Normalization v. Flow-through Accounting; Normalization Requirements and Violations

1. Normalization v. Flow-through Accounting;Normalization Requirements and Violations ByRichard E. MathenyPhelps Dunbar LLP

2. Normalization vs. Flow-through Accounting • The debate over normalization versus flow-through accounting for depreciation expense has been a hot topic in ratemaking for public utilities since Congress first authorized the use of accelerated depreciation methods in 1954. The issue is whether today's customers should pay lower utility rates if the actual (current) income tax expense of a public utility is lower for a year because it uses accelerated rather than straight line depreciation. The flip side of this question is whether future years' customers should pay higher utility rates when the accelerated depreciation benefits reverse. Normalization and flow- through are two possible methods of accounting for dealing with this issue.

3. Normalization • Normalization is the interperiod allocation of the income tax effects of accelerated depreciation deductions, the investment tax credit and the alternative minimum tax for regulatory ratemaking purposes. "Normalization" involves: (1) setting up a deferred tax reserve for the difference between depreciation expense used by regulators to determine cost of service (normally the straight line method) and the accelerated method used for calculating tax expense on income tax returns and then (2) drawing down that reserve in later years as the accelerated depreciation benefits reverse.

4. “Flow-through” • Under a “flow-through” treatment, the income tax effects of accelerated depreciation deductions, the investment tax credit and the alternative minimum tax are reflected in the utility’s cost of service for rate-making purposes in the year or years in which the tax effects are realized. • "Flow-through" uses actual (current) taxes payable to establish cost of service in the ratemaking process. Tax benefits such as accelerated depreciation and investment tax credits are applied dollar for dollar to reduce income tax expense for ratemaking. The effect is to reduce a utility's projected cost of service and to lower utility rates.

5. A Brief History of Income Tax Normalization • The IRS first promulgated normalization rules with respect to the investment tax credit under IRC Section 38. • Following the passage of the Revenue Act of 1962 several federal regulatory agencies mandated the flow-through of the tax benefits of the ITC to ratepayers. Congress imposed non-codified rules on federal agencies restricting flow-through because the purpose of the ITC was to stimulate capital investment not to subsidize the utility expenses of consumers. • The Tax Reform Act of 1969 extended normalization requirements to the tax effects of accelerated depreciation. Subsequent legislative and regulatory developments have confirmed the commitment to normalization of accelerated depreciation.

6. Why Normalization? • The flow-through method is a double whammy to the fisc: • the increased depreciation deduction reduces corporate income taxes; and, • corporate revenues are reduced in the initial years since the income tax component of the cost of service rates is lower. Normalization protects revenues from the effects of lower rates due to accelerated depreciation. Congress has repeatedly said that the purpose of accelerated depreciation is to encourage capital investment at the corporate level not to lower utility rates for consumers.

7. Normalization Requirements and Violations • Subject to certain limited exceptions, public utility property placed in service after 1986 is depreciated under the MACRS rules ( Code Sec. 168). The normalization method of accounting must be used for such property to qualify for MACRS depreciation ( Code Sec. 168(f)(2) and Code Sec. 168(i)(9)).

8. 168(i)(9) NORMALIZATION RULES • 168(i)(9)(A) IN GENERAL. --In order to use a normalization method of accounting with respect to any public utility property for purposes of subsection (f)(2) -- • 168(i)(9)(A)(i) the taxpayer must, in computing its tax expense for purposes of establishing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account, use a method of depreciation with respect to such property that is the same as, and a depreciation period for such property that is no shorter than, the method and period used to compute its depreciation expense for such purposes; and • 168(i)(9)(A)(ii) if the amount allowable as a deduction under this section with respect to such property differs from the amount that would be allowable as a deduction under section 167 using the method (including the period, first and last year convention, and salvage value) used to compute regulated tax expense under clause (i), the taxpayer must make adjustments to a reserve to reflect the deferral of taxes resulting from such difference.

9. Basic Normalization Rules • A taxpayer is considered to use a normalization method of accounting if: • It uses the same depreciation method in computing ratemaking tax expense as is used for purposes of determining depreciation expense for cost of service, and, • Any difference in tax attributable to the use of a method for ratemaking purpose different from the method use for federal income tax purposes is credited or debited to a reserve account. The reserve for deferred taxes attributable to normalization may be treated as a reduction from the rate base or a zero-cost capital for rate-making purposes.

10. The Penalty for Failure to Normalize • Failure to normalize causes the loss of accelerated depreciation deductions with respect to the taxpayer’s public utility property. • Other Normalization Issues • Normalization of investment tax credits • Normalization of alternative minimum tax • Normalization of excess deferred tax reserves • FERC normalization requirements