Cost of removal is excluded from the ARAM calculation returning a utility's TCJA excess deferred taxes to ratepayers

Plain-English summary

A regulated natural gas utility asked the IRS how the tax "normalization" rules apply to the way it returns to customers the excess deferred taxes created when the 2017 Tax Cuts and Jobs Act (TCJA) cut the corporate tax rate from 35% to 21%. When a utility uses accelerated depreciation on its property it must "normalize" the resulting deferred taxes, and after the rate cut it must return the excess reserve to ratepayers no faster than the Average Rate Assumption Method (ARAM) allows. The dispute was whether "cost of removal" (COR, the cost of eventually tearing down and disposing of utility property) should be part of the ARAM calculation. The utility's regulator had ordered a method that included COR; the utility argued COR should be excluded. The IRS ruled for the utility: COR is a section 162 deduction, not accelerated depreciation under section 168, so it is not protected by the normalization rules and should not be included in the ARAM calculation. It also ruled that the utility's temporary use of the regulator-ordered method (which included COR) is not a normalization violation, so long as the regulator approves a corrected method and lets the utility recover the difference in rates.

Ruling snapshot

• Question: Under the normalization rules, must "cost of removal" be excluded from the ARAM calculation used to return a utility's TCJA-created excess deferred taxes to ratepayers?
• Outcome: approved (rulings favorable to the utility: COR excluded from ARAM; no normalization violation)
• Key authorities: IRC § 168(i)(9), (f)(2); former IRC § 167(l); Treas. Reg. § 1.167(l)-1; TCJA § 13001(d) (Pub. L. 115-97); Rev. Proc. 2020-39

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202230005                                              Third Party Communication: None
 Release Date: 7/29/2022                                        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:
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                                                                CC:PSI:B06
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                                                                PLR-122708-21
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                                                                Date:
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 ------------------------------------------------------------   May 01, 2022
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LEGEND:

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

Taxpayer                  = -----------------------------------------------------------------------------

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

Commission 1              = ------------------------------------------------------------

Commission 2              = --------------------------------------------------------

Year A                    = -------------

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



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

        This letter responds to a request for a private letter ruling dated October 8, 2021,
and submitted on behalf of Taxpayer regarding § 168(i)(9) of the Internal Revenue Code
(Code), prior § 167(l) of the Code, and § 1.167(l)-1 of the Income Tax Regulations, and
Section 13001(d) of Pub. L. 115-97 (131 Stat 2054) (“ the TCJA”) (together, the
“Normalization Rules”), as applied to the calculation of the method used by Commission
2 in a recent rate proceeding to reflect federal income tax expense reductions for
PLR-122708-21                                 2

Taxpayer for excess deferred federal income taxes created by the corporate tax rate
reduction included in the TCJA.


FACTS:


       Parent is a State A corporation. Parent is the common parent of a consolidated
group that includes Taxpayer (a subsidiary of Parent). Taxpayer is also a State A
corporation. Taxpayer’s common stock is wholly owned by Parent through a different
subsidiary. The consolidated group, including Parent and Taxpayer, files its return on a
calendar year basis. Taxpayer is engaged is the business of supplying and delivering
natural gas to customers.

       For rate setting purposes, Taxpayer is under the jurisdiction of Commission 1
and Commission 2. Both regulators set the rates that Taxpayer charges its customers
on a cost-of-service rate of return basis – in which the regulators allow the Taxpayer to
charge an amount that will cover its costs of providing the energy and yield the
Taxpayer a predetermined rate of return on invested capital.

       Both Commission 1 and Commission 2 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 its federal income taxes deferred as a result of it claiming these deductions
in accordance with the Normalization Rules.

         Commission 1 has established the Uniform Systems of Accounts (“USOAs”),
prescribing the accounting rules which are used by most electric and gas utilities under
its jurisdiction. Taxpayer employs 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/gas] 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/gas] plant.
PLR-122708-21                                   3

        “service life” as the time between the date [electric/gas] plant is includible in
[electric/gas] plant in service, or [electric/gas] 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/gas] 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 an asset at the end of its life is incorporated into the annual
depreciation charge. Salvage Value and COR are, therefore, components of
establishing the applicable depreciation rate. The combined rate, including depreciation,
salvage, and COR, is considered the Composite Rate that is approved by Commission
2.

