. 

The bill would also require the Secretary of the Treasury to establish a financial risk pool 

to offset the modification costs resulting from the failure of qualifying advanced clean coal 

technology to achieve its design performance. 

E. S. 741, the “Nuclear Renewal Act of 2001”

On April 6, 2001, Senator Sessions, for himself and Senator Hutchinson, introduced S. 

741, the “Nuclear Renewal Act of 2001.” 

The bill would provide a credit, not to exceed $50,000,000, for production from nuclear 

power facilities and facility upgrades. In the case of a qualified nuclear power facility the credit 

would equal .34 cents multiplied by the kilowatt hours of electricity produced by the taxpayer, 

during the five-year period beginning on the date the facility is placed in service, and sold by the 

taxpayer to an unrelated person. In the case of a qualified nuclear power facility upgrade, the 

 

85 The bill is co-sponsored by Senators Breaux, Daschle, Rockefeller, Torricelli, Baucus, 

and others. 

86 A “qualifying advanced clean coal facility” is defined as a facility which: (1) replaces 

a conventional technology facility of the taxpayer, the original use of which commences with the 

taxpayer, or is a retrofitted or repowered conventional technology facility, the retrofitting or 

repowering of which is completed by the taxpayer, or is acquired through purchase; (2) is 

depreciable under section 167; (3) has a useful life of not less than four years; (4) is located in 

the United States; and (5) uses qualifying advanced clean coal technology, as specifically defined 

in the bill.
52

credit would equal .34 cents multiplied by the kilowatt hours of electricity produced by the 

taxpayer, during the three year period beginning on the date the upgrade is effective, and sold by 

the taxpayer to an unrelated person. The bill would extend the nuclear power production credit 

created by the bill to certain tax-exempt public utilities and the Tennessee Valley Authority. 

The bill would also classify property used in the generation of electricity as seven-year 

depreciable property, with a ten-year life for alternative depreciation purposes.

F. S. 794, the “Rural Electric Tax Equity Act”

On April 26, 2001, Senator Thompson87 introduced S. 794, the “Rural Electric Tax 

Equity Act.”

The bill would exclude from the 85-percent member income test certain specified income 

received by a tax-exempt electric cooperative, including: (1) income from discounted 

prepayments of any loan, debt, or obligation made, insured, or guaranteed under the Rural 

Electrification Act of 1936; (2) income from any organization in which the cooperative owns an 

interest until such income is paid to the cooperative; (3) income from any member that 

voluntarily waives any right to capital credits, patronage dividends, or similar amounts; (4) 

income from any member for sales of electric energy on the basis of the cooperative’s 

incremental costs; (5) income from the receipt of any money or capital that would be excluded 

under section 118(c) if received by a regulated public utility (i.e., contributions in aid of 

construction); (6) income from the transfer of any amount into a trust, fund, or instrument 

established to pay any nuclear decommissioning costs (if in connection with the transfer of a 

nuclear power plant), or from the distribution of such amounts; (7) income from any voluntary 

sale, exchange, or other transfer of any property, property right, asset, or service territory; and (8) 

income from any compulsory or involuntary requisition or condemnation (or threat thereof) of 

any property, asset, or service territory. The bill also would provide that income from electric 

energy sold to members on the basis of incremental cost and income from voluntary member 

waivers of capital credits, patronage dividends, or similar amounts do not affect the 

determination of whether an electric cooperative is operating in accordance with fundamental 

cooperative principles.

The bill would provide that certain specified income is included as member income in the 

85-percent member income test, including: (1) income from wheeling electricity to, with, or for 

members; (2) income received from a regional transmission organization for the use of the 

cooperative’s transmission facilities; (3) unbundling (i.e., billing and collection) income; (4) 

electric energy member sales income; (5) replacement electric energy sales income (i.e., income 

from the provision of electricity or related goods and services to non-members, to the extent that 

the cooperative loses member income as a result of restructuring); and (6) income from any 

organization or entity in which the cooperative owns an interest to the extent of amounts 

collected by such organization or entity from members in proportion to the cooperative’s 

ownership percentage in the organization or entity, provided that a Federal, State, or local law, 

regulation, holding, or order prohibits the cooperative from engaging in the business conducted 

 

87 The bill is co-sponsored by Senators Lincoln, Grassley, Baucus, and others.
53

by the organization or entity. The bill also would provide that such deemed member income is 

excluded from the tax on unrelated business taxable income of exempt electric cooperatives.

The bill would provide that certain specified income received by a taxable (non-exempt) 

electric cooperative is treated as excludible income, including: (1) income from the receipt of 

any money or capital that would be excluded under section 118(c) if received by a regulated 

public utility (i.e., contributions in aid of construction); (2) income from wheeling electricity to, 

with, or for patrons; (3) income received from a regional transmission organization for the use of 

the cooperative’s transmission facilities; (4) unbundling (i.e., billing and collection) income; (5) 

electric energy patron sales income; (6) replacement electric energy sales income (i.e., income 

from the provision of electricity or related goods and services to non-patrons, to the extent that 

the cooperative loses patron income as a result of restructuring); (7) income from any 

organization or entity in which the cooperative owns an interest; (8) income from any patron that 

voluntarily waives any right to capital credits, patronage dividends, or similar amounts; (9) 

income from any patron for electric energy sold based on the cooperative’s incremental costs; 

(10) income from the transfer of any amount into a trust, fund, or instrument established to pay 

any nuclear decommissioning costs (if in connection with the transfer of a nuclear power plant), 

or from the distribution of such amounts; (11) income from any voluntary sale, exchange, or 

other transfer of any property, property right, asset, or service territory; and (12) income from 

any compulsory or involuntary requisition or condemnation (or threat thereof) of any property, 

asset, or service territory. The bill also would provide that income from electric energy sold to 

patrons on the basis of incremental cost and income from voluntary patron waivers of capital 

credits, patronage dividends, or similar amounts do not affect the determination of whether an 

electric cooperative is operating in accordance with fundamental cooperative principles.

