IRS Rules Salvage is Protected, Cost of Removal is Not

 

On October 15, the IRS issued PLR 202141001 for regulated electric utilities. In its ruling, the IRS reiterated earlier assertions that the net deferred tax asset (DTA) related to the cost of removal (COR) is not subject to normalization, but also added clarification that the deferred tax liability (DTL) and DTA from the salvage value is subject to normalization rules.

 

Background

PLR 202141001 is a direct response to a request for a private letter ruling dated January 13, 2021 regarding the scope of the deferred tax normalization requirements required to comply with the average rate assumption method (ARAM).

In the submission requesting for ruling, the petitioner (“Taxpayer”) sets forth several relevant contextual facts, including that the taxpayer in question is an investor-owned regulated utility engaged in the business of supplying electricity and follows the Uniform Systems of Accounts (USOAs). The USOAs contain several definitions relevant to the taxpayer’s request, specifically:

  • Cost of removal (COR): the cost of demolishing, dismantling, tearing down or otherwise removing electric plant, including the cost of transportation and handling incidental thereto.

  • Salvage value: the amount received for property retired, less any expenses incurred in connection with the sale or in preparing the property for sale

  • Net salvage value: the salvage of property retired less the cost of removal

  • Service value: the difference between original cost and net salvage value of electric plant

  • Service life: the time between the date electric plant is includible in electric plant in service, or electric plant leased to others, and the date of its retirement

  • Depreciation: the loss in service value not restored by current maintenance, incurred in connection with the consumption or prospective retirement of electric plant in the course of service from causes which are known to be in current operation and against which the utility is not protected by insurance

For tax purposes, COR is deductible only when actually incurred. The taxpayer, therefore, reports its customer collections that fund the COR reserve as taxable income over the operating life of an asset, then claims an offsetting tax deduction only at the end of the life of that asset when the asset is removed. Since COR is normalized in setting rates, customers are provided a revenue benefit commensurate with their funding of COR. In other words, they are provided a COR revenue benefit as they fund the COR reserve – prior to the time the taxpayer actually claims that benefit on its tax return.

The tax effect of COR funding as described creates a deferred tax asset (DTA), which represents the future benefit to be derived from the eventual COR tax deduction. This derivation of this tax effect is contingent on the utility’s ability to identify the separate components of deprecation and COR reserve charges in book depreciation balances. As such, it can be presumed that the taxpayer’s fixed asset records are able to distinguish between COR book/tax differences and depreciation method/life differences and that systems, processes, and technology are in place to track the reversals of these differences separately.

 

The Impact of the Tax Cuts and Jobs Act

 Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), utilities paid income tax at a 35% rate on the recovery of the COR portion of book depreciation and provided its customers a tax benefit at that tax rate. However, as a result of the tax rate reduction enacted as part of the TCJA, the taxpayer will only receive a 21% benefit when the COR deduction is claimed or when any over-accrual is refunded and will pay only a 21% tax on the recovery of any COR under-accrual. As such, the tax rate reduction enacted as part of the TCJA has produced both a deferred tax shortfall as well as an excess tax reserve.

Because Taxpayer will not recover the 14% excess tax it paid on its recovery of the COR component of book depreciation when it claims its COR deduction, it will be recovered from its customers. Conversely, because Taxpayer will not pay the 14% excess deferred tax it accrued on its obligation to refund over-accrued COR, this value must be restored to the utility’s customers through ratemaking.

 

Rulings Requested

 In the private letter ruling request, petitioners sought clarification on several points given the circumstances described above:

  1. Whether the taxpayer's DTA for the cumulative timing differences between the accrual of gross COR and the subsequent tax deduction of such costs upon disposition (and the associated excess deferred tax) are subject to normalization rules

  2. Whether the taxpayer's DTL for the cumulative timing differences between the accrual of gross salvage value and the subsequent taxation of such salvage amounts upon disposition (and the associated excess deferred tax) is subject to normalization rules, regardless of whether the gross salvage value is offset in any amount by the gross COR timing difference

  3. Whether the reversal of the excess tax reserve for method/life differences based on book depreciation amounts inclusive of an accrual of gross COR is consistent with normalization requirements

  4. Whether the reversal of the excess tax reserve for method/life differences based on book depreciation amounts reflecting estimated gross salvage value but not an accrual of estimated gross COR complies with or violates the normalization rules of TCJA

 

Preamble to the Rulings

In their response, the IRS stated that the COR-related amounts at issue in this request are not protected by the normalization rules and that generally, § 168(i)(9)(A) does not refer to COR. Moreover, there is no acceleration of taxes for COR, but rather a deferral. While COR may be a component of the calculation of the amount treated as book depreciation, it is a deduction under § 162 and has nothing to do with actual accelerated tax depreciation.

While method and life differences closely related to depreciation are created and reversed solely through depreciation, such is not the case with COR. While the COR timing differences may often originate as a component of book depreciation, it reverses through the incurred COR expenditure.

With regard to the taxpayer’s request 2, while COR is not protected under the normalization rules, salvage value is specifically included as a protected part of the normalized excess tax reserve. Neither the Internal Revenue Code nor the regulations require or direct that salvage value must be affected by or is necessarily related to the computation of COR for purposes of the application of the normalization rules.

 

PLR Rulings

Addressing each of the requests in turn, the IRS concluded that:

  1. The taxpayer's DTA for the cumulative timing differences between the accrual of gross COR and the subsequent tax deduction of such costs upon disposition (and the associated excess deferred tax) is not subject to normalization rules.

  2. The taxpayer's DTL for the cumulative timing differences between the accrual of gross salvage value and the subsequent taxation of such salvage amounts upon disposition (and the associated excess deferred tax) is subject to normalization rules, regardless of whether the gross salvage value is offset in any amount by the gross COR timing difference.

  3. The reversal of the excess tax reserve for method/life differences based on book depreciation amounts inclusive of an accrual of gross COR is not consistent with normalization requirements.

  4. The reversal of the excess tax reserve for method/life differences based on book depreciation amounts reflecting estimated gross salvage value but not an accrual of estimated gross COR complies with normalization rules of TCJA.

 

Implications for Utilities and How Lucasys Can Help

This ruling, along with prior rulings, gives utilities additional clarity around the scope of the normalization rules as they are applied to cost of removal and salvage value and the computation of both DTA related to COR and DTL related to method/life differences, including gross salvage value.

As the IRS continually releases rulings to clarify the complexities of recent tax legislation, Lucasys has tools to provide flexibility and transparency to make sense of customer data. Lucasys Tax is the easiest solution for modeling and tracking excess and deficient deferred taxes. Scenario modeling for your tax department has never been easier of faster.

Master uncertainty by leveraging industry-leading modeling tools with Lucasys. Whether looking for new software or trying to get the most value out of existing 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/deferred-tax-solutions.