Utility had to prorate deferred taxes for interim rates

Plain-English summary

A regulated natural-gas utility used forecasted test periods to set interim and final rates, reducing rate base by accumulated deferred federal income taxes from accelerated depreciation. It had not used the normalization rules' proration formula when projecting those deferred-tax balances and asked the IRS eleven questions about interim rates, refunds, final rates, and averaging conventions. The IRS ruled that interim rates taking effect before the test period ended used a future or partly future period and therefore had to apply proration. By contrast, the later interim-rate refund and final-rate calculations used historical periods and did not require proration, although the proration already reflected in interim rates could not be undone. Using a simple average for some rate-base components and a 13-month average for deferred taxes did not violate the consistency rule because both covered the same period. The utility's earlier inadvertent nonuse of proration was not treated as a normalization violation, but nonconforming rates had to be corrected when legally possible or in the next rate proceeding.

Ruling snapshot

• Question: How did the depreciation normalization proration and consistency rules apply to the utility's interim rates, refunds, final rates, and averaging methods?
• Outcome: Approved, with eleven rulings defining required treatment and corrective action.
• Key authorities: IRC §§ 167 and 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: 201817006 Third Party Communication: None
Release Date: 4/27/2018 Date of Communication: Not Applicable
Index Number: 167.22-01
Person To Contact:
------------------------- --------------------------, ID No. ----------------
------------------------------------------------------------ -----------------
---------- Telephone Number:
---------------------------------- ----------------------
------------------------------ Refer Reply To:
------------------------------- CC:PSI:B06
PLR-123443-17
Date:
January 25, 2018

LEGEND:
Parent = -----------------------------------------------------------
Holdco = ---------------------------
Taxpayer = ----------------------------------------------------------------------------
State A = --------------
State B = ---------
State C = -------------
State D = --------------
State E = ---------------
State F = ----------------
State G = ---------------
Commission = ---------------------------------------------------------------
Date 1 = ----------
Date 2 = --------------
Date 3 = --------------------
Date 4 = ----------------------
Date 5 = -----------------------
Date 6 = -----------------------
Date 7 = ----------------------------
Director = ------------------------------------------------------------------------------------------

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

This letter responds to Parent’s request dated July 28, 2017, filed 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, as described below.

The representations set out in your letter follow.

Taxpayer is wholly owned by Holdco, a State A limited liability company that is
disregarded for federal income tax purposes. Holdco, is wholly owned by Parent, a
PLR-123443-17 2

corporation organized under the laws of State B. Parent is the common parent of an
affiliated group of corporations that includes Holdco and Taxpayer. Parent files a
consolidated federal income tax return on a calendar year basis employing the accrual
method of accounting. Parent is currently under the audit jurisdiction of the Large
Business and International Division of the Internal Revenue Service.

Taxpayer is a regulated public utility engaged in the provision of natural gas distribution
services in State B, State C, State D, State E, State F, and State G. The businesses in
these states are conducted through unincorporated divisions (local distribution
companies). Taxpayer’s State E local distribution company (LDC) is subject to
regulation as to rates and conditions of service by the Commission.

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 accumulated deferred federal income tax (ADFIT) that is
attributable to accelerated depreciation reflected on its regulated books of account.

While State E law allows utilities to use either historical or forecasted test periods, the
LDC has chosen to file its past several general rate cases using a fully forecasted test
period. Generally, the LDC has filed in Date 1, with a test period running from Date 2 of
that year through Date 3 of the following year. State E law provides that the
Commission must issue its final determination within ten months of the initial filing date
unless it has extended that time by up to ninety days due to its need to act on other
pending rate cases. After the issuance of a final order, additional procedures ensue.
These procedures may include a request for reconsideration and will always include the
submission by the subject utility of a compliance filing which is typically made within
thirty days of the date of an order. Parties to the proceeding then have thirty days to
submit comments on that filing. The rates established in that final order are typically not
put into effect prior to the end of the projected test period. In LDC’s most recent general
rate case final rates were not implemented until after the forecasted test period had
ended.

