IRS distinguishes projected and historical utility rate calculations

Plain-English summary

A regulated electric utility used a formula rate based mainly on historical data, with projected plant additions added to rate base, and also maintained three separate riders with projected-rate and true-up components. The IRS held that the formula rate did not violate the normalization consistency rule because tax expense, depreciation expense, and accumulated deferred federal income taxes were calculated consistently. The riders' projected-rate components used future test periods and therefore had to apply the deferred-tax proration formula. Prior failures to prorate would not violate the normalization rules if the utility took the required corrective action at its next filing. The riders' true-up components used historical periods and were not subject to proration.

Ruling snapshot

• Question: How do the depreciation normalization consistency and proration rules apply to the utility's formula rate, projected rider rates, and historical true-ups?
• 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: 201741004                                              Third Party Communication: None
Release Date: 10/13/2017                                       Date of Communication: Not Applicable
Index Number: 167.22-01
                                                               Person To Contact:
----------------------------                                   --------------------------, ID No. ----------------
------------------------------------------------------------   -----------------
---------------------------                                    Telephone Number:
-----------------------------------                            ----------------------
-------------------------------------                          Refer Reply To:
                                                               CC:PSI:B06
                                                               PLR-104760-17
                                                               Date:
                                                               July 17, 2017
LEGEND:
Taxpayer                  =         ---------------------------------------------------------------------------------
Parent                    =         ----------------------------------------------------
State                     =         --------------
Commission A              =         ---------------------------------------------------
Commission B              =         -------------------------------------------------------
Operator                  =         --------------------------------------
Date 1                    =         -----------
Date 2                    =         ----------
Form                      =         -------------------------
Rider A                   =         ---------------------------------------------------------------------------------
                                    ----------------------------
Rider B                    =        ---------------------------------------------------------------------------------
Rider C                    =        ---------------------------------------------------------------------------------
Year 1                     =        -------
Year 2                     =        -------
Director                   =        -------------------------------------------------


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

This letter responds to Parent’s request, made on behalf of Taxpayer, dated February 1,
2017, for a ruling on the application of the normalization rules of the Internal Revenue
Code (Code) to certain accounting and regulatory procedures, as described below.

The representations set out in your letter follow.

Taxpayer, a wholly-owned subsidiary of Parent, is an investor-owned regulated utility
incorporated in State. Taxpayer is a member of Parent’s consolidated group that files a
consolidated federal income tax return on a calendar year basis using an accrual
PLR-104760-17                                  2

method of accounting.

Taxpayer is engaged in the purchase, transmission, distribution, and sale of electric
energy in State. It is subject to regulation by Commission A and Commission B, with
respect to terms and conditions of services, including the rates it may charge for its
services. Both Commissions establish Taxpayer’s rates based on its costs, including a
provision for a return on the capital employed by Taxpayer in its regulated business.

Taxpayer’s electric transmission lines located in State are integrated into Operator, a
regional transmission operator. As a transmission-owning member of Operator,
Taxpayer is able to include in Operator’s tariff a rate that allows it to recover the costs it
incurs with respect to the transmission facilities it makes available to Operator. The
rate-setting mechanism used by Taxpayer is a formula rate approved by Commission B.
The formula rate is established in two parts: a basic rate and a true-up.

By Date 1 of each year, Taxpayer files with Commission B to update its formula rate.
The new rate takes effect the following Date 2 and remains in effect for one year. The
data used in calculating the basic rate portion of the updated rate is, for the most part,
taken from the historical test year which ended on the last day of the immediately
preceding calendar year (as reflected in Taxpayer’s Form for that period). All elements
of rate base, including plant in service, accumulated depreciation and accumulated
deferred federal income taxes (ADFIT) use, at least initially, “end of historical calendar
test year” balances. Depreciation expense (and all other operation and maintenance
expenses) reflected in the calculation are also historical calendar test year expense
amounts.

