Editor: Mary Van Leuven, J.D., LL.M.
In a recent private letter ruling, the IRS determined that a publicly regulated utility is entitled to claim benefits under Sec. 1341 for amounts paid to a purchaser of electricity to settle claims asserted against predecessor members of the publicly regulated utility’s affiliated group. Letter Ruling 200901029 is potentially significant for all taxpayers but, as this item points out, is particularly significant to the utility industry. The ruling is interesting because it addresses how a reorganization affects Sec. 1341 and how the Sec. 1341(b)(2) inventory exception applies to utilities whose rates are subject to the market authority of the Federal Energy Regulatory Commission (FERC) rather than formal rate proceedings.
When a taxpayer receives payments without restriction under a claim of right, the payments must be included in gross income. This is true even if the taxpayer discovers in a later year that it had no right to the payments in the earlier year and is required to repay the same amount. Upon repayment, a taxpayer is generally entitled to a deduction in the year of repayment; however, the deduction’s tax benefit may be less than the tax cost of originally including the payments in gross income. That is, when subsequent repayments exceed income for the year of repayment or when the tax rate for the year of repayment on the remaining income (after subtraction of such repayments) is lower than the tax rate for the year in which the income was previously taxed, the deduction does not adequately compensate the taxpayer for the tax paid in the earlier year.
Sec. 1341 can mitigate this adverse impact of a tax overpayment when the deduction in the year of repayment of an item previously included in income does not provide as great a reduction in tax liability as the tax liability generated when the item was previously included in income. It does this by providing a special tax computation for the year of repayment in a way that gives the taxpayer the equivalent of a tax refund (without interest) for the earlier year. The benefit can also take the form of a refundable tax credit if there is no tax liability in the year of repayment.
In Letter Ruling 200901029, the taxpayer asked the IRS to rule that it had met the specific Sec. 1341 requirements, including the requirement that sales income had been included in income based on only an apparent rather than an actual right to the income. Further, the taxpayer asked the Service to rule that currently deductible settlement payments qualified for Sec. 1341 relief even though they settled claims asserted against successors to the members of the taxpayer’s former consolidated group who had originally reported the income (the original income recipients).
The taxpayer in the ruling is engaged in the business of generating electricity and filed consolidated tax returns, which took into account the income and losses of all related entities, including those treated as partnerships or disregarded entities. Two disregarded entities owned by two members of the taxpayer’s group supplied electricity to an electric utility where the electric energy industry is regulated by the state and the rates are set by the FERC.
The amounts paid to the original income recipients were subject to refund if the FERC subsequently determined the rates were excessive. In this case, the FERC found the rates to be excessive. Under a settlement agreement approved by the FERC and the bankruptcy court, the successors to the original income recipients, which included the taxpayer, transferred money, stock, and assets to the claimant.
Impact of Reorganization
The taxpayer is a successor parent to an affiliated group that had received prior letter rulings on its tax-free restructuring transactions. Throughout the internal restructurings, the group’s business continued to be operated in substantially the same form. When the taxpayer’s predecessor and many members of the group entered chapter 11 bankruptcy, the electric utility that had purchased the electricity filed claims against the successors to the original income recipients for overcharging the utility for power sold under rate agreements. Before terminating the bankruptcy proceedings, the consolidated group reorganized, with the original members of the group, including the disregarded entities and corporations that owned them, going out of existence.
In the absence of explicit guidance on how Sec. 1341 applies when a successor to the original income recipient repays the original income and is in a different consolidated group, the IRS determined that the Sec. 1341 tax attribute of the disregarded entities attached to the individual members of the consolidated group and not to the group as a whole. The income from the electricity sales to the electric utility passed through those disregarded entities to the group members that owned them, and the members took the income into account in computing their separate taxable incomes, the Service reasoned. The IRS also ruled that successor entities in nontaxable reorganizations succeed to the Sec. 1341 tax attribute; however, the IRS did not rule on whether the taxpayer had satisfied the requirements under Sec. 381(a) or (c).
The IRS concluded that utilities subject to general FERC authority are considered to be regulated public utilities for purposes of the inventory exception and are therefore eligible for the benefits of Sec. 1341.
Congress provided a “public utility exception” to ensure that a regulated public utility would be able to benefit from Sec. 1341 when required by a regulatory authority to refund rate payments to its customers if the utility otherwise complied with the Sec. 1341 requirements. The relief provided by Sec. 1341 generally does not apply to deductions resulting from inventory sales or sales of stock in trade; however, under Sec. 1341(b)(2) it does apply if the deduction “arises out of [government-required] refunds or repayments with respect to rates made by a regulated public utility.”
The IRS concluded that the disregarded entities qualified as regulated public utilities even though the utilities were subject to competitive ratemaking because the rates were subject to FERC jurisdiction. Consequently, the exclusion for sales of inventory did not apply, and the disregarded entities qualified for the tax benefits provided by Sec. 1341.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.