EXPENDITURES FOR ENERGY CONSERVATION PROGRAMS ARE DEDUCTIBLE BY UTILITY, IRS RULES.

Rev. Rul. 95-32

ISSUE

Are expenditures incurred by a public utility for the implementation and operation of energy conservation and load management programs currently deductible as business expenses under section 162 of the Internal Revenue Code, or must they be capitalized under section 263?

FACTS

X, a public utility company, is primarily engaged in generating and distributing electrical energy. X is subject to regulation by its state public utility commission (PUC). In 1995, X provides demand-side management (DSM) programs to its customers to promote energy conservation and energy efficiency. These DSM programs are aimed at reducing electrical costs to X's customers, as well as addressing environmental and societal concerns with the adverse environmental effects of increased electrical generation. These programs may also enable X to reduce its future operating and capital costs. Many public utilities incur costs to implement and operate DSM programs similar to those of X.

Pursuant to its DSM programs, X pays contractors to install low-cost water heating and lighting systems in its customers' houses and to make energy-saving structural improvements to its customers' houses; offers rebates to its industrial customers for installing efficient lighting systems and high-efficiency motors; and incurs employee compensation costs by helping its industrial customers design efficient manufacturing processes. X makes these DSM expenditures without obligating any of its customers participating in these programs to purchase power from X in the future. X does not retain title to any of the property purchased in connection with these programs. For financial and regulatory accounting purposes, X capitalizes its DSM costs.

The PUC has ratemaking authority over X. In determining the appropriate rate for electricity sold by X, the PUC allows X to include its DSM costs in its rate base and to amortize those costs over several years, receiving a rate of return on the unamortized costs equal to the rate of return that it earns on its other rate- based investments. The PUC also allows X to receive an additional amount equal to a percentage of the costs that it would have incurred to generate the amount of electricity conserved by its DSM programs.

LAW AND ANALYSIS

Section 162 generally allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An expense incurred in a taxpayer's business may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. Commissioner v. Tellier, 383 U.S. 687 (1966); Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933).

Section 263(a) provides that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property, or any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Section 1.263(a)-2(a) of the Income Tax Regulations provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Through provisions such as sections 162(a), 263(a), and related sections, the Internal Revenue Code generally endeavors to match expenses with the revenues of the taxable period to which the expenses are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. , 112 S. Ct. 1039 (1992); Commissioner v. Idaho Power Co., 418 U.S. 1 (1974). Moreover, as the Supreme Court specifically recognized, the "decisive distinctions [between capital and ordinary expenditures] are those of degree and not of kind," and a careful examination of the particular facts of each case is required. Welch v. Helvering, 290 U.S. at 114; see Deputy v. du Pont, 308 U.S. at 496. In determining whether a current deduction or capitalization is the appropriate tax treatment for any particular expenditure, it is important to consider the extent to which the expenditure will produce significant future benefits. See INDOPCO, Inc. v. Commissioner, 112 S. Ct. at 1044-45.

X's DSM expenditures constitute ordinary and necessary business expenses under section 162. These expenditures are appropriate and helpful in carrying on X's business and are commonly and frequently incurred by utilities.

Further, X's DSM expenditures are not capital expenditures within the meaning of section 263. No asset is created or acquired and retained by X as a result of its DSM expenditures. Moreover, although X's DSM expenditures may reduce future operating and capital costs, these kinds of benefits, without more, do not require capitalization of these expenditures. See, e.g., Rev. Rul. 94-77, 1994-51 I.R.B. 4 (severance payments made to employees in connection with a business down-sizing are deductible even though they may reduce future operating costs and increase operating efficiencies). In addition, the treatment of an expenditure for ratemaking or rate base purposes is not determinative of its treatment for federal income tax purposes. See, e.g., Rev. Rul. 87-117, 1987-2 C.B. 61 (costs incurred in abandoning a nuclear power plant are deductible under section 165(a) even though they are included in cost of service for rate making purposes).

Therefore, X's DSM expenditures are business expenses that are deductible under section 162.

HOLDING

Under the circumstances described above, expenditures incurred by a public utility for the implementation and operation of energy conservation and load management programs are currently deductible under section 162.

APPLICATION

A public utility currently capitalizing costs associated with its DSM programs must seek the Commissioner's consent to change its method of accounting. A change to the method of accounting for DSM programs described in the holding of this revenue ruling is a change of accounting method to which sections 446(e) and 481 apply. This change in method of accounting must be made in accordance with Rev. Proc. 92-20, 1992-1 C.B. 685.

DRAFTING INFORMATION

For further information regarding this revenue ruling, contact Mr. John P. Moriarty of the Office of Assistant Chief Counsel (Income Tax and Accounting) on (202) 622-4950 (not a toll-free call).