The Domestic Production Deduction and the Normalization Rules

Transcription

1 I. Section Joseph C. Mandarino is a partner with Balch & Bingham LLP in Atlanta. Copyright 2006 Joseph C. Mandarino. All rights reserved. The Domestic Production Deduction and the Normalization Rules By Joseph C. Mandarino Oct. 23, 2006 Summary As it does for other taxpayers, section 199 provides an important tax incentive for utility companies. Last year, the Federal Energy Regulatory Commission provided guidance on how to take account of the section 199 tax benefit for some rate-setting purposes. This article examines how the tax normalization rules may apply in that context. Introduction The new deduction under section promises to be an important part of the tax code and tax planning for years to come. Indeed, recognition of its effect has even spread to other government agencies. Last year, the Federal Energy Regulatory Commission (FERC) issued "Guidance Order on Tax Deduction for Manufacturing Activities Under American Jobs Creation Act of 2004" (the order). 2 The order provides guidance on the treatment of the section 199 deduction in the ratemaking process. 3 This article considers how the tax normalization rules for electric utilities apply in connection with the order and it is divided into four parts: a brief overview of section 199, a description of the order, background and a description of the tax normalization rules, and a discussion of how the normalization rules and the order may interact. Section 199 provides taxpayers with a special deduction of up to 9 percent of a taxpayer's qualified production activity income (QPAI). 5 The statute defines QPAI as the excess of a taxpayer's domestic production gross receipts (DPGR) over the expenses allocable to those receipts. 6 DPGR in turn is defined as the gross receipts derived by the taxpayer from specified activities. 7 In general, the enumerated activities include the lease, rental, license, sale, exchange, or disposition of goods that are manufactured, produced, grown, or extracted by the taxpayer within the United States. 8 Also, and of relevance to this article, the statute specifically provides that DPGR includes receipts from the sale of electricity and natural gas produced in the United States. 9 (Although the examples in this article concern electric utilities, the discussion is also applicable to natural gas producers.) The section 199 deduction is unique in the code. It was enacted to lower the top marginal federal income tax rate for some types of economic activity. 10 For example, by permitting a deduction of 9 percent of a taxpayer's taxable income, the top marginal tax rate is reduced from 35 percent to slightly less than 32 percent. 11 Congress views section 199 as an economic incentive, just like a tax credit or actual rate reduction. 12 There are several limitations on the amount of the deduction. For example, the deduction is limited to the taxpayer's income for the tax year. 13 Also, the deduction cannot exceed an amount equal to 50 percent of the taxpayer's W-2 wages for the year. 14 In applying and computing the section 199 deduction, particularly in connection with producers of electricity and natural gas, several issues are raised, the resolution of which is unclear. However, a simplified example may be helpful. Assume a power company owns a generator that in 2006 produces $1,000 in DPGR and has $900 in allocable expenses (for example, fuel supplies, labor, overhead, and so on). That results in $100 of QPAI. Assume further that the taxable income 1 Posted: March 23, 2007

2 and W-2 wage limitations do not come into play. Under those facts, the company would be entitled to a section 199 deduction of $3 (3 percent x $100). (By 2010 that deduction would increase to $9 (9 percent x $100).) II. The Order In the United States, the production and sale of electricity is highly regulated. In many cases, the price of electricity is set by the government, typically the FERC or state-level public commissions. Depending on applicable law, the agencies will set the price of electricity based on one of two broad methods: market-based rates or cost-based rates. The latter method is the focus of this article. 