March 17, 2020 IRS rules that public utility's change in method of accounting results in accumulated deferred income tax no longer being subject to normalization In PLR 202010002, the IRS ruled that the normalization rules no longer apply to a public utility's accumulated deferred income tax (ADIT) following a change in method of accounting and the resulting IRC Section 481(a) adjustment (in this case attributable to repairs) because the ADIT is now associated with repairs instead of accelerated depreciation. In so finding, the IRS disagreed with Taxpayer's assertion that the "historic" ADIT (i.e., the ADIT value before the accounting method change) was still subject to normalization. The IRS also ruled that a net operating loss carryover (NOLC) is not required to be considered in the surcharge rate calculation because the accelerated depreciation in prior years that led to the NOLC was not used in computing the surcharge rates. Facts Taxpayer is an affiliate of a water and wastewater utility company. Taxpayer's prices are set by Commission, which sets base rates and infrastructure surcharge proceedings (which result in surcharges added to base rates). Water corporations may petition Commission for an infrastructure system replacement surcharge (surcharge) to recover the costs of eligible water utility main replacements and relocations. Taxpayer requested a surcharge rate to recover its costs in making these replacements (surcharge case) in periods between base rate proceedings (an interim rate proceeding). In addition, Taxpayer filed a change in method of accounting to claim a tax deduction for the repairs, with a resulting adjustment under IRC Section 481(a). Taxpayer had carried a net operating loss into the year in which the surcharge filing occurred. In determining its proposed surcharge, Taxpayer reduced its ADIT by its NOLC, which it believed the normalization rules required. This resulted in a higher surcharge, and, corresponding, a higher overall rate. The Commission disagreed with Taxpayer's approach on the grounds that surcharge calculations do not include financial information from prior periods, which the NOLC represented. As such, it excluded the NOLC from the surcharge calculation. This resulted in a lower surcharge and, correspondingly, a lower overall rate than Taxpayer requested. Law 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. When there is a change in method of accounting under IRC Section 481(a), Revenue Procedure 97-27, Section 2.05(1) requires income for the tax year preceding the year of change to be determined under the method of accounting that was used then; income for the year of change and the following tax years must be determined under the new method of accounting as if the new method had always been used. A repair expense is deductible under IRC Section 162 and may not be depreciated. Analysis Taxpayer argued that, for any public utility property subject to a change in tax accounting method for repairs and dispositions, the normalization method of accounting applies to the depreciation-related ADIT before and after the change. In other words, the historic deferred tax liability associated with the property would maintain its characteristic as depreciation-related, and the incremental deduction under the IRC Section 481(a) adjustment would be attributable to repairs, not subject to normalization. The IRS disagreed, finding that the portion of the ADIT attributable to the pre-change period is not subject to the normalization method of accounting. Instead, the IRS viewed the ADIT attributable to the pre-change period and the incremental ADIT resulting from the method change to all be attributable to the new tax method of accounting (i.e., repairs). Because depreciation is not allowed for repair expenses, the ADIT resulting from the repair-related IRC Section 481(a) adjustment is not subject to the normalization method of accounting. The IRS also found the normalization method of accounting does not apply to ADIT from property expenditures that are (1) includible in the rate base and recoverable as regulatory depreciation expense when determining the revenue requirement in the surcharge case; and (2) deducted as repairs for tax purposes. The IRS further found that the change resulted in the add-back of certain assets that were previously disposed for tax purposes (because a repair is not a replacement). As a result, normalization applies to assets that are restored to the tax depreciation records and will be depreciated. The IRS also ruled that the NOLC did not have to offset ADIT in the surcharge case because the accelerated depreciation that resulted in the creation of the NOLC occurred in a prior period, before the interim surcharge case. Only the deferred tax effects related to the income, expenses, and rate base included in the surcharge case had to be considered. If the activity of the surcharge rate calculation creates an NOLC, that would need to be considered the extent it relates to accelerated depreciation (the with-and-without method). Implications There is an increasing use of interim rate proceedings such as the surcharge in this case, so understanding how to handle ADIT and NOLCs is important for taxpayers to comply with the normalization rules. Changes in accounting method are fairly common, and this ruling provides some clarity around how to consider the resulting ADIT associated with an IRC Section 481(a) adjustment for purposes of the normalization rules. The clarity provided in this ruling may allow taxpayers and utility commissions to more easily agree on the deferred tax impacts to rate proceedings if either an interim rate proceeding or an accounting method change is part of the rate proceeding. ———————————————
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