Electric Companies Seek Clarifying Changes to Interest Regs

February 25, 2019

CC:PA:LPD:PR (REG-106089-18)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue N.W.
Washington, D.C.

The Honorable David Kautter
Assistant Secretary (Tax Policy)
United States Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington D.C. 20220

The Honorable Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

William M. Paul, Esq.
Acting Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Dear Messrs. Kautter, Rettig, and Paul:

The Edison Electric Institute wants to express its gratitude for the careful thought and attention that went into the development of the Notice of Proposed Rulemaking regarding § 163(j) of the Internal Revenue Code of 1986 ("Code") as amended by the Tax Cuts and Jobs Act (P.L. 115-97) (the "TCJA"), published on December 28, 2018 (the "NOPR"). The NOPR allows for the submission of comments. We herewith offer our comments to the NOPR. Because of the specific rules that apply to regulated public utility trades or businesses as defined in Code § 163(j)(7)(A)(iv), we ask that our requested clarifications be included in final regulations and, where possible, illustrated by example to avoid mistakes or controversy in ratemaking proceedings and tax filings. With respect to the matters on which we are commenting, our members believe that the clarity of the rule can be as important as the rule's substance.

IDENTIFYING A TRADE OR BUSINESS

The proposed regulations provide that the computations required for Code § 163(j) and the regulations thereunder generally are made for a group that files a consolidated federal income tax return on the basis of treating the group as a single taxpayer. The proposed regulations also require an allocation of assets used in a utility trade or business between excepted and non-excepted trades or businesses. EEI requests clarification of the appropriate methodology to allocate assets and interest expense between excepted and non-excepted trades or businesses whether conducted by members of a consolidated group or within a single corporation.

De Minimis Tests

The proposed regulations provide three de minimis tests potentially applicable to a taxpayer with an excepted regulated utility trade or business as described in Prop. Reg. § 1.163(j)-1(b)(13). EEI requests clarification regarding the order and proper application of three de minimis tests. Specifically, EEI requests clarification that the "Regulated Utility De Minimis Test" of Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(3), the "Assets De Minimis Test" of Prop. Reg. § 1.163(j)-10(c)(3)(iii)(B)(2), and the "All Taxpayer Assets De Minimis Test" of Prop. Reg. § 1.163(j)-10(c)(1)(ii) are each potentially applicable to a taxpayer involved in an excepted regulated utility trade or business, and that such application appropriately occurs in the order noted.

The Regulated Utility De Minimis Test will allow regulated utility taxpayers to measure their output and determine whether, based on the output of the entire group; the group is an excepted utility trade or business without further inquiry. This rule is a major simplification because it eliminates the need to apply several complex rules dealing with the allocation of asset basis. Only if the Regulated Utility De Minimis Test is not satisfied need a utility taxpayer consider the use of specific assets used in different trades or businesses of the group. In doing so it is appropriate to start at the asset level by (i) assigning the basis of assets to either excepted or non-excepted trades or businesses based on their use, or (ii) bifurcating the basis of assets that are used in both excepted and non-excepted trades or businesses. When assets are used in both excepted and non-excepted trades or businesses the predominant use of an asset (based on a 90-percent standard) will determine whether its basis is allocated fully to either an excepted or non-excepted trade or business under the Assets De Minimis Test. Only after all asset basis is allocated to either excepted or non-excepted trades or businesses is the taxpayer's trades or businesses considered under the All Taxpayer Assets De Minimis Test to determine if the taxpayer's trades or businesses are predominantly (based on a 90-percent standard) excepted or non-excepted trades or businesses.

The Treasury Department has asked for comment with respect to the mandatory nature of the de minimis rules. EEI believes the de minimis rules are appropriate and supports their mandatory use as a reasonable approach to simplify the administration of Code § 163(j) to the regulated utility industry.

Wholesale or Market Rate Sales

The proposed regulations imply that all electricity sold at market rates rather than on a cost of service or rate of return basis must be treated as electricity sold by a non-excepted regulated utility trade or business, and that the relative amounts of output determine the asset basis allocated to the excepted and non-excepted trades or businesses. The Treasury Department has asked for comments with respect to this allocation methodology. EEI believes wholesale or market rate sales that are taken into account by regulators when establishing or approving customer rates using cost of service or rate of return rate making as described in Prop. Reg. § 1.163(j)-1(b)(13)(B) are appropriately attributable to an excepted utility trade or business, and that such sales are properly distinguished from wholesale or market rate sales that are not taken into account in establishing or approving cost of service or rate of return rates. For example, it is common for regulators to determine the price at which a regulated utility will sell electricity to its retail customers based on its cost of service, including a rate of return on its investment, and to provide that any excess electricity generated will be sold on the wholesale market, with the proceeds of those sales taken into account in determining the utility's rates. In such cases, the sales on the wholesale market reduce the rates paid by, the regulated utility retail customers. This is in contrast to the rate making process that allocates only a portion of the plant output to retail customers based their expected share of the plant output, and allows the utility to sell other electricity from the plant to wholesale customers at market rates where the benefits of those other sales do not affect the regulated utility retail customer rates.

