20201104Attachment B.pdf

AVISTA
TAX CHANGE DEFERRAL APPLICATION
ATTACHMENT B
Internal Revenue Service Department of the Treasury
Washington, DC 20224
Number: 202033002
Release Date: 8/14/2020
Index Number: 168.24-01
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In Re: ----------------------------------------------------
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Third Party Communication: None
Date of Communication: Not Applicable
Person To Contact:
-----------------------, ID No. ------------
Telephone Number:
--------------------
Refer Reply To:
CC:PSI:B06
PLR-122510-19
Date:
March 26, 2020
LEGEND:
Taxpayer = --------------------------------------------------------
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Parent = ------------------------------------------------------------------------
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State A = ----------------
Commission A = -----------------------------------------------
Commission B = -----------------------------------------------------
Date 1 = --------------------------
Date 2 = -------------------------
Date 3 = -----------------------
Date 4 = ----------------------
Date 5 = -----------------------
Month 1 = --------------
Month 2 = -----------
Year 1 = -------
Page 1 of 31
Attachment B
PLR-122510-19 2
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Year 6 = -------
Dear -------------:
This letter responds to a request for a private letter ruling dated September 26,
2019, and submitted on behalf of Taxpayer regarding the application of the depreciation
normalization rules under § 168(i)(9) of the Internal Revenue Code and § 1.167(l)-1 of
the Income Tax Regulations (together, the “Normalization Rules”) to certain State A
state regulatory procedures which are described in this letter. The relevant facts as
represented in your submission are set forth below.
FACTS
Taxpayer is an investor-owned regulated utility incorporated under the laws of
State A. Taxpayer is an accrual basis taxpayer and reports on a calendar year basis.
Taxpayer is wholly owned by Parent. Parent is a State A corporation. Taxpayer
is included in a consolidated federal income tax return of which Parent is the common
parent.
Taxpayer is a regulated utility engaged principally in the purchase, transmission,
distribution, and sale of electric energy and the purchase, distribution, and sale of
natural gas in State A. Taxpayer is subject to regulation as to rates and conditions of
service by Commission A as well as Commission B. Both these regulators establish
Taxpayer’s rates based on its costs, including a provision for a return on the capital
employed by Taxpayer in its regulated businesses.
Taxpayer has claimed accelerated depreciation on all of its public utility property
(both electric and gas) to the full extent those deductions have been available.
Taxpayer has normalized 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 accelerated depreciation reflected on its regulated books
of account for each of its divisions. In accordance with State A ratemaking practice,
Taxpayer has reduced its rate base by its ADFIT balance.
Page 2 of 31
Attachment B
PLR-122510-19 3
Commission B has established a system to track accounts for both jurisdictional
electric and gas companies. These accounts prescribe the accounting rules which are
used by most large investor-owned electric and gas companies and are employed by
Taxpayer’s electric and gas divisions. The applicable regulations contain several
definitions relevant to Taxpayer’s inquiry including definitions for cost of removal (COR),
salvage value, net salvage value, service value, and depreciation.
In general, based on these definitions, for purposes of regulatory reporting, the
net positive value or net cost of disposing of an asset at the end of its life is incorporated
into the annual depreciation charge. COR is, therefore, most often (but not always) a
component of establishing the applicable depreciation rate. In Taxpayer’s case, due to
the amount of COR it anticipates, in almost all instances its assets have negative net
salvage values so that its book depreciation rate is higher than it would be were salvage
value not considered. In effect, the annual depreciation charge creates a reserve for
COR over the operating life of the asset. Since book depreciation expense is included
in Taxpayer’s cost of service used for establishing its rates, customers pay for the COR
as book depreciation is factored into their rates. This COR reserve is reflected as an
addition to Taxpayer’s accumulated depreciation account. When the COR is actually
incurred, the amount expended is debited to that same account, thereby reducing the
balance.
For tax purposes, COR is deductible only when actually incurred. Taxpayer,
therefore, reports its customer collections that fund the COR reserve as taxable income
over the operating life of an asset, claiming an offsetting tax deduction only at the end of
the life of that asset. Taxpayer has normalized COR since the Year 1 tax year. All
references below to COR-related deferred tax accounting relate only to COR associated
with assets placed in service after Year 2. Since COR is normalized in setting rates,
customers are provided a tax benefit commensurate with their funding of COR. In other
words, they are provided the COR tax benefit as they fund the COR reserve – prior to
the time Taxpayer actually claims that benefit on its tax return.
The tax effect of the COR funding as described creates a deferred tax asset
(“DTA”). This represents the future benefit to be derived from the eventual COR tax
deduction. The COR-related DTA is included in Taxpayer’s overall plant-related ADFIT
account that reduces Taxpayer’s ADFIT balance.
COR can (and does) impact ADFIT balances in an additional way. The COR
included in depreciation expense (that is, the accrual) is an estimate prepared for an
entire class of assets contained in a Commission B account. It is likely that any COR
estimate will be too high or too low with respect to any individual asset with the ultimate
answer remaining unknown until all vintages of each asset class are retired and
removed. Any running variance from the estimate is recorded on Taxpayer’s balance
sheet. Where the accrual exceeds the actual COR, it creates a net credit to the
accumulated depreciation account. Where the actual COR exceeds the accrual, it
creates a net debit to that account. This treatment means that Taxpayer will recover
Page 3 of 31
Attachment B
PLR-122510-19 4
under-accruals from customers and refund over-accruals to customers through future
rate adjustments. These future rate adjustments will give rise to future increases or
decreases in taxable income. Under applicable accounting principles, Taxpayer must
record the deferred tax consequences of these future events. An over-accrual produces
a DTA (the tax benefit of a future deduction due to the refund of the excess collection)
while an under-accrual produces a deferred tax liability “DTL” (the tax cost of future
taxable income due to the collection of the shortfall).
For the electric distribution division, the COR book/regulatory accrual has always
been included in the development of the book depreciation rate. Thus, instead of
waiting for the Taxpayer to incur the tax benefit of COR, its’ Customers are provided the
COR tax benefit as they fund the COR reserve – prior to the time Taxpayer actually
claims that benefit on its tax return. This produces a DTA as described. In addition, as
of Date 1, Taxpayer has, in total, incurred more COR than it has recovered from
customers and, thus, is under-accrued for COR. This has produced a DTL, also as
described. Both the DTA and DTL are included within Taxpayer’s overall plant-related
ADFIT Account.
