Southwest Power Pool, Inc. TAX GROSS-UP TASK FORCE MEETING January 11, 2007 Conference Call Dial-in: Passcode: AGENDA

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1 Southwest Power Pool, Inc. TAX GROSS-UP TASK FORCE MEETING January 11, 2007 Conference Call Dial-in: Passcode: AGENDA 1:30 PM 3:30 PM CST 1. Call to Order, Introduction...Tim King 2. Review of Agenda...Tim King 3. Approval of Minutes...Tim King 4. Review the Questions/Answers from the 12/19 TGUTF call... TGUTF 5. Review the draft TGUTF Report... TGUTF 6. Review of Action Items...Gerrud Wallaert 7. Future Meetings...Tim King 8. Adjournment...Tim King

2 Southwest Power Pool Tax Gross-up Task Force Tariff Questions Discussed During December 19, 2006 Conference Call 1. With reference to Attachment J to the Tariff (which deals with recovery of cost of new facilities), are "Direct Assignment Facilities" and "Network Upgrades" mutually exclusive? Answer: No. Network Upgrades may be Direct Assignment Facilities when the cost of Network Upgrades is directly assigned to a Transmission Customer. 2. What is meant by "the Transmission Customer shall be charged the full cost of such Direct Assignment Facilities" in Att. J? Up-front payment? Answer: No, "the Transmission Customer shall be charged the full cost does not mean through an up-front payment. 3. What types of facilities are included in Transmission Service Requests in Row 2 of the Upgrade Funding Matrix? Network upgrades? Answer: Upgrades needed in order to fulfill requests for transmission service. 4. Under what provision(s) of existing tariff does a Transmission Customer have the option to make an up-front payment for a requested upgrade? Are we referring to Expedited Service Requests for point-to-point service under section 19.8 of the Tariff? Is there a corresponding provision for Network Service (see section 32 of the Tariff)? Answer: There are no provisions in the existing tariff specifying that a Transmission Customer has the option to make an up-front payment for a requested upgrade. The CAWG has recommended in its White Paper on Attachment Z that Transmission Customers should have that option. 5. Regarding cost recovery for requested upgrades, is the "levelized monthly revenue requirement" in section VI of Attachment Z a fixed obligation of the Transmission Customer to fully amortize the cost of the upgrade over a fixed term, regardless of whether power is transmitted? Does the TC have to post a letter of credit to secure payment of this amount? Answer: Yes and yes. 6. What is a "Directly Assigned Network Upgrade" referred to in Section VII of Att. Z? Answer: "Directly Assigned Network Upgrade" simply means a Network Upgrade [all or part of] the cost of which has been directly assigned to a Transmission Customer. Although this appears as a defined term in Att. Z, no definition is provided and the term is not used elsewhere in the tariff documents. A definition of the term should be added to the definitions in section 1 of the main tariff.

3 7. What is meant by "the annual credit amount to be billed and paid monthly by a Network Customer" in section VII of Att. Z (re Service Crediting) at top of sheet 423C? Are Network Customers charged for credits paid to Transmission Customers? Answer: The credit is for incremental service over and above the transmission service provided to the TC. Subsequent Network Customers are billed an annual credit amount based on incremental impact on the Network Upgrade from new or increased use. 8. Does section VIII of Att. Z regarding future roll-in mean that TC is certain to be repaid in full for requested upgrades? Answer: Not necessarily.

