SERVICE ISSUES GUIDANCE FOR REDUCING PUBLIC UTILITY 'EXCESS TAX RESERVE.'

Rev. Proc. 88-12

SECTION 1. PURPOSE

This revenue procedure provides a method for reducing the "excess tax reserve" for certain public utility taxpayers. In general, the method satisfies the requirements of section 203(e) of the Tax Reform Act of 1986 (the Act), 1986-3 (Vol. 1) C.B. 63, if used by taxpayers that are unable to utilize the average rate assumption method because they have been required by a regulatory agency to compute depreciation on public utility property on the basis of an average life or composite rate method, as opposed to a method involving the use of vintage accounts.

SEC. 2. BACKGROUND

01 Under a normalization method of accounting, the amount of tax expense that a taxpayer reports for ratemaking purposes includes a deferred tax amount to reflect the fact that the taxpayer is using an accelerated method of depreciation for federal income tax purposes. For taxable years beginning on or after July 1, 1987, section 601 of the Act, 1986-3 (Vol. 1) C.B. 166, reduces from 46 percent to 34 percent the maximum federal income tax applicable to corporations. Section 203(e) of the Act provides rules for reducing the excess tax reserve resulting both from that reduction and from the smaller reduction in rates for tax years starting before and ending after (straddling) July 1, 1987.

02 Section 203(e) of the Act provides that a normalization method of accounting shall not be treated as being used with respect to any public utility property, for purposes of section 167 or 168 of the Internal Revenue Code, f the taxpayer, in computing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account, reduces its excess tax reserve more rapidly or to a greater extent than such reserve would be reduced under the average rate assumption method. Section 203(e)(2)(A) of the Act defines the term "excess tax reserve" as the excess of (i) the reserve for deferred taxes, described in section 167(1)(3)(G)(ii) of the Code (or former section 168(e)(3)(B)(ii) as in effect on the day before the enactment of the Act), over (ii) the amount that would be the balance in the reserve if the amount of the reserve were determined by assuming that the corporate tax rates provided by the Act were in effect for all prior periods. Section 203(e) also applies with respect to the excess tax reserve that occurs from the normalization requirement that taxpayers provide for deferred taxes at a rate in excess of 34 percent for any tax year (for example, a calendar year) that straddles July 1, 1987.

03 The legislative history of the Act, however, indicates that section 203(e) of the Act does not apply to any amount of excess tax reserve generated from reductions in corporate tax rates that occurred before the enactment of the Act. For example, section 203(e) does not apply to any excess tax reserve resulting from the reduction in the maximum corporate tax rate from 48 percent to 46 percent under the Revenue Act of 1978, section 301, 1978-3 (Vol.1) C.B. 54. See S. Rep. No. 313, 99th Cong., 2d Sess. 98 (1986), 1986-3 (Vol. 3) C.B. 98 (Senate Report); H.R. Rep. No. 426, 99th Cong., lst Sess. 149 (1985), 1986-3 (Vol. 2) C.B. 149 (House Report). The provisions of prior law apply to the treatment of any excess tax reserve occurring from such previous rate reductions. Of course, a taxpayer may use the average rate assumption method with respect to any excess tax reserve, including a reserve to which section 203(e) does not apply, without violating the normalization rules.

Moreover, the provisions of section 203(e) of the Act apply only with respect to the excess tax reserve resulting from depreciation occurring in years beginning before July 1, 1987, with respect to assets placed in service before January 1, 1987. See Senate Report at 98; see also House Report at 149.

Finally, the provisions of section 203(e) apply only with respect to the excess tax reserve resulting from depreciation "timing" differences that were required to be normalized under section 167 or 168 of the Code. Thus, for example, section 203(e) of the Act does not apply to the excess tax reserve resulting from the normalization of other book/tax timing differences, as described in section 1.167(1)-1(a)(1) of the Income Tax Regulations (for example, state income taxes). Cf. Rev. Rul. 87-139, 1987-52 I.R.B. 13, 14, which concludes that section 203(e) applies to the "voluntary" normalization method adopted by a taxpayer as described in that ruling.

04 Section 203(e)(2)(B) of the Act defines the average rate assumption method as the method under which the excess tax reserve is reduced over the remaining lives of the property (as used in a public utility's regulated books of account) that gave rise to the reserve for deferred taxes. Under this method, the amount of the annual adjustment to the reserve for deferred taxes is the product of (i) the ratio of the aggregate deferred taxes for the property to the aggregate timing differences for the property (the applicable average rate), and (ii) the amount of the timing differences that reverse during the year. The calculation is made as of the beginning of the year in which timing differences in the vintage account begin to reverse, that is, the first year in which the tax depreciation taken with respect to the vintage account is less than the amount of depreciation reflected in the regulated books of account computed on the tax basis. Thus, under the average rate assumption method, excess tax reserves pertaining to a particular vintage or vintage account are not flowed-through to ratepayers until such time as the timing differences in the particular vintage account reverse. Moreover, it is a violation of section 203(e) of the Act for taxpayers to adopt any accounting treatment that, directly or indirectly, circumvents the rule set forth in the previous sentence.