15 Under cost-based ratemaking, the sales price is a function of two amounts. First, rates include all the costs involved in the production of electricity (supplies, labor, and so on), including tax expenses. Second, a reasonable profit or rate of return on assets is permitted. That is computed by -- in general -- multiplying a company's "rate base" (the net book basis of the assets used in the production of electricity) by a reasonable rate of return. In the end, the rate allowed is intended to permit a power producer to recover all its reasonable costs (including taxes) and to provide it with a rate of return that represents a fair profit. Because cost-based ratemaking reimburses a power producer all of its reasonable costs -- including taxes -- ratemakers have occasionally had to address controversies over specific tax items, 16 for example, whenever there are significant booktax timing differences or permanent differences. Accelerated tax depreciation and the investment tax credit are examples of prior controversies. The tax benefit associated with the section 199 deduction and how it should be treated in the ratemaking process is perhaps the most recent example. In June 2005 the FERC issued special guidance on section Presumably, the impetus for the guidance is that taxes are an integral part of the computation of cost-based rates. The order sets out a description of the section 199 deduction and concludes that when fully implemented, the deduction will be "9 percent of qualified production activity income and could reduce the effective federal corporate income tax rate on production activities." 18 The order goes on to discuss how the tax benefits from the section 199 deduction should be integrated into cost-based ratemaking: [Section 199] is a special deduction that reduces the amount of income tax due from energy sales. [Section 199] will have ratemaking implications only for public utilities that make jurisdictional sales of electricity at stated cost-based rates and cost-based formula rates. Income taxes are a cost that is included in the determination of virtually all cost-based rates. Accordingly, we expect these public utilities to appropriately reflect the [section 199] amounts in future filings to change their cost-based stated rates and cost-based formula rates. Additionally, some public utilities utilize costbased formula rates that are designed to automatically track changes in costs. The Commission is concerned that certain of the formulas established to develop rates may not be structured in a way that will provide an adequate mechanism for tracking the [section 199] amount. Accordingly, we direct these public utilities to separately identify the [section 199] amounts in any future filings to change their cost-based formula rates. Moreover, since [section 199] only affects rates for jurisdictional entities to the extent that the [section 199] amounts are reflected in the cost of service, [section 199] will not have any ratemaking implications for jurisdictional entities to the extent that they engage in the sale of electricity at market-based rates. * * * Public utilities with cost-based stated rates or cost-based formula rates for electrical energy sales should appropriately reflect the [section 199 tax benefit] amounts in any future filing to change a stated cost-based rate or formula rate. 19 Given the foregoing, power producers subject to cost-based FERC ratemaking have begun including in their filings a computation of the tax benefit attributable to the section 199 deduction. Recall our example of a power producer with a generator that in 2006 produces $100 of QPAI and a section 199 deduction of $3. Consistent 2 Posted: March 23, 2007

3 with the order, the power producer would have to include a computation of the tax benefit of the $3 tax deduction in its FERC filings. Assuming a marginal 35 percent tax rate, the benefit would be approximately $1. Presumably that would reduce cost-based rate revenue that would otherwise be permitted by that $1. 20 Although only the FERC has issued that guidance as yet, it is likely that state and local regulators also will consider how to address the tax benefit from the section 199 deduction and whether to reflect that benefit in rates. III. The Tax Normalization Rules Because of the capital-intensive nature of the electric power industry, cost recovery is a critical issue. Generally, utilities use more accelerated cost recovery methods for tax purposes than for ratemaking or financial accounting purposes. That means tax depreciation will generally be greater than book depreciation in the beginning years of an asset's life cycle, and lower in the later years. That is but one of the many timing issues that arise from the difference between book and tax rules (book/tax differences). On the financial accounting side, there has long been concern that timing differences made the use of real tax expense potentially misleading. 21 For example, a significant future tax liability might be ignored if accounting statements contained only current tax expense. The approach of the Financial Accounting Standards Board was to create a system of deferred tax assets and liabilities to account for timing differences. 