NOTE 2: INCOME TAX EXPENSE

Under ASC 740, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. From time to time, the Company is assessed interest and penalties by taxing authorities. In those cases, the charges are recorded on the “Other” line item, within the “Other Income (Deductions), Net of Taxes” section of the Consolidated Statements of Income. There were no such charges or accruals for the years ended December 31, 2018, 2017, and 2016.

On December 22, 2017 H.R. 1, originally known as the Tax Act was enacted. Among the significant changes to the U.S. Internal Revenue Code, the Tax Act lowers the U.S. federal corporate income tax rate (“Federal Tax Rate”) from 35% to 21% effective January 1, 2018. In December 2017, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (SAB 118), which addresses how a company recognizes provisional amounts when a company does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete its accounting for the effect of the changes in the Tax Act. The measurement period ends when a company has obtained, prepared and analyzed the information necessary to finalize its accounting, but cannot extend beyond one year. Accounting for the income tax effects of the Tax Act was completed in December 2018. Amounts have been recorded as a Regulatory Liability to the extent that the tax savings over time will be returned to customers in utility rates, and a non-cash adjustment was recognized to record additional income tax expense to the extent revalued deferred income taxes are not believed to be recoverable in utility customer rates. These Regulatory Liabilities may be adjusted when decisions are reached by both PURA and the MPUC regarding the impact that will be reflected in utility customer rates.

As of December 31, 2017, the Company determined a reasonable estimate for remeasuring its net deferred tax assets and liabilities using the Federal Tax Rate that would apply when the amounts are expected to reverse. The Company recorded that estimate as a provisional amount. The effect of the provisional remeasurement is reflected entirely in the interim period that includes the enactment date and is allocated directly to income tax expense from continuing operations. The remeasurement of the deferred tax assets and liabilities resulted in a $1.5 million discrete tax expense which increased the effective tax rate by 6.1% in the year ended December 31, 2017. The Company remeasured deferred tax assets and liabilities to reflect the enacted legislation and recorded a regulatory liability of $27.1 million to capture the excess accumulated deferred income taxes for items included in rates that follow the normalized method of accounting. Unrecovered Income Taxes and Unfunded Future Income Taxes were written down by $32 million to reflect the reduced tax rate for items that follow the flow-through method of accounting.

As of December 31, 2018, the Company finalized its accounting for the Tax Act including remeasuring its net deferred tax assets and liabilities using the Federal Tax Rate that will apply when the amounts are expected to reverse. The effect of the adjustments to the remeasurement is reflected entirely in the measurement period as allowed by SAB 118 and is allocated directly to income tax expense from continuing operations. The completed analysis resulted in an additional remeasurement of the deferred tax assets and liabilities and resulted in a $900,000 discrete tax benefit which decreased the effective tax rate by 6.3% in the year ended December 31, 2018. In addition, the completed analysis resulted in an additional remeasurement of the deferred tax assets and liabilities to reflect the enacted legislation and the Company recorded an increase to its Regulatory Liability of $300,000 to capture the excess accumulated deferred income taxes for items included in rates that follow the normalized method of accounting. Unrecovered Income Taxes and Unfunded Future Income Taxes were written down by an additional $300,000 to reflect the reduced tax rate for items that follow the flow-through method of accounting.

Final accounting for the impacts of the Tax Act, recorded in the years ended December 31, 2018 and 2017 resulted in a remeasurement of deferred tax assets and liabilities resulting in $600,000 discrete tax expense. The Company remeasured deferred tax assets and liabilities to reflect the enacted legislation and recorded a regulatory liability of $27.4 million to capture the excess accumulated deferred income taxes for items included in rates that follow the normalized method of accounting. Unrecovered Income Taxes and Unfunded Future Income Taxes were written down by $32.3 million to reflect the reduced tax rate for items that follow the flow-through method of accounting.

