Part I. Rulings — Internal Revenue Bulletin 2003-30

Section 38.—General example, X burned natural gas to fuel boil- a hydrocarbon injectant which is recoverBusiness Credit ers that produced steam for use as an injec- able) which is used as a part of a tertiary

a hydrocarbon injectant which is recoverable) which is used as a part of a tertiary recovery method.

Section 193(c) provides that no deduction shall be allowed under § 193(a) with respect to any expenditure

(1) with respect to which the taxpayer has made an election under § 263(c), or

(2) with respect to which a deduction is allowed or allowable to the taxpayer under any other provision of chapter 1.

Section 43 was enacted as part of the Omnibus Revenue Reconciliation Act of 1990, Pub. L. 101–508, 104 Stat. 1388. As it was originally enacted, § 43(c)(1)(C) defined the term “qualified enhanced oil recovery costs” to include any qualified tertiary injectant expenses that are paid or incurred in connection with a qualified enhanced oil recovery project and for which a deduction is allowable under § 193 for the taxable year.

Section 317(a)(1)–(2) of the Community Renewal Tax Relief Act of 2000, Pub. L. 106–554, 114 Stat. 2673A–587, amended § 43(c)(1)(C) to provide that the term “qualified enhanced oil recovery costs” means any qualified tertiary injectant expenses (as defined in § 193(b)) that are paid or incurred in connection with a qualified enhanced oil recovery project and for which a deduction is allowable for the taxable year. The amendment was to take effect as if included in § 43 as it was originally enacted under the Revenue Reconciliation Act of 1990.

Consequently, the term “qualified tertiary injectant expenses” for purposes of § 43(c)(1)(C), as amended, has the same meaning as that term has for purposes of § 193(b).

The legislative history underlying § 193 indicates that tertiary injectant expenses include costs related to the use of a tertiary injectant, for example, “costs related to injecting a substance with a transitory effect on production” and “costs of producing and reinjecting gas or hydrocarbon liquids utilized in a recycling process.” See S. Rep. No. 394, 96 ^th Cong., 1 ^st Sess. 97 (1979), 1980–3 C.B. 131, 215. The legislative history further states that the purpose of § 193 is “to encourage the use of expensive tertiary enhanced oil recovery processes.” Id . 1980–3 C.B. 131, 216. Neither § 193 nor its legislative history,

The definition of the term "qualified tertiary injectant expenses" includes expenditures related to the use of a tertiary injectant as well as expenditures related to the acquisition of the tertiary injectant. Costs that would have been paid or incurred in the development or operation of a mineral property if an enhanced oil recovery project had not been implemented are not "qualified tertiary injectant expenses." Costs that are related to the use of a tertiary injectant and that also are related to other activities must be reasonably allocated among the tertiary injectant and the other activities. See Rev. Rul. 2003-82, page 125.

Section 43.—Enhanced Oil Recovery Credit

26 CFR 1.43–4: Qualified enhanced oil recovery costs. (Also §§ 38, 193.)

Tertiary injectant expenses. This ruling clarifies whether only the costs of acquiring tertiary injectants are eligible for the enhanced oil recovery credit provided in section 43 of the Code or whether the costs of using tertiary injectants also are eligible for the credit.

Rev. Rul. 2003–82

ISSUE

For purposes of § 43(c)(1)(C) of the Internal Revenue Code, what expenditures are included in the term “qualified tertiary injectant expenses” under § 193(b)?

FACTS

X, a domestic producer of oil, owns operating interests in numerous mineral properties located within the United States. Subsequent to December 31, 1990, X began the injection of liquids and gases into oil reservoirs in connection with enhanced oil recovery (EOR) projects X had implemented with respect to the mineral properties. All of the EOR projects that had been implemented by X qualify for the enhanced oil recovery credit provided in § 43.

In some cases, X purchased liquids and gases to inject into the reservoirs in connection with the EOR projects. In other cases, X produced tertiary injectants (for

example, X burned natural gas to fuel boilers that produced steam for use as an injectant) rather than purchasing them.