Prior to Month 1 Year 3, the gas distribution division accrued and collected COR
as a component of the book depreciation rate. However, pursuant to order of
Commission A, that collection practice was modified in Year 3. Beginning in Month 1
Year 3, the gas-only COR regulatory accrual was removed from the book depreciation
rate. Rather, Taxpayer was allowed to record and recover annually (through a fixed
dollar depreciation charge incremental to the normal depreciation computed via
application of the depreciation rate) an amount representing an estimate of the annual
COR that would be incurred in that year. At the time of this modification, the cumulative
COR accrued exceeded COR actually incurred (that is, Taxpayer was over-accrued).
At that time, Taxpayer had recorded a net DTA (to reflect the tax benefit of the future
reduction in rates associated with refunding the excess to customers).
Since converting to this methodology in Year 3, COR actually incurred has
significantly exceeded COR accrued and recovered, resulting in a DTL (the tax cost of
recovering the under-accrual in the future). As of Date 1, the two components (pre-
Month 1 Year 3 and post-Month 2 Year 3) combined represented a net DTL.
Effective Date 2, pursuant to an Order issued by Commission A, gas COR
regulatory recovery has reverted back to a component of the book depreciation rate.
The fixed dollar accrual which began in Year 3 has been eliminated.
Since Year 4, Taxpayer’s tax fixed asset system has separately identified the
portion of Taxpayer’s book depreciation expense that relates to COR since that date.
As a consequence, the system distinguishes between COR book/tax differences and
depreciation method/life differences even though they are both derived from Taxpayer’s
book depreciation. Though the system has the capability of tracking the reversals of
these differences separately, in order to set it up to do this, a significant amount of work
Page 4 of 31
Attachment B
PLR-122510-19 5
and data manipulation would be required. It is not currently configured in a manner that
would allow this.
In years prior to Year 5, Taxpayer paid income tax at a 35% rate on the recovery
of the COR portion of book depreciation (and provided its customers a tax benefit at that
tax rate). However, as a result of the tax rate reduction enacted as part of the Tax Cuts
and Jobs Act (“TCJA”), Taxpayer will only receive a 21% benefit when the COR
deduction is claimed or when any over-accrual is refunded and will pay only a 21% tax
on the recovery of any COR under-accrual. In other words, in the case of COR, the tax
rate reduction enacted as part of the TCJA has produced both a deferred tax shortfall as
well as an excess tax reserve. Because Taxpayer will not recover the 14% “excess” tax
it paid on its recovery of the COR component of book depreciation from the government
when it claims its COR deduction, it must recover it from its customers. Conversely,
because Taxpayer will not pay the 14% “excess” deferred tax it accrued on its obligation
to refund over-accrued COR, it must restore the amount to its customers (that is, it also
has COR-related excess deferred taxes).
Taxpayer’s Changes in Accounting Method for Mixed Service Costs and Repairs
Prior to Taxpayer’s Year 6 tax year, in capitalizing its indirect overhead costs –
including its mixed service costs – Taxpayer followed the same methodology for both
book and tax purposes. Effective for its Year 6 tax year, Taxpayer filed with the Internal
Revenue Service an Application for Change in Accounting Method (Form 3115) in which
it requested permission to depart from its book method for tax purposes. The result of
the change was to recharacterize a substantial quantity of mixed service costs that
Taxpayer had previously capitalized into depreciable assets as deductible costs
(including additions to cost of goods sold). This resulted in Taxpayer claiming a
negative adjustment under § 481(a) (that is, a deduction) to remove from the tax basis
of its existing assets all such recharacterized costs to the extent Taxpayer had not
previously depreciated them (“Section 481 Adjustment”).
Also, prior to Taxpayer’s Year 6 tax year, in identifying deductible repairs,
Taxpayer followed the same methodology for both book and tax purposes. Effective for
its Year 6 tax year, Taxpayer filed an Application for Change in Accounting Method
(Form 3115) in which it requested permission to depart from its book method for tax
purposes. In general, under its new tax method, Taxpayer elected to use larger units of
property than used for book purposes. The result of the change was to characterize
many projects that were capitalized for book purposes as deductible repairs for tax
purposes. This resulted in Taxpayer claiming a negative § 481 Adjustment to remove
from the tax basis of its existing assets all such recharacterized costs to the extent
Taxpayer had not previously depreciated them.
Adjustments (additions) were made to Taxpayer’s ADFIT accounts, which
already reflected the deferred tax consequences of having claimed accelerated
Page 5 of 31
Attachment B
PLR-122510-19 6
depreciation on both types of costs after they were capitalized for tax purposes for the
additional deferred taxes produced by the § 481 Adjustments.
Taxpayer’s Recent Commission A Proceedings
On Date 3, Taxpayer filed with Commission A to adjust both its electric and its
gas rates. The parties to the proceeding reached an agreement and, on or about Date
4, Taxpayer submitted a stipulation to Commission A for its approval. Commission A
approved the stipulation on Date 5.
The stipulation provides that:
1) Taxpayer will seek a private letter ruling to determine if excess deferred taxes
associated with excess tax over book depreciation that is subsequently reversed
by accounting method changes relating to repair deductions and the
capitalization of mixed service costs are protected by the normalization rules and
subject to reversal under the ARAM; and that
2) Taxpayer will seek a private letter ruling from the IRS to determine whether
post-Year 1 cost of removal is protected by the normalization rules and, if so,
whether it is to be treated as a separate temporary difference or part of the
overall depreciation temporary difference for purposes of ARAM amortization.
RULINGS REQUESTED
Taxpayer requests the following guidance:
1) Under the circumstances described above, is Taxpayer’s electric distribution COR-
related net DTL “protected” by the Normalization Rules?
2) If Taxpayer’s electric distribution COR-related deferred tax is “protected,” should that
shortfall be treated as a discrete “protected” item or as part of the “protected”
method/life difference?
3) Under the circumstances described above, is Taxpayer’s gas distribution COR-
related net DTA accumulated through the depreciation rate prior to Month 1 of Year 3
“protected” by the Normalization Rules?
