MidAmerican Energy Company v. Commissioner

114 T.C. No. 35

UNITED STATES TAX COURT

MIDAMERICAN ENERGY COMPANY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 22728-97, 22729-97, Filed June 30, 2000.
22730-97, 22731-97.

P is a public utility engaged in the retail
distribution of natural gas, electricity, and related
services. In 1987, in response to the enactment of
sec. 451(f), I.R.C., P modified its method of
accounting for tax purposes to coincide with its
financial and regulatory accounting method and made a
sec. 481 adjustment.

Federal income tax rates were reduced in 1986
pursuant to the Tax Reform Act of 1986, Pub. L. 99-514,
sec. 821, 100 Stat. 2372, creating an excess in
deferred Federal income tax. P was required to adjust
utility rates from 1987 through 1990 to compensate for
this overcollection.

Held: P’s method of accounting for utility
services from the unbilled period violates sec. 451(f)
and must be disallowed. Held, further, P must adjust
the sec. 481 adjustment it made in 1986 to include
revenue attributable to gas costs from the unbilled
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period as of Dec. 31, 1986. Held, further, P’s rate
reductions from 1987 through 1990 to compensate for
excess deferred Federal income tax are not deductible
business expenses within the meaning of sec. 1341, and,
therefore, P is not entitled to the beneficial
treatment of sec. 1341.

David E. Jacobson and Richard P. Swanson, for petitioner.

Robert M. Morrison and J. Anthony Hoefer, for respondent.

COHEN, Judge: Respondent determined the following

deficiencies in the Federal income tax of MidAmerican Energy

Company (petitioner):

Tax Year Ended Deficiency

Dec. 31, 1984 $ 698,682
Dec. 31, 1987 171,396
Dec. 31, 1988 994,913
Dec. 31, 1989 1,457,191
Dec. 31, 1989 715,208
Nov. 7, 1990 391,914
Dec. 31, 1990 5,121,384

On November 7, 1990, a merger took place, resulting in a short

tax year.

After concessions by the parties, the issues for decision in

these consolidated cases are whether petitioner’s accrual of

income from furnishing utility services was in accordance with

section 451(f) and whether the amount reported by petitioner

pursuant to section 481 for 1986 adequately reflects the change

in accounting method under section 451(f) (the unbilled revenue

issues), and whether petitioner is entitled to relief under
 - 3 -

section 1341 for its reduction in utility rates from 1987 through

1990 to compensate for excess deferred Federal income tax.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Petitioner, a public utility, is a subsidiary of MidAmerican

Energy Holding Company and is the successor in interest to

Midwest Resources, Inc. (Midwest Resources), a corporation formed

under the laws of Iowa. At the time the petitions in these cases

were filed, petitioner’s principal place of business was in

Des Moines, Iowa. Predecessors in interest of Midwest Resources

whose Federal income tax returns are in issue in these cases

include Iowa Resources, Inc., and Midwest Energy Company. Any

reference to petitioner herein includes its predecessors.

Petitioner engages in the retail distribution of natural gas

(gas), electricity, and related services to residential,

commercial, and industrial customers in Minnesota, Iowa,

Nebraska, and South Dakota. In the ordinary course of business,

petitioner purchases gas and either resells it to its customers

or consumes it to generate electricity for its customers. During
 - 4 -

the years in issue, petitioner was an accrual method taxpayer

reporting, except for 1990, on a calendar year basis.

Petitioner’s operations are subject to the rules and

regulations of Federal and State agencies, including the Federal

Energy Regulatory Commission (FERC), the Iowa Utilities Board

(IUB), the Minnesota Public Utility Commission, the South Dakota

Public Utility Commission, and certain municipal governments in

Nebraska (regulatory agencies). Under established procedures,

these regulatory agencies prescribe the rates at which petitioner

may sell gas and electricity (approved tariff rates), the

accounting methods and practices that petitioner may adopt for

regulatory and financial accounting purposes, the billing

practices, the payment practices, and other terms and conditions

for the sale of gas and electricity to its customers. The

approved tariff rates for gas are generally made up of gas costs

and the nongas margin. The nongas margin represents the recovery

of all costs other than gas costs, including physical plant

costs, meter-reading expenses, and labor and other nongas related

expenses, as well as overhead and a reasonable rate of return.

The approved tariff rates for electricity include several

components in addition to costs incurred to supply energy.

