IRS Rules Utility's NOL Carryforward Cannot Be Reduced by Tax Allocation Payments

The IRS recently issued private letter ruling (PLR) 107770-22 that involved a normalization issue of first impression, namely, whether payments received by a utility pursuant to an intercompany tax allocation agreement (TAA) can reduce the utility's net operating loss carryforward (NOLC) attributable to accumulated deferred income taxes (ADIT) consistent with the normalization rules.¹

The IRS ruled that the normalization rules precluded the reduction of the NOLC by reason of the TAA payments. Because the regulatory authority required the reduction of the NOLC, the restoration of the improperly reduced NOLC was required to avoid a normalization violation.

The IRS reasoned that the TAA payments did not represent an interest-free loan from the federal government, which it described as the sine qua non of depreciation normalization.

Background

The utility, a member of an affiliated group of corporations filing a consolidated return, had incurred net operating losses attributable to the use of accelerated depreciation for federal income tax purposes. Accordingly, the utility established a deferred tax asset (DTA) that offset the deferred tax reserve that would have ordinarily reduced rate base.

Other members of the affiliated group were profitable and were able to utilize the utility's NOLC to offset their separate company taxable income. The profitable members did not provide utility service to customers of the utility, and the property, costs of service or rate base of the affiliates were not taken into account in establishing the utility's rates.² Under the TAA of the affiliated group, the profitable members made cash payments to the parent corporation for their separate return tax liability, and the parent made payments to the utility for the tax benefit derived by the affiliated group from the current use of the utility's losses.

On its financial books prepared in accordance with generally accepted accounting principles (GAAP), the utility reduced the DTA established for the NOLC by the amount of the TAA payments it received. Similarly, in calculating its excess deferred income taxes (EDIT) created by the reduction in corporate income tax rates enacted by the Tax Cuts and Jobs Act, the utility relied on its financial books and did not make any adjustment for the NOLC DTA. Thus, when it began amortizing its EDIT using the average rate assumption method (ARAM), the EDIT balance was greater than it would have been had the DTA been taken into account.

In preparing its current general rate case (GRC), the utility became concerned that the failure to restore the DTA and to account for the DTA in the amortization of EDIT each constituted a normalization violation. It asserted that this treatment violated the consistency rules of Section 168(i)(9) as well as the mechanical deferred tax reserve computational rules of Treasury Regulation Section 1.168(l)-1(h)(2) by introducing a variable (the profits of the affiliates) other than the difference between book and tax depreciation and the statutory tax rate.

There are two basic methods of determining tax expense of an entity that is a member of an affiliated group filing consolidated returns: The "stand-alone method" and the "separate return method." Under the stand-alone method, the consolidated group tax expense is allocated among the members based on the benefits and burdens each member contributes to the consolidated return. Tax expense of a utility under the stand-alone method will reflect only the cost of service and the activities involved in providing service to the utility's customers. Given the top-down approach starting with the consolidated income tax liability, the aggregate tax expense allocated to the members will always equal the consolidated tax expense. Under the separate return method, each member is treated as if it filed a separate return, and the aggregate of those separate return tax liabilities will not equal the consolidated tax expense. The alternative treatments have been extensively analyzed by the Federal Energy Regulatory Commission (FERC), which has mandated the use of the stand-alone method by entities subject to its ratemaking jurisdiction.³

The Ruling

The IRS ruled that the mechanical deferred tax reserve computational rules are based exclusively on the difference between book and tax depreciation multiplied by the statutory tax rate. Thus, introducing another variable into the calculation, namely the profits of the affiliates who used the NOLC to offset their tax liability and/or the TAA payments, would violate those rules. Similarly, the IRS noted that the consistency rules required that any projections or adjustments to any one of the four normalization consistency elements (tax expense, depreciation expense, the reserve for deferred taxes and rate base) requires consistent adjustments to the other elements. Here, the adjustment is solely with respect to rate base, leaving the other elements unadjusted and thus "out of sync" from a consistency perspective.

The parties agreed that the resolution of the primary DTA issue would govern the EDIT issue as well and, thus, the NOLC DTA must reduce the excess deferred taxes available to be amortized under ARAM.

Finally, provided that the utility is allowed to take corrective action at the "next available opportunity," the sanction of a normalization violation, i.e., loss of the right to claim accelerated depreciation on all of the taxpayer's public utility property subject to the jurisdiction of the commission, will not be imposed.⁴

Please note: The authors assisted the taxpayer's in-house tax department in drafting and submitting the request for this PLR.

Notes

¹ This PLR is scheduled to be publicly released on June 28, 2024. However, the taxpayer filed the PLR in a public filing before its state public utility commission on April 12, 2024. Given the importance of this ruling, Holland & Knight is publishing this alert prior to release by the IRS.

² The affiliates were either unregulated businesses or were subject to the ratemaking jurisdiction of other regulatory bodies.

³ See FERC Opinion 173.

⁴ The parties had agreed to the commencement of a limited proceeding to make the required adjustments in the event the PLR concluded there would be a normalization violation.

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