12 July 2024 IRS releases three rulings on public-utility ratemaking where tax returns and financial statements differ
In PLRs 202426002, 202426003 and 202426004, the IRS ruled that setting public-utility rates on a separate-return basis violated the normalization and consistency rules when the public utility reduced a deferred tax asset (DTA) involving a net operating loss carryforward (NOLC) based on tax-sharing payments from its parent company, which was utilizing those losses. All three PLRs had similar facts. Generally, Taxpayer is a regulated public utility that is a subsidiary of Parent and joined the filing of a consolidated return with Parent's other operating companies. Taxpayer had an NOLC from a separate-basis return. In its rate-case filing, Taxpayer reflected an NOLC DTA attributable to tax losses and proposed an adjustment to its rates. The Parent Tax Allocation Agreement (TAA) allowed certain profitable members of the affiliated group to use the NOLC to offset their separate-company taxable income, even if those members were not subject to the regulating commission that was setting the rates. Under the TAA, Parent paid Taxpayer cash for the tax benefit from using Taxpayer's losses. Taxpayer then reduced its DTA for the NOLC to reflect the cash received for allowing other members of the group to use its loss and recorded an adjusted DTA balance of zero on its financial books. In the rate base for its rate case filing, Taxpayer restored the DTA to reflect a separate return basis. Taxpayer calculated its excess deferred income taxes (EDIT) based on the deferred tax balances on its actual financial books and did not include an adjustment for the separate-return NOLC DTA. Taxpayer determined that amortization under the average-rate-assumption method (ARAM) should take into account the NOLC DTA on the separate return to reduce the total EDIT to be amortized. In all three PLRs, Taxpayer asserted that excluding the standalone NOLC DTA from the rate base would violate the consistency rules and the deferred tax reserve computational rules.
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. Under IRC Section 1.167(l)-1(h)(1)(iii), the federal income tax liability deferred as a result of using different depreciation methods for tax and ratemaking purposes is the excess (computed without regard to credits) of what the tax liability would have been had the depreciation method for ratemaking purposes been used over the actual tax liability. IRC Section 1.167(l)-1(h)(2)(i) instructs the taxpayer to credit this amount of deferred taxes to a reserve for deferred taxes, a depreciation reserve or other reserve account. The deferred-tax-computation rules take into account the method and life differences between book and tax depreciation and the statutory tax rate. Under IRC Section 168(i)(9)(B)(ii), a procedure or adjustment that uses an estimate or projection of the taxpayer's (1) tax expense, (2) depreciation expense or (3) reserve for deferred taxes under Treas. Reg. Section 168(i)(9)(A)(ii) does not comply with the consistency rule unless the estimate or projection is also used, for ratemaking purposes, for all three of these items and the rate base. Therefore, the normalization rules generally do not permit Taxpayer to adjust its rate base by removing used and useful assets without making similar adjustments to book and tax depreciation expense, tax expense and the reserve for deferred taxes.
The IRS said that the Commission's tax allocation method for ratemaking purposes "aligns with the IRS's definition of 'separate return method' despite using the term 'standalone method' in that the tax expense is only attributable to the cost of service and the activities involved in providing service to a utility's customers." However, the financial statements following the TAAs that compensated the subsidiaries were based on the stand-alone method, creating a disconnect between financial reporting and regulatory reporting. The IRS ruled that reducing Taxpayer's standalone DTA by the TAA payments would introduce a variable (the profits of affiliates and/or the TAA payments), other than the method and life differences between book and tax depreciation and the statutory tax rate. Therefore, it would violate the deferred-tax-reserve-computational rules. The IRS also ruled that Taxpayer's amortization of its EDIT must take into account the separate-return NOLC DTA as a reduction to the total EDIT available for amortization. Finally, the IRS ruled that Taxpayer should be allowed to correct its treatment prospectively in the ratemaking case. The IRS said in PLR 202426003 that, in setting utility rates, "a utility's rate base is offset by its EDIT and/or ADIT balance. Taxpayer maintains that the amortization of its EDIT must take into account the $h related to the separate return NOLC DTA as a reduction to the total EDIT available to be amortized. The EDIT should be reduced because these are the amounts that did not actually defer tax due to the presence of the NOLC, as represented in the DTA account. If the EDIT is not reduced, this results in an inappropriate flow-through of tax benefits to ratepayers." Companies should review their rate filings to determine if they are using the separate-return or stand-alone method and then determine whether the tax-sharing arrangement works similarly or differently from ratemaking.
Document ID: 2024-1373 | ||||||