On its 2012 Federal tax return, filed in September 2013, Connecticut Water filed a change in accounting method to adopt the IRS temporary tangible property regulations. On its 2013 Federal tax return, filed in September 2014, Maine Water filed the same change in accounting method. This method change allowed the Company to take a current year deduction for expenses that were previously capitalized for tax purposes. Since the filing of the 2012 tax return, the IRS has issued final regulations. While the Company maintains the belief that the deduction taken on its tax return is appropriate, the methodology for determining the deduction has not been agreed to by the taxing authorities. Provisions for uncertain tax positions were recorded to reflect the possible challenge of the Company’s methodology for determining its repair deduction as required by FASB ASC 740. During the quarter ended September 30, 2018, $1.3 million was reversed due to statute expiration. During the year ended December 31, 2018, in conjunction with its review of the impacts of the Tax Act, the Company reviewed its provision associated with the repair deduction. Should the IRS challenge the Company’s tax treatment, and ultimately disallow a portion of the repair deduction, the Company expects the net operating loss carryforwards to offset any resulting liability. During the year ended December 31, 2018, a portion of the provision in the amount of $980,000 was reversed to reflect the offset by the remeasured net operating loss deferred tax asset. In addition, as required by FASB ASC 740, during the year ended December 31, 2018, the Company recorded a provision of $1.0 million for a portion of the benefit that is not being returned to customers resulting from any possible tax authority challenge. The Company had previously recorded a provision of $4.6 million in the prior year for a cumulative total of $3.3 million.

The Company remains subject to examination by federal and state tax authorities for the 2015 through 2017 tax years. On April 26, 2017, Avon Water was notified by the IRS that its stand-alone Federal tax filing for 2015 was selected to be reviewed beginning in the second quarter of 2017. On March 20, 2018, Avon Water received a notice of adjustment from the IRS related to the Federal tax audit for the tax years ended December 31, 2015 and 2016. As a result, a reduction in net operating loss carryover of $56,000 was recorded during the year ended December 31, 2018.

Income Tax (Benefit) Expense for the years ended December 31, is comprised of the following:



(in thousands)	2018			2017			2016
Federal Classified as Operating (Benefit) Expense	$	(1,931	)	$	(1,277	)	$	1,782
Federal Classified as Other Utility Income	287			434			385
Federal Classified as Other Income (Deduction)
Land Sales and Donations	175			17			57
Non-Water Sales	328			774			702
Other	(857		)	503			(686		)
Total Federal Income Tax (Benefit) Expense	(1,998		)	451			2,240
State Classified as Operating (Benefit) Expense	(77		)	(716		)	788
State Classified as Other Utility Income	111			104			92
State Classified as Other Income (Expense)
Land Sales and Donations	130			5			—
Non-Water Sales	141			175			172
Other	(489		)	149			(126		)
Total State Income Tax (Benefit) Expense	(184		)	(283		)	926
Total Income Tax (Benefit) Expense	$	(2,182	)	$	168		$	3,166

The components of the Federal and State income tax provisions are:



(in thousands)	2018			2017			2016
Current Income Taxes
Federal	$	(1,119	)	$	—		$	(15	)
State	4			521			463
Total Current	(1,115		)	521			448
Deferred Income Taxes, Net
Federal
Investment Tax Credit	(76		)	(76		)	(75		)
Excess Accumulated Deferred Taxes	(323		)	(293		)	(110		)
Excess Accumulated Deferred Taxes - Tax Act	(657		)	1,538			—
Deferred Revenue	415			731			(353		)
Land Donations	(27		)	—			37
Depreciation	1,165			2,151			1,769
Net Operating Loss Carry-forwards	(600		)	817			(1,258		)
NOL Carry-forwards valuation allowance	613			(613		)	—
Provision for uncertain positions	(1,040		)	(3,876		)	2,487
Other	(349		)	72			(242		)
Total Federal	(879		)	451			2,255
State
Land Donations	126			—			55
Provision for uncertain positions	(240		)	(958		)	611
Other	(74		)	154			(203		)
Total State	(188		)	(804		)	463
Total Deferred Income Taxes	(1,067		)	(353		)	2,718
Total Income Tax	$	(2,182	)	$	168		$	3,166

Deferred income tax (assets) and liabilities are categorized as follows on the Consolidated Balance Sheets:



(in thousands)	2018			2017
Unrecovered Income Taxes - Regulatory Asset	$	(75,763	)	$	(66,631	)
Deferred Federal and State Income Taxes	31,593			33,579
Unfunded Future Income Taxes	67,725			58,384
Unamortized Investment Tax Credits - Regulatory Liability	1,057			1,133
Net Deferred Income Tax Liability	$	24,612		$	26,465

Net deferred income tax liability decreased from December 31, 2017 to December 31, 2018. The decrease was attributed to the current year tax effects of temporary differences, mostly related to the taxability of contributions in aid of construction under the Tax Act, and the releasing of provisions for uncertain tax positions.