22 A similar issue exists in the world of rate regulation. Recall that under cost-based ratemaking, a power producer is reimbursed for its costs, including tax expense. However, if rates are based on actual tax expense, the entire benefit of accelerated tax depreciation will be passed on to ratepayers. That approach -- sometimes called the flow-through method -- will tend to prevent a power producer from enjoying any tax benefits. Industry, as expected, argued that an approach similar to that of FASB should be adopted. Under that approach, a power producer would still be reimbursed for its actual tax expense, but that amount would be increased (or decreased) by deferred tax liabilities (or assets). Congress sided, in part, with industry and in 1969 added the "normalization" requirements to the code. 23 Congress wanted to bar the flow-through of accelerated tax depreciation benefits. Part of the underlying rationale for accelerated tax depreciation was and is that it subsidizes the cost of new assets and spurs capital investment. If that tax benefit flowed through to ratepayers, no part of the benefit would vest in the power producer. Congress wanted accelerated tax depreciation to spur investment, not to help ratepayers. If the benefit was passed directly to ratepayers as a reduction in power rates, the underlying purpose of the benefit would be lost. 24 The gist of the legislation is that a taxpayer cannot claim accelerated tax depreciation on certain utility assets unless the normalization requirements are satisfied. The relevant property is "public utility property." Generally, most types of utility assets (power plants, transmission and distribution infrastructure, and so on) qualify as public utility property. 25 Very briefly, the normalization requirements are as follows: 26 the tax expense for ratemaking purposes must be computed by using the same depreciation method as is used for book purposes (which generally results in straight-line depreciation over a relatively long useful life); the difference between actual tax expense and tax expense determined for ratemaking purposes is aggregated into a deferred tax reserve account (generally referred to as the accumulated deferred federal income tax or ADFIT account); and in determining the return on assets or profit portion of rates, the rate base is reduced by the balance of the ADFIT account. If those requirements are met, a power producer is permitted to use accelerated depreciation for tax purposes. Conversely, if any of the requirements are not met, a power producer is barred from using accelerated tax depreciation. 27 Note that because accelerated tax depreciation is greater than book depreciation in the earlier years of an asset and lower than book depreciation in the later years, the effect is that a power prohttp://substanceforum.com/ 3 Posted: March 23, 2007

4 ducer's recovery for tax expense will be greater than actual tax expense in the early part of an asset's life cycle and less in the latter part of the asset's life cycle. If a ratemaker does not agree to those rules, the power producer will be permitted to claim only tax depreciation deductions that reflect book depreciation. In effect, the threat of the normalization rules is that if a ratemaker does not allow a utility to enjoy some tax benefits then those benefits are denied. The importance of the third requirement -- that the utility's rate base be reduced by the balance of the ADFIT account -- is that Congress did not want the tax benefit of accelerated depreciation to be totally free to a utility. In effect, the benefit is treated like an interest-free loan and reduces the utility's profits accordingly. Note that the account that contains the timing differences -- the ADFIT account -- is different than the system of deferred tax assets and liabilities created by FASB. The latter is created for all temporary book/tax timing differences, while ADFIT measures only the depreciation timing differences for regulated assets. Thus, while a sale for an installment note will create a deferred tax liability (because the income tax on the sale will be due over the term of the note, while for financial accounting purposes the income is booked currently), it will not have any effect on ADFIT. An important exception to the normalization rules is that they apply only to the extent an asset is subject to cost-based ratemaking. 28 Accordingly, if a power plant is subject to market-based rates, the owner is free to use accelerated tax depreciation without having to satisfy the normalization rules. The table located on page 5 shows a simplified example of the growth and decline of a normalization account over the life of an asset. Note that the account should zero out by the end of the asset's life. 29 Assume that the asset has a 20-year life for book purposes and book depreciation computed on the straight-line method (SLM). The example also assumes for tax purposes that the asset would be depreciated over a 10-year life and would be depreciated under the double declining balance method (DDM). 