On May 7, 2019, the Internal Revenue Service (IRS) released Notice 2019-33 (Notice) announcing its intention to issue guidance under section 168 of the Internal Revenue Code to clarify the normalization requirements for excess tax reserves resulting from the corporate tax rate decrease in the Tax Cuts and Jobs Act (TCJA). The Notice sets forth the general normalization requirements for the reserves mandated by the TCJA and also requests comments on the need for or desirability of the issuance of specific guidance on a variety of situations.
The TCJA reduced the corporate tax rate from 35% to 21%. Section 13001(d) of the TCJA contains accompanying normalization requirements.
- Section 13001(d)(1) provides that a taxpayer that reduces its excess tax reserve more rapidly than it would be reduced under the average rate assumption method (ARAM) in computing its cost of service for ratemaking purposes will not be treated as using a normalization method of accounting.
- Section 13001(d)(2) provides an alternative method for taxpayers previously required to compute depreciation for public utility property using an average life or composite rate method whose books and records do not contain the data necessary to apply ARAM, allowing them to be treated as using a normalization method of accounting if they use the alternative method subject to the regulatory authority of the jurisdiction.
- Section 13001(d)(3) defines excess tax reserve as the excess of the reserve for deferred taxes as of the day before the corporate tax rate reductions over the amount which would be the balance in such reserve if the amounts of such reserve were determined by assuming that the corporate tax rate reductions were in effect for all prior periods. ARAM and alternative method are also defined.
- Section 13001(d)(4) provides that if a taxpayer does not use a normalization method of accounting for the TCJA’s corporate tax rate reductions, then the taxpayer will not be treated as using a normalization method of accounting and the taxpayer’s tax will be increased by the amount by which it reduces excess tax reserves more rapidly than permitted under a normalization method of accounting.
The Tax Reform Act of 1986, which reduced the top corporate tax rate from 46% to 34%, contained similar rules for reducing excess tax reserves, but did not provide for an alternative method. An alternative method, referred to as the Reverse South Georgia Method (RSGM), was provided in Rev. Proc. 88-12. The RSGM generally will result in the immediate commencement of the amortization of the flow-through of the excess tax reserves, whereas ARAM does not produce amortization until the so-called book-tax depreciation crossover point is reached.
The Notice requests comments specifically on:
- Whether there should be a reasonableness test to determine whether taxpayers may use the alternative method if the cost of assembling data to apply ARAM would be excessive.
- Whether there are other situations where taxpayers should be permitted to use the alternative method, including when the taxpayer’s current method is the RSGM.
- What net operating loss (NOL) issues may arise, including treatment of depreciation-related NOL carryforwards in the context of excess deferred taxes and whether a depreciation-related NOL as of December 31, 2017 must be analyzed for normalization purposes based on the underlying loss year.
- Whether the 2008 regulations on treatment of excess deferred income tax reserve upon disposition of deregulated public utility property should apply to section 13001(d) of the TCJA.
- How to treat the implementation of interim rates to reflect the decrease in corporate tax rate and the meaning of “reduces the excess tax reserve more rapidly or to a greater extent than such reserve would be reduced under ARAM.”
- Whether the proration formula of Treas. Reg. section 1.167(l)-1(h)(6)(ii) must be applied to excess deferred tax activity related to reversals of excess deferred taxes if the company uses a future test period or a part-historical, part-future test period.
- The methodology of reversing protected vs. unprotected accumulated deferred income taxes after the corporate tax rate changes.
Comments to Notice 2019-33 are due to the IRS by July 29, 2019.
Eversheds Sutherland Observation: There have been questions about whether the use of the RSGM is permissible (where a Commission requires or accepts its use, but it is not clear whether vintage data exists or could be reconstructed), so clarification that it is permissible in those circumstances would be helpful. The Notice also reminds taxpayers that the penalty for a normalization violation not only is the loss of accelerated depreciation on public utility property going forward (which is not much of a deterrent for new property after 2016), but also to increasing tax liability by the amount of the excess flow-through. Some of the requests for comments could wade into areas where there is already diversity of practice in filed returns (i.e., protected vs. unprotected reserves), and might be better off left unanswered given the draconian consequences of a normalization violation and prohibitions on retroactive ratemaking.