[Federal Register Volume 70, Number 244 (Wednesday, December 21, 2005)]
[Proposed Rules]
[Pages 75762-75765]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-7583]



[[Page 75762]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104385-01]
RIN 1545-AY75


Application of Normalization Accounting Rules to Balances of 
Excess Deferred Income Taxes and Accumulated Deferred Investment Tax 
Credits of Public Utilities Whose Assets Cease To Be Public Utility 
Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking, notice of public hearing, and 
withdrawal of previous proposed regulations.

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SUMMARY: This document contains proposed regulations that provide 
guidance on the normalization requirements applicable to public 
utilities that benefit (or have benefited) from accelerated 
depreciation methods or from the investment tax credit permitted under 
pre-1991 law. The proposed regulations permit a utility whose assets 
cease to be public utility property to return to its ratepayers the 
normalization reserve for excess deferred income taxes (EDFIT) with 
respect to those assets and, in certain circumstances, also permit the 
return of part or all of the reserve for accumulated deferred 
investment tax credits (ADITC) with respect to those assets. This 
document also provides notice of a public hearing on these proposed 
regulations and a withdrawal of proposed regulations [REG-104385-01] 
published March 4, 2003, at 68 FR 10190.

DATES: Written or electronic comments must be received by March 21, 
2006. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for April 5, 2006, at 10 a.m. must be received 
by March 15, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-104385-01), Room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
104385-01), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking 
Portal at http://www.regulations.gov (indicate IRS and REG-104385-01). 
The public hearing will be held in the IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
David Selig, at (202) 622-3040; concerning submissions of comments, the 
hearing, or to be placed on the building access list to attend the 
hearing, Treena Garrett, at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR Part 1) relating to the normalization requirements 
of sections 168(f)(2) and 168(i)(9) of the Internal Revenue Code 
(Code), section 203(e) of the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2146), and former section 46(f) of the Code. Proposed 
regulations relating to the normalization requirements applicable to 
electric utilities that benefit (or have benefited) from accelerated 
depreciation methods or from the investment tax credit permitted under 
pre-1991 law [REG-104385-01] were published in the Federal Register on 
March 4, 2003 (the 2003 proposed regulations). The 2003 proposed 
regulations would have provided rules under which electric utilities 
whose electricity generation assets cease to be public utility 
property, whether by disposition, deregulation, or otherwise, could 
continue to flow through certain reserves associated with those assets 
without violating the normalization requirements. In response to public 
comments and after further analysis, the 2003 proposed regulations are 
withdrawn, and new regulations are proposed in this document.

Normalization Method of Accounting

    Section 168 of the Code permits the use of accelerated depreciation 
methods. Section 168(f)(2) provides, however, that accelerated 
depreciation is permitted with respect to public utility property only 
if the taxpayer uses a normalization method of accounting for 
ratemaking purposes.
    Under a normalization method of accounting, a utility calculates 
its ratemaking tax expense using depreciation that is no more 
accelerated than its ratemaking depreciation (typically straight-line). 
In the early years of an asset's life, this results in ratemaking tax 
expense that is greater than actual tax expense. The difference between 
the ratemaking tax expense and the actual tax expense is added to a 
reserve (the accumulated deferred federal income tax reserve, or 
ADFIT). The difference between ratemaking tax expense and actual tax 
expense is not permanent and reverses in the later years of the asset's 
life when the ratemaking depreciation method provides larger 
depreciation deductions and lower tax expense than the accelerated 
method used in computing actual tax expense.
    This accounting treatment prevents the immediate flow-through to 
utility ratepayers of the reduction in current taxes resulting from the 
use of accelerated depreciation. Instead, the reduction is treated as a 
deferred tax expense that is collected from current ratepayers through 
utility rates, and thus is available to utilities as investment 
capital. When the accelerated method provides lower depreciation 
deductions in later years, only the ratemaking tax expense is collected 
from ratepayers and the difference between actual tax expense and 
ratemaking tax expense is charged to ADFIT.

Excess Deferred Income Tax

    The Tax Reform Act of 1986 (the 1986 Act) reduced the highest 
corporate tax rate from 46 percent to 34 percent. The excess deferred 
federal income tax (EDFIT) reserve is the balance of the deferred tax 
reserve immediately before the rate reduction over the balance that 
would have been held in the reserve if the 34 percent rate had been in 
effect for prior periods. The EDFIT reserves were amounts that 
utilities had collected from ratepayers to pay future taxes that, as a 
result of the 1986 Act reduction in corporate tax rates, would not be 
imposed.
    Section 203(e) of the 1986 Act specifies the manner in which the 
EDFIT reserve must be flowed through to ratepayers under a 
normalization method of accounting. It provides that the EDFIT reserve 
may be reduced, with a corresponding reduction in the cost of service 
the utility collects from ratepayers, no more rapidly than the EDFIT 
reserve would be reduced under the average rate assumption method 
(ARAM). For taxpayers that did not have adequate data to apply the 
average rate assumption method, subsequent guidance permitted use of 
the reverse South Georgia method as an alternative. In general, both 
the average rate assumption method and the reverse South Georgia method 
spread the flow-through of the EDFIT reserve over the remaining lives 
of the property that gave rise to the excess.

