Repair-related deferred taxes are outside utility normalization rules

Plain-English summary

A regulated water and wastewater utility changed its tax accounting for repair costs and asset dispositions under an IRS consent agreement. It asked whether several categories of accumulated deferred income tax tied to tax-deductible repairs remained subject to the public utility normalization rules. The IRS ruled that deferred taxes from post-change repair deductions, the repair component of the section 481(a) adjustment, and pre-change depreciation differences for property whose remaining basis became a repair deduction were not subject to section 168(i)(9) normalization or the agreement's normalization condition. Returning those amounts to customers faster than the average rate assumption method would violate neither the normalization rules nor the consent agreement. The ruling did not cover the disposition-related section 481(a) adjustment or excess tax reserves caused by the Tax Cuts and Jobs Act rate reduction.

Ruling snapshot

• Question: Must repair-related deferred tax balances remain normalized after the utility's accounting-method change?
• Outcome: approved (all three categories at issue were outside normalization)
• Key authorities: IRC §§ 162, 167, 168(i)(9), 168(i)(10), 446(e), 481(a); Treas. Reg. §§ 1.167(l)-1, 1.446-1, 1.481-1, 1.481-4; Rev. Proc. 97-27

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202017015                                              Third Party Communication: None
 Release Date: 4/24/2020                                        Date of Communication: Not Applicable
 Index Number: 168.24-01                                        Person To Contact:
                                                             -----------------------, ID No. ------------
 -------------------------------------------------           Telephone Number:
 -----------------------------------------------------       --------------------
 ------------------------------------------------------      Refer Reply To:

 ------------------------------                              CC:PSI:B06
 In Re: ---------------------------------------------------- PLR-117557-19
                                                             Date:
 -------------------------------------------------------
                                                             January 23, 2020




LEGEND:

Taxpayer                         =        ----------------------------------------------------
                                          -------------------------

Parent                           =        ----------------------------------------------------
                                          -------------------------

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

Commission                       =        ---------------------------------------------------

Order                            =        ----------------------

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

Date 2                           =        ---------------------------

Date 3                           =        ------------------

Date 4                           =        ---------------------

Date 5                           =        -------------------

Date 6                           =        ----------------

Date 7                           =        ------------------

Year 1                           =        -------

Year 2                           =        -------

PLR-117557-19                                   2


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

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

c                           =      --------------

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

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

f                           =      ---------------

g                           =      ---------------

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

       This letter responds to a request for a private letter ruling dated July 26, 2019,
and submitted on behalf of Taxpayer for rulings under § 168(i)(9) of the Internal
Revenue Code and § 1.167(l)-1 of the Income Tax Regulations (together, the
“Normalization Rules”) regarding the scope of the deferred tax normalization
requirements in connection with a Consent Agreement related to a Form 3115,
Application for Change in Accounting Method, filed that was approved for the Year 1 tax
year. The relevant facts as represented in your submission are set forth below.

                                           FACTS

        Taxpayer files a consolidated federal income tax return on a calendar year basis
with its affiliates, including Parent. Taxpayer uses an accrual method of accounting as
its overall method of accounting.

      Parent is a water and wastewater utility company. Taxpayer is the regulated
water/wastewater utility subsidiary affiliate that operates in State A. Prices charged by
Taxpayer are set by the Commission in the manner described in this letter.

       Commission sets rates that Taxpayer may charge for the furnishing or sale of
water or sewage disposal services through a combination of periodic general rate case
proceedings and infrastructure surcharge proceedings.

       For general rate case proceedings, Taxpayer computes a revenue requirement
subject to Commission approval based on recovery of a debt- and equity-based return
on investment in rate base, including the cost of plant assets less accumulated book
depreciation, and a recovery of operating expenses, including depreciation expense,
property tax expense, salary expense, and income tax expense. In setting the allowed
return for the utilities that it regulates, Commission treats accumulated deferred income

PLR-117557-19                                 3

tax liabilities (ADIT) as zero-cost capital in the computation of a weighted-average costs
of capital to be applied to a rate base computation that is not reduced by ADIT.

