Historically, regulated utilities have generally treated repairs and maintenance expense for tax accounting purposes in the same manner as for accounting and regulatory purposes. However, in recent years many regulated utilities have filed with the IRS for a change in their tax accounting method, to define the applicable unit of property differently for tax purposes in determining the amount of deductible repairs. This has led to tax deductions being larger than book expense because repairs and maintenance expenses are being treated as an immediate tax deduction, rather than as a capitalizable item.

Although the IRS has provided guidance in this area, ¹ this change in tax accounting method has created some complexities for regulated utilities because regulators may require flow-through of repairs deductions that would have previously been normalized. The application of these changes has resulted in regulated utilities having to recalculate the tax bases of their assets as though they had always been using this new method (i.e., as if they had always treated repairs and maintenance as a repairs deduction rather than a capitalized asset). ² Once the tax basis is recalculated, the regulated utility makes a “net adjustment” that is recognized as the current repairs deduction in the current tax return. This net adjustment comprises two components: (1) tax deductions related to repairs and (2) an offset related to tax depreciation on assets taken to date that would not have been permitted if the expenditures had been deducted rather than capitalized and depreciated.

From an accounting standpoint, the change in tax accounting method for repairs and maintenance has created some complexity because accelerated deductions are required to be normalized whereas repairs deductions are not. Therefore, where a regulated utility may have previously normalized its accelerated deductions related to repairs, the regulator may now require flow-through of the repairs deduction. A question arises as to how much of the repairs and maintenance amount can be flowed through to ratepayers.

Example 19-5 illustrates the impact of these changes and the related normalization considerations.

EXAMPLE 19-5
Calculating the repairs deduction

Rosemary Electric & Gas Company (REG) purchased a 20-year asset in 20X1 for a cost of $100,000. For tax purposes, the asset is being depreciated using the modified accelerated cost recovery system (MACRS). The asset was depreciated 17% at the end of 20X3 under MACRS. In 20X4, REG applies the most recent IRS repairs guidance and reclassifies the original $100,000 expenditure as a repair expense.

What is the allowable repair deduction in 20x4?

The 20X4 deduction related to reclassifying this expenditure as a repair for tax would be $83,000. The deduction is computed as follows: $100,000 deduction minus $17,000 already recovered through depreciation ($100,000 × 17%). The remaining $83,000 of basis could be recovered through an accelerated repairs deduction in 20X4, rather than over future periods through MACRS depreciation.

REG would convert the recovery of the $100,000 from a normalized book/tax difference to flow-through treatment. In such cases, REG would determine whether to (1) reverse the normalized basis difference created by the previous accelerated depreciation (i.e., reverse the $17,000 of normalized temporary basis difference and now flow through the tax effect of all $100,000 repairs expense) or (2) flow through only the additional deductions from the tax method change and leave the normalized deferred taxes in place (i.e., leave the $17,000 as a normalized temporary basis difference and flow through only the tax effect of the remaining $83,000).

Regulated utilities often receive contributions in aid of construction (CIAC) from developers or other entities to defray the costs of extending existing facilities into a new service area or of making other system changes. Regulated utilities generally treat nonrefundable CIAC received by water utilities as nontaxable, if certain requirements are met. However, electric and gas utilities may consider CIAC taxable in certain circumstances. The determination of whether CIAC is taxable will typically require the regulated utility to analyze its facts and circumstances surrounding the receipt of the CIAC. For accounting and ratemaking purposes, electric utilities generally treat CIAC as a reduction of utility plant construction costs; therefore, it is not included in rate base. As a result, future depreciation is reduced by the amount of the CIAC.