       Although the Composite Rate is approved by Commission 2 and includes each of
these items, COR and salvage rates are tracked separately from accumulated
depreciation in Taxpayer’s property-related deferred tax records. Taxpayer
distinguishes between COR book/tax differences and depreciation method/life
differences in their records even though both are included in Taxpayer’s depreciation
book rates and expense. Taxpayer’s property-related software system tracks the
reversals of these differences separately.

        In order to fund its future COR, Taxpayer estimates its 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 2 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 have a negative net salvage
value – which will increase the depreciation rate (i.e. total accumulated depreciation will
be greater than the value of asset). Alternately, if the net salvage value is positive it too
will be reflected in Taxpayer’s depreciation rate. Depreciation expense based on the
deprecation rate will then be utilized by Commission 2 in computing the allowable rates
for Taxpayer to charge its customers. In most cases the COR is more than the salvage
value and thus net salvage value is negative, increasing the Taxpayer's accumulated
depreciation account. When the COR is actually incurred, the amount expended is
charged to that same accumulated depreciation account, 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 as they fund the COR reserve – prior to the
time Taxpayer actually claims that benefit on its consolidated tax return.
PLR-122708-21                                4

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

       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 (2) its
deferred tax liability (DTL) related to method/life differences and the associated EDFIT
to be returned to customers, which included gross salvage value.

Taxpayer’s Recent Commission 2 Proceeding:

       In Year A Taxpayer filed an application with Commission 2 to set its rates for
Period A. Upon the enactment of the TCJA, Taxpayer updated its filing with
Commission 2 to reflect the impact of the lowered corporate tax rate. Among the
impacts considered by Commission 2 was the proper computation of the Average Rate
Assumption Method (ARAM) used to determine the timing of the return of the EDFIT to
ratepayers. Specifically, when computing ARAM (as per TCJA Section 13001(d)(3)(B)),
whether the COR should be included or not. Ultimately, Commission 2 and Taxpayer
did not reach an agreement on the inclusion of COR into the ARAM and the resulting
disagreements relating to the COR-related EDFIT.

       In summary, Commission 2’s proposed method of computing the return of EDFIT
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 EDFITR to customers) than under
the computational method proposed by Taxpayer. (Taxpayer’s proposed method did not
include COR in the ARAM calculation.) Commission 2 adopted its method of computing
the return of EDFIT in its Period A decision. Despite the disagreement, Commission 2
emphasized that it intended for Taxpayer to comply with the Normalization Rules at all
times and found it prudent and reasonable to allow Taxpayer to seek recovery in the
event the Internal Revenue Service issued a ruling or other guidance clarifying that
COR should be excluded from ARAM calculations in these circumstances. Commission
2 recommended that Taxpayer seek a private letter ruling.


RULINGS REQUESTED:


   1) Whether, under the circumstances described above, Commission 2’s method of
      including book COR in the calculation of ARAM for the return of the EDFIT to
      ratepayers is inconsistent with the Normalization Rules?
PLR-122708-21                                5

   2) Whether, under the circumstances described above, the method proposed by
      Taxpayer excluding book COR from the ARAM calculation for return of the
      EDFIT to the ratepayers is consistent with the Normalization Rules?

   3) Whether, under the circumstances described above, if the Service rules that the
      method proposed by Commission 2 is inconsistent with the Normalization Rules,
      Taxpayer’s use of the method proposed by Commission 2 as provided in
      Commission 2’s Period A decision, will not be a violation of the Normalization
      Rules, provided Commission 2 (i) approves the method proposed by Taxpayer
      (or otherwise required by the Service) and (ii) allows Taxpayer to recover any
      difference in the rates charged to customers under Commission 2’s proposed
      method and Taxpayer’s method, as provided in Commission 2’s Period A
      decision?


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
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
PLR-122708-21                                         6

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 1 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.

       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.



