Tax Law and Business Organization Strategy

Thoughts and Questions on the Tax Aspects of Wind Energy

Wind energy is quickly becoming big business in the part of Texas west of the Dallas-Fort Worth to San Antonio corridor. I live in Amarillo and my children live in Austin and San Marcos. My in-laws live in Kingsland and the surrounding area. Each time I make the drive, the wind farms from Snyder through Sweetwater and Abilene are larger than the last time I made the drive. My law partner whose children live in San Angelo says the same thing each time he makes that drive. Speaking from personal experience, the wind blows even more in the Texas Panhandle than it does in those areas. There are projections for as many as 7,000 wind turbines in the Panhandle. Each turbine can produce as much as 2 megawatts. (A megawatt meets the electricity needs of about 240 homes.) So, it would seem only a matter of time (and transmission lines) before the wind farms in my neck of the woods exceed the size of those in central West Texas. The wind energy production capacity of Texas is already the largest in the nation, and seems destined to grow even larger and at a rapidly increasing rate. Boone Pickens has plans for a 4,000 megawatt wind farm in the northeast Panhandle, which includes plans for privately constructed transmission lines. (That is roughly the equivalent of two Comanche Peak nuclear power plants and enough juice to power several hundred thousand homes.) Wind energy, a renewable or, more likely, constant resource, has the potential to exceed the economic activity that oil and gas and now water has and is already pumping into the West Texas economy.

As a result, my firm is being called on more and more to advise land-owners and wind energy developers regarding wind energy activities. That means that I, as a tax practitioner, must begin to understand the tax implications of those activities, whether the practitioners involved in the agreements regarding wind energy development realize the importance of tax planning in those relationships as yet.

When I first began considering the tax implications of wind energy development, I assumed that the property rights and tax aspects of those activities would be analogous to other energy related mineral activities – i.e., oil and gas. However, the more I understand the technology and the relationships involved, the more I become convinced that we will experience the development of an entirely new area of law, and related tax law. While oil and gas law and its associated tax law are without a doubt instructive, the analogy is imperfect and may begin to break down as the industry becomes more mature.

There are many considerations that have to be taken into account when advising those involved in wind energy development. The developers, because of the large amounts of capital and financing necessary to develop, build, and operate wind farms (now in the neighborhood of $2 million dollars to simply construct a single wind turbine) are represented by large law firms with their large legal resources. But, landowners who are negotiating with wind energy developers, tend to rely on their personal advisors who may be well versed in real estate law and oil and gas law, but who are just beginning to understand the current implications of the legal attributes of wind development. Most of them are certainly not tax experts. And, even if they were, they might not fully comprehend all of the implications of wind energy, particularly as those implications have not been fully developed as an area of tax practice.

About the only thing we can currently be certain of regarding the tax implications of wind energy, particularly as they apply to land owners, is that the law is uncertain because of the novel concepts involved. What this article (including its related entries) hopes to achieve is to first dispel the idea that mineral energy deals are the same as wind energy deals and then to expose some issues where that difference might produce some tax planning opportunities. As I am dealing principally with large concepts in a new area of activities where there is not a lot of decided law, I am not even going to attempt to cite decided law. So, you are not going to see any citations to decided law.

 Wind Energy v. Oil and Gas Development

Is wind energy development and production analogous to oil and gas development and production or is it something else?

Mineral exploration, development, and production have a long history under the tax law. Over the years, several tax concepts that are unique to this industry have developed: notably the concept of “economic interest” and the “pool of capital” doctrine. The concept of “economic interest” was introduced into the tax law to determine who is taxable on the mineral income from the property and who is entitled to claim a depletion deduction on mineral production. It is the tax law’s way of determining “ownership” of the minerals to be produced from land.

If you are the owner for income tax purposes, you must pay the tax on your share of production. For example, if I am a working interest owner or a royalty owner, my share of production is taxable to me, directly, as my share of production. It is not income to the operator, who then makes a payment to me, resulting in income to me and a deduction to the operator. As a working interest owner or royalty owner, I own part of the “tree” that produces the “fruit.” Therefore, I am taxable on the fruit, even though it may actually be harvested by someone else who has been conveyed the legal rights and “ownership” necessary to do so.

So, does this concept have any relevance in the context of wind energy development? It is easy to conclude that since wind is a renewable resource, there is no depletion, and, therefore, no depletion deduction on which the concept of “economic interest” would depend.[1] And, certainly, it is important to know who owns the wind energy rights to know to whom the income from the transfer of those rights is taxable. But “economic interest,” at least in the mineral extraction context, may not be the correct concept to apply to determine who is taxable on the income from the energy produced. The income from wind energy production does not accrue from the mining a natural resource and the selling of that extracted mineral to which title, in Texas, can be held both while it resides in the ground and when it is extracted from the ground. The very concept of what produces the income from wind energy may be very different from that which produces income in mineral production.

While the ultimate result of both oil and gas production and wind energy activities is energy, that is about as close as each of them get. In the case of oil and gas, there is actual tangible property that resides under the surface of the ground to which title can be held and conveyed. Oil and gas activities consist of discovering where that property resides, extracting it from the ground, and then selling the now tangible personal property to someone who will use it to make energy or some other product. In Texas, ownership of the oil and gas prior to extraction resides in the owner of the fee simple, unless and until those rights are severed and retained or transferred to someone else. So, the oil and gas itself, and not just the energy that it represents, are property that is owned by someone even before discovery and production, and it continues to be property owned by someone as real estate until they are extracted. Extraction turns the minerals into personal property, but they are still property, title to which can be owned as such.

