LEXIS-NEXIS® Congressional Universe-Document

LEXIS-NEXIS® Congressional

OCTOBER 19, 1999, TUESDAY

SECTION: IN THE NEWS

LENGTH: 4560 words

HEADLINE: PREPARED STATEMENT OF
JOSEPH MIKRUT
TREASURY TAX LEGISLATIVE COUNSEL
BEFORE THE SENATE COMMITTEE ON FINANCE
SUBCOMMITTEE ON LONG-TERM GROWTH AND DEBT REDUCTION

BODY:

Mr. Chairman, Ranking Member, and Members of the Subcommittee:
It is a pleasure to speak with you today about the current-law tax provisions that may affect transactions undertaken with respect to the restructuring of the electric power industry.
The Administration supports restructuring of the electric power industry. Deregulation and increased competition, as envisioned by the Administration's Comprehensive Electricity Competition Plan, will encourage more efficient production and delivery of electricity resulting in savings for consumers, a more competitive American economy, and reduced greenhouse gas emissions. Almost all States have either adopted restructuring proposals that allow consumers to choose among competing power suppliers or are considering such proposals. Federal action is necessary, however, if State programs are to realize their full potential.
In April, the Administration delivered the Comprehensive Electricity Competition Plan to Congress. As Secretary Richardson noted when the Plan was delivered, the legislation it proposes will provide the tools needed to ensure that electricity markets operate as competitively and reliably as possible. The Administration estimates that creating a competitive electric industry will save consumers $20 billion per year.
Deputy Secretary Glauthier of the Department of Energy and I are here this morning to discuss the tax initiatives in the Administration's electricity restructuring proposals.
Certain Internal Revenue Code provisions may hinder certain transactions that may be undertaken pursuant to the restructuring of the electric power industry. In general, these provisions were drafted at a time when the electric power industry was subject to rate regulation and electric service generally was supplied by a local provider--whether the provider was a taxable investor-owned utility or a tax-exempt government-owned facility or cooperative. Toaddress these situations, the Administration has proposed changes in the rules governing taxexempt financing for electric companies owned by a State or local governmental entity, a provision that would allow unregulated utilities to make deductible contributions to nuclear decommissioning funds, and tax incentives for investments in distributed power and combined heat and power facilities.
TAX-EXEMPT FINANCING
Current Law
Under current law, interest on debts incurred by State or local governments is excluded from income if the proceeds of the borrowing are used to carry out governmental functions and the debt is repaid with governmental funds. If a bond is nominally issued by a State or local government, but the proceeds are used (directly or indirectly) by a private person and interest payments are derived from the funds of such a private person, interest on the bond is taxable unless the borrowing is for a purpose specifically permitted under the Code and certain other conditions are met.
Facilities for electricity generation, transmission, and distribution may be financed with tax-exempt bonds if the financed facilities are used by and debt service is paid by a State or local governmental entity. A facility can satisfy the governmental use requirement even when the electricity it generates or transmits is sold to private persons so long as those persons are treated as members of the general public. The general public for this purpose may include customers, such as large industrial users, that are charged lower rates than others, such as residential customers, under a reasonable and customary rate schedule. Private use occurs, however, when electricity is sold under terms, such as low-rate, take-or-pay contracts, not available to the general public or when facilities are operated by private persons (other than under certain permitted management contracts) or the benefits and burdens of ownership are otherwise transferred to private persons. Such private .use of a facility (including, under the change-in-use rules, private use that begins after an initial period of governmental use) may render the interest on bonds that financed the facility taxable.
Both the Code and Treasury regulations provide certain short term and de minimis exceptions to these general rules. For example, in some cases, up to ten percent of the bond proceeds of an issue may be used for certain private business uses without the entire issuance being treated as a private activity bond. In addition, temporary Treasury regulations issued in 1998 permit bonds outstanding on July 9, 1996 (the date of Federal Energy Regulatory Commission (FERC) action to promote the creation of nondiscriminatory, open-access transmission services) to retain their tax-exempt status when the transmission facilities financed with those bonds are used by private persons in connection with the provision of such openaccess services. Those temporary regulations also provide that bonds outstanding on July 9, 1996, may retain their tax-exempt status notwithstanding certain private use of the generation facility financed by the bonds. The private use must occur in connection with the sale of excess capacity resulting from opening the issuer's power system to competition. The regulations further require that the length of the sales contracts cannot exceed three years, that the issuer issue no further tax-exempt bonds to finance increased generation capacity during the term of thecontract, and that any stranded costs recovered by such sales be used to redeem outstanding taxexempt bonds.
The temporary regulations expire in January of 2001, about 14 months from now. We have received useful comments from interested parties regarding these regulations and will soon begin the process of developing permanent regulations. Regulations, however, are incapable of fully addressing the issues raised by restructuring.
Issues Raised by Deregulation and Restructuring
The rules prescribing favorable tax treatment for bonds issued to finance public power facilities were adopted at a time when such facilities generally were operated to serve a limited, local geographic area. The restructuring of the electric power industry may result in situations and transactions that were not contemplated when those rules were adopted, raising issues that require a re-examination of such rules. Specifically, achieving a restructured electricity industry is hampered by the following three issues that arise with respect to the tax-exempt bond rules:
First, municipal utilities may be reluctant to open up their service territories to competition due to concerns regarding private use of their bond-financed transmission facilities,
Second, some municipal utilities may be unable to compete effectively in a deregulated environment because their bond-financed generation facilities are subject to private-use limitations. Third, because municipal utilities may finance output facilities on a tax-exempt basis, they have a cost of capital advantage over private, for-profit providers of electricity.

