SERVICE ISSUES GUIDANCE RELATING TO CONTRIBUTIONS IN AID OF CONSTRUCTION RECEIVED BY UTILITIES.

Notice 87-82

This notice provides guidance with respect to the treatment of contributions in aid of construction after enactment of section 824 of the Tax Reform Act of 1986 (the "Act"), Pub. L. No. 99-514.

I. BACKGROUND

Section 118(b) of the Internal Revenue Code of 1954 (the "1954 Code") provided a special rule for contributions in aid of construction received by regulated public utilities ("utilities") providing certain services. Under this rule, contributions in aid of construction were treated as contributions to capital and were therefore excluded from gross income under section 118(a). Section 824 of the Act changed the treatment of amounts received as contributions in aid of construction after December 31, 1986, in taxable years ending after such date. New section 118(b) of the Internal Revenue Code of 1986 (the "1986 Code") expressly provides that contributions in aid of construction and other contributions made by a customer or potential customer (collectively, "CIACs") are not contributions to capital and thus are not excluded from gross income under section 118. Accordingly, such amounts are required to be included in gross income under section 61.

II. RELOCATION OF UTILITY FACILITIES

The Internal Revenue Service has received numerous inquiries regarding the Federal income tax treatment under the 1986 Code of fees and other amounts received by utilities for relocating utility facilities ("relocation fees"). Frequently, utilities are required to relocate utility facilities in order to accommodate a public right- of-way. For example, a utility line may have to be relocated in order to allow for the construction or improvement of a public highway. Similarly, overhead utility lines may be placed underground under a governmental program undertaken for reasons of community esthetics and public safety. In such cases, the utility typically receives, directly or indirectly, a relocation fee in reimbursement for the costs of relocating the utility facilities.

The legislative history to section 824 of the Act indicates that Congress viewed the receipt by utilities of CIACs as a prepayment for future services that the utilities would provide to their customers. H.R. Rep. No. 99-426, 99th Cong., lst Sess. 643-45 (1985) ("House Report"). Congress viewed the exclusion of these amounts from income as inappropriate and accordingly, required that a utility

report as an item of gross income the value of any property, including money, that it receives to provide, or encourage . . . the provision of, services to or for the benefit of the person transferring the property. A utility is considered as having received property to encourage the provision of services if the receipt of the property is a prerequisite to the provision of services, if the receipt of the property results in the provision of services earlier than would be the case had the property not been received, or if the receipt of the property otherwise causes the transferor to be favored in any way.

House Report at 644

The legislative history to the Act also indicates that a person transferring the property will be considered as having been benefitted [from such transfer] if he is the person who will receive the [utility] services, an owner the property that will receive the services, a former owner of the property that will receive the services, or if he derives any benefit from the property that will receive the services. Thus, a builder who transfers property to a utility in order to obtain services for a house that he was paid to build will be considered as having benefitted from the provision of the services . . . despite the fact that the builder may never have had an ownership interest in the property and may make the transfer to the utility after the house has been completed and accepted.

House Report at 644-45.

In contrast, the legislative history to the Act provides that the repeal of section 118(b) of the 1954 Code does not affect transfers of property which are not made in connection with the provision of services, including situations where "it is clearly shown that the benefit of the public as a whole was the primary motivating factor in the transfers." Id.

Based on the foregoing, the Federal income tax treatment of many types of relocation fees has not been affected by section 824 of the Act. If, for example, it can be shown that a particular payment received by a utility does not reasonably relate to the provision of services by such utility to or for the benefit of the person making the payment but rather relates to the benefit of the public at large, then the payment is not treated as a CIAC under section 118(b) of the 1986 Code. For example, relocation payments received by a utility under a government program for placing utility lines underground shall not be treated as CIACs where such relocation is undertaken for purposes of community esthetics and public safety and not for the direct benefit of particular customers of the utility in their capacity as customers. See Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950) (payments made by certain community groups as an inducement to location or expansion of taxpayer's factory were held to be contributions to taxpayer's capital because the payments were made to benefit the community at large, and not for services). Similar principles apply where the utility is being reimbursed for the costs of relocating utility lines to accommodate the construction or expansion of a highway and not for the provision of utility services.

Moreover, taxpayers failing to meet the criteria for exclusion of relocation fees under section 118(a) may treat such fees under the provisions of section 1031 or 1033 if the conditions of the respective section are otherwise met.

