In two private letter rulings, the IRS ruled that two regulated utilities did not violate the consistency rule of the normalization requirements of rate-making.  Additionally, the IRS ruled that the proration method must be used when basing calculations of future period data, but that no normalization violation will occur if the taxpayer takes appropriate corrective actions.

Facts

In PLR 201741004, Taxpayer is a utility regulated by two commissions and determines its rates annually in accordance with a commission-approved formula that includes a basic rate and a true-up calculation for the prior calendar year. The basic rate is based on Taxpayer’s costs, including a provision for a return on the capital expended. All data for determining the rate is from the prior year, including data for the physical plant in service, accumulated depreciation and accumulated deferred federal income taxes (ADFIT).  Taxpayer then projects physical plant additions that will be placed in service that year and weights that amount to reflect the number of months of service that year. No adjustments are made to depreciation expense or deferred taxes as a result of this calculation.

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. Thus, Taxpayer has a substantial ADFIT balance attributable to accelerated depreciation reflected on its regulated books of account. In calculating basic and true-up rates, the ADFIT balance is based on the prior year’s ending balance. As no projections are used, Taxpayer neither averages nor applies the proration methodology to the ADFIT balance in either calculation.

Taxpayer has three state riders that update rates annually with the calculation, including a rider-projected rate and a true-up. All of the riders use a future test period. Changes in ADFIT balances are not prorated in the calculation of either component.

The Taxpayer in PLR 201741005 is similarly situated, but does not have any state riders.

Law and analysis

Section 168(f)(2) states that accelerated depreciation does not apply to any public utility property if the taxpayer does not use the normalization method of accounting. The normalization method of accounting requires a taxpayer to depreciate its public utility property when computing its tax expense for rate-making purposes, using a depreciation method that is not shorter than the method and period used to compute its depreciation expense for rate-making purposes. A taxpayer is not using the normalization method of accounting if it uses a procedure or adjustment inconsistent with the requirements Section 168(i)(9)(B)(i). Inconsistent procedures and adjustments include the use of an estimate or projection of the taxpayer’s tax expense, depreciation expense, or reserve for deferred taxes unless the taxpayer also uses the same procedure or adjustment for rate-making purposes.

In both rulings, the IRS determined that the additions to rate base for plant additions provide a return on the equity reflected in these projected physical plant additions. As no modification is made to depreciation expense or deferred taxes and Taxpayer’s tax expense, depreciation expense and ADFIT are all calculated in a consistent fashion, Taxpayer has not violated the Consistency Rule.

Additionally, for PLR 201741004, the IRS ruled the Taxpayer’s rider-projected rates are subject to the Proration Requirement under Treas. Reg. Section 1.167(l)-1(h)(6)(ii) because they use a future test period. The IRS ruled that any failure to use the proration formula will not be a normalization violation if the Taxpayer takes appropriate corrective actions. Further, Taxpayer's rider true-ups use a historical test period and are not subject to the Proration Requirement.

Implications

These rulings highlight the three components that must be calculated in the same fashion in order to satisfy the consistency rule as it applies to the normalization provisions. Before these rulings, confusion existed over what items must be calculated consistently to satisfy the rule. These rulings clarify that calculating a Taxpayer’s tax expense, depreciation expense and reserve for deferred taxes in the same fashion is sufficient to satisfy the consistency rule.

In addition, the first ruling follows earlier-issued Revenue Procedure 2017-47(see Tax Alert 2017-1492) in stating that failure to properly apply the proration formula to future period deferred tax balances will not result in a normalization violation if necessary corrective action is taken at the next available opportunity.

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