The industry requests the noted clarifications with respect to identifying a trade or business, order and application of the de minimis tests, and wholesale or market rate sales be provided via new examples in the final regulations in-lieu of the example provided in Prop. Reg. § l.163(j)-10(c)(3)(iii)(C)(1).

Use of Output as Basis for Allocating
Asset Basis for Utility Trades or Businesses

In today's electric utility industry, it is common, although not universal, for the generation businesses of utilities to not be subject to cost of service, rate of return regulation. In contrast, it is almost universal that the distribution businesses of utilities are subject to cost of service, rate of return regulation. Another common practice in the electric industry is for one or more members of a group that files a consolidated federal income tax return to generate electricity ("Generator"), which they sell at non-regulated market rates (rates not described in Prop. Reg. § 1.163(j)-1(b)(13)(B)), through a regional transmission organization ("RTO"), including sales to other members of the group ("Distributor") whose rates are established or approved on a cost of service or rate of return basis as described in Prop. Reg. § 1.163(j)-1(b)(13)(B). This practice can also occur in a single utility corporation that has generation assets and distribution assets in the same legal entity, which is unimportant for purposes of considering this issue, since in both cases the proposed regulations treat the utility trade or business as a single taxpayer. While the proposed regulations would treat the consolidated group of Generator and Distributor as a single taxpayer and each as engaged in a trade or business of the furnishing or sale of items described in Prop. Reg. § 1.163(j)-1(b)(13)(A), the relative output of electricity sold or provided by each, as provided in Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(2), would not provide a reasonable basis by which to allocate the assets of the group since they are providing different functions and using different assets (generation versus distribution) with respect to the common output of electricity. Generator is selling electricity from assets dedicated to the generation of that electricity and Distributor is using its assets to furnish electricity, and passing through to its customers its cost for the electricity. Although Generator and Distributor are treated as a single taxpayer, the Generator's assets are used in a non-excepted trade or business and Distributor's assets are used in an excepted trade or business.

EEI believes that the mandatory use of output should be applied to the Regulated Utility De Minimis Test of Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C) and the Assets De minim is Test of Prop. Reg. § 1.163(j)-10(c)(3)(iii)(B)(2). EEI also believes that the use of output is appropriate when allocating an asset used in both an excepted trade or business and non-excepted trade or business, but it should not be used to allocate assets that exclusively perform either excepted or non-excepted activities, and should also not be used to apply the All Taxpayer Assets De Minimis Test of Prop. Reg. § 1.163(j)-10(c)(1)(ii). For example, if generation plant assets are used to produce electricity that is sold both at rates determined on a cost of service or rate of return basis ("regulated rates") and market rates not taken into account by the regulator in establishing or approving rates on a cost of service or rate of return basis, the relative output of the plant to customers paying regulated rates and customers paying market rates would provide a reasonable allocation for the generation plant assets. Similarly, if more than 90 percent of a taxpayer' s output of items described in Prop. Reg. § l.163(j)-1(b)(13)(A) are sold at rates that are established or approved on a cost of service or rate of return basis as described in Prop. Reg. § 1.163(j)-1(b)(13)(B), the taxpayer's entire trade or business is an excepted regulated utility trade or business. On the other hand, if a utility is generating electricity and selling all of its generated electricity at market rates and distributing electricity at regulated rates, it is not reasonable to allocate the utility's assets (the aggregate of generation assets and distribution assets) on the basis of their respective sales measured in kilowatts. Such treatment would needlessly comingle assets used in either an excepted trade or business (distribution) or a non-excepted trade or business (generation) and then allocate them in a manner different than their use based on output. To accommodate this recommendation, EEJ suggests that Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(2) be changed, a new Prop. Reg. § 1.163(j)-10 (c)(3)(iii)(C)(1) be added, and Prop. Reg. § 1.163(j)-10 (c)(3)(iii)(C)(1) be renumbered as Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(i). The amendment to Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(2) and the addition of new Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(1) would read as follows:

(2.) Permissible method for allocating an asset's basis for utility trades or businesses. In the case of a utility trade or business described in paragraph (c)(3)(iii)(C)(1) of this section, and except as provided in the de minimis rule in paragraphs (c)(3)(iii)(C)(3) and (c)(3)(iii)(C)(4) of this section, the method described in paragraph (c)(3)(ii)(C) of this section is the only permissible method for allocating the taxpayer's basis in an asset used in both the taxpayer's excepted and non-excepted trades or businesses of selling or furnishing the items described in § 1.163(j)-1(b)(13)(i)(A).

