IRS rules a water utility need not reduce rate-base deferred taxes for an NOL that was shrinking, revisiting an earlier ruling after a court decision

Plain-English summary

A regulated water and wastewater utility uses accelerated depreciation on its tax return but straight-line depreciation when setting customer rates. The tax law's "normalization" rules (IRC § 168(i)(9) and the old § 167(l) regulations) control how the resulting deferred taxes, tracked as accumulated deferred income tax (ADIT), reduce the "rate base" on which the utility earns a return. A wrinkle arises when the utility has a net operating loss carryforward (NOLC) tied to that accelerated depreciation: part of the deferred tax has not really been deferred, so it must be accounted for. An earlier 2020 ruling (PLR 202010002) had assumed the utility's NOL was growing during the surcharge period at issue. A later state court decision clarified that whether an NOL exists is measured across all of the utility's regulated operations, not just the one surcharge case, and on that basis the utility actually had taxable income and a shrinking NOL that year. Given the corrected facts, the IRS ruled that the depreciation-related ADIT reducing rate base in the surcharge case does not have to be decreased for any part of the NOLC, because that NOLC was not caused by the surcharge-case depreciation and was already reflected in the neighboring base-rate cases. This effectively reconsiders holding 9 of the 2020 ruling.

Ruling snapshot

• Question: Must depreciation-related ADIT reducing rate base in the surcharge case be decreased to reflect the utility's NOLC, when that NOLC was decreasing during the test period?
• Outcome: Approved (no reduction required; ruling requested is granted)
• Key authorities: IRC § 168(i)(9), (f)(2); former IRC § 167(l); Treas. Reg. § 1.167(l)-1(h); IRC § 172(c)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 202227002                                             Third Party Communication: None
Release Date: 7/8/2022                                        Date of Communication: Not Applicable
Index Number: 168.24-01
                                                              Person To Contact:
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--------------------------------------------                  Refer Reply To:
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----------------------------                                  PLR-119555-21
                                                              Date:
In Re: ---------------------------------------------------- March 24, 2022
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LEGEND:

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

        This letter responds to a request for a private letter ruling dated
September 22, 2021, and additional submission dated November 19, 2021, submitted
on behalf of Taxpayer for rulings under § 168(i)(9) of the Internal Revenue Code and
§ 1.167(l)-1 of the Income Tax Regulations regarding the application of the deferred tax
normalization requirements and the appropriate methodology for the reduction of the
accumulated deferred income tax ("ADIT") balance that decreases rate base
computation when a net operating loss carryforward ("NOLC") exists. An earlier letter
ruling (PLR 202010002, dated December 3, 2019, "2020 Ruling") to Taxpayer
addressed this issue, but judicial and regulatory developments since the issuance of the
2020 Ruling have clarified pertinent regulatory matters and must be taken into account
to apply the normalization rules.

      Taxpayer's representations in the earlier letter ruling and those in the current
request are as follows:

        Taxpayer is a water and wastewater utility company that operates in State with
rates set by Commission for the furnishing or sale of water or sewage disposal services
through a combination of periodic general rate case proceedings (resulting in what are
commonly referred to as "base rates") and infrastructure surcharge proceedings
(resulting in surcharges that are added to base rates).

        Under State statute and Commission rulemaking, eligible water corporations may
petition Commission and utilize an Infrastructure System Replacement Surcharge
("Surcharge") to recover the costs of eligible water utility main replacements and
relocations.

       For both general rate case proceedings and Surcharge proceedings, Taxpayer
computes a revenue requirement subject to Commission approval based on recovery of
a debt- and equity-based return on investment in rate base, including the cost of plant
assets less accumulated book depreciation and ADIT, and a recovery of operating
expenses, including depreciation expense, property tax expense, and income tax
expense.
       A State statute authorizes Commission to enter an order authorizing the water
corporation to impose a Surcharge that is sufficient to recover "appropriate pretax
revenues." The State statute defines the revenue requirement set in a Surcharge
proceeding and provides that "appropriate pretax revenues" are "the revenues
necessary to produce net operating income equal to . . . the water corporation's
weighted cost of capital multiplied by the net original cost of eligible infrastructure
system replacements, including recognition of accumulated deferred income taxes and
accumulated depreciation associated with eligible infrastructure system replacements . .
. " among other items.