30 The book/tax depreciation differences (column G) are multiplied by the applicable tax rate to determine the changes in the ADFIT account. The AD- FIT account is increased or decreased by the annual ADFIT amounts. Note that the ADFIT will rise and fall over the life of the asset, but it should end up at zero by the end of the asset's life cycle. That reflects the fact that the differences between book and tax depreciation are timing differences rather than permanent differences. As noted, the quid pro quo for this treatment is that ratemakers then adjust a utility's rate of return to exclude the ADFIT. For example, in year 15, the computation would be as follows: Utility's rate base less ADFIT Adjusted rate base weighted cost of capital $1,100 - $100 $1,000 x 10% Permitted return on capital $100 Thus, the utility's permitted return on capital is reduced to reflect the "interest-free government loan." 31 The net effect of the rules is to "normalize" the amount of tax depreciation reflected in rates. Thus, tax expense contained in rates will be artificially high in the early years of an asset, and artificially low in the later years, but should be relatively even over the entire period. This is a simplified example that considers only the effect of accelerated depreciation. In fact, as noted, the normalization rules also apply to the (now-repealed) investment tax credit. 32 Also, special transition rules were promulgated to deal with the significant reduction in federal corporate tax rates as part of the 1986 tax act Posted: March 23, 2007

5 Book Depreciation Tax Depreciation ADFIT Computations Book Balance 20-Yr. SLM Rate Book Deprec'n Tax Balance 10-Yr. DDB Rate Tax Deprec'n Book/ Tax Deprec'n Difference Tax Rate Change to ADFIT ADFIT Balance Year A B C D E F G H I J 1 $1,000 5% $50 $1, % $100 $50 40% $20 $20 2 $950 5% $50 $ % $180 $130 40% $52 $72 3 $900 5% $50 $ % $144 $94 40% $38 $110 4 $850 5% $50 $ % $115 $65 40% $26 $136 5 $800 5% $50 $ % $92 $42 40% $17 $153 6 $750 5% $50 $ % $74 $24 40% $9 $162 7 $700 5% $50 $ % $66 $16 40% $6 $168 8 $650 5% $50 $ % $66 $16 40% $6 $174 9 $600 5% $50 $ % $66 $16 40% $6 $ $550 5% $50 $ % $66 $16 40% $6 $ $500 5% $50 $ % $33 -$17 40% -$7 $ $450 5% $50 $0 0.00% $0 -$50 40% -$20 $ $400 5% $50 $0 0.00% $0 -$50 40% -$20 $ $350 5% $50 $0 0.00% $0 -$50 40% -$20 $ $300 5% $50 $0 0.00% $0 -$50 40% -$20 $ $250 5% $50 $0 0.00% $0 -$50 40% -$20 $80 17 $200 5% $50 $0 0.00% $0 -$50 40% -$20 $60 18 $150 5% $50 $0 0.00% $0 -$50 40% -$20 $40 19 $100 5% $50 $0 0.00% $0 -$50 40% -$20 $20 20 $50 5% $50 $0 0.00% $0 -$50 40% -$20 $0 100% $1, % $1, Posted: March 23, 2007

6 IV. Interaction The existing thicket of normalization rules does not contain any reference to section 199, in part because most of the normalization authorities predate section 199. However, to the extent the tax benefit of the section 199 deduction is required to be included in setting cost-of-service rates, it is possible that the normalization rules are implicated. As will be discussed below, it appears that there are two main pitfalls. That is, two areas in which attempts by rate setters to pass the benefits of section 199 through to ratepayers may constitute a violation of the normalization rules. A. Normalization Issues One area in which attempts by rate setters to "capture" the section 199 tax benefit could constitute a normalization violation is in the computation of QPAI. Recall that the section 199 deduction is computed as a percentage of QPAI (subject, as noted, to the taxable income and W-2 limitations). If a rate setter wants to determine the section 199 tax benefit for a specific asset or line of business (for example, a coal-fired generator), various allocation and apportionment issues come into play. 34 However, assuming those issues can be resolved, the final result should be a set of revenues and expenses for the asset or activity. Thus, for a generator, this exercise should lead to a computation of the DPGR attributable to the generator (that is, receipts for the electricity produced) and a set of expenses (supplies, labor, and so on) attributable to the generator. One of the expenses permitted in the computation of QPAI is depreciation. 35 As noted, because the power industry requires large capital investments, depreciation is a significant expense and accelerated depreciation can be a significant tax benefit. As noted, the normalization rules require that (in effect) only book depreciation be used in setting rates. However, if rate setters attempt to adjust (that is, reduce) rates by the amount of the section 199 tax benefit and that benefit incorporates depreciation, then arguably that benefit must be computed on a normalized basis. If actual tax depreciation is used in the computation of an item that has an effect on rates, the normalization rules would appear to be violated. The applicable statute provides that to conform to the normalization rules: the taxpayer must, in computing its tax expense for purposes of establishing its cost of service for ratemaking purposes..., use a method of depreciation with respect to [any public utility 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. 