One element of the calculation is then modified. A projection is made of plant additions
that will be placed in service during the calendar year in which the rates are being set.
The cost of these additions is weighted to reflect the number of months each addition
will be in service during the calendar year. This weighted amount is added to rate base.
Thus, this component of the rate provides a return on the equity reflected in the
projected plant additions being included in rate base. No modification is made to the
balances of the depreciation expense or deferred taxes due to these projected plant
additions. The basic rate is a revenue requirement calculated based on the historical
calendar year test period data so modified.

The true-up component of Taxpayer’s formula rate is calculated by comparing a
revenue requirement computed based on Taxpayer’s most recent Form to the revenue
requirement originally calculated for the prior test period. Any difference, both over- or
under-recoveries (plus interest), is incorporated into the formula rate as the true-up
component of that rate. Among other things, this component corrects any over- or
under-recovery of equity return arising from the prior year’s projection of plant additions,
based on actual plant additions during the year.
PLR-104760-17                                 3

Taxpayer has claimed (and continues to claim) accelerated depreciation on all of its
public utility property to the full extent those deductions are available under the Code.
Taxpayer normalizes the federal income taxes deferred as a result of its claiming these
deductions in accordance with the Normalization Rules. As a consequence, Taxpayer
has a substantial balance of ADFIT that is attributable to the accelerated depreciation
reflected on its regulated books of account. In its formula rate template, Taxpayer
reflects its ADFIT balance (as appropriately allocated to the jurisdiction) as a reduction
in its computation of rate base.

In calculating both its basic rate and its true-up, the ADFIT balance by which Taxpayer
reduces rate base is the end of period balance (i.e. the ending balance as reflected in
Taxpayer’s Form for the calendar year immediately preceding the year in which rates
are being updated). Because ADFIT is not projected in either component, Taxpayer
neither averages nor applies the proration methodology to the ADFIT balance in either
calculation.

Taxpayer also has three State riders: Rider A, Rider B, and Rider C. For each of the
riders, Taxpayer files to update the rider for the subsequent calendar year (“Annual
Filing”) for each of the years for which the rider is authorized. Each rider consists of two
components: the projected rate and the true-up.

The projected rate employs a revenue requirement calculation based on Taxpayer’s
projection of the qualified rider plan costs to be incurred during the year for which rates
are being set. Earnings are calculated upon a simple average of the beginning of the
period and end of the period net plant.

The true-up is calculated by computing a revenue requirement for the last three months
of the prior calendar year and the first nine months of the current calendar year based
on actual results for those periods and comparing that amount to the actual revenues
collected through the rider during that same twelve-month period. Any imbalance is
charged or credited to the subsequent year’s rider charge along with interest on the
amount.

Changes in ADFIT balances are not prorated in the calculation of either component.
Rather, they are calculated using a simple average of the beginning and the end of the
period ADFIT.

Taxpayer requests that we rule as follows:

1. Taxpayer’s projection of plant additions for inclusion in rate base in conjunction with
the use of historical ADFIT and depreciation expense in computing its basic rate is not a
violation of the Consistency Rule;

2. If the Service rules adversely with respect to Requested Ruling 1, provided that
PLR-104760-17                                 4

Taxpayer takes the necessary corrective action at the next Form filing following the
effective date of any related tariff changes approved by Commission B, any failure by
Taxpayer to comply with the Consistency Rule in connection with its formula rate at any
time prior to the Taxpayer taking the necessary corrective action was not a violation of
the Normalization Rules;

3. If the Service rules adversely with respect to Requested Ruling 1, incorporating
projected ADFIT (on a prorated basis), depreciation expense, and tax expense relating
to the projected additions included in the formula rate calculation going forward will
satisfy the Consistency Rule;

4. Taxpayer’s Rider A, Rider B, and Rider C projected rates employ a future test period
and, therefore, are subject to the Proration Requirement;

5. If the Service rules affirmatively with respect to Requested Ruling 4, provided that
Taxpayer takes the necessary corrective action at the next Annual Filing, any failure by
Taxpayer to comply with the Proration Requirement in connection with its Rider A, Rider
B, and Rider C projected rates at any time prior to the Taxpayer taking the necessary
corrective action was not a violation of the Normalization Rules; and

6. Taxpayer’s Rider A, Rider B, and Rider C true-ups employ an historical test period
and, therefore, are not subject to the Proration Requirement.