4 Southwest Power Pool, Inc. TAX GROSS-UP TASK FORCE Report to the Regional Tariff Working Group February, 2007 Organizational Roster The following persons are members of the Tax Gross-Up Task Force: [Type Name of Member, Company] [Type Name of Member, Company] Introduction The purpose of the SPP Tax Gross-up Task Force (TGUTF) is to determine whether and to what extent tax gross-up costs on transmission facility upgrades under SPP s OATT may be avoided or minimized. Under its charter adopted on September 21, 2006, the TGUTF is tasked to review existing and proposed tax regulations and FERC precedent regarding tax gross-up costs and to develop and recommend to the RTWG any appropriate methods or tariff changes for SPP and/or its members to avoid tax gross-up associated with funding construction of transmission facilities. A. Review of Tax Rules and FERC Precedent 1. The TGUTF first reviewed existing IRS ruling guidelines regarding the taxability of payments for interconnections or transmission facilities upgrades. The principle relevant tax authorities are section 118(b) of the Internal Revenue Code and its legislative history, IRS Notice as amended by Notice (generator interconnections) and IRS Rev. Proc (network upgrades/transmission credits). Section 118(b) of the Internal Revenue Code was amended in 1986 to make contributions in aid of construction ( CIAC ) to utilities taxable, i.e., to provide that CIAC or any other contribution as a customer or potential customer may not be excluded from income as a contribution to capital. The House Report on the Tax Reform Act of 1986, which is the controlling legislative history, states that the reason for the change was that Congress believed CIACs were really prepayments for service that were going untaxed. The stated intent of the provision is to require a utility to report as taxable any property, including money, it receives to provide, or encourage the provisions of services to or for the benefit of the transferor. The House Report explains that to encourage the provision of service means: if receipt of the property (or money) is a prerequisite to service; if it results in the provision of service earlier than would otherwise be the case; or if receipt otherwise cause the transferor to be favored in any way. The IRS carved out an exception to the general rule of taxability of CIAC for transfers relating to interconnections for Qualifying Facilities ( QF ). In Notice , the IRS held that QF payments for, or transfers of interconnections ( QF transfers ) were made as sellers of power, not as customers, and therefore were not taxable, provided the following safe-harbor conditions were met: 1. The utility entered into a power purchase agreement with the QF with a term of at least ten years; 2. If the interconnection is a dual-use intertie (i.e., the intertie may be used to transmit power from the utility to the QF, such as for back-up power), it is reasonably projected that during the first ten 1

5 years after the intertie is placed in service, no more than 5% of the total power projected to flow over the intertie will flow to the QF; 3. The QF transfer is not included in the utility s rate base; 4. The utility does not claim deductions for depreciation or amortization of the QF transfer; 5. And the QF must capitalize the QF transfer as an intangible and amortize it straight-line over 20 years. In 2001 the IRS issued Notice to amend the QF safe harbor so that it now applies to all standalone generators. A long-term interconnection agreement (at least ten years) may be used in lieu of a long-term power purchase agreement. The IRS added the safe harbor condition that title to the power sold by the generator must transfer to the power customer before it is transmitted on the utility s transmission system. [The latter requirement implies that the IRS views the provision of transmission service as the provision of service to a customer.] The most recent guidance from IRS is IRS Rev. Proc , released in July 2005, providing safe harbor conditions under which up-front payments from generators for network upgrades may be excluded by utilities from taxable income. Rev. Proc discusses FERC Order 2003-B, which was issued December 20, 2004 and requires up-front payments for network upgrades to be repaid in cash, with interest, within 20 years after the commercial operation date of the generator. Accordingly, for interconnection agreements ( IAs ) entered into on or after December 20, 2004, Rev. Proc requires that the IA must entitle the generator to be repaid, in cash, not less than the amount of the upfront payment, with interested computed in accordance with FERC Order 2003-B, in order for the up-front payment to be excluded from taxable income. For pre December 20, 2004 IAs, there must be reasonable expectation of repayment in cash or transferable credits. 2. The TGUTF also reviewed the FERC decisions that established the methodology for computing tax gross-up for interconnection facilities 1, as well as the FERC Standard Large Generator Interconnection Agreement ( FERC LGIA ), as revised to reflect the issuance of FERC Order 2003-C, issued June 16, In particular, sections 5.17 (Taxes), and 11.3 (Network Upgrades) 11.4 (Transmission Credits) of the FERC LGIA were reviewed. B. Tax Analysis of Upgrades The TGUTF then prepared an Upgrade Funding Matrix, a copy of which is attached, identifying six basic types of facilities or upgrades that may be requested under the SPP tariff documents. For each upgrade type, the columns of the matrix list: the funding mechanism and methodology, the cost-recovery methodology, the party likely to be responsible for providing funding, the likelihood of up-front payment and the expected tax gross-up impact. The following explanations provide support for the information in the upgrade funding matrix by reference to the relevant provisions of the SPP tariff (the Tariff ) and the applicable tax authorities. Reliability Upgrades. These are Base Plan Upgrades included in and constructed pursuant to the SPP Transmission Expansion Plan in order to ensure the reliability of the Transmission System (sec. 1.3h of Tariff). Funding of construction costs of reliability upgrades is generally provided by the Transmission 1 Transwestern Pipeline Company, Docket No. RP , 45 F.E.R.C. 61,116, October 28, 1988; Ozark Gas Transmission System, Docket Nos. RP and RP , 56 F.E.R.C. 61,349, September 6,