36 Because the section 199 deduction reduces tax expense, it follows that any computation of that benefit will reduce tax expense for ratemaking purposes. Accordingly, it follows that any computation of the section 199 tax benefit for purposes of the order must be made using book depreciation, rather than tax depreciation. Indeed, given that the rationale for enacting section 199 was to spur domestic manufacturing activities (including power generation), the flow-through of the intended benefit to ratepayers would undermine that rationale. Naturally, that would not apply to the calculation of the section 199 deduction on a taxpayer's actual return. In that case, true tax depreciation would be employed. However, there are several arguments that the normalization rules should not apply. First, the normalization rules apply to the computation of tax expense only for ratemaking purposes. It can be argued that the order's isolation of the section 199 tax benefit does not have any effect on a power producer's tax expense. That argument, however, seems weak. Even though the order does not explicitly state that rates will be reduced to reflect the section 199 tax benefit, or that tax expense should be so reduced, the net effect is the same: Because of the application of a tax attribute, the power producer's tax expense is lower, which in turn reduces the rates intended to reimburse that expense. A second argument is that the normalization rules are intended only to bar the flow-through of the 6 Posted: March 23, 2007

7 benefits arising from accelerated tax depreciation and should not bar attempts to pass through the section 199 tax benefit. That argument appears sound, except that, absent any adjustment, the section 199 tax benefit reflects accelerated tax depreciation. A third argument is based on the policy underlying section 199. One of the main rationales for section 199 is to benefit domestic activities. Yet it is not clear that applying normalization rules to the computation of the section 199 tax benefit will be beneficial. That is because it is not clear whether application of normalization principles to section 199 will ultimately benefit or harm regulated utilities. As noted above, in the early part of an asset's life, tax depreciation exceeds book depreciation, and that reverses in the later part of an asset's life. Accordingly, the QPAI of an asset will be lower for the early period if tax depreciation is used as compared with book depreciation and will be higher in the later period if tax depreciation is used. As a result, the amount of the section 199 tax benefit will tend to be smaller in the earlier part of an asset's life than in the later part if tax depreciation is used as compared with book depreciation. In other words, using book depreciation will artificially inflate the amount of the section 199 tax benefit in the early years and artificially reduce it in the tail years. Accordingly, cost-based rates that offset for the section 199 tax benefit will be lower in the early years and higher in the tail years if the tax benefit is computed using normalization principles. Recall our example of the utility. Under those facts, the generator produces $1,000 of DPGR and $900 of allocable expenses, for a net $100 of QPAI and a section 199 deduction of $3. Assuming a tax rate of 35 percent, that results in a tax benefit of about $1, and presumably the taxpayer's cost-based rates would have to reflect that $1 benefit. Now assume that of the $900 in expenses, the taxpayer has $150 of depreciation deductions for tax purposes and $750 of other expenses. Assume further that the corresponding book depreciation amount is $50. In that case, if normalization principles applied, the section 199 benefit would be computed as follows: DPGR (no change) less allocable expenses other depreciation less book depreciation QPAI 2006 applicable rate Section 199 deduction applicable tax rate $1,000 - $750 - $50 $200 x 3% $6 Section 199 tax benefit $2 x 35% Thus, under those facts, the use of book depreciation results in a section 199 tax benefit that is twice as large as when tax depreciation is used. Presumably, then, the net effect on cost-based rates is twice as large as when tax depreciation is used. Or to put it differently, if the normalization rules applied, the power producer would receive $2 less in recoveries but would lose only $1 if the use of actual tax depreciation was mandated. Further, the legislative quid pro quo discussed above would not apply. That is, in the traditional application of the normalization rules, tax expense is artificially increased (along with rates) in the early years. However, the increase in the cost recovery portion of rates is offset by a decrease in rate base, so that a utility's rate of