April 29, 2024

IRS: Use of "Attrition Allowance" to Calculate Rate Base Violates Normalization Consistency Rules

Holland & Knight Alert
Brad M. Seltzer | Mary Kate Nicholson

Consistent with a state commission's existing regulatory policy, a utility's rate base for the first two years of the three-year rate cycle was computed using traditional cost-of-service/rate of return principles.

For the third year, however, the commission's existing policy also provided that rate base additions would be computed by adding the difference between average rate base for the first year and the average rate base for the second year to the Year 2 rate base.

The utility testified that the attrition methodology violated the normalization deferred tax reserve computational rules of Treasury Regulation Section 1.167(l)-1(h), as well as the consistency rules of Section 168(i)(9) of the Internal Revenue Code. The commission ordered the utility to seek a private letter ruling (PLR) from the IRS regarding the propriety of the use of the attrition allowance.

On April 26, 2024, the IRS released PLR 202417002, agreeing with the utility that the attrition methodology essentially decoupled the cost of service elements (depreciation expense and tax expense) and the rate base elements (rate base and the deferred tax reserve). Indeed, the utility demonstrated that it was mathematically impossible for these elements to be "consistent" using the attrition methodology, although the detailed examples provided in the ruling request were not included in the ruling as issued. Moreover, the attrition allowance produced a deferred tax reserve used to reduce rate base that did not represent the deferral of taxes attributable to the use of different methods of depreciation for ratemaking and tax purposes. The IRS also ruled that the utility could avoid the consequences of a normalization violation by correcting the methodology at the "next available opportunity" under the safe harbor for inadvertent errors set forth in Rev. Proc. 2017-47, either before the Year 3 rates were put into effect or by using a tracker mechanism.

Holland & Knight Insight

The IRS properly determined that the attrition methodology violates both the computational rules under Treasury Regulation Section 1.167(l)-1(h) and the consistency rules of Section 168(i)(9) of the Internal Revenue Code. In certain earlier private letter rulings, the IRS had indicated some reluctance to insist upon strict "consistency," perhaps because of Tenth Amendment concerns that it not be dictating specific ratemaking methodologies, thus allowing for some minor deviations in the treatment of the normalization elements. In recognizing the mathematical veracity presented by the utility in PLR 202417002, the IRS appears to hew to strict compliance with the dictates of the consistency rules.

Please note: The authors represented the utility in connection with this PLR request.

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