PLR 200016020: Utility cannot pass remaining tax benefits to customers after asset sale

Plain-English summary

A regulated electric utility sold generating assets under a state restructuring law. It asked whether giving customers the remaining benefits from deferred income taxes and investment tax credits tied to those assets would violate tax normalization rules. The IRS concluded that the sale ended the regulatory lives and associated reserves for the assets. Reducing the utility's rate base for the remaining excess deferred income tax reserve after the sale would violate the normalization rules. The related unamortized investment tax credits also could not reduce the utility's cost of service once the assets were no longer used to compute regulated depreciation. The letter addresses those two accounts and the described asset sale.

Ruling snapshot

• Question: May the utility pass remaining deferred tax and investment credit benefits from sold generating assets to ratepayers?
• Outcome: The IRS agreed that the described post-sale reductions would violate the normalization rules.
• Key authorities: Former IRC §§ 46(f)(2) and 167(l); IRC § 168(i)(9); Tax Reform Act of 1986 § 203(e); Treas. Reg. § 1.46-6(g)(2).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

200016020
Index No.: 46.14-00R90
Washington, DC 20224

Contact Person:
Telephone Number:

In Reference to:

CC:DOM:P&SI:6-PLR-108377-99
JAN 6 2000

Re: Request for Private Letter Ruling
Regarding Normalization

Legend:

Taxpayer =

Subsidiary =

State =

Commission =

Dear :

This letter responds to the request, dated April 29, 1999, of Taxpayer on behalf of its Subsidiary for a private letter ruling on the proper treatment of two of the Subsidiary’s deferred tax accounts. Those tax accounts are the accumulated deferred investment tax credits (ADITC) under former §46(f)(2) of the Internal Revenue Code, and excess deferred income tax (EDIT) under former §167(l) and §168(f) and §203(e) of the 1986 Tax Reform Act, 1986-3(Vol.1) C.B. 1, 63 (Act).

Your representations set out in your letter follow.

Subsidiary is an investor-owned regulated public utility engaged in the generating, transmission, distribution, and sale of electrical power in State. Subsidiary has elected to use the ratable flow through method of normalizing its investment tax credits under former §46(f)(2) of the Code and has consistently applied this method to its unamortized investment tax credit balances associated with its public utility property placed in service prior to 1986, when the investment tax credit was repealed, as well as to its public utility property placed in service during the transition period after the repeal. Subsidiary also adopted a normalization method of accounting for purposes of claiming accelerated depreciation for public utility

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property in accordance with former §167(l) and §168(f) and
§168(i) (9). Subsidiary has normalized its EDIT in accordance with §203(e) of the Act and Rev. Proc. 88-12, 1988-1 C.B. 637.

Pursuant to a State statute to restructure State's electric utility industry, Subsidiary is required to divest itself of its generation assets. Consequently, Subsidiary agreed to sell its fossil, hydro, and biomass generating assets to an unrelated party. The purchaser will not be subject to rate regulation in the operation of these plants.

The sales price proceeds exceeded Subsidiary's book value of the plants. The proceeds up to net book value will be retained by Subsidiary; the proceeds in excess of net book value will be used to mitigate Subsidiary's stranded costs in connection with the above-market power purchase agreements and uneconomic nuclear investments. In general, Subsidiary will be given an opportunity to recover all prudently incurred generation-related stranded costs from ratepayers. Among the stranded costs which Subsidiary will be eligible to recover are generation-related federal income taxes which were not subject to the normalization rules and were not provided for by ratepayers.

Commission staff has proposed retention of the entire EDIT, but only the net present value of the unamortized investment tax credit benefits which the ratepayer would have received over the remaining regulatory life of the generation assets sold. Taxpayer had argued that any rate making treatment that directly or indirectly retained the economic benefits of the unamortized ADITC and EDIT for ratepayers upon the sale of the generation facilities would violate the governing normalization provisions of the Code. Taxpayer has been directed by the Commission to request a ruling concerning whether a final determination put into effect by Commission requiring Taxpayer to flow the unamortized ADITC and EDIT balances to ratepayers, directly or indirectly, following the sale of Taxpayer's generation assets pursuant to the State restructuring laws, would violate the normalization rules set forth in former §46(f) (2) and §168(i) (9).

The first issue involves the proper normalization treatment by Subsidiary of unamortized EDIT relating to the sale of its public utility property.

