In PLR 201717008, the Service has ruled that a utility's test periods for its transmission-projected rate and rider-projected rate are future test periods, so the utility is subject to the proration requirement of Reg. Section 1.167(l)-1(h)(6).

Facts

Taxpayer is a utility regulated by two commissions (Commission A and B) and determines its rates annually in accordance with a commission-approved formula that includes a transmission-projected rate and a true-up calculation for the prior calendar year. Taxpayer also applies a 13-month average to all elements of the rate base, except for accumulated deferred federal income tax (ADFIT).

Taxpayer claims accelerated depreciation on all of its public utility property to the full extent the deductions are available under the Code. Taxpayer also normalizes the federal income taxes deferred as a result of claiming the deductions in accordance with the normalization rules for purposes of Commission A. Thus, Taxpayer has a substantial ADFIT balance attributable to accelerated depreciation reflected on Taxpayer's Commission A regulated books of account.

To compute the transmission rate base, Taxpayer calculated the ADFIT balance by which it reduced the rate base by using a simple average of the beginning and ending balances for the rate year. Taxpayer did not use a proration methodology, which is required for future test periods under Reg. Section 1.167(l)-1(h)(6).

Additionally, Commission B allows Taxpayer to use riders to recover its costs for certain investments taken into account outside of a base rate case. For the riders, Taxpayer tracks the ratemaking elements and revenues are trued-up.

Each year, Taxpayer resets its rider rate and the new rate is effective on a specific date of the same year of the request and remains in effect for 12 months. The calculation includes a rider projected rate and a true-up. All of the riders use a future test period.

Like the transmission ratemaking, Taxpayer normalizes the federal income taxes deferred as a result of claiming accelerated depreciation in accordance with the normalization rules, as required by Commission B, for purposes of the rider ratemaking. Therefore, Taxpayer has a substantial ADFIT balance that is attributable to accelerated depreciation reflected on its state regulated books of account.

To calculate the rider rate base, Taxpayer calculated the ADFIT balance by which it reduced the rate base by using a simple average of the beginning and ending balances for the relevant rate month. Taxpayer did not use the proration methodology required for future test periods.

After the Service published several rulings that addressed ratemaking similar to Taxpayer's, the tax department concluded that Taxpayer was subject to the proration methodology when calculating the ADFIT balance it used to offset the rate base.

Taxpayer represents that it will initiate the measures necessary to conform to the normalization rules once the Service clarifies what measures are required for Taxpayer to conform its formulas to the normalization rules.

Analysis

Test periods

The Service ruled that the test periods for the Taxpayer's transmission-projected rate and rider-projected rate are future test periods that are subject to the proration requirement of Reg. Section 1.167(l)-1(h)(6). Taxpayer also must apply the proration formula to determine ADFIT for purposes of computing the rate base in those ratemakings.

The Service determined, however, that the test periods for the true-ups are historical because the test periods occur before the effective date of the rates, which result from the true-up calculations. Thus, the Service concluded that the proration formula does not apply to the true-ups.

Additionally, the Service ruled that, when averaging conventions are applied to entirely future test periods, the averaging conventions should be treated presumptively as having the same purpose as the proration requirement and, therefore, the conventions do not have to apply serially to changes in the ADFIT balances. The Service also concluded that Taxpayer's calculation of the average rate base and ADFIT complies with the consistency requirement of Section 168(i)(9)(B) because "both are determined by averaging and both are determined over the same period of time." It is not necessary for Taxpayer to use the same averaging convention it used in computing other elements of the rate base in computing the ADFIT balance for purposes of the transmission formula rate.

True-ups and proration

Regarding the true-ups, the Service determined that Taxpayer does not have to use the proration formula to calculate the differences between the projected ADFIT balance and the actual ADFIT balance because the true-up component is determined by reference to a historical period. To calculate the true-up, the Service noted that "proration applies to the original projection amount but the actual amount added to the ADFIT over the test year is not modified by application of the proration formula."

The Service also ruled that the normalization rules do not require Taxpayer to apply the proration methodology to a historical test period, such as a true up, and, therefore, "not applying the proration methodology to the variation between the projected and actual ADFIT balances is permissible under the [n]ormalization [r]ules." In addition, the Service concluded that, if a regulatory body determines "that proration of variations between projected and actual ADFIT is necessary to accurately reflect the changes captured by the true-up ratemaking" and the use of proration will not result in the impermissible flow-through of accelerated depreciation-related benefits, proration is permissible under the normalization rules. Thus, in the case of an over-projection in the transmission-projected rate and rider-projected rate of an increase or decrease in Taxpayer's ADFIT balance, Taxpayer may reverse the prorated ADFIT used to calculate the transmission-projected rate and rider-projected rate to the extent of the over-projection. Taxpayer also may choose to reflect the non-prorated change in the ADFIT balances.

Penalties

Because Commissions A and B, as well as Taxpayer, sought to comply with the normalization rules and because Taxpayer plans to take corrective action, the Service ruled that there is no need to deny the Taxpayer accelerated depreciation. Accordingly, the Service concluded that, if Taxpayer reduced the rate base by an amount in excess of the limitation in Reg. Section 1.167(l)-1(h)(6) because it failed to conform to the proration requirement, "any such failure by Taxpayer in any year prior to taking the necessary corrective action was not a violation of the [n]ormalization [r]ules."

Implications

There are three takeaways from this ruling. First, this ruling clarifies that taxpayers using the proration methodology for future test periods do not need to both apply the proration methodology and the averaging conventions to comply with the consistency rules. Prior rulings had included language implying that taxpayers were using the proration methodology and then applying the averaging conventions to the prorated amounts to comply with the normalization rules.

Secondly, when employing a true-up mechanism, taxpayers do not need to apply the proration methodology when looking back to true up the deferred balances. Doing so would cancel out the effects of the proration methodology once the true-up was done. Instead, the taxpayer would simply look at the changes in the deferred balances and apply the appropriate averaging convention to arrive at the incremental adjustment.

Thirdly, the Service ruled that, because the error in computation was inadvertent and would be corrected at the first available opportunity, there was no violation of the normalization rules. In prior rulings, the Service has indicated that, even though there was failure to conform, no penalties would be imposed. This distinction is important because it indicates that, absent a willful violation, no violation has likely occurred. In contrast, past rulings indicated a violation had occurred but that penalties were not warranted.

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