4) If Taxpayer’s gas distribution COR-related deferred tax accumulated through the
depreciation rate prior to Month 1 of Year 3 is “protected,” should that shortfall be
treated as a discrete “protected” item or as part of the “protected” method/life
difference?
Page 6 of 31
Attachment B
PLR-122510-19 7
5) Under the circumstances described above, is Taxpayer’s gas distribution COR-
related net DTL accumulated through the fixed estimated cash recovery after Month 1 of
Year 3 “protected” by the Normalization Rules?
6) If Taxpayer’s gas distribution COR-related net DTL accumulated through the fixed
estimated cash recovery after Month 1 of Year 3 is “protected,” should that shortfall be
treated as a discrete “protected” item or as part of the “protected” method/life
difference?
7) If Taxpayer’s COR-related deferred tax shortfall is “protected,” do the Normalization
Rules permit Taxpayer to collect a shortfall any more rapidly than using the ARAM?
8) Do Taxpayer’s depreciation-related ADFIT balances created pursuant to the
Normalization Rules that are attributable to costs that were capitalized into the basis of
depreciable assets prior to Taxpayer changing its method of accounting for those costs
remain subject to the Normalization Rules after the change in method of accounting
pursuant to which such costs were reclassified as current deductions?
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
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
§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.
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
Page 7 of 31
Attachment B
PLR-122510-19 8
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 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, Application for Change in Accounting Method).
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 accounting 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.
Because of their similarity, we address requests 1, 3, and 5 together. For all of
the COR-related amounts at issue in these requests, the amounts are not protected by
the Normalization Rules. Generally, § 168(i)(9)(A) does not refer to COR. Moreover,
there is no reference to an acceleration of taxes but only to a deferral. While COR may
be a component of the calculation of the amount treated as book depreciation, it is a
deduction under § 162 and has nothing to do with actual accelerated tax depreciation.
While depreciation method and life differences are created and reversed solely through
depreciation, such is not the case with COR. While the COR timing differences may
Page 8 of 31
Attachment B
PLR-122510-19 9
often originate as a component of book depreciation, it reverses through the incurred
COR expenditure.
Taxpayer’s ruling request 8 pertains to the depreciation-related ADIT existing
prior to the year of change (Year 6) for public utility property in service as of the end of
the taxable year immediately preceding the year of change. Beginning with the year of
change, the Year 6 Consent Agreement granted Taxpayer permission to change its
(1)method of accounting for mixed service costs to recharacterize a substantial quantity
of mixed service costs that Taxpayer had previously capitalized into depreciable assets
as deductible costs (including additions to cost of goods sold) and (2) to depart from its
book method for tax purposes electing to use for tax purposes larger units of property
than used for book purposes which resulted in characterizing many projects that were
capitalized for book purposes as deductible repairs for tax purposes.
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 6), the depreciation-related ADIT
existing prior to the year of change for the changes in methods of accounting subject to
the Year 6 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.
Based on the foregoing, we conclude that:
1) Under the circumstances described above, Taxpayer’s electric distribution COR-
related net DTL is not “protected” by the Normalization Rules.
3) Under the circumstances described above, Taxpayer’s gas distribution COR-related
net DTA accumulated through the depreciation rate prior to Month 1 of Year 3 is not
“protected” by the Normalization Rules.
5) Under the circumstances described above, Taxpayer’s gas distribution COR-related
net DTL accumulated through the fixed estimated cash recovery after Month 1 of Year 3
is not “protected” by the Normalization Rules.
Page 9 of 31
Attachment B
PLR-122510-19 10
Because these amounts in requests 1, 3, and 5 are not protected by the Normalization
Rules, requests 2, 4, 6, and 7 are moot.
8) Taxpayer’s depreciation related ADFIT balances created pursuant to the
Normalization Rules that are attributable to costs that were capitalized into the basis of
depreciable assets prior to Taxpayer changing its method of accounting for those costs
do not remain subject to the Normalization Rules after the change in method of
accounting pursuant to which such costs were reclassified as current deductions.
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.
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)
cc:
Page 10 of 31
Attachment B
Internal Revenue Service Department of the Treasury
Washington, DC 20224
Number: 202010002
Release Date: 3/6/2020
Index Number: 168.24-01
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In Re: ----------------------------------------------------
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Third Party Communication: None
Date of Communication: Not Applicable
Person To Contact:
-----------------------, ID No. ------------
Telephone Number:
--------------------
Refer Reply To:
CC:PSI:B06
PLR-113227-19
Date: December 3, 2019
LEGEND:
Taxpayer = -----------------------------------------------
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Parent = ----------------------------------------------------
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State A = -------------
State B = -----------
Commission = ------------------------------------------------------------------------
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Date 1 = -------------------------
Date 2 = --------------------------
Date 3 = ------------------
Date 4 = ----------------------
Date 5 = ----------------------
Date 6 = ------------------
Date 7 = --------------------
Date 8 = ---------------------------
Date 9 = --------------------------
Page 11 of 31
Attachment B
PLR-113227-19 2
Date 10 = -------------------------
Date 11 = --------------------------
Date 12 = --------------------------
Date 13 = ----------------------
Date 14 = -----------------------
Date 15 = ----------------------
Date 16 = --------------------------
Month 1 = -----
Month 2 = ------
Month 3 = ------
Month 4 = --------------
Month 5 = ---------
Month 6 = ---------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
a = -------------
b = -----------------
c = -------------
d = -------------
e = ---------------
Page 12 of 31
Attachment B
PLR-113227-19 3
f = -----------------
g = -----------------
h = ---------------
i = -----------------
j = ---------------
k = ---------------
l = ---------------
Dear --------------:
This letter responds to a request for a private letter ruling dated June 5, 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 and the appropriate methodology for the reduction of the accumulated
deferred income tax (“ADIT”) balance that decreases rate base computation when a net
operating loss carryforward (“NOLC”) exists. 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 its Parent. Taxpayer uses the accrual method of accounting.
Parent is incorporated in State A, and Taxpayer is incorporated in State B.
Parent is a water and wastewater utility company. Taxpayer is the affiliate that operates
in State B. Prices charged by Taxpayer are set by Commission. 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 (resulting in
what are commonly referred to as “base rates”) and infrastructure surcharge
proceedings (resulting in surcharges that are added to base rates.)
