WASHINGTON -- A local authority's contract to supply a U.S. Navy power plant with fuel will not cause its proposed bond issue to be treated as federally guaranteed and therefore taxable, the Internal Revenue Service said in a recent private-letter ruling.

The bonds would finance pollution control equipment at the power plant.

Under the tax law, bonds are not tax-exempt if they are federally guaranteed. The aim of the restriction is to ensure that a state or local government is not double-dipping into the federal coffers.

But in this case the IRS found that the take-or-pay contract that obligated the Navy power plant to purchase fuel from the local authority's refuse-derived fuel plant would not constitute a federal guarantee. The letter ruling was based in part on the finding that federal payments for the fuel are not fixed and are contingent upon production according to specifications.

The letter ruling did not identify the local authority, which it said was created by eight communities, or reveal that the purhaser of the refuse-derived fuel was the Navy. But sources familiar with the ruling said it involved the Navy.

Henry S. Klaiman, a lawyer with Brown & Wood in New York, which is a law firm that was involved in the ruling request, declined to identify the authority but said the ruling "is significant" and represents a turnaround by the IRS.

"This was a long time coming." Klaiman said, adding that the IRS "finally recognized facts as being important in looking at whether there is really a federal guarantee here."

Klaiman said the authority tried for years to get the IRS to allow it to issue tax-exempt bonds for the refuse-derived fuel plant, but was unsuccessful until now. Twice in the past, the authority was able to issue tax-exempt bonds for the plant but only because it was permitted to do so under transition rules and other provisions written into the tax laws by Congress, he said.

In the current case, the authority wanted to issue tax-exempt bonds to finance some pollution control equipment for the Navy power plant so that the plant could meet newly imposed Environmental Protection Agency standards while burning the refuse-derived fuel. The plant uses refuse-derived fuel and coal to generate electricity.

The take-or-pay contract between the authority and the Navy power plant obligates the authority to sell, and the power plant to buy, a certain amount of the refused-derived fuel from the authority's plant as long as the fuel meets contract specifications. The price of the fuel is tied to the price of coal.

Under the contract, the Navy power plant has the option to purchase additional refuse-derived fuel and redirect it to a third party or to generate electricity that would be sold to another party.

The contract had to be amended to cover the new pollution control equipment and the issuance of bonds. Provisions were added to require the authority to demonstrate that the pollution control equipment would allow the power plant to burn the refuse-derived fuel without violating EPA standards.

The contract amendments also provided for the Navy to make "buyout" and "setoff" payments in the event the EPA imposed new pollution control requirements that affected the burning of coal at the plant.

The Navy would make a buyout payment covering the retirement of the bonds and some costs if it decided to shut the power plant down rather than pay the cost of compliance with the new requirements and if the authority failed to exercise its option to continue operating the plant.

The Navy would make a setoff payment covering some pollution control expenses if the pollution control equipment that the authority added for the refuse-derived fuel enabled the Navy to continue energy production and meet new environmental requirements for coal at the power plant.

The IRS concluded in the ruling that the take-or-pay contract does not constitute a federal guarantee because the power plant's obligations under the contract do not arise unless the refuse-derived fuel is produced, meets contract specifications, and is delivered.

"Unlike a guarantee, the availability of federal revenue from sales of the [refuse-derived fuel] is wholly dependent upon the continued activity and viability of the authority rather than its default in debt service payment," the IRS said in the ruling.

In addition, the power plant's payments for the fuel are not fixed according to the debt service on the bonds and vary according to the price of coal. And even if the authority were to default on its debt service payments, the quantity and price of the refuse-derived fuel would not be increased, the IRS said.

The IRS also concluded that the buyout and setoff payment clauses of the contract would not constitute a federal guarantee, in part because they are conditional and dependent on the occurrence of certain events.

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