On November 26, 2018, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued much-anticipated proposed regulations (Proposed Regulations) under section 163(j) of the Internal Revenue Code of 1986, as amended (Code). The Proposed Regulations provide needed guidance to companies engaged in the trade or business of being a regulated utility including: 

• Providing a single permissible method of allocating interest expense and interest income between regulated and non-regulated trades or businesses; and
• Providing a 90% de minimis rule for utilities with both regulated and non-regulated sales to be excepted from the interest limitation. 

This alert summarizes certain provisions specifically applicable to utilities. For our more general alerts regarding the Proposed Regulations, visit www.taxreformlaw.com.

Background

The Tax Cuts and Jobs Act (TCJA) replaced “old” section 163(j) with an entirely new section 163(j), which generally limits the ability of taxpayers to deduct business interest expense allocable to a trade or business. However, that interest limitation does not apply to:

The trade or business of the furnishing or sale of …(I) electrical energy, water or sewage disposal services, (II) gas or steam through a local distribution system, or (III) transportation of gas or steam by pipeline, if the rates for furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, by a public service or public utility commission or other similar body of any State or political subdivision thereof, or by the governing or ratemaking body of any electric cooperative.

(Such entities are referred to in this alert as regulated utilities.) The TCJA, however, left open many questions, particularly for affiliated groups that include both regulated and unregulated entities.

Definitions

The Proposed Regulations provide that the interest limitation under section 163(j) is applicable with respect to interest “properly allocable to a non-excepted trade or business…” A “non-excepted trade or business” is a trade or business that is not an “excepted trade or business.” Generally consistent with the statutory language in section 163(j), section 1.163(j)-1(b)(13)(i) of the Proposed Regulations defines the term “excepted regulated utility trade or business” to include:

a trade or business that … furnishes or sells … electrical energy …[t]o the extent the rates for the furnishing or sale of the [electrical energy] [h]ave been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof and are determined on a cost of service or rate of return basis; or … [h]ave been established or approved by the governing or ratemaking body of an electric cooperative.

The preamble to the Proposed Regulations notes that section 163(j) does not define the term “electric cooperative,” but goes on to state that for purposes of section 163(j), the term “electric cooperative” includes an electric cooperative that is exempt from income tax under section 501(c)(12), an electric cooperative that is taxable under subchapter T, and an electric cooperative furnishing electric energy to persons in rural areas that is taxable under pre-subchapter T law.

Allocation

Section 1.163(j)-1(b)(13)(ii) of the Proposed Regulations provides that if a taxpayer is engaged in both an excepted and non-excepted trades or businesses, the taxpayer must allocate items between the trades or businesses to determine the amount of interest “properly allocable to excepted trades or businesses,” subject to the de minimis rule discussed below. The Proposed Regulations generally require taxpayers engaging in both excepted and non-excepted trades or businesses to allocate interest expense and interest income, using the relative adjusted basis of the assets used in excepted and non-excepted trades or businesses. As discussed in more detail below, adjusted basis is generally determined using the alternative depreciation system (ADS).

The Proposed Regulations provide non-utility taxpayers with multiple permissible methods of allocating adjusted basis between excepted and non-excepted trades or businesses, but prescribe a special rule for basis allocations by taxpayers in the excepted regulated utility trade or business and in the trade or business of selling electricity at market rates. Under this rule, the only permissible method of basis allocation to allocate the taxpayer’s adjusted basis of an asset used in both excepted and non-excepted businesses is based upon the relative amounts of output (i.e., kilowatt hours) generated by each trade or business. Though Treasury and the IRS have requested comments on this allocation methodology, they believe that for utilities, the other methods do not properly reflect the proportionate benefit derived from the use of the asset in each trade or business.

It is important to note that in applying the allocation rules provided in the Proposed Regulations, all members of a consolidated group are treated as one corporation. The group, and not individual members, can be engaged in excepted or non-excepted trades or businesses. Once a consolidated group has determined the percentage of the group’s interest expense allocable to an excepted trade or business, the exempt percentage is applied to interest paid or accrued to non-group member lenders. This generally results in an identical percentage of the interest paid or accrued by each member of the group to any non-group lender being treated as allocable to excepted trades or businesses, regardless of whether any particular member actually engaged in an excepted trade or business.

The Proposed Regulations require a taxpayer to determine its adjusted basis in its assets on a quarterly basis and to then average the quarterly amounts to determine the relative amounts of asset basis for excepted and non-excepted trades or businesses for a given taxable year. This is likely to create an increased burden on taxpayers, especially in asset-intensive businesses like utilities. Treasury and the IRS have requested comments on the frequency of asset basis determinations under the Proposed Regulations.

Special Rules for Allocation

De Minimis Rule

While utilities in the excepted regulated utility trade or business and in the trade or business of selling electricity at market rates must perform the allocation described above, the Proposed Regulations provide a de minimis rule in section 1.163(j)-10(c)(3)(iii)(C)(3). This de minimis rule states that if a taxpayer is engaged in a utility trade or business at both regulated and non-regulated rates, and if more than 90% of a taxpayer’s electricity sales are at regulated rates, the taxpayer’s entire trade or business is treated as an excepted regulated utility trade or business and the interest expense limitation does not apply.

Trust Funds

A special rule states that trusts required by law to fund specific liabilities, such as plant decommissioning trusts, are not taken into account for allocating interest expense and interest income. Without this rule, the large size of certain decommissioning funds could distort the true proportion of a taxpayer’s regulated and unregulated trades or businesses.

Anti-Distortion Rule

The Proposed Regulations also provide for an anti-distortion rule that provides that a taxpayer’s adjusted basis in tangible depreciable property (other than inherently permanent structures) would be determined using ADS under section 168(g). The rule ameliorates concern that distortion would arise when a non-excepted trade or business uses expensing under section 168(k) and the excepted regulated utility trade or business uses MACRS or ADS. As a result of the rule, additional first year depreciation, for example under section 168(k), would not be taken into account for purposes of the basis allocation rule.

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