UTILITIES SUBJECT TO EXCESS TAX RESERVE RULE ARE SUBJECT TO ACCELERATED DEPRECIATION RESTRICTIONS.

Rev. Rul. 87-139

ISSUE

A public utility taxpayer has property that under section 167(l)(2)(C) of the Internal Revenue Code could have been depreciated under an accelerated method even if the taxpayer used the flow-through method of regulatory accounting, but the taxpayer voluntarily adopted the normalization method of regulatory accounting. Does the excess tax reserve reduction rule of section 203(e) of the Tax Reform Act of 1986 (Act), 1986-3 (Vol. 1) C.b. 1, 63, apply to such taxpayer in the same manner as its applies to taxpayers to which either section 167(l)(2)(C) never applied or, as a result of an election under section 167(l)(4)(A), section 167(l)(2)(C) no longer applies?

FACTS

X, a regulated public utility company, was permitted by Y, a public utility commission, to normalize the difference between federal income tax depreciation and the regulatory depreciation it utilized in the ratemaking process. At the time of Y's decision to allow normalization, section 167(l)(2)(C) of the Code allowed X to use an accelerated method of depreciation with respect to the public utility property in issue, notwithstanding that the differences in depreciation were not normalized. As provided in Rev. Rul. 87- __ /*/, this Bulletin, even though X did not make the election under section 167(l)(4)(A) to be required to use normalization accounting, once that method was adopted section 167(l)(2)(C) ceased to apply to X. Thus, at that point, the normalization method had to be maintained for regulatory purposes, or an accelerated method of depreciation would not be allowed for federal tax purposes.

X, upon adopting the normalization method of accounting, made the necessary adjustments to a reserve account, in a manner consistent with the provisions of section 167(l)(3)(G)(ii) of the Code, to reflect the deferral of taxes resulting from the use of different methods of depreciation for tax and regulatory purposes.

Under the Act, corporate federal income tax rates were significantly reduced. As a consequence of this reduction in rates, there is an excess balance in X's deferred tax reserve. That is, the amount in X's deferred tax reserve is greater than the amount of taxes that eventually will be paid to the government under the reduced rates. Y issued a rate order that requires X to reduce its cost of service by reducing the excess tax reserve more rapidly than the reserve would have been reduced under the average rate assumption method as defined in section 203(e)(2)(B) of the Act. The reduction in the excess tax reserve is attributable to property that would have been eligible for flow-through treatment had X not adopted a normalization method.

LAW AND ANALYSIS

Section 167(l) and 168(i) of the Code provide that a public utility can use an accelerated method of depreciation only if it uses a "normalization" method of accounting for purposes of establishing cost of service and reflecting operating results on its regulated books of account. Under the normalization method of accounting the deferred taxes must be reflected in a reserve for deferred taxes account. The reserve is equal to the excess, if any, of the income tax liability that would have been due for current and past years if the taxpayer had used for tax purposes the same depreciation expense that was computed for regulatory purposes over the actual income tax liability for those years computed using an accelerated method of depreciation.

The reduction of corporate income tax rates by the Act results in an "excess amount" in the tax reserves that were established as a result of normalizing the difference between regulatory and tax depreciation of public utility property. Section 203(e) of the Act provides, in pertinent part, 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 Code if the taxpayer, in computing its cost of service for rate- making purposes and reflecting operating results in its regulated books of account, "reduces the excess tax reserve more rapidly or to a greater extent than such reserve would be reduced under the average rate assumption method."

As provided in Rev. Rul. 87-137, the normalization requirements of the Code are fully applicable to public utility property, even though the taxpayer voluntarily adopted a normalization method of accounting with respect to that property. Thus, based on the principles of Rev. Rul. 87-137, the requirements of section 203(e) of the Act should be applicable to excess deferred tax reserves regardless of whether the reserves resulted from the voluntary adoption of a normalization method of accounting that was not required under the Code at the time of the adoption. In addition, the reserve for deferred taxes resulting from the voluntary adoption of a normalization method of accounting for public utility property is clearly a reserve described in section 167(l)(3)(G)(ii) of the Code; thus, the requirements of section 203(e) of its face apply to that reserve and limit the extent to which that reserve may be reduced to cost of service.

Accordingly, the requirements of section 203(e) of the Act apply to the excess of the reserve for deferred taxes (as described in section 167(l)(3)(G)(ii) of the Code or former section 168(e)(3)(B)(ii) over the amount that would be the balance in the reserve if the corporate rate reductions provided by the Act had been in effect for all prior periods, regardless of whether the deferred tax reserve resulted from the voluntary adoption of a normalization method of accounting. Based on the foregoing, if, in computing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account, a public utility uses a method of accounting involving a deferred tax reserve and that utility reduces any excess tax reserve more rapidly or to a greater extent than the reserve would be reduced under the average rate assumption method, then the utility does not use a normalization method of accounting for purposes of section 167 or 168.

X's method of accounting reduces its cost of service by the excess tax reserve more rapidly than the reserve would be reduced under the average rate assumption method. Thus, under section 203(e) of the Act, that method is not a normalization method of accounting, even though the reserve is attributable to property for which X originally could have used a flow-through method of accounting and accelerated depreciation but for which it adopted a normalization method of accounting.

HOLDING

Section 203(e) of the Act applies to taxpayers that voluntarily adopted a normalization method of accounting in the same manner as it does to taxpayers to which either section 167(l)(2)(C) of the Code never applied or, as a result of an election under section 167(l)(4)(A), section 167(l)(2)(C) no longer applies.

DRAFTING INFORMATION

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