Purchased Gas Adjustment

Petitioner implements approved tariff rates for gas using

the purchased gas adjustment (PGA) mechanism. Once rate
 - 5 -

schedules and procedures are approved by the regulatory agencies,

the PGA mechanism allows petitioner to recognize fluctuations in

gas costs quickly and to incorporate those changes in its

customers’ bills without formal rate-setting procedures.

Accordingly, petitioner can recover its gas costs on a timely

basis throughout the year.

The period that the PGA mechanism covers runs from

September 1 of the first year to August 31 of the following year

(the PGA year). As part of the PGA mechanism, certain

disclosures are required throughout the year, including an annual

PGA filing, monthly PGA filings, and an annual PGA reconciliation

filing. The annual PGA filing is made prior to August 1 of each

year and estimates anticipated sales and expenses for the

upcoming PGA year. In the annual PGA filing, projected gas costs

are established and incorporated into the approved tariff rates.

This projection is based on gas actually used and actually billed

during the previous year with adjustments for weather

normalization.

Periodic PGA filings are made throughout the calendar year

at the end of each calendar month to adjust the billing rate to

reflect near-concurrent gas costs, as the price of gas

fluctuates. Accordingly, each month, rates that are set forth in

the annual PGA filing are increased or decreased without normal

rate-setting procedures by a pricing adjustment factor (PGA
 - 6 -

factor). The PGA factor is calculated based upon the weighted

average per unit price of gas for the upcoming month, using sales

volume that was established in the annual PGA filing. Each

month, the PGA factor, together with the approved tariff rate, is

applied to the gas usage to determine how much is billed to each

customer.

The final filing requirement of the PGA mechanism is the PGA

reconciliation filing. This filing is made by October 1 and

compares estimated gas costs with actual gas revenues that are

billed through the PGA mechanism during the year, net of the

prior year’s PGA reconciliation. Negative differences in the

reconciliation are underbillings, and positive differences are

overbillings. Petitioner internally tracks over and/or

underbillings for each month of the PGA year. The cumulative

annual over or undercollection is recorded in the annual PGA

reconciliation. Underbillings are recouped through 10-month

adjustments to the PGA factor from which the underbilling was

generated. Overbillings are returned to the customer class from

which they were generated either by bill credit, check, or 10-

month adjustments to the PGA factor from which the overbillings

were generated. If, however, the overcollection exceeds

5 percent of the annual cost of gas subject to recovery for a

specific PGA grouping, the amount overbilled is refunded by bill

credit or check. If a discrepancy between estimated nongas
 - 7 -

margin and actual nongas costs exists, petitioner is not entitled

to use the PGA mechanism, as described above, to adjust its

anticipated nongas margin revenues.

Energy Adjustment Clause

Petitioner adjusts approved tariff rates for electricity

using the energy adjustment clause (EAC), a mechanism similar to

the PGA mechanism. Approved tariff rates for electricity are set

at the beginning of each year, and the EAC mechanism allows

petitioner to adjust periodically the approved tariff rates for

electricity to recover increases in the costs of supplying

energy, including fluctuations in gas costs that are used to

generate electricity. The cost adjustments are determined on a

monthly basis and are applied to meter readings made during the

month. Yearly and monthly filings are required as part of the

EAC mechanism, but reconciliations are incorporated on a monthly

basis, alleviating the need for a yearly reconciliation.

Petitioner’s Accounting Method

In order to balance its workload each month, petitioner

reads meters and bills customers for gas and electricity based on

21 billing cycles. Accordingly, petitioner reads its customers’

meters every month on 21 different schedules and, on that basis,

submits bills for the price of gas actually consumed by each

customer from the last meter reading to the current meter
 - 8 -

reading. The amount of utility service that is provided from

meter reading to meter reading is the revenue month usage.

Prior to 1982, petitioner reported income for financial,

regulatory, and tax accounting purposes on the cycle

meter-reading method. Under this method, if the meter-reading

date fell within the current taxable year, the income

attributable to utility services provided on or before the

reading date was included in gross income in that taxable year.

Any utility service provided to customers within the current

taxable year but after the last meter-reading date of such year

was not recognized as income until the following taxable year.