      The issues presented in this ruling request are a result of the following two
separate but related proceedings (collectively referred to as “Rate Proceeding”
throughout the ruling request):

          •   Investigation into the impacts of the Tax Cuts and Jobs Act of 2017
              (“TJCA” or “Act”) and possible rate implications initiated by the
              Commission on Date 1 with respect to all jurisdictional rate-regulated,
              investor-owned utilities.
          •   Petition to increase its rates and charges for water utility service initiated
              by Taxpayer on Date 2.

      On Date 1, the Commission initiated an investigation to allow the Commission to
consider the impacts and resulting benefits from the Act and how any resulting benefit
should be realized by customers.

        In general, subject to future guidance expected to be issued by the Service
related to the excess accumulated deferred income taxes (EADIT) normalization rules,
Taxpayer and the other parties are generally in agreement as to which specific timing
differences and associated ADIT and EADIT are and are not subject to normalization
requirements. The only disputes that exist are related to the Taxpayer’s timing
difference with respect to its tax-only repair and maintenance deductions. The
disagreement with regard to repair-related EADIT is due to differing interpretations of
the Consent Agreement that Parent received from the Service on Date 3, on behalf of
itself and various affiliates, including Taxpayer, with respect to changes in tax methods
of accounting for costs to repair and maintain tangible property and for dispositions of
certain tangible depreciable property described in this letter.

       On Date 4, parties to the Rate Proceeding entered into a settlement agreement.
On Date 5, the Commission approved the settlement (“Order”). Rates became effective
on Date 6 and were based on a test period ending Date 7. The settlement agreement
resolved both the general rate case and the TCJA case, subject to clarification of the
uncertainty described in this letter concerning the scope of the deferred tax
normalization rules. Because of the uncertainty related to the Consent Agreement
described in this letter, a condition of the Order permits Taxpayer to submit this ruling
request.

        Specifically, the Order provides, in part, that the parties have agreed in the
pending rate case that, for purposes of certain rates, Taxpayer will use the estimate of
EADIT which produces a result that is approximately the same as an estimate using
ARAM for the entirety of Taxpayer’s EADIT. The parties further agreed that Taxpayer
will seek a private letter ruling from the Service requesting a determination whether the
Commission has the discretion to order an amortization of EADIT related to Taxpayer’s

PLR-117557-19                                4

tax deductions for repairs that is faster than the average rate assumption method
(ARAM). The parties agreed the ruling request is not an opportunity for advocacy for
one outcome or another and that the ruling request will be drafted using neutral and
unbiased language.

        As noted, Taxpayer and its affiliates changed their tax methods of accounting for
costs to repair and maintain tangible property and for dispositions of certain tangible
depreciable property in a prior tax year. The year of change was Year 1, and
Taxpayer’s net deductible § 481(a) adjustment was approximately $a. The Consent
Agreement granting permission for the tax accounting method changes states that this
amount represents a netting of the net negative § 481(a) adjustment for maintenance
and repairs with the net positive § 481(a) adjustment for dispositions. The Consent
Agreement described the netting as a one-time exception allowed to Taxpayer for the
year of change based on its particular situation. The net deductible § 481(a) adjustment
for the repair-related change in tax method of accounting was $b and the net taxable
§ 481(a) adjustment for the disposition-related change in tax method of accounting was
$c.

       The Consent Agreement provides nine conditions that Taxpayer must satisfy
including the following condition, at issue, related to the normalization rules:

      9) If any item of property subject to the taxpayer’s Form 3115 is public utility
property within the meaning of § 168(i)(10) or former § 167(l)(3)(A):
   • (A) A normalization method of accounting (within the meaning of § 168(i)(9),
      former § 168(e)(3)(B), or former § 167(l)(3)(G), as applicable) must be used for
      such public utility property;
   • (B) As of the beginning of the year of change, the taxpayer must adjust its
      deferred tax reserve account or similar reserve account in the taxpayer’s
      regulatory books of account by the amount of the deferral of federal income tax
      liability associated with the § 481(a) adjustment applicable to such public utility
      property; and
   • (C) Within 30 calendar days of filing the federal income tax return for the year of
      change or of receiving this letter ruling, whichever is later, the taxpayer must
      provide a copy of its Form 3115 (and any additional information submitted to the
      Service in connection with such Form 3115) to any regulatory body having
      jurisdiction over such public utility property.

