Utility's post-exchange liability accounting met normalization rules

Plain-English summary

Two regulated electric utilities planned to exchange transmission and distribution assets in a transaction expected largely to qualify for tax deferral under Section 1031. Each utility would remove from its regulated books the accumulated deferred federal income tax reserve tied to the assets it relinquished and would not carry over the replacement assets' pre-transaction deferred-tax reserve. The requesting utility would separately record a liability for taxes expected when it recovered the replacement assets' book value through rates. The IRS concluded that this liability was unrelated to the deferred-tax reserve for the relinquished property, so its regulatory treatment fell outside the depreciation normalization rules. Recording and recognizing the liability for ratemaking purposes was therefore consistent with Section 168(i)(9) and the normalization regulations. The IRS expressed no view on whether the exchange itself qualified under Section 1031.

Ruling snapshot

• Question: Could the utility recognize and record its post-exchange tax liability for ratemaking without violating the public-utility normalization rules?
• Outcome: Approved; the liability was unrelated to the relinquished assets' accumulated deferred-tax reserve.
• Key authorities: IRC §§ 167, 168(i)(9), and 1031; Treas. Reg. § 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201824006                                              Third Party Communication: None
Release Date: 6/15/2018                                        Date of Communication: Not Applicable
Index Number: 168.24-01
                                                               Person To Contact:
----------------------                                         ------------------------, ID No. -------------
------------------------------------------------------------   Telephone Number:
--------------                                                 ----------------------
----------------------------------------------------           Refer Reply To:
--------------------------------------------                   CC:PSI:B06
-------------------------                                      PLR-129810-17
                                                               Date:
In Re:                                                         March 14, 2018
----------------------------------------------------




                                               LEGEND

Taxpayer A                          =        ------------------------------------------------------

Taxpayer B                          =        ------------------------------------------------------------------------
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Partnership                         =        ---------------------------------

Taxpayer A, LLC                     =        ----------------------

Taxpayer B, LLC                     =        ------------------------------------------------------------------------
----------------------------------------------------------

State A                             =        ---------

State B                             =        --------------

Regulator                           =        -----------------------------------------------

Date 1                              =        -------------------

a                                   =        --------------

b                                   =        --------------

c                                   =        --------------
PLR-129810-17                                             2


d                                   =        ----------------

e                                   =        ----------------

Taxpayer A Liability                =        ------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
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-------------------------------------------------------------

Taxpayer B Liability                =        ------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
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Dear ------------:

       This letter responds to a request for a private letter ruling dated
September 22, 2017, and subsequent correspondence, submitted on behalf of
Taxpayer A by your authorized representatives. Taxpayer A requested a ruling
regarding the application of the normalization rules under § 168(i)(9) of the Internal
Revenue Code and § 1.167(l)-1 of the Income Tax Regulations to an exchange of like
kind properties between Taxpayer A and Taxpayer B. The relevant facts as
represented in your submissions are set forth below.

                                                     FACTS

       Taxpayer A is a State B limited liability company, which is classified as a
partnership for federal income tax purposes. Taxpayer A owns and operates a
regulated electricity transmission and distribution system in State A. Taxpayer A
provides distribution services to retail electric providers that sell electricity to consumers.
Taxpayer A also provides transmission services to other electricity distribution
companies, cooperatives, municipalities, and retail energy providers. Taxpayer A’s
operations are subject to the regulatory jurisdiction of the Regulator for rates and
conditions of service. The rates for the distribution and transmission services are
established under traditional ratemaking on a rate base/rate of return basis.

         Taxpayer B is a State A limited liability company, which is classified as a
partnership for federal income tax purposes. Taxpayer B owns regulated electricity
transmission and distribution facilities throughout State A. Taxpayer B leases these
facilities to Partnership, a State A limited partnership, which is classified as a
partnership for federal income tax purposes. Partnership operates the electricity
transmission and distribution facilities and provides both distribution services to retail
electric providers that sell electricity to consumers and transmission services to other
PLR-129810-17                                 3

electricity distribution companies, cooperatives, municipalities, and retail energy
providers. The operation of the electricity transmission and distribution facilities is
subject to the regulatory jurisdiction of the Regulator for rates and conditions of service.
The rates for the distribution and transmission services are established under traditional
ratemaking on a rate base/rate of return basis.

        On Date 1, Taxpayer A, Taxpayer B, and Partnership entered into an Agreement
and Plan of Merger, pursuant to which Taxpayer A will transfer certain of its electricity
transmission facilities to Taxpayer B, and Taxpayer B will transfer substantially all of its
electricity distribution facilities and certain of its electricity transmission facilities to
Taxpayer A (“Merger Agreement”). This transaction will allow Taxpayer A to expand its
existing distribution network into a growing service area it had not previously served,
and add additional retail customers. This transaction will provide Taxpayer B with
additional transmission assets to meet the infrastructure needs for safe, reliable, and
affordable electric power of a growing State A economy.

