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Tax Insights
from Power & Utilities
IRS guidance extends allocation
method for mixed service costs to
natural gas utilities
October 23, 2014
In brief
New IRS guidance extends the allocation method provided by Industry Director Directive (IDD) #5
regarding mixed service costs to natural gas utility taxpayers (LB&I Memo 2014-24930-1).
In detail
For utility companies, the
capitalization of indirect
costs, and in particular, of
mixed service costs, has been
an issue of disagreement with
the IRS. Around 2001, many
electric utilities elected to
adopt the simplified service
cost method (SSCM), also
referred to by the IRS as
Phase 1. In 2005, IRS
regulations governing mixed
service costs were revised to
effectively prohibit utilities
from using the SSCM to
allocate mixed service costs
to self-constructed assets for
the 2005 tax year and
Because of this change, utility
taxpayers had to identify a
new method to allocate these
costs under Section 263A.
The IRS originally designated
these new methods (Phase 2)
as a Tier One issue and
closely examined them.
fewer resources to less
significant issues.
IDD #5
The ‘less significant’ issues
The SSCM issue generally
was resolved through an
Appeals Settlement Position
(ASP) in which IRS Appeals
provided settlement
percentages for different
classes of eligible property.
This ASP then was delegated
to Exam. Exam received
authority to settle these
calculations in accordance
with the percentages in the
However, rather than issue a
broadly applicable settlement
for the new methods, on
September 15, 2009, the IRS
published IDD #5. This IDD
applied only to electric
utilities and provided
instructions to IRS revenue
agents to devote more
examination resources to
more significant issues and
 Consistent headcount
 Production cost allocation
ratio (provided only 50%
of purchased power costs
are included).
The ‘more significant’ issues
 Generation mixed service
 Cost of working more
 Overly broad or
inappropriate cost drivers
 Imputed or estimated
Tax Insights
New guidance
Ever since IDD #5 was released,
taxpayers expected the IRS to issue a
directive extending IDD #5 to natural
gas utilities and making some minor
clarifications to the method.
However, on June 26, 2014, LB&I
released a memo (LB&I-4-0812-010)
stating that the IRS was replacing its
tiered approach to certain issues with
the formation of Industry Practice
Groups (IPGs), was withdrawing all
previous IDDs, and would not issue
new IDDs.
It therefore was somewhat surprising
to many observers that on October 14,
2014, the IRS released LB&I Memo
2014-24930-1, which essentially
provides what was expected to be
included in a future IDD. This new
memo guidance applies to electric
utilities, natural gas utilities, and
combined electric and gas utilities. It
is similar to IDD #5, with several
The first difference between the new
memo and IDD #5 is that the memo’s
language addressed to Exam teams
appears somewhat stronger than
IDD #5 identified issues as ‘less
significant’ and ‘more significant’ in
terms of directing Exam to not to
challenge methods identified as being
relatively less significant to
compliance priorities. By contrast, the
new memo includes a clear statement
that “Examiners should not challenge
the reasonableness” of these issues.
Thus, in accordance with the new
memo, Exam should not challenge the
reasonableness of:
 Consistent headcount ratios. The
new memo explains which
departments are to be allocated
companywide. For example, fleet
costs are to be allocated only to
transmission & distribution (T&D)
departments and not companywide.
 Production cost allocation ratios
(provided only 50% of purchased
power costs are included). This
continues the IDD#5 exclusion for
costs of temporary facilities, plus
an exclusion for electricity or gas
sold outside the taxpayer’s service
Second, the ‘more significant’
language in IDD#5 has been replaced
with a statement that the new
directive does not apply to three of
those issues:
 cost of working more slowly,
 overly broad or inappropriate cost
drivers, and
 imputed or estimated costs.
The fourth ‘more significant’ IDD#5
issue — generation mixed service
departments — is not mentioned in
the new memo.
The takeaway
It is important to note that LB&I
Memo 2014-24930-1 is not a
settlement or a technical analysis, but
rather reflects an allocation of IRS
resources. However, release of the
new guidance indicates an IRS
commitment to resolving this industry
issue for both electric and gas
companies with the same approach as
first agreed to in 2009.
The details of the new memo closely
match IDD #5, with several revisions:
 Applicability to natural gas utilities
 Allocation of Fleet costs only to
T&D departments
 Exclusion of purchased power sold
outside the taxpayer’s service area
 No mention of generation mixed
service departments.
Tax Insights
Let’s talk
For a deeper discussion of how this might affect your business, please contact:
Power & Utilities
Kurt Mars
+1 (858) 677-2482
[email protected]
Federal Tax Services
Scott Rabinowitz
+1 (202) 414-4304
[email protected]
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