Electric utility's deferred-tax rate methods avoided normalization sanctions

Plain-English summary

A regulated electric utility used accumulated deferred federal income tax from accelerated depreciation as zero-cost capital when setting base rates and cost-recovery riders. It discovered that it had not applied the required proration formula to projected deferred-tax balances and that its rider calculations used different time conventions for deferred taxes and other rate components. The IRS concluded that the earlier proration failures did not trigger a normalization violation because they were inadvertent, neither the utility nor its regulators had recognized or required the inconsistent treatment, and the utility would correct the methods at the earliest opportunity. For both projected and true-up rider components, using differing conventions did not violate the consistency rule so long as the deferred-tax balance actually used did not exceed the maximum allowed by the regulatory limitation. The utility had to correct adjustable nonconforming rates, use the proper approach prospectively, and retain calculations showing compliance.

Ruling snapshot

• Question: Did the utility's proration and rider-calculation methods violate the tax normalization rules?
• Outcome: Approved with conditions, prior errors avoided sanctions and rider methods were acceptable within the deferred-tax limitation.
• Key authorities: IRC § 168(f)(2), (i)(9); Treas. Reg. § 1.167(l)-1(h)(6)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201743009                                              Third Party Communication: None
Release Date: 10/27/2017                                       Date of Communication: Not Applicable
Index Number: 167.22-01
                                                               Person To Contact:
--------------------------                                     --------------------------, ID No. ----------------
--------------------------------------------------------       -----------------
-----------------------------------                            Telephone Number:
--------------------------------                               ----------------------
--------------------------------                               Refer Reply To:
                                                               CC:PSI:B06
                                                               PLR-104580-17
                                                               Date:
                                                               August 02, 2017

LEGEND:
Taxpayer                   =        -------------------------------------------------------------
X                          =        --------------------------------------------------------
Y                          =        -------------------------------------------------------
Parent                     =        ------------------------------------------------------------
State A                    =        ----------
State B                    =        ---------------------
Commission A               =        ------------------------------------------------
Commission B               =        -------------------------------------------------------
Rider 1                    =        -------------------------------------------------------------
Rider 2                    =        ------------------------------------------------------------
Rider 3                    =        ---------------------------------------------------
Month                      =        ------
Report                     =        -----------------------------------------
Order                      =        ---------------------------------------------
Date                       =        -----------------------
Year 1                     =        -------
Year 2                     =        -------
Year 3                     =        -------
Year 4                     =        -------
Director                   =        -------------------------------------------------


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

This letter responds to Taxpayer’s request dated January 31, 2017, for a ruling on the
application of the normalization rules of the Internal Revenue Code to certain
accounting and regulatory procedures, as described below.

The representations set out in your letter follow.
PLR-104580-17                                2

Taxpayer, a State A limited liability company disregarded for federal income tax
purposes, is wholly owned by X, which is also a State A limited liability company
disregarded for federal income tax purposes. X is wholly owned by Y. Y is a State B
corporation that is wholly owned by Parent. For federal tax purposes, Taxpayer is
deemed to be owned by Y. Parent is the common parent of an affiliated group of
corporations that files a consolidated federal income tax return on a calendar year basis
using an accrual method of accounting. Y and therefore Taxpayer are included in this
return.

Taxpayer is a regulated public utility engaged in the generation, transmission,
distribution, and sale of electric energy in State A. It is subject to regulation by
Commission A and Commission B, with respect to terms and conditions of 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. Commission
A sets Taxpayer’s rates at a level that is intended to allow Taxpayer the opportunity to
collect from retail customers its total revenues equal to its cost of providing service,
including a reasonable rate of return on invested capital. To accomplish this,
Commission A uses base rates and cost recovery clauses (“Riders”).

Taxpayer has claimed (and continues to claim) accelerated depreciation on all of its
public utility property to the full extent those deductions are available. 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 accumulated deferred federal income tax (ADFIT) that is
attributable to accelerated depreciation reflected on its regulated books of account.

In its base rate-setting, ADFIT is treated as a component of Taxpayer’s capital structure
and is assigned a zero cost rate. In computing its weighted average cost of capital
(“WACC”), Taxpayer projects its capital structure and its costs for the various elements
of its capital structure (including ADFIT) by using a 13-month average. Taxpayer has
not applied the Proration Methodology to its ADFIT in determining the amount to which
to apply the 13-month averaging convention in its base rate cases.

