WASHINGTON -- The Internal Revenue Service has ruled for the first time that a privately owned cogeneration facility can be financed with tax-exempt private-activity bonds because it is considered part of the local utility system that contracted to purchase its power.
Several bond lawyers said the letter ruling, which was published this week without identifying the parties involved, is important because the IRS is going further than it has in the past in saying that a cogeneration facility in and of itself qualifies for tax-exempt financing.
The letter ruling is in step with federal energy laws that encourage utilities to buy power from cogeneration facilities, the lawyers said. Such facilities are waste heat from industrial processes to produce electricity.
"It's quite significant," said John MacMaster, a lawyer with Winthrop, Stimson, Putnam & Roberts in New York.
"It's a constructive step for the IRS to take," he said. "There will be a fair amount of discussion about this ruling."
The IRS concluded in the ruling that the cogeneration facility would qualify as a "facility for the furnishing of electric energy or gas."
Under federal tax laws and IRS rules, "facilities for the local furnishing of electric energy or gas" can be financed with tax-exempt private-activity bonds only if they serve an area no greater than two counties. They can also be part of utility systems that serve an area of that size.
Until now, some lawyers have worried that cogeneration facilities that are owned by private parties rather than utilities and that do not directly serve the general public might not meet these requirements.
But the IRS concluded in its letter ruling that the cogeneration facility would be part of the local utility system "through its sale of electric energy to [the] utility."
The cogeneration facility was to be built by a private partnership which hoped to finance the construction with the proceeds of private-activity bonds issued by an authority, the ruling says.
The net electric energy output of the cogeneration facility was to be sold to the local utility system under an agreement between the utility and the partnership, according to the ruling. The total utility system was a municipal utility that served customers in one county.
In reaching its conclusion, the IRS did not seem troubled that the partnership might sell the process steam produced by the cogeneration facility to a private company. The partnership had told the IRS that the process steam would either be sold to the company, used to reduce emissions, or condensed and used for a heat recovery steam generator.
The IRS also was not concerned that the municipal utility sometimes purchased or sold power to an investor-owned utility to meet peak demand for power. The investor-owned utility had a pooling agreement with utilities in other states.
The IRS said that "such activity does not expand [the] municipal utility's service area" beyond the two-county limit.
In making that finding, the IRS noted that the municipal utility was a net importer of electric energy from the investor-owned utility and that any obligations to supply power to the investor-owned utility would not affect its primary mission to serve local customers.
The lawyers said they were pleased the IRS was not troubled by the municipal utility's power-sharing arrangements.
"The IRS is continuing its practice of allowing power sales and pooling arrangements so long as the two-county utility is a net importer of electric energy," said Mr. MacMaster. "So far, the IRS has only permitted this for short-term and other efficiency sales."
The IRS included its standard statement that the ruling is directed only at the taxpayer that sought it, which in this case is the bond-issuing authority and private partnership. But bond lawyers said they sometimes rely on letter rulings such as this one when they addresses areas of the tax law where other guidance is unavailable.