Certainly there are some similarities here between oil and gas production and wind energy activities; but the differences are striking. And those differences may result in significantly different tax consequences for the parties involved in those activities. Conceptually, the air that sits on a person’s land (and goes all the way up to the end of the atmosphere and the beginning of “space”) is property just as much as is the gas that resides, initially, under the surface of the land. But the air itself is not acquired as such and sold to produce wind energy. Rather, the energy contained in the flow of the air is harnessed and converted into another type of energy, electricity. That electricity is sold, not the air itself.

So, is this air or the energy represented by the movement of the air owned by the fee owner like the gas below the surface is owned by the fee owner? There is, as yet, no clear authority on this subject in Texas. I believe that law regarding water might contain concepts that are applicable to this question.

In the case of water in Texas, the fee owner owns the water under the surface of the land. In fact, subsurface water that does not flow in an underground river or stream is treated just like a mineral or natural resource analogous to oil. But surface water is treated differently. Surface water, except that falling from the sky and captured before it flows into a watercourse, actually belongs to the state. The fee owner has riparian rights to use the surface water for the benefit of the surface estate. But the owner does not hold title to that water. The surface owner also has the right to use any water flowing over his property to produce energy. Thus, for example, a surface owner may construct a water wheel that extracts the energy from flowing water to grind grain. And the surface owner may even, in proper circumstances, construct a dam to capture the hydraulic energy of the water’s flow to produce electrical energy.

Applying similar concepts to wind would mean that the air above the fee owner’s surface does not actually belong to the fee owner. Rather, the surface owner has rights to the use of the air, and the energy it produces, like a surface owner that abuts a watercourse has riparian rights to use the water and energy in the watercourse. But the surface owner may not actually own title to the air that flows over the surface, only rights to use that air and the energy it may produce, so long as that use does not infringe on other surface owner’s similar rights and does not infringe on the rights of everyone to navigate that air. In fact, there is a long history of surface owners constructing wind mills to use wind energy to pump water from beneath the surface. These wind mills are icons of West Texas. Certainly, no one, as yet, has attempted to impinge those rights by arguing their use somehow infringes on other’s similar rights to harvest the energy from the air moving over the surface of the land. On the other hand, there does not appear to be any clearly established law that would grant title to the air to the fee owner under which the air flows. And, so far, our technology has not risen to the point where it would make sense to dispute air ownership, one way or the other. It is not yet economical to make such a use of the air flowing over one’s land that it could infringe on other’s similar rights to make use of that air. You can’t yet “capture” air on your land to the extent that it would drain the air or the energy from its flow from other land owners. If one could, would we find that the common law actually gives someone title or rights to do so?

So, what if there is an entire body of common law that has yet to be “made” by our common law judges or our legislature? (The law of ventian rights?) If there is, and that’s an awfully big and potentially consequential “if,” what difference does it make, particularly under today’s technologies? It could mean that one does not actually “own” the air and the energy it produces – only the rights to use it if one owns the surface, or at least that part of the surface estate to which those rights attach.[2] Perhaps, practically, it only means that one should not assume that the established laws regarding oil and gas and estates of real property apply to this new economic endeavor. In any case, I will leave the defining of ventian rights and estates to the scholars of that subject (or rather those who become scholars on this new subject).

Do these concepts would have any tax consequences? Certainly they could. But what would they be? What will follow is my current list of wind energy related tax issues. I do not pretend to yet have the answers. Only an idea of where the answers may lie. I’m sure I (and you) will add to these questions as the wind industry develops, our knowledge increases, and the courts and legislatures begin to provide answers.

Link to Part 2 of this discussion on Taxation of Wind Energy.

Link to Part 3 of this discussion on Taxation of Wind Energy.

Link to Part 4 of this discussion on Taxation of Wind Energy.

Link to Part 5 of this discussion on Taxation of Wind Energy.

Link to Part 6 of this discussion on Taxation of Wind Energy.

Link to Part 7 of this discussion on Taxation of Wind Energy.

[1] Although, it would certainly be possible that that the acquisition costs of wind energy property would be amortizable, even if not depletable.

[2] If that is the case, it raises at least one interesting question regarding the use of technology that has already been developed to “store” wind energy for sale at the times that energy use is most needed. Wind farms tend to produce the largest amount of electricity at night. (Contrary to our common observations, the wind blows more at night than during the day at the elevation that wind turbines operate.) But the demand for electricity is highest during the day. Technology now exists that allows one to “store” the energy produced by the wind at night. The wind harvested at night is used to compress air. When the compressed air is released, it is run through electricity generating turbines. Thus, the energy produced by wind at night can be turned into electricity by day.

If the surface owner does not own the air, then is it conversion or the like for the surface owner to capture the air above the surface of the fee and store it underground? Does it then belong to the surface owner or the mineral owner? Or does the surface owner actually own the air once captured, even though he doesn’t own it in its natural state?

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