• The IRS Continues Providing Normalization Guidance–This Time on Both the Consistency and Proration Rules
  • October 27, 2017 | Authors: Ellen McElroy; Amish M. Shah
  • Law Firm: Eversheds Sutherland (US) LLP - Washington Office
  • On October 13, 2017, the Internal Revenue Service (IRS) issued two private letter rulings (PLR 201741004 and PLR 201741005) that provide further guidance on applying the normalization consistency rules to the inclusion of projected plant additions in the computation of basic rates and applying the normalization proration rules to the projected rates and true-ups of riders. These rulings, following the issuance of PLR 201739001, on September 29 and Revenue Procedure 2017-47 provide consistent and helpful guidance that affords taxpayers the certainty needed in ratemaking proceedings.


    Normalization is a system of 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 these 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 embodied in the so-called consistency rules and the proration rules.

    To use a normalization method of accounting, section 168(i)(9)(A) requires that in calculating its tax expense for ratemaking purposes a taxpayer must use the same method of depreciation and a depreciation period that is no shorter than that used to compute its depreciation expense. The use of an estimate or projection of a taxpayer’s tax expense, depreciation expense or reserve for deferred taxes for ratemaking purposes would not satisfy the consistency rules if a consistent estimate or projection were not also used with respect to rate base. Simply stated, the consistency rules of section 168(i)(9)(B) require consistency in the treatment of projected costs for rate base, regulated depreciation expense, tax expense and the reserve for deferred taxes.

    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 reflected in the rates. 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.

    PLRs 201741004 and 201741005

    The taxpayers in these rulings annually filed to update their formula rates with their respective public utility commissions. In calculating the basic rate, data for the most part was taken from the historical test year ending on the last day of the immediately preceding calendar year. All elements of rate base along with depreciation expense were determined using end of historical calendar test year balances. One element of the calculation was modified, however, since a projection was made of plant additions that were anticipated to be placed into service during the calendar year in which the rates were being set. The cost of these additions was weighted, and no modification was made to the balances of depreciation expense or deferred taxes.

    Additionally, a true-up was calculated by comparing a revenue requirement based on the most recent revenue requirement originally calculated for the prior test period. Any difference was incorporated into the formula rate, correcting for any over or under-recovery equity return arising from the prior year’s projection of plant additions. The taxpayers requested rulings on applying the normalization consistency rules to the inclusion of projected plant additions in the computation of basic rates and applying the normalization proration rules to the projected rates and true-ups of riders.

    The IRS ruled that the projection of plant additions for inclusion in the rate base, in conjunction with the use of historical accumulated deferred federal income tax (ADFIT), tax expense and depreciation expense in computing its basic rate, was not a violation of the consistency rules. Although the taxpayers projected plant additions that would be placed in service, no modification was made to the depreciation expense or deferred taxes, and the taxpayers’ tax expense, depreciation expense and ADFIT were all calculated consistently using the end of historical calendar test year balances. In essence, by projecting the rate base, but not the other elements, the taxpayers were actually flowing through less of the benefit than normalization would otherwise allow.

    The IRS further ruled in PLR 201741004 that the taxpayer calculated its revenue requirements based on a projection of the costs to be incurred during the year for which the rates were being set. Since the projected rates employed a future test period, i.e., rates went into effect before the end of the test period, they are subject to the proration rule of Treas. Reg. § 1.167(l)-1(h)(6)(ii). The IRS then looked to the legislative history of the enactment of the normalization requirements to rule that where the taxpayer did not follow the proration rules for riders in the past, it could correct its rates to conform to the rules at its next regulatory filing or proceeding without facing sanctions. Lastly, the IRS ruled that while the projected rate component of taxpayer’s riders used a future test period, the rider true-ups used a purely historical period that did not require using the proration formula.