In 1982, petitioner changed its method of accounting for

financial and regulatory accounting purposes from the cycle

meter-reading method to the accrual method of accounting. Under

the accrual method of accounting, the sales price of gas and

electricity consumed after each customer’s last meter-reading

date to December 31 (unbilled period) was recorded as unbilled

revenue. Unbilled revenue consists of two components: (1) Nongas

margin and (2) gas costs of utility services provided to

customers during the unbilled period (unbilled gas costs).

However, on December 31, an adjustment was made to reduce

unbilled revenue by the amount of unbilled gas costs. For tax

purposes, petitioner continued to report taxable income on the

cycle meter-reading method, making adjustments on Schedule M-1 on
 - 9 -

its Federal income tax returns to reflect the difference between

tax and financial accounting for unbilled revenue.

In 1987, petitioner changed its method of accounting for

Federal income tax purposes and began including unbilled revenue

in taxable income. Consistent with its financial and regulatory

accounting method, petitioner reduced unbilled revenue by the

amount of unbilled gas costs, leaving only the nongas margin as

part of taxable income. As part of its change in method of

accounting, petitioner made a section 481 adjustment to include

in income the amount of revenue attributable to the unbilled

period as of December 31, 1986. This adjustment was reduced by

unbilled gas costs as of December 31, 1986. In years thereafter,

petitioner made Schedule M-1 adjustments to reflect the reduction

in unbilled revenue by the unbilled gas costs amounts.

Deferred Tax Expense

Federal income tax is also a component of the approved

tariff rates that petitioner charges its customers. However, the

Federal income tax that petitioner uses in determining approved

tariff rates is generally different from actual Federal income

tax currently owed to the Government. This is attributable to

timing differences of recognizing items of income and expense.

For example, straight-line depreciation is used for rate-making

purposes, while accelerated depreciation is used to calculate

current Federal income tax. In earlier years, when accelerated
 - 10 -

depreciation exceeds straight-line depreciation, the timing

difference causes a utility to collect more than the utility

currently owes to the Government. This excess of Federal income

tax collected is referred to as the deferred Federal income tax

expense and represents Federal income tax to be paid by

petitioner in subsequent years when depreciation for rate-making

purposes exceeds depreciation for Federal income tax purposes.

The utility uses amounts it overcollected in earlier years to pay

Federal income tax it owes in later years. Deferred tax expense

is tracked using a deferred Federal income tax account. If

Federal income tax rates remain constant, the deferred Federal

income tax account will zero out over the useful life of the

underlying assets.

In years prior to 1987, petitioner collected revenues based

on a 46-percent Federal income tax rate and increased the

deferred Federal income tax account by the amount that

collections exceeded the current Federal income tax. The Tax

Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 821, 100 Stat.

2372, effective for 1987 and years thereafter, reduced corporate

Federal income tax rates from 46 percent to 39.95 percent in 1987

and to 34 percent in 1988. As a result, petitioner’s accumulated

deferred Federal income tax as of December 31, 1986, exceeded the

amount of Federal income tax that petitioner would be expected to

pay in future years.
 - 11 -

The regulatory agencies had the authority to require

petitioner to adjust rates to reflect such an excess, but TRA

section 203(e), 100 Stat. 2146, provided that the normalization

provisions of sections 167 and 168 would be violated if a utility

reduced its excess deferred Federal income tax reserve more

rapidly than as provided under the average rate assumption method

(ARAM). This TRA provision generally applies to those excess

deferred Federal income taxes attributable to timing differences

relating to depreciation and property classifications described

in sections 167(a)(1) and 168(e)(3) (protected excess deferred

Federal income tax). Under ARAM, the protected excess deferred

Federal income tax can be reversed only through rate adjustments

as the timing differences that created them reverse.

Accordingly, the protected excess deferred Federal income tax is

reduced ratably over the underlying asset’s remaining useful

life, consistent with normalization, by reducing future utility

rates.

Consistent with these provisions, petitioner began reducing

its protected excess deferred Federal income tax account in

November 1987 by reducing utility rates. This continued through

1990. The rate reductions were allocated to each customer class

based on each customer class’s contribution to the excess

deferred Federal income tax, but rate reductions were not

specifically allocated to customers who paid pre-1987 utility
 - 12 -

fees. None of petitioner’s customers who paid pre-1987 utility

rates and subsequently left petitioner’s service asserted claims

against petitioner for repayment or refund of the excess deferred

Federal income tax. Petitioner was not required to nor did it

issue refund checks or billing credits to its customers, and the

regulatory agencies also did not require petitioner to pay

interest on amounts returned through rate reductions.