The efficiency and equity of a restructured industry depend on leveling the playing field with respect to capital costs while at the same time ensuring that government-owned facilities are not discouraged from fully participating.
To achieve efficient, nondiscriminatory transmission, it may be necessary to turn the operation of government-owned transmission facilities over to independent regional systems operators or in other ways use those facilities in a manner that may violate the private use rules. As traditional service areas of both investor-owned and government-owned systems are opened to retail competition, the latter may find it necessary to enter into long-term contracts with private users of electricity in order to prevent their generation facilities from becoming stranded costs. Without relief from the change-in-use rules, government-owned systems may be unwilling to open their service areas to competition or allow their transmission facilities to be operated by a private party.
To maintain fair competition between government-owned and investor- owned electric companies in a restructured industry, and to avoid unwarranted indirect federal subsidies in this restructured environment, no new facilities for electric generation or transmission should be financed with tax-exempt bonds. Because electric distribution facilities are inherently local andoften commingled with other public services, continued access to tax-exempt financing of such facilities by government-owned electric systems will not distort competitive balance in the industry. Moreover, these distribution facilities will continue to serve customers as members of the general public. Distribution facilities owned by for-profit providers will continue to be subject to rate regulation as natural monopolies. Continued tax-exempt financing of distribution facilities does, however, require a bright-line standard for the distinction between transmission and distribution facilities.
Administration Proposal
The Administration's Comprehensive Electricity Competition Plan proposes the following changes to the tax-exempt bond rules to resolve issues under current law and assure that restructuring of the electric power industry will deliver real savings for all Americans. To address the change-in-use issue, pre-effective date bonds (i.e., bonds issued before the date the proposal is enacted) used to finance transmission facilities would be permitted to retain their tax-exempt status notwithstanding private use resulting from actions pursuant to a FERC order requiring nondiscriminatory open access to those facilities. Under the Administration's broader plan for encouraging industry restructuring, FERC would be given the power to require governmental electric utilities to provide such open access,
To encourage municipal power systems to open their service areas to competition, preeffective date bonds used to finance generation or distribution facilities would be permitted to retain their tax-exempt status notwithstanding private use resulting from the issuer's implementation of retail competition or from the issuer entering into a contract for the sale of electricity or use of its distribution property that will become effective after implementation of retail competition.
These changes will not affect the treatment of a sale to a private entity of a facility financed with tax-exempt bonds. Such a sale will continue to constitute a change in use.
To establish fair competition in a restructured industry, interest on bonds (other than preeffective date bonds) that finance electric generation or transmission facilities would not be exempt. Distribution facilities, defined as those operating at 69 kilovolts or less (including - functionally related and subordinate property), could continue to be financed with tax-exempt bonds under the change-in-use rules of current law. In addition, tax-exempt bonds could be issued to refund bonds issued before the enactment of our proposal, but advance refunding would not be permitted.
NUCLEAR DECOMMISSIONING
Current Law
Under current law, an accrual basis taxpayer generally may not deduct an item until economic performance has occurred with respect to that item. This economic performance requirement defers deductions for costs incurred in decommissioning a nuclear power plant untildecommissioning occurs. A taxpayer that is liable for the decommissioning of a nuclear power plant may, however, deduct contributions to a qualified nuclear decommissioning fund that will be used to pay the decommissioning costs.