As part of the general rate case process and consistent with State E law, the LDC has
also been allowed recovery of “interim rates.” Interim rate recovery begins no later than
sixty days from the initial filing, meaning it generally coincides with the start of the
forecasted test period (Date 2). The Commission sets interim rates through an interim
rate order. Consequently, interim rates are established before a full review of the
utility’s proposed costs is completed and are based primarily on the data used to
support the utility’s proposed final rate request with the following differences: (1) the rate
of return on common equity used is equal to that authorized by the Commission in the
utility’s most recent general rate case, (2) the utility may include in interim rates only
rate base or expense items that are the same in nature and kind as those allowed in
PLR-123443-17 3

that most recent general rate case, and (3) interim rates may not reflect any change in
existing rate design. Each of these factors may differ from the ones incorporated into
the rates established in the final order that results from the conduct of the current
proceeding.

Interim rates are subject to refund (plus interest) if, at the end of the contested case,
amounts collected under the interim rate schedule exceed the Commission-approved
final rates (Interim Rate Refund). Any Interim Rate Refund occurs only with the
effective date of the final rates, which, as indicated above, typically occurs after the end
of the projected test period, even when there are no time extensions in a general rate
proceeding.

When an Interim Rate Refund is required, the percentage difference between the final
and the interim rates is calculated after the end of the test year. A bill credit is then
computed for each customer by applying that percentage to the amounts paid by that
customer while interim rates were in effect. The credit is posted in full to each
customer’s next bill. As a result, customers who receive gas service during the
projected test period collectively pay the allowed revenue level established in the final
order for that service regardless of when the final order is issued or when the rates
established by that order go into effect.

In determining its revenue requirement for the projected test period (including in
determining the appropriate level of interim rate recovery), the LDC calculates the net
plant component of rate base using a simple average of the beginning of test period and
end of the test period balances. All other elements of rate base, including ADFIT
balances, are calculated using a 13-month average. Rate base is reduced by the
ADFIT balance so computed.

There is no conventional true-up procedure applicable to rates established in the LDC’s
general rate cases. Hence there is no procedure by which rates established in its
general rate case (whether interim or final) and based on a projected test period are
trued-up to a revenue requirement for that period which is calculated by reference to the
actual results of LDC’s activities during the test period. Rather, the final order
establishes final rates based on representative levels of costs and revenues for the test
year. The interim rate refund reconciles the differential between the interim rates and
the final rates and is implemented only after the rate case is completed. Final rates
remain in effect until the utility chooses to file its next general rate case proceeding and
any interim rates that may be put into effect pursuant to that proceeding. As a result,
the general rate case may be seen as comprised of three elements: (1) setting interim
rates established by the interim rate order, (2) setting final rates established by the final
order subsequent to the rate case proceeding, and (3) calculating an Interim Rate
Refund subsequent to the rate case proceeding based on the difference between the
interim rates paid and the amount that would have been paid had final rates been in
effect for the same period.
PLR-123443-17 4

Previously, when the LDC has projected the changes in its ADFIT balances for
purposes of estimating its revenue requirement for the projected test period (whether for
the establishment of interim or final rates), it has not used the proration formula
provided in Treas. Reg. § 1.167(l)-1(h)(6) (Proration Methodology). Prior to and
including its most recent general rate case, this lack of the use of the Proration
Methodology has not been challenged or even commented upon by the Commission or
any party in any of the LDC’s proceedings.

The LDC filed its most recent general rate case with the Commission on Date 4. The
test period in the case ran from Date 5 through Date 7 with interim rates going into
effect on Date 6. In its general rate case filing, the LDC did not utilize the Proration
Methodology in its ADFIT calculation. After filing, Taxpayer considered whether it would
be possible to revise its pending rate request to incorporate the impact of the Proration
Methodology and determined that State E law provides that “in no event shall the rates
[approved by the Commission] exceed the level of rates requested by the public utility.”
Since a revision to reflect the Proration Methodology after the LDC had filed its request
would have increased the requested revenue requirement, the LDC could not take
corrective action at that time.

Additionally, Taxpayer considered whether a normalization issue may arise in the LDC’s
general rate case filing because ADFIT was averaged using a 13-month average while
other components of rate base were averaged using a simple beginning and ending
balance average. Both averages were over the same period of time.

