UTILITY'S LOSS IS DEDUCTIBLE, EVEN THOUGH INCLUDED IN RATE BASE.

Rev. Rul. 87-117

ISSUE

Can a public utility deduct the cost of an abandoned, partially completed nuclear power plant under section 165(a) of the Internal Revenue Code if the utility is granted a rate increase that takes into account the amortization of the cost of the abandoned project?

FACTS

Taxpayer, a public utility company engaged in the business of generating and distributing electricity, abandoned a partially completed nuclear generating plant. The state commission with ratemaking authority over Taxpayer, in determining to grant Taxpayer a subsequent rate increase, permitted Taxpayer to amortize the cost of the abandoned plant over a specified period and to include such costs in Taxpayer's cost of service for ratemaking purposes. The unamortized cost of the project was not included in Taxpayer's rate base.

LAW AND ANALYSIS

Section 165(a) of the Code provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

Section 1.165-1(d)(2)(i) of the Income Tax Regulations provides that if a casualty or other event occurs which may result in a loss and, in the year of such casualty or event, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim.

In Shanahan v. Commissioner, 63 T.C. 21 (1974), the Tax Court, in interpreting the words "insurance or otherwise" in section 165(a) of the Code, determined that the general term "or otherwise" must be construed consistently with the specific term "insurance." In finding that government payments under the 1969 Disaster Relief Act are of the same nature as insurance, the court stated that the general purpose of insurance is to spread the risk of loss from any peril among a large number of those who are exposed to a similar peril.

In Estate of Bryan v. Commissioner, 74 T.C. 725 (1980), the Tax Court, citing Shanahan, determined that in the phrase "insurance or otherwise" in section 2054 of the Code (reducing the taxable estate by the value of enumerated losses "not compensated for by insurance or otherwise") the general term "or otherwise" must be construed consistently with the specific term "insurance." The court stated that the phrase "insurance or otherwise" in sections 165(a) of the Code and 2054 contemplates that the type of compensation received must be such that it was structured to replace what was lost. The case concerned a disbursement in compensation for losses incurred due to an attorney's unethical behavior. The disbursement had been made from a trust fund established by a state bar association for that purpose. On these facts, the court found that the disbursement was in the nature of insurance.

The above cases indicate that the phrase "insurance or otherwise" in section 165(a) of the Code must be interpreted to mean insurance or other compensation of the same nature as insurance. Hence, a person who incurs a loss that otherwise qualifies for a deduction under section 165(a) is denied a deduction under that section only if that person has received for such loss compensation in the nature of insurance.

In the present case, Taxpayer has incurred a loss upon abandoning a partially constructed power plant. Such loss qualifies as a loss under section 165(a) of the Code and the Taxpayer is entitled to a deduction under that section unless the Taxpayer has received compensation for such loss in the nature of insurance.

Taxpayer has not directly received any compensation for its loss but has been granted authority to charge a higher price for the electricity it produces. As stated in Estate of Bryan, the phrase "insurance or otherwise" in section 165(a) of the Code contemplates that the type of compensation received must be such that it was structured to replace what was lost. Although a utility commission may give consideration to the fact that a utility suffered a loss in determining whether a rate increase is warranted, the rate is not structured to reimburse the utility for its loss. Rather the rate increase is structured to enable the utility to perform its functions of serving its customers at a fair charge, while at the same time maintaining its financial integrity and its ability to attract capital at reasonable terms by paying its investors a reasonable rate of return on their investment. Moreover, the increased revenue is taxable income to Taxpayer without regard to Taxpayer's basis in the nuclear power plant. This is unlike insurance, where the payment is treated as a sale or exchange and serves to reduce basis before any gain or income is recognized.

If Taxpayer were not a regulated company, it could raise its price at will, and revenues produced by its price increase could not be considered as compensation for a loss by "insurance or otherwise." The governmental grant of authority to increase rates is of the same nature as a price increase by an unregulated company. The function of the utility commission is merely to assure that the increase is warranted. Thus, such a grant of authority is not of the same nature as insurance, and Taxpayer's loss has not been compensated for by "insurance or otherwise."

HOLDING

For purposes of section 165(a) of the Code, the fact that a public utility company that has abandoned a partially constructed nuclear power plant obtains a rate increase that is based in part on such costs does not cause it to have been "compensated for by insurance or otherwise." Therefore, such costs are deductible.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Hahn of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Noel Sheehan on (202) 566-3928 (not a toll-free call).