taxable year ending before October 1, 1978, the tax liability limitation is the portion of tax liability that does not exceed $25,000 plus a percentage of the excess, as determined under section 46 (a) (3) (B). (ii) For a taxable year ending after September 30, 1978, the tax liability limitation for available nonrefundable energy credit is 100 percent of the year's tax liability. (4) Alternative limitations. Alternative limitations apply for certain utilities, railroads, and airlines in determining the regular tax liability limitation and, for nonrefundable energy credit carrybacks to taxable years ending before October 1, 1978, the nonrefundable energy credit tax liability limitation. These alternative limitations do not apply in determining the energy tax liability limitation for a taxable year ending after October 1, 1978. The provisions listed below set forth the alternative limitations: Code section, type, and years applicable 46 (a) (6), Utilities, Taxable years ending in 1975-1978. 46 (a) (7), Utilities, Taxable year ending in 1979. 46(a) (8), Railroads and Airlines, Taxable year ending in 1979 or 1980. 46 (a) (8)3, Railroads, Taxable years ending in 1977 or 1978. 46 (a) (9), Airlines, Taxable years ending in 1977 or 1978. (i) [Reserved] (j) Tax liability—(1) In general. "Tax liability" for purposes of the regular and ESOP credit and carrybacks of nonrefundable energy credit to a taxable year ending before Oc 1 1 Section 46 (a) (6) was added by section 301 (b)(2) of the Tax Reduction Act of 1975 [supra at 552] and redesignated as section 46(a) (7) by section 802(a)(1) of the Tax Reform Act of 1978. 'Section 46(a) (7) was amended by section 312(b)(1) of the Revenue Act of 1978 [supra at 59]. These provisions were repealed by section 312(b)(2) of the Revenue Act of 1978. tober 1, 1978, means the liability for tax as defined in section 46(a) (4). For ordering of regular, ESOP, and nonrefundable energy credits, see paragraph (m) of this section. In addition to taxes excluded under section 46(a) (4), tax liability does not include tax resulting from recapture of credit un der section 47 and the alternative minimum tax imposed by section 55. See sections 47 (c) and 55(c) (1). (2) Certain nonrefundable energy credit. For a taxable year ending after September 30, 1978, "tax liability" for purposes of the nonrefundable energy credit is liability for tax, as defined in section 46 (a) (4) and paragraph (j) (1) of this section, reduced by the regular and ESOP credit allowed for the taxable year. Thus, carrybacks of regular or ESOP credit to a taxable year may displace nonrefundable energy carryovers or credit earned taken into account in that year. However, carrybacks of regular, ESOP, or nonrefundable energy credit do not affect refundable energy credit which is treated as an overpayment of tax under section 6401(b). See paragraph (k) of this section. (k) Special rule for refundable energy credit. The amount of the refundable energy credit is determined under the rules of section 46 (other than section 46(a) (3)). However, to permit the refund, the refundable energy credit for purposes of the Internal Revenue Code (other than section 38, part IVB, and chapter 63 of the Code) is treated as allowed by section 39 and not by section 38. The refundable credit is not applied against tax liability for purposes of determining the tax liability limitation for other investment credits. Rather, it is treated as an overpayment of tax under section 6401 (b). (1) FIFO rule. If the credit available for a taxable year is not allowed in full because of the tax liability limitation, special rules determine the order in which credits are applied. Under the first-in-first-out rule of section 46(a) (1) (FIFO), carryovers (2) Regular and ESOP credit. Under § 1.46-8 (c) (9) (ii), regular and ESOP credits available are applied in the following order: (i) Regular carryovers; (3) Example. For an example of the order of application of regular and ESOP credits, see § 1.46-8 (c) (9) (iii). (n) Examples. The following examples illustrate paragraph (a) through (m) of this section. Example (1). (a) Corporation M's regular credit available for its taxable year ending December 31, 1979 is as follows: (b) M's "tax liability" for 1979 is $30,000. M's tax liability limitation for 1979 for the regular credit is $28,000, consisting of $25,000 plus 60 percent of the $5,000 of "tax liability" in excess of $25,000. (c) The regular carryovers and credit earned are allowed in full. However, only $13,000 of the regular carryback is allowed for 1979. The remaining $2,000 must be