In the context of renewable energy project development, power purchase agreements (“PPAs”) are the cornerstone upon which the project is built and operated. PPAs are contracts through which the developer or ultimate owner of a project sells power generated by the project to another party. PPAs typically represent the primary, and sometimes sole, revenue source for the project. Accordingly, PPAs should be drafted in a manner that recognizes their critical importance to both the project developer or owner and power purchaser.
A recent Internal Revenue Service ruling discussed the importance of PPAs to a taxpayer that purchased a renewable energy project developer and its affiliates (“Target”). According to the ruling, Target had entered into several PPAs with various third parties. These PPAs were clearly important assets in the Taxpayer’s decision to purchase the Target. The ruling answered the taxpayer’s question: Whether any portion of the purchase price of Target should be allocated to the PPAs?
Attributes of the PPAs
The ruling discussed some of the important attributes of PPAs that are commonly found in PPAs for traditional and renewable power. For instance, the PPAs were considered to be facility-specific PPAs, which means Target was required to sell – and purchasers were required to purchase – power from a specific generation facility. In fact, under the PPAs, Target was prohibited from obtaining capacity, energy, or environmental attributes from other sources.
In addition to energy output, these PPAs provided for the sale and purchase of capacity. That is, in addition to the purchase of power actually generated by the facility (MWh), the PPAs also required the purchase of the facilities’ output potential. Finally, because the facilities were powered by wind, these PPAs provided for the transfer of environmental and renewable attributes (e.g., green tags).
The ruling even discussed, to a limited extent, the pricing mechanism of the PPAs. They contained a specified price up to the maximum amount of output. For any amount of output delivered in excess of the maximum, the PPAs provided for a pricing adjustment to account for the then-current market price.
Allocation of Purchase Price to PPAs?
The primary issue of the ruling involved the allocation of the purchase price among the assets of the Target, including the PPAs. Taxpayer asked the Service to determine if any portion of the purchase price of Target should be allocated to the PPAs. The Service ruled that no portion of the purchase price should be allocated to the PPAs in this particular circumstance.
The Taxpayer was obviously concerned with the allocation of purchase price to the PPAs because it would have an impact on depreciation. The Service compared the facility-specific PPAs to leased property. Where acquired property is subject to a lease, the Code provides that no amount of the adjusted basis is allocated to the leasehold interest, and that for depreciation purposes, the entire adjusted basis is attributed to the property itself.
Relying on the particular attributes of the PPAs, the Service ruled that the facility-specific PPAs in this ruling should not be treated as assets separate from the facilities themselves. Specifically, for depreciation purposes, any amount of the purchase price that would otherwise be attributed to the facility-specific PPAs should be taken into account as part of the basis of the facilities.
The ruling provides a rare insight into the common provisions of PPAs that involve the purchase of renewable energy. It also serves as a reminder of the importance of PPAs for renewable energy project development, and the importance of including crucial provisions in renewable energy PPAs. Finally, purchasers of energy companies may find the ruling helpful in forecasting after-tax net income, including the tax effects of depreciation.