Utility's cost-of-removal deferred taxes are not protected by the depreciation normalization rules

Plain-English summary

A regulated electric and gas utility asked the IRS how the depreciation "normalization rules" of Section 168(i)(9) apply to two things: its deferred taxes tied to the cost of removing retired assets (COR), and its old depreciation-related deferred taxes after it changed its accounting methods for repairs and mixed service costs. The normalization rules limit how fast a utility can pass certain tax benefits from accelerated depreciation back to its customers. The utility wanted those deferred-tax balances treated as "protected" by the rules. The IRS said no across the board. It ruled that cost-of-removal deferred taxes (electric and gas, before and after a mid-period accounting change) are not protected, because normalization is about accelerated depreciation, not the separate cost-of-removal deduction under Section 162. It also ruled that depreciation deferred taxes on costs later reclassified as current deductions through accounting-method changes stop being subject to normalization once the new method takes effect. Because the protected-status questions were answered no, the follow-up questions about how to amortize those amounts were moot. The ruling matters to utilities and their ratepayers because it decides whether these tax balances must be given back to customers slowly under normalization or can be handled outside those constraints.

Ruling snapshot

• Question: Are the utility's cost-of-removal and post-method-change depreciation deferred taxes "protected" by the Section 168(i)(9) normalization rules?
• Outcome: denied (all items ruled not protected)
• Key authorities: IRC § 168(i)(9), (f)(2); former § 167(l); IRC § 481; Treas. Reg. § 1.167(l)-1; Rev. Proc. 97-27

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202033002 Third Party Communication: None
Release Date: 8/14/2020 Date of Communication: Not Applicable
Index Number: 168.24-01
Person To Contact:
------------------------------------------------------ -----------------------, ID No. ------------
------------------------------------------------ Telephone Number:
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----------------------------- Refer Reply To:
In Re: ---------------------------------------------------- CC:PSI:B06
------------- PLR-122510-19
Date:
March 26, 2020

LEGEND:
Taxpayer = --------------------------------------------------------
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Parent = ------------------------------------------------------------------------

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State A = ----------------

Commission A = -----------------------------------------------

Commission B = -----------------------------------------------------

Date 1 = --------------------------

Date 2 = -------------------------

Date 3 = -----------------------

Date 4 = ----------------------

Date 5 = -----------------------

Month 1 = --------------

Month 2 = -----------

Year 1 = -------
PLR-122510-19 2

Year 2 = -------

Year 3 = -------

Year 4 = -------

Year 5 = -------

Year 6 = -------

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

   This letter responds to a request for a private letter ruling dated September 26,

2019, and submitted on behalf of Taxpayer regarding the application of the depreciation
normalization rules under § 168(i)(9) of the Internal Revenue Code and § 1.167(l)-1 of
the Income Tax Regulations (together, the “Normalization Rules”) to certain State A
state regulatory procedures which are described in this letter. The relevant facts as
represented in your submission are set forth below.

                                         FACTS

   Taxpayer is an investor-owned regulated utility incorporated under the laws of

State A. Taxpayer is an accrual basis taxpayer and reports on a calendar year basis.

    Taxpayer is wholly owned by Parent. Parent is a State A corporation. Taxpayer

is included in a consolidated federal income tax return of which Parent is the common
parent.

    Taxpayer is a regulated utility engaged principally in the purchase, transmission,

distribution, and sale of electric energy and the purchase, distribution, and sale of
natural gas in State A. Taxpayer is subject to regulation as to rates and conditions of
service by Commission A as well as Commission B. Both these regulators establish
Taxpayer’s rates based on its costs, including a provision for a return on the capital
employed by Taxpayer in its regulated businesses.

   Taxpayer has claimed accelerated depreciation on all of its public utility property

(both electric and gas) to the full extent those deductions have been available.
Taxpayer has normalized 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 taxes
(ADFIT) that is attributable to accelerated depreciation reflected on its regulated books
of account for each of its divisions. In accordance with State A ratemaking practice,
Taxpayer has reduced its rate base by its ADFIT balance.
PLR-122510-19 3

    Commission B has established a system to track accounts for both jurisdictional

electric and gas companies. These accounts prescribe the accounting rules which are
used by most large investor-owned electric and gas companies and are employed by
Taxpayer’s electric and gas divisions. The applicable regulations contain several
definitions relevant to Taxpayer’s inquiry including definitions for cost of removal (COR),
salvage value, net salvage value, service value, and depreciation.

