April 6, 2022
IRS rules when proration must be applied to accumulated deferred income taxes for setting rates
In PLR 220213001, the IRS outlined when to apply the proration rules to calculate accumulated deferred income taxes (ADIT) for various components of the rate-setting calculation.
Taxpayer is a regulated public utility that distributes and transmits electricity. Taxpayer recovers wholesale transmission revenues through formula rates that are approved by Commission.
The rates are based on a cost-of-service model, and the rate base is reduced by ADIT. The rates for the future year are set by calculating the projected revenue requirements for the current year and the previous year, then later adjusting the rates by a "true-up" of the actual revenue requirements of the previous year once they are reported, including interest. The revenue requirements include projected depreciation-related ADIT related to acquiring public utility property (PUP). The adjusted rates are then built into the rates for transmission customers in the next annual rate cycle (the future year). In computing the true-up component, "the actual allowed return is based on the actual (recorded) net plant balances and depreciation-related ADFIT balances during such period."
Taxpayer asked the IRS to rule on whether the ADIT should be prorated for the various periods taken into account when calculating base rate. The PLR addressed the following periods:
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 deferred tax liability resulting from the use of different depreciation methods used for tax and ratemaking purposes.
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.
Under Treas. Reg. Section 1.167(l)-1(h)(6)(ii), the maximum reserve to be excluded from the rate base is the amount (determined under Treas. Reg. Section 1.167(l)-1(h)(2)) at the end of the historic period. If only a future period is used in making this determination, the reserve for the period is the amount at the beginning of the period and a pro rata portion of any projected increase to be credited or decrease to be charged in such period.
The IRS made several different rulings.
First, the IRS ruled that the normalization rules and the consistency rule must be applied separately to the two computations within the projected revenue requirement: (1) the portion of the revenue-requirement calculation based on the future rate filed with Commission and (2) the portion of the revenue-requirement calculation based on projected additions of PUP.
Second, the IRS ruled that the proration rules apply to the portion of the projected revenue requirement based on projected additions of PUP, which constitute the future "test period" portion of the computation. The IRS ruled that the proration formula requirement did not apply to the portion of the computation dealing solely with historic periods.
Third, the IRS agreed with Taxpayer that the normalization rules and Treasury regulations do not require Taxpayer to apply both conventions serially (first averaging and then proration) to changes in ADFIT balances. "When applied to entirely future test periods," the IRS said, "the averaging convention should presumptively be treated as having the same purpose as the proration requirement, thereby negating the necessity to apply both conventions serially to changes in ADFIT balances."
Fourth, the IRS agreed with Taxpayer that the proration formula may be applied to all ADIT increases or decreases, including to (1) amounts related to previous years of PUP for which the proration formula was not applied in estimating the revenue requirements for the historic period and (2) differences between actual and projected ADIT activity for previous years of PUP for which the proration formula was applied to a future test period to determine the actual revenue requirement and the true-up adjustment consistent with the normalization rules. This does not violate the consistency rule, the IRS added.
This PLR is helpful because it specifically addresses each period used in a formula rate calculation that includes a true-up provision and clarifies when proration is required as opposed to averaging. Taxpayers may wish to review their formula rate calculations to confirm they are complying with the normalization rules for all components of the computation.