Both Taxpayer and the Commission have at all times endeavored to use a proper
normalization method of accounting for the LDC’s public utility property.
Notwithstanding this intent, Taxpayer is now concerned that its prior LDC general rate
case filings may have been inconsistent with the Normalization Rules insofar as they did
not employ the Proration Methodology. Further, Taxpayer believes that there may be
an issue regarding the LDC’s practice of applying two different averaging conventions to
different components of its rate base calculation. Taxpayer represents that if required,
the LDC will take all necessary corrective actions in its next general rate case.

Taxpayer requests that we rule as follows:

1) In order to comply with the Normalization Rules, whether, in determining the
maximum amount of ADFIT by which the LDC can reduce rate base in establishing
the interim rates, it must employ the Proration Methodology described in Treas. Reg.
§ 1.167(l)-1(h)(6)(i);

2) Whether, for purposes of the Normalization Rules, the effective date of the
differential between the interim rates and the final rates established for the Interim
Rate Refund process calculated at the end of the rate proceeding is the effective
PLR-123443-17 5

date for the interim rates established in the interim rate order or the effective date for
final rates established by the final order;

3) If, with respect to Requested Ruling 2, the Service rules that the effective date of the
differential between the interim rates and the final rates established by the Interim
Rate Refund process calculated at the end of the rate proceeding is the effective
date for final rates established by the final order, whether the Interim Rate Refund
process uses an historical test period and therefore, is not required to employ the
Proration Methodology described in Treas. Reg. § 1.167(l)-1(h)(6)(i);

4) If, with respect to Requested Ruling 2, the Service rules that the effective date of the
differential between the interim rates and the final rates established by the Interim
Rate Refund process is the effective date for the interim rates that were established
in the interim rate order, whether the Interim Rate Refund process uses a future test
period and must, therefore, employ the Proration Methodology described in Treas.
Reg. § 1.167(l)-1(h)(6)(i);

5) Whether, for purposes of the Normalization Rules, the effective date of the final rates
established by the final order and implemented subsequent to the rate case
proceeding is the effective date for the interim rates that were established by an
interim rate order or the effective date for the final rates established by the final
order;

6) If, with respect to Requested Ruling 5, the Service rules that the effective date of the
final rates established by the final order and implemented subsequent to the rate
case proceeding is the effective date of the final rates established by the final order,
whether the computation of these rates uses an historical test period and, therefore,
is not required to employ the Proration Methodology described in Treas. Reg.
§ 1.167(l)-1(h)(6)(i);

7) If, with respect to Requested Ruling 5, the Service rules that the effective date of the
final rates established by the final order is the effective date for the interim rates
established by the interim rate order, whether the computation of the final rates
implemented subsequent to the rate case proceeding uses a future test period and
must, therefore, employ the Proration Methodology described in Treas. Reg.
§ 1.167(l)-1(h)(6)(i);

8) If the Service rules in the affirmative with respect to Requested Ruling 3, in
computing the Interim Rate Refund, whether the Proration Requirement does not
apply only to the difference between (1) the ADFIT balance used to set interim rates,
and (2) the ADFIT balance used in the final rates to establish the Interim Rate
Refund (that is, the Proration Requirement would continue to apply to the changes in
ADFIT balances reflected in setting the interim rates);
PLR-123443-17 6

9) If the Service rules that the Proration Methodology applies to any of the three
elements of Taxpayer’s base rate process (interim rates, Interim Rate Refund, and
final rates) the Consistency Rule does not require that the LDC apply to its prorated
ADFIT balance the regulatory averaging procedure it applies to its other components
of rate base in the relevant computation;

10) The Taxpayer’s use of a simple average for certain components of rate base in
conjunction with its use of a 13-month average for ADFIT is not violative of the
Consistency Rule of § 168(i)(9)(B); and

11) In the event that the Service concludes with respect to Requested Rulings 1, 4, or 7
that the LDC must use the Proration Methodology to comply with the Normalization
Rules and/or concludes with respect to Requested Ruling 10 that the LDC’s use of
differing averaging conventions is violative of the Consistency Rule, Taxpayer
requests a ruling that, in any year prior to its taking the necessary corrective action,
Taxpayer’s relevant regulatory practice were not a violation of the Normalization
Rules.