In addition to base rates, Taxpayer also has three main Riders (Riders 1 - 3) that are re-
calculated at least annually and are each comprised of three components: (1) a basic
amount that is computed using projected costs and customer usage for the current
calendar year, (2) a preliminary true-up amount for the prior year, and (3) a final true-up
amount from two years prior. In each Rider case, all elements of Taxpayer’s rate base
(for those Riders having a rate base component) are computed using a simple monthly
average (beginning plus ending divided by two for each month).

As with base rates, ADFIT is treated as a component of Taxpayer’s capital structure and
is assigned a zero cost rate. However, unlike with base rates, in its Rider cases
Taxpayer does not project it’s WACC. Instead, in all three Rider cases it uses the more
PLR-104580-17                                3

recent of (1) the WACC approved in Taxpayer’s last base rate case, or (2) the WACC
reflected in Taxpayer’s most recently filed Month Report.

Reports are prepared and filed with Commission A monthly to reflect a “rolling” 13-
month average WACC. This methodology was approved by Commission A in Order
issued on Date. Reports are based on actual, historical results and Taxpayer did not
apply the Proration Methodology to its ADFIT in determining the WACC for purposes of
its Reports. Consequently, the WACC used in its Rider cases has not reflected the
application of the Proration Methodology either.

In its Rider cases, Taxpayer does not explicitly compute income tax expense. Instead,
it merely “grosses up” the equity return at the statutory rate to derive the revenue
requirement necessary to fund that return after-tax. Thus, in its Rider cases, Taxpayer
makes no distinction between current and deferred income tax expense.

In Year 2, Taxpayer’s tax department personnel reviewed Taxpayer’s treatment of its
ADFIT in its base rate filings and concluded that Taxpayer was obliged to employ the
Proration Methodology in calculating the ADFIT balance that it used as a component of
its capital structure.

Under the Year 1 Agreement that it entered into in its last base rate case, Taxpayer
does not expect to be able to change its base rates until Year 4. Therefore, it does not
anticipate filing another base rate case until, at the earliest, sometime in Year 3.
Taxpayer will implement the Proration Methodology as required and will propose to alter
its use of disparate conventions in computing rate base and its WACC if the Service
rules that such alterations are necessary to remain compliant with the Normalization
Rules.

Taxpayer requests that we rule as follows:

1. To the extent that, in computing Taxpayer’s base rates and its cost recovery clauses
   (“Riders”), Taxpayer’s inclusion in its capital structure of an amount of depreciation-
   related ADFIT computed without applying the Proration Methodology was
   inconsistent with the Normalization Rules, any such action by Taxpayer in any year
   prior to taking the necessary corrective action as described above was not a
   violation of the Normalization Rules;

2. In computing the projected component of its Riders, Taxpayer’s use of projected
   costs, including the projection of all elements of rate base, in conjunction with the
   use of historical deprecation-related ADFIT balance which is a component of the
   historical WACC does not conflict with the Consistency Rule of § 168(i)(9)(B) in any
   year in which the depreciation-related ADFIT balance used to compute Taxpayer’s
   WACC is equal to or less than the maximum depreciation-related ADFIT balance
   Taxpayer could have used under the Limitation of Treas. Reg. § 1.167(l)-1(h)(6)(i);
PLR-104580-17                                 4



3. In computing the true-up components of its Riders, Taxpayer’s use of a simple
   monthly average applied to all elements of rate base in conjunction with the use of
   the depreciation-related ADFIT balance that is a component of the WACC reflected
   in the Report from Month of the year to which that historical data relates or from a
   combination of that Report and the Report from Month of the prior year does not
   conflict with the Consistency Rule of § 168(i)(9)(B); and

4. In the event that Requested Ruling 2 and/or Requested Ruling 3 is negative,
   Taxpayer’s use of regulatory conventions for determining all elements of rate base
   which differed from the convention it used to derive the depreciation-related ADFIT
   balance which is a component of the WACC it applied to that rate base in any year
   prior to taking the necessary corrective action as described above was not a
   violation of the Normalization Rules.

Law and Analysis

In General

Former § 167(l) 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), which provides that if a utility uses anything but regulatory
depreciation for tax purposes, it must make an adjustment to a reserve to reflect the
deferral of taxes resulting from the difference. Similarly, § 1.167(l)-1(h)(1)(b) provides
that any tax deferral attributable to accelerated depreciation must be reflected in a
reserve account.

