In two substantially similar private letter rulings (PLR 201824005 and PLR 201824006), the IRS ruled that a public utility's restructuring transaction did not violate normalization rules because it is satisfied that the liability created by the transaction is unrelated to the relinquished properties' accumulated deferred federal income tax (ADFIT), and thus, its regulatory treatment is beyond the scope of the normalization rules.

Facts

For simplicity, the facts of the two rulings are combined here. Taxpayer A is a partnership that, in the course of owning a regulated electricity transmission and distribution system, provides distribution services to retail electric providers that sell electricity to consumers and provides transmission services to other electricity distribution companies, cooperatives, municipalities and retail energy providers.

Taxpayer B also owns a regulated electricity transmission and distribution system, but leases it to Partnership, which provides distribution services to retail electric providers that sell electricity to consumers and provides transmission services to other electricity distribution companies, cooperatives, municipalities and retail energy providers. Both taxpayers and Partnership are subject to the regulatory jurisdiction of Regulator for ratemaking.

Taxpayer A, Taxpayer B and Partnership entered into a Plan of Merger, under which Taxpayer A will transfer certain electricity transmission facilities (Taxpayer A assets) to Taxpayer B, and Taxpayer B will transfer electricity distribution facilities and certain of its electricity transmission facilities (Taxpayer B assets) to Taxpayer A (Merger Agreement).

To fulfill the agreement, Taxpayer A will transfer the Taxpayer A Assets to Taxpayer A LLC, a wholly owned disregarded entity and Taxpayer A will be deemed to continue to own the Taxpayer A Assets for federal income tax purposes. Taxpayer B will do the same with the Taxpayer B assets to Taxpayer B LLC.

Next, in what is expected to be treated as a Section 1031 like-kind exchange, Taxpayer A, LLC will merge with and into Taxpayer B, with Taxpayer B as the surviving entity. As a result, Taxpayer B will become the direct owner of the Taxpayer A Assets. Since Taxpayer A, LLC is disregarded, Taxpayer A will be deemed to transfer the Taxpayer A Assets to Taxpayer B. Simultaneously, Taxpayer B, LLC will merge with and into Taxpayer A, with Taxpayer A as the surviving entity. Taxpayer A will also pay cash to Taxpayer B and Taxpayer A will become the direct owner of the Taxpayer B Assets. Taxpayer B will be deemed to transfer the Taxpayer B Assets to Taxpayer A. As a result of the cash, Taxpayer B, and possibly Taxpayer A, are expected to have some amount of "exchange group deficiencies" or "exchange group surpluses" within the meaning of Treas. Reg. Section 1.1031(j)-1(b)(4) and thus may recognize some amount of taxable gain in the like-kind exchange.

Both taxpayers will record the new assets with the same regulatory net book value as immediately before the like-kind exchange.

Before the transaction, each taxpayer claimed accelerated depreciation and recorded an ADFIT reserve to reflect the resulting deferral of federal income taxes and for other temporary differences for its public utility assets. Both taxpayers propose to remove from their regulated books of account the amount of ADFIT attributable to the transferred assets and will increase a non-operating income account in the amount of the ADFIT reserve so removed. As Taxpayer A and Taxpayer B recover the book-carrying value of the replacement property in rates, they will have to pay the Taxpayer A Liability and Taxpayer B Liability, respectively, to the government.

Taxpayer A represents that its accounting entries accord with GAAP applicable to rate-regulated enterprises and, Taxpayer A has concluded that it will not collect the Taxpayer A Liability from customers. Thus, Taxpayer A does not anticipate establishing a regulatory asset. As a result, Taxpayer A's post-like-kind exchange rate base computation will be reduced by its Taxpayer A Liability balance in addition to any additional ADFIT balances that are created after the transaction.

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, as it is satisfied that the Taxpayer A Liability is unrelated to the relinquished properties' ADFIT, and thus, its regulatory treatment is beyond the scope of the normalization rules.

Implications

This rulings go one step further in analyzing the normalization rules as applicable to Section 1033 transactions. The IRS ruled in PLRs 201532024 and 201532025 that the historic deferred tax liability (DTL) must be removed once the asset is disposed. The current rulings apply this logic but also examine whether a liability for the future DTL that is recorded is subject to the normalization rules. In the current rulings, the historic DTL is written off through the P&L and the future liability is recorded through the P&L as incurred, thus a permanent item. The rulings conclude that this new liability is not subject to normalization. Utilities contemplating like-kind exchanges or similar gain deferral transactions should take care that the proper accounting entries are recorded to clearly show the normalization rules are being followed as articulated in these rulings.

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ENDNOTES

¹ Section 168(i)(9)(A)(i).

² Section 168(i)(9)(B)(ii).