Normalization v' Flowthrough Accounting Normalization Requirements and Violations

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Normalization v. Flow-through AccountingNormaliz
ation Requirements and Violations

• ByRichard E. MathenyPhelps Dunbar LLP

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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.

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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.

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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 utilitys 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.

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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.

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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.

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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)).

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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.

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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.

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The Penalty for Failure to Normalize

• Failure to normalize causes the loss of
  accelerated depreciation deductions with respect
  to the taxpayers 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