In a private letter ruling,¹ the IRS concluded that the condemnation of public utility property is in effect a "retirement" or "disposition" that requires the elimination of accumulated deferred income taxes (ADIT) associated with the condemned property.

Addressing Condemned Property

The water and waste water treatment utility subject to rate regulation on a cost of service/rate of return basis had certain of its public utility property condemned by a local government. The taxpayer elected to defer the gain attributable to the condemnation of its facilities under Section 1033(a)(2) of the Code, reducing the basis of the replacement assets it acquired by the amount of the deferred gain under Section 1033(b). Following the condemnation, the companies became non-operating utilities, owned no operational assets or public utility property subject to cost of service/rate of return regulation, and served no customers.

In accordance with the Uniform System of Accounts, the taxpayer had recorded ADIT to reflect the method/life timing differences resulting from the use of accelerated depreciation (MACRS) for federal income tax purposes and the book depreciation method used for ratemaking purposes.² The proper treatment of the ADIT under the normalization rules of Section 168(i)(9) upon the condemnation of the taxpayer's public utility property was the subject of a rate proceeding with the taxpayer's public commission (Commission). The Commission ordered the taxpayer to seek a private letter ruling to confirm or refute the author's testimony in that proceeding that the failure to eliminate the ADIT upon the condemnation would violate the normalization rules.

The IRS noted that under Treas. Reg. § 1.168-8, tax depreciation ceases when an asset is transferred or permanently withdrawn from service. For purposes of this rule, a disposition includes a sale, exchange, retirement, physical abandonment or destruction of an asset. The ruling concluded that the condemnation was such a disposition because it was the "functional equivalent" of a retirement. Accordingly, under Treas. Reg. §§ 1.168-(a)(8)(a), 168-8(b)(2) and 1.167(l)-1(h)(2), the ADIT associated with those retired former public utility assets must be eliminated.

In addition, under the so-called "consistency rules" of Section 168(i)(9), there must be consistent treatment of depreciation expense, tax expense, rate base and the reserve for deferred taxes for ratemaking purposes. Thus, when depreciation ceases upon the condemnation and the property is removed from rate base, the associated ADIT must be removed from the reserve for deferred taxes.

Notes

¹ The IRS has not yet publicly released the private letter ruling.

² See Treas. Reg. § 1.167(l)-1(h)(2).