        In the request resulting in the 2020 Ruling, Taxpayer represented that
Commission and the State courts have interpreted this statute in a strict manner thereby
limiting the costs eligible for recovery or to earn a return in a Surcharge proceeding and
causing costs not eligible for ratemaking consideration in a Surcharge proceeding to
only be eligible for recovery or return in the next base rate proceeding. As described
below, a court decision after issuance of the 2020 Ruling has clarified the applicable
interpretation of this statute.

        The deferred tax normalization matters in the original request and in this request
pertain to the Surcharge proceeding initiated by Taxpayer in Month 1 Year 1 (the
"Surcharge Case") and resulting in a Commission order on Date 1 (the "Date 1 Order").
The Surcharge Case relates to additions of certain property placed in service from Date
2 through Date 3 and accumulated depreciation and estimated ADIT on such assets
was through Date 4. The Surcharge resulting from the Surcharge Case became
effective on Date 5.

      On a consolidated basis, Parent incurred tax losses in various years from Year 2
to Year 3 and, as of Date 6, had an NOLC of approximately $a. On a separate
company basis, Taxpayer incurred tax losses in various tax years from Year 2 to Year 4
and, as of Date 6, had a separate company NOLC of approximately $b (after tax-
sharing payments). For Year 1, Parent (on a consolidated basis) and Taxpayer (on a
separate company basis) estimated and then ultimately reported that taxable income
was earned and, thus, NOLC was utilized.

       As of the date of the rate base determination (Date 4), a taxable loss of
approximately $c had been incurred with respect to the plant-related expenditures with
rates set by the Surcharge Case and associated Surcharge revenues as of such date.
However, Taxpayer reported taxable income for the tax year that included the
Surcharge Case test period on the basis of all of the gross income and deductions from
Commission-regulated operations.

        The NOLC reflected in ratemaking for the base rate case proceeding with rates
effective in Month 2 Year 1 was based on the estimated NOLC as of the end of Year 4
of $d, including an estimated Year 4 tax loss of $e. The actual Year 4 tax loss reported
on the Year 4 tax return was $f. The excess of the actual Year 4 tax loss over the
estimated Year 4 tax loss had yet to be reflected in ratemaking at the time of the
Surcharge Case but was reflected in the subsequent base rate case.

          Issues disputed by participants in the Surcharge Case included whether the tax
effect of an NOLC must, pursuant to the normalization requirements, decrease the ADIT
reduction to rate base related to the expenditures in the Surcharge Case and, if so, the
methodology to determine the amount of the NOLC adjustment subject to the
normalization requirements. The revenue requirement approved in Commission's Date
1 Order was lower than the revenue requirement sought by Taxpayer and is entirely
attributable to differing ADIT calculations with respect to the NOLC and the resulting
effects on rate base and allowed return. The approved revenue requirement in the
Surcharge case was based on a rate base computation that reflects the gross ADIT
liabilities associated with depreciation-related and repair-related book/tax differences,
but did not reflect an ADIT asset for any portion of Taxpayer's NOLC as of the date that
rate base was determined (Date 4), including the tax loss resulting from the
infrastructure expenditures addressed in the Surcharge Case.

       On Date 7, Taxpayer filed an Application for Rehearing and Motion to Defer
Ruling, asking the Commission for the time to seek a private letter ruling form of
guidance from the Service to address any uncertainties regarding the application of the
deferred tax normalization requirements to the rate base treatment of the NOLC-related
ADIT asset in computing the Surcharge case revenue requirement. On Date 8, the
Commission denied Taxpayer's request for rehearing. Taxpayer filed a notice of appeal
by Date 9, that initiated an appeal of the order in the Surcharge case to the State Court
of Appeals. Taxpayer filed a private letter ruling request that resulted in the 2020
Ruling.

       Taxpayer received the 2020 Ruling on Date 10 and notified the Commission that
it had been received by way of correspondence dated Date 11.

      On Date 12, Taxpayer filed a petition with Commission seeking to establish a
Surcharge rate to provide for the recovery of costs for eligible infrastructure system
replacements and relocations for a test period that included such date. In addition,
Taxpayer sought to recover the incremental revenue requirement associated with the
Surcharge Case attributable to the holdings of the 2020 Ruling.