The most recent two base rate changes resulting from general rate case
authorizations by Commission affecting water and wastewater revenue requirements
were effective in Month 1 Year 1 and Month 2 Year 2. The most recent three rate
changes resulting from infrastructure surcharge authorizations by Commission were
effective in Month 3 Year 3, Month 4 Year 4 and Month 4 Year 2. Taxpayer questions
whether the rates set pursuant to the most recent infrastructure surcharge proceeding
comply with the deferred tax normalization requirements.
Page 13 of 31
Attachment B
PLR-113227-19 4
Infrastructure surcharges are regulatory mechanisms to permit recovery of
capital investments and results in adjustments to rates charged outside of a general rate
case for specified costs and investments. Under State B statute and Commission
rulemaking, eligible water corporations may petition Commission and utilize a
Infrastructure System Replacement Surcharge (“Surcharge”) to recover the costs of
eligible water utility main replacements and relocations.
For both general rate case proceedings and Surcharge 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 ADIT, and a recovery of operating
expenses, including depreciation expense, property tax expense, and income tax
expense. For Surcharge proceedings, rate base is determined based on incremental
plant expenditures incurred during a historical measurement period (not necessarily 12
months) ending shortly before rates become effective, less accumulated book
depreciation and ADIT computed as of a date subsequent to the date at which gross
plant is computed and closer to (but preceding) the date that rates become effective.
For Surcharge proceedings, operating expenses include 12 months of annualized
depreciation expense on the incremental investment in the Surcharge proceeding and
any property taxes that will be paid within 12 months of filing the Surcharge application.
The deferred tax normalization matters in this request arose during the
Surcharge proceeding initiated by Taxpayer in Month 5 Year 2 and resulting in a
Commission order on Date 1 (the “Surcharge Case”). The Surcharge resulting from the
Surcharge Case became effective on Date 2. Some of the normalization matters
addressed in this ruling request related to deductions and ADIT resulting from 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 method of
accounting for costs to repair and maintain tangible property and dispositions of certain
tangible depreciable property (“Consent Agreement”).
State B statutes and Commission B rules provide eligible water corporations with
the ability to recover certain infrastructure system replacement costs outside of a formal
rate case filing via a Surcharge. A petition must be filed with the Commission for review
and approval before an adjustment can be made to a water corporation’s rates and
charges to provide for the recovery of the costs associated with eligible infrastructure
system replacements. A State B statute authorizes Commission to enter an order
authorizing the water corporation to impose a Surcharge that is sufficient to recover
appropriate pretax revenues. The State B statute defines the revenue requirement set
in a Surcharge proceeding and provides that “appropriate pretax revenues” are the
revenues necessary to produce net operating income equal to the water corporation’s
weighted cost of capital multiplied by the net original cost of eligible infrastructure
system replacements, including recognition of accumulated deferred income taxes and
accumulated depreciation associated with eligible infrastructure system
Page 14 of 31
Attachment B
PLR-113227-19 5
replacements. . .” among other items. Taxpayer represents that Commission and the
State B courts have interpreted this statute in a strict manner thereby limiting the costs
eligible for recovery or to earn a return in a Surcharge proceeding and causing costs not
eligible for ratemaking consideration in a Surcharge proceeding to only be eligible for
recovery or return in the next base rate proceeding.
Taxpayer, per its petition filed with Commission on Date 4, sought to establish a
Surcharge rate to provide for the recovery of actual costs for eligible infrastructure
system replacements and relocations from Date 5 through Date 6, and estimated
investment accounts for Date 7 through Date 8. During the course of the Surcharge
case, Taxpayer provided Commission with actual expenditures for Month 5 and Month
6. The proposed Surcharge rate schedule reflected the pre-tax Surcharge revenues
necessary to produce net operating income equal to Taxpayer’s weighted cost of capital
multiplied by the original cost of the requested infrastructure replacements that are
eligible for the Surcharge, reduced by net ADIT and accumulated depreciation
associated with eligible infrastructure system replacements through Date 9. Taxpayer
also sought to recover all state, federal and local income or excise taxes applicable to
such Surcharge income and to recover all other Surcharge costs including annualized
depreciation expense and property taxes due within 12 months.
The specific test period and service period information pertaining to the Surcharge Case
is:
•Rates became effective Date 2
•Actual gross plant was based on additions of certain property placed in service
from Date 5 through Date 8
•Accumulated depreciation on such assets was estimated through Date 9
•Estimated ADIT related to depreciation book/tax differences associated with such
expenditures to the extent also capitalized for tax purposes was computed
through Date 9
•Estimated ADIT related to repair book/tax differences associated with such
expenditures to the extent not capitalized for tax purposes was computed
through Date 9
•Recoverable operating expenses were estimated for the period beginning Date
10 and ending Date 9
In a Surcharge proceeding, replacement mains and associated valves and
hydrants comprise the plant assets included in rate base and result in the accumulated
depreciation reducing rate base and the recoverable depreciation expense. The
expenditures for replacement mains and associated valves addressed in a Surcharge
proceeding are capitalizable for regulatory accounting purposes, but may result in a
repair deduction for tax purposes or depreciable plant for tax purposes. The ADIT
balance reducing rate base in a Surcharge proceeding is caused by depreciation-
related and repair-related book/tax differences.
Page 15 of 31
Attachment B
PLR-113227-19 6
The key issues in the Surcharge case and, thus, in this ruling request, pertain to
whether the tax effect of an NOLC must, pursuant to the normalization requirements,
decrease the ADIT reduction to rate base related to the expenditures in the Surcharge
case and, if so, the methodology to determine the amount of the NOLC adjustment
subject to the normalization requirements. The return on rate base is based on the pre-
tax rate of return authorized in the most recent rate order resulting from a general rate
proceeding.
