IRS Rules Energy Contract Is Not a Commodity

By Richard Larkin, J.D., CPA, Washington, DC; Mike Semes, J.D., Philadelphia, PA; and Alan Munro, CPA, J.D., LL.M., Washington, DC

Editor: Michael Dell, CPA

Tax Accounting

In Chief Counsel Advice (CCA) 201132021, the IRS analyzed whether a taxpayer properly applied mark-to-market treatment under Sec. 475(e) to certain portions of a contract (the tolling agreement). The IRS concluded that the tolling agreement was not a commodity and that mark-to-market treatment of the agreement did not clearly reflect income. However, the IRS requested more information before determining if the taxpayer should be classified as a commodities dealer due to other activities.


The taxpayer is an energy company engaged in electricity generation operations and retail electricity sales. The taxpayer is a partnership that elected under Rev. Proc. 2002-9 to be treated as a dealer in commodities under Sec. 475(e) starting in year 3. Accordingly, the taxpayer attached an election statement to its year 2 Form 8736, Application for Automatic Extension of Time to File U.S. Return for a Partnership, REMIC, or for Certain Trusts, filed on date 1. On date 2, the taxpayer filed its Form 3115, Application for Change in Accounting Method, requesting permission to change from the accrual method to the mark-to-market method required for electing dealers by Sec. 475(e). The taxpayer represented that it was a dealer in commodities with different trades and businesses and that it sold electricity to related and unrelated parties, as well as to retail customers in its service territory. Automatic consent was granted pursuant to Rev. Proc. 2002-9.

Since date 3, the taxpayer agreed to sell electricity to X, which X uses to power its Operation A near Location 1. X planned to construct a power generating station near its smelter to ensure the availability of power but did not want to operate the plant. X and a predecessor to the taxpayer, B, entered into a contract whereby the taxpayer would operate X’s power generating station at Location 1 (which later became known as Unit A). X and the taxpayer entered into a power contract that required the taxpayer to build certain transmission lines and to provide electricity to power X’s smelter operations. It also allowed the taxpayer to sell certain excess power over and above the power used for the smelter. Additionally, X acquired certain fuel source reserves and mining assets from the taxpayer, which resulted in X’s developing and owning what came to be known as Mine. X owned Unit A and Mine, but the taxpayer and its successors operated both facilities under contracts.

The taxpayer and X entered into another agreement (i.e., the tolling agreement) for the taxpayer to build, own, and operate a fourth electric plant, Unit B. Under the tolling agreement, the taxpayer is required to sell X a certain amount of power; however, that power is not required to come from Unit B. If Unit B is not operating, X must pay the taxpayer an agreed market rate for the power provided. X may not sell power it receives from the taxpayer to any other party. X may purchase power from other sources, but only if it is purchasing the full contract amount from the taxpayer. The taxpayer may sell power to other parties.


The IRS identified four issues relating to the application of the mark-to-market rules to the taxpayer: (1) whether the taxpayer was a dealer in commodities for purposes of Sec. 475; (2) whether the taxpayer’s tolling agreement with X , or certain components thereof, represents a commodity or evidence of an interest in a commodity for purposes of Sec. 475; (3) whether the taxpayer’s mark-to-market treatment of the tolling agreement clearly reflected the taxpayer’s income within the meaning of Sec. 446; and (4) whether the taxpayer’s position with respect to the tolling agreement created a straddle with the taxpayer’s capacity to produce electricity.

Law and Analysis

Taxpayer may be a dealer in commodities: The CCA responds to an examiner’s finding that the taxpayer was not a dealer for purposes of Sec. 475. Apparently, the examiner’s finding was based on the body of dealer/trader case law, which requires that a dealer necessarily perform an intermediation function—be a middleman that both purchases and sells commodities—and the fact that the taxpayer does not purchase and resell electricity under the agreement. However, the IRS pointed out that the statutory definition of a dealer in securities or commodities under Sec. 475 is broader than the dealer requirements discussed in case law distinguishing between a dealer and a trader.

The IRS asserted that the case law was addressing Code sections other than Sec. 475 and noted that, under the case law, dealers were required to both buy and sell securities/commodities, while under the statutory requirement of Sec. 475, a dealer need only buy or sell. Specifically, Sec. 475(c)(1)(A) defines a dealer in securities as a taxpayer that regularly purchases or sells securities from or to customers in the ordinary course of a trade or business or that is willing to enter into, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of business. Presumably, the term “dealer in commodities” would be defined identically, except with respect to commodities as defined in Sec. 475(e)(2). Hence, a dealer under Sec. 475 can include a taxpayer that regularly only purchases securities or commodities from customers in the ordinary course of business, regardless of whether it sells those securities or commodities.