X paid or incurred costs either to acquire or produce the liquids and gases used as tertiary injectants in X ’s EOR projects. In addition to the costs of acquiring or producing the tertiary injectants, X also incurred costs to inject, recover, and reinject the purchased and produced tertiary injectants.

LAW AND ANALYSIS

Section 43(a) provides that, for purposes of § 38, the enhanced oil recovery credit for any taxable year is an amount equal to 15 percent of the taxpayer’s qualified enhanced oil recovery costs for the taxable year.

Section 43(c)(1) provides that the term “qualified enhanced oil recovery costs” means any of the following:

(A) Any amount paid or incurred during the taxable year for tangible property

(i) which is an integral part of a qualified enhanced oil recovery project, and

(ii) with respect to which depreciation (or amortization in lieu of depreciation) is allowable under chapter 1;

(B) Any intangible drilling and development costs

(i) which are paid or incurred in connection with a qualified enhanced oil recovery project, and

(ii) with respect to which the taxpayer may make an election under § 263(c) for the taxable year.

(C) Any qualified tertiary injectant expenses (as defined in § 193(b)) which are paid or incurred in connection with a qualified enhanced oil recovery project and for which a deduction is allowable for the taxable year.

Section 193(a) allows as a deduction for the taxable year an amount equal to the qualified tertiary injectant expenses of the taxpayer for tertiary injectants injected during the taxable year.

Section 193(b)(1) provides that the term “qualified tertiary injectant expenses” means any cost paid or incurred (whether or not chargeable to capital account) for any tertiary injectant (other than

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however, indicates that the term “qualified tertiary injectant expenses” was intended to include costs a taxpayer would have paid or incurred in the development or operation of a mineral property if an enhanced oil recovery project had not been implemented with respect to the property, for example, costs paid or incurred to plug and abandon wells.

Accordingly, for purposes of § 43(c)(1)(C), X ’s costs paid or incurred to either acquire or produce the liquids and gases used as tertiary injectants in X ’s EOR projects are “qualified tertiary injectant expenses” as defined in § 193(b). The term “qualified tertiary injectant expenses” also includes X ’s costs to inject, recover, and reinject the purchased and produced tertiary injectants.

HOLDING

For purposes of § 43(c)(1)(C), the definition of the term “qualified tertiary injectant expenses” includes expenditures related to the use of a tertiary injectant as well as expenditures related to the acquisition (whether produced or acquired by purchase) of the tertiary injectant. The term “qualified tertiary injectant expenses”, however, does not include costs a taxpayer would have paid or incurred in the development or operation of a mineral property if an enhanced oil recovery project had not been implemented with respect to the property. Costs that are related to the use of a tertiary injectant and that also are related to other activities (for example, primary or secondary recovery) must be reasonably allocated among the tertiary injectant and the other activities to determine the amount of tertiary injectant expenses paid or incurred by the taxpayer for the taxable year.

DRAFTING INFORMATION

The principal author of this revenue ruling is Jaime C. Park of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Ms. Park at (202) 622–3120 (not a toll-free call).

Section 167.—Depreciation

26 CFR 1.167(a)-11: Depreciation based on class lives and asset depreciation ranges for property placed in service after December 31, 1970.

How are assets owned by a utility and used in its general business operations classified for depreciation purposes? See Rev. Rul. 2003-81, page 126.

Section 168.—Accelerated Cost Recovery System

(Also §§ 167, 446, 481; 1.167(a)–11.)

Depreciation of assets. This ruling provides guidance as to the proper asset class under Rev. Proc. 87–56, 1987–2 C.B. 674, to depreciate assets owned by a utility that are used in the business operations of the utility. Rev. Proc. 2002–9 modified and amplified.

Rev. Rul. 2003–81

ISSUE

What is the proper asset guideline class under Rev. Proc. 87–56, 1987–2 C.B. 674, as clarified and modified by Rev. Proc. 88–22, 1988–1 C.B. 785, for the depreciation of assets owned by a utility that are used in the general business operations of the utility?