1
  ETR is used in section 13001 to refer to that portion of the reserve for deferred taxes described in §
168(i)(9)(A)(II) that is determined by the decrease in the corporate tax rate by the TCJA. It is sometimes
referred to herein as EDFIT.
PLR-122708-21                                  7

        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,
which is deductible under § 162. Moreover, there is no acceleration of taxes for COR
that inures to the benefit of the utility company initially but must be reflected in a reserve
and returned pro-rata to ratepayers, but rather, a deferral of the payment of those taxes.
While COR may be a component of the calculation of the amount treated as book
depreciation, it is a deduction under § 162 and not, like actual accelerated tax
depreciation, under § 168. 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.

       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 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, COR related amounts are not used in the computation of the ETR.

       Because of their similarity, we address requests 1 and 2 together. As discussed
previously, ARAM is the required method for the reduction/reversal of the ETR.
Because COR is not included in the ETR, COR should not be included in the ARAM
calculations to return the ETR to ratepayers under the Normalization Rules.

        The third Issue requires that we consider the question of whether, under these
facts, the inclusion of COR in the ARAM calculation as directed by Commission 2 in its
Period A decision constitutes a normalization violation.

         Section 4.01(6) of Rev. Proc. 2020-39, 2020-36 I.R.B. 546, provided transition
rules due to the reality that many utilities had already been required to adjust rates due
to the TCJA. According to this provision in Rev. Proc. 2020-39, “[u]tilities may correct
any method of reversing ETR that is not in accord with this revenue procedure at the
next available opportunity. The methods adopted prior to the publication of this revenue
procedure that are not in accord with this revenue procedure are not considered to be a
violation of the Normalization Rules if so corrected. This corrective action will require the
utility to consult with its regulator and obtain its regulator’s consent. Utilities are not in
conflict with section 13001(d) of the TCJA if the utilities follow such a path to correct
potential normalization violations prospectively. These rules extend to companies that
may not have started the amortization of ETRs or may be re-deferring the amortization
as they evaluate their records.”

      Additionally, § 168(f)(2) itself provides that the depreciation deduction determined
under § 168 shall not apply to any public utility property (within the meaning of §
PLR-122708-21                                8

168(i)(10)) if the taxpayer does not use a normalization method of accounting. However,
in the legislative history to the enactment of the normalization requirements of the
Investment Tax Credit (ITC), Congress has stated that it hopes that sanctions will not
have to be imposed and that disallowance of the tax benefit (there, the ITC) should be
imposed only after a regulatory body has required or insisted upon such treatment by a
utility. See Senate Report No. 92-437, 92nd Cong., 1st Sess. 40-41 (1971), 1972-2 C.B.
559, 581.

       Commission 2 has not required or insisted upon treatment by Taxpayer that it
knows is noncompliant with the Normalization Rules. Rather, Commission 2 recognized
that the matter was not clear at the time and recommended that Taxpayer seek a ruling
from the Service. Further, Commission 2 has directed Taxpayer to comply with the
Service’s interpretation of the applicable tax laws by filing with Commission 2 to seek an
appropriate adjustment to its revenue requirement and/or rate base in the event that
Taxpayer requests and receives a private letter ruling from the IRS.

      Taxpayer's failure to comply with the Normalization Rules was inadvertent.
Because Commission 2, as well as Taxpayer, has at all times sought to comply, and
because corrective actions will promptly be taken, Taxpayer's use of the method
proposed by Commission 2 does not constitute a normalization violation.


CONCLUSIONS:


   Based on the foregoing, we conclude as follows:

   1) Commission 2’s method of including COR in the ARAM for the return of the
      EDFIT to ratepayers is inconsistent with the Normalization Rules.

   2) Taxpayer’s method of excluding COR from the ARAM computation for return of
      the EDFIT to ratepayers is consistent with the Normalization Rules.

   3) As stated in Conclusion 1, the method proposed by Commission 2 is inconsistent
      with the Normalization Rules. However, Taxpayer's use of the method proposed
      by Commission 2 as reflected in Commission 2’s Period A decision, is not a
      violation of the Normalization Rules, provided Commission 2 (i) approves the
      method proposed by Taxpayer (or otherwise required by the Service) and (ii)
      allows Taxpayer to recover any difference in the rates charged to customers
      under Commission 2's proposed method and the Taxpayer's method.

       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-122708-21                                  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,

                                                   /s/

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




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