(3) Permissible method for allocating the taxpayer's basis in assets among the taxpayer's utility trades or businesses. In the case of a utility trade or business described in paragraph (c)(3)(iii)(C)(1) of this section, and except as provided in the de minim is rule in paragraph (c)(3)(iii)(C)(4) of this section, the taxpayer allocates assets on the basis of their use in its trades or businesses. Thus, for example, a taxpayer that generates and distributes electricity allocates assets used to generate electricity to the generation trade or business and allocates assets used to distribute electricity to the distribution trade or business before allocating the assets between any excepted and non-excepted generation or distribution trades or businesses under paragraph (c)(3)(iii)(C)(2) of this section.

Proposed Examples

The following examples illustrate the principles of Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C).

Example (1). The first example illustrates the allocation between an excepted trade or business and non-excepted trade or business as did the example at Prop. Reg. §1.163(j)-10(c)(J)(iii)(C)(4), with the addition that X sells the 20 percent of the kilowatts on the wholesale markets at rates not established on a cost of service, rate of return basis or by the governing or ratemaking body of an electric cooperative and those wholesale market sales are not taken into account by the public utility commission in establishing X's retail rates. EEI suggests the example read as follows:

X, a C corporation, is engaged in the trade or business of generating electric energy. During each determination period in the taxable year, 80 percent of the kilowatts generated in the electric generation trade or business are sold in retail markets at rates established by a public utility commission on a cost of service, rate of return basis. The remaining 20 percent of the kilowatts are sold on the wholesale markets at rates not established on a cost of service, rate of return basis or by the governing or ratemaking body of an electric cooperative and those wholesale market sales are not taken into account by the public utility commission in establishing X's retail rates. None of the assets used in X's utility generation trade or business are used in any other trade or business.

For purposes of section 163(j), under paragraph (c)(3)(iii)(C)(1) of this section, 80 percent of X's electric generation business is an excepted regulated utility trade or business, and the remaining 20 percent of X's business is a non-excepted utility trade or business. Under paragraph (c)(3)(iii)(C)(2) of this section, X must allocate 80 percent of the basis of the assets used in its utility business to excepted trades or businesses and the remaining 20 percent of the basis in its assets to non-excepted trades or businesses.

Example (2). The second example illustrates a conclusion that differs from the result in the first example because in the second example, in establishing X's rates the public utility commission takes into account that X will sell 20 percent of the kilowatts at market rates in establishing X's cost of service including a return on its investment when setting retail rates. Also, because 100 percent of the electricity output is more than 90 percent of X's items described in Prop. Reg. § 1.163(j)-1(b)(13)(i)(A). the de minimis rule of Prop. Reg. §1.163(j)-10(c)(3)(iii)(C)(3) applies and no allocation is made to non-excepted trades or businesses under Prop. Reg. § 1.163(j)-10(c)(3)(iii)(C)(2). EEI suggests the example read as follows:

The facts are the same as in Example (1) except the 20 percent of the kilowatts sold by X at market rates not established on a cost of service, rate of return basis or by the governing or ratemaking body of an electric cooperative are taken into account by the public utility commission in establishing X's retail rates.

For purposes of section 163(j), under paragraph (c)(3)(iii)(C)(1) of this section, 100 percent of X's electric generation business is an excepted regulated utility trade or business. Under paragraph (c)(3)(iii)(C)(4) [as renumbered] of this section, X's entire trade of business is an excepted regulated utility trade or business and paragraph (c)(3)(iii)(C)(2) of this section does not apply.

Example (3). The third example further illustrates the application of the asset basis allocation rules for utility trades or businesses as discussed above in the section, Use of Output as Basis for Allocating Asset Basis for Utility Trades or Businesses, and the application of the de minimis and output allocation rules.

Y and Z are both C corporations that file a consolidated federal income tax return as the YZ Group. Y is engaged in the trade or business of distributing electric energy and Z is engaged in the trade or business of generating electric energy. Y sells 1,000X kilowatts of electricity to retail customers at rates established by a public utility commission on a cost of service, rate of return basis. Z generates 2,000X kilowatts of electricity at rates not established on a cost of service, rate of return basis or by the governing or ratemaking body of an electric cooperative. Du ring the taxable year, Z delivers all its 2,000X kilowatts of electricity to a regional transmission organization ("RTO") for which it is paid $224X. RTO delivers 800X kilowatts of electricity to Y under the terms of a power purchase agreement between Y and Z, for which Y pays $BOX, and purchases the remaining 1,200X kilowatts from Z at rates based on market bids, for which it pays $144X. Y purchases the remaining 200 kilowatts of electricity required to serve its customers from RTO at market prices, for which it pays $24X. In establishing or approving Y's rates to its retail customers, the public utility commission that sets Y's rates allows Y to recover the purchase price of electricity that Y purchases from Z and its other sources, without any markup on those costs as a cost of service and takes none of Z's costs into account in setting Y's rates. Y's assets are $600X, Z's assets are $400X, and the assets of the YZ Group are $1,000X. None of the assets used in the YZ Group's utility trade or business are used in any other trade or business.