In other cases, however, relocation fees are treated as CIACs and included in gross income because they relate to the provision of services by the utility to or for the benefit of the person making the payment. Assume, for example, that a customer of a utility moves its business office to another location and is required to pay the utility a fee to relocate the utility facilities to the new office site. The utility has received the fee as a prerequisite to the provision of services to the new location, and thus the fee is a CIAC under section 118(b) and is included currently in the utility's income. In addition, assume a real estate developer pays a fee to a utility in return for the utility extending new underground services to a particular tract being deveoped. Since the payment is being made to or for the benefit of the developer and since the fee is a prerequisite to the provision of underground services to the tract, the fee is a CIAC and currently included in the utility's gross income.

Similarly, assume that a potential customer of a utility is required (either by the utility or by a governmental entity) to pay the utility for the costs of relocating utility facilities in order to obtain access to utility services for a site the customer is developing. Since the payment of the relocation fees is a prerequisite to obtaining utility services, the payment is a CIAC and is included in the utility's income, regardless of whether the particular utility facilities being relocated are related to the site the customer is developing.

Relocation fees are treated as CIACs and included in gross income if such payments relate to the provision of services by the utility, regardless of the status or identity of the customer from whom the fees are received. For example, assume a utility receives a payment relating to the relocation or extension of utility facilities to a newly constructed municipal building (e.g., a public hospital, civic center, or museum) whose operations are conducted for the benefit of the community at large. Assume also that payment of the relocation fee was required in order to obtain utility services for the new building. Since the relocation fee is a prerequisite to the provision of services to the customer, the fee is a CIAC and included in gross income even though the customer is exclusively engaging in activities for the public benefit. Similarly, payments that are made to a utility as a prerequisite to the utility providing new or additional services to particular customers are treated as CIACs and included in gross income because such payments are a prerequisite to the provision of services by the utility, although a governmental entity may be making the payments in question.

III. FAIR MARKET VALUE OF CIACs

A utility shall include in income the amount of any cash received as a CIAC and the fair market value of all property received as a CIAC. If the property received by the utility will be used in the provision of utility services, all of the relevant facts and circumstances are taken into account in determining the fair market value of the property. Absent unusual circumstances, normally the value of such property provided to a utility is the "replacement cost" of the property, i.e., the cost that another party would incur to construct property that is functionally similar to the subject property and thus could replace such subject property in the performance of the property's intended function. The fact that property received as a CIAC is not included in the utility's rate base or cost of service for regulatory accounting purposes shall not, in any manner, affect the determination of the fair market value of the property for this purpose. See Rev. Rul. 87-117, 1987-46 I.R.B. 8.

IV. OTHER TRANSACTIONS QUALIFYING AS CIACs

A transaction will be treated as a CIAC if such treatment is in accordance with the substance of the transaction, regardless of the form in which such transaction is conducted. For example, a sale of property to a utility at less than its fair market value (with fair market value being determined as described in the provisions of section III of this notice) will be treated as a CIAC that is taxable to the utility to the extent of the bargain element in the sale. A lease of property to a utility at less than its fair market rental value will be treated in a similar manner, with the bargain element inherent in each periodic rent payment taxed to the utility at the time such payment is made.

In addition, a transaction will be treated as a CIAC if the utility effectively obtains the burdens and benefits of ownership with respect to property, although legal title to such property is held by the customer, a governmental entity, or another person. Transactions which purportedly avoid CIAC characterization through the retention of legal title to property by a person other than a utility will be scrutinized carefully and will be treated as taxable CIACs to the utility if, in fact, the utility is, for Federal income tax purposes, the owner of the property. Factors which suggest ownership of the property by the utility include, but are not limited to, (i) whether the utility is responsible for maintaining the property; (ii) whether the utility effectively has unrestricted access to and control of the property; and (iii) whether the utility would bear legal liability with respect to a malfunction of or accident involving the property.

Similarly, any payment to a utility (whether such payment is direct or indirect) will be treated as a CIAC if such payment is made to obtain the provision of services from the utility and otherwise meets the requirements of this notice. Thus, for example, a utility will be taxed on a CIAC regardless of whether the customer engages the services of an unrelated contractor to construct the property to which the CIAC relates or whether the customer instead directly pays the CIAC to the utility with the utility itself assuming responsibility to construct the related property.

Moreover, a purported loan to a utility from a person benefitting from utility services relating to the loan (e.g., a real estate developer, customer, or potential customer) will be treated as a CIAC and included in the utility's gross income if the transaction lacks the economic characteristics of a genuine loan for Federal income tax purposes. As an example, where repayment of a "loan" by a utility to the lender is contingent and the contingent loan is made to allow or to encourage the utility to provide services for the benefit of the person making the loan, the amount received by the utility will be treated as a taxable CIAC. Where a utility included the entire amount of such a "loan" in taxable income as a CIAC repayments of such loan by the utility to the lender would normally be deductible by the utility when made.