In the course of the Surcharge Case, Taxpayer and other participants in the
proceeding analyzed the expenditures for which Taxpayer sought recovery via the
Surcharge and debated the proper regulatory treatment of Taxpayer’s NOLC and tax
loss incurred through the rate base determination date of the Surcharge case with
respect to the costs incurred that are recoverable in the Surcharge case. The revenue
requirement approved in Commission’s order issued on Date 1 was lower than the
revenue requirement sought by Taxpayer and is entirely attributable to differing ADIT
calculations with respect to the NOLC and the resulting effects on rate base and
allowed return. The approved revenue requirement in the Surcharge case was based
on a rate base computation that reflects the gross ADIT liabilities associated with
depreciation-related and repair-related book/tax differences, but did not reflect an ADIT
asset for any portion of Taxpayer’s NOLC as of the date that rate base was determined
(Date 9) , including the tax loss resulting from the infrastructure expenditures addressed
in the Surcharge Case.
On a consolidated basis, Parent incurred tax losses in various years from Year 5
to Year 1 and, as of Date 11, had an NOLC of approximately $a. On a separate
company basis, Taxpayer incurred tax losses in various tax years from Year 5 – Year 1
and, as of Date 11, had a separate company NOLC of approximately $b. For Year 2,
Parent (on a consolidated basis) and Taxpayer (on a separate company basis) estimate
that taxable income was earned and, thus, NOLC was utilized.
The revenue requirement related to the Surcharge Case is approximately $c
(pursuant to the rate order). Taxpayer asserts that the revenue requirement should
have been computed to be $d. The difference in the revenue requirement computations
relates entirely to the exclusion of Taxpayer’s NOLC from rate base. As of the date of
the rate base determination, none of the Surcharge revenues had been billed to
customers and, thus, as of such date, a taxable loss of approximately $e had been
incurred with respect to the plant-related expenditures with rates set by the Surcharge
Case.
During the loss years resulting in Taxpayer’s NOLC estimated as of the end of
the test period for the Surcharge Case, separate company deductible depreciation-
related book/tax differences were approximately $f and separate company deductible
repair-related book/tax differences were approximately $g (plus the § 481(a) adjustment
with respect to the tax accounting method changes subject to the Consent agreement
deducted in Year 5 of approximately $h.
Page 16 of 31
Attachment B
PLR-113227-19 7
The NOLC reflected in ratemaking for the base rate case proceeding with rates
effective in Month 2 Year 2 was based on the estimated NOLC as of the end of Year 4
of $i, including an estimated Year 4 tax loss of $j. The actual Year 4 tax loss reported
on the Year 4 tax return was $k. The excess of the actual Year 4 tax loss over the
estimated Year 4 tax loss of $l has yet to be reflected in ratemaking.
On Date 12, Taxpayer filed an Application for Rehearing and Motion to Defer
Ruling, asking the Commission for the time to seek a private letter ruling form of
guidance from the Service to address any uncertainties regarding the application of the
deferred tax normalization requirements to the rate base treatment of the NOLC-related
ADIT asset in computing the Surcharge case revenue requirement. On Date 13, the
Commission denied Taxpayer’s request for rehearing. Taxpayer filed a notice of appeal
by Date 14, that initiated an appeal of the order in the Surcharge case to the State B
Court of Appeals. Taxpayer anticipates receiving a private letter ruling from the
Service prior to the State B Court of Appeals issuing a final opinion in Taxpayer’s
appeal of the Commission denial of Taxpayer’s Motion for Rehearing. If the Service
rules that the Commission’s decision in Taxpayer’s Surcharge case ordered a method
of regulatory accounting that is inconsistent with the deferred tax normalization
requirements, Taxpayer believes that the Commission and Taxpayer would be
procedurally able to correct the revenue requirement in a manner that compensates
Taxpayer for any foregone revenue requirement relative to ADIT and rate base
computations that comply with the normalization requirements.
Because Taxpayer is concerned that the order issued by Commission as part of
the Surcharge case on Date 1, and the prices that became effective on Date 2, are
inconsistent with the deferred tax normalization requirements, Taxpayer submitted a
letter to the Service on Date 14 intended to provide the notification pursuant to
§1.167(l)-1(h)(5) of the Regulations.
As noted, on Date 3, Taxpayer’s parent corporation received the Consent
Agreement from the Internal Revenue Service granting certain of its subsidiaries,
including Taxpayer, permission to change their (1) method of accounting for costs to
repair and maintain tangible property from capitalizing and depreciating these costs to
deducting these costs under § 162 of the Internal Revenue Code, and (2) unit of
property for determining dispositions of depreciable network assets from using a
method other than the functional interdependence test to using the functional
interdependence test to determine the units of property. These changes in methods of
accounting were effective for the taxable year beginning Date 15, and ended Date 16
(the “year of change”).
These changes in methods of accounting resulted in an overall net negative
§481(a) adjustment for Taxpayer as stated in the Consent Agreement. This overall net
negative § 481(a) adjustment consists of a net negative § 481(a) adjustment for the
Page 17 of 31
Attachment B
PLR-113227-19 8
repair and maintenance change in method of accounting and a net positive § 481(a)
adjustment for the disposition change in method of accounting.
The Service’s consent to the above changes in methods of accounting is subject
to several terms and conditions stated in the Consent Agreement. Condition nine of the
Consent Agreement requires that 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(I)(3)(A):
(A) a normalization method of accounting (within the meaning of § 168(i)(9), former §
168(e)(3)(B), or former § 167(I)(3)(G), as applicable) must be used for the public utility
property subject to the Form 3115; (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 the public utility
property subject to the Form 3115; and (C) within 30 calendar days of filing the federal
income tax return for the year of change, the taxpayer must provide a copy of the Form
3115 (and any additional information submitted to the Service in connection with such
Form 3115) to any regulatory body having jurisdiction over the public utility property
subject to the Form 3115. See page 6 of the Consent Agreement.
Based on Taxpayer’s interpretation of this condition in the Consent Agreement,
Taxpayer has applied the normalization requirements to its repair-related and
disposition-related deferred tax computations in rate proceedings since the year of
change.
Prior to the year of change (Year 5), Taxpayer depreciated public utility property
that was in service as of the end of the taxable year immediately preceding the year of
change using different book and tax methods and lives. As a result, an amount of ADIT
subject to the normalization requirements was recorded prior to the above changes in
methods of accounting for repairs and dispositions (depreciation-related ADIT).
Differing assertions were made as part of the Surcharge Case. Ultimately the
Commission in its final order determined that because there was not an NOL expected
to be generated in Year 4, no portion of the NOLC deferred tax asset can be associated
with the Surcharge property.
