Utility normalization excludes cost of removal but includes salvage value

Plain-English summary

A regulated electric utility asked how the tax-rate reduction in the 2017 tax law affected its accumulated deferred taxes and the average rate assumption method used to return excess deferred taxes to customers. Its regulated depreciation charges included estimated future costs of removing utility property, while the federal tax deduction for those costs arises only when removal actually occurs. The IRS ruled that cost-of-removal timing differences are not protected by the Section 168 normalization rules because they do not arise from accelerated tax depreciation and reverse through a Section 162 expenditure. By contrast, gross salvage-value timing differences are expressly part of the normalized reserve, even when they are offset by cost-of-removal amounts. A method that included cost of removal when reversing the excess tax reserve was not consistent with the normalization rules. The utility’s proposed method, which reflected estimated salvage value but excluded estimated cost of removal, complied with the rules.

Ruling snapshot

• Question: How must cost-of-removal and salvage-value timing differences be treated when a utility computes and reverses its excess deferred tax reserve?
• Outcome: Mixed, cost of removal is outside normalization, salvage value is protected, and only the method excluding cost of removal complies
• Key authorities: IRC §§ 162, 167, and 168(i)(9); TCJA § 13001(d); Treas. Reg. § 1.167(l)-1; Rev. Proc. 2020-39

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202141001                                              Third Party Communication: None
 Release Date: 10/15/2021                                       Date of Communication: Not Applicable
 Index Number: 168.00-00
                                                                Person To Contact:
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 ---------------------------------------------                  Telephone Number:
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 --------                                                       Refer Reply To:
                                                                CC:PSI:B06
 ----------------------------------------------------------     PLR-101169-21
                                                                Date:
                                                                July 15, 2021




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

Parent                     =        ----------------------------------------------------

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

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

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

Year A                     =        -------

Year B                     =        -------

Month A                    =        ------

Period A                   =        --------------

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

       This letter responds to a request for a private letter ruling dated January 13,
2021, and submitted on behalf of Taxpayer regarding § 168(i)(9) of the Internal
Revenue Code and § 1.167(l)-1 of the Income Tax Regulations (together, the
“Normalization Rules”), and Section 13001(d) of Pub. L. 115-97 (131 Stat 2054)
(“TCJA”) and Rev. Proc. 2020-39, 2020-36 IRB 546, regarding the scope of the deferred
tax normalization requirements and computations required to comply with the average
PLR-101169-21                                 2

rate assumption method (“ARAM”). 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 principally engaged in the business of supplying electricity in State A.
Taxpayer is subject to regulation as to rates and conditions of service by Commission A
as well as Commission B. Both of 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. Commission A and Commission B treat accumulated deferred
federal income tax liabilities (“ADFIT”) and excess deferred federal income tax liabilities
(“EDFIT”) as a reduction to rate base in setting the allowed return for the utilities that
they regulate. Taxpayer has claimed accelerated depreciation on its public utility
property to the full extent those deductions have been available. Taxpayer has
normalized the federal income taxes deferred as a result of it claiming these deductions
in accordance with the Normalization Rules.

        Commission B has adopted the Uniform Systems of Accounts “USOAs” and all
electric utilities under the jurisdiction of Commission A, including Taxpayer, follow the
USOAs. 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-101169-21                                  3

“service life” as:

       … the time between the date electric plant is includible in electric plant in service,
       or electric plant leased to others, and the date of its retirement.

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. Taxpayer breaks 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.

       In order to fund its future COR, Taxpayers estimates the future COR and then
spreads the estimated cost ratably over the life of the asset through adding the COR to
the annual depreciation charge used by commission A to calculate the allowable rate for
Taxpayer to charge its customers. If the COR is greater than the salvage value of the
public utility property, then the Taxpayer’s property will in effect have a negative salvage
value – which will create a negative depreciation rate (i.e. a depreciation rate that is
greater than the value of asset). Alternately, if the net salvage value is positive it too will
be reflected in Taxpayer’s depreciation rate. The deprecation rate will then be utilized by
Commission A in computing the allowable rates for Taxpayer to charge its customers. In
most cases the COR is negative, and therefore a component of establishing the annual
depreciation charge. The 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 when the asset is removed. 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 a 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 COR funding as described creates a deferred tax asset (“DTA”).
This represents the future benefit to be derived from the eventual COR tax deduction.
PLR-101169-21                                4

The COR-related DTA is included in Taxpayer’s overall plant-related ADFIT account
that reduces Taxpayer’s ADFIT balance.

        Prior to the Tax Cut and Jobs Act (“TCJA”), Taxpayer incorporated the COR into
the annual depreciation charge without identifying the separate components of the
deprecation and COR reserve charges. However, Taxpayer did maintain records that
identified the separate components of non-COR and COR related depreciation that was
reflected in the Taxpayers book depreciation balances. 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.