Finally, where a genuine loan with a "below-market" interest rate is made from persons benefitting from utility services to the utility, the utility shall currently include in income as a CIAC the benefit that the utility receives from the below-market interest rate. See section 7872.

V. NORMALIZATION OF CIACs

Section 168(f)(2) of the 1986 Code effectively provides that a utility is required to use a normalization method of accounting with respect to public utility property in order to use the accelerated methods of depreciation under section 168 with respect to that property. Under section 168(i)(9)(C), a utility not using a normalization method of accounting with respect to public utility property is required to use a method of depreciation and a depreciation period for such property that is the same as the method and period used by the taxpayer in computing its depreciation expense for purposes of establishing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account. Public utility property is defined in section 167(1)(3)(A) as property used predominantly in the trade or business of furnishing or selling various enumerated utility services at rates established or approved by certain governmental entities, public utility commissions, and other similar bodies. Public utility property includes property that is received as a CIAC or that is financed or acquired with the proceeds of CIACs. In any such case, the CIAC property is subject to the normalization rules of sections 167 and 168.

For regulatory accounting purposes, utilities typically disregard the receipt of CIACs on their regulated books of account and do not include CIACs or CIAC property in income, cost of service, or rate base. This method of accounting (the "noninclusion method") is equivalent to including a CIAC in income in the year of receipt and depreciating the related CIAC property in its entirety in the same year. Accordingly a utility using the noninclusion method of accounting for a CIAC will be treated for purposes of the normalization rules as if it computed its regulated tax expense by depreciating the related CIAC property in its entirety in the year in which the CIAC is received. The Internal Revenue Service believes that this treatment is consistent with the noninclusion method of accounting and is necessary in order to carry out the purposes of the normalization rules.

Under the normalization rules, a utility must make adjustments to a reserve to reflect the deferral of taxes resulting from the difference between the amount of depreciation used to determine the utility's Federal income tax liability and the amount of depreciation used to compute regulated tax expense. In the typical case, part of the utility's tax expense is deferred (i.e., taxes are actually paid to the Federal government after they are taken into account under the regulatory accounting method) because property is depreciated more rapidly in determining Federal income tax liability than in computing regulated tax expense. If a utility uses the noninclusion method of accounting for CIACs, however, CIAC property is depreciated less rapidly in determining Federal income tax liability than in computing regulated tax expense, and taxes are paid before they are taken into account under the regulatory accounting method. This prepayment, or negative deferral, of tax is also subject to the normalization rules, and the utility must make adjustments to the reserve for deferred taxes to reflect the prepayment.

Under these adjustments, the amount of deferred taxes on the utility's regulated books of account is offset or decreased by the prepayment of tax resulting from the taxable receipt of the CIAC. Thus, if a taxpayer reduces rate base by the deferred taxes resulting from normalization, any prepayment to tax resulting from the normalization of CIACs will increase the rate base to which the utility's rate of return is applied. Similarly, if a taxpayer treats the deferred taxes resulting from normalization as "zero-cost" or "no-cost" capital for ratemaking purposes, any prepayment of taxes resulting from the normalization of CIACs will decrease the amount of zero-cost capital or no-cost capital for ratemaking purposes.

Further adjustments are made to the reserve for deferred taxes when the timing differences with respect to CIAC property reverse. This occurs as depreciation is taken into account in determining Federal income tax liability over the applicable recovery period prescribed under section 168. As the reversal occurs, previously paid taxes will be taken in account under the regulatory accounting method that will reduce, ultimately to zero, the amount of prepaid tax resulting from the normalization of the CIAC.

If, in its regulatory accounting for CIACs, a utility uses or changes to a method other than the noninclusion method, the normalization rules apply to timing differences determined under the regulatory accounting method used by the utility. For example, if a utility changes to a regulatory accounting method under which CIAC property is depreciated over its useful life, the deferral of tax resulting from the normalization of a CIAC taken into account under the new method would depend on the difference between the depreciation taken into account under the new method and the depreciation taken into account in determining Federal income tax liability.

VI. NORMALIZATION RULES NOT APPLICABLE TO CERTAIN CIACs

The normalization rules do not apply to a CIAC (or property related thereto) if the following conditions are satisfied:

(1) The CIAC is included in gross income solely by reason of the amendments to section 118(b) of the Code by section 824 of the Act;

(2) The utility uses the noninclusion method of accounting for the CIAC;

(3) The Federal income tax attributable to the receipt of the CIAC is not taken into account in determining cost of service for any person (other than, perhaps, the person from whom the CIAC is received, i.e., the "contributor"); and

(4) The contributor pays the utility an additional amount that is reasonably intended to indemnify or reimburse the utility for the prepayment of tax resulting from receipt of the CIAC (an "indemnification").

