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July 21, 2022

IRS addresses normalization requirements of surcharge rate calculations for public utility

  • This PLR modifies an earlier ruling as it pertains to surcharges and net operating losses (NOLs).
  • When evaluating surcharges that contain an NOL, the overall tax position of the utility must be considered as opposed to just during the surcharge test period.
  • Public utilities should consider revisiting their ratemaking for surcharges to comply with this new ruling.

In PLR 202227002, the IRS addressed an earlier ruling regarding the normalization requirements of surcharge rate calculations and net operating loss carryovers (NOLCs) after the NOL calculations were changed in compliance with a state court holding.

In the earlier ruling, PLR 202010002 (2020 Ruling), the IRS said that for a surcharge "rider" rate calculation that included additions to the plant, related depreciation, operating expenses, return on investment and accumulated deferred income tax (ADIT), the public utility had to determine if there was an NOL attributable to this activity, and if so, reduce the ADIT by the amount of the NOL during the surcharge test period (see Tax Alert 2020-0578). This conclusion was premised on the fact that the public utility had an overall NOL that was included in the base rate case and the NOL was increasing during the time that the surcharge rider was being determined.

After a state court ruling that the overall NOL had to be considered, Taxpayer revised the facts to state that the NOL was decreasing during the relevant time period. The IRS thus ruled in the current PLR that any NOL generated by the surcharge rider was consumed by the taxable income of the company, such that no increase to the NOL was being generated as a result of the surcharge rider. As a result, the NOL attributable to the surcharge period was not required to be included as part of the surcharge ADIT.


Taxpayer is an affiliate of a water and wastewater utility company. Taxpayer's prices are set by Commission, which sets base rates and infrastructure surcharge proceedings (which result in surcharges added to base rates).

Water corporations may petition Commission for an infrastructure system replacement surcharge (surcharge) to recover the costs of eligible water utility main replacements and relocations. Taxpayer requested a surcharge rate to recover its costs in making these replacements (surcharge case) in periods between base rate proceedings (an interim rate proceeding). In addition, Taxpayer filed a change in method of accounting to claim a tax deduction for the repairs, with a resulting adjustment under IRC Section 481(a). Taxpayer had carried an NOL into the year in which the surcharge filing occurred.

In determining its proposed surcharge, Taxpayer reduced its ADIT by its NOLC, which it believed the normalization rules required. This reduction resulted in a higher surcharge, and, correspondingly, a higher overall rate.

In the 2020 Ruling, Commission disagreed with Taxpayer's approach on the grounds that surcharge calculations do not include financial information from prior periods, which the NOLC represented. As such, it excluded the NOLC from the surcharge calculation. This exclusion resulted in a lower surcharge and, correspondingly, a lower overall rate than Taxpayer requested.

After the 2020 Ruling, Taxpayer sought to recover the increased revenue requirement associated with the surcharge. Commission granted Taxpayer the rate recovery associated with the NOLC-related normalization. A participant in the regulatory proceeding objected to Commission's findings and filed a case against Commission and Taxpayer in the state appeals court.

The state appeals court ruled that Commission was required to reduce the revenue requirement calculation for the surcharge case to eliminate the component attributable to the NOLC-related normalization. In so finding, the state appeals court said Commission had misinterpreted "holding 9" of the 2020 Ruling. Under "holding 9," to comply with the normalization accounting method under IRC Section 168(i)(9), a taxpayer must decrease "the amount of depreciation-related ADIT reducing rate base used to determine the revenue requirement set in the Surcharge Case" to reflect the amount of the NOL for the Surcharge Case's test period that would not have occurred had the taxpayer "not reported depreciation-related book/tax differences during the test period." The depreciation-related ADIT reduction "must be an amount that is no less than the amount computed using the With-and-Without Method."

The state appeals court held "that whether an NOL exists for a test period is based on the entirety of the taxpayer's Commission-regulated operations, not simply the gross income and deductions for a particular Surcharge proceeding."


Under IRC Section 168(f)(2), accelerated depreciation does not apply to public utility property if a utility does not use the normalization method of accounting.

Under IRC Section 168(i)(9)(A)(i), the normalization method of accounting requires a utility to depreciate its public utility property when computing its tax expense for ratemaking purposes using a depreciation method that is not shorter than the method and period used to compute its depreciation expense for ratemaking purposes.

A utility is not using the normalization method of accounting if it uses a procedure or adjustment inconsistent with the requirements of IRC Section 168(i)(9)(B)(i). Under IRC Section 168(i)(9)(B)(ii), inconsistent procedures and adjustments include the use of an estimate or projection of a utility's tax expense, depreciation expense, or reserve for deferred taxes unless a utility also uses the same procedure or adjustment for ratemaking purposes.

Under Treas. Reg. Section 1.167(l)-1(h)(6)(i), a taxpayer does not use a normalization method of regulated accounting if, for ratemaking purposes, the reserve for deferred taxes excluded from the base to which the taxpayer's rate of return is applied exceeds the reserve for deferred taxes for the period used in determining the taxpayer's expense in computing cost of service in such ratemaking. Because the reserve account for deferred taxes (i.e., ADIT) reduces rate base, "it is clear that the portion of the NOLC that is attributable to accelerated depreciation must be taken into account in calculating the amount of the ADIT account balance." Thus, the ADIT resulting from the NOLC should be included in the rate base.

Correct interpretation of holding 9

Given the revised facts, the IRS ruled that the correct interpretation of "holding 9" is that the amount of ADIT related to depreciation that is used in determining the revenue requirement in the surcharge case does not have to be decreased to reflect Taxpayer's NOLC during the surcharge case test period because Taxpayer expected to decrease its overall NOLC during that time. Additionally, the remaining depreciation-related NOLC was reflected in ADIT used to compute rate base in the base rate proceedings immediately before and after the surcharge case.

Under the state appeals court's decision, Commission was required to reduce Taxpayer's rate base for the surcharge case by reflecting depreciation-related ADIT without reducing Taxpayer's NOLC.

On remand, Commission ordered Taxpayer to refund amounts that were previously recovered from customers in accordance with the original interpretation by Taxpayer and Commission of holding 9 of the 2020 Ruling.


This ruling clarifies that while surcharges/riders are to be treated as separate and distinct rate cases, the overall tax posture of the company must be considered when applying the normalization rules as they pertain to NOLCs. As the use of surcharges/riders increase, the application of the normalization rules to these ratemaking situations will be important. Rulings such as this will help taxpayers navigate the sometimes challenging rules of normalization.


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