IRS approves correction of utility ITC and deferred-tax amortization errors

Plain-English summary

The IRS ruled for a regulated electric utility that had used outdated asset lives when calculating investment tax credit amortization and excess deferred income tax amortization for ratemaking. The errors flowed the benefit of the investment tax credit to customers faster than the applicable pro rata rate, but the IRS concluded that the actions were not inconsistent with the normalization rules under the facts presented. Because the state commission had not specifically required or insisted on the treatment in a final order, the IRS said no accelerated depreciation disallowance or investment tax credit recapture was required. The ruling was conditioned on the utility correcting its amortization rates in its next rate case.

Ruling snapshot

• Question: Did the utility's amortization errors violate normalization requirements or require ITC recapture?
• Outcome: Approved, no disallowance or recapture was required on the stated facts, subject to correction in the next rate case.
• Key authorities: IRC §§ 168, 167, 46, and 38; Treas. Reg. §§ 1.167(l)-1 and 1.46-6; Rev. Proc. 88-12.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201334036 Third Party Communication: None
Release Date: 8/23/2013 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
------------------------------------------------------------ ------------------------, ID No. ------------------
---------------------------- ----------------------------------------------------
----------------------------- Telephone Number:
----------------------------------------------- ----------------------
------------------------------------------------- Refer Reply To:
CC:PSI:B06
PLR-151999-12
Date:
May 21, 2013

LEGEND:

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

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

State A = -----------------
Commission A = ------------------------------------------------------------
Commission B = -------------------------------------------------------
Plant A = ----------------------------------------
Plant B = -----------------------------------------------------
Year A = -------
Year B = -------
Year C = -------
Year D = -------
Date A = ------------------------
Date B = --------------------------
Date C = --------------------
Date D = -----------------
Date E = ----------------------------
Date F = --------------------
Date G = -------------------
Date H = -----------------
Date I = ------------------
Date J = -------------------
Date K = -----------------------
Case X = --------------------------------------------
Case Y = --------------------------------------------
Case Z = --------------------------------------------
PLR-151999-12 2

Director = ---------------------------------------------------------------------------------
-----------------------------------------------------------------------------------

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

   This letter responds to the request, dated December 5, 2012, of Taxpayer for a

ruling on the consequences of Taxpayer’s accounting and regulatory treatment of the
Investment Tax Credit (ITC) and the excess deferred income taxes (EDFIT) associated
with the treatment of the ITC.

    The representations set out in your letter follow.

    Taxpayer is a regulated electric utility, incorporated under the laws of State A.

Taxpayer provides rate-regulated electric generation, transmission, and distribution
services to customers in State A. It is owned by and files a consolidated return with,
Parent. Taxpayer is subject to the regulatory jurisdiction of Commission A with respect
to its retail electric business. A portion of Taxpayer’s electric transmission business and
a small portion of its wholesale power business is regulated by Commission B.
Taxpayer’s rates are established by Commission A on a “rate of return” basis.
Commission A has a policy of full normalization of ITC and deferred income taxes.
Commission has approved the use of the Average Rate Assumption Method to
calculate the reversal of EDFIT for ratemaking purposes. The Taxpayer periodically
performs depreciation studies which may result in changes to the estimated useful life of
its various assets.

   Taxpayer, among other assets, owns an interest in Plant A, a multi-unit coal fired

plant. The four units of Plant A were placed into service between Year A and Year B
and all four units are currently included in retail rates. In addition to the interest in Plant
A, Taxpayer owns an interest in Plant B, a multi-unit nuclear generating facility. Unit
one of Plant B was placed in service for tax and regulatory purposes in Year C and unit
two of Plant B was placed in service in Year D. In addition to the ownership shares in
units one and two of Plant B, Taxpayer leases additional portions of both units. The ITC
and EDFIT relating to the leased portions is not at issue in this ruling request. Only
units one and two of Plant B are included in retail rates and so no ITC or EDFIT relating
to Taxpayer’s ownership share of unit three of Plant B is at issue in this ruling request.

