Different averaging rules would violate utility tax normalization

Plain-English summary

A regulated electric utility used a 13-month average to calculate rate-base items, including accumulated deferred federal income taxes. An IRS audit settlement reduced a deferred tax asset tied to net operating losses, which increased the utility's net deferred-tax balance. Intervenors in two state rate cases proposed recognizing the settlement's full effect immediately instead of applying the 13-month convention used for other rate-base elements. The utility argued that this special treatment would violate the consistency requirement in the public-utility tax normalization rules. The IRS agreed, ruling that applying an end-of-test-period convention only to the settlement while averaging the other relevant items was not acceptable under Section 168(i)(9)(B).

Ruling snapshot

• Question: Could regulators apply a 13-month average to most rate-base and deferred-tax items but use an end-of-test-period convention for one IRS settlement adjustment?
• Outcome: Approved in the utility's favor. The proposed inconsistent convention was not acceptable under the normalization rules.
• Key authorities: IRC §§ 167(l), 168(i)(9)(A), 168(i)(9)(B), 6110(k)(3)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201828010 Third Party Communication: Government
Release Date: 7/13/2018 Agency
Date of Communication: March 20, 2018
Index Number: 167.22-01
Person To Contact:
---------------------------- --------------------------, ID No. ----------------
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--------------------------- Telephone Number:
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----------------------------------- Refer Reply To:
CC:PSI:B06
PLR-132097-17
Date:
April 17, 2018
LEGEND:
Taxpayer = ---------------------------------------------------------------------------------

X = -------------------------------------
Parent = ----------------------------------------------------
State A = --------------
State B = ---------------------------
State C = -----------
State D = --------------
Commission A = -----------------------------------------------------------------
Commission B = ---------------------------------------------------------------------------------
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Commission C = ------------------------------------------------------------------
Intervenor 1 = --------------------------------------------------------------
Intervenor 2 = ---------------------------------------------------------------------------------

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Order 1 = --------------------------------------------
Order 2 = --------------------------------------------
Order 3 = ---------------------------------------------
Case = ----------------------------------------------------
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b = ----------------
c = ------------
d = ----------------
e = ----------------
f = --------------
g = ----------------
h = ------------
i = ----------------
j = ----------------
k = --------------
l = ----------------

Date 1 = ---------------------------
Date 2 = ----------------------
Date 3 = ---------------------------
Date 4 = -------------------
Date 5 = ---------------------
Date 6 = ----------------------
Date 7 = --------------------
Date 8 = -------------------
Date 9 = --------------------
Date 10 = ---------------------------
Date 11 = ------------------------
Date 12 = -----------------
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Date 14 = -----------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Director = -------------------------------------------------

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

This letter responds to Parent’s request, made on behalf of Taxpayer, dated October
19, 2017, for a ruling on the application of the Normalization Rules of the Internal
Revenue Code (Code) to certain accounting and regulatory procedures, as described
below.

The representations set out in your letter follow.

Taxpayer is an investor-owned regulated utility incorporated in State B and State C.
Taxpayer is a wholly-owned subsidiary of X, a State D limited liability company
classified as a corporation for income tax purposes. X is wholly-owned by Parent.
Taxpayer is a member of Parent’s consolidated group that files a consolidated federal
income tax return on a calendar year basis using an accrual method of accounting.

Taxpayer is engaged in the purchase, transmission, distribution, and sale of electric
energy in State A and State B. Taxpayer is subject to regulation with respect to terms
and conditions of services by Commission A, Commission B, and Commission C. Each
of these regulators establishes Taxpayer’s rates based on its costs, including a
provision for a return on the capital employed by Taxpayer in its regulated business.

Taxpayer has claimed (and continues to claim) accelerated depreciation on all of its
public utility property to the full extent those deductions are available under the Code.
Taxpayer normalizes the federal income taxes deferred as a result of its claiming these
deductions in accordance with the Normalization Rules. As a consequence, Taxpayer
has a substantial balance of Accumulated Deferred Federal Income Taxes (ADFIT) that
is attributable to the accelerated depreciation reflected on both its State A and State B
regulated books of account. In its general rate cases, Taxpayer reduces its rate base
upon which its return component was computed by its ADFIT balance.