Law and Analysis

Requested Rulings 1 - 7

Section 1.167(l)-1(h)(6) of the Regulations sets forth normalization requirements with
respect to 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.

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 § 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.

Section 1.167(l)-1(h)(6)(ii) provides if, in determining depreciation for ratemaking tax
expense, a period (the “test period”) is used which is part historical and part future, then
PLR-123443-17 7

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. This is generally referred to as “the
proration formula” or the “proration methodology.”

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 the same as that of the requirement for
consistent periods 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
PLR-123443-17 8

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 may be 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 truly 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.

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
PLR-123443-17 9

reserve, whether actual or estimated. Once the period over which accruals to the
reserve were projected is completed and the final rates are in effect, the question of
when the amounts in the reserve accrued is no longer being estimated or projected (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 initially on estimates).

In the LDC’s general rate case, the interim rates, subject to refund, became effective
Date 6. The interim rates were based on test year from Date 5 through Date 7. The net
plant component of rate base is calculated by using a simple average of the beginning
of test period and end of the test period balances. All other elements of rate base,
including ADFIT balances, are calculated using a 13-month average. Rate base is
reduced by the ADFIT balance so computed. The averages were each over the same
period of time. The future portion of a part-historical and part-future period for purposes
of interim rates charged began on Date 6, for purposes of determining the total number
of days in the future portion of the period under § 1.167(l)-1(h)(6).

In response to Requested Ruling 1, we conclude that the test period for LDC’s interim
rates is a future test period, subject to the proration formula rules under § 1.167-1(h)(6).
Therefore, Taxpayer is required to apply the proration formula rules as they apply to
part-historical and part-future periods to calculate the amount of ADFIT by which LDC
may reduce rate base in establishing interim rates.

In response to Requested Ruling 2, we conclude that the effective date of the
differential between the interim rates and the final rates established for the Interim Rate
Refund process calculated at the end of the rate proceeding is the effective date for the
final rates established by the final order. Accordingly, Requested Ruling 4, above, is
moot.

In response to Requested Ruling 3, we also conclude that because the Interim Rate
Refund process uses an historical test period it is not required to employ the Proration
Methodology described in Treas. Reg. § 1.167(l)-1(h)(6)(i).

In response to Requested Ruling 5, we conclude that the effective date of the final rates
established by the final order and implemented subsequent to the rate case proceeding
is the effective date for the final rates established by the final order. Accordingly,
Requested Ruling 7, above, is moot.

The LDC’s computation of ADFIT for purposes of the final rates occurs after the end of
the test period on which those amounts are based. Thus, the calculation is determined
by reference to a purely historical period. Accordingly, in response to Requested Ruling
6, we conclude that the computation of ADFIT for purposes of final rates is not subject
to the proration formula rules under § 1.167-1(h)(6); there is no need to follow the
proration formula rules designed for future test periods or part-historical and part-future
PLR-123443-17 10

periods to calculate the differences between Taxpayer’s projected ADFIT balance and
the actual ADFIT balance during the period.

Requested Ruling 8

We have concluded above that the interim rates charged during the pendency of the
rate case until final rates are implemented, because they are in effect before the end of
the test period, are considered calculated using a future test period. Once final rates
are determined, the Interim Rate Refund is calculated, based on the difference between
the interim rates and the final rates. As discussed above, the Interim Rate Refund is in
effect after the conclusion of the test year and thus, the Interim Rate Refund is not
considered calculated using a future test period. Requested Ruling 8 requires that we
apply the proration formula rules of § 1.167(l)-1(h)(6) to these situations.

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. Specifically, while interim rates are charged during the test year, the projected
test year ADFIT increases have accrued only as allowed using the proration formula.
Once the test year has ended and the Interim Rate Refund is calculated and is in effect,
the amounts to be excluded from rate base are no longer projected but historical, even
though based on estimates. At this point, the purpose of the proration formula has been
accomplished and associated prevention of flow-through accounting has been avoided
by its application during the future test period. To permit the effects of the proration
formula on interim rates charged during the test year to be reversed in a subsequent
phase of the ratemaking would be economically equivalent to not applying the proration
formula in the first place.