return suffers. If normalization principles applied to the computation of the section 199 tax benefit for ratemaking purposes, the use of book depreciation could create "phantom" section 199 benefits that would reduce rates. However, there would be no countervailing decrease in rate base because the normalization rules require that only changes to the ADFIT account (that is, book/tax timing differences stemming from depreciation) are reflected in the rate base. That is because changes to the ADFIT account are traced to book/tax depreciation differences. The reduction in tax expense from the flowthrough of the section 199 tax benefit does not appear to require any reduction in the ADFIT account and therefore no increase in rate base. Thus, in the example just shown, the utility suffers 7 Posted: March 23, 2007

8 reduced costs for phantom section 199 tax benefits, without any compensating increase in rate of return. One caveat is that the age of a taxpayer's assets should be taken into account. If, on average, the assets are in the tail part of their useful life, the application of normalization principles to the section 199 tax benefit will tend to be less advantageous than if the assets are in the later part of their useful life. Therefore, the application of normalization principles may be beneficial for older assets. For example, assume the same facts as in the previous example, but assume that of the $900 expense amount the taxpayer has no depreciation deductions for tax purposes and that the corresponding book depreciation amount is $100. In that case, if normalization principles applied, the section 199 benefit would be computed as follows: DPGR (no change) less allocable expenses other depreciation less book depreciation QPAI 2006 applicable rate Section 199 deduction applicable tax rate $1,000 - $900 - $100 $0 x 3% $0 x 35% Section 199 tax benefit $0 Thus, under those facts, the application of normalization principles results in a section 199 tax benefit that is zero. Accordingly, there would be no reduction in rates because there is no section 199 benefit to pass through. In contrast, use of actual tax depreciation would result in a section 199 benefit worth about $1, which would be reflected in a reduction of fees. B. Allocation Issues Another normalization issue is the allocation of expenses among assets and activities. As discussed above, in most cases only some portion of a taxpayer's activities will qualify for the deduction. Thus, the taxpayer must compute QPAI separately for each qualifying activity. As noted, QPAI is defined as the excess (if any) of DPGR over the expenses allocable to those receipts. In rare cases, a taxpayer will carry on only a single activity and all the revenue and expenses associated with the activity will be included in the determination of QPAI. In that case, the computation would be relatively simple: In effect, all expenses and all revenues would be netted to determine QPAI. In that rare case, the taxpayer's taxable income (determined without the section 199 deduction) will be equivalent to QPAI. However, in most cases a taxpayer conducts a mix of qualifying and nonqualifying activities. That is particularly so for an integrated utility, as the statute specifically provides that the transmission and distribution of power is not a qualifying activity. 37 It may be difficult to determine which expenses are properly allocable to qualifying activities and which are allocable to nonqualifying activities. That problem is compounded in the case of the order, because the FERC is interested only in the section 199 tax benefits associated with assets that are the subject of the rate filing (that is, "jurisdictional" assets and tax benefits). Thus, even if it were possible to determine whether and to what extent the revenues from a power plant qualify under section 199, it is likely more burdensome to determine allocable expenses for purposes of the order than for purposes of the code. In part that is because the order focuses on discrete assets while section 199 looks to all the taxpayer's activities and therefore permits a certain amount of aggregation. The methods sanctioned by the IRS for allocating expenses are not designed to be used on an asset-by-asset basis. The recently issued tax regulations divide allocated expense into two categories - - the cost of goods sold (COGS) and all other expenses and then set forth special rules for allocating each to DPGR. For COGS, the rules generally require the use of a facts and circumstances test that does not contain much conhttp://substanceforum.com/ 8 Posted: March 23, 2007

