Rev. Rul. 80-308

ISSUE

When must a public utility company that uses the accrual method of accounting include in its gross income its increased fuel costs that are passed through to the utility's customers over a 6-month cycle by a fuel adjustment charge?

FACTS

M is a natural gas company that files its federal income tax return on a calendar year basis using the accrual method of accounting. The rates for natural gas charged by M to its customers are regulated by the Federal Energy Regulatory Commission (FERC). The FERC determines the amount of any increase in M's rates based upon, among other things, 12 months of actual increased operating expenses, adjusted for any known changes that will occur within the following 9 months. This 12-month period is called the "base period." Generally a FERC rate increase does not become effective until about 10 months after the end of the base period. M does not receive payment until it delivers gas to its customers and bills them. Thus, under the normal rate-making process, M cannot recover any increased costs until a considerable time after they are incurred. This delay is often referred to as "regulatory lag."

Because of regulatory lag and unusual increases in the cost of gas, the FERC authorized a special method for M to recover its increased gas costs charged by M's suppliers by inserting a "purchased gas adjustment" (PGA) clause in M's tariff. Under the PGA clause M can adjust its rates every 6 months to recover its increased gas costs during that period (first six months). This adjustment (fuel adjustment charge) is based on estimated sales and is in addition to the normal rate M is otherwise authorized to charge its customers. It is effective for the succeeding full 6-month period (second six months). Any overcollections or undercollections resulting from the fuel adjustment charges must be included in the calculation of the next 6 months' fuel adjustment charge (third six months). Thus, the PGA clause has significantly reduced regulatory lag for M's increased gas costs.

For financial reporting purposes M defers the increased gas costs for the first six months until the second six months, the period during which it includes the fuel adjustment charges in its customers' bills. For income tax purposes M deducts the increased gas costs in the year the gas is delivered to its customers, the first six months. See Rev. Rul. 75-407, 1975-2 C.B. 197. For financial reporting and income tax purposes M includes the fuel adjustment charges in its gross income when they are added to a customer's bill as part of the selling price of fuel sold during the 6 months the fuel adjustment charge is in effect, the second six months.

LAW

Section 451(a) of the Internal Revenue Code provides that the amount of any item of gross income is included in the gross income for the taxable year in which received by the taxpayer, unless under the method of accounting used in computing taxable income this amount is to be properly accounted for as of a different period.

Section 1.451-1(a) of the Income Tax Regulations provides that under an accrual method of accounting income is includable in gross income when all the events have occurred that fix the right to receive the income and its amount can be determined with reasonable accuracy.

All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due, or (3) payment is made, whichever happens first. See Schlude v. Commissioner, 372 U.S. 128 (1963), Ct. D. 1879, 1963-1 C.B. 99 and Rev. Rul. 79-195, 1979-1 C.B. 177.

Rev. Rul. 63-182, 1963-2 C.B. 194 discusses a situation in which a natural gas distributor using the accrual method of accounting receives a refund from its supplier because of a retroactive decrease in the price of previously purchased gas. The refund was the result of a settlement agreement reached between the distributor and its supplier and was conditioned upon approval by the Federal Power Commission (FPC). The distributor was required by the FPC to adjust its gas charges to its customers to reflect any decrease in its price paid for gas. The distributor passed the refund on to its customers by adjusting their gas bills over the 12 months following receipt of the refund by offsetting or crediting the refund against future charges.

Rev. Rul. 63-182 concludes that the distributor's liability to make refunds to its customers was established on the date the FPC issued its order approving the rate settlement agreement entered into by the distributor and its supplier and not over the 12-month period during which the customer's gas bills are being adjusted.

ANALYSIS

The fuel adjustment charge is an addition to the normal approved billing rate that M uses to bill its customers. It is intended to permit M to recover its increased gas costs sooner than the normal billing-rate process allows. Although the fuel adjustment charge is calculated by reference to the increased cost of gas purchased by M during the first six months, it is not a charge that is a part of the selling price of this gas. Rather, it is an adjustment to the selling price of gas that is sold during the 6 months the fuel adjustment charge is in effect, the second six months.

M is authorized by the PGA clause to adjust its rates every six months when it incurs increased gas costs. M must make additional sales in the future in order to recover, or to have the right to recover, the increased costs represented by the fuel adjustment charge. Accordingly, the "all events test" under section 1.451-1(a) of the regulations is not met until M sells gas during the 6 months the fuel adjustment clause is in effect.

In Rev. Rul. 63-182 the taxpayer was required to make refunds to its customers when the FPC issued its order approving the settlement agreement. Although the taxpayer chose to make the refunds by adjusting its customers' bills over 12 months, the taxpayer's liability to its customers was unconditional upon the FPC's approval of the agreement. The liability was fixed at that time and not contingent upon the taxpayers having future sales. Thus, the "all events test" was met upon approval of the settlement agreement by the FPC.

HOLDING

A public utility company that uses the accrual method of accounting must include fuel adjustment charges that are applied as part of the rate charged for future sales in its gross income as part of the selling price of fuel sold during the specific 6-month period the fuel adjustment charge is in effect.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 63-182 is distinguished.