In response to Requested Ruling 8, we conclude that the Proration Requirement does
not apply only to the difference between (1) the ADFIT balance used to set the interim
rates, and (2) the ADFIT balance used in the final rates to establish the Interim Rate
Refund. The Proration Requirement continues to apply to the changes in ADFIT
balances reflected in setting the interim rates.

Requested Rulings 9 & 10

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 § 167(l)(3)(G)
in a manner consistent with that found in § 168(i)(9)(A). Section 1.167(1)-1(a)(1)
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
PLR-123443-17 11

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.

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 of 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 § 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, ADFIT was averaged using a 13-month
average while other components of rate base were averaged using a simple beginning
and ending balance average. But are all calculated in consistent fashion - all are
averaged over the same period. While there are minor differences in the convention
used to average all elements of rate base including depreciation expense on the one
hand, and ADFIT on the other, for purposes of § 168(i)(9)(B), it is sufficient that both are
determined by averaging and both are determined over the same period of time. Thus,
the calculation of average rate base and ADFIT as described above complies with the
consistency requirement of § 168(i)(9)(B).

Accordingly, in response to Requested Ruling 9, we conclude that the Consistency Rule
does not require that the LDC apply to its prorated ADFIT balance the precise
PLR-123443-17 12

regulatory averaging procedure it applies to its other components of rate base in the
relevant computation.

Similarly, in response to Requested Ruling 10, we conclude that the Taxpayer’s use of a
simple average for certain components of rate base in conjunction with its use of a 13-
month average for ADFIT is not violative of the Consistency Rule of § 168(i)(9)(B).

Requested Ruling 11

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 1,
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.

Taxpayer’s failure to comply with the Normalization Rules in its general rate case 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 the Commission. Because the
Commission, as well as Taxpayer, at all times sought to comply, and because the LDC
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.

Accordingly, in response to Requested Ruling 11, we conclude that in any year prior to
the LDC taking the necessary corrective action Taxpayer’s relevant regulatory practices
were not a violation of the Normalization Rules.
PLR-123443-17 13

Conclusions

1) In order to comply with the Normalization Rules, the LDC must employ the Proration
Methodology described in Treas. Reg. § 1.167(l)-1(h)(6)(i) to determine the
maximum amount of ADFIT by which the LDC can reduce rate base in establishing
the interim rates.

2) For purposes of the Normalization Rules, the effective date of the differential
between the interim rates and the final rates established for the Interim Rate Refund
process calculated at the end of the rate proceeding is the effective date for the final
rates established by the final order.

3) The Interim Rate Refund process uses an historical test period and therefore, is not
required to employ the Proration Methodology described in Treas. Reg. § 1.167(l)-
1(h)(6)(i).

4) As a result of our conclusion for Requested Ruling 2 the issue is moot.

5) For purposes of the Normalization Rules, the effective date of the final rates
established by the final order and implemented subsequent to the rate case
proceeding is the effective date for the final rates established by the final order.

6) The computation of the final rates uses an historical test period and, therefore, is
not required to employ the Proration Methodology described in Treas. Reg.
§ 1.167(l)-1(h)(6)(i).

7) As a result of our conclusion for Requested Ruling 5 the issue is moot.

8) The Proration Requirement does not apply only to the difference between (1) the
ADFIT balance used to set the interim rates, and (2) the ADFIT balance used in the
final rates to establish the Interim Rate Refund. The Proration Requirement
continues to be reflected in the changes in ADFIT balances reflected in setting the
interim rates.

9) The Consistency Rule does not require that the LDC apply to its prorated ADFIT
balance the regulatory averaging procedure it applies to its other components of
rate base in the relevant computation.

10) The Taxpayer’s use of a simple average for certain components of rate base in
conjunction with its use of a 13-month average for ADFIT is not violative of the
Consistency Rule of § 168(i)(9)(B).

11) In any year prior to Taxpayer taking the necessary corrective action Taxpayer’s
PLR-123443-17 14

  relevant regulatory practices were not a violation of the Normalization Rules.

These rulings are based on the representations submitted by Taxpayer and are 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,


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

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