Petitioner’s 1987, 1988, 1989, and 1990 Federal income tax

returns used the method of accruing unbilled revenue, as set

forth above, in calculating taxable income. Also for those

years, petitioner claimed section 1341 relief for the amount in

which it reduced utility rates to compensate for excess deferred

Federal income tax. Respondent audited petitioner’s 1987, 1988,

1989, and 1990 Federal income tax returns. Upon review,

respondent rejected petitioner’s method of accruing unbilled

revenue (unbilled revenue issue) and denied petitioner’s claims

for relief under section 1341 for rate reductions associated with

excess deferred tax (section 1341 issue).

OPINION

Unbilled Revenue Issues

The unbilled revenue issue is essentially an accounting

dispute. Petitioner maintains that its regular method of

accounting, which uses the PGA and EAC mechanisms to recover gas

costs, already includes December gas costs in the taxable year
 - 13 -

and that to accrue revenue from gas costs for the period

following the December meter-reading date to December 31

(unbilled period) results in double counting. Respondent

contends that petitioner’s method of accounting fails the

requirements of section 451(f) and that petitioner must include

in taxable income amounts attributable to utility services, gas

costs and nongas margin, provided during the taxable year,

including the unbilled period.

Section 446(a) generally provides that taxable income shall

be computed under the method of accounting that the taxpayer

regularly uses to compute income for financial accounting

purposes. If such method of accounting does not clearly reflect

income, “the computation of taxable income shall be made under

such method as, in the opinion of the Secretary, does clearly

reflect income.” Sec. 446(b).

Prior to the passage of section 451(f) in the Tax Reform Act

of 1986, Pub. L. 99-514 sec. 821, 100 Stat. 2372, petitioner

recognized taxable income from utility services based on the

taxable year in which its customers’ utility meters were read

(the cycle meter-reading method). See Rev. Rul. 72-114, 1972-1

C.B. 124. Under the cycle meter-reading method, utility services

provided to customers during the unbilled period were not

recognized as income until the following taxable year. See id.

Recognizing that the cycle meter-reading method allowed utilities
 - 14 -

to defer yearend income, S. Rept. 99-313, 1986-3 C.B. (Vol. 3),

120-121, Congress passed section 451(f).

Section 451(f)(1) provides:

In the case of a taxpayer the taxable income of which
is computed under an accrual method of accounting, any
income attributable to the sale or furnishing of
utility services to customers shall be included in
gross income not later than the taxable year in which
such services are provided to such customers.

This section effectively requires taxpayers to discontinue using

the cycle meter-reading method of accounting and adopt a method

of accounting that includes taxable income from utility service

provided during the taxable year, including the unbilled period.

Effective for 1987 and years thereafter, petitioner changed

its method of accounting for tax purposes and began accruing

utility fees attributable to nongas margin from the unbilled

period. Petitioner did not, however, make an accrual for utility

fees attributable to gas costs from the unbilled period.

Consistent with this change in method of accounting, petitioner

made a section 481 adjustment, including in taxable income that

portion of utility fees from the unbilled period attributable to

the nongas margin, as of December 31, 1986.

Petitioner’s method of accounting violates the literal

requirements of section 451(f) because it does not accrue utility

fees attributable to gas costs from the unbilled period. In

practice, petitioner calculates taxable income using meter

readings as a proxy for actual utility services provided during
 - 15 -

the calendar year and makes an accrual for nongas margin from the

unbilled period. According to section 451(f), a utility must

include in taxable income the revenue attributable to utility

services provided during the taxable year. See S. Rept. 99-313,

supra, 1986-3 C.B. (Vol. 3) at 120-121. Utility services are

“provided” when such services are made available to, and used by,

the customer. Id. “The taxable year in which services are

treated as provided to customers shall not, in any manner, be

determined by reference to (i) the period in which the customers’

meters are read, or (ii) the period in which the taxpayer bills

(or may bill) the customers for such service.” Sec.

451(f)(2)(B). On average, petitioner’s method of accounting

includes in taxable income utility services provided from

December 15 of the prior year to December 15 of the current year.

With respect to the unbilled period, we see no difference in

petitioner’s treatment of revenue from gas costs under its

current method of accounting and the cycle meter-reading method

of accounting that section 451(f) was intended to eliminate.