A qualified nuclear decommissioning fund is a segregated fund that accepts only contributions for which a deduction is allowable and that is used exclusively for the payment of decommissioning costs, taxes on fund income, payment of management costs of the fund, and making investments. The taxpayer establishing or maintaining the fired must have a direct ownership interest or, subject to certain restrictions, a leasehold interest in a nuclear power plant and must be liable for decommissioning the plant. A nuclear power plant is defined for this purpose as a nuclear plant used predominantly in the trade or business of furnishing or selling electricity at rates that have been established or approved by a public utility commission. The fund is prohibited from dealing with the taxpayer that established the fund. The fund is subject to tax at a flat 20-percent rate. In general, tax is imposed on the fund's net investment income after the deduction of management costs.
The taxpayer maintaining a qualified nuclear decommissioning fund generally must include in income any amount distributed by the fund, other than for payment of management costs. Thus, amounts withdrawn by the taxpayer to pay nuclear decommissioning costs are included in income when the withdrawal occurs. At that time, however, the taxpayer will be allowed a deduction for decommissioning costs with respect to which economic performance has occurred.
Except to the extent provided in regulations, a taxpayer is also required to include in gross income any amounts that are properly includible when (1) the disqualification of a qualified fund results in a deemed distribution of its assets, (2) the taxpayer is required to terminate a qualified fund because decommissioning of the nuclear power plant to which the fund relates is substantially complete, or (3) the taxpayer disposes of the nuclear power plant to which a qualified fund relates.
The regulations provide rules that apply when a taxpayer disposes of a nuclear power plant and, in connection with the disposition, transfers its interest in a qualified fund relating to that plant. If the transferee is eligible to maintain a qualified fund and continues to maintain the fund after the transfer while satisfying certain other conditions, the transfer of the fund is treated as a nontaxable transaction. The transferor does not recognize any gain or loss on the transfer and the transfer is not treated as a distribution of fund assets with respect to which an inclusion in gross income is required. The transferee also does not recognize any gain or loss on the transfer and takes the transferor's basis in the fund. Under the regulations, the IRS may, if necessary and appropriate to carry out the purposes of the statutory and regulatory provisions relating to qualified funds, apply these rules (and permit continued qualification of the fund) even in cases in which the transferee would not otherwise be permitted to maintain a qualified fund.
The amount that may be contributed to a qualified nuclear decommissioning fund for a taxable year is limited to the lesser of the cost of service amount or the ruling amount. The cost of service amount is the amount of nuclear decommissioning costs included in the taxpayer's cost of service for ratemaking purposes for the taxable year. The ruling amount is the amountthat the IRS determines to be necessary to provide for level funding of an amount equal to a specified percentage of the nuclear decommissioning costs of the taxpayer. The percentage of nuclear decommissioning costs that can be funded through a qualified fund is determined by dividing the period during which the fund is in effect by the useful life of the nuclear power plant. In general, the effect of this limitation is that qualified funds cannot be used to fund nuclear decommissioning liabilities that relate to taxable years beginning before the enactment in 1984 of the provision permitting taxpayers to establish such funds. The IRS specifies a schedule of ruling amounts in a ruling issued to the taxpayer. If circumstances change, a taxpayer may request a revised schedule of ruling amounts. In addition, the schedule is reviewed at intervals of no more than 10 years (5 years if, instead of a schedule prescribing a dollar amount for each taxable year, the IRS has approved a formula or method for determining the schedule of ruling amounts).