Law and Analysis

Requested Rulings 1, 2 and 3

Former § 167(l) 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 § 167(l)(3)(G) in a manner
consistent with that found in § 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
§ 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 168(f)(2) provides that the depreciation deduction determined under § 168 shall
not apply to any public utility property (within the meaning of § 168(i)(10)) if the taxpayer
does not use a normalization method of accounting.
PLR-104760-17                                5

In order to use a normalization method of accounting, § 168(i)(9)(A) requires that a
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, 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 § 168(i)(9)(A)(ii), if
the amount allowable as a deduction under § 168 differs from the amount that would be
allowable as a deduction under § 167 using the method, period, first and last year
convention, and salvage value used to compute regulated tax expense under
§ 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) provides that one way the requirements of § 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 § 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
§ 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.

In order to satisfy the requirements of § 168(i)(9)(B), there must be consistency in the
treatment of costs for rate base, regulated depreciation expense, tax expense, and
deferred tax revenue purposes. In this case, all elements of rate base, including plant in
service, accumulated depreciation, and ADFIT use, at least initially, “end of historical
calendar test year” balances. Depreciation expense (and all other operation and
maintenance expenses) reflected in the calculation are also historical calendar year test
year expense amounts.

Taxpayer uses a projection of plant additions that will be placed in service during the
calendar year in which rates are being set to compute a weighted amount that is added
to rate base. The addition of the projected plant additions to rate base provides a return
on the equity reflected in these projected plant additions. No modification is made to
depreciation expense or deferred taxes as a result of these expected additions to
Taxpayer’s equity. Taxpayer’s tax expense, depreciation expense, and ADFIT are all
calculated in a consistent fashion. Therefore, Taxpayer is not in violation of the
Consistency Rule.

Because of the conclusion reached above, Taxpayer is also not in violation of the
Normalization Rules. Accordingly, Taxpayer’s Requested Issues 2 and 3 are moot and
will not be considered further.

Requested Ruling 4

Section 1.167(l)-1(h)(6) sets forth additional normalization requirements with respect to
PLR-104760-17                                 6

public utility property. Under § 1.167(l)-1(h)(6)(i), a taxpayer does not use a
normalization method of accounting if, for ratemaking purposes, the amount of the
reserve for deferred taxes excluded from the rate base, or treated as cost-free capital,
exceeds the amount of the reserve for the period used in determining the taxpayer’s
ratemaking tax expense. Section 1.167(l)-1(h)(6)(ii) also provides the procedure for
determining the amount of the reserve for deferred taxes to be excluded from rate base
or to be included as no-cost capital. If, in determining depreciation for ratemaking tax
expense, a period (the “test period”) is used which is part historical and part future, then
the amount of the reserve account for this period is the amount of the reserve at the end
of the historical portion of the period and a pro rata amount of any projected increase to
be credited to the account during the future portion of the period. The pro rata amount
of any increase during the future portion of the period is determined by multiplying the
increase by a fraction, the numerator of which is the number of days remaining in the
period at the time the increase is to accrue, and the denominator of which is the total
number of days in the future portion of the period.

Section 1.167(l)-1(h)(6)(i) makes it clear that the reserve excluded from rate base must
be determined by reference to the same period as is used in determining ratemaking tax
expense. A taxpayer may use either historical data or projected data in calculating
these two amounts, but it must be consistent. As explained in § 1.167(l)-1(a)(1), the
rules provided in § 1.167(l)-1(h)(6)(i) are to insure that the same time period is used to
determine the deferred tax reserve amount resulting from the use of an accelerated
method of depreciation for cost of service purposes and the reserve amount that may
be excluded from the rate base or included in no-cost capital in determining such cost of
services.

If a taxpayer chooses to compute its ratemaking tax expense and rate base exclusion
amount using projected data then it must use the formula provided in § 1.167(l)-
1(h)(6)(ii) to calculate the amount of deferred taxes subject to exclusion from the rate
base. This formula prorates the projected accruals to the reserve so as to account for
the actual time these amounts are expected to be in the reserve. As explained in
§ 1.167(l)-1(a)(1), the formula in § 1.167(l)-1(h)(6)(ii) provides a method to determine
the period of time during which the taxpayer will be treated as having received amounts
credited or charged to the reserve account so that the disallowance of earnings with
respect to such amounts through rate base exclusion or treatment as no-cost capital will
take into account the factor of time for which such amounts are held by the taxpayer.