   In general, based on these definitions, for purposes of regulatory reporting, the

net positive value or net cost of disposing of an asset at the end of its life is incorporated
into the annual depreciation charge. COR is, therefore, most often (but not always) a
component of establishing the applicable depreciation rate. In Taxpayer’s case, due to
the amount of COR it anticipates, in almost all instances its assets have negative net
salvage values so that its book depreciation rate is higher than it would be were salvage
value not considered. In effect, the annual depreciation charge creates a reserve for
COR over the operating life of the asset. Since book depreciation expense is included
in Taxpayer’s cost of service used for establishing its rates, customers pay for the COR
as book depreciation is factored into their rates. This COR reserve is reflected as an
addition to Taxpayer’s accumulated depreciation account. When the COR is actually
incurred, the amount expended is debited to that same account, thereby reducing the
balance.

    For tax purposes, COR is deductible only when actually incurred. Taxpayer,

therefore, reports its customer collections that fund the COR reserve as taxable income
over the operating life of an asset, claiming an offsetting tax deduction only at the end of
the life of that asset. Taxpayer has normalized COR since the Year 1 tax year. All
references below to COR-related deferred tax accounting relate only to COR associated
with assets placed in service after Year 2. Since COR is normalized in setting rates,
customers are provided a tax benefit commensurate with their funding of COR. In other
words, they are provided the COR tax benefit as they fund the COR reserve – prior to
the time Taxpayer actually claims that benefit on its tax return.

  The tax effect of the COR funding as described creates a deferred tax asset

(“DTA”). This represents the future benefit to be derived from the eventual COR tax
deduction. The COR-related DTA is included in Taxpayer’s overall plant-related ADFIT
account that reduces Taxpayer’s ADFIT balance.

   COR can (and does) impact ADFIT balances in an additional way. The COR

included in depreciation expense (that is, the accrual) is an estimate prepared for an
entire class of assets contained in a Commission B account. It is likely that any COR
estimate will be too high or too low with respect to any individual asset with the ultimate
answer remaining unknown until all vintages of each asset class are retired and
removed. Any running variance from the estimate is recorded on Taxpayer’s balance
sheet. Where the accrual exceeds the actual COR, it creates a net credit to the
accumulated depreciation account. Where the actual COR exceeds the accrual, it
creates a net debit to that account. This treatment means that Taxpayer will recover
PLR-122510-19 4

under-accruals from customers and refund over-accruals to customers through future
rate adjustments. These future rate adjustments will give rise to future increases or
decreases in taxable income. Under applicable accounting principles, Taxpayer must
record the deferred tax consequences of these future events. An over-accrual produces
a DTA (the tax benefit of a future deduction due to the refund of the excess collection)
while an under-accrual produces a deferred tax liability “DTL” (the tax cost of future
taxable income due to the collection of the shortfall).

   For the electric distribution division, the COR book/regulatory accrual has always

been included in the development of the book depreciation rate. Thus, instead of
waiting for the Taxpayer to incur the tax benefit of COR, its’ Customers are provided the
COR tax benefit as they fund the COR reserve – prior to the time Taxpayer actually
claims that benefit on its tax return. This produces a DTA as described. In addition, as
of Date 1, Taxpayer has, in total, incurred more COR than it has recovered from
customers and, thus, is under-accrued for COR. This has produced a DTL, also as
described. Both the DTA and DTL are included within Taxpayer’s overall plant-related
ADFIT Account.

   Prior to Month 1 Year 3, the gas distribution division accrued and collected COR

as a component of the book depreciation rate. However, pursuant to order of
Commission A, that collection practice was modified in Year 3. Beginning in Month 1
Year 3, the gas-only COR regulatory accrual was removed from the book depreciation
rate. Rather, Taxpayer was allowed to record and recover annually (through a fixed
dollar depreciation charge incremental to the normal depreciation computed via
application of the depreciation rate) an amount representing an estimate of the annual
COR that would be incurred in that year. At the time of this modification, the cumulative
COR accrued exceeded COR actually incurred (that is, Taxpayer was over-accrued).
At that time, Taxpayer had recorded a net DTA (to reflect the tax benefit of the future
reduction in rates associated with refunding the excess to customers).