FACTS

U, a utility, owns a steam production plant and engages in the production of electricity for sale (production of electricity). U purchases a work bench for the maintenance garage and uses the work bench to help repair various plant machinery and equipment that are damaged during the production of electricity. U also purchases a bookcase and uses the bookcase to hold training manuals and operation protocols in the plant supervisor’s office. Additionally, U constructs a new parking lot outside the plant facility (parking lot A ) for use by U ’s plant employees. Finally, U constructs a new parking lot adjacent to its corporate headquarters (parking lot B ), located 100 miles from the plant, for use by U ’s corporate headquarters employees.

For regulatory accounting purposes, U includes certain assets that are used in its general business operations in various

general plant accounts under the Uniform System of Accounts prescribed for public utilities by the Federal Energy Regulatory Commission (FERC). Specifically, U includes the work bench in FERC account 394 (Tools, shop, and garage equipment), the bookcase in FERC account 391 (Office furniture and equipment), and both parking lots in FERC account 390 (Structures and improvements).

LAW AND ANALYSIS

Section 167(a) of the Internal Revenue Code provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion and wear and tear of property used in a trade or business or held for the production of income. The depreciation deduction provided by § 167(a) for tangible property placed in service after 1986 generally is determined under § 168. This section prescribes two methods of accounting for determining depreciation allowances: (1) the general depreciation system in § 168(a); and (2) the alternative depreciation system in § 168(g). Under either depreciation system, the depreciation deduction is computed by using a prescribed depreciation method, recovery period, and convention.

For purposes of either § 168(a) or § 168(g), the applicable recovery period is determined by reference to class life or by statute. See, for example, § 168(e). Section 168(i)(1) provides that the term “class life” means the class life (if any) that would be applicable with respect to any property as of January 1, 1986, under former § 167(m) as if it were in effect and the taxpayer had made an election under that section. Prior to its revocation, § 167(m) provided that in the case of a taxpayer who elected the asset depreciation range system of depreciation, the depreciation deduction would be computed based on the class life prescribed by the Secretary that reasonably reflects the anticipated useful life of that class of property to the industry or other group.

Section 1.167(a)–11(b)(4)(iii)( b ) of the Income Tax Regulations provides rules for classifying property under former § 167(m). Property is included in the asset guideline class for the activity in which the property is primarily used. Property is

July 28, 2003 126 2003-30 I.R.B.

producing electricity that is described in asset class 49.13. Because the work bench is used in connection with U ’s business activity of producing electricity, and is not described in an asset category, the work bench is classified in asset class 49.13.

The bookcase that U includes in FERC account 391 is used to hold training manuals and operation protocols. The bookcase is used in connection with U ’s business activity of producing electricity and therefore is included in asset class 49.13, an activity category. The bookcase is also included in asset class 00.11, an asset category. An asset that is included in both an asset category and an activity category is placed in the asset category unless it is specifically excluded from the asset category or specifically included in the activity category. See Norwest . Because the bookcase is included in both asset class 00.11 and asset class 49.13, and not specifically excluded from asset class 00.11 or specifically included in asset class 49.13, the bookcase is classified in asset class 00.11.

U includes both parking lots in FERC account 390. Both parking lot A and parking lot B are used in connection with U ’s business activity of producing electricity that is described in asset class 49.13, an activity category, and both are also described in asset class 00.3, an asset category. An asset that is included in both an asset category and an activity category is placed in the asset category unless it is specifically excluded from the asset category or specifically included in the activity category. Asset class 00.3 specifically excludes land improvements that are explicitly included in any other class. Asset class 49.13 specifically includes land improvements that are related to assets used in the steam power production of electricity for sale. Thus, any land improvements used in connection with U ’s business activity of producing electricity and related to assets used in the steam power production of electricity for sale are classified in U ’s activity category, asset class 49.13. Parking lot A, located outside the plant facility, is considered a “related land improvement” under asset class 49.13 because parking lot A is related to the plant that produces the electricity. Conversely, parking lot B, located adjacent to U ’s corporate headquarters 100 miles from the plant, is not considered a “related land improvement” under asset class 49.13 because parking lot B

classified according to primary use even though the use is insubstantial in relation to all of the taxpayer's activities.