When CIAC is nontaxable, there are no differences between book and tax to be considered. However, when CIAC is taxable, the different book and tax treatment results in a deductible temporary difference (deferred tax benefit) and the regulated utility will need to consider the normalization implications. The normalization requirements vary depending on whether the regulator allows the regulated utility to gross up the amount collected from the developer or other entity for the taxes to be paid on the CIAC. If a regulated utility is permitted to collect a grossed-up amount from the developer (thereby insulating ratepayers from the income tax effects), then it is not required to normalize the temporary difference related to CIAC. However, if the regulator precludes a regulated utility from collecting taxes on CIAC, there is no amount to flow through to ratepayers and the temporary difference is normalized.

Example 19-6 illustrates the accounting for taxable CIAC.

EXAMPLE 19-6
Accounting for taxable contributions in aid of construction

Rosemary Electric & Gas Company (REG) is constructing a $150,000 substation to service a new development and receives $100,000 of CIAC from the developer. REG concludes that the CIAC will be taxable at 35%. Therefore, although the accounting basis of the asset will be $50,000, the tax basis will be $150,000, creating a temporary basis difference of $100,000.

Should REG normalize depreciation for the substation?

Normalization rules also apply to excess deferred income taxes on depreciation-related temporary differences arising from a reduction in corporate tax rates that went into effect in 1986. The rules require regulated utilities to normalize and amortize the impacts of the TRA rate change. Regulated utilities commonly apply an approach called the average rate assumption method (ARAM), which was mandated as a result of the TRA. Under ARAM, the reversal of the excess deferred income taxes cannot occur more rapidly than would occur over the remaining regulatory lives of the assets as the temporary differences related to the assets reverse.

Reducing rates charged to ratepayers relating to excess accumulated deferred income taxes in the wrong period may constitute a violation of the normalization requirements. However, not all regulated utilities maintain their depreciation records in a manner that will readily allow them to apply ARAM. For example, some regulated utilities may not have the records to compute depreciation consistent with ARAM. To address this situation, the IRS allows an alternative method for reducing the excess deferred taxes, referred to as the “Reverse South Georgia method.” Under the Reverse South Georgia method, regulated utilities determine reversals based on the composite rate and begin immediately, in contrast to the ARAM method, which delays recognition until the book-tax depreciation timing differences reverse. However, the Reverse South Georgia method is not permissible if the regulated utility uses a composite method of depreciation and has the records to determine the reversal period of the book/tax differences to which the excess deferred income taxes relate.

As explained in UP 19.3, ADIT generally reduces rate base. However, this calculation can be complicated by the presence of income tax reserves for uncertain tax positions under ASC 740-10 (formerly FIN 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No.109). Under the concepts illustrated in ASC 740-10-55-110 through ASC 740-10-55-112, in which a temporary difference would normally create a deferred tax liability, but the temporary difference is created in whole or in part through an uncertain tax position, the regulated utility should separate the liability recorded between (1) the deferred tax liability based on the sustainable book/tax difference on each reporting date and (2) the liability for the uncertain tax position.

Regulators sometimes provide different answers with respect to how the uncertain tax position liability should be treated for rate base purposes. In some jurisdictions, such as the FERC, the regulated utility generally reclasses the uncertain tax position liability back to a deferred tax liability and treats it as if it were a deferred tax liability. However, this approach has been criticized by certain regulatory experts as being contrary to the logic of including the deferred tax liability as a rate base offset. As explained in UP 19.3, deferred tax liabilities are typically considered as a rate base offset because the utility is deemed to receive an interest free loan from the government for accelerated deductions such as depreciation. If the accelerated deduction is uncertain, however, then it is likely that the utility is not receiving the loan interest free. If it is not ultimately able to sustain the deduction, it will have to pay the tax and any accrued interest for the deduction back to the government.

Based on this logic, some other regulatory jurisdictions have excluded uncertain tax position liabilities from deferred tax liabilities as a rate base offset. However, these jurisdictions have typically built a regulatory tracker mechanism onto the uncertain tax position liabilities. The trackers allow for the rate base exclusion for uncertain tax position liabilities, but if the utility ultimately sustains all or part of the deduction subject to the liability, the utility must compensate the ratepayers for the time value of money through a return on capital.