Utility rate base must reflect NOL-related deferred tax assets

Plain-English summary

An electric utility used accelerated and bonus depreciation, generating net operating loss carryforwards while maintaining accumulated deferred income tax liabilities for ratemaking. The utility also recorded a deferred tax asset for the portion of those losses that meant accelerated depreciation had not yet produced an actual tax deferral. The IRS ruled that this NOL-related deferred tax asset had to be included in rate base when the full deferred tax liability reduced rate base. The amount attributable to accelerated depreciation had to be computed using the “with and without” method. Excluding the asset, or including less than the amount calculated by that method, would violate the normalization rules by overstating the no-cost capital supplied by ratepayers.

Ruling snapshot

• Question: Must the utility's rate base include the deferred tax asset attributable to accelerated-depreciation NOL carryforwards?
• Outcome: approved, inclusion is required under the represented facts
• Key authorities: IRC § 168(i)(9); Treas. Reg. § 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201709008 Third Party Communication: None
Release Date: 3/3/2017 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
--------------------- ------------------------, ID No. ------------------
----------------------------------------- ---------------------------------------------------
---------------------------- Telephone Number:
------------------------------ --------------------
------------------------------------------------ Refer Reply To:
CC:PSI:B06
PLR-119381-16
Date:
December 02, 2016
LEGEND:
Taxpayer = --------------------------------------------------------------------------------------
Parent = -----------------------------------------------------
State = -----------------
Commission A = -----------------------------------------------------------------------
Commission B = ----------------------------------------------------------------
Date 1 = --------------------------
Date 2 = -------------------
Date 3 = --------------------
Date 4 = --------------------
Date 5 = --------------------
Case = ----------------------------------
Year 1 = ------
Year 2 = ------
Director = ----------------------------------------------------------------------------------

Dear ------------:

   This letter responds to the request, dated June 15, 2016, submitted by Parent on

behalf of Taxpayer for a ruling on the application of the normalization rules of the
Internal Revenue Code to certain accounting and regulatory procedures, described
below.

     The representations set out in your letter follow.

   Taxpayer is an integrated electric utility headquartered in State. Taxpayer is a

wholly owned subsidiary of Parent and is included in Parent’s consolidated federal
income tax return. Taxpayer employs the accrual method of accounting and reports on
a calendar year basis.

   Taxpayer’s business includes retail electric utility operations regulated within

State by Commission A and Taxpayer is subject to the regulatory jurisdiction of
Commission B with respect to terms and conditions of its wholesale electric
PLR-119381-16 2

transmission service and as to the rates it may charge for the provision of such
services. Taxpayer’s rates are established on a cost of service basis.

   On Date 1, Taxpayer filed a rate case application (Case) with Commission B

requesting authorization to change from charging stated rates for wholesale electric
transmission service to a formula rate mechanism pursuant to which rates for wholesale
transmission service are calculated annually in accordance with an approved formula.
The proposed formula consisted of updating cost of service components, including
investment in plant and operating expenses, based on information contained in
Taxpayer’s annual financial report filed with Commission B, as well as including
projected transmission capital projects to be placed into service in the following year.
The projections included are subject to true-up in the following year’s formula rate.

    In computing its income tax expense element of cost of service, the tax benefits

attributable to accelerated depreciation were normalized and were not flowed thru to
ratepayers.

   In its rate case filing, Taxpayer anticipated that it would claim accelerated

depreciation, including “bonus depreciation” on its tax returns to the extent that such
depreciation was available. Taxpayer incurred a net operating loss (NOL) in each of
Year 1 through Year 2 due to Taxpayer’s claiming bonus depreciation, producing a net
operating loss carryover (NOLC).

     On its regulatory books of account, Taxpayer “normalizes” the differences

between regulatory depreciation and tax depreciation. This means that, where
accelerated depreciation reduces taxable income, the taxes that a taxpayer would have
paid if regulatory depreciation (instead of accelerated tax depreciation) were claimed
constitute “cost-free capital” to the taxpayer. A taxpayer that normalizes these
differences, like Taxpayer, maintains a reserve account showing the amount of tax
liability that is deferred as a result of the accelerated depreciation. This reserve is the
accumulated deferred income tax (ADIT) account. Taxpayer maintains an ADIT
account. In addition, Taxpayer maintains an offsetting series of entries – a “deferred tax
asset” and a “deferred tax expense” – that reflect that portion of those ‘tax losses’
which, while due to accelerated depreciation, did not actually defer tax because of the
existence of a NOLC.