carried to the next year to which it may be carried under section 46 (b). Example (2). (a) For its taxable year ending December 31, 1980, corporation N has $30,000 regular credit earned and $9,000 nonrefundable energy credit earned. N has no carryovers to 1980 and no "tax liability" for pre-1980 years. (b) N's "tax liability" for 1980 for the regular credit is $35,000. N's tax liability limitation for 1980 for the regular credit is $32,000, consisting of $25,000 plus 70 percent of the $10,000 of "tax liability" in excess of $25,000. (c) The entire regular credit is allowed in 1980. (d) N's "tax liability" for 1980 for the nonrefundable energy credit is $5,000, consisting of $35,000 less $30,000 regular credit allowed for 1980. N's tax liability limitation for 1980 for the nonrefundable energy credit is 100 percent of $5,000. (e) $5,000 of the nonrefundable energy credit is allowed for 1980. The remaining $4,000 energy credit is an unused nonrefundable energy credit which must be carried to the next year to which it may be carried under section 46(b). Example (3). (a) Assume the same facts as in example (2) except that in its taxable year ending December 31, 1981, N earns a regular credit of which it may carry back $2,000 to 1980. (b) The $30,000 regular credit earned and $2,000 of the regular carryback is allowed for 1980. N's "tax liability" for 1980 for the nonrefundable energy credit is reduced to $3,000, consisting of $35,000 less $32,000 regular credit allowed for 1980. The nonrefundable energy credit allowed for 1980 is reduced to $3,000. The remaining $6,000 is an unused nonrefundable energy credit which must be carried to the next year to which it may be carried under section 46(b). Example (4). (a) For its taxable year ending December 31, 1980, corporation P's regular credit earned is $20,000. P also has a $9,000 refundable energy credit for 1980. There are no carryovers or carrybacks to 1980. (b) P's "tax liability" for 1980 for the regular credit is $25,000 which is also the tax liability limitation for the regular credit. (c) The entire $20,000 regular credit is allowed for 1980. The entire $9,000 refundable energy credit is treated as an overpayment of tax under section 6401 (b), even though "tax liability" remains. Example (5). Assume the same facts as in example (4), except that in the following year P earns a regular credit, $5,000 of which it may carry back to 1980. The $5,000 carryback is allowed in full in 1980. (0) Married individuals. If a separate return is filed by a husband or wife, the tax liability limitation is computed by substituting a $12,500 amount for the $25,000 amount that applies under section 46 (a) (3). *** (p) Apportionment of $25,000 amount among component members of a controlled group-(1) In general. In determining the tax liability limitation under section 46 (a) (3) for corporations that are component members of a controlled group on a December 31, only one $25,000 amount is available to those component members for their taxable years that include that December 31. *** (4) Members of a controlled group filing a consolidated return. * * * In that case, the tax liability limitation for the group filing the consolidated return is computed by substituting for the $25,000 amount under section 46 (a) (3) the total amount apportioned to each component member that joins in filing the consolidated return. * * Par. 2. Section 1.46-2 is amended to read as follows: § 1.46-2 Carryback and carryover of unused credit. (a) Effective date. This section is effective for taxable years beginning after December 31, 1975. For taxable years beginning before January 1, 1976, see 26 CFR 1.46-2 (Rev. as of April 1, 1979). (b) In general. Under section 46 (b) (1), unused credit may be carried back and carried over. Carrybacks and carryovers of unused credit are taken into account in determining the amount of credit available and the credit allowed for the taxable years to which they may be carried. In general, the application of the rules of this section to regular and ESOP credits are separate from their application to nonrefundable energy credits. For example, the limitations on carrybacks and carryovers of unused nonrefundable energy credit under section 46 (b) (2) and (3), respectively, differ in amount from the limitations on the regular and ESOP credits because the tax liability limitations for those credits differ. See § 1.46-1 (h). For a further example, see the special ordering rule in § 1.46-1 (m). Section 46(b) does not apply to the refundable energy credit. (c) Unused credit. If carryovers and credit earned (as defined in § 1.46-1(c)(1)) exceed the applicable tax liability limitation, the excess attributable to credit earned is an unused credit. The taxable year in which an unused credit arises is referred to as the "unused credit year". (d) Taxable years to which unused credit may be carried. An unused credit is a carryback to each of the 3 taxable years preceding the unused credit year and a carryover to each of the 7 taxable years succeeding the unused credit year. An unused credit must be carried first to the earliest of those 10 taxable years. An unused credit then must be carried to each of the other 9 taxable years (in order of time) to the extent that the unused credit was not absorbed during a prior taxable year because of the limitations under section 46(b) (2) and (3). (e) Special rule for pre-1971 years (1) In general. For unused credit years ending before January 1, 1971, unused credit is allowed a 10-year carryover rather than the 7-year carryover. The principles of paragraph (d) of this section apply to this 10-year carryover. (2) Cross reference. For limitations on the taxable years to which unused credit from pre-1971 credit years may be carried, see paragraph (g) of this section. (f) Limitations on carrybacks. Under the FIFO rule to section 46 (a) (1), carryovers and credit earned are applied against the tax liability limitation before carrybacks. Thus, carrybacks to a taxable year may not exceed the amount by which the applicable tax liability limitation for that year exceeds the sum of carryovers to and credit earned for that year. Carrybacks from an unused credit year are applied against tax liability before carrybacks from a later unused credit year. To the extent an unused credit cannot be carried back to a particular preceding taxable year, the unused credit must be carried to the next succeeding taxable year to which it may be carried. For line "A" each year: Lesser of (1) tax liability or (2) $25,000+ (percentage in col. (3) × [col. (2) § 1.46-1(h). For other lines: Amount in col. (6) on preceding line. Example (2). (a) Assume the same facts as in example (1) except for 1979 M earns a $35,000 nonrefundable energy credit. The following table shows the determinations for each year. (b) Although, in general, a nonrefundable energy credit may be carried back to taxable years ending before October 1, 1978, in this example the unused nonrefundable energy credit from 1979 may not be absorbed in 1977. The 1977 tax liability limitation for the nonrefundable energy credit is the same as it is for the regular credit, reduced by regular credit previously allowed for 1977. See §§ 1.46-1(h) (3) and 1.46-1 (m). Example (3). (a) Assume the same facts as in example (2) except M has regular credit of $37,000 for 1981 and M's tax liability for 1981 is $32,500. The determinations for 1980 and 1981 are set forth in the following table. (b) Allowance of the regular carryback in 1980 from 1981 requires that the computations for 1980 be restated. The energy tax liability limitation for 1980 is reduced from $15,000 (as determined in example (2)) to $9,000. Thus, $1,000 of the $10,000 energy credit allowed for 1980 is displaced by the regular carryback. That amount may not be carried back because there is no remaining energy tax liability limitation for the prior 3 years (see table in example (2)). It may be carried over to 1981 and allowed in full in that year. (i) [Reserved] (j) Electing small business corporation. A shareholder of an electing small business corporation (as defined in sec- (k) Periods of less than 12 months. A fractional part of a year that is considered a taxable year under sections 441 (b) and 7701 (a) (23) is treated as a preceding or succeeding taxable year for determining under section 46(b) the taxable years to which an unused credit may be carried. (j) Corporate acquisitions. For carryover of unused credits in the case of certain corporate acquisitions, see section 381 (c) (23). This Treasury decision is issued under the authority contained in Code sections 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38(b) (76 Stat. 962, 26 U.S.C. 38). WILLIAM E. WILLIAMS, Internal Revenue. Approved December 29, 1980. EMIL M. SUNLEY, Acting Assistant Secretary (Filed by the Office of the Federal Register on December 12, 1980, 4:00 p.m., and published in the issue of the Federal Register for January 7, 1981, 46 F.R. 1676) 26 CFR 1.46-6: Limitation in case of certain regulated companies. Investment credit; public utilities; ratable flow-through. A regulated public utility that files a consolidated return with nonpublic