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Accumulated Deferred Investment Tax Credits (ADITC)

    Former section 46 of the Code similarly addressed the flow-through 
to ratepayers of the investment tax credit determined under that 
section. Under former section 46(f)(1), the rate base (the amount on 
which the utility is permitted to collect a return from ratepayers) 
could be reduced by reason of the credit if the reduction in the rate 
base was restored not less rapidly than ratably. If the rate base is 
reduced, the credit may not also be used to reduce the utility's cost 
of service. Under former section 46(f)(2), an electing utility could 
flow through the investment credit not more rapidly than ratably (that 
is, could reduce the cost of service collected from ratepayers by no 
more than a ratable portion of the credit) over the investment's 
regulatory life. The balance of the credit remaining to be flowed 
through to ratepayers would be held in a reserve for accumulated 
deferred investment tax credits (ADITC). If the utility elected ratable 
flow-through of the credit, the rate base could not be reduced by 
reason of any portion of the credit.

Private Letter Rulings

    The IRS has issued a number of private letter rulings holding that 
flow-through of the EDFIT and ADITC reserves associated with an asset 
is not permitted after the asset's deregulation, whether by disposition 
or otherwise. These rulings were based on the principle that flow-
through is permitted only over the asset's regulatory life and when 
that life is terminated by deregulation no further flow-through is 
permitted. After further consideration, the IRS and Treasury have 
concluded that former section 46(f) does not, in all cases, prohibit 
flowthrough of ADITC reserves after deregulation and that section 
203(e) of the Tax Reform Act does not preclude flowthrough of the EDFIT 
reserve with respect to deregulated property.

Explanation of Provisions

    The 2003 proposed regulations provided that utilities whose 
generation assets cease to be public utility property, whether by 
disposition, deregulation, or otherwise (deregulated public utility 
property), may continue to flow through EDFIT reserves associated with 
those assets without violating the normalization requirements. The rate 
of flowthrough was limited to the rate that would have been permitted 
under a normalization method of accounting if the assets had remained 
public utility property. But for section 203(e) of the 1986 Act, the 
entire EDFIT reserve would have been flowed through to ratepayers when 
the reduction in rates became effective, whether the assets to which 
the EDFIT reserve was attributable remained public utility property for 
their entire useful life or were subsequently deregulated or sold. As 
noted in the preamble of the 2003 proposed regulations, the IRS and 
Treasury have concluded that section 203 of the 1986 Act provides a 
schedule for flowing through the EDFIT reserve but that nothing in that 
section suggests that something less than the entire reserve should 
ultimately be flowed through to ratepayers. Accordingly, these proposed 
regulations retain the rule of the 2003 proposed regulations, with the 
effective date changes described below, for generation assets and 
extend the application of the rule to all other public utility 
property.
    The 2003 proposed regulations also provided similar rules under 
which utilities could continue to flow through ADITC reserves 
associated with deregulated generation assets without violating the 
normalization requirements. The proposed regulations did not address 
the treatment of deregulated assets under former section 46(f)(1) 
(relating to the use of the investment credit to reduce the taxpayer's 
rate base). After further consideration, the IRS and Treasury have 
concluded that flowthrough of the ADITC reserve should not continue 
after deregulation except to the extent the utility is permitted to 
recover stranded costs after deregulation.
    If an asset qualifying for the investment tax credit is purchased 
by a utility, the allowance of the credit, without flowthrough, lowers 
the utility's actual tax expense but does not result in higher tax 
expense for ratepayers than would have been the case if the asset had 
not been purchased. Thus, in the absence of flowthrough, the investment 
tax credit is a subsidy from the Federal government for the purchase of 
the asset rather than a transfer from ratepayers to the utility. The 
underlying policy of former section 46(f) is to share this subsidy 
between ratepayers and utilities in proportion to their respective 
contributions to the purchase price. In general, former section 46(f) 
treats ratepayers as contributing to the purchase price when ratemaking 
depreciation expense with respect to the asset is included in the rates 
they pay, resulting in full flowthrough over the asset's regulatory 
life. In the case of a deregulated asset, the contribution of 
ratepayers can be appropriately measured by the ratemaking depreciation 
expense they are charged with respect to the asset and any additional 
stranded cost that the utility is permitted to recover with respect to 
the asset after its deregulation.
    Accordingly, the proposed regulations permit flowthrough of the 
ADITC reserve with respect to public utility property to continue after 
its deregulation only to the extent the reduction in cost of service 
does not exceed, as a percentage of the ADITC with respect to the 
property at the time of deregulation, the percentage of the total 
stranded cost that the taxpayer is permitted to recover with respect to 
the property. In addition, the credit may not be flowed through more 
rapidly than the rate at which the taxpayer is permitted to recover the 
stranded cost with respect to the property.
    As in the case of the EDFIT reserve, these proposed regulations 
extend the flowthrough rule for generation assets to all public utility 
property. In addition, these proposed regulations provide equivalent 
rules for property to which former section 46(f)(1) (relating to rate 
base restoration) applies.