        As part of this Surcharge proceeding, Commission Staff filed its recommendation
and memorandum agreeing with Taxpayer's calculations and recommending the
Commission approve Taxpayer's requested rate changes including an adjustment
related to the NOLC normalization matter in the Surcharge Case and subsequent
Surcharge proceedings prior to the Surcharge proceeding initiated on Date 12. Another
participant in the regulatory proceeding filed its objections and a request for an
evidentiary hearing. The Commission conducted an evidentiary hearing and issued an
order on Date 13 with respect to this Surcharge proceeding ("Date 13 Order") that
permitted the rate recovery sought by Taxpayer with respect to the NOLC-related
normalization matter addressed in the 2020 Ruling for the periods covered by the
Surcharge Case and subsequent Surcharge proceedings prior to the Surcharge
proceeding initiated on Date 12.

       The participant in the regulatory proceeding that had filed objections during this
Surcharge proceeding subsequently filed a motion for rehearing related to the Date 13
Order. The Commission denied the application for rehearing. This participant then filed
a Notice of Appeal with Commission and initiated litigation against the Commission and
Taxpayer in the State Court of Appeals with respect to the Date 13 Order.

       On Date 14, the State Court of Appeals rendered an opinion requiring the
Commission to reduce its revenue requirement calculation for the Surcharge Case to
eliminate the component attributable to the NOLC-related normalization matter ("Date
14 Decision"). The State Court of Appeals held that the Commission misinterpreted
holding 9 of the 2020 Ruling and further held that whether an NOL exists for a test
period is based on the entirety of the taxpayer's Commission-regulated operations, not
simply the gross income and deductions for a particular Surcharge proceeding. The
Date 14 Decision remands the Date 13 Order to the Commission and orders reduction
of Taxpayer's computation of rate base for the Surcharge Case by reflecting
depreciation-related ADIT subject to the deferred tax normalization requirements
without reduction for Taxpayer's NOLC.

       On Date 15, Taxpayer filed an Application for Rehearing or Motion to Transfer
with State Court of Appeals, asking that the Court rehear the matter or, in the
alternative, transfer the case to the State Supreme Court. On Date 16, the State Court
of Appeals denied the motion for rehearing and denied transfer of the case to the State
Supreme Court.

       On Date 17, Taxpayer filed an Application for Transfer to the State Supreme
Court and on Date 18, the State Supreme Court denied the application. Taxpayer has
no further avenues to appeal the Date 14 Decision.

       In accordance with the Date 14 Decision, the Date 13 Order was remanded back
to Commission, and Commission had 60 days (subject to extension) to issue a revised
order. At the time this ruling request was submitted to this office, Taxpayer expected
Commission to comply with the Date 14 Decision and revise the Surcharge Case
revenue requirement computation in a manner contradictory to holding 9 of the 2020
Ruling. On Date 19, Commission issued an order on remand, effective Date 20, with
respect to the rate refund resulting from the Date 14 Decision. As expected, the
Commission ordered Taxpayer to refund amounts that were previously recovered from
customers in accordance with the original interpretation by Taxpayer and the
Commission of holding 9 of the 2020 Ruling. Taxpayer intends to set prices in
accordance with this order.


       Holding 9 of the 2020 Ruling was premised on Taxpayer's interpretation of the
statute and applicable regulatory and judicial precedent that considered Taxpayer's
NOLC to be increasing during the Surcharge Case test period for purposes of setting
the Surcharge. Based on the clarification provided by the Date 14 Decision, Taxpayer
submitted a revision to its facts represented in the earlier ruling request to reflect that
Taxpayer is instead considered to have decreased its NOLC during the Surcharge Case
test period for purposes of setting the Surcharge. Thus, the analysis resulting in holding
9 of the 2020 Ruling must be reconsidered.

