CCA 1036001: Customer rate increase does not offset utility casualty loss

Plain-English summary

Chief Counsel advised that a temporary increase in a regulated utility's customer rate was not compensation for the utility's casualty losses. The rate increase was treated as additional revenue from providing service, rather than as insurance or an insurance-like payment that would reduce a casualty-loss deduction under section 165. The analysis emphasized that customers, not the government, supplied the funds, and that customers made the payment for utility service rather than primarily to reimburse the utility. The memorandum compared the facts with Rev. Rul. 87-117 and noted that several other casualty-related issues were outside its scope. The advice concluded that the situation was not sufficiently different from Rev. Rul. 87-117 to justify a different result.

Ruling snapshot

• Question: Does a regulated utility's temporary customer rate increase constitute compensation for casualty losses that reduces its section 165 deduction?
• Outcome: Advice given
• Key authorities: IRC §§ 162, 165, 1033, and 2054; Rev. Rul. 87-117; Boston Elevated Rwy. v. Commissioner

Full text (IRS public release)

+Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201036001
Release Date: 9/10/2010
CC:ITA:B01: ---------
POSTS-149008-09

UILC: 165.04-02

 date:   June 03, 2010

   to:   Appeals Officer


 from:   Andrew M. Irving
         Senior Counsel, Branch 1
         (Income Tax & Accounting)

subject: Casualty Loss Issue

This Chief Counsel Advice responds to your request for assistance dated November 4,
2009. This advice may not be used or cited as precedent.

LEGEND

Taxpayer: --------------------------------

Local Commission: ----------------------------------------------

State: ---------

Successive Storms: ---------------------------------------------------------------

Public Counsel: ------------------------------------------

year 1: -------

year 2: -------

year 3: -------

x: --------------
POSTS-149008-09 2

y%: ------

Issue

------------------------------ , a ratemaking body, awarded Taxpayer, --- --------- utility, a -------
----------------------customer ------------- representing costs incurred to recover from --- ------
---------------------------------------------in year 1.

Does the ------------- constitute compensation for the loss, which precludes a casualty
loss deduction under § 165 of the Internal Revenue Code, or should the utility take the
full amount of the casualty loss deduction in year 1, and treat the ------------- as income
from providing ------------ in successive years when it is collected?

Conclusion

The ------------- is an increase to the rate charged by Taxpayer for ------------ -------------- --
-------, not compensation for the ------------ losses in year 1.

Facts

Taxpayer is a regulated utility ----------------------------------. Taxpayer is regulated by the
Local Commission an agency of State.

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------------. In year 1, State was hit by --------------- -------
Taxpayer incurred approximately $ x in damages. -------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Specifically, Local Commission ruled that Taxpayer did not have to amortize the costs,
but could recover the full amount of the -----------------------costs through a ------------- ------

------------------------------------------------------------------------------------------------.
POSTS-149008-09 3

Taxpayer claimed a casualty loss deduction under § 165 for the year 1 ---------.
Because there are some features of this situation that arguably distinguish it from the
fact pattern considered in Rev. Rul. 87-117, discussed below, you ask whether the ------
------------- should be treated as compensation or reimbursement for the loss for
purposes of § 165 and the corresponding regulations.1

Law

Section 165(a) allows a deduction for any sustained loss not compensated for “by
insurance or otherwise.”

In Boston Elevated Rwy v. Commissioner, 16 T.C. 1084, 1111-1112 (1951), aff’d on
another issue, 196 F.2d 923 (1st Cir. 1952), interpreting the phrase “insurance or
otherwise,” the Service argued that loss resulting from the abandonment of an elevated
railway structure was compensated for by legislation (the Public Control Act)
guaranteeing the taxpayer operating profits sufficient to pay dividends. The court
disagreed, stating that “regardless of the amounts of any possible losses sustained by
petitioner, no payments would be forthcoming to it if its income were sufficiently high,
after absorbing the losses and other charges, to pay the required dividends.” Id. at
1112.

In Shanahan v. Commissioner, 63 T.C. 21 (1974), which involved federal disaster relief
payments, the Tax Court determined that the general term “or otherwise” must be
construed consistently with the specific term “insurance.” The court stated that the
general purpose of insurance is to spread the risk of loss from any peril among a large
number of those who are exposed to a similar peril.

In Estate of Bryan v. Commissioner, 74 T.C. 725 (1980), the court, citing Shanahan,
determined that the phrase “insurance or otherwise” in an analogous provision, § 2054,
contemplates that the type of compensation received must be such that it was
“structured to replace what was lost.” Id. at 727. The court held that a disbursement
from a trust fund established by a state bar association, in compensation for losses
incurred due to an attorney’s unethical behavior, was in the nature of insurance.