The purpose of the proration formula is to prevent the immediate flow-through of the
benefits of accelerated depreciation to ratepayers. The proration formula stops flow-
through by limiting the deferred tax reserve accruals that may be excluded from rate
base, and thus the earnings on rate base that may be disallowed, according to the
length of time these accruals are actually in the reserve account.

The effectiveness of § 1.167(l)-1(h)(6)(ii) in resolving the timing issue has been
PLR-104760-17                                  7

questioned by its failure to define some key terms. Nowhere does this provision state
what is meant by the terms “historical” and “future” in relation to the period for
determining depreciation for ratemaking tax expense (the “test period”). One
interpretation focuses on the type or quality of the data used in the ratemaking process.
According to this interpretation, the historical period is that portion of the test period for
which actual data is used, while the portion of the period for which data is estimated is
the future period. The second interpretation focuses on when the utility rates become
effective. Under this interpretation, the historical period is that portion of the test period
before rates go into effect, while the portion of the test period after the effective date of
the rate order is the future period.

The first interpretation, which focuses on the quality of the ratemaking data, is an
attractive one. It proposes a simple rule, easy to follow and to enforce: any portion of
the reserve for deferred taxes based on estimated data must be prorated in determining
the amount to be deducted from rate base. The actual passage of time between the
date ratemaking data is submitted and the date rates become effective is of no
importance. But this interpretation of the regulations achieves simplicity at the expense
of precision; in other words, it is overbroad. The proration of all estimated deferred tax
data does serve to magnify the benefits of accelerated depreciation to the utility, but this
is not the purpose of normalization. Congress was explicit: normalization “in no way
diminishes whatever power the [utility regulatory] agency may have to require that the
deferred taxes reserve be excluded from the base upon which the utility’s permitted rate
of return is calculated.” H.R. Rep. No. 413, 91st Cong., 1st Sess. 133 (1969).

In contrast, the second interpretation of § 1.167(l)-1(h)(6)(ii) of the regulations is
consistent with the purpose of normalization, which is to preserve for regulated utilities
the benefits of accelerated depreciation as a source of cost-free capital. The availability
of this capital is ensured by prohibiting flow-through. But whether or not flow-through
can even be accomplished by means of rate base exclusions depends primarily on
whether, at the time rates become effective, the amounts originally projected to accrue
to the deferred tax reserve have actually accrued.

If rates go into effect before the end of the test period, and the rate base reduction is not
prorated, the utility commission is denying a current return for accelerated depreciation
benefits the utility is only projected to have. This procedure is a form of flow-through,
for current rates are reduced to reflect the capital cost savings of accelerated
depreciation deductions not yet claimed or accrued by the utility. Yet projected data is
often necessary in determining rates, since historical data by itself is rarely an accurate
indication of future utility operating results. Thus, the regulations provide that as long as
the portion of the deferred tax reserve based on projected (future estimated) data is
prorated according to the formula in § 1.167(l)-1(h)(6)(ii), a regulator may deduct this
reserve from rate base in determining a utility’s allowable return. In other words, a utility
regulator using projected data in computing ratemaking tax expense and rate base
exclusion must account for the passage of time if it is to avoid flow-through.
PLR-104760-17                                 8


However, if rates go into effect after the end of the test period, the opportunity to flow
through the benefits of future accelerated depreciation to current ratepayers is gone,
and so too is the need to apply the proration formula. In this situation, the only question
that is important for the purpose of rate base exclusion is the amount in the deferred tax
reserve, whether actual or estimated. Once the future period, the period over which
accruals to the reserve were projected, is no longer future, the question of when the
amounts in the reserve accrued is no longer relevant (at the time the new rate order
takes effect, the projected increases have accrued, and the amounts to be excluded
from rate base are no longer projected but historical, even though based on estimates).