Rev. Proc. 87–56 sets forth the class lives of property that are necessary to compute the depreciation allowances under § 168. Rev. Proc. 87–56 establishes two categories of depreciable assets: (1) asset classes 00.11 through 00.4, which consist of specific assets used in all business activities (asset categories); and (2) asset classes 01.1 through 80.0, which consist of assets used in specific business activities (activity categories) based on broadly defined industry classifications. The same item of depreciable property may be described in both an asset category and an activity category, in which case the item is classified in the asset category unless specifically excluded from the asset category or specifically included in the activity category. See Norwest Corpora- tion & Subsidiaries v. Commissioner, 111 T.C. 105 (1998) (item included in both an asset category and an activity category (furniture and fixtures) should be placed in the asset category). The asset classes described below are set forth in Rev. Proc. 87–56. Asset class 00.11, Office Furniture, Fixtures, and Equipment, includes furniture and fixtures that are not a structural component of a building. This asset class includes assets such as desks, files, safes, and communications equipment. Assets in this class have a recovery period of 7 years for purposes of § 168(a) and 10 years for purposes of § 168(g).

Asset class 00.3, Land Improvements, includes improvements directly to or added to land, whether the improvements are section 1245 property or section 1250 property, provided the improvements are depreciable. Examples of the assets might include sidewalks, roads, canals, waterways, drainage facilities, sewers (not including municipal sewers in Class 51), wharves and docks, bridges, fences, landscaping, shrubbery, or radio and television transmitting towers. Asset class 00.3 does not include land improvements that are explicitly included in any other class, and buildings and structural components as defined in § 1.48–1(e) of the regulations. Assets in this class have a recovery period of 15 years for purposes of § 168(a) and 20 years for purposes of § 168(g).

Asset class 49.13, Electric Utility Steam Production Plant, includes assets used in the steam power production of electricity for sale, combustion turbines operated in a combined cycle with a conventional steam unit and related land improvements. This asset class also includes package boilers, electric generators and related assets such as electricity and steam distribution systems as used by a waste reduction and resource recovery plant if the steam or electricity is normally for sale to others. Assets in this class have a recovery period of 20 years for purposes of § 168(a) and 28 years for purposes of § 168(g).

Rev. Proc. 87–56 is an extension and modification of Rev. Proc. 62–21, 1962–2 C.B. 418. Rev. Proc. 62–21 abandoned the asset by asset approach of depreciation. Instead, all assets used in a particular industry classification (business activity), regardless of their nature, were grouped into a single class. See also The Adoption of the Asset Depreciation Range (ADR) System, Announcement 71–76, 1971–2 C.B. 503, 507. Rev. Proc. 62–21 included, in addition to assets grouped by broad industrial classifications, certain broad general asset classifications.

Non-tax categorizations such as FERC account practices generally are not controlling for purposes of asset classification for federal income tax depreciation. The number of federal income tax depreciation activity categories for the utility services industry is significantly smaller than the number of FERC accounts. The limited number of utility services activity categories does not mean that the assets listed in FERC accounts, but not specifically mentioned in the utility services activity categories, are excluded from the utility services activity categories. Instead, the utility services activity categories for federal income tax depreciation purposes (subclasses of asset class 49) are broad and include many activities and assets that are separately described in greater detail in FERC accounts.

The work bench that U includes in FERC account 394 is used to help repair various plant machinery and equipment items that are damaged during the production of electricity. The work bench helps keep U ’s business activity running smoothly and efficiently and is used in connection with U ’s business activity of

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if an enhanced oil recovery project had not been implemented are not "qualified tertiary injectant expenses." Costs that are related to the use of a tertiary injectant and that also are related to other activities must be reasonably allocated among the tertiary injectant and the other activities. See Rev. Rul. 2003-82, page 125.

Section 412.—Minimum Funding Standards

26 CFR 1.412(c)(3)–1: Reasonable funding methods.

Minimum funding; entry age nor- mal; reasonableness. This ruling addresses two situations where the aggregate entry age normal method of funding is not a reasonable funding method within the meaning of section 412(c)(3) of the Code and section 1.412(c)(3)–1 of the regulations.