Rev. Rul. 87-117, 1987-2 C.B. 61, involves a regulated public utility that abandons a
partially-completed nuclear plant. The ratemaking authority, in determining to grant the
utility a subsequent rate increase, permits the utility to amortize the cost of the plant
over a specified number of years and include that amortization in its cost of service for
ratemaking purposes. Holding that the rate increase does not reduce the utility’s loss
deduction on abandoning the plant, the ruling reasons that although the utility

1
Other casualty-related issues in the case involve capitalization of post-casualty restoration costs, see ,
e.g., AM 2006-006, and identification of the “single, identifiable property” damaged or destroyed by the
casualties, see, e.g., TAM 200902011. These are independent issues that are not addressed, directly or
by implication, in this memorandum.
POSTS-149008-09 4

commission may give consideration to the fact that a utility suffered a loss in
determining whether a rate increase is warranted, the rate is not structured to reimburse
the utility for its loss. Rather the rate increase is structured to enable the utility to
perform its functions of serving its customers at a fair charge, while at the same time
maintaining its financial integrity and its ability to attract capital at reasonable terms by
paying its investors a reasonable rate of return on their investment. If the taxpayer were
not a regulated company, it could raise its price at will, and revenues produced by its
price increase could not be considered as compensation for a loss by “insurance or
otherwise.” The governmental grant of authority to increase rates is of the same nature
as a price increase by an unregulated company. The function of the utility commission
is merely to assure that the increase is warranted.

Analysis

Applying this case law and Rev. Rul. 87-117 to the ------------- in this case, in some
respects the --------------was “structured to replace what was lost” and insurance-like in
nature – at least in its effect on Taxpayer--------------------------------------------------------------

---- ---------------------------. It is also clear that government compensation for casualty
damage – whether in the form of a cash grant, debt forgiveness, or a purchase of
property for pre-casualty value – is “insurance-like” compensation that reduces or
eliminates a loss deduction (and, if it exceeds the basis of property, is eligible for
deferral under § 1033).2 The right to the --------------arose after the loss occurred, and is
contingent on future sales; however, for a payment to be treated as compensation that
reduces a loss under § 165, it is not essential that the right to the payment exist at the
time of the loss, or even that there be a legal or moral obligation to make the payment.
See Estate of Bryan, 74 T.C. at 728, citing Shanahan, 63 T.C. at 23.

On the other hand, here, as in Rev. Rul. 87-117, the utility’s customers are the source of
the funds, not the government, whose role is only to set rates for ------------. In paying
the -------------, the customers are not primarily interested in compensating Taxpayer for
its losses. From the customers’ point of view, the ------------- is simply part of a
mandatory payment for ------------—deductible under § 162, for a business customer—
whether the ------------- is separately identified on the customer’s bill or not.3

The ------------- is temporary, which is also a common characteristic of insurance.
However, this does not distinguish Rev. Rul. 87-117, where the cost of the abandoned
plant was amortized over a set time period. Arguably, whether costs are amortized, as

2
In addition to Shanahan, see Spak v. Commissioner, 76 T.C. 464 (1981); Rev. Rul. 74-206, 1974-1 C.B.
198; Rev. Rul. 71-160, 1971-1 C.B. 75.
3
Treating the -------------- as compensation for the loss would require that Taxpayer exclude a portion of
what would normally be ordinary income from operations and, presumably, apply that amount to reduce
the basis of assets that were affected by the casualties, a potentially complex task from an administrative
standpoint.
POSTS-149008-09 5

in Rev. Rul. 87-117, or recovered directly, as here, is largely a matter of form; in both
cases, the taxpayer is arguably "recovering" over a set period the amounts the taxpayer
seeks to deduct as a loss.

The ------------- was granted --------------------------------------------------------------------------------
------------------------------------------------------------------------------. Unlike the compensation in
Boston Elevated Railway, it was not limited to amounts necessary to achieve a certain
level of profit. Nevertheless, as in Rev. Rul. 87-117, the ------------- was granted
because --------------------------------------------------------------------------------------------------------

-----------------------------------------------------------------------------------------------------.

Finally, as noted in Rev. Rul. 87-117, treatment of the ------------- as a reimbursement
arguably treats Taxpayer, a regulated business, differently from a similarly-situated
unregulated business. Since the basic method for setting a regulated rate is to allow
the business to recover its costs plus a reasonable rate of return, arguably all of a
regulated business’ expenses and capital expenditures are “reimbursed,” which would
lead to treatment of a regulated business largely as a conduit for tax purposes.
However, regulated businesses are not taxed in this way, but generally compute their
gross income and offsetting deductions in the same manner as unregulated businesses.
If an unregulated business incurs a casualty loss, it must reduce its deduction by any
insurance or insurance-like payment, such as a government grant, but the loss
deduction is not denied because the business intends to, and does, “recover” the
amount of the loss by selling goods or services, and its business income is not treated
as an excludible return of capital to the extent of the denied loss deduction. Arguably
the result should not differ because a business’ rates are set by a government regulator
rather than the market.--

Taking all these factors into account, we conclude that this situation is not sufficiently
distinguishable from the situation in Rev. Rul. 87-117 to call for a different result.

Please call (202) 622-5020 if you have any further questions.

                                         By: _____________________________
                                             Andrew M. Irving
                                             Senior Counsel, Branch 1
                                             (Income Tax & Accounting)