    Since converting to this methodology in Year 3, COR actually incurred has

significantly exceeded COR accrued and recovered, resulting in a DTL (the tax cost of
recovering the under-accrual in the future). As of Date 1, the two components (pre-
Month 1 Year 3 and post-Month 2 Year 3) combined represented a net DTL.

   Effective Date 2, pursuant to an Order issued by Commission A, gas COR

regulatory recovery has reverted back to a component of the book depreciation rate.
The fixed dollar accrual which began in Year 3 has been eliminated.

   Since Year 4, Taxpayer’s tax fixed asset system has separately identified the

portion of Taxpayer’s book depreciation expense that relates to COR since that date.
As a consequence, the system distinguishes between COR book/tax differences and
depreciation method/life differences even though they are both derived from Taxpayer’s
book depreciation. Though the system has the capability of tracking the reversals of
these differences separately, in order to set it up to do this, a significant amount of work
PLR-122510-19 5

and data manipulation would be required. It is not currently configured in a manner that
would allow this.

    In years prior to Year 5, Taxpayer paid income tax at a 35% rate on the recovery

of the COR portion of book depreciation (and provided its customers a tax benefit at that
tax rate). However, as a result of the tax rate reduction enacted as part of the Tax Cuts
and Jobs Act (“TCJA”), Taxpayer will only receive a 21% benefit when the COR
deduction is claimed or when any over-accrual is refunded and will pay only a 21% tax
on the recovery of any COR under-accrual. In other words, in the case of COR, the tax
rate reduction enacted as part of the TCJA has produced both a deferred tax shortfall as
well as an excess tax reserve. Because Taxpayer will not recover the 14% “excess” tax
it paid on its recovery of the COR component of book depreciation from the government
when it claims its COR deduction, it must recover it from its customers. Conversely,
because Taxpayer will not pay the 14% “excess” deferred tax it accrued on its obligation
to refund over-accrued COR, it must restore the amount to its customers (that is, it also
has COR-related excess deferred taxes).

Taxpayer’s Changes in Accounting Method for Mixed Service Costs and Repairs

    Prior to Taxpayer’s Year 6 tax year, in capitalizing its indirect overhead costs –

including its mixed service costs – Taxpayer followed the same methodology for both
book and tax purposes. Effective for its Year 6 tax year, Taxpayer filed with the Internal
Revenue Service an Application for Change in Accounting Method (Form 3115) in which
it requested permission to depart from its book method for tax purposes. The result of
the change was to recharacterize a substantial quantity of mixed service costs that
Taxpayer had previously capitalized into depreciable assets as deductible costs
(including additions to cost of goods sold). This resulted in Taxpayer claiming a
negative adjustment under § 481(a) (that is, a deduction) to remove from the tax basis
of its existing assets all such recharacterized costs to the extent Taxpayer had not
previously depreciated them (“Section 481 Adjustment”).

   Also, prior to Taxpayer’s Year 6 tax year, in identifying deductible repairs,

Taxpayer followed the same methodology for both book and tax purposes. Effective for
its Year 6 tax year, Taxpayer filed an Application for Change in Accounting Method
(Form 3115) in which it requested permission to depart from its book method for tax
purposes. In general, under its new tax method, Taxpayer elected to use larger units of
property than used for book purposes. The result of the change was to characterize
many projects that were capitalized for book purposes as deductible repairs for tax
purposes. This resulted in Taxpayer claiming a negative § 481 Adjustment to remove
from the tax basis of its existing assets all such recharacterized costs to the extent
Taxpayer had not previously depreciated them.

  Adjustments (additions) were made to Taxpayer’s ADFIT accounts, which

already reflected the deferred tax consequences of having claimed accelerated
PLR-122510-19 6

depreciation on both types of costs after they were capitalized for tax purposes for the
additional deferred taxes produced by the § 481 Adjustments.

Taxpayer’s Recent Commission A Proceedings

   On Date 3, Taxpayer filed with Commission A to adjust both its electric and its

gas rates. The parties to the proceeding reached an agreement and, on or about Date
4, Taxpayer submitted a stipulation to Commission A for its approval. Commission A
approved the stipulation on Date 5.