For purposes of section 163(j), under paragraph (c)(3)(iii)(C)(1) of this section, the YZ Group is engaged in the trade or business of the furnishing or sale of items described in § 1.163(j)-1(b)(13)(i)(A) and is treated as a single taxpayer in the same manner as an integrated utility that generates and distributes electricity through a single entity. Since the kilowatts of electricity generated by Z are not sold at rates described in §1.163(j)-1(b)(13)(i)(B) and the kilowatts of electricity furnished by Y are sold at rates described in § 1.163(j)-1(b)(13)(i)(B), the YZ Group must allocate the basis of assets used in its utility trade or business between its excepted and non-excepted trades or businesses under this paragraph (c). Because the YZ Group furnishes or sells 2,200X kilowatts of electricity, only 1,000X kilowatts (1,000X ÷ 2,200X = 45%) of which are sold at rates described in § 1.163(j)-1(b)(13)(i)(B), the de minimis rule of paragraph (c)(3)(iii)(C)(4) [as revised] of this section does not apply and the YZ Group must allocate its assets between its excepted and non-excepted trades or businesses under paragraph (c)(3)(iii)(C)(2) of this section. Under paragraph (c)(3)(iii)(C)(3) [as revised], the YZ Group allocates its distribution assets to its distribution business and its generation assets to its generation business. Since 100 percent of Y's assets are used in the trade or business of the furnishing or sale of items described in § 1.163(j)-1(b)(13)(i)(A), and the rates for those items furnished and sold are described in § 1.163(j)-1(b)(13)(i)(B), 100 percent of Y's assets are allocated to the excepted trade or business of the YZ Group. Since 100 percent of Z's assets are used in the trade or business of the furnishing or sale of items described in § 1.163(j)-1(b)(13)(i)(A), and the rates for none of those items furnished and sold are described in § 1.163(j)-1(b)(13)(i)(B), 100 percent of Z's assets are allocated to the non-excepted trade or business of the YZ Group. Since Y's excepted trade or business assets are 60 percent of the taxpayer's assets ($600X of Y assets ÷ $1,000X of YZ Group assets) and Z's non-excepted trade or business assets are 40 percent of the taxpayer's assets ($400X of Z assets ÷ $1,000X of YZ Group assets), 90 percent or more of the taxpayer's basis in its assets is not allocated to either excepted trades or businesses or non-excepted trades or businesses during the determination period, the de minimis exception of paragraph (c)(1)(ii) of this section does not apply.

Under paragraph (c)(3)(iii)(C)(Z) of this section, the YZ Group must allocate 40 percent of its net interest expense to its non-excepted trades or businesses and apply the limitation of section 163(j) to that interest in computing its interest deduction.

For purposes of applying section 163(j) to that interest, the adjusted taxable income of that non-excepted trade or business includes the items properly allocable to that non-excepted trade or business of the YZ Group. This includes the $BOX revenue of the YZ Group from the sale of electricity generated by Z to RTO, which was purchased by Y and charged to Y's customers, and the $144X revenue of the YZ Group from the sale of electricity generated by Z to RTO, which was sold to other market participants, and all Z's cost of producing electricity. The revenue of the YZ Group from the sale of electricity generated by Z does not include the revenue the YZ Group derives from retail customers for the distribution of that electricity to those retail customers by the YZ Group's excepted trade or business.

Computation of Adjusted Taxable Income ("ATI")

It is common for the trades or businesses that generate and sell electricity to be non-excepted trades or businesses and therefore subject to the limitation on interest deductions provided by Code § 163(j). While taxpayers that produce electricity typically do not maintain inventories, the Internal Revenue Service ("IRS") has concluded that the costs to produce electricity are inventoriable costs, and thus are recovered through cost of goods sold. See, e.g., T.A.M. 200916004 (Apr. 17, 2009) and G.C.M. 37199 (July 25, 1977).

Code § 163(j)(8) defines ATI as taxable income computed without regard to certain items including, "in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion." A taxpayer's ATI is taken into account in determining its interest deduction limitation. Generally, the higher the ATI, the higher the limitation on the amount of interest the taxpayer is permitted to deduct. Code § 163(j)(8) is intended to provide taxpayers with relief for taxable year beginning before 2022, as the tax regime transitions to the new interest limitation rules. Prop. Reg. § 1.163(j)-1(b)(iii) provides that "[d]epreciation, amortization, or depletion expense that is capitalized to inventory under section 263A is not a depreciation, amortization, or depletion deduction for purposes of [determining ATI)." If finalized, this provision would effectively eliminate the transition relief provided by Code § 163(j)(8) for taxpayers who produce inventory (manufacturers including producers of electricity). The preamble to the proposed regulations provides that "the Treasury Department and the IRS note that an amount incurred as depreciation, amortization, or depletion, but capitalized to inventory under section 263A and included in cost of goods sold, is not a deduction for depreciation, amortization, or depletion for purposes of section 163(j)" without further explanation.