        Prior to the enactment of the TCJA, Taxpayer paid income tax at a 35 percent
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 TCJA, Taxpayer will only receive a 21 percent benefit when the
COR deduction is claimed or when any over-accrual is refunded and will pay only a 21
percent 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
percent "excess" tax it paid on its recovery of the COR component of book depreciation
from the government when it claims its COR deduction, it will recover it from its
customers. Conversely, because Taxpayer will not pay the 14 percent "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).

       In anticipation of complying with the TCJA excess deferred tax Normalization
Rules and the subsequent return of the TCJA Section 13001(d) excess tax reserve
(“ETR”) to customers, Taxpayer used its historical plant-related records in its regulatory
books of account to separately compute both (1) its DTA related to COR and the
associated excess tax deficit to be recovered from customers and (2) its DTL related to
method/life differences and the associated ETR to be returned to customers, which
included gross salvage value.

Taxpayer’s Recent Commission A Proceeding

       In Year A, Taxpayer filed an application with Commission A to set its rates for
Period A. Upon the enactment of the TCJA in 2017, Taxpayer updated its filing with
Commission A to reflect the impact of the lowered corporate tax rate. Among the
impacts considered by Commission A was the proper computation of the ETR.
Specifically, when computing the ARAM (as per TCJA Section 13001(d)(3)(B)), should
the COR be included or not. Ultimately, Commission A and Taxpayer did not reach an
agreement on the inclusion of COR into the ETR and the resulting disagreements
relating to the COR-related EDFIT. In summary, Commission A’s proposed method of
PLR-101169-21                                5

computing the return of ADFIT to customers under ARAM included the accrual for COR,
resulting in a larger amount of book depreciation in all years (and an earlier return of
ETR to customers) than under the computational method proposed by Taxpayer.
Commission A, In Month A of Year B, stated that it intended that Taxpayer comply with
the Normalization rules at all times, and permitted Taxpayer to request a private letter
ruling from the Internal Revenue Service.

                                RULINGS REQUESTED

   1) Whether, under the circumstances described above, Taxpayer's DTA for
      cumulative timing differences between (a) recognition of accrued gross COR with
      respect to public utility property as an increase in depreciation expense in its
      regulatory books of account and (b) the subsequent tax deduction of such costs
      upon disposition is subject to the normalization rules of Code Section 168(i)(9)
      and whether the associated excess deferred tax amount is subject to the
      normalization rules of TCJA Section 13001(d)?

   2) Whether, under the circumstances described above, Taxpayer's DTL for the
      cumulative timing differences between (a) recognition of accrued gross salvage
      value with respect to public utility property as a reduction of depreciation expense
      in its regulatory books of account and (b) the subsequent taxation of such
      salvage amounts upon disposition is subject to the normalization rules of Code
      Section 168(i)(9) and whether the associated excess deferred tax amount is
      subject to the normalization rules of TCJA Section 13001(d) regardless of
      whether the gross salvage value timing differences are partially or fully offset by
      gross COR timing differences and whether the DTL related to gross salvage
      value differences is partially or fully offset by the DTA for gross COR differences?

   3) Whether, under the circumstances described above, the computation of the
      reversal of the excess tax reserve for depreciation method and life
      differences for public utility property based on book depreciation amounts
      inclusive of an accrual of gross COR pursuant to the State Commission Method
      is consistent with the normalization requirements?

   4) Whether, under the circumstances described above, computation of the reversal
      of the excess tax reserve for depreciation method and life differences for public
      utility property based on book depreciation amounts reflecting estimated gross
      salvage value but not an accrual of estimated gross COR pursuant to the
      Proposed Approach complies with or violates the normalization rules of TCJA
      Section 13001(d)?
                                 LAW AND ANALYSIS
      Section 168(f)(2) of the Internal Revenue Code, provides that the depreciation
deduction determined under § 168 shall not apply to any public utility property (within
PLR-101169-21                                6

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). Treas. Reg. § 1.167(l)-1(a)(1)
provides that the normalization requirements for public utility property pertains only to
the deferral of federal income tax liability resulting from the use of an accelerated
method of depreciation for computing the allowance for depreciation under § 167 and
the use of straight-line depreciation for computing tax expense and depreciation
expense for purposes of establishing cost of services and for reflecting operating results
in regulated books of account. These regulations do not pertain to other book-tax timing
differences with respect to state income taxes, F.I.C.A. taxes, construction costs, or any
other taxes and items.

       Section 13001(a) of the TCJA reduced the corporate tax rate from 35 percent to
21 percent for taxable years beginning after December 31, 2017. TCJA Section
13001(d)(1) provides that a normalization method of accounting shall not be treated as
being used with respect to any public utility property for purposes of § 167 or § 168 if
the taxpayer, in computing its cost of service for ratemaking purposes and reflecting
operating results in its regulated books of account, reduces the ETR more rapidly or to a
greater extent than such reserve would be reduced under the average rate assumption
method (ARAM).

