On August, 15, 2020, the Internal Revenue Service (IRS) issued PLR 202033002, in which it addressed whether cost of removal (COR) is “protected” by the normalization rules of section 168(i)(9). COR is often embedded in a utility’s composite depreciation rate for ratemaking purposes and contributes to a net deferred tax liability (DTL). PLR 202033002 also addressed whether depreciation-related Accumulated Deferred Income Taxes (ADIT) existing prior to the year of a change in method of accounting to deduct additional repairs using larger units of property as well as mixed service costs previously capitalized remain protected by the normalization rules. Somewhat surprisingly, there has been limited extant guidance regarding the proper treatment of COR, perhaps because of the diversity of practice among taxpayers and public utility commissions in addressing it. Although the IRS correctly concluded that neither item is protected by the normalization rules, questions remain regarding the actual implementation of the ruling’s conclusions.
Cost of removal
In essence, COR represents the net positive value, or more often, the net cost, of disposing of an asset at the end of its life. COR is often incorporated into the composite depreciation rate used for regulatory purposes. Typically, because utility assets often have negative salvage value, the regulatory/book depreciation rate is higher than it would be without consideration of salvage value. Effectively, the higher regulatory depreciation expense is an element of cost of service that results in a reserve until the COR is actually incurred.
For tax purposes, COR is not deductible until actually incurred. However, because of the incremental income associated with inclusion of the higher depreciation expense in taxable income over the life of the asset, the taxpayer establishes a deferred tax asset (DTA) for the future tax benefit of the ultimate tax deduction for COR. Generally, the COR-related DTA is included in, and reduces, the taxpayer’s overall plant-related ADIT account. In PLR 202033002, the taxpayer’s tax fixed asset accounting system distinguished between originating COR book/tax differences and depreciation method/life differences, but was not configured to track the reversals of those differences separately.
To make matters slightly more complicated, the tax rate changes enacted as part of the Tax Cuts and Jobs Act also impact the analysis. The pre-funding of COR through depreciation expense was taxed at a 35% rate, but, absent future changes in tax rates, the COR, when incurred, will only generate a 21% deduction, producing a deferred tax shortfall.
Mixed service costs and repairs
Like many other utilities, the taxpayer previously capitalized mixed service costs into depreciable assets, but later filed an Application for Change in Accounting Method (Form 3115) to deduct (or include in cost of goods sold) such costs. The removal from the tax basis of its existing assets of the recharacterized costs (to the extent not previously depreciated) produced a negative section 481(a) adjustment.
Similarly, the utility sought to use larger units of property for tax purposes than for book purposes, resulting in additional deductible repairs for tax purposes. Again, the removal from the tax basis of its existing assets all recharacterized costs to the extent not previously depreciated produced a negative section 481(a) adjustment.
Adjustments were made to the ADIT accounts for the additional deferred taxes produced by the section 481(a) adjustments.
The normalization consequences
The ruling correctly notes that the statutory normalization rules of section 168(i)(9)(A) do not refer to COR.1 Moreover, the normalization rules focus on the deferral of taxes associated with the use of accelerated depreciation for tax purposes and (typically) straight-line depreciation for regulatory/book purposes whereas COR produces an acceleration of taxes given the deferral of the tax deduction until cost of removal is incurred. More importantly, under Treas. Reg. Sec. 1.167(l)-1(h)(2)(i), the deferral properly reverses only when book depreciation exceeds tax depreciation. In the case of COR, although it originates as a component of regulated depreciation expense, the timing difference is reversed as a section 162 deduction, not through depreciation.
Similarly, the depreciation-related ADIT existing prior to the year of change switching from depreciation for mixed service cost and repairs to deductible section 162 costs are no longer subject to the normalization rules. This is consistent with prior rulings on the same or similar issues.2
|Eversheds Sutherland Observation: Given the constraints of normalization – timing differences attributable to book/tax differences in method and life – PLR 202033002 undoubtedly reached the right conclusions. Nevertheless, the ruling did not necessarily anticipate the challenges of unbundling the aggregate net DTL in calculating excess deferred taxes subject to the average rate assumption method or the alternative method under Rev. Proc. 2020-39.3
1The Ruling might have referenced Treas. Reg. Sec. 1.167(l)-1(h)(2) which states that “the use of an unrecovered cost or other basis or salvage value for Federal income tax purposes different from the basis or salvage value used on the taxpayer’s regulated books of account is not treated as a different method of depreciation.”
2See PLRs 201640005 and 20201002.
3For a discussion of Rev. Proc. 2020-39, see our Legal Alert, here.