July 2, 2021
IRS rules that normalization rules do not protect cost of removal
In PLR 202124003, the IRS ruled that the normalization rules do not apply to a regulated gas and electric company's net deferred tax asset (DTA) related to the cost of removal (COR). Accordingly, the company does not have to comply with certain depreciation rules and can recover the effects of a tax rate deduction under the Tax Cuts and Jobs Act (TCJA) with respect to COR in any manner on which the taxpayer and the commission agree.
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 (rate of return).
Taxpayer has claimed accelerated depreciation and normalized the federal income taxes deferred under the normalization rules. Consequently, Taxpayer has a substantial balance of accumulated deferred federal income taxes (ADFIT) attributable to accelerated depreciation reflected on its regulated books.
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 and the removal costs are incurred. Taxpayer reports the customer payments that fund the COR reserve as taxable income over the operating life of the asset, claiming an offsetting tax deduction only at the end of the asset's life. Recovering COR through rates before the applicable tax deduction can be claimed creates a deferred tax asset (DTA).
In its accounting, Taxpayer distinguishes between COR book/tax differences and depreciation life/method differences. In response to a Commission inquiry of how the TCJA changing the corporate tax rate from 35% to 21% would impact rates, Taxpayer calculated its excess tax reserve (ETR) after the change. In computing its ETR, Taxpayer contended that COR is not subject to the normalization rules because it is not a depreciation life/method difference.
Law and analysis
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.
To use a normalization method of accounting, the taxpayer must, under IRC Section 168(i)(9)(A)(i), use the same depreciation method in determining its tax expense for ratemaking and operations purposes. The method used may not be shorter in period than the method and period used to compute the taxpayer's depreciation expenses.
If the amount allowable as a deduction under IRC Section 168 differs from the amount that would be allowable as a deduction under IRC Section 167, the taxpayer must, under IRC Section 168(i)(9)(A)(ii), adjust the reserve to reflect the deferral of taxes resulting from such difference.
Because Treas. Reg. Section 168(i)(9)(A) generally does not refer to COR, the IRS noted, the COR-related amounts are not "protected" by the normalization rules. Rather, the IRS said, COR is a deduction under IRC Section 162 and not related to actual accelerated tax depreciation.
Before the TCJA, Taxpayer paid income tax at a rate of 35% rate on the receipt of the COR portion of book depreciation (and provided its customers a tax benefit at that rate). After the TCJA's new rates, Taxpayer will receive a 21% benefit when the COR deduction is actually claimed.
Because Taxpayer will not recover the 14% excess tax it paid on its recovery of the COR component of book depreciation from the government when it claims its COR deduction, the IRS ruled Taxpayer is not constrained by the normalization rules and the manner in which it may recover this amount from its customers.
This ruling, along with prior rulings, gives companies additional clarity around the scope of the normalization rules. This clarity allows for companies to plan for future rate changes and finalize any of their open agreements with commissions.