In this case, for Rider A, Rider B, and Rider C, Taxpayer uses a projected rate to
calculate Taxpayer’s revenue requirement based on a projection of the qualified rider
plan costs to be incurred during the year for which rates are being set. Therefore,
because Taxpayer’s Rider A, Rider B, and Rider C projected rates employ a future test
period, they are subject to the Proration Requirement under § 1.167(l)-1(h)(6)(ii).

Requested Ruling 5

Section 168(f)(2) provides that the depreciation deduction determined under § 168 shall
not apply to any public utility property (within the meaning of § 168(i)(10)) if the taxpayer
does not use a normalization method of accounting. However, in the legislative history
to the enactment of the normalization requirements of the Investment Tax Credit (ITC),
Congress has stated that it hopes that sanctions will not have to be imposed and that
disallowance of the tax benefit (there, the ITC) should be imposed only after a
regulatory body has required or insisted upon such treatment by a utility. See Senate
Report No. 92-437, 92nd Cong., 1st Sess. 40-41 (1971), 1972-2 C.B. 559, 581.

Because the Service has ruled affirmatively with respect to Requested Ruling 4 that
Taxpayer was required to use the proration formula applicable to future test periods for
the projected rate for Rider A, Rider B and Rider C, prospectively adhering to the
Service’s interpretation of § 1.167(l)- 1(h)(6)(ii) may require adjustments to conform to
this ruling. Any rates that have been calculated using procedures inconsistent with this
ruling (“nonconforming rates”) which are or which have been in effect and which, under
applicable state or federal regulatory law, can be adjusted or corrected to conform to the
requirements of this ruling, must be so adjusted or corrected. Where nonconforming
rates cannot be adjusted or corrected to conform to the requirements of this ruling due
to the operation of state or federal regulatory law, then such correction must be made in
the next regulatory filing or proceeding in which Taxpayer’s rates are considered.

Specifically, Taxpayer has represented that it will submit rate filings to Commission A
within six months of receipt of this ruling letter and that Taxpayer’s Year 1 rate filings
have or will conform the Rider A, Rider B, and Rider C projected rates to the
Normalization Rules with rates becoming effective for calendar Year 2.
PLR-104760-17                                9


Requested Ruling 6

As discussed above, where a taxpayer computes its ratemaking tax expense and rate
base exclusion amount using projected data then it must use the proration formula
provided in § 1.167(l)-1(h)(6)(ii) to calculate the amount of deferred taxes subject to
exclusion from the rate base.

In contrast to the projected rate component of Rider A, Rider B, and Rider C as
discussed above, Taxpayer’s Rider A, Rider B, and Rider C true-ups are determined by
reference to a purely historical period. Accordingly, there is no need to use the
proration formula to calculate the differences between Taxpayer’s projected ADFIT
balance and the actual ADFIT balance during the period. As a result, Taxpayer’s Rider
A, Rider B, and Rider C true-ups are not subject to the Proration Requirement.

Conclusions

1. Taxpayer’s projection of plant additions for inclusion in rate base in conjunction with
the use of historical ADFIT and depreciation expense in computing its basic rate is not a
violation of the Consistency Rule.

2. This issue is moot as discussed above.

3. This issue is moot as discussed above.

4. Taxpayer’s Rider A, Rider B, and Rider C projected rates employ a future test period
and, therefore, are subject to the Proration Requirement;

5. Any failure by Taxpayer to comply with the Proration Requirement in connection with
its Rider A, Rider B, and Rider C projected rates at any time prior to the Taxpayer taking
the necessary corrective action does not constitute a violation of the Normalization
Rules, provided that Taxpayer takes the necessary corrective action at the next Form
filing; and

6. Taxpayer’s Rider A, Rider B, and Rider C true-ups employ an historical test period
and, therefore, are not subject to the Proration Requirement.

Except as specifically determined above, no opinion is expressed or implied concerning
the Federal income tax consequences of the matters described above.
PLR-104760-17                                 10


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,


                                                   Patrick S. Kirwan
                                                   Chief, Branch 6
                                                   Office of the Associate Chief Counsel
                                                   (Passthroughs & Special Industries)



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