Utility must account for NOLs when reducing rate base for deferred taxes

Plain-English summary

A regulated natural gas utility used accelerated tax depreciation while carrying net operating losses. For ratemaking, its accumulated deferred income tax account normally reduces rate base because deferred taxes provide cost-free capital. The utility argued that this reduction must be offset for the part of its net operating loss carryforward attributable to accelerated depreciation, since that depreciation did not actually defer tax while losses existed. The IRS agreed that reducing rate base by the full deferred-tax balance without the NOL-related offset would violate the normalization rules. It also ruled that, on these facts, using less than the accelerated-depreciation amount calculated under the utility's “last dollars deducted” method would be inconsistent with those rules.

Ruling snapshot

• Question: Must a utility account for the accelerated-depreciation portion of its net operating loss when using deferred taxes to reduce rate base, and may it use less than the last-dollars-deducted amount?
• Outcome: Approved
• Key authorities: IRC §§ 167, 168(f)(2), 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: 201534001 Third Party Communication: None
Release Date: 8/21/2015 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
------------------------------------------------------- ----------------------, ID No. ----------------
----------------------------------- Telephone Number:
-------------------------------------------- --------------------
------------------------ Refer Reply To:
------------------------------- CC:PSI:B06
PLR-103300-15
Date:
May 13, 2015

LEGEND:

Taxpayer = -----------------------------------
----------------------
State A = --------
State B = ---------
State C = ------------
Commission = --------------------------------------------------
Year A = ------
Year B = ------
Date A = ------------------
Date B = --------------------------
Date C = ------------------
Date D = -----------------------
Case = -----------------------------
Director = ---------------------------------------------------------------------------------
------------------------

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

  This letter responds to the request, dated January 9, 2015, 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.

  Taxpayer is the common parent of an affiliated group of corporations and is

incorporated under the laws of State A and State B. Taxpayer is engaged primarily in
the businesses of regulated natural gas distribution, regulated natural gas transmission,
and regulated natural gas storage. Taxpayer’s regulated natural gas distribution
PLR-103300-15 2

business delivers gas to customers in several states, including State A. Taxpayer is
subject to, as relevant for this ruling, 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 its gas distribution service in State A. Taxpayer’s rates are established on a
“rate of return” basis.

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

application was based on a fully forecasted test period consisting of the twelve months
ending on Date B. Taxpayer updated, amended, and supplemented its data several
times during the course of the proceedings. In a final order dated Date C, rates were
approved by Commission for service rendered on or after Date D.

     In each year from Year A to Year B, Taxpayer incurred a net operating loss

carryforward (NOLC). In each of these years, Taxpayer claimed accelerated
depreciation, including “bonus depreciation” on its tax returns to the extent that such
depreciation was available. 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.

   In the setting of utility rates in State C, 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 by its
federal ADIT balance net of the deferred tax asset account attributable to the federal
NOLC. 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. The attorney general for State C argued against Taxpayer’s proposed calculation
of ADIT.

   Commission, in its final order, agreed with Taxpayer but concluded that the

ambiguity in the relevant normalization regulations warranted an assessment of the
issue by the IRS and this ruling request followed.

   Taxpayer requests that we rule as follows:

PLR-103300-15 3

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 that is less than the amount attributable to accelerated
   depreciation computed on a “last dollars deducted” 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.

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
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
PLR-103300-15 4

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.

     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
PLR-103300-15 5

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
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, to reduce
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.

 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)-
PLR-103300-15 6

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 “last dollars deducted” methodology
employed by Taxpayer ensures 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 “last dollars
deducted” method would not provide the same level of certainty and therefore the use of
any other methodology is inconsistent with the normalization rules.

     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)

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