Deferred income tax (assets) and liabilities are comprised of the following:



(in thousands)	2018			2017
Tax Credit Carry-forward (1)	$	(1,087	)	$	(1,092	)
Charitable Contribution Carry-forwards (2)	(291		)	(257		)
Valuation Allowance on Charitable Contributions	49			63
Prepaid Income Taxes on CIAC	(1,480		)	31
Net Operating Loss Carry-forwards (3)	(4,537		)	(3,806		)
Valuation Allowance on Net Operating Losses	1,871			1,671
Deferred Revenue	2,219			1,644
Other Comprehensive Income	(145		)	(158		)
Accelerated Depreciation	36,175			34,989
Provision on Repair Deductions	3,350			4,630
Long-Term Compensation Agreements	(3,341		)	(3,260		)
Unamortized Investment Tax Credits	1,057			1,133
Gross-up on Regulatory Liability - Excess Accumulated Deferred Taxes	(8,038		)	(8,247		)
Other	(1,190		)	(876		)
Net Deferred Income Tax Liability	$	24,612		$	26,465


(1)	State tax credit carry-forwards expire beginning in 2019 and ending in 2040.


(2)	Charitable Contribution carry-forwards expire beginning with the filing of the 2017 Federal and State Tax Returns in 2019 and ending in 2023.


(3)	Net operating loss carry-forwards expire beginning in 2029 and ending in 2037. Federal net operating loss carry-forwards generated after December 31, 2017 have no expiration.

The calculation of Pre-Tax Income is as follows:



(in thousands)	2018			2017		2016
Pre-Tax Income
Net Income	$	16,695		$	25,054	$	23,387
Income Taxes	(2,182		)	168		3,166
Total Pre-Tax Income	$	14,513		$	25,222	$	26,553

In accordance with required regulatory treatment, certain deferred income taxes are not provided for certain timing differences. This treatment, along with other items, causes differences between the statutory income tax rate and the effective income tax rate. The differences between the effective income tax rate recorded by the Company and the statutory federal tax rate are as follows:



	2018		2017		2016
Federal Statutory Tax Rate	21.0	%	34.0	%	34.0	%
Tax Effect Differences:
State Income Taxes Net of Federal Benefit	0.3	%	(0.9	)%	2.6	%
Property Related Items	(25.8	)%	(19.9	)%	(30.4	)%
Pension Costs	(1.3	)%	(2.3	)%	(0.4	)%
Repair Regulatory Liability (1)	(0.1	)%	(1.2	)%	(3.9	)%
Change in Estimate of Prior Year Income Tax Expense	(2.8	)%	2.7	%	0.3	%
Provision for Uncertain Tax Positions (2)	(2.1	)%	(16.7	)%	10.2	%
Valuation Allowance	3.8	%	(2.3	)%	0.2	%
Impact of Tax Act	(6.3	)%	6.1	%	—	%
Excess Deferred Tax Amortizations (3)	(7.0	)%	0.6	%	(0.3	)%
Performance Shares (4)	(11.7	)%	(0.1	)%	(0.8	)%
Acquisition Costs (5)	14.7	%	0.4	%	0.4	%
Other	2.3	%	0.3	%	—	%
Effective Income Tax Rate	(15.0	)%	0.7	%	11.9	%


(1)	The return to customers of the repair tax benefit is reflected under Repair Regulatory Liability and was fully returned to customers in 2018.


(2)	Provisions for uncertain tax positions were recorded to reflect the possible challenge of the Company’s methodology for determining its repair deduction as required by FASB ASC 740. In 2017, the Company assessed new information in regards the previously recorded provision for uncertain tax positions and released a portion of the provision.


(3)	In the quarter ended December 31, 2017, the Company recorded provisional charges to tax expense to account for the estimated impact of the Tax Act. In the year ended December 31, 2018, accounting for the impact was finalized and excess deferred tax balance began reversing under the average rate assumption method.


(4)	Performance shares were issued to the former CEO upon his separation from the Company.


(5)	Management has estimated a portion of the transaction costs related to acquisition activity will not be deductible.