PLR 1318005: IRS declines to disallow or recapture investment tax credit after rate-template error

Plain-English summary

The IRS ruled that a regulated public utility did not have to disallow or recapture its investment tax credit after an error in the formula templates used to set transmission rates. The templates reduced rate base and did not reduce tax expense as required under the taxpayer’s elected treatment under former section 46(f)(2). The IRS concluded that the utility corrected the templates after discovering the error, and that the relevant regulatory commission had not specifically required or insisted on the inconsistent treatment in a final order. Based on those facts, the IRS found that the utility’s actions were not inconsistent with former section 46(f) and that no disallowance or recapture was required.

Ruling snapshot

• Question: Whether an investment tax credit must be disallowed or recaptured after errors in a regulated utility’s rate-setting templates.
• Outcome: No disallowance or recapture required.
• Key authorities: IRC §§ 38, former 46(f), former 46(f)(2), former 46(f)(6); Treas. Reg. § 1.46-6.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201318005 Third Party Communication: None
Release Date: 5/3/2013 Date of Communication: Not Applicable
Index Number: 46.06-02 R 1990
Person To Contact:
---------------------------------------------------- ------------------------, ID No. ------------------
----------------------------------- ----------------------------------------------------
-------------------------------- Telephone Number:
---------------------------- ----------------------
Refer Reply To:
CC:PSI:B06
PLR-134944-12
Date:
January 18, 2013

LEGEND:

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

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

State A = -------
State B = --------------
Commission A = -------------------------------------- -----------
Commission B = -------------------------------------------------------
Operator A = ---------------------------------------------------------------------------------
Operator B = ------------------------------------
Date A = ---------------------------
Year A = -------
Director = --------------------------------------------------------------------------------
------------------------------------------------------------------------------------

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

   This letter responds to the request, dated August 10, 2012, of Taxpayer for a

ruling on the consequences of Taxpayer’s accounting and regulatory treatment of the
Investment Tax Credit (ITC).

     The representations set out in your letter follow.

   Taxpayer is a regulated public utility incorporated in State A. It is an indirect

wholly-owned subsidiary of Parent, which is incorporated in State B. Taxpayer is
included in the consolidated federal income tax return of Parent. Taxpayer is principally
engaged in the generation, transmission, distribution, and sale of electricity in State A,
PLR-134944-12 2

as well as the sale of various transmission and other services at negotiated rates under
the jurisdiction of Commission B. Taxpayer is regulated with respect to the terms and
conditions of service and, most particularly, regarding the rates it may charge for its
services by Commission A and Commission B. Taxpayer was a member of Operator A,
an independent transmission system operator, through Date A. Since that time,
Taxpayer has been a member of Operator B, also an independent transmission system
operator. With respect to the jurisdiction of each of the commissions, Taxpayer’s rates
are determined using a “rate of return” basis that allows Taxpayer to earn a reasonable
rate of return. Taxpayer has elected to account for its ITC pursuant to former § 46(f)(2).

  Taxpayer has unamortized accumulated deferred ITC relating to generation,

transmission, and distribution assets placed in service prior to 1986.

   With respect to transmission activities, formula rates have been employed by

Taxpayer since Year A. Taxpayer uses a formula rate structure to establish its rates,
subject to the jurisdiction of Commission B. Formula rates, in general, allow for self-
executing adjustments to rates on an annual basis to reflect increases and decreases in
costs and investments since the prior year. They incorporate a calculation of both rate
base and tax expense. Thus, they reflect Taxpayer’s ADITC balance as well as the
amount being amortized. The formula is periodically updated, resulting in changes to
rates. The tariff that Taxpayer may charge its wholesale customers and third parties for
their use of its transmission assets, the Open Access Transmission Tariff (OATT), is
regulated by Commission B. In establishing its OATT rates, Taxpayer currently uses a
template approved by Commission B that was developed by Operator B. Prior to Date
A Taxpayer established its OATT rates using a template developed by Operator A.

   Taxpayer’s rates were established using procedures consistent with former §

46(f)(2), meaning that Taxpayer reduced the tax expense element of cost of service by
no more than a ratable portion of its ITC and that Taxpayer did not reduce rate base by
any portion of the ADITC balance. Under this provision, in no event can ITC be
reflected in the rate-setting process until the later of (1) the placement in service of the
asset which generated the credit or (2) the use of the credit on a taxpayer’s tax return.

