Wind Energy Part 2 -- Assignment of the "Tree" or the Income the "Tree" Produces

If I assign “wind rights,” either for a term of years or in perpetuity, have I actually assigned “property” from which income is produced, or have I simply assigned income from that property?

Here, for federal income tax purposes, the concept of “economic interest” and its related concept of “assignment of income” may be instructive or even applicable. The concept of “economic interest” arose to determine to whom the income from the production of minerals is taxable and whether there is “property” that can be depleted (or amortized or depreciated). Even if the term does not apply to wind energy, the concept does. The income that a property produces, for tax purposes, belongs to the person who owns the property for tax purposes and will be taxed to that person. If a person desires to change to whom the income is taxed, they must assign not only the income but the tax ownership of the property that produces the income. For example, if I own real estate that I lease to another, I cannot simply assign the rent income, and not the property that produces the income, if I am to make the rents taxable to the person to whom I made the assignment – or can I?

So, the discussion in the first part of this series regarding the nature of wind rights under state and federal law may be important in determining whether wind rights may be severed for federal income tax purposes, which may be required before the taxation of the income from those wind rights may be transferred to someone else. That is, if state law will not permit the severance and conveyance or retention of wind rights without any surface ownership, will federal tax law follow state law and only tax the person who owns the surface for the rents produced in a wind lease?

Federal tax law, typically, looks to the rights created under local law to determine the federal tax consequences of those rights. But it does not always follow the labels that local law imposes. Thus, it is possible to have a partnership for federal income tax purposes where one does not exist for state law purposes. Likewise, in states where subsurface minerals cannot actually be owned until they are produced, the concept of “economic interest” treats persons as owners even where they may not hold “title” to something under local law. Therefore, it is likely that the severability of wind rights for state law purposes will not govern ownership of wind rights for federal income tax purposes. But it will still be necessary to determine who, for federal tax purposes, owns the various properties or “economic interests,” involved in wind production to determine to whom the income produced by energy will be taxed, and to determine its character.

While the tax law itself determines to whom income is taxable, the tax law first looks to the rights and duties created by local law, and then applies tax law concepts to those rights and duties. Therefore, if, under Texas law, the ownership rights and duties pertinent to the production of energy from wind cannot be assigned separate from ownership of the surface, it may still be possible under Texas law to create sufficient rights in a non-surface owner that they are considered to be an owner of property that produces income for federal tax purposes.

Many of the practitioners in this area recognize this and advise that if one is going to attempt to make a conveyance of “wind rights,” that conveyance should describe those rights in detail. But I would also caution practitioners: I have seen some “severances” of “wind rights” and “wind royalties” that only describe the specific types of income that are being assigned. If you do not convey some bundle of rights that is considered to be property for federal income tax purposes other than just income, you may not have created something that qualifies as property, or an “economic interest,” for tax purposes. If that is the case, you may not have shifted the federal income tax burden.

If you’ve looked at a wind lease, they are, in essence or economically, just ground leases with “bonus” rentals based on the income of the lessee from their use of those rights to produce income. That is, the lessee pays to acquire the rights to use, as a lessee and holder of easements (or perhaps usufructs), certain parts of the surface (or the immediate space above the surface and the immediate subsurface) to construct turbines and related gathering and transmission facilities. Regardless of what the payments for use of the land are called, for tax purposes, they will be characterized according to how payments for the use of land are taxed. In the case of arrangements for the use of land for periods of less than 30 years, they would probably be most analogous to, and be treated as, rents for real property. (More on treatment of longer term leases later.) And, they would probably be treated as such no matter what they are called in the document. That is, even if the documents call them rents, royalties, bonus, etc., they would probably be treated as rents arising from the “sale” of the rights to use the “surface.” And they would be taxed to the person who owns the “surface” that is being leased – or would they?

Wind Contracts As Property for Federal Tax Purposes

Certainly, in the case where the owner of the property leased is also the lessor under the lease, the rents produced by the lease would be taxed to the owner/lessor as something in the nature of rents. But what if that owner/lessor assigns the lease (or a portion of it) to someone else? What if the lease is for a term of 50 years, and it is assigned to someone else? What if the assignment of the lease occurs before the lease is even entered into?

The answers to these questions may depend on whether you can sever the rights to wind energy from the surface to create an “economic interest,” or the like, in wind energy or a royalty interest in the income produced by the wind energy. They may also depend on whether leases with a term of more than 30 years carry some sort of “ownership” or “economic interest” with them for tax purposes.