G. S. 972, the “Electric Power Industry Tax Modernization Act” 

On May 25, 2001, Senator Murkowski88 introduced S. 972, the “Electric Power Industry 

Tax Modernization Act.” 

The bill would provide special, liberalized private business use rules for bonds issued by 

public power entities to finance electric output facilities when the entities participate in 

qualifying electric industry restructuring arrangements. These rules would apply both to 

facilities financed with currently outstanding bonds and to certain facilities financed with bonds 

issued in the future. The bill would further allow public power entities that engage in activities 

beyond those allowed under the liberalized private business use rules to elect to forego certain 

future issuances of tax-exempt bonds while preserving the tax-exempt status of their previously 

issued bonds. (This portion of the bill would primarily affect electric generation facilities.) The 

bill would modify current rules regarding issuance of tax-exempt bonds for the acquisition of 

existing electric output faculties. The provision would apply only to governmental bonds issued 

by public power entities. Thus, bond-financed facilities would have to be governmentally 

owned, determined under generally applicable tax rules. 

 

88 The bill is co-sponsored by Senators Breaux, Thompson, Jeffords, Kyl, and others.
54

The bill would allow a taxpayer to elect to treat qualifying electric transmission 

transactions89 as involuntary conversions if the proceeds from the transaction are invested in 

exempt utility property within four years. The bill would also provide that stock distributed in a 

qualifying electric transmission transaction90 shall be treated as qualifying property for purposes 

of section 355(c)(2) and section 361(c)(2) (relating to distributions of appreciated property). 

Additionally, the bill would provide that certain amounts received by electric utilities are 

excluded from gross income as contributions to capital. 

The bill would also revise the special rules concerning the tax treatment of nuclear 

decommissioning costs to: permit the full cost of nuclear decommissioning to be ratably 

contributed to a Nuclear Decommissioning Reserve Fund; permit funding in excess of the ratable 

amount in two cases, (1) where a taxpayer is permitted to charge customers an amount greater 

than such amount for decommissioning costs, and (2) on certain transfers of nuclear powerplants; 

repeal the requirement to obtain a ruling amount from the IRS; and clarify that nuclear 

decommissioning costs are deductible when paid or incurred. 

H. S. 1131, the “Clean Power Plant and Modernization Act of 2001”

On June 28, 2001, Senator Leahy introduced S. 1131, the “Clean Power Plant and 

Modernization Act of 2001.” The bill would provide several tax and non-tax provisions. Those 

tax provisions relating to electricity are included below. 

 The bill would impose a tax equal to 30 cents per megawatt hour of electricity produced 

by certain electric utility generating units powered by fossil fuels, to be paid by the unit’s owner 

or operator.91 The bill would provide that amounts equivalent to the tax would be appropriated 

to a newly established Clean Air Trust Fund, the funds of which could only be used for purposes 

specified in the bill. 

The bill would provide accelerated depreciation for investor-owned generating units. The 

bill would classify any 45-percent efficient fossil fuel-fired generating unit as 15-year property 

and any 50-percent efficient fossil fuel-fired generating unit as 12-year property. The bill would 

also provide grants for certain publicly owned generating units equal to the monetary value of 

 

89 A “qualifying electric transmission transaction” is defined as any sale or other 

disposition of property used in the trade or business of electric transmission, or an ownership 

interest in a person whose primary trade or business consists of providing electric transmission 

services, to another person that is an independent transmission company. 

90 For this provision, a “qualifying electric transmission transaction” is defined as any 

distribution of stock in a corporation whose primary trade or business consists of providing 

electric transmission services, where such stock is later acquired (or where the assets of such 

corporation are later acquired) by another person that is an independent transmission company.

91 A “covered fossil fuel-fired generating unit” is defined as an electric utility generating 

unit which: (1) is powered by fossil fuels; (2) has a generating capacity of five or more 

megawatts; and (3) because of the date operation commences, is not subject to all of the 

regulations promulgated under section 111 of the Clean Air Act.
55

depreciation deduction that would be realized by a similarly situated investor-owned generating 

unit.

I. S. 1212, the “Smart Metering Promotion Act of 2001”

On July 20, 2001, Senator Cantwell introduced S. 1212, the “Smart Metering Promotion 

Act of 2001.” The bill would allow a tax credit for qualified energy management devices and 

retrofitted qualified meters. The credit would be equal to the lesser of (1) 50 percent of the cost 

of any qualified energy management device92 placed in service during the taxable year, or (2) 

$30 ($250 for nonresidential consumers), plus for each qualified retrofitted meter93 placed in 

service during the taxable year, the lesser of (1) 50 percent of meter’s adjusted basis, or $30 

($250 for nonresidential consumers).

 

92 “Qualified energy management device” is defined as equipment, systems, software, 

and related devices which have as a purpose allowing electric energy or natural gas consumers, 

suppliers, and service providers to manage the purchase, sale, and use of electricity or natural gas 

in response to energy price and usage signals, in order to improve the efficiency of energy and 

energy facility utilization. 

93 “Qualified retrofitted meter” is defined as an electric energy or natural gas meter or 

metering device that has been modified by the addition of equipment which has as a purpose 

allowing electric energy or natural gas consumers, suppliers, and service providers to manage the 

purchase, sale, and use of electricity or natural gas in response to energy price and usage signals, 

in order to improve the efficiency of energy and energy facility utilization.