       The parties to the Rate Proceeding generally agree that the EADIT related to the
repairs method change and ongoing repairs deductions are not subject to the
normalization requirements under the applicable statute and regulations.
Notwithstanding that agreement, however, Taxpayer is party to the Consent Agreement
that has very specific terms and conditions, including the condition nine above.
Taxpayer and other parties disagree whether the condition nine applies to Taxpayer’s
request to change its method of accounting for repairs pursuant to § 162, or to
Taxpayer’s request to change its units of property for determining dispositions under

PLR-117557-19                               5

§ 168. Further, depending upon how this issue is answered, there is an additional
question of whether the EADIT that existed immediately prior to the beginning of the
year of change for the changes in tax method of accounting and resulted from
depreciation method and life differences remains subject to the deferred tax
normalization rules after implementation of the new tax method of accounting and
recognition of the § 481(a) adjustment.

       Since the beginning of Year 1, the year of change for the new tax method of
accounting for repairs, and through the end of Year 2, Taxpayer has deducted
approximately $d of costs as repairs under § 162. These amounts were capitalized and
are depreciable for regulatory and financial reporting purposes. No income tax
depreciation was claimed on any of the $d of costs claimed as repairs under § 162 of
the Code. The gross tax-only repair amounts are originating timing differences. During
these years, approximately $e of depreciation was reported for regulatory and financial
reporting purposes with respect to these costs. The book-only depreciation related to
the tax-only repairs has been the mechanism that Taxpayer was using prior to the TCJA
to reverse this timing difference. Similarly, the deductible repair-related component of
the § 481(a) adjustment of $f constituted an originating timing difference and the book-
only depreciation related to this amount has been the mechanism to reverse this timing
difference. Through the end of Year 2, approximately $g of book depreciation was
reported for regulatory and financial reporting purposes with respect to the repair-
related component of the § 481(a) adjustment.

      The deferred tax normalization issues for which Taxpayer requests rulings are:

   1) Whether net EADIT attributable to expenditures deducted as repairs for tax
      purposes under § 162 after the beginning of the year of change through the end
      of Year 2 pursuant to Taxpayer’s Consent Agreement and capitalized and
      depreciated for regulatory and financial reporting purposes is subject to the
      normalization rules of § 168(i)(9)(A).

   2) Whether net EADIT attributable to expenditures deducted as repairs as the
      deductible (negative) component of the net § 481(a) adjustment recognized in
      Year 1 related to the change in tax method of accounting for repairs (net of tax
      depreciation deducted under the former tax method of accounting) pursuant to
      Taxpayer’s Consent Agreement is subject to the normalization rules of
      § 168(i)(9)(A).

   3) Whether EADIT associated with depreciation method and life differences arising
      prior to the beginning of the year of change with respect to property that was
      public utility property under the former method of accounting and for which its
      remaining tax basis was deducted as part of the repair component of the net
      § 481(a) adjustment pursuant to Taxpayer’s Consent Agreement remains subject
      to the normalization rules of § 168(i)(9)(A).

PLR-117557-19                                 6

                                 RULINGS REQUESTED
                                            (1)
        The net EADIT resulting from expenditures (1) related to an item of property
includible in rate base and recoverable as regulatory depreciation expense and (2)
deducted as repairs under § 162 to public utility property within the meaning of
§ 168(i)(10) pursuant to the tax method of accounting for repairs permitted in
Taxpayer’s Consent Agreement, is not subject to the normalization method of
accounting within the meaning of § 168(i)(9) and is not required to be treated as subject
to a normalization method of accounting pursuant to the Consent Agreement. As such
return of net EADIT related to such timing difference faster than ARAM would not be a
violation of the EADIT normalization rules and would not be a violation of the Consent
Agreement.

