Cost-of-removal tax shortfall is not normalization-protected

Plain-English summary

A regulated electric and gas utility collected estimated asset-removal costs from customers through book depreciation before those costs could be deducted for tax purposes. The federal corporate rate reduction caused a deferred tax shortfall because the utility had paid tax at 35 percent on those collections but would receive only a 21 percent benefit when it later incurred and deducted the removal costs. The utility asked whether that shortfall was protected by the public-utility depreciation normalization rules. The IRS ruled that it was not protected because cost of removal is a Section 162 expense rather than an accelerated depreciation method or life difference. The utility may therefore recover the shortfall from customers consistently with the normalization rules, and its two questions about handling a protected item were moot.

Ruling snapshot

• Question: Is a utility's cost-of-removal deferred tax shortfall protected by the depreciation normalization rules?
• Outcome: Approved as requested: no, the shortfall is not protected, and the remaining questions are moot.
• Key authorities: IRC §§ 162, 167(l), 168(f)(2), 168(i)(9); Treas. Reg. § 1.167(l)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202124003 Third Party Communication: None
Release Date: 6/18/2021 Date of Communication: Not Applicable
Index Number: 168.24-01
Person To Contact:
----------------------- ---------------, ID No. ------------
--------------- Telephone Number:
---------------------------------- --------------------
----------------------------- Refer Reply To:
----------------------- CC:PSI:B06
PLR-120934-20
Date:
March 22, 2021

In Re: ----------------------------------

LEGEND:

Taxpayer = ----------------------------------
-------------------------
Parent = ----------------------------------------------------------
Commission A = ----------------------------------------------
Commission B = -----------------------------------------------------
State A = ---------
State B = -------------
Electric Division = --------------------
Gas Division = ----------------------------
Date 1 = ------------------------
Year A = -------
Year B = -------
Director = ---------------------------------------

Dear --------------------

  This letter responds to a request for a private letter ruling dated September 24,

2020, and submitted on behalf of Taxpayer regarding the application of the depreciation
normalization rules under § 168(i)(9) of the Internal Revenue Code (the 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.
PLR-120934-20 2

                                    FACTS

  Taxpayer is an investor-owned “combination” regulated utility that is incorporated

and operates in State A. It is an indirect, wholly-owned subsidiary of Parent, a State B
corporation. Taxpayer is included on the consolidated federal income tax return of
Parent. Through its Electric Division, Taxpayer is engaged in the business of
generation, purchase, transmission, distribution and sale of electric energy. Through its
Gas Division, Taxpayer is engaged in the purchase, distribution, and sale of natural gas.
Taxpayer employs the accrual method of accounting and reports on the calendar year
basis. Both Divisions of Taxpayer are subject to regulation by Commission A. Rates for
both divisions are set on a “rate of return” basis.

   Taxpayer has claimed accelerated depreciation on its public utility properties to

the full extent allowed by the Code. Taxpayer has normalized the federal income taxes
deferred in accordance with the Normalization Rules. Consequently, Taxpayer has a
substantial balance of Accumulated Deferred Federal Income Taxes “ADFIT”
attributable to accelerated depreciation reflected on its regulated books of account for
both divisions. In accordance with ratemaking practices under Commission A,
Taxpayer has included its ADFIT balance in its capital structure as cost-free capital.

 Commission B has, by regulation, established Uniform Systems of Accounts

“USOAs” which are applicable to both divisions of Taxpayer. The USOAs contain
several definitions relevant to Taxpayer’s request. Specifically, the USOAs define cost
of removal “COR” as:

  … the cost of demolishing, dismantling, tearing down or otherwise
  removing electric plant, including the cost of transportation and handling
  incidental thereto.

“salvage value” as:

  … the amount received for property retired, less any expenses incurred in
  connection with the sale or in preparing the property for sale.

“net salvage value” as:

  … the salvage of property retired less the cost of removal.

“service value” as:

  … the difference between original cost and net salvage value of electric
  plant.

PLR-120934-20 3

and “depreciation” as:

  … the loss in service value not restored by current maintenance, incurred
  in connection with the consumption or prospective retirement of electric
  plant in the course of service from causes which are known to be in
  current operation and against which the utility is not protected by
  insurance.