       TCJA Section 13001(d)(3)(A) provides that ‘‘excess tax reserve’’ means the
excess of reserve for deferred taxes (as described in § 168(i)(9)(A)(ii) as of the day
before the corporate rate reductions provided in the amendments made by TCJA
Section 13001(a) take effect, over the amount which would be the balance in such
reserve, if the amount of such reserve were determined by assuming that the corporate
tax rate reductions provided in the TCJA were in effect for all prior periods.
PLR-101169-21                                 7

       TCJA Section 13001(d)(3)(B) defines ARAM as the method under which the
excess in the reserve for deferred taxes is reduced over the remaining lives of the
property as used in its regulated books of account which gave rise to the reserve for
deferred taxes. Under such a method, during the time period in which the timing
differences for the property reverse, the amount of the adjustment to the reserve for the
deferred taxes is calculated by multiplying – the ratio of the aggregate deferred taxes for
the property to the aggregate timing differences for the property as of the beginning of
the period in question, by the amount of the timing differences which reverse during
such period.

       Rev. Proc. 2020-39, Section 4.01 provides that under Section 13001(d)(1) of the
TCJA, taxpayers must use ARAM to calculate the reversal of their ETR, if the taxpayer's
regulatory books are based upon the vintage account data necessary to use ARAM.
However, if the taxpayer's regulatory books are not based upon the vintage account
data that is necessary for the ARAM, use of the ARAM is not required. Rev. Proc. 2020-
39, Section 4.02 provides that the determination of whether a taxpayer's regulatory
books contain sufficient vintage account data necessary to use the ARAM is determined
based on all the facts and circumstances. Rev. Proc. 2020-39, Section 5 states that the
TCJA ETR normalization requirements are part of the overall pre-existing deferred tax
Normalization Rules and that the revenue procedure is intended to be consistent with
those rules.

       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 acceleration of taxes for COR, but rather, 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 method and life differences closely related to depreciation 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.

       Taxpayer’s request 2 addresses the question of whether COR-related DTA
(determined above to not be subject to the Normalization Rules) impacts the application
of those rules to salvage value. While COR is not protected under the Normalization
Rules, salvage value is specifically included – see § 168(i)(9)(A)(ii) – as a protected part
of the normalized ETR. Neither the Internal Revenue Code nor the regulations require
or direct that salvage value must be affected by or is necessarily related to the
computation of COR, for purposes of the application of the Normalization Rules.

        Because of their similarity, we address requests 3 and 4 together. The ETR
created by the TCJA is the excess of the reserve for deferred taxes under §
168(i)(9)(A)(ii), as of the date before the corporate rate reductions under TCJA take
effect, over the amount the reserve balance would be if the rate reductions had been in
effect for all prior periods. The ETR is reduced over the remaining lives of the property
PLR-101169-21                               8

which gave rise to such reserve for deferred taxes based on the reversal of the
underlying depreciation method and life differences subject to the normalization rules of
Code Section 168(i)(9)(A)(ii). Thus, because COR is not subject to normalization, as
concluded above, including the COR-related amounts in the excess taxes used to
compute the ETR does not satisfy the requirements of TCJA Section 13001(d).
Conversely, leaving the COR out of the ETR computation does satisfy the requirements
of TCJA Section 130001(d).


Based on the forgoing we conclude that:
   1) Taxpayer's DTA for cumulative timing differences between (a) recognition of
      accrued gross COR with respect to public utility property as an increase in
      depreciation expense in its regulatory books of account and (b) the subsequent
      tax deduction of such costs upon disposition is not subject to the normalization
      rules of Code Section 168(i)(9) and the associated excess deferred tax amount is
      not subject to the normalization rules of TCJA Section 13001(d).

   2) Taxpayer's DTL for cumulative timing differences between (a) recognition of
      accrued gross salvage value with respect to public utility property as a reduction
      of depreciation expense in its regulatory books of account and (b) the
      subsequent taxation of such salvage amounts upon disposition is subject to the
      normalization rules of Code Section 168(i)(9) and the associated excess deferred
      tax amount is subject to the normalization rules of TCJA Section 13001(d)
      regardless of whether the gross salvage value timing differences are partially or
      fully offset by gross COR timing differences and whether the DTL related to gross
      salvage value differences is partially or fully offset by the DTA for gross COR
      differences.

   3) The computation of the reversal of the excess tax reserve for depreciation
      method and life differences for public utility property based on book depreciation
      amounts inclusive of an accrual of gross COR pursuant to the State Commission
      Method is not consistent with the normalization rules of TCJA Section 13001(d).

   4) The computation of the reversal of the excess tax reserve for depreciation
      method and life differences for public utility property based on book depreciation
      amounts reflecting estimated gross salvage value but not an accrual of estimated
      gross COR pursuant to the Proposed Approach complies with the normalization
      rules of TCJA Section 13001(d).
   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.
PLR-101169-21                                  9

  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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