RULINGS REQUESTED
1) The property otherwise depreciable under § 168(a) and for which cost
recovery and return on investment initially occur as part of the Surcharge Case, rather
than as part of base rates set in less frequent general rate case proceedings,
constitutes public utility property within the meaning of § 168(i)(10).
2) The ADIT amounts used in computing the revenue requirement set in the
Surcharge Case with respect to public utility property within the meaning of § 168(i)(10)
Page 18 of 31
Attachment B
PLR-113227-19 9
must comply with the normalization method of accounting within the meaning of
§168(i)(9).
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 method
of accounting subject to Taxpayer’s Consent Agreement, the depreciation-related ADIT
prior to the change in tax method of accounting for repairs and dispositions remains
subject to the normalization method of accounting within the meaning of § 168(i)(9) after
implementation of the new tax method of accounting.
4) For any public utility property within the meaning of § 168(i)(10) and subject to
Taxpayer’s Consent Agreement, 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).
5) The ADIT resulting from expenditures (1) related to an item of property
includible in rate base and recoverable as regulatory depreciation expense in the
determination of the revenue requirement set in the Surcharge Case and (2) deducted
as repairs under § 162 to public utility property within the meaning of § 168(i)(10), or a
predecessor provision of the normalization requirements, 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) or, as applicable,
a predecessor statutory provision.
6) The ADIT resulting from book/tax differences related to depreciable method
and life for public utility property that exists at the date of a retirement of the property for
regulatory accounting purposes in a transaction involving a replacement or relocation
that is not treated as a disposition under Taxpayer’s tax method of accounting for
dispositions permitted in Taxpayer’s Consent Agreement remains subject to the
normalization method of accounting within the meaning of § 168(i)(9) after the book-only
retirement.
7) For any public utility property within the meaning of § 168(i)(10) for which a
disposition had been recognized for tax purposes in a tax year prior to the tax year of
change for the changes in tax method of accounting subject to Taxpayer’s Consent
Agreement and for which the taxable gain or loss upon such disposition was reversed
as part of the disposition-related § 481(a) adjustment, the ADIT related to the restored
tax basis of such public utility property is subject to the normalization method of
accounting within the meaning of § 168(i)(9), despite the book-only retirement.
8) If the Service rules as Taxpayer has requested with respect to issue # 5 and
holds that ADIT resulting from repair-related book/tax differences is not subject to the
normalization requirements, Taxpayer requests that the Service also rule: In order to
comply with the normalization method of accounting within the meaning of § 168(i)(9),
the amount of depreciation-related ADIT reducing rate base used to determine the
Page 19 of 31
Attachment B
PLR-113227-19 10
revenue requirement set in the Surcharge Case is limited to the amount of depreciation-
related deferred tax expense recovered in rates as of the Surcharge Case rate base
determination date.
9) If the Service rules as Taxpayer has requested with respect to issue # 5 and
holds that ADIT resulting from repair-related book/tax differences is not subject to the
normalization requirements, Taxpayer requests that the Service also rule: Under the
circumstances described above, in order to comply with the normalization method of
accounting within the meaning of § 168(i)(9), the amount of depreciation-related ADIT
reducing rate base used to determine the revenue requirement set in the Surcharge
Case must be decreased to reflect a portion of the NOL for the test period for the
Surcharge Case which would not have arisen had Taxpayer not reported depreciation-
related book/tax differences during the text period for the Surcharge Case and such
decrease in depreciation-related ADIT must be an amount that is no less than the
amount computed using the With-and-Without Method.
10) If the Service (a) rules as Taxpayer has requested with respect to issue # 5
and holds that ADIT resulting from repair-related book/tax differences is not subject to
the normalization requirements, but (b) does not grant ruling # 9 in accordance with
Taxpayer’s analysis, Taxpayer requests that the Service instead rule: Under the
circumstances described above, in order to comply with the normalization method of
accounting within the meaning of § 168(i)(9), the amount of depreciation-related ADIT
reducing rate base used to determine the revenue requirement set in the Surcharge
Case must be decreased to reflect a portion of the NOLC which would not have arisen
(or an increase in such NOLC which would not have arisen) had Taxpayer not reported
depreciation-related book/tax differences during the test period for the Surcharge Case
and such decrease in depreciation-related ADIT must be an amount that is no less than
the amount computed using the With-and-Without Method but only to the extent that the
NOLC has not reduced depreciation-related ADIT in rate base computation in another
rate proceeding with prices still in effect.
11) If the Service rules as Taxpayer has requested with respect to issue # 5 and
holds that ADIT resulting from repair-related book/tax differences is not subject to the
normalization requirements, Taxpayer requests that the Service also rule: Under the
circumstances described above, in order to comply with the normalization method of
accounting within the meaning of § 168(i)(9), it is not necessary to decrease ADIT or
otherwise increase rate base for the Surcharge Case by the portion of the NOLC which
would not have arisen (or an increase in such NOLC which would not have arisen) had
Taxpayer not reported depreciation-related book/tax differences in prior periods or
during the test period for the Surcharge Case with respect to public utility property with
rates not set by the Surcharge Case.
12) If the Service does not rule as Taxpayer has requested with respect to issue
# 5 and holds that ADIT resulting from repair-related book/tax differences is subject to
the normalization requirements, Taxpayer requests that the Service also rule: Under
Page 20 of 31
Attachment B
PLR-113227-19 11
the circumstances described above, in order to comply with the normalization method of
accounting within the meaning of § 168(i)(9), the amount of ADIT reducing rate base
used to determine the revenue requirement set in the Surcharge Case must be
decreased to reflect the portion of the Surcharge Case test period NOL which would not
have arisen had Taxpayer not reported the depreciation-related book/tax difference or
repair-related book/tax difference permitted in Taxpayer’s Consent Agreement with
respect to expenditures with ratemaking determined pursuant to the Surcharge Case,
by an amount that is no less than the amount computed using the With-and-Without
Method. If, instead, the Service rules as Taxpayer has requested with respect to issue
# 5, ruling request # 12 would be moot.
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.
Section 168(i)(10) defines, in part, public utility property as property used
predominantly in the trade or business of the furnishing or sale of electrical energy if the
rates for such furnishing or sale, as the case may be, have been established or
approved by a State or political subdivision thereof.