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) of the Code requires the taxpayer, in computing

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its tax expense for establishing its cost of service for rate making 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) of the Code provides that one way the requirements of §168(i) (9) (A) will not be satisfied is if the taxpayer, for rate making 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 rate making purposes, with respect to all three of these items and with respect to the rate base.

Former §167(l) of the Code 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) of the Income Tax Regulations 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) of the regulations 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 rate making purposes.

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Section 1.167(l)-1(h) (1) (iii) of the regulations provides that the amount of federal income tax liability deferred as a result of the use of different depreciation methods for tax and rate making purposes is the excess (computed without regard to credits) of the amount the tax liability would have been had the depreciation method for rate making purposes been used over the amount of the actual tax liability. This amount shall be taken into account for the taxable year in which the different methods of depreciation are used.

Section 1.167(l)-1(h) (2) (i) of the regulations provides that the taxpayer must credit this amount of deferred taxes to a reserve for deferred taxes, a depreciation reserve, or other reserve account. This regulation further provides that the aggregate amount allocable to deferred taxes may be reduced to reflect the amount for any taxable year by which federal income taxes are greater by reason of the prior use of different methods of depreciation under §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 203(e) of the Act provides another way in which a normalization method of accounting is not being used for public utility property.

According to §203(e)(1) of the Act, a normalization method of accounting shall not be treated as being used with respect to any public utility property for purposes of §167 or 168 of the Code if the taxpayer, in computing its cost of service for rate making purposes and reflecting operating results in its regulated books of account, reduces the excess tax reserve more rapidly or to a greater extent that this reserve would be reduced under the average rate assumption method (ARAM).

The term "excess tax reserve" is defined in §203(e) (2) (A) of the Act as the excess of:

(i) the reserve for deferred taxes as described in former
§167(l) (3) (G) (ii) or 168(e) (3) (B) (ii) of the Code as in effect on the day before the date of the enactment of the Act, over;

(ii) the amount that would be the balance in this reserve if the amount of the reserve were determined by assuming that the corporate rate reductions provided in the Act were in effect for all prior periods.

Section 203 (e) (2) (B) of the Act defines the ARAM and explains the calculations under this method. ARAM is the method under which the excess in the reserve for deferred taxes is reduced over the remaining lives of the property as used in its

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books of account that gave rise to the reserve for deferred taxes. Under the ARAM, if timing differences for the property reverse, the amount of the adjustment to the reserve for the deferred taxes is calculated by multiplying:

(i) the ratio of the aggregate deferred taxes for the property to the aggregate timing differences for the property as of the beginning of the period in question, by;

(ii) the amount of the timing differences that reverse during this period.

Rev. Proc. 88-12, 1988-1 C.B. 637, provides further guidance as to the application of the ARAM to the excess tax reserve. Section 2.04 of Rev. Proc. 88-12 provides that under the ARAM, excess tax reserves pertaining to a particular vintage or vintage account are not flowed through to ratepayers until such time as the timing differences in the particular vintage account reverse. Moreover, it is a violation of §203(e) of the Act for taxpayers to adopt any accounting treatment that, directly or indirectly, circumvents the rule set forth in the previous sentence. Section 2.04 also provides that §203(e) of the Act does not modify the normalization requirements of former §167(l) or §168(i) of the Code.

Sections 3 and 4.01 of Rev. Proc. 88-12 provide that a taxpayer who lacks sufficient vintage account data necessary to apply the ARAM, can use the “Reverse South Georgia Method." In general, a taxpayer uses that method if it (a) computes the excess tax reserve on all public utility property included in the plant account on the basis of the weighted average life or composite rate used to compute depreciation for regulatory purposes, and (b) reduces the excess tax reserve ratably over the remaining regulatory life of the property.

For a public utility to use accelerated depreciation in determining its federal income tax liability, §203(e) of the Act requires that normalization accounting be used to reduce the excess tax reserve in calculating the rates to be charged the utility's customers and in maintaining the regulated books of account. Under §203(e) of the Act, the immediate flow through of the excess tax reserve to the utility's customers is prohibited. Instead, the excess tax reserve is to be reduced and flowed through to cost of service no more rapidly that this reserve would be reduced under the ARAM, or, where appropriate, the Reverse South Georgia Method.

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Section 203(e) of the Act limits the rate at which the excess tax reserve may be reduced and flowed through to the utility's customers in setting rates. It does not require the utility to flow through the excess tax reserve to its customers, but permits the utility to do so provided the reduction to cost of service is not more rapidly than would be under the ARAM. Thus, §203(e) of the Act imposes a limitation on when the excess tax reserve may be returned to the utility's customers in the form of reduced .rates.

