Utilities Keep Tax Benefits In Asset Divestitures

Utilities Keep Tax Benefits In Asset Divestitures

March 01, 2000

The Internal Revenue Service said in a private letter ruling recently that utilities must be allowed to retain balances in certain tax accounts kept for regulatory purposes when they divest themselves of assets. Anyone bidding on  ssets in a divestiture should probably take this into account as a benefit to the utility when computing his bid price. The ruling was released to the public on January 28. Since it applies only to one utility, the  National Association of  Regulatory Utility Commissioners, or NARUC, sent the US Treasury a letter asking it to issue broader guidance. 

Background 

Utilities generally pass through their taxes to ratepayers as a cost of service. However, Congress directed that utilities be allowed to keep the benefits from accelerated depreciation and investment tax credits without having to share them with ratepayers in the form of lower rates. These tax benefits are supposed to induce companies to invest in additional plant and equipment that will create jobs. The argument was that if utilities had to “flow through” the tax benefits to ratepayers, they would not have the same incentive as other industries to make new investments. 

This requirement that utilities use “normalization” accounting — rather than flow-through accounting — led (in the past before deregulation) to distortions since a utility might report higher taxes for purposes of rates in some years than it actually paid. The distortions were caused by three factors.

One was the difference in tax and regulatory depreciation. Tax depreciation could be claimed on an accelerated schedule. Regulatory depreciation is generally straight line. Thus, the amount of taxes a utility is treated as having paid for purposes of setting rates is higher than it actually paid — at least initially after it has made significant capital investments. Over time, the depreciation reverses, but the utility has effectively had an interest-free loan from  ratepayers. The utility keeps a “deferred tax account” to track the benefit. 

Another factor creating distortion is that tax rates change during the period in which the utility is depreciating its assets. For example, Congress reduced the maximum corporate tax rate from 46% to 34% in 1986. Prior to the  change, ratepayers had been paying prices for electricity based in part upon calculations of future taxes at the higher rate. Because of the reduction, the utilities had more money in their deferred tax accounts than they would be required to pay out at the 34% rate. To that extent, the interest-free loan became a grant. 

The regulators made utilities keep a separate “excess tax reserve” account for the overpayments attributable to the reduction in the tax rate. The utility returns the balance in the account to its ratepayers ratably under one of two  methods that link the recovery period to the regulatory life of the asset. Finally, utilities often have a third account to reflect the benefit of any investment tax credits the utility claimed. The federal government used to let US companies claim a tax credit for a percentage of the cost of new equipment as a further inducement to invest. The credit was repealed at the end of 1985, but could still be claimed on many power plants and other equipment placed in service as late as 1990. The IRS has interpreted the normalization accounting requirement that Congress imposed on utilities to mean that the lower taxes due to tax credits can be reflected in rates charged to utility customers, but not more quickly than a schedule determined by reference to the plant’s useful life for regulatory purposes. 

Issue

The question arises: what happens to the balance in these tax accounts when a utility divests itself of its assets? 

Consumer advocates have argued that the balances in the accounts ought to be used as an offset against the “stranded costs” the utility will be allowed to recover after deregulation. The utilities argue that the benefits are illusory
since, when a utility sells generating assets that have been fully depreciated, it has a large capital gain on which it must pay taxes. These taxes are not passed through to ratepayers and therefore effectively recapture some of the earlier benefit — at least in the deferred tax account. 

IRS Ruling

Now the IRS had waded into the picture. The IRS told one utility in a private letter ruling that its regulators must allow it to keep the balances in its tax accounts when assets are sold or else the utility will not be considered to have  used normalization accounting — the accounting method that is a precondition to its ability to qualify for accelerated tax depreciation and investment credits in the first place. The utility in the ruling was required to sell its
generating assets as part of state-wide electricity deregulation. It had claimed investment tax credits and thus, under the normalization rules, had a balance in the related account. Similarly, it depreciated its power plants using an accelerated method and had a balance in its deferred tax account. Income tax rates had dropped, so the taxpayer also had a balance in its excess deferred tax account. The utility asked the IRS whether it would violate the normalization rules if it returned to the ratepayers the balances in its excess deferred tax account and its investment tax credit account by amortizing them to a transition cost balancing account.

With respect to the investment tax credit account, the IRS said that when the plant is sold the property upon which the tax credits were claimed would no longer be available for computing regulatory depreciation expense. The normalization rules only permit utilities to pass along to ratepayers the benefits of the tax credits ratably over the regulatory depreciation period. At the point of the sale, reasoned the IRS, “there could no longer be any correlation between the property and the credit.” As a result, no portion of remaining balances in the utility’s tax credit account could be returned to customers without violating the normalization rules. 

The IRS also held that under the normalization rules the utility’s deferred tax reserve and its excess deferred tax account would disappear upon sale. Therefore, any flowthrough of benefits to ratepayers after the sale would violate the normalization rules. In addition, like investment tax credits, the IRS noted that the benefits of accelerated depreciation and lower tax rates could only be passed along to consumers slowly, over the asset’s regulatory life. When the asset is sold, that regulatory life evaporates and, thus, no further benefits may be passed along to ratepayers without violating the normalization rules. 

A private letter ruling only applies to the taxpayer to whom it was issued. NARUC, the association of regulatory commissioners, sent Treasury Secretary Lawrence Summers a letter in November — after the ruling had apparently been shown to a
regulatory commission but before the text was released to the public — asking the government to issue formal regulations addressing the issue because of its significance to state deregulation of electric utilities.