  Therefore, for the 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, a component of establishing the applicable
depreciation rate. Both Divisions of Taxpayer break out the COR and salvage rates
separately from depreciation. The net rate is considered the Life Rate that is approved
by Commission A. The COR and salvage reserves are tracked separately from
accumulated depreciation in Taxpayer’s continuing property records.

   Since depreciation expense is included in Taxpayer’s cost of service used for

establishing its rates, customers pay for the COR as book depreciation in their rates.
However, for tax purposes, COR is deductible only when actually incurred. Therefore,
for tax purposes, Taxpayer 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. Since COR is normalized in setting
rates, customers are provided a tax benefit commensurate with their funding of COR.

   Accounting Standards Codification “ASC” 98-740-25-2, which is followed by the

Taxpayer, provides that if, as a result of an action by a regulator, it is probable that the
future increase or decrease in taxes would be recovered from or returned to customers
through future rates, an asset or liability shall be recognized for that probable future
revenue or reduction in future revenue. Moreover, that asset or liability also shall be a
temporary difference for which a deferred tax liability (DTL) or asset shall be
recognized.

  The tax effect of recovering COR through rates before the associated tax

deduction can be claimed creates a deferred tax asset (DTA). This represents the
future benefit to be derived from the eventual COR tax deduction.

 Since Year A, Taxpayer has been able to separately identify the portion of its

accumulated book depreciation reserve that relates to the COR accrual balance.
Consequently, Taxpayer distinguishes between COR book/tax differences and
depreciation method/life differences even though they are both derived from Taxpayer’s
book depreciation rates and expense. Taxpayer’s system can, therefore, track the
reversals of these differences separately.
PLR-120934-20 4

Taxpayer’s Recent Commission A Proceedings

   On Date 1, Commission A opened two dockets for Taxpayer for the purpose of

identifying and quantifying the potential impact of the TCJA on both Divisions of
Taxpayer tax-related costs and to determining a method of incorporating that impact
into their respective rates. Among the impacts considered was quantification of the
deferred federal income taxes previously provided that, as a result of the tax rate
reduction enacted by the TCJA, are no longer necessary to fund the reversal of prior
timing differences (Excess Deferred Federal Income Taxes “EDFIT”). As a component
of this amount, Taxpayer calculated its Excess Tax Reserve “ETR” as defined in
Section 13001(d) of the TCJA. Taxpayer also quantified the effect of applying the
Average Rate Assumption Method “ARAM” to that reserve. Since, by statute, the ETR
consists only of ADFIT required to be provided under the Normalization Rules, the
ARAM is only mandatorily applicable to such ADFIT.

  One of the issues Taxpayer had to consider in computing its ETR in each of the

dockets was whether or not the ADFIT shortfall created by COR is “protected”.
Taxpayer concluded that COR is not subject to the Normalization Rules because it is
not a depreciation life/method difference. It, therefore, treated the COR-related ADFIT
shortfall as unprotected in each of the two dockets. Consistent with this view, Taxpayer
believes that the recovery of the COR-related ADFIT shortfall from customers is not
constrained by the Normalization Rules.

                            RULINGS REQUESTED

Taxpayer requests the following guidance:

1) Under the circumstances described above, is Taxpayer’s COR-related deferred tax
shortfall “protected” by the Normalization Rules?

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

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

                              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
PLR-120934-20 5

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
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.

   For the COR-related amounts at issue in this request, 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 often originate as a component of book depreciation, it reverses
through the incurred COR expenditure. Prior to Year B, Taxpayer paid income tax at a
rate of 35% rate on the receipt of the COR portion of book depreciation (and provided
its customers a tax benefit at that rate) from its customers. However, as a result of the
tax rate reduction enacted as part of the TCJA, Taxpayer will receive a 21% benefit
when the COR deduction is actually claimed. Thus, the situation is precisely the
opposite from that of method/life differences where accelerated deductions produced a
35% tax benefit but, when reversed, will become subject to only a 21% income tax.
Thus, in the case of COR, the tax rate reduction enacted as part of the TCJA produced
a deferred tax shortfall, not an excess deferred 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 may recover this
amount from its customers consistent with the Normalization rules.

  Based on the foregoing, we conclude that:

PLR-120934-20 6

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

Because the amounts in request 1 are not protected by the Normalization Rules,
requests 2 and 3 are moot.

 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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