                                RULINGS REQUESTED

       Taxpayer requests that the Service rule:

       Under the circumstances described, in order to comply with the normalization
method of accounting within the meaning of § 168(i)(9), the amount of depreciation-
related ADIT reducing rate base used to determine the revenue requirement set in the
Surcharge Case is not required to be decreased to reflect any portion of Taxpayer's
NOLC existing during the test period for the Surcharge Case because Taxpayer
expected to decrease its NOLC during the Surcharge Case test period and the
remaining depreciation-related NOLC was reflected in ADIT used to compute rate base
in the base rate proceedings immediately preceding and immediately subsequent to the
Surcharge Case.

                                 LAW AND ANALYSIS

       Section 168(f)(2) of the Code 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) of the
Code 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) 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(l)-1(a)(1) of the
Regulations 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.

        Section 1.167(l)-1(h)(1)(i) provides that the reserve established for public utility
property should reflect the total amount of the deferral of federal income tax liability
resulting from the taxpayer's use of different depreciation methods for tax and
ratemaking purposes.

         Section 1.167(l)-1(h)(1)(iii) provides that the amount of federal income tax liability
deferred as a result of the use of different depreciation methods for tax and ratemaking
purposes is the excess (computed without regard to credits) of the amount the tax
liability would have been had the depreciation method for ratemaking purposes been
used over the amount of the actual tax liability. This amount shall be taken into account
for the taxable year in which the different methods of depreciation are used. If,
however, in respect of any taxable year the use of a method of depreciation other than a
subsection (l) method for purposes of determining the taxpayer's reasonable allowance
under § 167(a) results in a NOL carryover to a year succeeding such taxable year which
would not have arisen (or an increase in such carryover which would not have arisen)
had the taxpayer determined his reasonable allowance under § 167(a) using a
subsection (l) method, then the amount and time of the deferral of tax liability shall be
taken into account in such appropriate time and manner as is satisfactory to the district
director.

        Section 1.167(l)-1(h)(2)(i) provides that the taxpayer must credit this amount of
deferred taxes to a reserve for deferred taxes, a depreciation reserve, or other reserve
account. This regulation further provides that, with respect to any account, the
aggregate amount allocable to deferred tax under § 167(l) shall not be reduced except
to reflect the amount for any taxable year by which Federal income taxes are greater by
reason of the prior use of different methods of depreciation. That section also notes
that the aggregate amount allocable to deferred taxes may be reduced to reflect the
amount for any taxable year by which federal income taxes are greater by reason of the
prior use of different methods of depreciation under § 1.167(l)-1(h)(1)(i) or to reflect
asset retirements or the expiration of the period for depreciation used for determining
the allowance for depreciation under § 167(a).

       Section 1.167(l)-(h)(6)(i) provides that, notwithstanding the provisions of
subparagraph (1) of § 1.167(l)-(h), a taxpayer does not use a normalization method of
regulated accounting if, for ratemaking purposes, the amount of the reserve for deferred
taxes under § 167(l) which is excluded from the base to which the taxpayer's rate of
return is applied, or which is treated as no-cost capital in those rate cases in which the
rate of return is based upon the cost of capital, exceeds the amount of such reserve for
deferred taxes for the period used in determining the taxpayer's expense in computing
cost of service in such ratemaking.

       Section 1.167(l)-(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 subdivision (i) of § 1.167(l)-(h)(6), above, 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 that period is the amount of the
reserve (determined under § 1.167(l)-1(h)(2)(i)) at the end of the historical period. If
such determination is made by reference both to an historical portion and to a future
portion of a period, the amount of the reserve account for the period is the amount of
the reserve at the end of the historical portion 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 the future portion of the period.

       Therefore, § 1.167(l)-1(h) requires that a utility must maintain a reserve reflecting
the total amount of the deferral of federal income tax liability resulting from the
taxpayer's use of different depreciation methods for tax and ratemaking purposes.

         The normalization requirements pertain only to deferred income taxes for public
utility property resulting from the use of accelerated depreciation for tax purposes and
the use of straight-line depreciation for establishing cost of service and reflecting the
operating results in regulated books of account. Generally, amounts that do not actually
defer tax because of the existence of an NOL need to be reflected as offsetting entries
to the ADIT account to show the portion of tax losses which did not actually defer tax
due to accelerated depreciation.