9 crete guidance. 39 For all other expenses, the rules specify the use of one of three alternate methods: the small-business simplified overall method, the simplified deduction method, and the section 861 method. 40 The small-business simplified overall method overrides the COGS rules and permits the taxpayer to allocate virtually all expenses between qualifying and nonqualifying activities on the basis of the ratio of DPGR to all gross receipts. 41 Thus, if 40 percent of a taxpayer's gross receipts constitute DPGR, that taxpayer would be permitted to allocate 40 percent of all expenses (including COGS) to DPGR. The benefit of this method is that it tends to avoid much of the burdensome matching, tracking, and facts and circumstances determinations of the other methods. Unfortunately, it is available only to taxpayers that are farmers, have annual gross receipts of no more than $5 million, or qualify for the cash method of tax accounting. 42 Thus, most integrated utilities could not use this method. The second allocation method, the simplified deduction method, applies only to expenses other than COGS. 43 Thus, COGS are allocated under the more difficult facts and circumstances approach described above. The balance of the taxpayer's expenses are allocated between qualifying and nonqualifying activities on the basis of the ratio of DPGR to all gross receipts. 44 While this approach does nothing to simplify the allocation of COGS, it should substantially ease the allocation of other expenses. However, as with the first method, there are restrictions on who can use it. Specifically, it is available only to taxpayers with annual gross receipts of no more than $100 million or total assets of no more than $10 million. 45 Those thresholds are applied by treating all members of a consolidated group as one taxpayer. Again, most integrated power producers would not qualify to use this method. Finally, the section 861 method will typically be the default method for most large power producers. This approach provides that expenses are allocated and apportioned under the section 861 regulations. 46 Section 861 provides incomesourcing rules for various purposes of the code. The regulations under section 861 contain special rules for allocating and apportioning expenses to U.S.- and foreign-source income. At the outset, it is worth noting that in most cases a domestic utility will not have any section 861 expertise because most utilities are largely confined to domestic operations only. Thus, applying the complex allocation and apportionment principles of section 861 will pose a significant burden to most wholly domestic taxpayers. The use of section 861 principles raises an issue in connection with the allocation of interest and some other expenses. Under the applicable regulations, interest expense is allocated based on the relative value of assets. 47 Also, the section 861 regulations permit a taxpayer to apportion other expenses based on the relative value of assets, provided that such method reflects the factual relationship between the deduction and income. 48 Thus, a taxpayer could allocate all or a significant portion of its expenses on the basis of relative asset values. If a taxpayer elects to use tax book values in making that allocation, it will be necessary to determine the as-depreciated basis of various assets. Again a normalization issue arises: Should book or tax depreciation be used in determining adjusted tax basis? Arguably, book depreciation should be used in allocating expenses for purposes of computing the section 199 tax benefit for ratemaking purposes. As discussed above, it is not altogether clear which approach is correct, and reasonable arguments can be made for each position. However, it does seem relatively clear that if a normalization approach is chosen, the level of complexity ramps up considerably. Conclusion Absent guidance from Congress or the IRS, it is not clear whether an attempt to pass through the section 199 tax benefit requires the application of normalization principles. There are strong arguments to be made for either position. Even less clear is whether, in the long run, the application of those principles would undermine or buttress the rationale behind section 199. That latter question will vary from taxpayer to taxpayer and is highly fact- specific. FOOTNOTES 1 All section references are to the Internal Revenue Code of 1986, as amended, or to the regulahttp://substanceforum.com/ 9 Posted: March 23, 2007