EEI asks that the Treasury Department modify the proposed regulations so that all depreciation, amortization, and depletion is treated the same in the computation of ATI without regard to whether it is capitalized to inventory under Code § 263A and recovered as cost of goods sold, or otherwise recovered, in arriving at taxable income, for tax years beginning after December 31, 2017, and prior to January 1, 2022. To not do so would unfairly disadvantage manufacturers (including producers of electricity) during this transition period. As proposed, the rule arbitrarily differentiates between similarly situated taxpayers and places manufacturers at a disadvantage.

This disparity in treatment is inconsistent with the broader intent of the legislation. EEI has found nothing in the statute or the legislative history to suggest that Congress intended to differentiate the ability to add back depreciation expense between similarly situated taxpayers. However, Congress did specifically show its concern that it had not properly identified all appropriate adjustments to taxable income required in arriving at ATI, by its specific delegation to the Treasury Department to identify other adjustments. Code § 163(j)(8)(B). Even if the Treasury Department believes that a literal reading of the statute does not allow the add back of certain depreciation, there is no question that the Treasury Department has the authority to allow that add back.

When considering this issue, the Treasury Department should be mindful that the Supreme Court has acknowledged that it is often necessary to look beyond the literal words of a statute where a literal reading produces an unreasonable result "plainly at variance with the policy of the legislation." U.S. v. American Trucking Ass'ns,310 U.S. 534, 543 (1940). "It is a well-established canon of statutory construction that a court should go beyond the literal language of a statute if reliance on that language would defeat the plain purpose of the statute." Bob Jones Univ. v. U.S., 461 U.S.574, 586 (1983). The Supreme Court has further stated that "the plain meaning of legislation should be conclusive, except in the rare cases [in which) the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters." U.S. v. Ron Pair Enters., Inc., 489 U.S. 235, 242 (1989).

Thus, even if the Treasury Department believes that a literal reading of Code § 163(j)(8)(A)(v) does not allow the addback of depreciation capitalized into cost of goods sold, it needs to address the question whether such a reading would "produce a result demonstrably at odds with the intentions of its drafters." There is no view suggested by the legislative history that manufacturers should be treated differently than other taxpayers. EEI sees no tax policy reason to distinguish manufacturers from other taxpayers in determining the point at which to impose the interest deduction limitation, which is based on the concept of earnings before interest, taxes, depreciation and amortization ("EBITDA"). To the contrary, the approach in the proposed regulations appears arbitrary, especially when the treatment of taxpayers engaged in the electric generation business is compared to non-manufacturers with similar depreciation costs and capital structures. As a practical matter, taxpayers who produce electricity typically recover their depreciation costs in the same year that the electricity is produced and delivered to the customer just as in the case of non-manufacturers.

In allowing taxpayers to add back depreciation for years prior to 2022, Congress intended to provide taxpayers some relief as the tax regime transitions to the new interest limitation rules of Code § 163(j), as well as not remove the incentive for taxpayers to make capital expenditures by allowing them 100-percent additional first year depreciation. This is consistent with other provisions of the TCJA, which were intended to incentivize capital investment and stimulate economic growth. The current rule in the proposed regulations frustrates this intent. By not including depreciation that is capitalized to inventory under Code § 263A as depreciation for purposes of computing ATI under Code § 163(j)(8), the proposed regulations extend this relief to some taxpayers (e.g., service providers or resellers of goods) while denying the relief to others (e.g., manufacturers and energy producers). The proposal runs counter to the TCJA goal of incentivizing and encouraging capital development by potentially preventing any taxpayer that operates a capital-intensive business (e.g., manufacturing and energy production) from enjoying the same benefits as other similarly situated taxpayers.

This is not the first time the Treasury Department has been faced with the question of whether Congress intended the term "deduction" to include the recovery of costs through costs of goods sold. Previous IRS administrative guidance interpreted "deduction" broadly to include cost of goods sold in order to effectuate Congress's intent in enacting the relevant statute. In A.O.D. 1977-77, the IRS expressed disagreement with the Tax Court decision in B.C. Cook & Sons, 65 T.C.422 (1975) herein the court rejected the government's argument that the amount included in cost of goods sold was a "deduction" for purposes of applying the mitigation provisions of Code §§ 1311-1315. The IRS concluded that the court applied an "overly-literal interpretation" of the word "deduction" that was inconsistent with Congressional intent, and that such word should be interpreted to refer to items which reduce gross income whether included in cost of goods sold or deducted from gross income in a technical sense. The IRS has consistently followed the logic in A.O.D. 1977-77 to conclude that the term "allowable as a deduction" should be read broadly to include amounts taken into account as cost of goods sold. Some examples include: (1) Non-Docketed Significant Advice Review 020407 (May 31, 2002), which applied the rationale of A.O.D. 1977-77 to conclude that an insurance company's reduction of unpaid loss reserves constitutes the denial of a "deduction" for purposes of the mitigation provisions even though the unpaid losses were accounted for in the calculation of gross income, rather than claimed as a deduction and (2) FSA 199932014 (May 5, 1999), which applied the rationale of A.O.D. 1977-77 to conclude that an adjustment to cost of goods sold as a result of royalty payments constitutes the denial of a "deduction" for purposes of the mitigation provisions.