         Section 1.167(l)-1(h)(6)(i) provides that a taxpayer does not use a normalization
method of regulated accounting if, for ratemaking purposes, the amount of the reserve
for deferred taxes which is excluded from the base to which the taxpayer's rate of return
is applied, or which is treated as no-cost capital in those rate cases in which the rate of
return is based upon the cost of capital, exceeds the amount of such reserve for
deferred taxes for the period used in determining the taxpayer's expense in computing
cost of service in such ratemaking. Because the reserve account for deferred taxes
(ADIT), reduces rate base, it is clear that the portion of the NOLC that is attributable to
accelerated depreciation must be taken into account in calculating the amount of the
ADIT account balance. Thus, the ADIT asset resulting from the NOLC should be
included in rate base, given the inclusion in rate base of the full amount of the ADIT
liability resulting from accelerated tax depreciation.

       Section 1.167(l)-1(h)(1)(iii) makes clear that the effects of an NOLC must be
taken into account for normalization purposes. Section 1.167(l)-1(h)(1)(iii) provides
generally that, if, in respect of any year, the use of other than regulatory depreciation for
tax purposes results in an NOLC carryover (or an increase in an NOLC which would not
have arisen had the taxpayer claimed only regulatory depreciation for tax purposes),
then the amount and time of the deferral of tax liability shall be taken into account in
such appropriate time and manner as is satisfactory to the district director.

        At issue in the Surcharge Case is the computation of the amount by which
Taxpayer’s NOLC as of the rate base determination date for the Surcharge Case is
attributable to depreciation-related book/tax differences pertaining to expenditures for
public utility property which are reflected in the Surcharge Case and subject to
§ 1.167(l)-1(h)(1)(iii). Based on the State statute and judicial decisions, whether an
NOL exists for a Surcharge proceeding test period and, thus, whether an overall NOLC
existing prior to such test period is increasing or decreasing during a Surcharge
proceeding test period are based on gross income and deductions related to all of
Taxpayer’s Commission-regulated operations during such test period and are not
limited to the gross income and deductions pertaining to the Surcharge Case in
isolation.

         Taxpayer has indicated that all of the property placed in service in the test period
for the Surcharge Case was placed in service in Year 1. During Year 1, gross income
of Taxpayer exceeded deductions allowed of Taxpayer and, thus, an NOL as defined in
§ 172(c) of the Code did not occur. Similarly, gross income of the consolidated group
exceeded deductions allowed of the consolidated group and, thus, an NOL as defined in
§ 172(c) of the Code did not occur on a consolidated basis either. Accordingly, during
Year 1, both Taxpayer and its consolidated group utilized a portion of their NOLCs
existing at the end of Year 4. No portion of the NOLC of Taxpayer at the beginning or
end of the test period for the Surcharge Case is attributable to depreciation of public
utility property with rates set in the Surcharge Case. Instead, depreciation of Surcharge
Case public utliity property reduced current-year (Year 1) taxable income.

         On this basis, taxable income rather than an NOL resulted during the Surcharge
Case test period and, thus, Taxpayer’s NOLC decreased during the Surcharge Case
test period. The NOLC normalization requirement of § 1.167(l)-1(h)(1)(iii) does not
apply to depreciation-related book/tax differences pertaining to expenditures for public
utility property reflected in the Surcharge Case because Taxpayer’s NOLC did not arise
or increase due to the Surcharge Case depreciation-related book/tax differences with
respect to public utility property. Significantly, Taxpayer’s depreciation-related NOLC is
reflected in the ADIT amount used to compute rate base in the base rate proceedings
immediately preceding and immediately subsequent to the Surcharge Case.

                                      CONCLUSION

       Based on the foregoing, we conclude as follows:

       Under the circumstances described, in order to comply with the normalization
method of accounting within the meaning of § 168(i)(9), the amount of depreciation-
related ADIT reducing rate base used to determine the revenue requirement set in the
Surcharge Case is not required to be decreased to reflect any portion of Taxpayer's
NOLC existing during the test period for the Surcharge Case because Taxpayer
expected to decrease its NOLC during the Surcharge Case test period and the
remaining depreciation-related NOLC was reflected in ADIT used to compute rate base
in the base rate proceedings immediately preceding and immediately subsequent to the
Surcharge Case.

      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 representative.

                                           Sincerely,

                                               /S/

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


Enclosure:
   Copy for § 6110 purposes



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