Taxpayer has generated significant net operating losses (“NOLs”) in a number of prior
tax years and continues to have an NOL carryforward (“NOLC”) balance. To accurately
reflect the economics of this NOLC, Taxpayer has recorded a deferred tax asset
(“DTA”) on both its State A and State B regulated books of account. Taxpayer properly
takes this DTA into account when computing the ADFIT balance by which it reduces its
rate base and both Commission A and Commission B have accepted this treatment.

Prior to Year 4, Taxpayer had been a member of an affiliated group of corporations of
which X was the common parent (“X Group”). The members of the X Group had, for
many years, joined in the filing of a consolidated federal income tax return. By Year 3,
the X Group had been under IRS audit for a considerable period of time with respect to
its federal income taxes for Year 1 through Year 2. The audit resulted in proposed
adjustments, both positive and negative, to the taxable income of a number of X Group
members, including both regulated and non-regulated members.

On Date 1, the IRS and X Group entered into a settlement (“IRS Settlement”). The IRS
Settlement resulted in a net positive adjustment to the X Group’s consolidated taxable
income during the audit period which absorbed a portion of the then-existing
consolidated NOLC. Of the consolidated NOLC absorbed, approximately $a was
attributable to Taxpayer. Under the tax sharing agreement for the X Group Taxpayer
received approximately $b in net payments during Date 4 and Date 5 from the X Group
for use of Taxpayer’s NOLC.

In Date 2, the month subsequent to the IRS Settlement being finalized, the results were
recorded in the appropriate DTA accounts on Taxpayer’s books and records. The
recordation resulted in a reduction in Taxpayer’s NOLC-related DTA. By reducing
Taxpayer’s DTA, this recordation increased Taxpayer’s net ADFIT balance.

State A Ratemaking

On Date 7, Taxpayer filed an application with Commission A to request an increase in
its retail rates for electricity. Taxpayer’s application used a 12-month test period ending
Date 3, with an effective date of Date 8 for the rates established in this proceeding.
Thus, the test period was an historic test period. In computing its rate base, Taxpayer
employed a 13-month averaging convention for all of the constituent elements, including
ADFIT. During the proceeding, the proper calculation of the ADFIT balance by which
rate base should be reduced became an issue in dispute.

In computing the amount of ADFIT by which rate base should be reduced, Taxpayer
applied its applicable rate base convention, a 13-month average, to its monthly ADFIT
balances for the test period and multiplied this amount by the State A distribution
jurisdictional factor (c%). In its general rate case, Taxpayer reflected the impact of the
IRS Settlement on Taxpayer’s ADFIT balance as being $d. Applying the jurisdictional
factor to this ADFIT impact, Taxpayer calculated that approximately $e was attributable
to its State A electric distribution business. Since the IRS Settlement was recorded on
Date 2, the last month of the test period, using the regulatory convention employed for
all other elements of rate base, only 1/13th of the effect of the IRS Settlement ($e/13 or
approximately $f) was included in the Taxpayer’s calculation of the ADFIT balance by
which it reduced rate base.

A third party intervenor (Intervenor 1) proposed to adjust Taxpayer’s computation of
ADFIT on account of the impact of the IRS Settlement. Specifically, Intervenor 1
proposed to treat the full impact of the IRS Settlement as a reduction in Taxpayer’s
ADFIT balance. Thus, Intervenor 1 proposed to take into account not just the $f
reduction Taxpayer reflected in its rate base calculation but an additional $g, such that
the entire jurisdictional impact of the IRS Settlement ($e) was incorporated into rates.

On Date 10, Commission A issued Order 1 in which it adopted Intervenor 1’s proposed
ADFIT adjustment based on the proposition that the impact of the IRS Settlement is
“known” and will continue through the rate effective period. On Date 11, Taxpayer filed
a motion in which Taxpayer asserted its view that incorporating the treatment of the IRS
Settlement proposed by Intervenor 1 would constitute a violation of the Normalization
Rules. In response to Taxpayer’s filing, on Date 12, Commission A issued Order 2 in
which it directed Taxpayer to request a Private Letter Ruling (“PLR”) from the Service to
clarify the impact of the normalization rule within the context of Order 2.