6 Owner ( TO ) in the TO s zone. Cost recovery is addressed in sections 40 and 41 of the Tariff and Attachment J thereto. The cost of reliability upgrades is recovered through an annual revenue requirement collected through transmission rates. Generally, 33% of the annual revenue requirement is allocated to the Region-wide Annual Transmission Revenue Requirement and 67% is allocated to the Base Plan Zonal Annual Transmission Revenue Requirement. Because there is no up-front payment from a Transmission Customer to fund reliability upgrades, nor obligation on the part of a Transmission Customer to repay a fixed amount, there should be no tax gross-up impact. Transmission Service Requests ( TSRs ). This refers to upgrades needed in order to accommodate requests for transmission service, including facilities required for TSRs associated with new generators. TSRs are classified into two types. The first type is TSRs receiving base plan funding. As in the case of reliability upgrades, up-front customer funding of construction costs for facilities is highly unlikely in the case of a TSR that receives base plan funding. In that case there would be no up-front payment by the Transmission Customer, and therefore no tax gross-up impact. The second category of TSRs is those for which costs of facility upgrades are directly assigned to the Transmission Customer. Construction costs are funded by the TO. Cost recovery is spelled out in section VI.A of Attachment Z. For Point-to-Point service, the Transmission Customer pays the higher of the total monthly transmission access charges of Sections 1 and 7 of Schedule 7 to the Tariff or the monthly revenue requirement associated with the facility upgrades ( or pricing)[?]. Network Integration Service customers will be required to pay the monthly revenue requirement associated with the facility upgrades and the total monthly transmission charges applicable under Sections 1 and 6 of Schedule 9 to the Tariff ( and pricing)[?]. The Transmission Customer would receive credits for incremental transmission revenue resulting from use of the facility upgrades, as provided in section VII of Attachment Z. In accordance with section VI of Attachment Z, the cost of directly assigned facility upgrades associated with TSRs is recovered through an annual revenue requirement. Though an up-front payment from the Transmission Customer is possible 2, it is unlikely. No tax impact is likely unless there is an up-front payment. Requested Upgrades. Requested Upgrades, as defined in section 1.38a of the Tariff, are upgrades requested by a Transmission Customer (or other entity) that do not meet the definition of any other category of Network Upgrades. As provided in Attachment J to the Tariff, the cost of a Requested Upgrade is allocated in accordance with Attachment Z and the TC shall receive transmission credits in accordance with Attachment Z, both in the same manner as for directly assigned upgrades associated with TSRs as described above. Although an annual revenue requirement is the standard cost recovery mechanism for Requested Upgrades under Att. Z, it is likely that Requested Upgrades will be funded by an up-front payment from an unaffiliated Transmission Customer or other entity. [For discussion on January 11 call: An up-front payment would create a potential CIAC tax issue.] Economic Upgrades. As defined in section 1.10 of the Tariff, Economic Upgrades are elective upgrades, identified in the SPP Transmission Expansion Plan, that have potential economic benefit but are not required for reliability reasons. Per Att. J, the cost of an Economic Upgrade is borne voluntarily by the Project Sponsor(s) and the Project Sponsor(s) receive transmission credits in accordance with Att. Z in the same manner as for directly assigned upgrades associated with TSRs as described above. [Discuss funder type during January 11 call.] 2 The November 2, 2006 CAWG White Paper on Attachment Z, at p. 6, recommends that lump sum, up-front payments should be allowed as a contractual arrangement between Project Sponsors, SPP and Transmission Owners. 3