Prior to the Revenue Reconciliation Act of 1990, the definition of public utility
property was contained in § 167(l)(3)(A) and § 168(i)(10), which defined public utility
property by means of a cross reference to § 167(l)(3)(A). The definition of public utility
property is unchanged. Section 1.167(l)-1(b) provides that under § 167(l)(3)(A),
property is public utility property during any period in which it is used predominantly in a
§ 167(l) public utility activity. The term “section 167(l) public utility activity” means, in
part, the trade or business of the furnishing or sale of electrical energy if the rates for
such furnishing or sale, as the case may be, are regulated, i.e., have been established
or approved by a regulatory body described in § 167(l)(3)(A). The term “regulatory body
described in § 167(l)(3)(A)” means a State (including the District of Columbia) or political
subdivision thereof, any agency or instrumentality of the United States or a public
service or public utility commission or other body of any State or political subdivision
thereof similar to such a commission. The term “established or approved” includes the
filing of a schedule of rates with a regulatory body which has the power to approve such
rates, though such body has taken no action on the filed schedule or generally leaves
undisturbed rates filed by the taxpayer.
The definitions of public utility property contained in § 168(i)(10) and former
§46(f)(5) are essentially identical. Section 1.167(l)-1(b) restates the statutory definition
providing that property will be considered public utility property if it is used
predominantly in a public utility activity and the rates are regulated. Section 1.167(l)-
1(b)(1) provides that rates are regulated for such purposes if they are established or
approved by a regulatory body. The terms established or approved are further defined
Page 21 of 31
Attachment B
PLR-113227-19 12
to include the filing of a schedule of rates with the regulatory body that has the power to
approve such rates, even if the regulatory body has taken no action on the filed
schedule or generally leaves undisturbed rates filed.
The regulations under former § 46, specifically § 1.46-3(g)(2), expand the
definition of regulated rates. The expanded definition embodies the notion of rates
established or approved on a rate of return basis. This notion is not specifically
provided for in the regulations under former § 167. Nevertheless, there is an expressed
reference to rate of return in § 1.167(l)-1(h)(6)(i). The operative rules for normalizing
timing differences relating to use of different methods and periods of depreciation are
only logical in the context of rate of return regulation. The normalization method, which
must be used for public utility property to be eligible for the depreciation allowance
available under § 168, is defined in terms of the method the taxpayer uses in computing
its tax expense for purposes of establishing its cost of service for ratemaking purposes
and reflecting operating results in its regulated books of account. Thus, for purposes of
applying the normalization rules, the definition of public utility property is the same for
purposes of the investment tax credit and depreciation.
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 §
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
(referred to as the “Consistency Rule”).
Former § 167(l) generally provided that public utilities were entitled to use
accelerated methods for depreciation if they used a “normalization method of
Page 22 of 31
Attachment B
PLR-113227-19 13
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
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
Page 23 of 31
Attachment B
PLR-113227-19 14
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
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.
Section 1.167(l)-1(a)(1) of the Income Tax Regulations 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 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,
Page 24 of 31
Attachment B
PLR-113227-19 15
97-27, 1997-1 C.B. 680 (the operative method change revenue procedure at the time
Taxpayer filed its Form 3115, Application for Change in Accounting Method).
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 accounting 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.
Regarding ruling requests 1 and 2, the key factors in determining whether
property is public utility property are that (1) the property must be used predominantly in
the trade or business of the furnishing or sale of, inter alia, water and wastewater; (2)
the rates for such furnishing or sale must be established or approved by a State or
political subdivision thereof, any agency or instrumentality of the United States, or by a
public service or public utility commission or similar body of any State or political
subdivision thereof; and (3) the rates so established or approved must be determined
on a rate-of-return basis. State B statutes and Commission B rules provide eligible
water corporations with the ability to recover certain infrastructure system replacement
costs outside of a formal rate case filing via a Surcharge. These infrastructure system
replacements will be predominantly used in the trade or business of the furnishing or
sale of water and wastewater and therefore, it will possess the first of the three
characteristics. Moreover, as a regulated public utility subject to the jurisdiction of
federal or state law, including the ratemaking jurisdiction of the State B commission, the
second requirement is met. Lastly, as evidenced by the facts, these rates are
determined on a rate-of-return basis. After establishing that this involves public utility
property, the law makes clear that the depreciation deduction determined under § 168
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Attachment B
PLR-113227-19 16
shall not apply to any public utility property if the taxpayer does not use a normalization
method of accounting. The normalization regulations require a taxpayer to credit this
amount of deferred taxes to a reserve for deferred taxes, a depreciation reserve, or
other reserve account.
Taxpayer’s ruling request 3 pertains to the depreciation-related ADIT existing
prior to the year of change (-------) for public utility property in service as of the end of
the taxable year immediately preceding the year of change. Beginning with the year of
change, the ------- Consent Agreement granted Taxpayer permission to change its
(1)method of accounting for costs to repair and maintain tangible property from
capitalizing and depreciating these costs to deducting these costs under § 162, and
(2)unit of property for determining dispositions of depreciable network assets from
using a method other than the functional interdependence test to using the functional
interdependence test to determine the units of property.
As stated previously, 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 (-------), 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 under ruling request 3, 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
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Attachment B
PLR-113227-19 17
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, 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).
Similarly, 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, ADIT resulting
from expenditures (1) related to an item of property includible in rate base and
recoverable as regulatory depreciation expense in the determination of the revenue
requirement set in the Surcharge Case and (2) deducted as repairs under § 162 to
public utility property within the meaning of § 168(i)(10), or a predecessor provision of
the normalization requirements, 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) or, as applicable, a predecessor
statutory provision.
Regarding ruling request 6, § 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. 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)(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). In this case, the transaction involves a
replacement or relocation that is not treated as a disposition under Taxpayer’s tax
method of accounting. The depreciation-related ADIT existing immediately prior to a
transaction considered a retirement for regulatory accounting purposes but not treated
as a disposition for federal income tax purposes continues to be subject to the
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Attachment B
PLR-113227-19 18
normalization requirements because adjusted tax basis is not affected and the § 168(a)
depreciation deductions continue.
For ruling request 7, as stated previously under ruling request 3, 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.