In the present case, Subsidiary has sold the aforementioned public utility assets. Retirements of public utility property subject to the normalization requirements of §168 are reflected in adjustments to Subsidiary's deferred tax reserve as well as its excess tax reserve (see §1.167(l)-1(h) (2) (i), and Rev. Proc. 88-12, 1988-1 C.B. at 638). As a result of the sale, the reserves cease to exist. A violation of the normalization rules will occur if there is any reduction to Subsidiary's rate base, after the acquisition date, for the unamortized EDIT reserve attributable to accelerated depreciation on public utility property. Further, both ARAM and the Reverse South Georgia Method rely on mechanisms requiring a regulatory life. Once the asset is sold, the regulatory life ceases to exist.

The second issue involves the proper normalization treatment by Subsidiary, a former §46(f) (2) elector, of ADITC relating to the sale of its public utility property.

Former §46(f) of the Code provides an election for ratable flow through under which an elector may flow through the investment tax credit to cost of service. However, former
§46(f) (2) (A) provides that no investment tax credit is available if the taxpayer's cost of service for rate making purposes or in its regulated books of account is reduced by more than a ratable portion of the credit determined under former §46(a) and allowable by §38. Also, under former §46(f) (2) (B) no investment tax credit is available if the base to which the taxpayer's rate of return for rate making purposes is applied is reduced by reason of any portion of the credit determined under former
§46(a) and allowable by §38.

Former §46(f) (6) of the Code provides that for purposes of determining ratable portions under former §46(f) (2) (A), the period of time used in computing depreciation expense for purposes of reflecting operating results in the taxpayer's regulated books of account shall be used.

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Under §1.46-6(g) (2) of the regulations, "ratable" for purposes of former §46(f) (2) of the Code is determined by considering the period of time actually used in computing the taxpayer's regulated depreciation expense for the property for which a credit is allowed. Regulated depreciation expense is the depreciation expense for the property used by a regulatory body for purposes of establishing the taxpayer's cost of service for rate making purposes. Such period of time shall be expressed in units of years (or shorter periods), units of production, or machine hours and shall be determined in accordance with the individual useful life or composite (or other group asset) account system actually used in computing the taxpayer's regulated expense. A method of reducing is ratable if the amount to reduce cost of service is allocated ratable in proportion to the number of such units. Thus, for example, assume that the regulated depreciation expense is computed under the straight line method by applying a composite annual percentage rate to original cost (as defined for purposes of computing depreciation expense). If cost of service is reduced annually by an amount computed by applying a composite annual percentage rate to the amount of the credit, cost of service is reduced by a ratable portion. If such composite annual percentage rate were revised for purposes of computing depreciation expense beginning with a particular accounting period, the computation of ratable portion must also be revised beginning with such period. A composite annual percentage rate is determined solely by reference to the period of time actually used by the taxpayer in computing its regulated depreciation expense without reduction for salvage or other items such as over and under accruals.

The method prescribed by §1.46-6(g) (2) of the regulations for determining whether the taxpayer's cost of service for rate making is reduced by more than a ratable portion of the investment tax credit depends upon correlating the credit with the regulatory depreciable useful life actually used for the property that generated the credit. That the correlation must remain constant and current is illustrated by the requirement that the ratable portion must be adjusted to reflect correspondingly any revision to the composite annual percentage rate applied for purposes of computing regulated depreciation expense.

Should the property for which the investment tax credit is allowed become no longer available for computing the regulated depreciation expense, there could no longer be any correlation between the property and the credit. In that event, the requirements of former §46(f) (2) of the Code are violated if any portion of the credit is used to reduce the taxpayer's cost of service.

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In this case, Subsidiary has sold the assets that generated the investment tax credit and, as a result, the asset for which regulated depreciation expense is computed is no longer available. Consequently, no portion of the related unamortized ADITC remaining at the date of sale may be used to reduce Subsidiary's cost of service.

PLR-108377-99

This letter ruling is directed only to the taxpayer who requested it. Section 6110(k) (3) of the Code provides that it may not be used or cited as precedent. Pursuant to a power of attorney on file with this office, the original of this letter ruling has been sent to Taxpayer's authorized representative and a copy has been sent to Taxpayer.

Sincerely yours,

KATHLEEN REED

Senior Technician Reviewer, Branch 6
Office of Assistant Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2):

6110 copy
copy of ruling