      Pursuant to the Merger Agreement, the following transactions will occur after the
taxpayers receive the necessary approvals:

       1) Taxpayer A will transfer certain of its electricity transmission facilities
(“Taxpayer A Assets”) to a newly-formed limited liability company (Taxpayer A, LLC).
Taxpayer A, LLC will be wholly-owned by, and treated as a disregarded entity as to,
Taxpayer A. Taxpayer A represents that as a result, Taxpayer A will be deemed to
continue to own the Taxpayer A Assets for federal income tax purposes.

        2) Taxpayer B will transfer assets comprising substantially all of its electricity
distribution facilities and certain of its electricity transmission facilities (“Taxpayer B
Assets”) to a newly-formed limited liability company, Taxpayer B, LLC. Taxpayer B,
LLC will be wholly-owned by, and treated as a disregarded entity as to, Taxpayer B.
Taxpayer A represents that as a result, Taxpayer B will be deemed to continue to own
the Taxpayer B Assets for federal income tax purposes.

       3) Taxpayer A, LLC will merge with and into Taxpayer B, with Taxpayer B as the
surviving entity. As a result, Taxpayer B will become the direct owner of the Taxpayer A
Assets. Taxpayer A represents that for federal income tax purposes, because Taxpayer
A, LLC is disregarded, Taxpayer A will be deemed to transfer the Taxpayer A Assets to
Taxpayer B.

       4) Substantially simultaneously with, and as consideration for, the transfer of the
Taxpayer A Assets by Taxpayer A to Taxpayer B, Taxpayer B, LLC will merge with and
into Taxpayer A, with Taxpayer A as the surviving entity. Taxpayer A will also pay cash
to Taxpayer B for a small portion of the Taxpayer B Assets. As a result, Taxpayer A will
become the direct owner of the Taxpayer B Assets. Taxpayer A represents that for
PLR-129810-17                                4

federal income tax purposes, because Taxpayer B, LLC is disregarded, Taxpayer B will
be deemed to transfer the Taxpayer B Assets to Taxpayer A.

        The third and fourth transactions are expected to be treated for tax purposes as a
like kind exchange under § 1031 between Taxpayer A and Taxpayer B of the Taxpayer
B Assets for the Taxpayer A Assets (and cash). Substantially all of this exchange is
expected to be treated as an exchange of properties that are of “like kind” within the
meaning of § 1031 and, thus, qualify for tax deferred treatment. However, Taxpayer B,
and possibly Taxpayer A, are expected to have some amount of “exchange group
deficiencies” or “exchange group surpluses” within the meaning of § 1.1031(j)-1(b)(4).
Therefore, the taxpayers may recognize some amount of taxable gain in the like kind
exchange. Taxpayer A and Taxpayer B will take a substituted tax basis in the assets
acquired by each of them, adjusted as specified in § 1.1031(j)-1(c) for exchange group
deficiencies and surpluses and taxable gain recognized.

       For regulatory purposes, Taxpayer A will record the Taxpayer B Assets it will
receive at the same regulatory net book value at which those assets had been recorded
by Taxpayer B immediately prior to the like kind exchange. Similarly, Taxpayer B will
record the Taxpayer A Assets it will receive at the same regulatory net book value at
which those assets had been recorded by Taxpayer A immediately prior to the like kind
exchange. The regulatory net book value of the Taxpayer B Assets is expected to
approximately equal the regulatory net book value of the Taxpayer A Assets, plus the
amount of cash paid by Taxpayer A to Taxpayer B in the like kind exchange.

      For federal income tax purposes, Taxpayer A and Taxpayer B claimed
accelerated depreciation (including, in certain cases, bonus depreciation) on the assets
they owned. The Taxpayer A Assets include electricity transmission systems. The
Taxpayer B Assets include electricity distribution systems and electricity transmission
systems.

        Prior to the like kind exchange, each taxpayer recorded an accumulated deferred
federal income tax (“ADFIT”) reserve to reflect the deferral of federal income taxes
attributable to its claiming accelerated depreciation and for other temporary differences
for its public utility assets. Immediately prior to the consummation of the like kind
exchange, it is projected that Taxpayer A will have an ADFIT reserve balance
attributable to the Taxpayer A Assets of approximately $a, approximately $b of which
will be attributable to accelerated depreciation. Further, immediately prior to the
consummation of the like kind exchange, Taxpayer B is projected to have an ADFIT
reserve balance attributable to the Taxpayer B Assets of approximately $c, substantially
all of which will be attributable to accelerated depreciation. Taxpayer A and Taxpayer B
propose to record the following entries to their regulated books of account to reflect the
like kind exchange.
PLR-129810-17                                5

        Taxpayer A will remove from its regulated books of account the entire
approximately $a of ADFIT reserve balance associated with the Taxpayer A Assets it is
relinquishing. Similarly, Taxpayer B will remove the entire approximately $c of ADFIT
reserve balance associated with the Taxpayer B Assets it is relinquishing. Taxpayer A
will increase a non-operating income account in the amount of the ADFIT reserve so
removed. Similarly, Taxpayer B will increase a non-operating income account in the
amount of the ADFIT reserve balance it removed.