    Taxpayer has determined that, the template Taxpayer used to establish its OATT

rates beginning in Year A reflected its ADITC balance as a reduction in rate base.
Further, the amortization of Taxpayer’s ADITC balance was not reflected as a reduction
in tax expense. Thus, Taxpayer applied the requirements of § 46(f)(1), notwithstanding
that it had elected to apply the requirements of § 46(f)(2). The effect of Taxpayer’s
treatment of its ADITC in the rate templates was a reduction in rates to wholesale
customers.

   The formula templates were completed by Taxpayer’s regulatory personnel and

they did not recognize the normalization issue raised. Personnel in Taxpayer’s tax
department became suspicious and reviewed the use of the templates by regulatory
PLR-134944-12 3

personnel. Once they became aware of the errors, Taxpayer has not yet made a
formula filing with the corrected template but will do so at its next annual filing.
Commission B did not specifically address or consider any of the rates or calculations at
issue here in any order to Taxpayer.

Law and Analysis

    Former section 46(f)(2) 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 ratemaking 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 section 38. Also, under former section 46(f)(2)(B) no investment tax
credit is available if the base to which the taxpayer's rate of return for ratemaking
purposes is applied is reduced by reason of any portion of the credit determined under
former 46(a) and allowable by section 38.

   Former section 46(f)(6) of the Code provides that for purposes of determining

ratable portions under former section 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.

    Under section 1.46-6(g)(2) of the regulations, "ratable" for purposes of former

section 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 ratemaking purposes.

    Section 1.46-6(f)(4) provides that the ITC is disallowed for any section 46(f)

property placed in service by a taxpayer before the date a final decision of a regulatory
body that is inconsistent with section 1.46-6(f)(2) is put into effect on or after such date
and before the date a subsequent decision consistent with section 1.46-6(f)(2) is put
into effect.

     Section 1.46-6(f)(2) provides that there is no disallowance of a credit before the

first final inconsistent determination is put into effect for the taxpayer’s § 46(f) property.

   Section 1.46-6(f)(8)(1) provides that “inconsistent” refers to a determination that

is inconsistent with § 46(f)(1) or (2). For example, a determination to reduce the
taxpayer’s cost of service by more than a ratable portion of the credit would be a
determination that is inconsistent with § 46(f)(2).
PLR-134944-12 4

   Senate Report No. 94-36, 94th Cong., 1st Sess. 44-45 (1975), 1975-1 C.B. 590,

610, provides, in its explanation of the ratemaking treatment to be accorded the
additional ITC allowed public utilities under the 1975 Act, that the additional ITC is to be
disallowed if the regulatory agency requires the flowing-through of a company’s
additional ITC at a rate faster than permitted, or insists upon a greater rate base
adjustment than is permitted, but only after a final determination is put into effect. That
report further provides that the rules provided under existing law with respect to
determinations made by a regulatory body and the finality of its orders would apply to
this provision.

    Senate Report No. 92-437, 92nd Cong., 1st Sess. 40-41 (1971), 1972-2 C.B. 559,

581, provides, in its explanation of amendments to the Revenue Act of 1971 dealing
with the limitations on the ratemaking treatment of the ITC under section 46(e)(1) and
(e)(2), that the Committee hopes that the sanctions of disallowance of the ITC will not
have to be imposed.

   For the periods during which Taxpayer erroneously calculated the template and

thus improperly reduced rate base, the practical effect of this error was to lower rates
and thus, to flow the ITC to its transmission customers more rapidly than if the template
had been correctly applied. This reduction was not the intent of either the Taxpayer or
Commission B. Further, Taxpayer has acted upon discovery of these errors and
adjusted its template so that they will reflect the same amounts as if no errors had
occurred when filed. We conclude that Taxpayer’s actions as described above are not
inconsistent with the requirements of former § 46(f). Finally, Commission B never
specifically addressed these matters in a rate case involving Taxpayer and so did not
issue and order on these matters during this period. In accord with the Senate Reports
quoted above, disallowance or recapture of the ITC should be imposed only after a
regulatory body has required or insisted upon such treatment by a utility. Because
Commission B did not insist on the errors discussed above, no disallowance or
recapture is required in this case.

   Except as specifically determined above, no opinion is expressed or implied

concerning the Federal income tax consequences of the matters described above. In
particular, orders concerning this matter finalized by either of the Commissions after the
date of this ruling are not necessarily subject to the same analysis as those considered
above.

   This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)

of the Code provides it may not be used or cited as precedent. In accordance with the
power of attorney on file with this office, a copy of this letter is being sent to your
PLR-134944-12 5

authorized representative. We are also sending a copy of this letter ruling to the
Director.

                                  Sincerely,



                                  Peter C. Friedman
                                  Senior Technician Reviewer, Branch 6
                                  (Passthroughs & Special Industries)

cc: