In PLR 201816005, the IRS ruled that a public utility's restructuring transaction did not violate normalization rules since the federal deferred tax balances recovered for ratemaking purposes did not include Section 743(b) partnership basis adjustments, resulting in no impact to cost of service or rate base.

Facts

Taxpayer is an electric transmission utility operating in multiple states and regulated by two regulators. Taxpayer is taxed as a partnership and is owned by various investors, including investor-owned utilities (IOUs). Taxpayer uses accelerated depreciation and a normalization method of accounting for its public utility property.

For ratemaking purposes in accordance with Regulator 1 policy, Taxpayer calculates deferred tax expense and accumulated deferred federal income tax (ADFIT) consistent with the normalization method of accounting. For ratemaking purposes, deferred tax expense is recovered in Taxpayer's cost of service and ADFIT is an offset to Taxpayer's rate base.

In Year 1, Taxpayer restructured its business, transferring business development activities relating to jurisdictions outside Taxpayer's traditional footprint to Development Company. Investors in Taxpayer that also invested in Development Company own their interest in Development Company through Holding Company.

To approve the restructuring, Regulator 2 required certain of Taxpayer's IOU members to transfer their Taxpayer partnership interests to affiliated nonregulated entities. The transfers were made to affiliated entities in the respective members' consolidated federal income tax groups. As Taxpayer had a Section 754 election in effect, the transfers were treated as "exchanges" for Section 743(b) purposes. Thus, Taxpayer made Section 743(b) basis adjustments to its assets for the benefit of the transferee partners (the non-regulated affiliates) at the time of the transfers. Taxpayer represented that no transfer of Taxpayer assets took place.

Any IOU member's gain resulting from the transfers remains deferred for as long as the IOU member's transferred interest remains within its respective consolidated groups. In accordance with the matching rule in Treas. Reg. Section 1.1502-13(c) of the consolidated return regulations, the deferred intercompany gain will be recognized as the Taxpayer allocates to the non-regulated affiliates depreciation and amortization deductions attributable to the Section 743(b) basis adjustments.

Taxpayer made several representations:

— Taxpayer retained all public utility property assets at all times before, during, and after the transaction.

— The Section 743(b) adjustments are not increases in the basis of the property on Taxpayer's regulated books.

— The Section 743(b) adjustments and the depreciation of those adjustments do not change Taxpayer's public utility property for ratemaking purposes and are not associated with Taxpayer's cost of service ratemaking.

— The members of the consolidated group will treat the transaction consistent with Treas. Reg. Section 1.1502-13.

— The transfers of interests in Taxpayer do not result in a disparity between the partners' basis in their interests in Taxpayer and Taxpayer's basis in its assets.

— The IOU intercompany transfers did not result in a termination of Taxpayer under Section 708(b)(1)(B).

Regulator 1 approved Taxpayer's reorganization, conditioned on Taxpayer's representations, including Taxpayer's commitment to hold customers harmless from any transaction-related costs.

Law and analysis

Under Section 168(f)(2), accelerated depreciation does not apply to any public utility property if a utility does not use the normalization method of accounting. The normalization method of accounting requires a utility to depreciate its public utility property when computing its tax expense for ratemaking purposes using a depreciation method that is not shorter than the method and period used to compute its depreciation expense for ratemaking purposes.¹ A utility is not using the normalization method of accounting if it uses a procedure or adjustment inconsistent with the requirements of Section 168(i)(9)(B)(i). Inconsistent procedures and adjustments include the use of an estimate or projection of a utility's tax expense, depreciation expense or reserve for deferred taxes unless a utility also uses the same procedure or adjustment for ratemaking purposes.²

The IRS ruled that no normalization violation will occur if Taxpayer does not adjust existing ADFIT balances to account for the consequences of the Section 743(b) basis adjustment resulting from Taxpayer's restructuring transaction. The IRS noted that the ruling was expressly conditioned upon Taxpayer's representation that the restructuring transaction will not impact Taxpayer's public utility property for ratemaking purposes.

Implications

This ruling provides welcomed guidance that, in the context of a partnership holding regulated utility assets, Section 743(b) basis adjustments are not required to be considered as tax basis in the regulated utility assets subject to the normalization requirements under Section 168(f)(2). While the conclusion was the expected result, having clarity around the IRS's view of partnership basis adjustments as a result of restructuring transactions helps eliminate some uncertainty in the application of the normalization rules.

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ENDNOTES

¹ Section 168(i)(9)(A)(i).

² Section 168(i)(9)(B)(ii).