August 17, 2020
IRS rules on the application of the normalization rules for a utility company with respect to cost of removal and certain accounting method changes
The IRS ruled in PLR 202033002 that the normalization rules do not apply to a regulated gas and electric company's excess deferred taxes associated with either cost of removal (COR) or with mixed service costs that were capitalized after an IRC Section 481(a) change in tax method of accounting.
In so finding, the IRS said the average rate assumption method (ARAM) did not have to be applied to: (1) excess deferred income taxes (EDIT) resulting from book/tax differences related to COR; or (2) EDIT related to accumulated deferred federal income tax (ADFIT) balances attributable to mixed service costs (indirect overhead costs) that were capitalized into the depreciable tax basis of the public utility property prior to a change in tax method of accounting reclassifying the costs as current deductions.
Taxpayer is a regulated electric and gas utility company. A Commission establishes Taxpayer's rates based on its costs, including a return on the capital
Taxpayer has a substantial balance of ADFIT attributable to accelerated depreciation reflected on its regulated books of account and has reduced its rate base by its ADFIT balance. COR is a normalized expenditure and is a component of book depreciation, which is factored into customer rates. From a tax perspective, the costs are deductible when the asset is removed from service. Thus, the inclusion in book depreciation creates a deferred tax asset (DTA) representing the future benefit from the eventual COR tax deduction and is included in Taxpayer's overall plant-related ADFIT account.
The COR included in depreciation expense is an estimate, with a variance from the estimate recorded on Taxpayer's balance sheet. If the estimate is wrong, it could create a net credit or debit to the Taxpayer's accumulated depreciation account. "This treatment means that Taxpayer will recover under-accruals from customers and refund over-accruals to customers through future rate adjustments," according to the IRS. "An over-accrual produces a DTA (the tax benefit of a future deduction due to the refund of the excess collection) while an under-accrual produces a deferred tax liability 'DTL' (the tax cost of future taxable income due to the collection of the shortfall)," the IRS said.
Due to the TCJA, and the change in the corporate tax rate from 35% to 21%, Taxpayer will not recover the 14% excess tax it paid on its recovery of the COR component of book depreciation and will not pay the 14% excess deferred tax it accrued on its obligation to refund over-accrued COR.
Taxpayer requested a change in method of accounting to depart from the book method for certain capitalized costs. Before the change, Taxpayer capitalized mixed service costs in the same manner for both book and tax purposes. After requesting permission to change, Taxpayer had to recharacterize a substantial quantity of mixed service costs that Taxpayer had previously capitalized into depreciable assets as deductible costs. This resulted in Taxpayer's claiming a deduction under IRC Section 481(a) to remove from the tax basis of its existing assets all such recharacterized costs to the extent Taxpayer had not previously depreciated them.
Taxpayer filed with the Commission to adjust both its electric and gas rates as a result of reclassifying the EDIT related to these changes from protected to unprotected.
Law and analysis
IRC Section 481(a) requires an adjustment in the current year to prevent amounts from being duplicated or omitted when a taxpayer computes its taxable income under a method of accounting different from the method used to compute its taxable income for the preceding tax year(s).
When an IRC Section 481(a) change in accounting method occurs, 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 then employed. Conversely, income for the year of change and the following tax years must be determined under the new method of accounting, as if the taxpayer had always used the new method.
Under IRC Section 168(f)(2), the depreciation deduction determined under IRC Section 168 does not apply to any public utility property if the taxpayer does not use a normalization method of accounting.
IRC Section 168(i)(9)(A)(i) requires that to use a normalization method of accounting, the taxpayer, in determining its tax expense for ratemaking and operations purposes, use the same depreciation method, and one that is not shorter in period than the method and period used to compute its depreciation expenses.
The IRS said generally, Treas. Reg. Section 168(i)(9)(A) does not refer to COR. Thus, the COR-related amounts are not "protected" by the normalization rules. The IRS said COR is a deduction under IRC Section 162 and not related to actual accelerated tax depreciation. As a result, the IRS ruled the normalization rules do not apply to Taxpayer's (1) electric distribution COR-related net DTL, (2) gas distribution COR-related net DTA accumulated through the depreciation rate, and (3) gas distribution COR-related net DTL accumulated through the fixed estimated cash recovery.
In addition, the IRS ruled that the deduction for mixed service costs is not related to depreciation and is not subject to normalization. As a result, the method of accounting change applies to the historic treatment of mixed service costs such that the depreciation-related ADFIT existing prior to the year of change does not remain subject to the normalization method of accounting within the meaning of IRC Section 168(i)(9) after the implementation of the new method of accounting.
The taxpayer in this situation was able to reclassify certain amounts of EDIT from protected to unprotected, allowing for it to provide rate relief to its customers more rapidly. In the current economic situation facing the country, taxpayers may wish to proactively determine if they potentially have a similar situation to propose to regulators. Alternatively, taxpayers may wish to understand the potential arguments intervenors could raise in response existing rate negotiations.