In C.C.L.A. 2008-012, the IRS concluded that environmental remediation costs and workers' compensation costs that are allocated to inventory under Code § 263A and recovered through cost of goods sold constitute amounts "allowable as a deduction," satisfying the definition of specified liability losses under Code § 172(f). The IRS reasoned that "Congress used the phrase 'allowable as a deduction' in [Code §] 172(f)(1)(B)(i) to mean amounts that may be taken into account in computing taxable income. Congress did not mean to distinguish 'deductions' from 'cost of goods sold."' Furthermore, an interpretation of Code § 172(f) that prohibits capitalized costs from qualifying as specified liability losses would effectively limit application of that provision to service providers and others not subject to Code § 263A. Such a reading would produce an unintended limitation and "[i]f Congress had intended to limit [Code §] 172(f) so, it would have stated it explicitly." The IRS determined that there was nothing in the legislative history of Code § 172(f) indicating that Congress intended to exclude manufactures from obtaining specified liability loss treatment. Accordingly, the C.C.L.A. concludes that Congress did not intend the phrase "allowable as a deduction" to disqualify expenditures merely because those expenditures are allocated to inventories under Code § 263A and recovered through cost of goods sold. The IRS has followed through with this position by providing field direction for the examination of Code § 172(f) specified liability loss claims and citing C.C.L.A. 2008-012 to specify that workers' compensation costs allocated to inventory under Code § 263A are taken into account in determining specified liability losses to the extent included in cost of goods sold for that year. Industry Director's Directive #2 on Specified Liability Losses IRC 172(f), LMSB-4-0309-011 (June 19, 2009).

Specifically dealing with the generation of electricity, in C.C.A. 200931007 (July 31, 2009), the IRS concluded that nuclear decommissioning costs that must be recovered through cost of goods sold, though not deductible by the producer of electricity under Code § 162(a), are "allowable" deductions that can be taken into account in computing taxable income under the Code. As "allowable" deductions, such nuclear decommissioning costs qualified as specified liability losses under Code § 172(f). Like C.C.L.A. 2008-012, the IRS reasoned that Congress used the phrase "allowable as a deduction" to mean an amount that may be taken into account in computing taxable income and did not intend to distinguish "deductions" from "cost of goods sold."

Analogous to the IRS's position with respect to the mitigation and specified liability loss provisions, "deduction" for purposes of Code§ 163(j)(8)(A)(v) should be interpreted broadly to refer to items that reduce gross income whether included in cost of goods sold or deducted from gross income. In adopting an EBITDA test for taxable years prior to 2022, Congress did not mean to distinguish "deductions" from cost of goods sold. In addition, neither the statute nor the legislative history provides any support for treating manufacturers differently than other taxpayers. Instead, the TCJA was intended to incentivize capital investment, which is significantly driven by manufacturers. The limitation on the term "depreciation" in the proposed regulations contradicts this intent. Accordingly, EEI requests that the proposed regulations be amended to be consistent with Congressional intent and with the IRS's previously stated position under substantially similar facts by providing that depreciation included in cost of goods sold is added back to taxable income in arriving at ATI.

Partnership Look-Through Rule

The proposed regulations treat a single corporation or a group of corporations that file a consolidated federal income tax return as a single taxpayer for purposes of Code § 163(j). Prop. Reg. § 1.163(j)-4. They also treat a partnership as a taxpayer separate from its partners, including corporate partners. Prop. Reg. § 1.163(j)-6. Code § 163(j)(4)(A) requires taxpayers to apply a separate limitation on the deduction for business interest expense at the partnership level. For corporate partners, the general rule under Prop. Reg. § 1.163(j)-10(c)(5)(ii)(A)(k)(iv) treats the partner's entire basis of a partnership interest as an asset allocable to a non-excepted trade or business. However, there is a special rule, which provides an important exception to that general rule of Prop. Reg. § 1.163(j)-10(c)(5)(ii)(A)(2)(iv) for allocating the adjusted tax basis in a partnership interest of a corporate partner as attributable to an excepted trade or business or non-excepted trade or business based on the use of the assets in excepted or non-excepted trades or businesses at the partnership level (the "Look-Through Rule"). The Look-Through Rule is mandatory when the partner's interest constitutes 80 percent or more of the partnership's capital or profits. Otherwise, it is elective. Prop. Reg. § 1.163(j)-10(c)(5)(ii)(A)(2)(i).

