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February 15, 2022

IRS rules that water utility's proposed ratemaking method complied with normalization rules

In PLR 202206010, the IRS ruled that a public utility acted consistently with the normalization rules by proposing to include the portion of its net operating losses (NOLs) attributable to accelerated depreciation in calculating the deferred tax liability (DTL) used to offset its rate base.

The IRS also found that the Commission would violate the normalization rules by determining excess accumulated deferred income tax (EADIT), which is also used in calculating rates, without including the utility's NOL deferred tax asset (DTA).


Taxpayer and its Subsidiary are public utilities that operate water and wastewater systems. Two of Subsidiary's divisions (Combined Division) requested a rate increase for water and sewer service, supplying a rate case with the calculations for the new rate base.

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 EADIT because Taxpayer will pay less taxes in the future.

Taxpayer maintains its books and records on a consolidated basis but also computes it book and records on a separate-company basis for ratemaking purposes. Subsidiary established a deferred liability for the EADIT resulting from the tax rate reduction. As part of the ratemaking calculations, Subsidiary calculated a DTL and DTA for each division and then allocated Combined Division's DTA from its NOL carryforward back to individual divisions based on their contributions to the taxable loss from the relevant years. The Commission, however, asserted that the NOL DTA should not be allocated to the individual divisions for ratemaking purposes.

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 Treas. Reg. Section 1.167(l)-1(h), a utility must maintain a reserve that reflects the DTL resulting from the use of different depreciation methods used for tax and ratemaking purposes.

The IRS concluded that the Commission would violate the normalization rules by failing to include the portion of NOLs attributable to accelerated depreciation when calculating the DTL used to offset the rate base. To the extent an NOL carryforward is attributable to accelerated depreciation, the IRS noted, it must be included in the calculation.

The IRS explained that a DTL only serves as an offset to rate base to the extent it is a "cost-free" source of capital, which only occurs to the extent tax liability is actually deferred. Thus, an NOL represents an unfunded portion of a DTL, as there is no economic effect until the NOL offsets taxable income in a future period. As a result, the rate base reduction stemming from the DTL generated because of the corporate rate reduction from 34% to 21%, without regard to a consolidated NOL DTA, would violate normalization rules.

According to the IRS, the normalization rules require allocating the Taxpayer's consolidated NOL among its subsidiaries and using a separate return methodology is appropriate for this computation.

Finally, where a subsidiary's divisions are subject to separate rate filings, the consolidated NOL appropriately attributed to the subsidiary must be allocated among the divisions. Performing this allocation based on the ratio of division taxable income to the separate company during the period of losses is consistent with normalization rules.


The IRS has detailed in numerous PLRs how to apply the normalization rules to accumulated deferred income tax (ADIT). There was very little guidance, however, on how to apply those rules to EADITs, which were created by the rate change after the TCJA lowered the income tax rate (resulting in an excess of ADIT). This ruling, combined with a recent ruling on the consistency rule (Tax Alert 2021-1928), supports the conclusion that taxpayers can apply the normalization rules as they pertain to ADIT to EADIT.


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