Proposed Effective Date

    The 2003 proposed regulations would have applied to public utility 
property deregulated after March 4, 2003. Utilities would have been 
permitted an election to apply the proposed rules to property that was 
deregulated on or before that date.
    Comments suggested that deregulation agreements between utilities 
and their regulators entered into before the March 4, 2003 proposed 
effective date were based on the only guidance then available (i.e., 
the private letter rulings issued by the IRS) and that the availability 
of a retroactive election could effectively change the terms of those 
agreements. Although private letter rulings are directed only to the 
taxpayers who requested them and may not be used or cited as precedent, 
the IRS and Treasury have concluded that the Secretary's authority 
under section 7805(b)(7) to provide for retroactive elections should 
not be exercised in a manner that impairs existing agreements between 
utilities and their regulators. Accordingly, these proposed regulations 
do not include a similar election to apply the regulations 
retroactively.
    As noted above, these proposed regulations are broader in scope 
than the 2003 proposed regulations. Accordingly, these regulations are 
proposed to apply to public utility property that becomes deregulated 
public utility property after [DATE OF PUBLICATION OF FINAL RULE IN THE 
Federal Register]. For public utility property that becomes

[[Page 75764]]

deregulated public utility property on or before [DATE OF PUBLICATION 
OF FINAL RULE IN THE Federal Register], the IRS will follow the 
holdings set forth in the private letter rulings that prohibit flow-
through of the EDFIT and ADITC reserves associated with an asset after 
the asset's disposition. Flowthrough will be permitted, however, if it 
is consistent with the 2003 proposed regulations, and occurs during the 
period March 5, 2003, through the earlier of the last date on which the 
utility's rates are determined under the rate order in effect on [DATE 
OF PUBLICATION OF FINAL RULE IN THE Federal Register], or [DATE 2 YEARS 
AFTER PUBLICATION OF FINAL RULE IN THE Federal Register].

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations and, because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted (in the 
manner described in the ADDRESSES caption) timely to the IRS. All 
comments will be available for public inspection and copying. Treasury 
and IRS specifically request comments on the clarity of the proposed 
regulations and how they may be made clearer and easier to understand.
    A public hearing has been scheduled for April 5, 2006, at 10 a.m. 
in room 7218 of the Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 30 minutes before the hearing starts. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit comments and submit an outline of the topics to be discussed and 
the time to be devoted to each topic (signed original and eight (8) 
copies) by March 15, 2006.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is David Selig, Office of 
the Associate Chief Counsel (Passthroughs and Special Industries), IRS. 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Proposed Regulations

    Under the authority of 26 U.S.C. 7805, the notice of proposed 
rulemaking (REG-104385-01) published in the Federal Register on March 
4, 2003 (68 FR 10190) is withdrawn.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.46-6 is amended by adding paragraph (k) to read 
as follows:


Sec.  1.46-6  Limitation in case of certain regulated companies.

