In PLR 201828010, the Internal Revenue Service (IRS) considered the proper ratemaking treatment for reflecting the results of a federal income tax settlement. The taxpayer was a member of an affiliated group filing consolidated returns reflecting accumulated net operating losses (NOLs). Accordingly, it had recorded the yet-unused NOLs in a deferred tax asset (DTA) account and took that DTA into account in computing the accumulated deferred federal income taxes (ADFIT) used to reduce rate base.1 For ratemaking purposes the public utility commissions employed a historic test year and, in computing ADFIT used to reduce rate base, used a 13-month average commonly adopted in ratemaking. Because the IRS settlement adjusting taxable income was recorded on the last month of the test period, only 1/13th of the effect of the settlement was reflected as an adjustment to the ADFIT balance.
Intervenors proposed that the ADFIT balance reflect the entire amount of the IRS settlement as of the end of the test year, not merely 1/13th of such amount. The IRS properly observed that the normalization rules require consistent conventions in calculating depreciation expense, tax expense, rate base and the ADFIT used to reduce rate base. Accordingly, it concluded that the use of the 13-month average convention to compute depreciation, tax expense and rate base, but an end-of-test year convention to compute the ADFIT in reflecting the IRS settlement, would violate the consistency requirement of the normalization provisions of the Internal Revenue Code.
Eversheds Sutherland Observation: This PLR is the first instance in which the IRS has applied the consistency rule to tax settlements in private or public guidance. The utility taxpayer was required by public utility commissions to obtain the ruling following claims by intervenors that the end-of-test year adjustment was permissible because the rate case involved a historic test period. Although the normalization proration rules did not preclude the adjustment because of the use of a historic test year, the IRS nevertheless properly concluded that the consistency rules did preclude the proposed adjustment using a 13-month average for three of the ratemaking elements (tax expense, depreciation expense and rate base) and an end-of test year adjustment for the ADFIT used to reduce rate base.