On September 29, 2017, the IRS issued a private letter ruling (PLR 201739001) providing helpful guidance on the application of normalization proration rules for the calculation of accumulated deferred federal income taxes (ADFIT) used to reduce rate base or treated as zero cost capital. The ruling confirms that whether the proration rules apply is determined not based on whether actual (historical) versus estimated (or projected) data is used in a rate case, but rather based on whether rates are effective prior to the expiration of at least some portion of the test year.
Normalization is a system of regulated accounting used by many regulated public utilities to reconcile the tax treatment of the investment tax credit (ITC) or accelerated depreciation with their regulatory treatment. The effect of normalization is that the regulated utility obtains the immediate tax benefits of the ITC and accelerated depreciation when permitted by the Internal Revenue Code (IRC) and shares such benefits with ratepayers and shareholders over the regulatory life of the utility property. In order for a taxpayer to be entitled to the tax benefits of the ITC and accelerated depreciation with respect to public utility property, it must adhere to the normalization rules and, more specifically, the calculation guidelines of those rules.
The proration formula furthers the objectives of the normalization rules by accounting for the actual time that projected accruals of deferred taxes are expected to be included in the deferred tax liability. The proration formula set forth in Treas. Reg. § 1.167(l)-1(h)(6)(ii) provides a method to determine the period of time during which the taxpayer will be treated as having received amounts to be credited or charged to the reserve account so that the disallowance of earnings with respect to such amounts through rate base exclusion or treatment as zero-cost capital will take into account the factor of time for which such amounts are held by the taxpayer.
In PLR 201739001, the taxpayer used a test year (Year 1) as the basis for both interim rates as well as for final rates. Rates were not final until Year 2. As the final rates could not be calculated until Year 2, the taxpayer was permitted to charge interim rates, subject to a refund in Year 2 if the final rates were less than the interim rates. The final rates were expected to become effective Month 2 Year 2, and any interim rate refund was expected to be paid Month 3 Year 2. The taxpayer requested rulings on the proper application of the proration rules of Treas. Reg. § 1.167(l)-1(h)(6)(ii) to both its interim and final rates.
The IRS ruled that because the terms “historical” and “future” test periods are determined with reference to when utility rates become effective, a historical period is the portion of the test period before the rates go into effect and the future period is the portion of the test period that remains after rates become effective. Thus to the extent a test period straddles when rates become effective, it contains both a historical test period (as to which proration is not required) and a future test period (as to which proration is required for the reserve expected to be accumulated in such future period). When rates go into effect before the end of a test period without proration, the utility is denied a current return for accelerated depreciation benefits a taxpayer is expected to have, but has not yet received, creating a flow-through that reduces current rates to reflect yet unaccrued capital cost savings. When rates go into effect after a test period, however, the benefits have been received and a premature flow-through opportunity is no longer present, eliminating the need to apply the proration formula.
In this instance, the calculation of ADFIT for the purposes of the final rate was to occur after the end of the test period, making it a historical test period. As such, the IRS ruled that the ADFIT calculation was not subject to the proration formula rules of Treas. Reg. §1.167(l)-1(h)(6). The calculation of ADFIT for the purposes of the interim rate, however, was based on costs that taxpayer projected it would incur during the test year, and since the interim rates went into effect before the end of the test period, it contained a future test period subject to the proration formula rules. The IRS further ruled that the date at which the future portion of the part historical, part future test period is determined for purposes of interim rates was the date on which the interim rates began being charged to ratepayers.
Additionally, the IRS ruled that the computation of the interim rate refund in Year 2, such that the effects of the proration rules on the interim rates in Year 2 are returned in Year 2, would not violate the normalization requirements of IRC §168(i)(9). However, the computation of the interim rate refund in Year 2, such that the effects of the proration rules on the interim rates in Year 1 are returned in Year 2, would violate these normalization requirements. The fact that by the time the refund was ordered, the test year had arguably become “historical” did not alter the fact that at the time the interim rates were charged, there was a future test period subject to proration. To allow the refund of unprorated amounts would, in the view of the IRS, defeat the purpose of the proration rules. Additionally, the IRS ruled that reduction of the taxpayer’s tax expense or depreciation expense recoverable in final rates or the computation of any interim rate refund that effectively offset proration would indirectly flow-through these benefits to ratepayers, violating the normalization requirements of IRC §168(i)(9). In general, the normalization rules preclude the adoption of any ratemaking method that directly or indirectly circumvent their intent. See Treas. Reg. Sec. 1.46-6(b)(2)(ii); Rev. Proc. 88-12, 1988-1 C.B. 637.
Eversheds Sutherland Observation: Because of the general prohibition against retroactive ratemaking, in general, utilities prefer clarity and certainty regarding the proper application of the normalization rules versus any particular result. This recent private letter ruling adds helpful guidance to the understanding of the proration rules.