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October 22, 2021

IRS rules that normalization rules do not allow adjustment based on excess deferred income taxes without other adjustments to rate base

In PLR 202142002, the IRS ruled that the "Consistency Rule" in IRC Section 168(i)(9)(B)(i) precludes taxpayers from adjusting one aspect of ratemaking under the normalization rules without the others. The Consistency Rule requires that the reserve for accumulated deferred income tax (ADIT), tax expense and book depreciation expense must be consistent. This ruling extends that concept to excess deferred income taxes (EDIT) to find that a public utility could not adjust its amortization of EDIT using the average rate assumption method (ARAM) without making similar adjustments to its ADIT, book depreciation expense and tax expense.


Taxpayer is a regulated electric and gas utility company. Commission establishes Taxpayer's rates based on its costs, including a return on the capital (rate of return).

The Tax Cuts and Jobs Act (TCJA) reduced Taxpayer's income tax rate from 35% to 21% for tax years beginning after December 31, 2017. The deferred taxes Taxpayer had accumulated at 35% were reduced to those that would have accumulated at 21%, resulting in EDIT because the taxpayer will pay less taxes in the future. The Taxpayer could use the 14-percentage-point reduction in the tax rate to reduce the tax expense that Taxpayer included in setting rates.

Taxpayer stated that it intends to apply the ARAM because it has the vintage records necessary to do so, consistent with the normalization rules. Taxpayer does not know if the EDIT balance and the annual amount of EDIT reversal (which affects rates) will vary each year. Taxpayer intends to apply ARAM to all plant-related timing differences, whether or not required by the normalization rules.

In accounting for EDIT balances in ratemaking, Taxpayer includes the ARAM reversal of EDIT in its monthly calculation of tax expense. The EDIT balance is included in its ADIT, so the rate base is reduced by the proper amount of deferred taxes.

Taxpayer's rates are set periodically using a historical test period. Taxpayer used tax year 2018 as the historical test year in setting rates for Year 2. Commission did not agree with Taxpayer's historical treatment. Instead, the Commission ordered Taxpayer to (1) separately track EDIT on a tariff rate schedule, (2) update the schedule annually for the reversal of the EDIT for the current year, and (3) true-up for the difference between the EDIT set in the schedule and the actual EDIT passed back due to volumetric balances. Commission said the resulting schedule must produce an annual adjustment to Taxpayer's rates for ARAM amortization of EDIT, but not produce any adjustments in Taxpayer's rates for annual changes in depreciation expense, income tax expense, rate base or ADIT (including EDIT). Specifically, Commission ordered Taxpayer to adjust the cost of service by removing the test year ARAM amortization of EDIT and substituting the estimated EDIT amortization for the year following the test year plus the next year that includes part of the rate year, without adjusting anything else.

Taxpayer requested permission to track the difference between its approach and the Commission's approach and record the difference in Taxpayer's balance sheet as a monthly entry. Taxpayer said any necessary corrections would involve two elements: (1) a new tariff rate that becomes a new base tariff and (2) a temporary tariff rate to bring the EDIT balance back into alignment with a normalization method of accounting.

Taxpayer requested a ruling on whether Commission's method of requiring the accounting for EDIT is consistent with the normalization rules. Specifically, Taxpayer asked whether the normalization rules allow Taxpayer to adjust its ARAM amortization of EDIT (1) based on a different year (instead of the test year), (2) annually, and (3) with a true-up based on volume variances; all without adjusting its rate base, ADIT, book depreciation expense and tax expense. Taxpayer also requested a ruling that following the corrective actions it suggested would protect it from violating the normalization rules.

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.

Under the Consistency Rule in IRC Section 168(i)(9)(B)(i), a taxpayer complies with IRC Section 168(i)(9)(A), for ratemaking purposes, by using the same estimate or procedure for its tax expense, depreciation expense and reserve for deferred taxes.

The IRS said the threshold question is whether the Consistency Rule applies to EDIT being accounted for under ARAM. The IRS answered in the affirmative, saying that the EDIT remains subject to the normalization rules because it was originally deferred under a normalization method of accounting. "Thus, if the EDIT being accounting for under ARAM is subject to the [n]ormalization [r]ules, the Consistency Rule must apply to EDIT," the IRS said. Subsequently, Taxpayer cannot adjust its ARAM amortization of EDIT without making similar adjustments to rate base, ADIT, book depreciation expense and tax expense.

Regarding the corrective actions proposed by Taxpayer, the IRS said that tracking the difference between the two approaches allowed Commission to correct any normalization infraction. In addition, since Commission's order violated the normalization rules, Taxpayer will not violate the normalization rules if it follows the proposed corrective actions.

The IRS concluded by noting that it would not be appropriate to deny accelerated depreciation to Taxpayer because both Taxpayer and Commission tried to comply with the normalization rules and corrective actions will be taken as appropriate.


Many regulatory commissions have struggled with how to properly capture the amortization of EDIT and employed various measures from base rates to riders and trackers. This ruling clarifies the application of the Consistency Rule to EDIT and allows taxpayers to review their current agreements for compliance with the normalization rules. The finding that EDIT remains subject the normalization rules because it was originally deferred under the normalization method of accounting offers additional insight into the IRS's view of how to account for net operating losses when they are factored into EDIT. In addition, future rate changes might fall under the normalization rules even if the accompanying legislation does not indicate that the normalization rules apply.


Contact Information
For additional information concerning this Alert, please contact:
Americas Power & Utilities Tax Group
   • Mike Reno (
   • Jim Barrett (
   • Brian Murphy (