Accordingly, the ADIT resulting from the disposition-related § 481(a) adjustment and
related to the 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 is subject to the normalization method of accounting within the
meaning of § 168(i)(9).
Regarding ruling requests 8, 9, and 11, generally, Taxpayer is arguing that the
ADIT balance should be reduced by the amounts that Taxpayer calculates did not
actually defer tax during the Surcharge Case test period due to the presence of the
NOLC. The normalization requirements pertain only to deferred income taxes for public
utility property resulting from the use of accelerated depreciation for tax purposes and
the use of straight-line depreciation for establishing cost of service and reflecting the
operating results in regulated books of account. Generally, amounts that do not
actually defer tax because of the existence of an NOL need to be reflected as offsetting
entries to the ADIT account to show the portion of tax losses which did not actually
defer tax due to accelerated depreciation.
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 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 ADIT asset resulting
from the NOLC should be included in rate base, given the inclusion in rate base of the
full amount of the ADIT liability resulting from accelerated tax depreciation.
Section 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 suggested by Taxpayer is specifically designed to ensure that the
Page 28 of 31
Attachment B
PLR-113227-19 19
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.
Taxpayer also raises the issue of the computation of the amount by which
depreciation-related Taxpayer’s NOLC as of the rate base determination date for the
Surcharge Case must be included in rate base. This focuses on whether the NOLC
taken into account in the Surcharge Case is limited to depreciation-related book/tax
differences related to expenditures reflected in the Surcharge Case or must also reflect
the full net increase in depreciation-related NOLC occurring since the rate base
determination date of the immediately preceding base rate proceeding. In this case,
based on the State B statute, the revenue requirement of a Surcharge Case is limited to
the following income tax amounts: ADIT associated with property-related costs for
property with rates set by the Surcharge Case and income taxes applicable to the
Surcharge Case revenue requirement. The normalization requirements do not require
that all incremental NOLC arising since the most recent general rate proceeding must
be reflected in an interim (here a Surcharge) proceeding. Instead, the normalization
requirements permit an increase in NOLC resulting from non-Surcharge Case public
utility property to be disregarded for the Surcharge Case and considered in the next rate
proceeding that reflects the depreciation expense and rate base inclusion of the public
utility property resulting in the depreciation-related book/tax differences included in the
NOLC.
Based on the foregoing, we conclude that:
1) The property otherwise depreciable under § 168(a) and for which cost
recovery and return on investment initially occur as part of the Surcharge Case, rather
than as part of base rates set in less frequent general rate case proceedings,
constitutes public utility property within the meaning of § 168(i)(10).
2) The ADIT amounts used in computing the revenue requirement set in the
Surcharge Case with respect to public utility property within the meaning of § 168(i)(10)
must comply with the normalization method of accounting within the meaning of
§168(i)(9).
3) For any public utility property within the meaning of § 168(i)(10) of the Code as
of the end of the tax year immediately preceding the year of change for the changes in
tax method of accounting subject to Taxpayer’s Consent Agreement, the depreciation-
related ADIT prior to the change in tax method of accounting for repairs and dispositions
is not subject to the normalization method of accounting within the meaning of §
168(i)(9) of the Code after implementation of the new tax method of accounting.
4) For any public utility property within the meaning of § 168(i)(10) and subject to
Taxpayer’s Consent Agreement, the ADIT resulting from the repair-related § 481(a)
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Attachment B
PLR-113227-19 20
adjustment is not subject to the normalization method of accounting within the meaning
of § 168(i)(9).
5) The ADIT resulting from expenditures (1) related to an item of property
includible in rate base and recoverable as regulatory depreciation expense in the
determination of the revenue requirement set in the Surcharge Case and (2) deducted
as repairs under § 162 to public utility property within the meaning of § 168(i)(10), or a
predecessor provision of the normalization requirements, 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) or, as applicable,
a predecessor statutory provision.
6) The ADIT resulting from book/tax differences related to depreciable method
and life for public utility property that exists at the date of a retirement of the property for
regulatory accounting purposes in a transaction involving a replacement or relocation
that is not treated as a disposition under Taxpayer’s tax method of accounting for
dispositions permitted in Taxpayer’s Consent Agreement remains subject to the
normalization method of accounting within the meaning of § 168(i)(9) after the book-only
retirement.
7) For any public utility property within the meaning of § 168(i)(10) for which a
disposition had been recognized for tax purposes in a tax year prior to the tax year of
change for the changes in tax method of accounting subject to Taxpayer’s Consent
Agreement and for which the taxable gain or loss upon such disposition was reversed
as part of the disposition-related § 481(a) adjustment, the ADIT related to the restored
tax basis of such public utility property is subject to the normalization method of
accounting within the meaning of § 168(i)(9), despite the book-only retirement.
8) In order to comply with the normalization method of accounting within the
meaning of § 168(i)(9), the amount of depreciation-related ADIT reducing rate base
used to determine the revenue requirement set in the Surcharge Case is limited to the
amount of depreciation-related deferred tax expense recovered in rates as of the
Surcharge Case rate base determination date.
9) Under the circumstances described, in order to comply with the normalization
method of accounting within the meaning of § 168(i)(9), the amount of depreciation-
related ADIT reducing rate base used to determine the revenue requirement set in the
Surcharge Case must be decreased to reflect a portion of the NOL for the test period for
the Surcharge Case which would not have arisen had Taxpayer not reported
depreciation-related book/tax differences during the text period for the Surcharge Case
and such decrease in depreciation-related ADIT must be an amount that is no less than
the amount computed using the With-and-Without Method.
10) Ruling request 10 is moot because we grant ruling 9 in accordance with
Taxpayer’s analysis.
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Attachment B
PLR-113227-19 21
11) Under the circumstances described above, in order to comply with the
normalization method of accounting within the meaning of § 168(i)(9), it is not necessary
to decrease ADIT or otherwise increase rate base for the Surcharge Case by the portion
of the NOLC which would not have arisen (or an increase in such NOLC which would
not have arisen) had Taxpayer not reported depreciation-related book/tax differences in
prior periods or during the test period for the Surcharge Case with respect to public
utility property with rates not set by the Surcharge Case.
12) Ruling request 12 is moot because we rule as Taxpayer requests with
respect to ruling request 5.
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.
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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Attachment B