A partner determines its share of partnership assets using a reasonable method, which takes into account (i) special allocations under Code §704(b), (ii) adjustments under Code §§734(b) and 743(b), and (iii) direct allocations made under Prop. Reg. § 1.163(j)-10(d)(4). A partner's share of partnership assets used in the partnership's excepted and non-excepted trades or businesses provides the basis of allocating the partner's interest in the partnership between assets used in excepted and non-excepted trades or businesses. Prop. Reg. § 1.163(j)-10(c)(5)(ii)(A)(2)(i). Prop. Reg. § 1.163(j)-10(c)(5)(i) provides special rules for calculating basis ("Basis Determination Rules"). The proposed regulations provide that the partner's interest in the partnership that is subject to allocation is the partner's adjusted basis in the partnership reduced, but not below zero, by the partner's share of the partnership's liabilities as determined under Code §752 (the "Code § 752 Basis Reduction"). Prop. Reg. § 1.163(j)-10(c)(5)(ii)(A)(1).

As discussed below, EEI believes that the final regulations should clarify that (1) the Basis Determination Rules apply both in determining (i) the partnership' s basis in assets allocable to the partnership's excepted and non-excepted trades or businesses, which provides the basis of allocating the partner's interest in the partnership under the Look-Through Rule, and (ii) the partner's basis in the partnership interest which is allocated under the Look-Through Rule.

Partnership Assets Allocable to Excepted
and Non-Excepted Trades or Businesses

EEI proposes that the final regulations clarify that the taxpayer applies the Basis Determination Rules at the partnership level before allocating assets between excepted and non-excepted trades or businesses and determining the partner's share of those assets. For example, the Basis Determination Rules provide that a taxpayer determines its adjusted basis in certain tangible depreciable property using the alternative depreciation system under Code § 168(g). The final regulations should specify that the taxpayer makes this adjustment, and the other adjustments required by the Basis Determination Rules, before allocating the partnership assets between the partnership' s excepted and non-excepted trades or businesses and determining the partner's share of each.

The preamble to the proposed regulations explains the necessity for the Basis Determination Rules, in part, as a means of neutralizing the distortive effects of different depreciation systems on the adjusted basis of assets. Without the Basis Determination Rules, a taxpayer's method of depreciation would directly impact the allocation of its business interest expense to excepted and non-excepted trades or businesses. This is particularly the case when allocating between excepted trades or businesses, which are not eligible for the 100-percent additional first year depreciation, and non-excepted trades or businesses, which are eligible for the 100-percent additional first year depreciation. For the same reason, the Basis Determination Rules are necessary to neutralize the distortive effects of depreciation claimed by a partnership on assets used in excepted and non-excepted trades or businesses. Application of the Basis Determination Rules in this manner is also necessary to ensure that interest income and expense is allocated to excepted and non-excepted businesses consistent with the way it would be allocated if the assets of the partnership were held directly by a partner.

In addition, EEI asks that the final regulations clarify the manner in which a partner determines its share of the tax basis of a specific partnership asset. By indicating that Code §§743(b) and 704(b) should be taken into account, the proposed regulations seem to imply that a partner's share of the partnership's basis in an asset is determined by reference to the future depreciation deductions that a partner would be allocated with regard to such asset or the amount of basis to be taken into account by that partner in determining its allocable share of gain or loss on the partnership' s disposition of the asset. EEI proposes that final regulations expressly confirm that implication. The proposed regulations are also silent as to the impact, if any, of remedial allocations under Code § 704(c) on a partner's share of the partnership' s basis in an asset. EEI proposes that final regulations address whether and, if so, how allocations under §704(c) impact a partner's share of the partnership's basis in its assets.

Partner's Basis in its Partnership Interest.

Similarly, to avoid distortions, EEI asks that the final regulations clarify that a partner reflects the basis adjustments made under the Basis Determination Rules, including the use the alternative depreciation system under Code § 168(g), at the partnership level in computing its adjusted tax basis in its partnership interest before allocating that adjusted basis of its partnership interest between assets used in excepted trades or businesses and non-excepted trades or businesses for purposes of allocating the partner's items under Prop. Reg. § 1.163(j)-10.

Deemed Asset Sale

EEI supports the deemed asset sale rule of Prop. Reg. § 1.163(j)-10(c)(5)(iv). This rule deems a taxpayer that acquires a partnership interest or corporate stock in a transaction eligible for an election under Code § 336, 338, or 754 as having made such election for purposes of allocating asset basis between excepted and non-excepted trades or businesses. Under the proposed regulations, use of the deemed asset sale rule requires the taxpayer "to demonstrate to the satisfaction of the Commissioner . . . that the taxpayer was eligible to make an election but was actually or effectively precluded from doing so by a regulatory agency with respect to an excepted regulated utility trade or business."

