Private business use of municipally-owned power plants and transmission lines can subject the interest paid on bonds used to finance such projects to federal income taxes.

An example of private business use is where a long-term power purchase agreement is signed to supply the electricity from a municipal power plant to a private company.

No more than 10 percent private business use is allowed.

A joint action agency that supplies,  transmits and distributes electricity for municipal utilities in two states asked the IRS whether several contracts that one of its members signed could be viewed as private business use of a power plant that is owned partly by the joint action agency. The member entering into the contracts is a municipal utility.

The joint action agency financed its share of the power plant using tax-exempt bonds.

The joint action agency signed a long-term PPA to sell the municipal utility a share of the capacity and energy from the power plant. The municipal utility had to pay the joint action agency the same share of the fixed costs (including debt service on the bonds) and variable operating costs of the power plant on a take-or-pay basis, meaning the municipal utility had to pay even if it chose not to take its share of the electricity from the plant.

The municipal utility is required as a load-serving entity — meaning a utility that serves retail customers —  under the rules of the independent system opera-tor that runs the state or regional grid to have an amount of “zonal resource credits” or ZRCs equal to its retail load during the year.

There are four ways for a utility to get the ZRCs it requires: by owning a power plant (in which case it is awarded ZRCs by the ISO), by entering into a take-or-pay PPA to buy power (which the ISO considers equivalent to an owner-ship interest in the power plant), by contracting to buy ZRCs from a third party, or by buying ZRCs in an annual auction run by the ISO.

If it comes up short on number of ZRCs, then it must pay a penalty to the ISO. If it has too many ZRCs, then it can sell the excess in the ISO auction.

The municipal utility signed three contracts.

The IRS said in a private letter ruling made public at the end of September that none of the contracts is a private business use of the power plant owned partly by the joint action agency. The ruling is Private Letter Ruling 201739002. The municipal utility arranged for a tax-exempt electric cooperative to supply all the city’s electricity needs. Thus, it no longer needs the power from the joint action agency’s power plant. Therefore, it will resell that power into the spot market or under short-term contracts.

It plans to enter into a swap with another “G&T” electric cooperative (of which the coop supplying electricity to the city is a member) to swap its floating electricity sales revenue, to the extent it exceeds the amount the municipal utility pays the joint action agency for variable operating costs (but not the fixed costs like debt service on the bonds), in exchange for payments by the swap counterparty for any shortfall in merchant revenue below the variable operating costs.

The resource adequacy burden of having to have enough ZRCs to match the municipal utility’s load will transfer to the coop serving the city. Thus, the ZRCs the ISO issues the municipal utility for entering into the long-term PPA with the joint action agency will free up. The municipal utility plans to sign a long-term contract to sell the ZRCs to the coop.

The IRS said none of these contracts involves any use of output from, or gives the contracting parties any control over, the power plant owned partly by the joint action agency. They are being undertaken on the sidelines of that power plant. The joint agency must have asked the question because electricity is fungible.