While it is true that a full year’s worth of income from utility

service is included in determining taxable income, the included

year is not the same as the year intended by section 451(f).

Congress there specified that the income attributable to utility

services must be reported for the same year in which the services

were provided.
 - 16 -

Petitioner contends that its agency-imposed accounting

method, which uses the PGA and EAC mechanisms to recover current

gas costs, allows petitioner to recover December gas costs and

alleviates the need to accrue gas costs from the unbilled period.

We disagree. Section 451(f) focuses on the inclusion of income

from utility services actually provided during the taxable year,

and the PGA and EAC mechanisms address only the pricing of

utility services billed. Irrespective of its pricing mechanisms,

petitioner is still using meter readings as a proxy for utility

services actually provided during the taxable year in direct

contravention of section 451(f). It is also well settled that

consistency with agency-imposed accounting practices is not

determinative of the adequacy of petitioner’s accounting method

for tax purposes. See Thor Power Tool Co. v. Commissioner, 439

U.S. 522, 542-543 (1979) (there are “vastly different objectives

that financial and tax accounting have”, and “any presumptive

equivalency between tax and financial accounting would be

unacceptable.”), affg. 563 F.2d 861 (7th Cir. 1977), affg. 64

T.C. 154 (1975). Accordingly, we conclude that petitioner’s

accounting method violates the requirements of section 451(f).

To reflect properly the requirements of section 451(f) and

prevent double counting, petitioner’s section 481 adjustment in

1986 should have also included the unbilled revenue attributable

to gas costs from the unbilled period as of December 31, 1986.
 - 17 -

In years thereafter, an adjustment should have been made to

January bills removing revenues from the unbilled period of the

prior taxable year, and a corresponding adjustment should have

been made to include revenue from the unbilled period for the

current year for both gas costs and nongas margin. The relevant

legislative history suggests:

where it is not practical for the utility to determine
the actual amount of services provided through the end
of the current year, this estimate may be made by
assigning a pro rata portion of the revenues determined
as of the first meter reading date or billing date of
the following taxable year. [See S. Rept. 99-313,
supra, 1986-3 C.B.(Vol. 3) at 121.]

Respondent has made the necessary adjustment in the statutory

notice, and respondent’s determination of this issue is

sustained.

Section 1341 Issue

Petitioner also argues that it is entitled to section 1341

treatment for the amount by which it reduced utility rates from

1987 to 1990 to compensate for excess deferred Federal income

taxes. Section 1341(a) provides in pertinent part:

SEC. 1341(a). In General.--If–-

(1) an item was included in gross income for
a prior taxable year (or years) because it
appeared that the taxpayer had an unrestricted
right to such item;

(2) a deduction is allowable for the taxable
year because it was established after the close of
such prior taxable year (or years) that the
taxpayer did not have an unrestricted right to
such item or to a portion of such item; and
 - 18 -

(3) the amount of such deduction exceeds
$3,000,

then the tax imposed by this chapter for the
taxable year shall be the lesser of the
following:

(4) the tax for the taxable year
computed with such deduction; or

(5) an amount equal to–-

(A) the tax for the taxable year
computed without such deduction, minus

(B) the decrease in tax under this
chapter * * * for the prior taxable year (or
years) which would result solely from the
exclusion of such item (or portion thereof)
from gross income for such prior taxable year
(or years).

Section 1341 was enacted by Congress to mitigate the

sometimes harsh results of the application of the claim of right

doctrine. See United States v. Skelly Oil Co., 394 U.S. 678, 681

(1969). Under that doctrine, a taxpayer must recognize income

for an item in the year it is received under a claim of right

even if it is later determined that the right of the taxpayer to

the item was not absolute and it is returned in a subsequent

year. See North Am. Oil Consol. v. Burnet, 286 U.S. 417, 424

(1932). Although the taxpayer is allowed to take a deduction in

the year of return for the amount of the item, the deduction

would fail to make the taxpayer whole if the applicable tax rate

was higher in the year of recognition than it was in the year of

return. See United States v. Skelly Oil Co., supra. Section
 - 19 -

1341 makes the taxpayer whole by reducing taxable income in the

year of return by the amount of the allowable deduction or by

giving a credit in the year of return for the hypothetical

decrease in tax that would have occurred in the year of

recognition had the item been excluded from income in that year.