7 Generator Interconnection Facilities. Generator interconnections are governed by Attachment V to the Tariff. Under Attachment V as currently in effect, the Interconnection Customer is required to pay directly for the cost of Interconnection Facilities, as defined to include both Transmission Provider's (Owner s) Interconnection Facilities and the Interconnection Customer's Interconnection Facilities. Interconnection Facilities include all facilities and equipment between the Generating Facility and the Point of Interconnection that are necessary to physically and electrically interconnect the Generating Facility to the Transmission Provider's Transmission System. Transmission Provider's (Owner s) Interconnection Facilities, defined as those facilities from the Point of Change of Ownership to the Point of Interconnection, are typically constructed by the TO and ownership remains with the TO. The IC receives no transmission credits for the cost of Interconnection Facilities. The IC, TO and SPP are required to execute and file with FERC, or file unexecuted, a Standard Large Generator Interconnection Agreement ( LGIA ) in the form of Appendix 6 to Attachment V. The current LGIA is substantially identical to the FERC LGIA. Section 5.17 of the LGIA contains tax provisions addressing CIAC. In particular, in section the IC and TO make the representations necessary to satisfy the safe harbor conditions of IRS Notice , as modified by Notice As a result, no tax liability should result from, and no tax gross-up should be collected on, the IC s payment of the cost of Transmission Provider's (Owner s) Interconnection Facilities. Under section , the TO is indemnified for any tax liability that may arise from subsequent events. Note that TO must agree in writing to be bound by TP requirements this should be included in documentation of each IA. SPP will soon file with FERC a revision of Attachment V. Under the proposed revision the IC will be directly assigned the cost of Interconnection Facilities and Attachment Facilities. The IC would not be eligible to receive credits for the cost of Interconnection Facilities and Attachment Facilities. [Need Bob Tumilty review/comments] Network Upgrades Associated With Generator Interconnections. Under the current Attachment V (LGIA), the cost of Network Upgrades associated with generator interconnections is directly assigned to the Interconnection Customer and funded by an up-front payment to the TO. The Interconnection Customer is entitled to transmission credits under section 11.4 of the LGIA equal to the amount paid for Network Upgrades, plus interest at the rate required by FERC. The credits are paid on a dollar-for-dollar basis for the non-usage sensitive portion [what does non-usage sensitive portion mean?] of transmission charges. Full reimbursement may not extend 20 years from COD. Since the transmission credit provisions of the current LGIA are identical to the FERC LGIA as modified by Order 2003-B, they match up with the conditions of the IRS Rev. Proc Thus payments under the current LGIA from Interconnection Customers for Network Upgrades should be excludable from taxable income by Tos and no tax gross-up should be required. Under the proposed revision of Attachment V, upgrades required to relieve stability and short circuit problems will be mandatory upgrades, which will be required as part of the generator interconnection. Funding would be handled as a Requested Upgrade under Attachments J and Z to the Tariff [annual revenue requirement or optional up-front payment?]. Transmission crediting would also be governed by section VII of Attachment Z in the same manner as for Requested Upgrades, i.e., credits would be received for incremental transmission revenue. Any other upgrades would be identified and addressed through the Transmission Service Request process. [TGUTF needs to address the likely tax treatment of transmission credits under Attachment Z for incremental transmission revenue.] 4