or

        The net EADIT resulting from expenditures (1) related to an item of property
includible in rate base and recoverable as regulatory depreciation expense and (2)
deducted as repairs under § 162 to public utility property within the meaning of
§ 168(i)(10) pursuant to the tax method of accounting for repairs permitted in
Taxpayer’s Consent Agreement, is not subject to the normalization method of
accounting within the meaning of § 168(i)(9), but is required to be treated as subject to a
normalization method of accounting pursuant to the Consent Agreement. As such,
return of net EADIT related to such timing difference faster than ARAM would not be a
violation of the EADIT normalization rules, but would be a violation of the Consent
Agreement.

                                               (2)
        For any public utility property within the meaning of § 168(i)(10) as of the end of
the tax year immediately preceding the year of change for the changes in tax methods
of accounting subject to Taxpayer’s Consent Agreement, the net EADIT resulting from
the repair-related component of the § 481(a) adjustment is not subject to the
normalization method of accounting within the meaning of § 168(i)(9), and is not
required to be treated as subject to a normalization method of accounting pursuant to
the Consent Agreement. As such, return of net EADIT related to such timing difference
faster than ARAM would not be a violation of the EADIT normalization rules and would
not be a violation of the Consent Agreement.

or

       For any public utility property within the meaning of § 168(i)(10) as of the end of
the tax year immediately preceding the year of change for the changes in tax methods
of accounting subject to Taxpayer’s Consent Agreement, the net EADIT resulting from
the repair-related component of the § 481(a) adjustment is subject to the normalization
method of accounting within the meaning of § 168(i)(9), or is required to be treated as
subject to a normalization method of accounting pursuant to the Consent Agreement.

PLR-117557-19                                7

As such, return of EADIT related to such timing difference faster than ARAM would be a
violation of the EADIT normalization rules and would be a violation of the Consent
Agreement.

                                              (3)
       For any public utility property within the meaning of § 168(i)(10) as of the end of
the tax year immediately preceding the year of change for the changes in tax methods
of accounting subject to Taxpayer’s Consent Agreement, the net depreciation-related
ADIT that existed prior to the changes in tax methods of accounting for repairs and
dispositions remains subject to the normalization method of accounting within the
meaning of § 168(i)(9) even after implementation of the new tax method of accounting.
As such, return of any net EADIT related to such timing difference faster than ARAM
would be a violation of the EADIT normalization rules. Under the circumstances
described above, return of any EADIT related to such timing difference faster than
ARAM would not be a violation of the Consent Agreement.

or

       For any public utility property within the meaning of § 168(i)(10) as of the end of
the tax year immediately preceding the year of change for the changes in tax methods
of accounting subject to Taxpayer’s Consent Agreement, the net depreciation-related
ADIT that existed prior to the changes in tax methods of accounting for repairs and
dispositions is not subject to the normalization method of accounting within the meaning
of § 168(i)(9) even after implementation of the new tax method of accounting and is not
required to be normalized pursuant to the Consent Agreement. As such, return of any
net EADIT related to such timing difference faster than ARAM would not be a violation
of the EADIT normalization rules and would not be a violation of the Consent
Agreement.

or

       For any public utility property within the meaning of § 168(i)(10) as of the end of
the tax year immediately preceding the year of change for the changes in tax methods
of accounting subject to Taxpayer’s Consent Agreement, the net depreciation-related
ADIT that existed prior to the changes in tax methods of accounting for repairs and
dispositions is not subject to the normalization method of accounting within the meaning
of § 168(i)(9) after implementation of the new tax method of accounting. However,
pursuant to the Consent Agreement, a normalization method of accounting is required.
As such, return of any net EADIT related to such timing difference faster than ARAM
would not be a violation of the EADIT normalization rules, but would be a violation of the
Consent Agreement.

                                  LAW AND ANALYSIS

PLR-117557-19                                  8

       Section 1.167(l)-1(a)(1) provides that the normalization requirements of former
§ 167(l) with respect to public utility property defined in former § 167(l)(3)(A) 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 method of 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.