Rev. Rul. 2003–83

ISSUE

Does the aggregate entry age normal funding method constitute a reasonable funding method within the meaning of § 412(c)(3) of the Internal Revenue Code and § 1.412(c)(3)–1 of the Income Tax Regulations?

FACTS

Situation 1 . Plan M uses the following version of the aggregate entry age normal funding method. The normal cost under Plan M equals the product of the normal cost per participant and the number of active participants under the latest assumed retirement age. The normal cost per participant is equal to A divided by B, where A is the sum, for all active participants under the latest assumed retirement age, of the present value (as of each participant's entry age) of the participant's projected benefits and B is the sum, for all active participants under the latest assumed retirement age, of the present value (as of each participant's entry age) of a level annuity of 1 per year payable from the participant's entry age until the participant's retirement age. The accrued liability for the plan as of any valuation date is equal to the excess of C over D, where C is the sum, for all participants, of the present value (as of the participant's attained age) of the participant's projected benefits and

is not related to the plant that produces the electricity. Accordingly, U ’s parking lot A is classified in asset class 49.13; U ’s parking lot B is classified in asset class 00.3.

HOLDINGS

Based on the facts described above, the workbench is classified in asset class 49.13; the bookcase is classified in asset class 00.11; parking lot A (located outside the plant facility) is classified in asset class 49.13; and parking lot B (adjacent to U ’s corporate headquarters located 100 miles from the plant) is classified in asset class 00.3.

CHANGE IN METHOD OF ACCOUNTING

A change in a taxpayer’s treatment of depreciable property to conform with this revenue ruling is a change in method of accounting to which the provisions of §§ 446(e) and 481 and the regulations thereunder apply.

A taxpayer wanting to change the method of accounting for depreciable property that is owned by the taxpayer at the beginning of the year of change and for which the taxpayer has used an impermissible method of accounting for two or more consecutive taxable years immediately preceding the year of change, to conform with this revenue ruling must follow the automatic change in method of accounting provisions in Rev. Proc. 2002–9, 2002–3 C.B. 327 (as modified and amplified by Rev. Proc. 2002–19, 2002–13 C.B. 696, as amplified, clarified, and modified by Rev. Proc. 2002–54, 2002–35 I.R.B. 432, and as modified and clarified by Announcement 2002–17, 2002–8 C.B. 561) or any successor, with the following modifications:

(1) The scope limitations in section 4.02 of Rev. Proc. 2002–9 do not apply to a taxpayer that wants to change its method of accounting for the cost of depreciable property to conform with this revenue ruling for either its first or second taxable year ending after December 31, 2001, provided the taxpayer’s method of accounting for the cost of depreciable property is not an issue under consideration (within the meaning of section 3.09 of Rev. Proc. 2002–9) for taxable years under examination, before an appeals office, or before a

federal court at the time the Form 3115 is filed with the national office; and

(2) To assist the Internal Revenue Service in processing changes in method of accounting under this revenue ruling, and to ensure proper handling, section 6.02(4)(a) of Rev. Proc. 2002–9 is modified to require that a Form 3115 filed under this revenue procedure include the statement: “Automatic Change Filed Under Rev. Rul. 2003–81.” This statement should be legibly printed or typed on the appropriate line on the Form 3115.

AUDIT PROTECTION

A utility taxpayer, which owns a steam production plant and engages in the production of electricity for sale, may continue to use its present method of treating the cost of depreciable property described in an asset category (asset classes 00.11 through 00.4) or a specific utility services activity class (asset classes 49.11 through 49.4) that was placed in service during any taxable year ending on or before June 27, 2003, if use of such method results in a longer recovery period than would be required by this revenue ruling.

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 2002–9 is modified and amplified to include this change in method of accounting under section 2 of the APPENDIX.

DRAFTING INFORMATION

The principal author of this revenue ruling is Alan Cooper of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact John Huffman at (202) 622–3110 (not a toll-free call).

Section 193.—Tertiary Injectants

26 CFR 1.193-1(b)(1): Qualified tertiary injectant expenses.

July 28, 2003 128 2003-30 I.R.B.