Taxpayers may set aside funds for nuclear decommissioning in addition to the amounts they contribute to qualified funds. In some instances, State or Federal regulators require such additional funding. In addition, some taxpayers maintained segregated nuclear decommissioning funds prior to the effective date of the qualified decommissioning fund rules. In the case of amounts irrevocably set aside for nuclear decommissioning before July 19, 1984 (the effective date of the economic performance requirement), taxpayers may have taken the position that a deduction was allowable at the time the funds were set aside. Alternatively, taxpayers may have taken the position in taxable years ending before that date that such amounts, if set aside to comply with State or Federal regulatory requirements, were not includible in gross income. Since 1984, no deduction or exclusion from gross income has been allowable with respect to contributions to, or segregation of amounts in, nonqualified funds and the income of a nonqualified fund is taxed to the taxpayer at the taxpayer's marginal rate.
Issues Raised by Deregulation and Restructuring
The rules prescribing favorable tax treatment for qualified nuclear decommissioning funds were adopted at a time when almost all nuclear power plants were operated by regulated public utilities and a nuclear power plant and decommissioning fund would not be transferred except between regulated public utilities. Deregulation and restructuring of the electric power industry have resulted in situations and transactions that were not contemplated when those rules were adopted. These novel circumstances have given rise to a number of questions, including the following:
May an unregulated taxpayer maintain a qualified nuclear decommissioning fund? This issue may arise when, as part of deregulation, a nuclear power plant and the related decommissioning fund are transferred from a taxpayer subject to rate regulation to an unregulated taxpayer. Alternatively, a taxpayer that was previously subject to rate regulation with respect to electricity produced at a nuclear power plant may, because of deregulation, no longer be subject to such regulation.
Does the transfer of a qualified nuclear decommissioning fund to an unregulated taxpayer result in recognition of gain or loss by the transferor or the fund? Is such a transfertreated as a distribution of fired assets required to be included in the gross income of the transferor?
Is the transferor of a nuclear power plant entitled to a deduction for decommissioning liabilities assumed by the transferee?
To what extent may the purchaser of a nuclear power plant derive an immediate tax benefit from assumption of the seller's decommissioning liabilities?
May an unregulated taxpayer make deductible contributions to a qualified nuclear decommissioning fund? This issue also arises with respect to both previously regulated taxpayers and unregulated transferees.
Guidance under Current Law
Under current law, the IRS may permit the transfer, without disqualification, of a qualified nuclear decommissioning fund, together with the nuclear power plant to which it relates, to a taxpayer that is not a regulated public utility. In addition, the IRS may permit the unregulated transferee to maintain the qualified fund after the transfer. In the cases that have been brought to our attention, it is our view that such treatment is both necessary and appropriate to carry out the purposes of the statutory and regulatory provisions relating to qualified funds. Similarly, a regulated taxpayer that becomes unregulated should also be permitted, in appropriate cases, to continue maintaining a qualified fund.
The IRS may similarly permit the transfer of a qualified nuclear decommissioning fund from a regulated taxpayer to an unregulated taxpayer to qualify as a nontaxable transaction that (1) does not result in recognition of gain or loss by either the transferor or the fund and (2) is not treated as a distribution of fired assets required to be included in the gross income of the transferor. If the transaction is nontaxable, the basis of fund assets will not change and the transferee will take the transferor's basis in the fund. Again, in the cases that have been brought to our attention, it is our view that such treatment is necessary and appropriate under current law.
Under current law, the seller of a nuclear power plant will be allowed a current deduction for any amount treated as realized or otherwise recognized as income as a result of the purchaser's assumption of the seller's decommissioning liability. The economic performance rules would ordinarily defer the seller's deduction until decommissioning occurs. However, regulations provide that, if a trade or business is sold and the purchaser assumes one of its liabilities, economic performance occurs with respect to the liability when the amount of the liability is included in the amount realized by the seller.
Under current law, a liability is not treated as incurred until economic performance occurs with respect to the liability. Thus, the purchaser of a trade or business is not allowed a deduction for liabilities assumed in connection with the purchase until economic performance occurs with respect to the liabilities. The regulations clarify, in the case of nondeductible items, that the economic performance requirement also defers the tax benefit of an increase in basis. The regulations state, "an amount a taxpayer expends or will expend for capital improvements toproperty must be incurred (i.e., economic performance must occur) before the taxpayer may take the amount into account in computing its basis in the property." In the case of decommissioning liabilities assumed in connection with the purchase of a nuclear power plant, the regulations suggest that the liabilities may not be taken into account in determining the basis of the acquired assets until decommissioning occurs.
