Utility must net NOL carryforward against deferred-tax reserve

Plain-English summary

A regulated natural-gas utility projected net operating losses while claiming accelerated and bonus depreciation. Its regulator proposed reducing rate base by the full accumulated deferred income tax balance without offsetting the deferred tax asset attributable to the NOL carryforward and assigning that NOL-related balance no return. The IRS ruled that normalization requires the accelerated-depreciation portion of the NOL carryforward to reduce the ADIT rate-base offset, measured on these facts by the utility’s “with and without” method. A zero return would improperly flow accelerated-depreciation benefits to ratepayers.

Ruling snapshot

• Question: How must the utility account for its depreciation-related NOL carryforward when applying the normalization rules to ADIT and rate base?
• Outcome: Approved on all three requested rulings: the NOL-related balance must offset ADIT, use the “with and without” measure, and receive a nonzero return.
• Key authorities: IRC §§ 167 and 168(i)(9); Treas. Reg. § 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201519021 Third Party Communication: None
Release Date: 5/8/2015 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
------------------------------------------------------------ ----------------------, ID No. ----------------
------------------------ Telephone Number:
--------------------------------------------- --------------------
-------------------------- Refer Reply To:
-------------------------------------- CC:PSI:B06
PLR-136851-14
Date:
February 04, 2015

LEGEND:

Taxpayer = ---------------------------------------------
----------------------
Parent = --------------------
----------------------
State A = ------------
Commission = ---------------------------------------------------------------------------------

Year A = ------
Year B = ------
Year C = ------
Year D = ------
Date A = --------------------------
Date B = ---------------------
Date C = --------------------------
Date D = ----------------
Case = --------------------------
Director = --------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
---------------

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

  This letter responds to the request, dated October 1, 2014, submitted on behalf

of Taxpayer for a ruling on the application of the normalization rules of the Internal
Revenue Code to certain accounting and regulatory procedures, described below.

     The representations set out in your letter follow.

PLR-136851-14 2

   Taxpayer is a regulated, investor-owned public utility incorporated under the laws

of State A primarily engaged in the business of supplying natural gas service in State A.
Taxpayer is subject to the regulatory jurisdiction of Commission with respect to terms
and conditions of service and as to the rates it may charge for the provision of service.
Taxpayer’s rates are established on a cost of service basis.

   Taxpayer is wholly owned by Parent, and Taxpayer is included in a consolidated

federal income tax return of which Parent is the common parent. Taxpayer employs the
accrual method of accounting and reports on a calendar year basis.

   Taxpayer filed a rate case application on Date A (Case). In its filing, Taxpayer

used as its starting point actual data from the historic test period, calendar Year A. It
then projected data for Year B through Year D. Taxpayer updated, amended, and
supplemented its data several times during the course of the proceedings. Rates in this
proceeding were intended to, and did, go into effect for the period Date B through Date
C.

    In computing its income tax expense element of cost of service, the tax benefits

attributable to accelerated depreciation were normalized and were not flowed thru to
ratepayers.

   In its rate case filing, Taxpayer anticipated that it would claim accelerated

depreciation, including “bonus depreciation” on its tax returns to the extent that such
depreciation was available in all years for which data was provided. Additionally,
Taxpayer forecasted that it would incur a net operating loss (NOL) in each of Year B,
Year C, and Year D. Taxpayer anticipated that it had the capacity to carry back a
portion of this NOL with the remainder producing a net operating loss carryover (NOLC)
as of the end of Year C and Year D, the beginning and end of the test period.

     On its regulatory books of account, Taxpayer “normalizes” the differences

between regulatory depreciation and tax depreciation. This means that, where
accelerated depreciation reduces taxable income, the taxes that a taxpayer would have
paid if regulatory depreciation (instead of accelerated tax depreciation) were claimed
constitute “cost-free capital” to the taxpayer. A taxpayer that normalizes these
differences, like Taxpayer, maintains a reserve account showing the amount of tax
liability that is deferred as a result of the accelerated depreciation. This reserve is the
accumulated deferred income tax (ADIT) account. Taxpayer maintains an ADIT
account. In addition, Taxpayer maintains an offsetting series of entries – a “deferred tax
asset” and a “deferred tax expense” - that reflect that portion of those ‘tax losses’ which,
while due to accelerated depreciation, did not actually defer tax because of the
existence of an NOLC.
PLR-136851-14 3