Section 5.01 of Rev. Rul. 81–213 provides that the “actual unfunded liability” as of any valuation date is the excess, if any, of the accrued liability over the actuarial value of assets as of that date. Section 6.01 of Rev. Rul. 81–213 provides that, in general, for an immediate gain type funding method, there is an experience gain if the expected unfunded liability as of a valuation date exceeds the actual unfunded liability as of that date. Conversely, there is an experience loss if the actual unfunded liability at a valuation date exceeds the expected unfunded liability as of that date. Section 6.02 of Rev. Rul. 81–213 generally defines the “expected unfunded liability” for an immediate-gain type funding method as (1) the actual unfunded liability as of the prior valuation date, plus (2) the normal cost, minus (3) contributions, all adjusted with interest to the valuation date.

ANALYSIS

In Situation 1, the accrued liability under Plan M's version of the aggregate entry age normal funding method is determined solely from the computations with respect to the liabilities under Plan M, without reference to plan assets. In addition, the accrued liability is an integral part of Plan M's funding method ( i.e., the accrued liability is calculated as part of the funding method and is used to determine plan costs). Furthermore, the accrued liability under Plan M's funding method satisfies the definition of section 3(29) of ERISA ( i.e., the accrued liability is equal to the present value of future benefits less the present value of the plan's anticipated future normal costs determined under the funding method). Therefore, Plan M's version of the aggregate entry age normal funding method directly calculates an accrued liability. Accordingly, Plan M's version of the aggregate entry age normal funding method is an immediate gain method for purposes of applying the rules of Rev. Rul. 81–213 for computing experience gains and losses.

In Plan M's version of the aggregate entry age normal funding method, both the numerator and the denominator of the fraction used to determine the normal cost per participant are equal to the sum of several present values, with each present value being determined as of a given participant's

D is the present value of future normal costs. The present value of future normal costs is equal to the product of the normal cost per participant and the present value of future lives. The present value of future lives is the sum, for all active participants under the latest assumed retirement age, of the present values (determined as of each participant's attained age) of an annuity of 1 per year payable from the participant's attained age until the participant's retirement age. The valuation date for Plan M for each plan year is January 1, the first day of the plan year, and the actuarial value of the assets is determined as the fair market value of the assets.

Situation 2 . Plan N uses the following version of the aggregate entry age normal funding method. The normal cost under Plan N equals the product of the normal cost accrual rate and the total current compensation of all active participants under the latest assumed retirement age. The normal cost accrual rate is equal to A divided by B, where A is the sum, for all active participants under the latest assumed retirement age, of the present value (as of each participant's entry age) of the participant's projected benefits and B is the sum, for all active participants under the latest assumed retirement age, of the present value (as of each participant's entry age) of each participant's compensation beginning with the assumed compensation as of the participant's entry age (determined by retroactively applying the pay increase factor to the participant's current compensation) until the participant's retirement age. The accrued liability for the plan as of any valuation date is equal to the excess of C over D, where C is the sum, for all participants, of the present value (as of each participant's attained age) of the participant's projected benefits and D is the present value of future normal costs. The present value of future normal costs is equal to the product of the normal cost accrual rate and the present value of future compensation. The present value of future compensation is defined as the sum, for all active participants under the latest assumed retirement age, of the present value (determined as of each participant's attained age) of the participant's future compensation from the participant's attained age until the participant's retirement age. The valuation date for Plan N

for each plan year is January 1, the first day of the plan year, and the actuarial value of the assets is determined as the fair market value of the assets.

APPLICABLE LAW

Section 412(c)(3) of the Internal Revenue Code requires that all costs and liabilities of a pension plan be determined on the basis of assumptions and methods that are reasonable. Section 1.412(c)(3)–1 of the Income Tax Regulations prescribes rules for determining whether or not, in the case of an ongoing plan, a funding method is reasonable for purposes of § 412(c)(3). Section 1.412(c)(3)–1(c)(2) provides that a funding method is reasonable only if it produces no experience gains and losses when each actuarial assumption is exactly realized.

Rev. Rul. 81–213, 1981–2 C.B. 101, provides guidelines for the determination of experience gains and losses, including separate rules for immediate gain type funding methods and spread gain type funding methods. Under section 2.02 of Rev. Rul. 81–213, an immediate-gain type funding method is a funding method that directly calculates an accrued liability.