    In the setting of utility rates by Commission B, a utility’s rate base is offset by its

ADIT balance. In its rate case filing, Taxpayer maintained that the ADIT balance should
be reduced by the amounts that Taxpayer calculates did not actually defer tax due to
the presence of the NOLC, as represented in the deferred tax asset account. Thus,
Taxpayer argued that the rate base should be reduced by its federal ADIT balance net
of the deferred tax asset account attributable to the federal NOLC. It based this position
on its determination that this net amount represented the true measure of federal
income taxes deferred on account of its claiming accelerated tax depreciation
PLR-119381-16 3

deductions and, consequently, the actual quantity of “cost-free” capital available to it. It
also asserted that the failure to reduce its rate base offset by the deferred tax asset
attributable to the federal NOLC would be inconsistent with the normalization rules.

   On Date 2, Commission B issued an order accepting Taxpayer’s revisions to its

rates. On Date 3, new rates went into effect, subject to refund. Several intervenors
submitted challenges to the rate case and on Date 4, Taxpayer and those intervenors
entered into a Settlement Agreement, which was filed with Commission B. On Date 5,
Commission B issued an order accepting the Settlement Agreement, which allows for
the inclusion of the ADIT related to the NOLC asset in rate base.

   Commission B further stated in the order that it is the intent of Commission B that

Taxpayer comply with the normalization method of accounting and tax normalization
regulations. The order also requires Taxpayer to seek a private letter ruling (PLR) from
the Service regarding Taxpayer’s treatment of the ADIT related to the NOLC asset.
Commission B also noted that after the Service issues a PLR, Taxpayer shall adjust, to
the extent necessary, its ratemaking treatment of the ADIT related to the NOLC asset
prospectively from the date of the PLR.

Taxpayer requests that we rule as follows:

1. In order to avoid a violation of the normalization requirements of § 168(i)(9) and
   Treasury Regulation § 1.167(l)-1, it is necessary to include in rate base the
   Accumulated Deferred Income Tax (ADIT) asset resulting from the Net Operating
   Loss Carryforward (NOLC), given the inclusion in rate base of the full amount of the
   ADIT liability resulting from accelerated tax depreciation.

2. The exclusion from rate base of the entire ADIT asset resulting from the NOLC, or
   the inclusion in rate base of a portion of that ADIT asset that is less than the amount
   attributable to accelerated tax depreciation, computed on a “with and without” basis,
   would violate the normalization requirements of § 168(i)(9) and § 1.167(l)-1.

Law and Analysis

   Section 168(f)(2) of the Code provides that the depreciation deduction

determined under § 168 shall not apply to any public utility property (within the meaning
of § 168(i)(10)) if the taxpayer does not use a normalization method of accounting.

   In order to use a normalization method of accounting, § 168(i)(9)(A)(i) requires

the taxpayer, in computing its tax expense for establishing its cost of service for
ratemaking purposes and reflecting operating results in its regulated books of account,
to use a method of depreciation with respect to public utility property that is the same
as, and a depreciation period for such property that is not shorter than, the method and
period used to compute its depreciation expense for such purposes. Under
PLR-119381-16 4

§ 168(i)(9)(A)(ii), if the amount allowable as a deduction under § 168 differs from the
amount that-would be allowable as a deduction under § 167 using the method, period,
first and last year convention, and salvage value used to compute regulated tax
expense under § 168(i)(9)(A)(i), the taxpayer must make adjustments to a reserve to
reflect the deferral of taxes resulting from such difference.

    Section 168(i)(9)(B)(i) provides that one way the requirements of § 168(i)(9)(A)

will not be satisfied is if the taxpayer, for ratemaking purposes, uses a procedure or
adjustment which is inconsistent with such requirements. Under § 168(i)(9)(B)(ii), such
inconsistent procedures and adjustments include the use of an estimate or projection of
the taxpayer's tax expense, depreciation expense, or reserve for deferred taxes under
§ 168(i)(9)(A)(ii), unless such estimate or projection is also used, for ratemaking
purposes, with respect to all three of these items and with respect to the rate base.