EEI is concerned that the requirement that a taxpayer demonstrate "to the satisfaction of the Commissioner" that it was "actually or effectively precluded" from making the election will result in unnecessary requests to regulatory agencies in already complex and difficult proceedings. The provision also could unduly limit the scope and effectiveness of this relief provision because of the ambiguity of an "effectively precluded" standard. The experience of EEI members is that ambiguous standards coupled with a "satisfaction of the Commissioner" burden of proof lead to controversies and the inconsistent application of standards between similarly situated taxpayers. Since taxpayers already bear the burden of proof, there is no need for the regulations to signal a higher burden of proof, given the circumstances that create the need for this relief provision.

The need for the deemed asset sale rule is based on the reality that a Code § 336, 338, or 754 election involving a regulated utility generally results in adverse consequences for the utility's customers because the election results in an increase in the utility's rate base on which it earns a return through the prices it charges its customers. This is so because the election requires the elimination of the deferred tax liability ("DTL") account associated with the assets that receive the step-up in basis. Under general rate making principles the DTL reduces rate base, but under federal income tax rules the DTL must be eliminated when the step-up occurs. This elimination of the DTL increases the utility's rate base. Although state laws vary, in most jurisdictions regulatory approval of the sale of a utility is contingent on a determination that the acquisition is in the best interests of the ratepayers or, at a minimum, that the acquisition will not have an adverse impact on ratepayers. For these reasons, regulatory agencies frequently will not approve transactions in which a Code § 336, 338,754 election is proposed out of concern that the election will increase customer rates. EEI asks that the Treasury Department accept this reality and modify the standard in the final regulations to provide:

(iv) Deemed asset sale. Solely for purposes of determining the amount of basis allocable to excepted and non-excepted trades or businesses under this section, an election under section 336, 338, or 754, as applicable, is deemed to have been made for any acquisition of corporate stock or partnership interests if the taxpayer was eligible to make such an election with respect to an excepted regulated utility trade or· business. The taxpayer shall provide, in the information statement required by paragraph (c)(6)(iii)(B) of this section, information to demonstrate its eligibility to determine allocable basis under this paragraph. Any additional basis taken into account under this rule is reduced ratably over a 15-year period beginning with the month of the acquisition and is not subject to the anti-abuse rule in paragraph (c)(B) of this section.

Determination Date and Determination Period

Under Prop. Reg. § 1.163(j)-10(c)(6), a taxpayer would determine the adjusted basis in its assets on a quarterly basis and average those amounts to determine the relative amounts of asset basis for its excepted and non-excepted trades or businesses for a taxable year. The taxpayer would determine the adjusted basis in its assets as of the dose of each quarter in the taxable year and average those amounts to determine the relative amounts of asset basis for its excepted and non-excepted trades or businesses for that year. The Treasury Department requested comments on the frequency of asset basis determinations.

EEI believes that the proposed quarterly determination results in an unwarranted administrative complexity without a significant improvement in determining a reasonable allocation of assets. The burden is significant because taxpayers must make numerous complex determinations under the proposed regulations, which are specific to the application of Code § 163(j). To reduce the number of times a taxpayer must make these complex determinations, EEI suggests the use of a simple average based on the first and last day of the taxpayer's taxable year. This would result in the "determination date" being the last day of the taxpayer's taxable year and a "determination period" beginning the first day of the taxpayer's taxable year and ending on the last day of the taxpayer's taxable year. This proposal would reduce the number of determinations a taxpayer generally would make each year from three to a single determination.

EEI believes that the Code § 861 interest apportionment principles serve as a model for the interest apportionment rules for Code § 163(j). The Code § 861 rules have been developed over a long period of time, and both taxpayers and the IRS have significant experience in their application. The Treasury Department issued Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act, 83 Fed. Reg. 235 (proposed December 7, 2018). Consistent with Code § 163(j) interest apportionment, Code §864(e)(2) requires taxpayers to apportion interest expense based on assets. Prop. Reg. § 1.861-9(g)(2)(i)(A) continues the long-standing principle that in determining the value of assets, an average of values is computed for the year based on values of assets at the beginning and end of the year. Instead of requiring more frequent determinations to deal with a substantial distortion of asset values that might result from averaging beginning-of-year and end-of-year values, the Code §861 proposed regulations provide that the taxpayer must use a different method of asset valuation that more clearly reflects the average value of assets weighted to reflect the time such assets are held by the taxpayer during the taxable year. EEI believes that the averaging principles proposed for Code § 861 more appropriately balance the administrative burden of making asset value determinations and provide a reasonable safeguard for episodic events such as a major acquisition or a change in business.

We appreciate your consideration of these comments and are available to answer any questions. If you have any questions or need further clarifications, please contact Alex Zakupowsky (202-626-5950) of Miller & Chevalier or Eric Grey (202-508-5471) of EEI.

Sincerely,

Thomas R. Kuhn
President
Edison Electric Institute
Washington, DC