The stipulation provides that:

   1) Taxpayer will seek a private letter ruling to determine if excess deferred taxes
   associated with excess tax over book depreciation that is subsequently reversed
   by accounting method changes relating to repair deductions and the
   capitalization of mixed service costs are protected by the normalization rules and
   subject to reversal under the ARAM; and that

   2) Taxpayer will seek a private letter ruling from the IRS to determine whether
   post-Year 1 cost of removal is protected by the normalization rules and, if so,
   whether it is to be treated as a separate temporary difference or part of the
   overall depreciation temporary difference for purposes of ARAM amortization.

                             RULINGS REQUESTED

Taxpayer requests the following guidance:

1) Under the circumstances described above, is Taxpayer’s electric distribution COR-
related net DTL “protected” by the Normalization Rules?

2) If Taxpayer’s electric distribution COR-related deferred tax is “protected,” should that
shortfall be treated as a discrete “protected” item or as part of the “protected”
method/life difference?

3) Under the circumstances described above, is Taxpayer’s gas distribution COR-
related net DTA accumulated through the depreciation rate prior to Month 1 of Year 3
“protected” by the Normalization Rules?

4) If Taxpayer’s gas distribution COR-related deferred tax accumulated through the
depreciation rate prior to Month 1 of Year 3 is “protected,” should that shortfall be
treated as a discrete “protected” item or as part of the “protected” method/life
difference?
PLR-122510-19 7

5) Under the circumstances described above, is Taxpayer’s gas distribution COR-
related net DTL accumulated through the fixed estimated cash recovery after Month 1 of
Year 3 “protected” by the Normalization Rules?

6) If Taxpayer’s gas distribution COR-related net DTL accumulated through the fixed
estimated cash recovery after Month 1 of Year 3 is “protected,” should that shortfall be
treated as a discrete “protected” item or as part of the “protected” method/life
difference?

7) If Taxpayer’s COR-related deferred tax shortfall is “protected,” do the Normalization
Rules permit Taxpayer to collect a shortfall any more rapidly than using the ARAM?

8) Do Taxpayer’s depreciation-related ADFIT balances created pursuant to the
Normalization Rules that are attributable to costs that were capitalized into the basis of
depreciable assets prior to Taxpayer changing its method of accounting for those costs
remain subject to the Normalization Rules after the change in method of accounting
pursuant to which such costs were reclassified as current deductions?

                               LAW AND ANALYSIS

   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)(i) requires

the taxpayer, in computing its tax expense for establishing its cost of service for
ratemaking purposes and reflecting operating results in its regulated books of account,
to use a method of depreciation with respect to public utility property that is the same
as, and a depreciation period for such property that is not shorter than, the method and
period used to compute its depreciation expense for such purposes. Under
§ 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.

   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(l)-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
purposes of establishing cost of services and for reflecting operating results in regulated
PLR-122510-19 8

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 481(a) requires those adjustments necessary to prevent amounts from

being duplicated or omitted to be taken into account when a taxpayer's taxable income
is computed under a method of accounting different from the method used to compute
taxable income for the preceding taxable year. See also § 2.05(1) of Rev. Proc. 97-27,
97-27, 1997-1 C.B. 680 (the operative method change revenue procedure at the time
Taxpayer filed its Form 3115, Application for Change in Accounting Method).

    An adjustment under § 481(a) can include amounts attributable to taxable years

that are closed by the period of limitation on assessment under § 6501(a). Suzy's Zoo
v. Commissioner, 114 T.C. 1, 13 (2000), aff'd, 273 F.3d 875, 884 (9th Cir. 2001);
Superior Coach of Florida, Inc. v. Commissioner, 80 T.C. 895, 912 (1983), Weiss v.
Commissioner, 395 F.2d 500 (10th Cir. 1968), Spang Industries, Inc. v. United States, 6
Cl. Ct. 38, 46 (1984), rev'd on other grounds 791 F.2d 906 (Fed. Cir. 1986). See also
Mulholland v. United States, 28 Fed. Cl. 320, 334 (1993) (concluding that a court has
the authority to review the taxpayer's threshold selection of a method of accounting de
novo, and must determine, ab initio, whether the taxpayer's reported income is clearly
reflected).

    Sections 481(c) and 1.481-4 provide that the adjustment required by § 481(a)

may be taken into accounting in determining taxable income in the manner, and subject
to the conditions, agreed to by the Service and a taxpayer. Section 1.446-1(e)(3)(i)
authorizes the Service to prescribe administrative procedures setting forth the
limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain
consent to change a method of accounting in accordance with § 446(e). See also
§ 5.02 of Rev. Proc. 97-27.