* * * * *
    (k) Treatment of accumulated deferred investment tax credits upon 
the deregulation of public utility property--(1) Scope. This paragraph 
(k) provides rules for the application of former sections 46(f)(1) and 
46(f)(2) of the Internal Revenue Code with respect to public utility 
property that ceases, whether by disposition, deregulation, or 
otherwise, to be public utility property (deregulated public utility 
property).
    (2) Ratable amount--(i) Restoration of rate base reduction. A 
reduction in the taxpayer's rate base on account of the credit with 
respect to public utility property that becomes deregulated public 
utility property is restored ratably during the period after the 
property becomes deregulated public utility property if the amount of 
the reduction remaining to be restored does not, at any time during the 
period, exceed the restoration percentage of the recoverable stranded 
cost of the property at such time. For this purpose--
    (A) The stranded cost of the property is the cost of the property 
reduced by the amount of such cost that the taxpayer has recovered 
through regulated depreciation expense during the period before the 
property becomes deregulated;
    (B) The recoverable stranded cost of the property at any time is 
the stranded cost of the property that the taxpayer will be permitted 
to recover through rates after such time; and
    (C) The restoration percentage for the property is determined by 
dividing the reduction in rate base remaining to be restored with 
respect to the property immediately before the property becomes 
deregulated public utility property by the stranded cost of the 
property.
    (ii) Cost of service reduction. Reductions in the taxpayer's cost 
of service on account of the credit with respect to public utility 
property that becomes deregulated public utility property are ratable 
during the period after the property becomes deregulated public utility 
property if the cumulative amount of the reduction during such period 
does not, at any time during the period, exceed the flow-through 
percentage of the cumulative stranded cost recovery for the property at 
such time. For this purpose--
    (A) The stranded cost of the property is the cost of the property 
reduced by the amount of such cost that the taxpayer has recovered 
through regulated depreciation expense during the period before the 
property becomes deregulated;
    (B) The cumulative stranded cost recovery for the property at any 
time is the stranded cost of the property that the taxpayer has been 
permitted to recover through rates on or before such time; and
    (C) The flow-through percentage for the property is determined by 
dividing the amount of credit with respect to the property remaining to 
be used to reduce cost of service immediately before the property 
becomes deregulated public utility property by the stranded cost of the 
property.
    (3) Cross reference. See Sec.  1.168(i)-(3) for rules relating to 
the treatment of balances of excess deferred income

[[Page 75765]]

taxes when public utility property becomes deregulated public utility 
property.
    (4) Effective dates--(i) In general. This paragraph (k) applies to 
public utility property that becomes deregulated public utility 
property after [DATE OF PUBLICATION OF FINAL RULE IN THE Federal 
Register].
    (ii) Application of regulation project REG-104385-01 to pre-
effective date reductions in cost of service. A reduction in the 
taxpayer's cost of service will be treated as ratable if it is 
consistent with the proposed rules in regulation project REG-104385-01 
(2003-1 C.B. 634) and occurs during the period March 5, 2003, through 
the earlier of the last date on which the utility's rates are 
determined under the rate order in effect on [DATE OF PUBLICATION OF 
FINAL RULE IN THE Federal Register], or [DATE 2 YEARS AFTER PUBLICATION 
OF FINAL RULE IN THE Federal Register].
    Par. 3. Section 1.168(i)-3 is added to read as follows:


Sec.  1.168(i)-(3)  Treatment of excess deferred income tax reserve 
upon disposition of deregulated public utility property.

    (a) Scope. This section provides rules for the application of 
section 203(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 
Stat. 2146) with respect to public utility property (within the meaning 
of section 168(i)(10)) that ceases, whether by disposition, 
deregulation, or otherwise, to be public utility property (deregulated 
public utility property).
    (b) Amount of reduction. If public utility property of a taxpayer 
becomes deregulated public utility property to which this section 
applies, the reduction in the taxpayer(s excess tax reserve permitted 
under section 203(e) of the Tax Reform Act of 1986 is equal to the 
amount by which the reserve could be reduced under that provision if 
all such property had remained public utility property of the taxpayer 
and the taxpayer had continued use of its normalization method of 
accounting with respect to such property.
    (c) Cross reference. See Sec.  1.46-6(k) for rules relating to the 
treatment of accumulated deferred investment tax credits when utilities 
dispose of regulated public utility property.
    (d) Effective dates--(1) In general. This section applies to public 
utility property that becomes deregulated public utility property after 
[DATE OF PUBLICATION OF FINAL RULE IN THE Federal Register].
    (2) Application of regulation project REG-104385-01 to pre-
effective date reductions of excess deferred income tax reserve. A 
reduction in the taxpayer's excess deferred income tax reserve will be 
treated as ratable if it is consistent with the proposed rules in 
regulation project REG-104385-01 (2003-1 C.B. 634) and occurs during 
the period March 5, 2003, through the earlier of the last date on which 
the utility's rates are determined under the rate order in effect on 
[DATE OF PUBLICATION OF FINAL RULE IN THE Federal Register], or [DATE 2 
YEARS AFTER PUBLICATION OF FINAL RULE IN THE Federal Register].

Mark E. Matthews,
 Deputy Commissioner for Services and Enforcement.
 [FR Doc. E5-7583 Filed 12-20-05; 8:45 am]
BILLING CODE 4830-01-P