Rev. Rul. 81–13, 1981–1 C.B. 229, provides that an accrued liability can be directly calculated under the funding method used for the plan if the following three conditions are met: (1) the accrued liability may be determined solely from the computations with respect to the liabilities (without reference to plan assets); (2) the accrued liability is an integral part of the funding method used; and (3) the accrued liability satisfies the definition of section 3(29) of the Employee Retirement Income Security Act of 1974 (ERISA). In order for the accrued liability to be an integral part of the funding method used for the plan, such accrued liability or both the present value of future benefits and the present value of future normal costs must be calculated as part of the funding method and must be used to determine plan costs. In order to satisfy the definition of section 3(29) of ERISA, the accrued liability must be equal to the present value of future benefits less the present value of future normal costs. The normal costs that are so used are the plan's anticipated future normal costs under the funding method as of the valuation date.

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As noted above, the expected unfunded liability as of January 1, 2004, is equal to $24,381.38, but the actual unfunded liability as of that date is $37,268.69. Thus, despite the fact the actuarial assumptions were exactly realized during 2003, the plan has experienced an actuarial loss for 2003 of $12,887.31 (equal to the difference between the actual unfunded liability and the expected unfunded liability).

In Situation 2, the funding method used by Plan N is similar to that used by Plan M in Situation 1, in that both the numerator and the denominator of the fraction used to determine the normal cost accrual rate (which is analogous to the normal cost per participant in Situation 1) are equal to the sum of several present values, with each present value calculated as of the respective participants' entry ages. For participants with different entry ages, these present values are calculated as of different points in time and this inconsistency will cause the normal cost under Plan M to follow a different pattern over time than the expected aggregate compensation of active plan participants ( i.e., the normal cost accrual rate will not remain level over time). In turn, this failure of the normal cost to remain level as a percent of compensation will cause the method to produce experience gains or losses even if all actuarial assumptions are exactly realized.

HOLDING

Because it can create experience gains or losses even if all actuarial assumptions are exactly realized, the aggregate entry age normal funding method that determines the normal cost per plan participant by dividing the sum of the present values (determined as of each participant's entry age) of each participant's projected benefits by the sum of the present values (determined as of each participant's entry age) of an annuity for each participant equal to 1 per year payable from the participant's entry age until the participant's retirement age does not constitute a reasonable funding method within the meaning of § 1.412(c)(3)–1 of the regulations.

Because it can create experience gains or losses even if all actuarial assumptions are exactly realized, the aggregate entry age normal funding method that determines the normal cost accrual rate by

entry age. For participants with different entry ages, these present values are calculated as of different points in time and this inconsistency will cause the normal cost under Plan M to follow a pattern over time that is different than the pattern of the expected number of active plan participants ( i.e., the normal cost per participant will not remain level over subsequent valuation dates). In turn, this failure of the normal cost per participant to remain level will cause the method to produce experience gains or losses even if all actuarial assumptions are exactly realized. This phenomenon is illustrated by the following simplified example. The actuarial assumptions used in this example were chosen to simplify the illustration and are not necessarily reasonable actuarial assumptions for an actual plan.

As of January 1, 2003, (the valuation date for the plan year beginning January 1, 2003), a plan using the method described in situation 1 has 20 active participants, 10 of whom are age 35, and 10 of whom are age 55. There are no inactive participants. The participants who are age 35 all entered the plan at age 35 and have projected annual retirement benefits of $12,000. The participants who are age 55 all entered the plan at age 30 and have projected annual retirement benefits of $10,000. The expected retirement age for all participants is 65. Under the actuarial assumptions used by the plan, the present value as of age 65 of an annual retirement benefit of 1 is 10.000. The pre-retirement interest rate is 7%. There are no pre-retirement decrements other than at age 35 (for which the probability of remaining an active participant until age 36 is 50%), and there are no benefits payable under the plan on account of a decrement at age 35. For funding purposes, the plan sets the value of assets equal to their fair market value. As of January 1, 2003, the value of the plan's assets is $450,000.