Deregulation will generally eliminate traditional cost of service determinations for ratemaking purposes. Because the amount of the deductible contribution to a qualified nuclear decommissioning fund is limited to the amount of nuclear decommissioning costs included in the taxpayer's cost of service for ratemaking purposes, deregulation may result in complete loss of the deduction for contributions to the fund. In many cases, a line charge or other fee will be imposed by a State or local government or a public utility commission to ensure that adequate funds will be available for decommissioning. This charge or fee could be viewed as the equivalent of an amount included in cost of service for nuclear decommissioning, but there is no assurance that all State deregulation plans will provide for such a funding mechanism.
Administration Proposal
The favorable tax treatment of contributions to nuclear decommissioning funds recognizes the national importance of the establishment of segregated reserve funds for paying nuclear decommissioning costs. Although the favorable tax treatment was adopted at a time when nuclear power plants were operated by regulated public utilities, deregulation will not reduce the need for such funds. Accordingly, the Administration's Comprehensive Electricity Competition Plan proposes to repeal the cost of service limitation on deductible contributions to nuclear decommissioning funds. Under the Administration proposal, unregulated taxpayers would be allowed a deduction for amounts contributed to a qualified nuclear decommissioning fund. As under current law, the maximum contribution and deduction for a taxable year could not exceed the ruling amount for that year. The new rules would apply in taxable years beginning after December 31, 1999.
DISTRIBUTED POWER AND COMBINED HEAT AND POWER PROPERTY
The Administration's Plan also includes two tax proposals intended to reduce current barriers to the development of distributed power and combined heat and power technologies. Distributed Power Property
Newly developed distributed-power technologies have made it possible to place electricity generation assets in or adjacent to commercial and residential establishments, as well as in industrial settings. The current depreciable property classification system, however, does not adequately account for these assets, particularly when they are used to produce both electricity or mechanical power and usable heat. Also, under current law, distributed power assets used to produce electricity in a commercial or residential setting are likely to be depreciated over much longer lives than are similar, or identical, assets used to produce process energy in an industrial setting.The Administration's Plan proposes to clarify that distributed power property has a 15-year depreciation recovery period. Such property would include assets used to produce electricity that is primarily used in a building owned or leased by the taxpayer. Such assets may also be used to produce usable thermal energy. To avoid abuse, at least 40 percent of the total energy produced would have to consist of electrical power, and no more than 50 percent of the electricity produced could be sold to, or used by, unrelated persons.
This proposal will simplify current law by clarifying the assignment of recovery periods to distributed power property. It will remove taxpayer uncertainty, reduce future tax litigation, and level the playing field for distributed power assets. It should also encourage the use and development of more energy-efficient and less polluting electrical generation technologies.
ClIP Investment Tax Credit
Combined heat and power (CHP) systems utilize thermal energy that is otherwise wasted in producing electricity by more conventional methods. Such systems achieve a greater level of overall energy efficiency, and thereby lessen the consumption of primary fossil fuels, lower total energy expenditures, and reduce carbon emissions. The Administration's Plan proposes a temporary tax credit for investments in CHP equipment. The eight-percent credit would be available for investments in large CHP systems that have a total energy efficiency exceeding 70 percent and in smaller systems that have a total energy efficiency exceeding 60 percent. It would be available for qualifying investments made through 2002. To prevent abuses, a qualifying CHP system would be required to produce at least 20 percent of its total useful energy in the form of thermal energy and at least 20 percent of its total useful energy in the form of electrical or mechanical power.
The CHP investment tax credit is expected to accelerate planned investments and induce additional investments in such systems. The increased demand for CHP equipment should, in turn, reduce production costs and spur additional technological innovation in improved CHP systems.
We urge Congress to enact the tax proposals I have outlined in my testimony. These proposed changes are needed to encourage restructuring plans that are being developed by individual States and to permit those plans to realize their full potential.
Mr. Chairman, this concludes my prepared testimony. I will be pleased to answer any questions you or other members of the Subcommittee may have.
END

LOAD-DATE: October 21, 1999