In addition, section 203(e) of the Act does not modify the normalization requirements of section 167(1) or section 168(i) of the Code. For example, a violation of the normalization rules occurs if a taxpayer provides for deferred taxes with respect to a particular vintage account at a tax rate less than the statutory rate applicable to the taxpayer for the current year in question.

05 Some taxpayers have been required by regulatory agencies to depreciate property for regulatory purposes using a weighted average life or composite rate. A method of depreciation that uses a weighted average life or composite rate focuses on the entire plant and does not account for property by vintage accounts. Consequently, taxpayers that use this method may not have adequate data to apply the average rate assumption method.

SEC. 3 SCOPE

A taxpayer is described in this section 3 if, as of the first day of the taxable year that includes July 1, 1987, (i) the taxpayer was required by a regulatory agency to compute depreciation for public utility property on the basis of an average life or composite rate method, and (ii) the taxpayer's books and underlying records did not contain the vintage account data necessary to apply the average rate assumption method. If a taxpayer is subject to the jurisdiction of more than one regulatory body, the determination of the adequacy of the vintage accounting records for each asset or group of assets shall be determined on a jurisdiction-by-jurisdiction basis.

SEC. 4. DEFINITION OF REVERSE SOUTH GEORGIA METHOD

01 In general, a taxpayer uses a method described in this section 4 if it (a) computes the excess tax reserve on all public utility property included in the plant account on the basis of the weighted average life or composite rate used to compute depreciation for regulatory purposes, and (b) reduces the excess tax reserve ratably over the remaining regulatory life of the property. This method is sometimes referred to as the "Reverse South Georgia Method."

02 SPECIAL RULE IF A TAXABLE YEAR STRADDLES JULY 1, 1987. A taxpayer uses the method described in section 4 if the excess tax reserve is computed as of the first day of the year by subtracting from the reserve for deferred taxes (described in section 167(1) or 168(i)(9) of the Code) the amount that would be the balance of such reserve if the amount were determined by assuming that the weighted average tax rate for the year were in effect for all prior periods. (However, any reserve amount to which section 203(e) of the Act does not apply, as discussed in section 2.03 of this revenue procedure, is not required to be included in the excess tax reserve that is subject to ratable reduction under the Reverse South Georgia Method. Instead, the requirements of prior law apply to any such reserve amount). For a taxable year that straddles July 1, 1987, any reasonable method of calculating the weighted average tax rate shall be allowed under section 203(e). or example, under one acceptable method, the weighted average tax rate may be computed by using the marginal tax rate (46 percent) for the portion of the taxable year prior to July 1, 1987, and the marginal tax rate (34 percent) for the portion of the taxable year after July 1, 1987, weighted by the number of days in each period.

If the taxpayer has a taxable year that straddles July 1, 1987, then the taxpayer uses the method described by this section 4 for its succeeding taxable year if the excess tax reserve as of the first day of the succeeding taxable year is redetermined by subtracting from the reserve for deferred taxes (described in section 167(1) or 168(i)(9) of the Code) the amount that would be the balance of such reserve if the amount were determined by assuming that a 34 percent tax rate had been in effect for all prior periods. Redeterminations of the excess tax reserve are not made for subsequent years. Adjustments to the unamortized excess tax reserve may only be made to reflect asset retirements.

SEC. 5. APPLICATION

01 If a taxpayer that is described in section 3 of this revenue procedure with respect to a jurisdiction uses the Reverse South Georgia Method described in section 4 for public utility property that is subject to the regulatory authority of that jurisdiction, then with respect to that property for that taxable year the taxpayer is deemed to satisfy the normalization requirements of section 203(e) of the Act.

02 The use of the method described in section 4 by a taxpayer whose books and underlying records contain vintage year data for public utility property constitutes a violation of the requirements contained in section 203(e) of the Act if that method reduces the excess tax reserve more rapidly than the reserve would be reduced under the average rate assumption method.

SEC. 6. EFFECTIVE DATE

This revenue procedure is effective for any taxable year subject to section 203(e) of the Act.

DRAFTING INFORMATION

The principal author of this revenue procedure is Michael J. Hahn of the Corporation Tax Division. For further information regarding this revenue procedure, contact Noel J. Sheehan on (202) 566-3928 (not a toll-free call).