Tax and Accounting Considerations Affecting Energy Service and Outsourcing Agreements

Customers, as well as energy service marketing and business development personnel, frequently contemplate the structuring of their contract arrangements, including those provisions related to the design, financing, procurement, installation, operation and maintenance of utility subsystem improvements, as being in the nature of a service agreement or operating lease which is "off-balance sheet" to the customer.

In theory, this permits the customer to focus its capital financing resources more directly on its core business and improve the efficiency of utility subsystem operations through the resources and expertise of the energy service provider. The concept of total energy and utility outsourcing is growing in interest among large industrial and commercial entities as utility deregulation creates more opportunities and complex choices for customers.

Energy Service Companies

As energy service companies expand the scope of their customer arrangements beyond the more traditional service arrangements involving electricity, gas, thermal energy and chilled water, to include the design, financing and ownership of energy efficiency, power conversion, power quality, wastewater and water treatment, compressed air and other utility subsystems and equipment, care needs to be taken up-front to analyze applicable tax and/or accounting restrictions in order to ensure the proper characterization of these transactions for book and tax purposes.

This analysis can also be used to confirm assumptions concerning the classification of the transaction that were assumed for purposes of negotiating contract pricing and projecting investment returns. The parties mutual understanding of these limitations upfront may also help avoid future contract disputes and strengthen the long term relationship between the parties.

Lease Versus Service Agreement Classification for Tax Purpose

The Internal Revenue Code ("IRC") provides that a contract which purports to be a service contract shall be treated as a lease if the contract is properly treated as a lease of property taking into account all relevant factors, including whether or not:

1. the service recipient is in physical possession of the property,
2. the service recipient controls the property,
3. the service recipient has s significant economic or possessory interest in the property,
4. the service provider does not bear any substantial diminished receipts or substantially increased expenditures if there is nonperformance under the contract,
5. the service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient, and
6. the total contract price does not substantially exceed the rental value of the property for the contract period.

The presence or absence of any one of these six factors is not necessarily dispositive concerning the contract's classification. In addition, the IRC provides exceptions to these requirements for certain contracts involving the

1. operation of a qualified solid waste disposal facility;
2. sales of electrical or thermal energy from a cogeneration or alternative energy facility; and
3. the operation of a water treatment works facility.

However, these exceptions are not available if the customer (or related entity)

1. operates the facility;
2. bears any significant financial burden if there is nonperformance, other than due to reasons beyond the control (e.g. change in law, force majeure) of the service provider;
3. the customer receives any significant financial benefit (other than due to increased production or efficiency or the recovery of energy or other products) if facility operating costs are less than provided in the contract, or
4. the customer has an option to purchase the property at a predetermined price other than fair market value.

The dedication of the use of the property to the customer for a substantial portion of its economic life, as well as the presence of a contract pricing structure which provides for separate charges for services and the use of the property will tend to point to the contract being classified as a lease.

The IRS has also issued guidelines concerning the criteria that must be satisfied in order for a lease to be considered valid, including, but not limited to, requirements with respect to the lessor's minimum at risk investment, the lessee's investment, purchase and sale rights in the leased property, lessor profit expectations exclusive of any benefits derived from the tax attributes of the transaction, and whether the lease involves limited use property.

Synthetic Leases

Some energy service companies have also considered the use of "synthetic" leases which are treated as an operating lease for accounting purposes and a conditional sale for federal income tax purposes. This allows the lease to be off balance sheet to the energy service company for accounting purposes, while allowing the energy service company lessee to be considered the tax owner of the property and entitled to the benefits of accelerated depreciation. Under this structure, the energy service company ("lessee") enters into a lease agreement with a highly leveraged third party special purpose entity ("lessor"), which is typically created by an independent bank or financial institution. The design and installation of the project is undertaken by the energy service company as agent to the lessor.

Construction financing for the lessor is typically provided through commercial paper or bank loans, with the lessee, or an affiliate, providing any necessary credit support. The energy service company, as lessee, is responsible for the operation and maintenance of the leased property and has specific rights concerning the sublease and sale of the property.

Given the fact that synthetic leases are structured to play off the differences between accounting and tax rules and are more complicated and expensive to structure than traditional leases, their use is typically limited to circumstances involving very capital intensive projects or master lease programs involving multiple projects that individually are too small to justify the up-front legal, financial and accounting costs involved.

A synthetic lease structure also requires a thorough understanding by the lessee of the potential risks associated with lease cancellation rights, renewals and residual value and may create additional complexities in terms of customer contract negotiations relative to the rights of the third party lessor in the leased property.

Lease Classification for Accounting Purposes

In the event that the contract arrangement constitutes a lease, it is then necessary to determine the correct characterization of the lease for accounting purposes. All leases are classified for accounting purposes as either operating leases or capital (financing) leases. If the lease is a capital lease, the lessee records the lease on its balance sheet as both an asset and a liability. If the lease is an operating lease, the lease does not appear on the lessee's balance sheet, although certain accounting disclosures may be required.

FASB Statement No. 13 (FAS 13), Accounting for Leases, requires a lease transaction to be classified as either an operating lease or capital lease. Under this standard, a lease is classified as a capital lease if it meets any one of the following criteria:

• The lease transfers ownership of the property to the lessee by the end of the lease term.
• The lease contains a bargain purchase option.
• The lease term is equal to 75% or more of the property's estimated economic life.
• The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased property.

Under FASB guidelines, the lease term includes, among other things, any periods during which the lessee provides or guarantees the lessor's debt or any periods in which the lessee is subject to an economic penalty for failure to renew the base lease such that renewal of the lease appears reasonably assured at its inception. In addition, FASB Statement No. 13 defines a bargain purchase option as an option that would permit the lessee to purchase the property at a price sufficiently below fair value that the exercise of the purchase option appears reasonably assured at the inception. The minimum lease payments include any payments which the lessee is required to make plus any guaranteed residual or other payments the lessee is required to make to the lessor upon failure to renew or extend the lease.