10 tions promulgated thereunder, except as otherwise noted FERC para. 61,351 (2005). 3 Id. 4 The discussion herein purports to be only a general overview of section 199. For a more extensive discussion of the statute and the newly issued proposed regulations, see Carol Conjura, Timothy A. Zuber, and Katherine M. Breaks, "Do the Section 199 Prop. Regs. Clarify or Complicate the Domestic Production Deduction?" 104 J. Tax'n 9 (2006). 5 Section 199(a)(1). The deduction is phased in over several years: The rate is 3 percent for 2005 and 2006, 6 percent for 2007, 2008, and 2009, and 9 percent thereafter. Section 199(a)(2). 6 Section 199(c)(1). 7 Section 199(c)(4). 8 Section 199(c)(4)(A)(i)(I). 9 Section 199(c)(4)(A)(i)(III). Note that receipts from the transmission or distribution of electricity or natural gas do not qualify as DPGR. 10 See, e.g., H.R. Rep. No , at 115 (2004). The rationale set forth for a predecessor version of section 199 is as follows: The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster economic strength also will contribute to the continuation of the recent increases in employment levels. To accomplish this objective, the Committee believes that Congress should enact tax laws that enhance the ability of domestic businesses, and domestic manufacturing firms in particular, to compete in the global marketplace. The Committee believes that a reduced tax burden on domestic manufacturers will improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive. Such investment will create and preserve U.S. manufacturing jobs. Id. Congress ultimately rejected the overt tax rate reduction approach first advanced by the House in favor of the deduction approach advanced by the Senate. H.R. Conf. Rep , at 266, 270 (2004). 11 See 111 FERC para. 61,351 at 1. The deduction, as noted, is based on the lesser of QPAI or taxable income. Section 199(a)(1). In some cases, QPAI will be the same as taxable income. However, for most taxpayers, QPAI will be less than taxable income (because, for example, the taxpayer is engaged in nonqualifying activities). As a result, the full rate reduction will not be achieved. 12 See note 10, supra. 13 Section 199(a)(1)(B). 14 Section 199(b). 15 As discussed below, the normalization rules apply only to the extent an asset is subject to cost-based rates. 16 See, e.g., 111 FERC para. 61,334 (addressing income tax allowance issues for noncorporate entities) FERC para. 61, FERC para. 61,351 (as corrected by Errata Notice issued July 6, 2005, 70 Fed. Reg. 40,327) FERC para. 61, Note that the state tax aspects of section 199 are not clear. Some states have adopted or conformed to it, while some have not. See, e.g., the neighboring states of Alabama (section 199 adopted by virtue of general federal conformity statute; Ala. Code section (2005)) and Georgia (section 199 specifically excluded from general federal conformity rules; Ga. Code Ann. section (14)). 21 See, e.g., Financial Accounting Standard (FAS) 109, para. 6-9 (Financial Accounting Standards Board, 1992). 22 FAS 109, para Posted: March 23, 2007

11 23 They are now found in sections 168(f)(2), (i)(9), and (i)(10). 24 See generally Joint Committee on Taxation, "Federal Tax Issues Relating to Restructuring of the Electric Power Industry," p. 35 (JCX-72-99). 25 Under section 168(i)(10), public utility property is defined as property that meets two requirements. First, it must be "property used predominantly in the trade or business of the furnishing or sale of -- (A) electrical energy, water, or sewage disposal services, (B) gas or steam through a local distribution system, (C) telephone services, or other communication services if furnished or sold by the Communications Satellite Corporation for purposes authorized by the Communications Satellite Act of 1962 (47 U.S.C. 701), or (D) transportation of gas or steam by pipeline." Second, "the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof." 26 See section 168(i)(9). 27 Section 168(f)(2). 28 Id. 29 This article does not address the normalization accounts that stem from section 203(e) of the Tax Reform Act of 1986 (the "excess deferred federal income tax" account established to explain the reduction in federal tax rates as part of the 1986 tax law changes and their effect on existing ADFIT balances) and from former section 46(f) (the "accumulated deferred investment tax credit" account established to ratably explain the benefit of any investment tax credits). 33 See, e.g., prop. reg. section 1.168(i)-3; 68 Fed. Reg (Mar. 4, 2003). 34 Those issues may themselves present a normalization problem. See infra Part IV.B. 35 Were there any doubt about this, the recently finalized regulations under section 199 include several examples that specifically discuss depreciation as one of the expenses to be taken into account in determining QPAI. Reg. section (e), Examples 1, 2, and 8. See also the references to cost recovery in reg. section (k)(4). 36 Section 168(i)(9)(A)(i). 37 Section 199(c)(4)(B)(ii). 38 Reg. section (b), (c). 39 Reg. section (b)(2)(i). 40 Reg. section (c)(1). 41 Reg. section (f)(1). 42 Reg. section (f)(2). 43 Reg. section (e)(1). 44 Id. 45 Reg. section (e)(2). 46 Reg. section (d)(1). 47 Reg. section T(g)(1)(i). 48 Reg. section T(c)(2). 30 See, e.g., section 168(b)(1)(A). 31 A slightly different approach is to leave the rate base alone and adjust the weighted cost of capital by assuming a zero interest loan in the amount of the ADFIT balance. Algebraically, that should yield exactly the same result. 32 See, e.g., reg. section Posted: March 23, 2007