       Section 481(a) requires those adjustments necessary to prevent amounts from
being duplicated or omitted to be taken into account when a taxpayer's taxable income
is computed under a method of accounting different from the method used to compute
taxable income for the preceding taxable year. See also § 2.05(1) of Rev. Proc. 97-27,
97-27, 1997-1 C.B. 680 (the operative method change revenue procedure at the time
Taxpayer filed its Form 3115).

        An adjustment under § 481(a) can include amounts attributable to taxable years
that are closed by the period of limitation on assessment under § 6501(a). Suzy's Zoo
v. Commissioner, 114 T.C. 1, 13 (2000), aff'd, 273 F.3d 875, 884 (9th Cir. 2001);
Superior Coach of Florida, Inc. v. Commissioner, 80 T.C. 895, 912 (1983), Weiss v.
Commissioner, 395 F.2d 500 (10th Cir. 1968), Spang Industries, Inc. v. United States, 6
Cl. Ct. 38, 46 (1984), rev'd on other grounds 791 F.2d 906 (Fed. Cir. 1986). See also
Mulholland v. United States, 28 Fed. Cl. 320, 334 (1993) (concluding that a court has
the authority to review the taxpayer's threshold selection of a method of accounting de
novo, and must determine, ab initio, whether the taxpayer's reported income is clearly
reflected).

        Sections 481(c) and 1.481-4 provide that the adjustment required by § 481(a)
may be taken into account in determining taxable income in the manner, and subject to
the conditions, agreed to by the Service and a taxpayer. Section 1.446-1(e)(3)(i)
authorizes the Service to prescribe administrative procedures setting forth the
limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain
consent to change a method of accounting in accordance with § 446(e). See also
§ 5.02 of Rev. Proc. 97-27.

       When there is a change in method of accounting to which § 481(a) is applied, §
2.05(1) of Rev. Proc. 97-27 provides that income for the taxable year preceding the year
of change must be determined under the method of accounting that was then employed,
and income for the year of change and the following taxable years must be determined
under the new method of accounting as if the new method had always been used.

       Taxpayer’s ruling request # 3 pertains to whether EADIT associated with
depreciation method and life differences arising prior to the beginning of the year of
change (Year 1) with respect to property that was public utility property under the former
method of accounting and for which its remaining tax basis was deducted as part of the
repair component of the net § 481(a) adjustment pursuant to Taxpayer’s Consent

PLR-117557-19                                 9

Agreement remains subject to the normalization rules of § 168(i)(9)(A). Beginning with
the year of change, Taxpayer’s Consent Agreement granted Taxpayer permission to
change its method of accounting for costs to repair and maintain tangible property from
capitalizing and depreciating these costs to deducting these costs under § 162.

       Condition nine of the Consent Agreement provides that if any item of property
subject to the Form 3115 is public utility property within the meaning of § 168(i)(10), a
normalization method of accounting (within the meaning of § 168(i)(9)) must be used for
such public utility property. Public utility property (within the meaning of § 168(i)(10)) is
a depreciable asset. Consequently, condition nine of the Consent Agreement is
intended to apply to Taxpayer’s public utility property that continues to be depreciated
for federal income tax purposes under Taxpayer’s new method of accounting for the
year of change and subsequent taxable years.

       When there is a change in method of accounting to which § 481(a) is applied,
income for the taxable year preceding the year of change must be determined under the
method of accounting that was then employed by Taxpayer, and income for the year of
change and the following taxable years must be determined under Taxpayer’s new
method of accounting as if the new method had always been used. See § 481(a);
§ 1.481-1(a)(1); and § 2.05(1) of Rev. Proc. 97-27. In other words: (1) Taxpayer’s new
method of accounting is implemented beginning in the year of change; (2) Taxpayer’s
old method of accounting used in the taxable years preceding the year of change is not
disturbed; and (3) Taxpayer takes into account a § 481(a) adjustment in computing
taxable income to offset any consequent omissions or duplications.