In the case of a CIAC that satisfies these conditions (a "grossed-up" CIAC), neither the utility nor its ratepayers (other than the contributor) are affected by the prepayment of taxes that results from receipt of the CIAC. Thus, it is not necessary to normalize a grossed-up CIAC in order to carry out the purposes of the normalization rules. See section 167(1)(5). Alternatively, grossed-up CIACs may be normalized in the same manner as other CIACs. Thus, a utility may use an accelerated method of depreciation under section 168 with respect to its public utility property whether or not grossed-up CIACs are normalized by the utility. The utility's depreciable basis in the CIAC property is determined under other provisions of the Code and is independent of the existence of an indemnification. If, for example, a utility receives a total payment from a contributor of $160 and expends $100 in constructing the CIAC property, the utility's depreciable basis in the property is $100. Similarly, if a utility receives a total payment from a contributor of $100 and expends $100 in constructing the CIAC property (with the income tax payments pertaining to the CIAC being obtained from other sources), the utility's depreciable basis in the property is also $100.

The condition of indemnification, necessary in order for a payment to qualify as a grossed-up CIAC, is required only for the prepayment of tax that results from receipt of the CIAC. Thus, the amount of the indemnification may be determined by reducing the amount of tax attributable to the receipt of the CIAC by the present value of the tax benefits to be obtained by depreciating the CIAC property in determining the utility's Federal income tax liability. A reduction attributable to such tax benefits is not required, however, because the identity of the ultimate recipient of those benefits pertaining to the grossed-up CIAC (i.e., the contributor, the utility, or the utility's ratepayers) is a matter outside the scope of the normalization rules and Federal income tax laws.

A utility may establish that an indemnification has occurred (i) by reference to a contract or agreement in which the contributor and the utility provide for such indemnification, (ii) by reference to an indemnification requirement contained in a rate order issued by a regulatory commission or in the record of a hearing or similar proceeding conducted by such a commission, or (iii) by any other reasonable method or procedure. Moreover, the Internal Revenue Service will not scrutinize the adequacy of an indemnification in any case in which the parties have attempted in good faith to indemnify or reimburse the utility for the prepayment of tax that results from receipt of the CIAC.

VII. ACCOUNTING TREATMENT OF CIACs BY CUSTOMERS

Sections 1.461-1(a)(1) and (2) of the Income Tax Regulations provide that taxpayers using the cash and accrual methods of accounting, respectively, may not currently deduct the total amount of an expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year. Instead, such taxpayers are required to capitalize such expenditures as assets and deduct the costs of the expenditures over the useful life of the asset in question. See, e.g., Rev. Rul. 70-413, 1970-2 C.B. 103.

Any taxpayer paying a CIAC to a utility is incurring an expenditure which results in the creation of an intangible asset having a useful life extending substantially beyond the close of the taxpayer's taxable year. If a taxpayer incurs a CIAC with respect to property used in a trade or business and is required to replace the CIAC property upon its obsolescence or deterioration, the amount of such payment is capitalized and deducted on a pro rata basis over the useful life of the asset. In such a situation, the useful life of the intangible asset would correspond to the economic life (in contrast to the tax life or recovery period) of the public utility property to which the CIAC creates. See, e.g., Rev. Rul. 69-229, 1969-1 C.B. 86. In contrast, if the taxpayer incurs a CIAC with respect to property used in a trade or business and is not required to replace the CIAC property upon its obsolescence or deterioration, the intangible asset has an indeterminate economic life. In such a case, the taxpayer must capitalize the payment and is not permitted to amortize the amount of the prepaid asset. See, e.g. Rev. Rul. 68-607, 1968-2 C.B. 115.

In the case of a taxpayer (e.g., a real estate developer or home builder) who incurs CIACs with respect to property primarily held for sale to customers in the ordinary course of the taxpayer's business, the cost of the CIAC should be capitalized. The intangible asset should be allocated to the property held for sale to customers and deducted when such property and the related intangible asset are sold.

VIII. TRANSACTIONS NOT AFFECTED BY THIS NOTICE

This notice does not apply to transactions which do not involve CIACs as described under section 118(b) and this notice. Thus, for example, this notice does not apply to "customer connection fees" as defined in section 118(b)(3)(A) of the 1954 Code. (Such connection fees are currently included in gross income by utilities under both the 1986 and 1954 Codes.) Similarly, this notice does not apply to payments made from utilities to their customers. Thus, for example, this notice does not apply to payments made to a public utility in connection with the supply of electricity to such utility by a cogenerating facility under the Public Utilities Regulatory Policy Act of 1978 ("PURPA"), Pub. L. No. 95-617. No inference is intended herein as to the treatment of such transactions.