   When there is a change in method of accounting to which § 481(a) is applied,

§ 2.05(1) of Rev. Proc. 97-27 provides that income for the taxable year preceding the
year of change must be determined under the method of accounting that was then
employed, and income for the year of change and the following taxable years must be
determined under the new method of accounting as if the new method had always been
used.

   Because of their similarity, we address requests 1, 3, and 5 together. For all of

the COR-related amounts at issue in these requests, the amounts are not protected by
the Normalization Rules. Generally, § 168(i)(9)(A) does not refer to COR. Moreover,
there is no reference to an acceleration of taxes but only to a deferral. While COR may
be a component of the calculation of the amount treated as book depreciation, it is a
deduction under § 162 and has nothing to do with actual accelerated tax depreciation.
While depreciation method and life differences are created and reversed solely through
depreciation, such is not the case with COR. While the COR timing differences may
PLR-122510-19 9

often originate as a component of book depreciation, it reverses through the incurred
COR expenditure.

    Taxpayer’s ruling request 8 pertains to the depreciation-related ADIT existing

prior to the year of change (Year 6) for public utility property in service as of the end of
the taxable year immediately preceding the year of change. Beginning with the year of
change, the Year 6 Consent Agreement granted Taxpayer permission to change its
(1) method of accounting for mixed service costs to recharacterize a substantial quantity
of mixed service costs that Taxpayer had previously capitalized into depreciable assets
as deductible costs (including additions to cost of goods sold) and (2) to depart from its
book method for tax purposes electing to use for tax purposes larger units of property
than used for book purposes which resulted in characterizing many projects that were
capitalized for book purposes as deductible repairs for tax purposes.

   When there is a change in method of accounting to which § 481(a) is applied,

income for the taxable year preceding the year of change must be determined under the
method of accounting that was then employed by Taxpayer, and income for the year of
change and the following taxable years must be determined under Taxpayer’s new
method of accounting as if the new method had always been used. See § 481(a);
§ 1.481-1(a)(1); and § 2.05(1) of Rev. Proc. 97-27. In other words: (1) Taxpayer’s new
method of accounting is implemented beginning in the year of change; (2) Taxpayer’s
old method of accounting used in the taxable years preceding the year of change is not
disturbed; and (3) Taxpayer takes into account a § 481(a) adjustment in computing
taxable income to offset any consequent omissions or duplications.

   Accordingly, for public utility property in service as of the end of the taxable year

immediately preceding the year of change (Year 6), the depreciation-related ADIT
existing prior to the year of change for the changes in methods of accounting subject to
the Year 6 Consent Agreement does not remain subject to the normalization method of
accounting within the meaning of § 168(i)(9) after implementation of the new tax
methods of accounting in the year of change and subsequent taxable years.

   Based on the foregoing, we conclude that:

1) Under the circumstances described above, Taxpayer’s electric distribution COR-
related net DTL is not “protected” by the Normalization Rules.

3) Under the circumstances described above, Taxpayer’s gas distribution COR-related
net DTA accumulated through the depreciation rate prior to Month 1 of Year 3 is not
“protected” by the Normalization Rules.

5) Under the circumstances described above, Taxpayer’s gas distribution COR-related
net DTL accumulated through the fixed estimated cash recovery after Month 1 of Year 3
is not “protected” by the Normalization Rules.
PLR-122510-19 10

Because these amounts in requests 1, 3, and 5 are not protected by the Normalization
Rules, requests 2, 4, 6, and 7 are moot.

8) Taxpayer’s depreciation related ADFIT balances created pursuant to the
Normalization Rules that are attributable to costs that were capitalized into the basis of
depreciable assets prior to Taxpayer changing its method of accounting for those costs
do not remain subject to the Normalization Rules after the change in method of
accounting pursuant to which such costs were reclassified as current deductions.

  Except as specifically set forth above, no opinion is expressed or implied

concerning the federal income tax consequences of the above described facts under
any other provision of the Code or regulations.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

    This ruling is based upon information and representations submitted by Taxpayer

and accompanied by penalty of perjury statements executed by an appropriate party.
While this office has not verified any of the material submitted in support of the request
for rulings, it is subject to verification on examination.

     In accordance with the power of attorney on file with this office, a copy of this

letter is being sent to your authorized representatives.

                                           Sincerely,



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

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