State B Ratemaking

On Date 9, Taxpayer filed an application with Commission B to request an increase in
its retail rates for electricity. This application was considered by Commission B in Case.
Taxpayer’s application used a 12-month test period ending Date 6, with an effective
date of Date 14 for the rates established in this proceeding. Thus, the test period was
an historic test period. In computing its rate base, Taxpayer employed a 13-month
averaging convention for all of the constituent elements. ADFIT was also computed by
Taxpayer based on the 13-month averaging convention.

In computing the amount of ADFIT by which rate base should be reduced, Taxpayer
applied its applicable rate base convention, a 13-month average, to its monthly ADFIT
balances for the test period and multiplied this amount by the State B distribution
jurisdictional factor (h%). In basing the test year ADFIT balance on the 13-month
averaging convention, Taxpayer applied the jurisdictional factor to the impact of the IRS
Settlement detailed above. In its filings in Case, Taxpayer proposed that the impact of
the IRS Settlement on Taxpayer’s ADFIT balance should be $i. Applying the
jurisdictional factor to this ADFIT impact, Taxpayer calculated that approximately $j was
attributable to its State B electric distribution business. Since the IRS Settlement was
recorded on Date 2, using the regulatory convention employed for all other elements of
rate base, only 4/13th of the effect of the IRS Settlement or approximately $k was
included in the Taxpayer’s calculation of the ADFIT balance by which it reduced rate
base.

A third party intervenor (Intervenor 2) proposed to adjust Taxpayer’s computation of
ADFIT on account of the impact of the IRS Settlement. Specifically, Intervenor 2
proposed to treat the full impact of the IRS Settlement as a reduction in Taxpayer’s
ADFIT balance (without application of the 13-month averaging convention). Intervenor
2 characterized the proposed adjustment as “annualizing” the impact of the IRS
Settlement to take into account not just the reduction Taxpayer reflected in its rate base
calculation but an additional $l such that the entire jurisdictional impact of the IRS
Settlement would be incorporated into rates. Intervenor 2 indicated that while the
reduction in the NOL DTA was not booked by the Taxpayer until Date 2, the NOL DTA
was on the Taxpayer’s books before the beginning of the test year.

Taxpayer contested this proposed adjustment asserting that its implementation would
constitute a violation of the Normalization Rules. In response to Taxpayer’s filings, on
Date 13, Commission B issued Order 3 in which it directed that the Taxpayer to request
a PLR from the Service to clarify the impact of the Normalization Rules before
Commission B finally decides whether to annualize the cash that Taxpayer received on
Date 2 as part of the IRS Settlement.

Taxpayer requests that we rule as follows:

Whether, the application of a 13-month average regulatory convention to most elements
of rate base, including most elements of Taxpayer’s ADFIT balance, and the application
of a different regulatory convention (end of test period) to the impact of the IRS
Settlement is acceptable under the Normalization Rules.

Law and Analysis

Former section 167(l) of the Code generally provided that public utilities were entitled to
use accelerated methods of 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).

In order to use a normalization method of accounting, § 168(i)(9)(A) requires that 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, 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 § 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. This
is known as the Consistency Rule.

In order to satisfy the requirements of § 168(i)(9)(B), there must be consistency in the
procedures and adjustments used in ratemaking to calculate elements in rate base,
depreciation expense, tax expense, and the reserve for deferred taxes. In this case, the
IRS settlement has an effect on Taxpayer’s ADFIT balance and the Taxpayer, along
with Commission A and Commission B, agree that the settlement must be taken into
account in setting Taxpayer’s rates. The only question is whether the same convention
used to calculate other elements of rate base, including ADFIT, a 13-month averaging
convention, must also apply to calculate the effect of the IRS Settlement, or whether a
different convention may apply to this element. Using the same convention would result
in the consistent calculation of Taxpayer’s tax expense, depreciation expense, and
ADFIT as required by § 168(i)(9)(B). Applying a different regulatory convention solely to
calculate the effect of the IRS Settlement would not satisfy the requirements of §
168(i)(9)(B) and the Consistency Rule.

Conclusion

We conclude that the application of a 13-month average regulatory convention to most
elements of rate base, including most elements of Taxpayer’s ADFIT balance, and the
application of a different regulatory convention (end of test period) to the impact of the
IRS Settlement is not acceptable under the Normalization Rules.

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)