Section 168(i)(9)(B) provides that one way the Normalization Rules are not satisfied is if
the taxpayer, for ratemaking purposes, uses a procedure or adjustment which uses an
estimate or projection of tax expense, depreciation expense, or a reserve for deferred
taxes unless such estimate or projection is also used with respect to the other two items
and with respect to rate base. This prohibition is generally referred to as “the
Consistency Rule”.

Section § 1.167(l)-1(h)(6)(i) provides that 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 (ADFIT), or treated as cost-free capital,
exceeds the amount of the ADFIT reserve for the period used in determining the
taxpayer’s ratemaking tax expense. This is generally referred to as “the Limitation”.

Requested Ruling 1

Section 1.167(l)-1(h)(6)(ii) provides that for the purpose of determining the maximum
PLR-104580-17                                 5

amount of the reserve to be excluded from the rate base (or to be included as no-cost
capital) under § 1.167(l)-1(h)(6)(i), 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 the period is the amount of the reserve (determined under
§ 1.167(l)-1(h)(2)) at the end of the historical period. Section 1.167(l)-1(h)(6)(ii)
provides that if solely a future period is used for such determination, the amount of the
reserve account for the period is the amount of the reserve at the beginning 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 such period. This calculation of the
portion of the amount of any projected increase or decrease to be charged in the future
period (or the future portion of a part historical and part future period) is done by
application of the “Proration Formula”, described below.

Section 1.167(l)-1(h)(6)(ii) provides if, in determining depreciation for ratemaking tax
expense, a 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. Therefore, a taxpayer may use either historical data or projected data in
calculating these two amounts, but they 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 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. The Proration 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 Proration 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.
PLR-104580-17                                 6



The purpose of the Proration Formula is the same as that of the Consistency Rule
discussed above: 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 limited
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 test period for determining
depreciation for ratemaking tax expense. How are these time periods to be measured?
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) 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,
PLR-104580-17                                  7

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 truly projected (future estimated) data
is computed according to the Proration Formula, 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.

But 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).

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 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.

Both Commission A and Commission B have, at all times, required that utilities under
their respective jurisdictions use normalization methods of accounting. Taxpayer also
intended at all times to comply with the Normalization Rules.

Taxpayer is required to follow the Proration Requirement applicable to future test
periods for the projected revenue requirement for Taxpayer’s base rate and Rider
cases. Prospectively adhering to the Service’s interpretation of § 1.167(l)-1(h)(6)(ii) by
using the Proration Formula requires adjustments to conform to this ruling.

Any rates that have been calculated using procedures inconsistent with this ruling
(“nonconforming rates”) which are or 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
PLR-104580-17                                8

the next regulatory filing or proceeding in which Taxpayer’s rates are considered.

Taxpayer requests that any such failure to use the Proration Formula in any year prior
to taking the necessary corrective action not be considered to be a violation of the
Normalization Rules. Taxpayer has represented that it will initiate the measures
necessary to conform to the Normalization Rules for its base rate and Rider cases.
Taxpayer also stated that it will initiate those measures at the earliest available
opportunity.

Taxpayer’s failure to comply with the Normalization Rules in its prior base rate and
Rider cases was inadvertent. It was not an inconsistency with the Normalization Rules
that Taxpayer, any participant in any of the proceedings, or the regulator in any of the
proceedings recognized. No potential proration-related normalization issue was ever
identified. Thus, there was clearly no required treatment that was inconsistent with the
Normalization Rules. Therefore, there was no determination made with respect to
Taxpayer’s calculation of its ADFIT balance by either Commission. Because the
Commissions, as well as Taxpayer, at all times sought to comply, and because
Taxpayer will take corrective actions at the earliest available opportunity, it is not
appropriate to conclude that the failure to use the Proration Formula constituted a
normalization violation and apply the sanction of denial of accelerated depreciation to
Taxpayer.

Requested Rulings 2, 3, and 4

As explained in § 1.167(l)-1(h)(6)(i), the Limitation applies to ensure that the amount of
the ADFIT reserve that can be excluded from rate base (or, as here, treated as zero-
cost capital) does not exceed “the amount of such reserve for deferred taxes for the
period used in determining the taxpayer’s tax expense in computing cost of service in
such ratemaking.” Thus, the Normalization Rules do not permit rate base to be reduced
by an ADFIT balance in excess of the amount reflected in cost of service.

