Many electric cooperatives are facing declining revenues because of energy efficiencies, and increasing costs from infrastructure investments also are a contributing factor. Therefore, expanding their service offerings to include broadband internet services can help generate more revenue. While fiber for broadband internet is probably the most common additional service offered by electric cooperatives, other services that can be built along power lines may be a good fit for electric cooperatives looking to expand their offerings.
A cooperative is typically a nontaxable organization. However, it may choose to be a taxable entity or may be required to become taxable if it meets certain revenue thresholds, i.e., the 85/15 income test. When expanding their services, electric cooperatives will generally place their fiber operations in a separate related entity. This new entity is taxable and at the very least records the revenues generated from the fiber operations. The taxable entity may operate in accordance with one of the following:
- It only records the revenue for fiber operations
- It is a fully operational entity whereby it earns revenue, employs operational and management personnel and incurs all costs associated with its operations
- Its operational depth falls somewhere in between 1 and 2
The electric cooperative and the fiber company are affiliated through ownership, i.e., are related parties, and generally interact in the following way(s): (i) the electric cooperative may provide various management, administrative and/or operational/technical services to the fiber company, and/or (ii) if the electric cooperative owns the fiber network, it may lease the fiber network to the taxable fiber company. In both of these situations, the taxable entity would need to compensate the tax-exempt entity on an arm’s-length basis. Other related-party transactions may exist between these two entity types, such as intercompany loans.
This is where the concept of transfer pricing (the compensation paid by one related to another related party) enters the picture and becomes important. To effectuate proper transfer prices, the two parties need to transact with each other as if they are unrelated parties by setting transfer prices that accord with the arm’s-length standard as outlined in the Internal Revenue Code. The arm’s-length standard is used by tax authorities to analyze whether or not the pricing in a transaction between related parties is consistent with what third parties would agree to in principle. In other words, meeting the arm’s-length standard demonstrates that favor is not being shown with regards to intercompany payments simply because the entities are affiliated, or that profits are not unduly shifted from the taxable entity to the nontaxable entity. Transfer pricing also can be used for tax planning to move an appropriate amount of profit from the taxable entity to the nontaxable entity. The fact that there is a nontaxable entity, i.e., the electric cooperative, interacting in some form with a taxable entity, i.e., the fiber entity, demonstrates the need to show to tax authorities that all transfer prices are arm’s length. Having transfer pricing documentation that analyzes the transfer prices being used for the intercompany transaction(s) is necessary during an examination by the tax authority. Transfer pricing documentation helps an electric cooperative avoid an adjustment and penalties during a tax authority examination.
BKD’s transfer pricing group has considerable expertise helping electric cooperatives establish and document arm’s-length transfer prices for their related party transactions.
For more information on transfer pricing for electric cooperatives or other nontaxable/taxable entities, contact Elizabeth or your trusted BKD advisor.