In PLR 202009014, the IRS ruled that a public utility partnership would not violate the normalization rules under IRC Section 168(i)(9) and Treas. Reg. Section 1.167(l)-1 by not adjusting its accumulated deferred federal income tax (ADFIT) balances to account for IRC Section 743(b) basis adjustments resulting from mergers.

The normalization rules govern how utilities can set their rates incorporating certain tax incentives. Utilities that do not comply with the normalization rules are not eligible for the incentives, such as accelerated depreciation, which reduce taxable income. Accelerated depreciation creates a book to tax difference in the basis of depreciable property that results in deferred income taxes, which impact the ratemaking process. Various transactions, such as acquisitions or mergers, affect the tax basis, impact the book-tax difference, and subsequently the utility rates.

In the instant case, the transaction increased tax basis at the partner level and not at the partnership level. Because the regulated utility rates were determined at the partnership level, these adjustments to tax basis were not required to be taken into account. As long as the transaction did not affect the tax basis at the partnership level, nothing changed the partnership's tax basis, so the transaction did not affect the rates and the partnership did not have to adjust how it calculated its rates.

Facts

Taxpayer is a partnership and owns a percentage of Disregarded Entity, which is a member of LLC. LLC owns regulated electricity transmission facilities and electricity distribution substations. Following the merger transactions described in PLR 202009014, LLC became wholly owned by Disregarded Entity. Acquirer, on behalf of LLC, operated the electricity transmission facilities and distribution substations under an operation and service agreement. The rates for the transmission and distribution services are established under traditional ratemaking on a cost-of-service, rate-of-return basis. Although LLC was taxed as a partnership, LLC maintained accumulated deferred federal income tax (ADFIT) on its regulatory books of account as an entity in the same manner as if it were a corporation.

Merger Sub is a wholly-owned subsidiary of Acquirer (a partnership) and Acquirer Affiliate is an indirectly wholly-owned subsidiary. Merger Partnership and Acquirer Affiliate are limited partnerships formed by Acquirer in connection with the merger transactions.

After the merger transactions, Taxpayer represents the following:

• Both the REIT Merger (in which the REIT that was a general partner of Taxpayer merged with Merger Sub) and the Partnership Merger (in which the Merger Partnership merged with and into Taxpayer, with Taxpayer surviving) are properly treated as "a transfer of an interest in a partnership" under IRC Section 743(b).
• Acquirer intends to cause Taxpayer to make an election under IRC Section 754 effective for the tax year that includes the mergers.
• Acquirer will be entitled to a special basis adjustment for the Taxpayer's property under IRC Section 743(b).
• LLC recorded an ADFIT liability balance consistent with the normalization method of accounting, which reduces its regulatory rate base.
• Any IRC Section 743(b) tax basis adjustments resulting from the mergers and the depreciation of those adjustments will not change or otherwise affect LLC's public utility property for ratemaking purposes and will not be associated with LLC's cost-of-service, rate-of-return ratemaking.
• Neither the mergers nor the IRC Section 743(b) basis adjustments will result in any adjustment to the net book value of, or ADFIT liability attributable to, such property on LLC's (or Taxpayer's) regulatory books of account.

Law and analysis

Under IRC Section 168(f)(2), accelerated depreciation does not apply to public utility property if a utility does not use the normalization method of accounting.

Under IRC Section 168(i)(9)(A)(i), 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.

A utility is not using the normalization method of accounting if it uses a procedure or adjustment inconsistent with the requirements of IRC Section 168(i)(9)(B)(i). Under IRC Section 168(i)(9)(B)(ii), 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.

Taxpayer requested a ruling that it will not violate the normalization rules by not adjusting the existing ADFIT balances to account for the consequences of IRC Section 743(b) basis adjustments resulting from the mergers.

In making its conclusion, the IRS said Taxpayer is a public utility and the rates are regulated (established or approved on a rate-of-return basis). The IRS said "there must be consistency in the treatment of costs for rate base, regulated depreciation expense, tax expense, and deferred tax revenue purposes." The normalization rules would be violated if the federal income tax component of cost of service reflected depreciation of Taxpayer's costs that are not included in rate base or the depreciation component of cost of service. Not adjusting the ADFIT balances in this case, however, would not violate the normalization rules, the IRS concluded. The IRS added that the ruling "is expressly conditioned" on the Taxpayer's representation that any IRC Section 743(b) tax basis adjustments resulting from the mergers, and the depreciation of those adjustments, will not change or impact LLC's public utility property for ratemaking purposes and will not be associated with LLC's cost-of-service, rate-of-return ratemaking.

Implications

The ruling is consistent with PLR 201816005 regarding partnership restructuring (see Tax Alert 2018-0895). As in the previous ruling, this IRS ruling is beneficial to Taxpayer. If the normalization rules had been found to be violated, the use of accelerated depreciation would not have been allowed.

When dealing with business transactions (such as acquisitions or mergers), care must be taken in determining the transaction's effect on the ADFIT included in rate base. For example, in an IRC Section 338(h)(10) deemed asset sale, the assets' tax basis is stepped up to fair market value, which reduces the utility's ADFIT. In contrast, the basis adjustments resulting from the merger in PLR 202009014 occurred at the partner level, not at the partnership level, so the tax basis in the utility's assets and its ADFIT remain unchanged. Understanding the nature of the transaction and the entities balance sheet accounts is crucial to applying the normalization rules.

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