If the Consistency Rule is, in whole or in part, integrated with the Limitation then the
outcome of any technical violation of the Consistency Rule may be mitigated by a
mathematical analysis showing that, despite the lack of consistency, the Limitation has
not been exceeded and, therefore, the Normalization Rules have not been violated.

In this case, Taxpayer relies on projected costs for its determination of rate base to
compute the projected component of its Riders. However, its ADFIT is not similarly
projected. With regard to Taxpayer’s two true-up Rider calculations, while Taxpayer
applies a simple monthly average to historical test period data, for its ADFIT, Taxpayer
does not rely on data from the same period. Accordingly, in Taxpayer’s computation of
both the basic amount and the true-up components of its Rider cases, a facial
inconsistency exists between the convention applied to ADFIT and to depreciation
PLR-104580-17                                 9

expense, tax expense, and rate base that does not satisfy the mechanical application of
the Consistency Rule.

Importantly, the ADFIT balance Taxpayer actually incorporates into its WACC for any
given Rider case is likely to be significantly less than what the ADFIT balance would be
if Taxpayer projected the ADFIT balance changes for the test period. If a failure to
comply with the Consistency Rule is a per se violation of the Normalization Rules, then
Taxpayer’s procedure constitutes a violation of these rules without regard to compliance
with the Limitation. However, proper consideration of this issue arguably involves the
interaction between the Consistency Rule and the Limitation found in § 1.167(l)-
1(h)(6)(i).

We believe that the Limitation and Consistency Rule should be read together where the
purposes of the Normalization Rules are achieved thereby. Under this approach,
compliance with the Consistency Rule can be achieved by calculating the ADFIT
balance by which rate base would be reduced using the same conventions used for the
other aspects of rate base (i.e., by adhering to the Consistency Rule). Provided that the
amount of ADFIT actually used in Taxpayer’s present method does not exceed the
Limitation, the purpose of the Normalization Rules has been vindicated because no
benefits that belong to the utility are being “flowed through” to ratepayers.

Accordingly, we conclude that, under the facts presented here, with regard to
Requested Rulings 2 and 3, Taxpayer has not violated the Normalization Rules by
virtue of using a computational methodology that is inconsistent with the Consistency
Rule of § 168(i)(9)(B) because the ADFIT used in such methodology does not exceed
that allowed by the Limitation in § 1.167(l)-1(h)(6)(i). Because of these conclusions,
Request Ruling 4 is moot and will not be considered further.

Conclusions

1. To the extent that, in computing Taxpayer’s base rates and its Rider cases,
Taxpayer’s inclusion in its capital structure of an amount of depreciation-related ADFIT
computed without applying the Proration Methodology was inconsistent with the
Normalization Rules, any actions taken by Taxpayer in any year prior to taking the
necessary corrective action as described above was not a violation of the Normalization
Rules.

2. In computing the projected component of its Riders, Taxpayer’s use of projected
costs, including the projection of all elements of rate base, in conjunction with the use of
historical deprecation-related ADFIT balance which is a component of the historical
WACC does not conflict with the Consistency Rule of § 168(i)(9)(B) in any year in which
the depreciation-related ADFIT balance used to compute Taxpayer’s WACC is equal to
or less than the maximum depreciation-related ADFIT balance Taxpayer could have
used under the Limitation of Treas. Reg. § 1.167(l)-1(h)(6)(i).
PLR-104580-17                                 10



3. Similarly, in computing the true-up components of its Riders, Taxpayer’s use of
monthly averages for the historical test period for all elements of rate base in
conjunction with the use of an historical depreciation-related ADFIT balance which is a
component of the WACC from a different period does not conflict with the Consistency
Rule of § 168(i)(9)(B) in any year in which the depreciation-related ADFIT balance used
to compute Taxpayer’s WACC is equal to or less than the maximum depreciation-
related ADFIT balance Taxpayer could have used under the Limitation of Treas. Reg. §
1.167(l)-1(h)(6)(i).

4. Because we have found no violation of the Consistency Rule of § 168(i)(9)(B) in
either Requested Rulings 2 or 3, this issue is moot.

Except as specifically determined above, no opinion is expressed or implied concerning
the Federal income tax consequences of the matters described above. We note that
the calculations described above to determine the Limitation in the ratemaking
processes related to its Riders, and thus whether Taxpayer’s ADFIT exceeds that
amount, should be retained by Taxpayer as part of their normal retention of records
under § 6001.

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)