The taxpayer may use whichever method is most beneficial. See

sec. 1.1341-1(i), Income Tax Regs.

Prior to 1987, the payments that petitioner received from

its customers for utility services included a deferred Federal

income tax component attributable to accelerated depreciation.

Petitioner paid Federal income tax on those amounts at a rate of

46 percent. Federal income tax rates were reduced in 1986 to

39.95 percent for 1987 and to 34 percent for 1988 and years

thereafter, creating an excess in petitioner’s deferred Federal

income tax account. Petitioner corrected this excess by reducing

utility rates that were charged to its customers from 1987

through 1990. However, due to the reduction in rates, petitioner

paid a greater amount of tax in years prior to 1987 than the tax

benefit it received from 1987 to 1990 when it reduced its utility

rates. Accordingly, on its Federal income tax returns for 1987

through 1990, petitioner claimed section 1341 relief.

The first requirement of section 1341(a)(1) is that the item

in question be included in taxable income by the taxpayer because

it appeared that the taxpayer had an unrestricted right to the
 - 20 -

item. Respondent argues that petitioner fails to meet this

requirement because it had an actual, and not an apparent,

unrestricted right to income from utility fees that it collected

prior to 1987. See, e.g., Kraft v. United States, 991 F.2d 292,

299 (6th Cir. 1993); Bailey v. Commissioner, 756 F.2d 44, 47 (6th

Cir. 1985); Van Cleave v. United States, 718 F.2d 193, 196-197

(6th Cir. 1983); Prince v. United States, 610 F.2d 350, 352 (5th

Cir. 1980). Petitioner asks us to adopt the substantial nexus

test recently adopted in two separate Federal District Court

opinions on fact patterns nearly identical to the one at hand.

See Dominion Resources, Inc. v. United States, 48 F. Supp.2d 527

(E.D. Va. 1999); WICOR, Inc. v. United States, 84 AFTR2d 99-6905,

99-2 USTC par. 50,951 (E.D. Wis. 1999). We do not resolve this

dispute over the proper test, however, because of our conclusion

that petitioner does not satisfy another requirement for relief

under section 1341.

The second requirement that petitioner must satisfy, in

order to qualify for relief under section 1341, is that a

deduction must be allowable in the year of return for the refunds

that were made. Respondent argues that petitioner fails to meet

this requirement because petitioner’s rate reductions from 1987

to 1990 do not qualify as deductible expenses within the meaning

of section 1341(a)(2). Petitioner maintains that the right to

claim a deduction under section 162 for funds or property
 - 21 -

returned after a taxpayer has previously included such funds or

property in income rests in the claim of right doctrine itself.

United States v. Skelly Oil Co., supra at 680-681; North Am. Oil

Consol. v. Burnet, supra at 424(stating that, if the taxpayer

were obliged to refund amounts previously included under the

claim of right doctrine, it would be entitled to a deduction when

the amount was returned).

This issue was recently addressed in both Dominion

Resources, Inc. v. United States, supra, and WICOR, Inc. v.

United States, supra, with the courts reaching different

conclusions. The court in Dominion Resources held that the

return of excess deferred Federal income tax is a deductible

expense, whereas, in WICOR, Inc., the court distinguished

Dominion Resources and decided that a mere reduction of future

utility rates did not constitute a deductible business expense.

See also Florida Progress Corp. & Subs. v. Commissioner, 114 T.C.

___ (2000) (also filed this date).

The use of the word “deduction” in section 1341(a)(2) limits

section 1341 applicability to refunds or returns that would

otherwise be deductible under another section of the Internal

Revenue Code. United States v. Skelly Oil Co., supra at 683.

Therefore, the decision on this issue depends upon whether the

return of excess deferred Federal income tax by petitioner is an
 - 22 -

ordinary and necessary business expense deductible under section

162.

Respondent argues that there is a difference between a mere

rate reduction on future sales to take into account

overrecoveries in a previous year and an expense for which a

deduction is allowable. See, e.g., Roanoke Gas Co. v. United

States, 977 F.2d 131 (4th Cir. 1992); Iowa S. Utils. Corp. v.

United States, 841 F.2d 1108 (Fed. Cir. 1988); Southwestern

Energy Co. v. Commissioner, 100 T.C. 500 (1993).