The actuarial valuation results for the 2003 plan year are as follows: The sum, for all active participants, of the present value (as of each participant's entry age) of the participant's projected benefits is $125,651.72. The sum, for all active participants, of the present value (as of each participant's entry age) of a level annuity of 1 per year payable from the participant's entry age until the participant's retirement age is 166.1594. Accordingly,

the normal cost per participant is $756.21 ($125,651.72 divided by 166.1594), and the normal cost for the plan is $756.21 × 20 (the number of participants), or $15,124.24.

The present value of projected benefits (as of January 1, 2003) is $587,169.50 and the present value of future lives is 146.5407. Therefore, the present value of future normal costs (as of January 1, 2003) is $110,815.82 (equal to $756.21 × 146.5407) and the accrued liability as of the valuation date is $476,353.69.

The actual unfunded liability for the current year is $26,353.69 (equal to the excess of the accrued liability over the asset value of $450,000). Assuming the employer makes a single contribution of $20,000 at the end of the year, the expected unfunded liability at the next valuation is $24,381.39 (equal to $26,353.69 × 1.07 + $15,124.24 × 1.07 - $20,000).

During 2003, all actuarial assumptions are exactly realized and there are no new hires. Thus, all 10 of the participants aged 55 remain active participants at age 56, 5 of the participants aged 35 remain active participants at age 36 and the value of assets on January 1, 2004, is equal to $501,500 ($450,000 × 1.07 + $20,000).

As of January 1, 2004, the actuarial valuation results are as follows:

The sum, for all active participants, of the present value (as of each participant's entry age) of the participant's projected benefits is $86,241.59. The sum, for all active participants, of the present value (as of each participant's entry age) of a level annuity of 1 per year payable from the participant's entry age until the participant's retirement age is 130.4652. Accordingly, the normal cost per participant is $661.03 ($86,241.59 divided by 130.4652), and the normal cost for the plan is $661.03 × 15 (the number of participants), or $9,915.47.

The present value of projected benefits (as of January 1, 2004) is $628,271.38 and the present value of future lives is 135.3986. Accordingly, the present value of future normal costs (as of January 1, 2004) is $89,502.70 (which is equal to $661.03 × 135.3986) and the accrued liability is $538,768.69.

The actual unfunded liability as of January 1, 2004, is $37,268.69 (equal to the excess of the accrued liability over the asset value of $501,500).

July 28, 2003 130 2003-30 I.R.B.

dividing the sum of the present values (determined as of each participant's entry age) of each participant's projected benefits by the sum of the present values (determined as of each participant's entry age) of future compensation from the participant's entry age until the participant's retirement age does not constitute a reasonable funding method within the meaning of § 1.412(c)(3)–1 of the regulations.

EFFECTIVE DATE AND TRANSITION RULE

This ruling will be effective for valuations performed for plan years beginning after December 31, 2003. For plans that are currently using a funding method as described in this revenue ruling, the funding method may be changed to a reasonable funding method by following the procedures set forth in Rev. Proc. 2000–40, 2000–2 C.B. 357 or Rev. Proc. 2000–41, 2000–2 C.B. 371.

DRAFTING INFORMATION

The principal author of this revenue ruling is James E. Holland, Jr. of the Employee Plans, Tax Exempt and Government Entities Division. For further information regarding this revenue ruling, contact the Employee Plans taxpayer assistance telephone service between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time, Monday through Friday, by calling (877) 829–5500 (a toll-free number). Mr. Holland may be reached at (202) 283–9699 (not a toll-free number).

Section 446.—General Rule for Methods of Accounting

If a utility changes the asset or activity classification under Rev. Proc. 87-56 of assets used by the utility in its general business operations, is this

change a change in method of accounting under section 446(e) of the Internal Revenue Code? See Rev. Rul. 2003-81, page 126.

Section 481.—Adjustments Required by Changes in Method of Accounting

If a utility changes the asset or activity classification under Rev. Proc. 87-56 of assets used by the utility in its general business operations, is an adjustment under section 481 of the Internal Revenue Code taken into account in computing taxable income? See Rev. Rul. 2003-81, page 126.

2003-30 I.R.B. 131 July 28, 2003