Further, the IRS pointed out that the taxpayer had filed a Form 3115 in connection with making the election under Sec. 475(e) in which the taxpayer stated that it is a dealer in retail gas contracts and that it may also sell electricity to customers other than X . The IRS concluded that the examiners appeared to have inappropriately based their conclusion that the taxpayer was not a dealer in commodities solely on its activities in connection with the tolling agreement. According to the IRS, once a Sec. 475(e) election has been made, a taxpayer must mark to market all commodities under Sec. 475(e)(2) that have not been specifically identified as held for investment or otherwise exempt from marking. Thus, if it is determined that the taxpayer is a dealer in commodities because of its sales of electricity outside the tolling agreement, then any other commodities must be marked, regardless of whether the taxpayer is a dealer in that commodity, unless the commodity has been properly identified as exempt from marking.

Therefore, even though the IRS agreed with the examiner that the taxpayer was not a dealer in commodities solely because of its activities under the tolling agreement, the IRS concluded that the taxpayer’s other activities should be considered because the taxpayer may qualify as a dealer due to activities outside the tolling agreement. In view of this possibility, the IRS requested more information on the taxpayer’s retail gas contracts and electricity sales, specifically asking whether the purchases or sales occur regularly and with customers in the ordinary course of the taxpayer’s business. The IRS also noted that water and certain fuel, which the taxpayer regularly purchased, could be considered commodities and may cause a dealer classification.

Tolling agreement is not a commodity: The taxpayer asserted that certain provisions of the tolling agreement when severed from the rest of the tolling agreement constitute a Sec. 475(e)(2)(C) commodity. According to the taxpayer, the underlying commodity is electricity. But in the view of the requesting examiner, the tolling agreement is not severable, and as such the tolling agreement is not a commodity under Sec. 475(e)(2). In addition, the examiner argued that, even if the tolling agreement were severable, the specified sections of the tolling agreement are not a commodity under Sec. 475(e)(2)(C).

The IRS agreed with the examiner that the agreement is not a commodity under Sec. 475(e)(2)(C) and that it is a cost-of-services contract. According to the IRS, the tolling agreement is not severable under relevant state law and, if severed, would not be like a forward contract or futures contract because the provisions are not based on market rates. Instead, the IRS found that the provisions are based upon cost of services and that the electricity rates are below market rates. Thus, the tolling agreement is not eligible to be marked to market under Sec. 475 even if the taxpayer were a dealer in commodities.

Treatment of agreement does not clearly reflect income: The IRS agreed with the examiner’s finding that the mark-to-market method of accounting did not accurately reflect the taxpayer’s income or economic reality. The IRS noted that, although the taxpayer was claiming a huge mark-to-market loss on two provisions of the tolling agreement, the taxpayer amended the tolling agreement to be in force for additional years. According to the IRS, if this mark-to-market loss from two provisions were a true reflection of the economics of the tolling agreement, the taxpayer would not have extended the agreement for the additional years. In effect, the IRS appears to be challenging the taxpayer’s valuation of the tolling agreement.

Potential application of the straddle rules: The IRS agreed with the examiner’s finding that the taxpayer’s obligation to sell electricity under the tolling agreement is a straddle offsetting the taxpayer’s capacity to generate electricity. This seems a particularly odd conclusion, given the IRS’s previously expressed view that a tolling agreement does not constitute a position in a commodity that can be marked to market under Sec. 475.


This CCA is significant because many power producers (regulated and unregulated) and other types of energy companies frequently employ tolling agreements. Many of these taxpayers likely have taken a position similar to the taxpayer in the CCA and mark their tolling agreements to market. Therefore, the CCA’s conclusion to the contrary has the potential of having a negative impact on a large number of taxpayers.

If a taxpayer can sustain the position (contrary to the conclusion in the CCA) that the tolling agreement can be marked to market under Sec. 475, the IRS’s acknowledgment that an examination of the taxpayer’s activities outside an isolated tolling agreement could allow the taxpayer to qualify as a dealer in commodities blunts any further potential negative impact of the CCA. Nonetheless, taxpayers in this industry should heed the warning of the CCA and review the basis on which they have made mark-to-market elections under Sec. 475. In a more specific regard, the IRS’s apparent challenge to the taxpayer’s valuation of its tolling agreement industry should cause taxpayers to confirm the validity of the manner in which they have valued their tolling agreements.

The CCA’s impact on rate-regulated utilities that employ tolling agreements could be even more significant. For instance, if the tax allocation of a regulated utility’s cost of service assumes qualification for mark-to-market treatment under Sec. 475 and the IRS subsequently denies that treatment, rate-making principles (e.g., denial of prior-period expenses) may preclude the utility from recovering those costs in the future. Similarly, reports of change could concomitantly increase state income taxes in prior periods. These increases to prior-period tax liabilities that the utility does not recover in future rates would negatively affect its earnings.


Michael Dell is a partner at Ernst & Young LLP in Washington, DC.

For additional information about these items, contact Mr. Dell at (202) 327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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