Revenue Procedure 2020-39 and the Future of Excess Deferred Income Taxes
On August 14, 2020, the Internal Revenue Service (IRS) issued Revenue Procedure 2020-39 to clarify normalization requirements following the corporate tax rate reduction provided in the Tax Cuts and Jobs Act (TCJA). Though this Revenue Procedure addressed several open questions posed by the utility industry, in some regards, the publication raised more questions than it answered.
One thing was made clear: now is the time that forward-thinking utilities will benefit from preparing for the future treatment of excess deferred income taxes.
Background
In order for a regulated public utility to take advantage of accelerated depreciation under Section 168, the utility must use a normalization method of accounting for ratemaking purposes. Under this method, if a regulated public utility uses a different method of depreciation for tax purposes (i.e. accelerated depreciation) than it uses for ratemaking purposes (i.e. straight-line depreciation) then the deferral of taxes resulting from the depreciation difference must be tracked at statutory rates. This value is referred to as Accumulated Deferred Income Taxes (ADIT).
ADIT value is generated when tax depreciation exceeds regulatory depreciation and is reduced when regulatory depreciation exceeds tax depreciation. Complexities arise if income tax rates change while assets are still depreciating, as was the case when the TCJA revised the federal income tax rate from 35% to 21%. When tax rates are reduced, the ADIT reflects deferred taxes collected at 35% that will be paid when they become due at 21%. This disparity is referred to as Excess Deferred Income Taxes (EDIT) and the treatment of this value is the focal point of Revenue Procedure 2020-39.
Amortization of the Excess Deferred Income Taxes
Revenue Procedure 2020-39 clarifies several rules regarding the amortization and reversals of EDIT:
If the taxpayer’s regulatory books are maintained with vintage account data necessary to use the Average Rate Assumption Method (ARAM), then the EDIT must be reversed using ARAM. If the taxpayer’s regulatory books do not contain sufficient vintage account data to apply ARAM, then the Alternative Method is allowed. Under this method, the taxpayer uses the weighted average life or composite depreciation rate to reduce the EDIT ratably over the remaining regulatory life of the property. The Alternative Method has also been commonly referred to as the Reverse South Georgia Method (RSGM).
Taxpayers are not required to either restructure their existing data or create new vintage account records in order to apply ARAM if deficiencies are present in their fixed asset account records. Instead, the Alternative Method can be applied.
The prior use of the Alternative Method does not entitle taxpayers to continue to use it if their data is now sufficiently detailed.
Taxpayers currently using ARAM to reverse existing EDIT are presumed to maintain data with vintage account detail necessary to continue using ARAM in the future.
In the interest of economy and efficiency, taxpayers utilizing a composite method approved by FERC or another regulatory agency may use either ARAM or the Alternative Method, provided that the regulatory bodies agree.
If taxpayers have already begun reversing EDIT with a method that is not consistent with the Revenue Procedure, they may correct the process “at the next available opportunity” (note that the IRS did not provide a precise definition of this phrase). Any existing reversal methods not in accordance with the Revenue Procedure will not be considered a violation of normalization rules so long as they are corrected.
Normalization rules require a determination of the source of a net operating loss carryforward (NOLC) so that rate base is not overstated in jurisdictions in which net deferred tax liabilities reduce rate base. There is not a single methodology provided for determination of the portion of an NOLC that is attributable to method/life depreciation, and rather than provide explicit guidance the Revenue Procedure maintains that “any reasonable method… that does not clearly violate the normalization requirements” can be applied.
Normalization rules adopted in 2008 apply to EDIT arising under the Tax Reform Act of 1986. The rules are generally applied to the EDIT generate by TCJA as if the limitation date language is not present. Revenue Procedure 2020-39 addresses this defect by allowing the TCJA EDIT to be shared with ratepayers upon a retirement or disposition and upon the sale of public utility property to another regulated utility.
Normalization Issues Not Yet Addressed
Although Revenue Procedure 2020-39 addressed a number of open issues that the utility industry has been awaiting guidance on, many important questions remain to be addressed. It is not clear when additional normalization rules will be forthcoming, and in the meantime, utilities are left to speculate on not only the content of future rulings but also the specificity that will be provided in upcoming instructions. Notable among the omissions in the Revenue Procedure are the following:
How should EDIT generated from cost of removal (COR) be separated from method/life for TCJA?
What timing differences are considered protected versus unprotected?
How do the proration and consistency rules apply to EDIT?
What impacts do ordinary retirements have on EDIT? Should EDIT reverse immediately with a retirement or continue reversing through ARAM or the Alternative Method?
Not only do outstanding questions exist with regards to current EDIT treatment, but new uncertainties are arising related to potential future tax reform. Democrats have proposed increasing the federal income tax rate from 21% to 28%, which would necessitate yet another calculation of EDIT. Not only will utilities need guidance on the normalization rules surrounding this new portion of EDIT, but they will also need to a firm understanding of how the EDIT impact generated by a future rate change will interact with EDIT generated by the recent TCJA .
Several areas of uncertainty are easily identifiable when considering the repercussions of another rate change:
Can the EDIT (or deficient deferred income tax) impact generated by an increased tax rate be netted against the EDIT being tracked for the TCJA, or will they need to be maintained and tracked as separate layers?
Will the EDIT impact generated by an increased tax rate amortize using the same period and method as that of the TCJA EDIT, or will a fixed amortization period be used instead?
If a fixed amortization period is used, will the period depend on the type of property the EDIT is related to?
How Lucasys Can Help
In an environment of uncertain normalization rules, utilities need an adaptive toolset that provides the control and flexibility to react to evolving methods of accounting. While other approaches and technologies have become outdated, Lucasys has developed processes to directly address the growing complexity of EDIT accounting.
The Lucasys Deferred Tax solution has native functionality to automatically generate EDIT accounts to derive and record the impacts of any rate change at a level of detail that allows for precise reporting. As tax rates change, associated EDIT is tracked separately for each event and is easily identifiable in distinct, customizable accounts. This makes Lucasys the best method for tracking EDIT associated with TCJA as well as the excess and deficient deferred taxes generated by state tax rate changes.
Complete control over how deferred income taxes are organized and tracked provides the flexibility that meets the demands of the utility industry. In addition to facilitating the maintenance and analysis of existing data, the Lucasys Deferred Tax Solution provides the ability for users to enhance their modeling and forecasting for ratemaking and tax planning purposes. What had once been a strenuous process involving teams of tax professionals and third-party support is now streamlined into automated systems.
Once the Lucasys Deferred Tax Solution captures the EDIT value generated by a rate change, amortization methods can be edited by users at any time with the click of a button. Changing EDIT reversals between ARAM and Alternative Method (or any other method) no longer requires third party consulting. With the Lucasys Deferred Tax solution, control of your data has been returned to your hands.
To discover how utilities are applying Lucasys tax solutions visit https://www.lucasys.com/tax-solutions.