       Accordingly, for public utility property in service as of the end of the taxable year
immediately preceding the year of change (Year 1), the depreciation-related ADIT
existing prior to the year of change for the changes in methods of accounting subject to
the Consent Agreement does not remain subject to the normalization method of
accounting within the meaning of § 168(i)(9) after implementation of the new tax
methods of accounting in the year of change and subsequent taxable years.

       As stated previously, condition nine of the Consent Agreement is intended to
apply to Taxpayer’s public utility property that continues to be depreciated for federal
income tax purposes under Taxpayer’s new method of accounting for the year of
change and subsequent taxable years. A repair expense is an item of expense that is
deductible under § 162 and for which depreciation is not allowable. Accordingly, in
regard to ruling request 2, the ADIT resulting from the repair-related § 481(a)
adjustment is not subject to the normalization method of accounting within the meaning
of § 168(i)(9).

      Lastly, condition nine of the Consent Agreement is intended to apply to
Taxpayer’s public utility property that continues to be depreciated for federal income tax
purposes under Taxpayer’s new method of accounting for the year of change and
subsequent taxable years. A repair expense is an item of expense that is deductible

PLR-117557-19                               10

under § 162 and for which depreciation is not allowable. Accordingly, in regard to ruling
request 1, net EADIT attributable to expenditures deducted as repairs for tax purposes
under § 162 after the beginning of the year of change through the end of Year 2
pursuant to Taxpayer’s Consent Agreement and capitalized and depreciated for
regulatory and financial reporting purposes is not subject to the normalization rules of
§ 168(i)(9)(A)

      Based on the foregoing, we conclude that:

        For ruling request # 1, the net EADIT resulting from expenditures (1) related to
an item of property includible in rate base and recoverable as regulatory depreciation
expense and (2) deducted as repairs under § 162 to public utility property within the
meaning of § 168(i)(10) pursuant to the tax method of accounting for repairs permitted
in Taxpayer’s Consent Agreement, is not subject to the normalization method of
accounting within the meaning of § 168(i)(9) and is not required to be treated as subject
to a normalization method of accounting pursuant to the Consent Agreement. As such
return of net EADIT related to such timing difference faster than ARAM would not be a
violation of the EADIT normalization rules and would not be a violation of the Consent
Agreement.

       For ruling request # 2, for any public utility property within the meaning of
§ 168(i)(10) as of the end of the tax year immediately preceding the year of change for
the changes in tax methods of accounting subject to Taxpayer’s Consent Agreement,
the net EADIT resulting from the repair-related component of the § 481(a) adjustment is
not subject to the normalization method of accounting within the meaning of § 168(i)(9),
and is not required to be treated as subject to a normalization method of accounting
pursuant to the Consent Agreement. As such, return of net EADIT related to such
timing difference faster than ARAM would not be a violation of the EADIT normalization
rules and would not be a violation of the Consent Agreement.

       For ruling request # 3, for any public utility property within the meaning of
§ 168(i)(10) as of the end of the tax year immediately preceding the year of change for
the changes in tax methods of accounting subject to Taxpayer’s Consent Agreement,
the net depreciation-related ADIT that existed prior to the changes in tax methods of
accounting for repairs and dispositions is not subject to the normalization method of
accounting within the meaning of § 168(i)(9) even after implementation of the new tax
method of accounting and is not required to be normalized pursuant to the Consent
Agreement. As such, return of any net EADIT related to such timing difference faster
than ARAM would not be a violation of the EADIT normalization rules and would not be
a violation of the Consent Agreement.

      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 are not ruling on the
ADIT resulting from the disposition-related § 481(a) adjustment and related to the

PLR-117557-19                                  11

restored tax basis of public utility property that was treated as disposed under the old
method of accounting but is not treated as disposed under the new method of
accounting.

        To note, the EADIT at issue in this request does not address the excess tax
reserves resulting from the corporate tax rate decrease in the Tax Cuts and Jobs Act
(TCJA), Pub. L. 115-97 (131 Stat 2054). The EADIT at issue is only that as described
in this letter ruling.

      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,



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



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