There are also issues revolving around long term leases. The like-kind exchange rules treat leases of real estate with a potential term of 30 years or more as being of a like-kind to ownership estates in real property. There are indications in the sale and lease-back arena that the IRS would like to treat long-term leases as equivalent to ownership of the real estate involved. Most wind leases have terms exceeding 30 years. In fact, it is not unusual for them to have 50 year terms without regard to options to extend. So this raises the question of whether, for federal income tax purposes, a 50 year lease is actually a sale of property, rather than a lease, and whether the lease itself is property separate and apart from ownership of the surface or the thing being leased. If a long term lease is actually a sale of property, then, instead of a lease producing rental income, I may have entered into an installment sale producing gains and imputed interest income or original issue discount. Such a result would come as a surprise to almost everyone involved; and, with the lack of authority in this new and unique situation, it could be risky to take either position – that the lease is actually a sale or that the lease is actually a lease.

But there does seem to be authority for treating the lease, once entered into as property – at least as property that may be exchanged in a like-kind exchange. And if it may be exchanged in a like-kind exchange, why can’t it be sold in a taxable transaction? Or gifted? Why couldn’t the rights under such a lease be transferred even before such a lease is entered into and exists? And, if sold, wouldn’t any of those properties, if properties for tax purposes, qualify for capital gain treatment?

The answer to these questions become even more uncertain when you consider that wind arrangements usually include the grant of easements in addition to the renting of the surface. Easements are generally considered to be real property estates, which may be severed from the fee ownership. How do these additional rights granted affect the characterization of the transaction as a lease or a sale? Or as the creation of another “property” that can be bought and sold?

These questions will eventually have answers. And the answers for state law purposes may be different from those for federal income tax purposes. I, personally, find it likely that it will be, and in fact already is, possible to convey a bundle of rights for a sufficient period of time that those rights will be considered as property, or an “economic interest,” for federal income tax purposes. But exactly what rights must be conveyed, for what period of time, and in what fashion are, for the time being, undecided.

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?

Noose Tightened Further on Patented Tax Strategies

The Treasury this week issued proposed regulations that would add patented transactions to the list of reportable transactions. As noted in our July 20, 2007 post, Congress is moving towards making tax planning techniques unpatentable. While classifying a transaction as a reportable transaction does not make it incorrect or illegal, the fact that a taxpayer must report a transaction has a chilling effect on taxpayers entering into such transactions. After all, who wants to face the resources of the government to prove they have properly reported a transaction, no mater how defensible their reporting might be?

Under Code Sec. 6011 and its regulations, taxpayers must disclose their participation in reportable, tax-shelter-type transactions by attaching an information statement to their income tax returns. And, just in case the taxpayer fails to report the transaction, Code Sec. 6111 requires material advisors who are involved to disclose reportable transactions to the IRS.

The government explains its adding of patented transactions to those that must be disclosed by claiming concern for taxpayers who might interpret a patent for tax advice or a tax strategy as IRS approval for the transaction. That, in turn, could somehow impede the IRS’ efforts to obtain information on tax avoidance transactions and impact the IRS’ effective tax administration. Thus, it has proposed adding patented transactions as a new category of reportable transactions.

As proposed, a “patented transaction” would be a transaction for which a taxpayer pays (directly or indirectly) a fee in any amount to a patent holder or the patent holder's agent for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of the patent. A patented transaction also would include a transaction for which a taxpayer (the patent holder or the patent holder's agent) has the right to payment for another person's use of a tax planning method that is the subject of the patent. [Excluded from the definition are patents for mathematical calculations or mechanical assistance in the preparation of tax returns, which would exclude patent-protected tax preparation software or other tools used to perform or model mathematical calculations or to provide mechanical assistance in the preparation of tax or information returns.] For this purpose, a patent includes not only a patent that has been issued, but also pending patents.

A taxpayer would be considered to have participated in a patented transaction if his return reflects a tax benefit from the transaction (including a deduction for fees paid in any amount to the patent holder or patent holder's agent). A taxpayer also would be considered to have participated in a patented transaction if he is the patent holder or the patent holder's agent and the taxpayer's tax return reflects a tax benefit in relation to obtaining a patent for a tax planning method (including any deduction for amounts paid to the United States Patent and Trademark Office as required by title 35 of the United States Code and attorney's fees) or reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent.

The proposed regulations also describe when a person is a material advisor regarding a patented transaction under Code Sec. 6111. Because of the nature of patented transactions and how they are marketed, the threshold amount as described in Code Sec. 6111(b) would be reduced from $50,000 to $250 and from $250,000 to $500.

Once the proposed regulations become final, they would apply transactions entered into after Sept. 25, 2007. The material advisor reporting requirements would apply to transactions for which a material advisor makes a tax statement after that same date.