Cost of Removal, Normalization, and Other Thorny Issues for Utilities

On August 14, 2020, the Internal Revenue Service (IRS) issued PLR 202033002 to address outstanding ruling requests on the application of the Section 168 normalization rules to cost of removal (COR). The IRS concluded that the net deferred tax liability (DTL) created by COR is not protected by the normalization rules but did not provide guidance on the actual implementation of the ruling’s conclusions. Although the PLR is non-binding for other taxpayers, its conclusions will need to be evaluated by all utilities as they seek to comply with the continuous guidance and clarifications provided. Some taxpayers had already reached the conclusion set out by the PLR before it was published, and for the time being they will need to use the same insight to determine the correct method of application while they wait for the IRS to provide explicit instructions.

Overview of Cost of Removal

COR represents the normalized cost of disposing of an asset at the end of its life. For regulatory purposes, this cost is typically incorporated as a component of book depreciation and factored into customer rates. The COR component of book depreciation accrues as a reserve that is drawn against when the removal cost is incurred at the end of the asset’s life.

For tax purposes, COR is not deductible until actually incurred. Thus, the inclusion of COR in book depreciation creates a deferred tax asset (DTA) representing the future benefit from the eventual COR tax deduction. This DTA is included in taxpayers’ total plant-related accumulated deferred income tax (ADIT) account.

Matters are complicated because the COR included in book depreciation expense is an estimate of future incurred value, whereas the amount incurred at the end of the asset’s life represents the true removal cost. If the COR incorporated into book depreciation is overestimated, refunds to customers will be necessary. Conversely, if the COR incorporated into book depreciation is underestimated, recovery of under-accruals are required to make the taxpayer whole.

Further complications arise due to the Tax Cuts and Jobs Act (TCJA) and the resulting change in the federal income tax rate from 35% to 21%. Taxpayers paid 14% excess tax on their recovery of the COR component of book depreciation, and 14% excess deferred tax was generated on the obligation to refund over-accrued COR.

PLR 202033002 Rulings

The IRS makes clear that the normalization requirements for public utility property pertain only to the deferral of federal income tax liability resulting from the use of an accelerated depreciation for tax depreciation allowance with the use of straight-line depreciation for book depreciation. The regulations do not pertain to other book-tax timing differences.

COR is not covered by normalization rules because there is no acceleration of taxes but only a deferral. PLR 202033002 states that “While COR may be a component of the calculation of the amount treated as book depreciation, it is a deduction under Section 162 and has nothing to do with actual accelerated tax depreciation”. Although COR originates as a component of regulated depreciation expense, the timing difference is reversed as a Section 162 deduction, not through depreciation. As such, the COR-related amounts are not "protected" by the normalization rules.

The PLR further ruled the method of accounting changes related to mixed service costs or repairs are not related to depreciation and are also not subject to normalization. When 481(a) adjustments are applied to the historical treatment of assets, ADIT existing prior to the year of change does not remain subject to the normalization rules after the implementation of the new method of accounting.

COR and Rev Proc 2020-39

In PLR 202033002 the IRS reached a conclusion that many had already reached via their own analysis of the constraints of normalization rules. However, the IRS ruling seemingly did not anticipate the challenges associated with carving out the COR DTA from the method/life DTL when calculating excess deferred taxes subject to the average rate assumption method (ARAM) or the alternative method (AM) under Revenue Procedure 2020-39.

Revenue Procedure 2020-39 stated that there is no requirement for taxpayers to recreate or restructure their tax records to support an ARAM calculation if they are not currently able to do so. But what if a utility has data to support ARAM, but its COR value is integrated as a component of method/life, as is common practice in the utility industry? Now that PLR 202033002 has stated unequivocally that COR is unprotected, utilities will need to consider how their data can be restated such that they are able to report on their true protected ADIT.

Apart from the reporting limitations of intermingling protected and unprotected amounts, there are logistical issues with maintaining COR as a component of method/life. Using a composite book depreciation rate (which includes COR accrual) to reverse protected method/life timing differences will artificially accelerate the reversal of protected ADIT. Similarly, utilities that have a COR DTA integrated in their method/life DTL are understating their total protected ADIT value and may therefore be reversing deferred taxes too quickly through the accelerated amortizations of unprotected ADIT.

How Lucasys can help

Whether utilities are tracking their tax data with the latest technologies or they are maintaining older legacy tax systems, Lucasys has consulting expertise to help. Our knowledgeable team of consultants has experience in untangling COR and method/life timing differences, providing an effective bifurcation of protected and unprotected ADIT. For those utilities that have not yet reformatted their deferred tax records, now is the time to consider what your tax data should look like in the coming tax years. Organizing tax value correctly ahead of time prevents utilities from having to play catch-up later when processing deadlines are approaching.

For utilities correcting an existing data defect or looking for new solutions, Lucasys can provide insights into the latest tax issues of the utility industry. To learn more about how Lucasys can help visit https://www.lucasys.com/tax-solutions.