   On Date A, Taxpayer filed with Commission A a list of proposed changes to the

depreciation rates for its interest in Plant A. These changes resulted from a study by a
third party consultant and the new rates were calculated in part by an extension of the
terminal date of Plant A by twenty years. On Date B, these revised rates were used as
a component of cost of service in Case X, Taxpayer’s first filed rate case using the
revised rates. On Date C, Commission A issued a final rate order that was based in
part on the revised depreciation rates for Plant A. These rates went into effect on Date
D.
PLR-151999-12 3

   On Date E, Taxpayer filed Case Y, a rate request that included, as a component

of cost of service, the revised depreciation rates for Plant A. On Date F, Taxpayer filed
a stipulation in Case Y in which the depreciation rates for units one and two of Plant B
were revised to reflect an anticipated extension of the Plant B operating license by the
Nuclear Regulatory Commission (an extension that was later granted). On Date G,
Commission A issued an order in Case Y, conditionally approving the stipulation filed by
Taxpayer. On Date H, consumer rates went into effect including the revised
depreciation rates for units one and two of Plant B.

 On Date I, the revised depreciation rates discussed above were included by

Taxpayer as components of cost of service in its filing of Case Z. On Date J,
Commission A issued an order in Case Z, setting new rates based on the filings of
Taxpayer. On Date K, customer rates in Case Z went into effect.

  In none of the orders issued by Commission A was ITC or EDFIT specifically

addressed.

     Subsequent to Date K, Taxpayer discovered that it had inadvertently failed to

extend the ITC amortization periods for Plant A as well as the owned portions of units
one and two of Plant B to correspond to the extended terminal dates for Plant A and the
license extension of Plant B. In addition, it was discovered that Taxpayer had also
inadvertently failed to extend the ARAM amortization of the EDFIT related to these
assets. For the periods during which Taxpayer erroneously failed to use the extended
life of these assets in calculating ITC and EDFIT, the practical effect of those actions
was to flow the benefit of the ITC thru to customers more rapidly than pro rata and to
reduce the tax expense element of cost of service, thus providing lower rates to
customers of Taxpayer. Taxpayer has represented that it will correct its ITC
amortization rates and EDFIT amortization rates in its next rate case filed before
Commission A.

Law and Analysis

  Section 168(f)(2) of the Code provides that the depreciation deduction

determined under section 168 shall not apply to any public utility property (within the
meaning of section 168(i)(10)) if the taxpayer does not use a normalization method of
accounting.

   In order to use a normalization method of accounting, section 168(i)(9)(A)(i) of

the Code 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
PLR-151999-12 4

section 168(i)(9)(A)(ii), if the amount allowable as a deduction under section 168 differs
from the amount that-would be allowable as a deduction under section 167 using the
method, period, first and last year convention, and salvage value used to compute
regulated tax expense under section 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

section 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 section
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 section 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.

     Former section 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
section 167(l)(3)(G) in a manner consistent with that found in section 168(i)(9)(A).
Section 1.167(1)-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 section 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 ratemaking purposes.

   Section 1.167(1)-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 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.

    Section 1.167(1)-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
PLR-151999-12 5

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 section 1.167(1)-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 section 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 section 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 section 167 or 168 of the Code if the taxpayer, in computing its cost of service for
ratemaking 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 section 203(e)(2)(A) of the Act as the

excess of:

   (i) the reserve for deferred taxes as described in former section 167 (1)(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 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
PLR-151999-12 6

differences in the particular vintage account reverse. Moreover, it is a violation of
section 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 section 203(e) of the Act does not modify the normalization requirements
of former section 167(l) or section 168(i) of the Code.

   For a public utility to use accelerated depreciation in determining its federal

income tax liability, section 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 section 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.

    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, section 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.

    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.
PLR-151999-12 7

    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).

   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, explains 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 failed to use the extended life

of the Plant in calculating ITC and EDFIT, the practical effect of those actions was to
flow the benefit of the ITC thru to customers more rapidly than pro rata and to reduce
the tax expense element of cost of service. These effects were not intended by either
the Taxpayer or Commission A. Further, Taxpayer will correct its amortization rates in
the next rate case it files before Commission A. We conclude that Taxpayer’s actions
as described above are not inconsistent with the requirements of §168(i)(9) and former
§§ 167(l) and 46(f). Finally, Commission A never specifically addressed these matters
in any rate case involving Taxpayer and so did not issue an 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 A did not insist on the
PLR-151999-12 8

errors discussed above, no disallowance of accelerated depreciation or recapture of ITC
is required in this case.

     This ruling is based on the representations submitted by Taxpayer and is only

valid if those representations are accurate. Specifically, this ruling is expressly
conditioned on the Taxpayer correcting its ITC amortization rates and EDFIT
amortization rates in its next rate case filed before Commission A.

   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 Commission A 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
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)

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