Over the last twenty-five years, the electric power industry has been transformed from one that favored vertically-integrated monopolies to one that now generally endorses competitive generation supply. The evolution of the industry has created new suppliers of power and new forms of grid ownership and governance. One of the issues generators have had to confront through this evolution is that of interconnecting a new plant to the grid. Without an interconnection, few generators would be able to serve load.
The Federal Energy Regulatory Commission (FERC) is currently considering the standardization of interconnection agreements and policies through a rulemaking proceeding.1 Among other things, the FERC recognizes that a generator's payment for a grid owner's interconnection facilities has federal income tax implications.2 The FERC's approach has been to allow parties to an interconnection agreement to include tax gross-ups or indemnity provisions.3 While the FERC's order in the Interconnection Rulemaking may provide clarity with regard to which party bears the risk and the economic burden of taxes associated with an interconnection, it will not address the taxation of an interconnection per se. Instead, taxpayers, the Internal Revenue Service (IRS or Service), and perhaps Congress must address the federal income tax consequences of an interconnection transaction.
Taxes associated with interconnections will inherently affect the cost of power from, and the cost of entry for, competitive generators. Accordingly, utilities, generators, and consumers should each want the lowest possible tax burden. In addition, the tax liability is often significant and will affect the amount that needs to be recouped in either the generator's or the transmission owner's rates The parties to an interconnection agreement generally desire IMAGE FORMULA4
certainty as to the tax consequences for two reasons. First, if the tax liability falls on the utility and there is no gross-up or indemnity provision, the regulated utility would want to reflect this expense as soon as possible in its next-filed rate case. On the other hand, if the tax liability ultimately falls on the generator, the generator would want to know its full costs associated with constructing its plant (including taxes) before entering into long-term sales agreements for its output. To accommodate the need for certainty, the IRS has issued several IRS notices that provide details of safe harbor electric interconnection transactions that are not taxable, the most recent of which is IRS Notice 2001-82.5
A review of the historical regulatory and tax treatment of interconnection facilities since the beginning of the twentieth century may help to frame the analysis of the appropriate tax treatment of interconnections for the modern electric industry. Although safe harbors provide certainty, the IRS has not issued guidance on all issues. Extending the safe harbors to all stand-alone generators, as the Service did in IRS Notice 2001-82, was a welcome and necessary step. But issues that continue to be unanswered by the safe harbors, such as the tax treatment of transmission credits to generators paying for system upgrades, the tax implications for transmission providers not treated as corporations for tax purposes, and the tax treatment of transactions falling outside the safe harbors, must be analyzed under general tax principles.
II. OVERVIEW OF RATEMAKING TREATMENT OF INTERCONNECTION COSTS
A. Interconnection Cost Recovery Prior to Competition
The electric power industry in the United States can trace its roots to the late nineteenth century. From its inception until the 1920s, electric utility regulation existed only at state and local levels.6 For the most part, utilities were very limited geographically and did not have interstate operations. Given the intensive capital investment required, the general belief was that a "natural monopoly" approach to electric service was more efficient economically than a competitive approach. …