In Iowa S. Utils. Corp., a taxpayer utility collected a

surcharge from its customers in order to help finance the

construction of a new power plant. The regulatory agency

approved the surcharge on the condition that the surcharge would

be refunded by the taxpayer without interest to customers over

the next 30 years. The taxpayer argued that the obligation to

refund was a liability satisfying the all events test of section

461 and that it was entitled to a current deduction for the full

amount of the refunds it expected to make during the next

30 years. Iowa S. Utils. Corp. concerned tax years prior to the

date when the economic performance rules of section 461(h) went

into effect. The Court of Appeals held that the taxpayer did not

have a deductible liability to refund, but, instead, the refunds

resulted from a regulatory policy setting the allowable rates for
 - 23 -

future electric services. See id. at 1113. In reaching its

conclusion, the court stated:

In reality, Iowa Southern must be viewed simply as
enjoying higher rates, and greater income, during the
construction period, and lower rates, and presumably
less income, during the thirty years that follow
completion of the plant. As a result, it is also
incorrect to view the change in the rate structure as a
cost of goods sold. * * * [Id. at 1114.]

One of the factors considered by the court was that future

refunds were to be made to future customers, some of whom were

not in privity with the customers who paid the original surcharge

during plant construction. See Chernin v. United States, 149

F.3d 805, 816 (8th Cir. 1998).

In Roanoke Gas Co., the taxpayer collected utility fees that

were based on the costs that it incurred for purchasing gas. Due

to the lag between the effective date of a price change for gas

and implementation of a rate adjustment to reflect this change,

the taxpayer overcollected from its customers when gas prices

dropped. The taxpayer was required at the end of each year to

determine the amount, if any, that it had overcollected and to

adjust rates accordingly for the next year. The taxpayer claimed

that the obligation to refund excessive collections through a

rate adjustment constituted a deductible business expense. The

years in issue predated the section 461(h) economic performance

rules.
 - 24 -

In holding that the taxpayer was not entitled to a current

deduction for refunds not yet made, the court, relying on Iowa S.

Utils. Corp., found that the taxpayer’s obligation to refund was

not a deductible liability but was merely an obligation to reduce

its future income. See Roanoke Gas Co. v. United States, supra

at 136-137. The Court of Appeals pointed to several factors that

supported its determination. First, rather than an actual

movement of funds from the taxpayer to its customers, a setoff on

customers’ bills was used as the medium for carrying out the

refunds. Second, the identity of the customers who received the

refunds was not identical to the customers who had overpaid funds

in the earlier year of overcollection. Finally, no interest

component was included with the refund for the time span between

when the refunds were ordered by the regulatory agency and when

the refunds were actually carried out on customers’ bills. In

the view of the court, these factors, when combined, made the

refunds resemble a reduction in future income rather than a

deductible expense.

The decision of this Court in Southwestern Energy was based

on facts nearly identical to those of Roanoke Gas Co. This Court

recognized that there is a difference between an expenditure,

deductible under section 162, and a mere reduction in income

under a regulatory requirement that a taxpayer utility compute

its rates in a manner that offsets overrecoveries from a previous
 - 25 -

year. See Southwestern Energy Co. v. Commissioner, supra at 505.

In holding that the refund by the taxpayer was a reduction in

income and did not qualify as a deduction, this Court pointed to

several determining factors. First, no interest component was

included with the refund on customers’ bills. Second, the

overrecoveries were not amounts that exceeded the rates approved

by the regulatory agencies and thus were collected as part of an

authorized rate scheme. Third, the identity of the customers who

received the refunds was not identical to the customers who had

overpaid funds in the earlier year of overcollection. Finally,

there was no current outlay of funds involved but, instead, a

setoff that reduced income that would otherwise have been

received in a later year. These factors, when combined, made the

refunds more resemble a reduction in future income than a

deductible expense.

In these cases, a reduction in future rates occurred to take

into account overrecoveries in earlier tax years. Petitioner

reduced utility rates based on each customer class’ contribution

to excess deferred Federal income tax but did not match

reductions to customers who actually contributed to the excess.