   Former § 167(l) generally provided that public utilities were entitled to use

accelerated methods for depreciation if they used a "normalization method of
accounting." A normalization method of accounting was defined in former § 167(l)(3)(G)
in a manner consistent with that found in § 168(i)(9)(A). Section 1.167(l)-1(a)(1)
provides that the normalization requirements for public utility property pertain only to the
deferral of federal income tax liability resulting from the use of an accelerated method of
depreciation for computing the allowance for depreciation under § 167 and the use of
straight-line depreciation for computing tax expense and depreciation expense for
purposes of establishing cost of services and for reflecting operating results in regulated
books of account. These regulations do not pertain to other book-tax timing differences
with respect to state income taxes, F.I.C.A. taxes, construction costs, or any other taxes
and items.

    Section 1.167(l)-1(h)(1)(i) provides that the reserve established for public utility

property should reflect the total amount of the deferral of federal income tax liability
resulting from the taxpayer's use of different depreciation methods for tax and
ratemaking purposes.

     Section 1.167(l)-1(h)(1)(iii) provides that the amount of federal income tax liability

deferred as a result of the use of different depreciation methods for tax and ratemaking
purposes is the excess (computed without regard to credits) of the amount the tax
liability would have been had the depreciation method for ratemaking purposes been
used over the amount of the actual tax liability. This amount shall be taken into account
for the taxable year in which the different methods of depreciation are used. If,
however, in respect of any taxable year the use of a method of depreciation other than a
subsection (1) method for purposes of determining the taxpayer’s reasonable allowance
under § 167(a) results in a net operating loss carryover to a year succeeding such
taxable year which would not have arisen (or an increase in such carryover which would
not have arisen) had the taxpayer determined his reasonable allowance under § 167(a)
using a subsection (1) method, then the amount and time of the deferral of tax liability
PLR-119381-16 5

shall be taken into account in such appropriate time and manner as is satisfactory to the
district director.

    Section 1.167(l)-1(h)(2)(i) provides that the taxpayer must credit this amount of

deferred taxes to a reserve for deferred taxes, a depreciation reserve, or other reserve
account. This regulation further provides that, with respect to any account, the
aggregate amount allocable to deferred tax under § 167(1) shall not be reduced except
to reflect the amount for any taxable year by which Federal income taxes are greater by
reason of the prior use of different methods of depreciation. That section also notes
that the aggregate amount allocable to deferred taxes may be reduced to reflect the
amount for any taxable year by which federal income taxes are greater by reason of the
prior use of different methods of depreciation under § 1.167(l)-1(h)(1)(i) or to reflect
asset retirements or the expiration of the period for depreciation used for determining
the allowance for depreciation under § 167(a).

    Section 1.167(l)-1(h)(6)(i) provides that, notwithstanding the provisions of

subparagraph (1) of that paragraph, a taxpayer does not use a normalization method of
regulated accounting if, for ratemaking purposes, the amount of the reserve for deferred
taxes under § 167(l) which is excluded from the base to which the taxpayer’s rate of
return is applied, or which is treated as no-cost capital in those rate cases in which the
rate of return is based upon the cost of capital, exceeds the amount of such reserve for
deferred taxes for the period used in determining the taxpayer’s expense in computing
cost of service in such ratemaking.

   Section 1.167(l)-1(h)(6)(ii) provides that, for the purpose of determining the

maximum amount of the reserve to be excluded from the rate base (or to be included as
no-cost capital) under subdivision (i), above, if solely an historical period is used to
determine depreciation for Federal income tax expense for ratemaking purposes, then
the amount of the reserve account for that period is the amount of the reserve
(determined under § 1.167(l)-1(h)(2)(i)) at the end of the historical period. If such
determination is made by reference both to an historical portion and to a future portion
of a period, the amount of the reserve account for the period is the amount of the
reserve at the end of the historical portion of the period and a pro rata portion of the
amount of any projected increase to be credited or decrease to be charged to the
account during the future portion of the period.

