On August 14, 2020, the Internal Revenue Service (IRS) issued Rev. Proc. 2020-39 to provide guidance on the proper treatment of excess deferred taxes under the normalization provisions of section 168(i)(9) of the Internal Revenue Code following the enactment of the Tax Cuts and Jobs Act (TCJA). After reviewing comments received in response to Notice 2019-33,1 the IRS also addressed certain other normalization issues in Rev. Proc. 2020-39, in some ways helpful, in other ways, less so.
Background
The Revenue Procedure contains a concise explanation of the normalization rules and how excess deferred taxes are created. In order to take advantage of accelerated depreciation under section 168, a regulated public utility (RPU) must use a normalization method of accounting for ratemaking purposes. That method requires that if a RPU uses a different method of depreciation for tax purposes (i.e., accelerated depreciation), than it uses for ratemaking purposes (i.e., typically straight-line depreciation), it must make adjustments to a reserve to reflect the deferral of taxes, computed at statutory rates, resulting from the difference. This reserve is commonly referred to as the Accumulated Deferred Income Taxes (ADIT) reserve. Under Treas. Reg. Sec. 1.167(l)-1(h)(2) the reserve can only be reduced when and as regulatory depreciation exceeds tax depreciation, or upon the retirement of the subject asset or expiration of tax depreciation. When tax rates are reduced, however, as they were in the TCJA from 35% to 21%, the ADIT reflects deferred taxes collected at a 35% rate that will be paid when they become due at 21%.
2 This difference is denominated as excess deferred taxes, or in the nomenclature of the Revenue Procedure, “ETR.”
3 Section 13001(d)(1) of the TCJA essentially adopted the same approach prescribed by section 203(e) of the Tax Reform Act of 1986, regarding the proper treatment of the excess deferred taxes under the normalization rules.
Allowable Methodologies for Amortization of the Deferred Tax Reserves
The Revenue Procedure provides the following rules governing amortization of the excess deferred taxes:
- If the taxpayer has adequate vintage account data, it may not reduce the ETR more rapidly than under the Average Rate Assumption Method (ARAM).
- If the taxpayer regularly computes regulatory depreciation using average life or composite rate methods, and therefore lacks the requisite vintage account data to utilize ARAM, it may use the “Alternative Method.”4 Under this method the taxpayer uses the weighted average life or composite depreciation rate to reduce the ETR ratably over the remaining regulatory life of the property.
- Taxpayers that currently use ARAM must continue to use ARAM as they are presumed to have adequate vintage data.
- Taxpayers are not required to create or cure deficiencies in their vintage data if they do not currently have adequate data, but the current or prior use of the Alternative Method does not entitle the taxpayer to use the Alternative Method if they in fact have adequate vintage data.
- Taxpayers utilizing a composite method approved by FERC or another regulatory agency may use the Alternative Method.
- Utilities that commenced reversing the ETR in a manner inconsistent with the Revenue Procedure are not considered to be in violation of the normalization rules provided they prospectively correct the method “at the next available opportunity.”
| Eversheds Sutherland Observation – It would have been helpful for the Revenue Procedure to have clarified the meaning of “the next available opportunity.” Presumably, RPUs do not need to initiate a rate proceeding to correct the reversal methodology. Similarly, RPUs presumably need not correct the method if they have a limited rate proceeding, e.g., addressing “true-ups” of estimated items such as purchased power adjustments.5 The most logical approach is to treat the next available opportunity as one in which the regulatory depreciation expense is an issue in the rate proceeding. |
Other Issues
The IRS has issued a series of private letter rulings regarding the treatment of net operating loss carryforwards (NOLCs).
6 Those rulings recognize that until the RPUs actually utilize the net operating loss, they have not received the interest-free loan from the government provided by accelerated depreciation. Virtually all of these rulings require the use of the “with and without” method to determine the portion of the NOLC that is attributable to accelerated depreciation and hence cannot be used to reduce the rate base of the utility. Rev. Proc. 2020-39 departs from this consistent guidance and authorizes the use of “any reasonable method… that does not clearly violate the normalization requirements.”
| Eversheds Sutherland Observation – Although it is true that the existing regulations do not prescribe a single method for addressing NOLCs, and the IRS is understandably reluctant to overstep its jurisdiction over regulatory issues consistent with the Tenth Amendment to the U.S. Constitution, the adoption of this flexible standard and uncertainty over whether a method “clearly” violates normalization introduces unnecessary potential future disputes (and a proliferation of private letter ruling requests) in an otherwise settled area. |
As noted above, the ETR mandates in the Tax Reform Act of 1986 and the TCJA have not been codified. Treasury Regulation Sec. 1.168(i)-3 addressed the treatment of the ETR arising under the former, but not the latter. Rev. Proc. 2020-39 cures this defect by allowing the TCJA ETR to be shared with ratepayers upon a retirement or disposition of public utility property.
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1 2019-22 I.R.B. 1255.
2 We note that whether corporate tax rates will be increased (likely necessitating recalculation of the ETR) in the future remains an area of uncertainty.
3 Given that ETR is universally recognized as referring to the “Effective Tax Rate,” it would have been preferable for the Revenue Procedure to refer to the excess tax reserve as EDIT (Excess Deferred Income Taxes).
4 Traditionally the Alternative Method has been commonly referred to as the “Reverse South Georgia” method.
5 See PLR 202010002. For more information on PLR 202010002, see our legal alert
here.
6 See, e.g., PLRs 201548017, 201519021, 201534001, 201438003, 201709008, and 202010002.
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