Rather, petitioner returned the excess deferred Federal income

tax to customer classes based upon current energy consumption,

not upon amounts each individual customer actually overpaid

during the years of overrecovery; rate reductions also applied to
 - 26 -

customers who were not customers of petitioner during the years

of overcollection because they had only recently moved into

petitioner’s service area. There was also no interest component

to the rate reductions, and no out-of-pocket payments in the form

of checks or bill credits were made. In sum, petitioner was not

repaying its customers the excess deferred Federal income tax

that it collected in prior years. Rather, the rate reductions

served only to reduce income in future years and did not directly

compensate petitioner’s customers for prior overcollection.

Because we conclude that petitioner is not entitled to a

deduction, petitioner fails to qualify for the preferential

treatment of section 1341 for the taxable years in issue.

In Dominion Resources, Inc. v. United States, supra, refunds

of the entire amount of unprotected excess deferred Federal

income tax were made to customers within 60 days of the

regulatory authority’s order to refund excess deferred Federal

income tax, whereas, in the cases at hand, the returns were

spread out over 3 years. Also, the media used by the taxpayer in

Dominion Resources to carry out such refunds were wire transfers

to customers, checks to customers, or one-time credits on

customers’ bills. See id. at 532-533. Finally, at least some of

the utility’s customers received interest on a portion of their

refund from the date when the income tax rates lowered until the

date of refund. See id. at 533. These factors, which differ
 - 27 -

from the facts of the cases at hand, combined to persuade the

District Court in Dominion Resources that the refunds were more

like deductible expenses than future rate reductions.

Our holding is also consistent with our prior opinion in

Andrews v. Commissioner, T.C. Memo. 1992-668. In Andrews, a

taxpayer, injured while on the job, received excess disability

payments from Met Life, her insurance carrier, while she was

involved in a legal action with the Social Security

Administration to receive benefits. The payments were made

subject to the condition that, if the taxpayer won her dispute

and was awarded funds for past Social Security benefits, the

taxpayer would refund the excess disability payments to the

insurance company. The taxpayer won her legal action and

satisfied her refund obligation by setting off her liability to

Met Life against future ordinary disability payments to which she

was entitled from Met Life. This Court denied section 1341

relief, stating that the taxpayer’s return of funds by means of a

setoff would not qualify as a deduction because:

there has been no “restoration”, i.e., nothing has been
repaid to Met Life by Mrs. Andrews. We reject the
contention that, under these facts, there can be a
constructive restoration when no actual repayment is
made.

In 1987, Mrs. Andrews received all the Social
Security payments to which she had been entitled for
the years 1983 through 1986. At that point, Met Life
had paid Mrs. Andrews more than it was obligated to
pay, and reduced its payments to her in subsequent
years until it had setoff its obligation to
 - 28 -

Mrs. Andrews by the amount of Mrs. Andrews’ obligation
to Met Life. The payments which Mrs. Andrews received
are properly taken into account in the years in which
she received them. There was no constructive
restoration to Met Life in 1987 or any subsequent year,
as no out-of-pocket payment was made. [Id.; see also
Chernin v. United States, 149 F.3d at 816.]

Petitioner argues that section 1.461-4(g)(3), Income Tax

Regs., allows for a refund by means of a setoff to qualify as a

section 162 deductible expense. That section reads in pertinent

part:

(3) Rebates and refunds. If the liability of a
taxpayer is to pay a rebate, refund, or similar payment
to another person (whether paid in property, money, or
as a reduction in the price of goods or services to be
provided in the future by the taxpayer), economic
performance occurs as payment is made to the person to
which the liability is owed. This paragraph (g)(3)
applies to all rebates, refunds, and payments or
transfers in the nature of a rebate or refund
regardless of whether they are characterized as a
deduction from gross income, an adjustment to gross
receipts or total sales, or an adjustment or addition
to cost of goods sold. In the case of a rebate or
refund made as a reduction in the price of goods or
services to be provided in the future by the taxpayer,
“payment” is deemed to occur as the taxpayer would
otherwise be required to recognize income resulting
from a disposition at an unreduced price. * * *
[Emphasis added.]

This regulation does not assist petitioner, because there is

no liability of petitioner to repay its customers. Petitioner

reduced rates in accordance with ARAM, but, as set forth above,

it was unable to show that it was compensating its customers for

prior overcollections. In addition, section 1.461-4(g)(3),

Income Tax Regs., was not in effect for the years in issue. It
 - 29 -

is effective only for years after December 31, 1991. See sec.

1.461-4(k)(3), Income Tax Regs.

To reflect the foregoing,

Decisions will be entered

under Rule 155.