utility subsidiaries that historically incur losses elected to flowthrough its investment credit as a cost of service reduction under section 46(f)(2) of the Code. In establishing the utility's cost of service, its regulatory agency ignores nonpublic utility income or loss and computes all components of ratemaking as though the utility was operated as a separate corporation. The amount of the investment credit that the utility flows-through to income does not exceed the ratable portion allowed to be flowedthrough by reason of the utility's election of section 46(f)(2). Rev. Rul. 81-16 ISSUE Under the circumstances described below does the amount of investment tax credit (ITC) that a public utility taxpayer flows-through to income exceed the ratable portion allowed to be flowed-through by reason of the taxpayer's election of section 46(f) (2) of the Internal Revenue Code? FACTS The taxpayer is a regulated public utility that holds "public utility property" as that term is defined in section 46(c) (3) (B) of the Code and that timely elected to flow-through ratably its ITC as a cost of service reduction under section 46 (f) (2). The taxpayer filed a consolidated federal income tax return with three wholly owned nonpublic utility subsidiaries. Historically, these nonpublic utility subsidiaries have incurred taxable losses that reduced the income taxes required to be paid by the taxpayer on its combined operations. As a result of such reduced income taxes, the ITC otherwise allowable to the taxpayer is reduced by reason of the limitation based on tax under section 46(a). In establishing the utility's cost of service, the regulatory commission having jurisdiction uses the most recent 12 consecutive month period, called a test year, for which all of the cost factors used to determine rates are known. In so doing, the commission ignores nonpublic utility income or loss for tax purposes and computes test year federal income tax expense and all other components of ratemaking, including the ITC, as though the regulated utility were operated as a separate corporation filing a separate return. Statutory tax rates are applied to the test year taxable income of the utility. The amount of federal income. tax expense so obtained for ratemaking purposes is used to compute the limitation of ITC based on the amount of tax provided by section 46(a) of the Code. Because such test year federal income tax expense computed for the utility alone would be higher than the actual income tax on the consolidated return, the ratable portion of the amount of ITC, applicable to public utility property, that the taxpayer used to reduce cost of service is greater than the ratable portion of the actual amount allowed on the consolidated return. LAW AND ANALYSIS Section 46(a) of the Code limits the amount of allowable ITC to an amount based on a percentage of tax liability. Section 46(c) (3) (B) of the Code provides that the term "public utility property" means property used predominantly in the trade or business of the furnishing or sale of (i) electrical energy, water, or sewage disposal services, (ii) was through a local distribution system, or (iii) telephone service, domestic telegraph service, or other communication services, if the rates for such furnishing or sale have been established or approved by a governmental agency or instrumentality. Section 46(f) (2) of the Code provides a special rule that, if the taxpayer makes an election under section 46(f) (2), the general rule of section 46 (f) (1) (which considers reduction and restoration of rate base) does not apply, but no credit shall be allowed by section 38 with respect to any public utility property if the taxpayer's cost of service for ratemaking purposes or in its regulated books of account is reduced by more than a ratable portion of the credit allowable by section 38, or if the base to which the taxpayer's rate of return for ratemaking purposes is applied is reduced by reason of any portion of the credit allowable by section 38. Section 1.46-6(b) (1) of the Income Tax Regulations provides that "section 46(f) property" is public utility property within the meaning of section 46 (c) (3) (B) of the Code. The term "credit allowable by section 48" is used in section 46 (f) of the Code with respect to property over which the regulatory commission has utility property within the meaning of ratemaking authority, namely, public section 46(c) (3) (B). Therefore, the exclusion by the regulatory commission of nonpublic utility operations from the computation of ratemaking costs (which include the ITC for pub |