    Section 1.167(l)-1(h) requires that a utility must maintain a reserve reflecting the

total amount of the deferral of federal income tax liability resulting from the taxpayer's
use of different depreciation methods for tax and ratemaking purposes. Taxpayer has
done so. Section 1.167(l)-1(h)(6)(i) provides that a taxpayer does not use a
normalization method of regulated accounting if, for ratemaking purposes, the amount
of the reserve for deferred taxes which is excluded from the base to which the
taxpayer’s rate of return is applied, or which is treated as no-cost capital in those rate
cases in which the rate of return is based upon the cost of capital, exceeds the amount
PLR-119381-16 6

of such reserve for deferred taxes for the period used in determining the taxpayer’s
expense in computing cost of service in such ratemaking. Section 56(a)(1)(D) provides
that, with respect to public utility property the Secretary shall prescribe the requirements
of a normalization method of accounting for that section.

   Regarding the first issue, § 1.167(l)-1(h)(6)(i) provides that a taxpayer does not

use a normalization method of regulated accounting if, for ratemaking purposes, the
amount of the reserve for deferred taxes which is excluded from the base to which the
taxpayer’s rate of return is applied, or which is treated as no-cost capital in those rate
cases in which the rate of return is based upon the cost of capital, exceeds the amount
of such reserve for deferred taxes for the period used in determining the taxpayer’s
expense in computing cost of service in such ratemaking. Because the reserve account
for deferred taxes (ADIT), reduces rate base, it is clear that the portion of the net
operating loss carryover (NOLC) that is attributable to accelerated depreciation must be
taken into account in calculating the amount of the ADIT account balance. Thus, the
order by Commission to include in rate base the ADIT asset resulting from the NOLC,
given the inclusion in rate base of the full amount of the ADIT liability resulting from
accelerated tax depreciation is in accord with the normalization requirements.

    Regarding the second issue, § 1.167(l)-1(h)(1)(iii) makes clear that the effects of

an NOLC must be taken into account for normalization purposes. Section 1.167(l)-
1(h)(1)(iii) provides generally that, if, in respect of any year, the use of other than
regulatory depreciation for tax purposes results in an NOLC carryover (or an increase in
an NOLC which would not have arisen had the taxpayer claimed only regulatory
depreciation for tax purposes), then the amount and time of the deferral of tax liability
shall be taken into account in such appropriate time and manner as is satisfactory to the
district director. The “with or without” methodology employed by Taxpayer is specifically
designed to ensure that the portion of the NOLC attributable to accelerated depreciation
is correctly taken into account by maximizing the amount of the NOLC attributable to
accelerated depreciation. This methodology provides certainty and prevents the
possibility of “flow through” of the benefits of accelerated depreciation to ratepayers.
Under these specific facts, any method other than the “with or without” method would
not provide the same level of certainty and therefore the use of any other methodology
in computing the portion of the ADIT asset attributable to accelerated depreciation is
inconsistent with the normalization rules.

We rule as follows:

1. In order to avoid a violation of the normalization requirements of § 168(i)(9) and
   Treasury Regulation § 1.167(l)-1, it is necessary to include in rate base the
   Accumulated Deferred Income Tax (ADIT) asset resulting from the Net Operating
   Loss Carryforward (NOLC), given the inclusion in rate base of the full amount of the
   ADIT liability resulting from accelerated tax depreciation.
   PLR-119381-16 7

2. The exclusion from rate base of the entire ADIT asset resulting from the NOLC, or
   the inclusion in rate base of a portion of that ADIT asset that is less than the amount
   attributable to accelerated tax depreciation, computed on a “with and without” basis,
   would violate the normalization requirements of § 168(i)(9) and § 1.167(l)-1.

    This ruling is based on the representations submitted by Taxpayer and is only
   

   valid if those representations are accurate. The accuracy of these representations is
   subject to verification on audit.

   Except as specifically determined above, no opinion is expressed or implied
   concerning the Federal income tax consequences of the matters described above.

   This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
   of the Code provides it may not be used or cited as precedent. In accordance with the
   power of attorney on file with this office, a copy of this letter is being sent to your
   authorized representative. We are also sending a copy of this letter ruling to the
   Director.

                                            Sincerely,
   
                                            Patrick S. Kirwan
                                            Chief, Branch 6
                                            Office of the Associate Chief Counsel
                                            (Passthroughs & Special Industries)
   

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