    In the setting of utility rates in State, a utility’s rate base is offset by its ADIT

balance. In its rate case filing and throughout the proceeding, Taxpayer maintained that
the ADIT balance should be reduced by the amounts that Taxpayer calculates did not
actually defer tax due to the presence of the NOLC, as represented in the deferred tax
asset account. Thus, Taxpayer argued that the rate base should be reduced as of the
end of Year D by its federal ADIT balance net of the deferred tax asset account
attributable to the federal NOLC. It based this position on its determination that this net
amount represented the true measure of federal income taxes deferred on account of its
claiming accelerated tax depreciation deductions and, consequently, the actual quantity
of “cost-free” capital available to it. It also asserted that the failure to reduce its rate
base offset by the deferred tax asset attributable to the federal NOLC would be
inconsistent with the normalization rules Testimony by another participant in Case
argued against Taxpayer’s proposed calculation of ADIT.

   Commission, in an order issued on Date D, held that it is inappropriate to include

the NOL in rate base for ratemaking purposes. Commission further stated that it is the
intent of the Commission that Taxpayer comply with the normalization method of
accounting and tax normalization regulations. Commission noted that if Taxpayer later
obtains a ruling from the IRS which affirms Taxpayer’s position, Taxpayer may file
seeking an adjustment. Commission also held that to the extent tax normalization rules
require including the NOL in rate base in the specified years, no rate of return is
authorized.

   Taxpayer requests that we rule as follows:

1. Under the circumstances described above, the reduction of Taxpayer’s rate base
   by the full amount of its ADIT account balance unreduced by the balance of its
   NOLC-related account balance would be inconsistent with (and, hence, violative
   of) the requirements of § 168(i)(9) and § 1.167(l)-1 of the Income Tax
   regulations.
2. For purposes of Ruling 1 above, the use of a balance of Taxpayer’s NOLC-
   related account balance that is less than the amount attributable to accelerated
   depreciation computed on a “with and without” basis would be inconsistent with
   (and, hence, violative of) the requirements of § 168(i)(9) and § 1.167(l)-1 of the
   Income Tax regulations.
3. Under the circumstances described above, the assignment of a zero rate of
   return to the balance of Taxpayer’s NOLC-related account balance would be
   inconsistent with (and, hence, violative of) the requirements of § 168(i)(9) and
   § 1.167(l)-1.

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
PLR-136851-14 4

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
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(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 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) 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.
PLR-136851-14 5

     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 section 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 section
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 section 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 section 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 section 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
regulated accounting if, for ratemaking purposes, the amount of the reserve for deferred
taxes under section 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 section 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
PLR-136851-14 6

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.

   Regarding the first issue, § 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 ADIT account,
the reserve account for deferred taxes, reduces rate base, it is clear that the portion of
an NOLC that is attributable to accelerated depreciation must be taken into account in
calculating the amount of the reserve for deferred taxes (ADIT). Thus, the order by
Commission is not in accord with the normalization requirements.

    Regarding the second issue, § 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. While that section provides no specific mandate on methods, it does
provide that the Service has discretion to determine whether a particular method
satisfies the normalization requirements. The “with or without” methodology employed
by Taxpayer is specifically designed to ensure that the 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. Under these specific facts, any method other than the “with and without”
PLR-136851-14 7

method would not provide the same level of certainty and therefore the use of any other
methodology is inconsistent with the normalization rules.

  Regarding the third issue, assignment of a zero rate of return to the balance of

Taxpayer’s NOLC-related account balance would, in effect, flow the tax benefits of
accelerated depreciation deductions through to rate payers. This would violate the
normalization provisions.

  We rule as follows:

1. Under the circumstances described above, the reduction of Taxpayer’s rate base
   by the full amount of its ADIT account balance unreduced by the balance of its
   NOLC-related account balance would be inconsistent with the requirements of
   § 168(i)(9) and § 1.167(l)-1 of the Income Tax regulations.
2. For purposes of Ruling 1 above, the use of a balance of Taxpayer’s NOLC-
   related account balance that is less than the amount attributable to accelerated
   depreciation computed on a “with and without” basis would be inconsistent with
   the requirements of § 168(i)(9) and § 1.167(l)-1 of the Income Tax regulations.

3. Under the circumstances described above, the assignment of a zero rate of
   return to the balance of Taxpayer’s NOLC-related account balance would be
   inconsistent with the requirements of § 168(i)(9) and § 1.167(l)-1.

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

   valid if those representations are accurate. The accuracy of these representations is
   subject to verification on audit.

   Except as specifically determined above, no opinion is expressed or implied
   concerning the Federal income tax consequences of the matters described 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
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)