        Taxpayer A will record the Taxpayer B Assets it is acquiring as an asset on its
regulated books of account in an amount equal to Taxpayer B’s regulatory net book
value in the Taxpayer B Assets immediately prior to the like kind exchange. Similarly,
Taxpayer B will record the Taxpayer A Assets it is acquiring as an asset on its regulated
books of account in an amount equal to Taxpayer A’s regulatory net book value in the
Taxpayer A Assets immediately prior to the like kind exchange. As a result, Taxpayer
A’s initial net book basis in the Taxpayer B Assets it is acquiring is projected to be
approximately $d, and Taxpayer B’s initial net book basis in the Taxpayer A Assets it is
acquiring is projected to be approximately $e.

       Taxpayer A will book Taxpayer A Liability. Similarly, Taxpayer B will book
Taxpayer B Liability. When Taxpayer A and Taxpayer B recover the book carrying
value of the replacement property in rates, they will have to pay the Taxpayer A Liability
and Taxpayer B Liability, respectively, to the government. Taxpayer A and Taxpayer B
will have removed the ADFIT associated with the relinquished property from their
regulated books of account, and will not record any of the replacement properties’ pre-
transactional ADFIT.

        Taxpayer A represents that its accounting entries are in accordance with GAAP
applicable to rate regulated enterprises. Based on discussions with Regulator staff and
others, Taxpayer A has concluded that it will not collect the Taxpayer A Liability from
customers. Thus, Taxpayer A does not anticipate establishing a regulatory asset. As a
result, Taxpayer A’s post-like kind exchange rate base computation will be reduced by
its Taxpayer A Liability balance in addition to any additional ADFIT balances that are
created after the transaction.

                                 RULING REQUESTED

       Subsequent to the like kind exchange, it will be consistent with the requirements
of § 168(i)(9) and § 1.167(1)-1 for Taxpayer A to recognize the Taxpayer A Liability
balance for ratemaking purposes and record such balance on its regulated books of
account.
PLR-129810-17                                  6

                                   LAW AND ANALYSIS

       Section 168(f)(2) 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 a
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 for 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 § 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), then 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 the definition 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.
PLR-129810-17                                  7

         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.

       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 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 section 1.167(1)-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 section 167(a).

        Taxpayer A has transferred the Taxpayer A Assets and received replacement
assets in exchange. Taxpayer A has disposed of Taxpayer A Assets, and those assets
have been removed from Taxpayer A’s regulatory books of account. Taxpayer A’s
ADFIT was created due to the deferral of federal taxes attributable to Taxpayer A's
claiming accelerated depreciation and other temporary differences with respect to the
relinquished property as required by § 1.167(l)-1(h)(2). The disposal of the relinquished
property from Taxpayer A's regulatory books of account is the functional equivalent of a
retirement of the property (see generally §§ 1.167(a)-8(a) and 1.168(i)-8(b)(2)). Section
1.167(l)-1(h)(2) provides that the accumulated ADFIT balance is adjusted to reflect such
dispositions. The required adjustment is the removal of the ADFIT balance with respect
to the relinquished property from Taxpayer A's regulated books of account.

       In accordance with this requirement, Taxpayer A will remove from its regulated
books of account the entire approximately $a of ADFIT reserve balance associated with
the Taxpayer A Assets it is relinquishing. Taxpayer A will not record on the utility’s
regulated books of account any of the replacement properties’ pre-transactional ADFIT

       In this case, we are satisfied that the Taxpayer A Liability is unrelated to the
relinquished properties’ ADFIT, and thus, its regulatory treatment is beyond the scope of
the normalization rules. Therefore, we conclude that subsequent to the like kind
exchange, it will be consistent with the requirements of § 168(i)(9) and § 1.167(1)-1 for
Taxpayer A to recognize the Taxpayer A Liability balance for ratemaking purposes and
record such balance on its regulated books of account.

      Except as specifically set forth above, no opinion is expressed or implied
concerning the federal income tax consequences of the above described facts under
any other provision of the Code or regulations. Specifically, we express no opinion
PLR-129810-17                                  8

regarding any consequences of the exchange described above, including whether such
exchange satisfies the provisions of § 1031.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

        This ruling is based upon information and representations submitted by Taxpayer
and accompanied by penalty of perjury statements executed by an appropriate party.
While this office has not verified any of the material submitted in support of the request
for rulings, it is subject to verification on examination.

         In accordance with the power of attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.



                                        Sincerely,



                                        David A. Selig
                                        Senior Counsel, Branch 6
                                        Office of Associate Chief Counsel
                                        (Passthroughs & Special Industries)