9. INCOME TAX

An estimate of annual income tax expense is made each interim period using estimates for annual pre-tax income, regulatory flow-through adjustments, tax credits, and other items. The estimated annual effective tax rate is applied to year-to-date, pre-tax income to determine income tax expense for the interim period consistent with the annual estimate.

The effective income tax rate varied from the combined federal and state statutory tax rates due to the following:



	Three Months Ended September 30,						Nine Months Ended September 30,
Dollars in thousands	2018			2017			2018			2017
Income taxes at statutory rates (federal and state)	$	(4,136	)	$	(5,440	)	$	11,097		$	24,472
Increase (decrease):
Differences required to be flowed-through by regulatory commissions	(266		)	(302		)	569			1,282
Other, net	117			20			(475		)	(1,298		)
Total provision (benefit) for income taxes on continuing operations	$	(4,285	)	$	(5,722	)	$	11,191		$	24,456
Effective tax rate for continuing operations	27.8		%	42.0		%	26.8		%	39.4		%

The effective income tax rate for the three and nine months ended September 30, 2018 compared to the same periods in 2017 decreased primarily as a result of the TCJA and lower pre-tax income. See "U.S. Federal TCJA Matters" below and Note 9 in the 2017 Form 10-K for more detail on income taxes and effective tax rates.

The IRS Compliance Assurance Process (CAP) examination of the 2016 tax year was completed during the first quarter of 2018. There were no material changes to the return as filed. The 2017 tax year is subject to examination under CAP and the 2018 tax year CAP application has been accepted by the IRS.

U.S. Federal TCJA Matters

On December 22, 2017, the TCJA was enacted and permanently lowered the U.S. federal corporate income tax rate to 21% from the previous maximum rate of 35%, effective for the tax year beginning January 1, 2018. The TCJA includes specific provisions related to regulated public utilities that provide for the continued deductibility of interest expense and the elimination of bonus depreciation on a prospective basis.

Under pre-TCJA law, business interest expense was generally deductible in the determination of taxable income. The TCJA imposes a new limitation on the deductibility of net business interest expense in excess of approximately 30% of adjusted taxable income beginning January 1, 2018. Taxpayers operating in the trade or business of public regulated utilities are excluded from these new interest expense limitations. There is ongoing uncertainty with regards to the application of the new interest expense limitation to non-regulated operations, primarily with respect to the allocation of interest between regulated and non-regulated trades or businesses. See Note 9 in the 2017 Form 10-K.

The TCJA generally provides for immediate full expensing for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. This would generally provide for accelerated cost recovery for capital investments. However, the definition of qualified property excludes property used in the trade or business of a public regulated utility. The definition of utility trade or business is the same as that used by the TCJA with respect to the imposition of the net interest expense limitation discussed above. As a result, ongoing uncertainty exists with respect to the application of full expensing to non-regulated activities. See Note 9 in the 2017 Form 10-K.

NW Natural had an estimated regulatory liability of $216.6 million and $213.3 million for the change in regulated utility deferred taxes as a result of the TCJA as of September 30, 2018 and December 31, 2017, respectively. These balances included a gross-up for income taxes of $57.4 million and $56.5 million, respectively. It is possible that this estimated balance may increase or decrease in the future as additional authoritative interpretation of the TCJA becomes available, or as a result of regulatory guidance from the OPUC or WUTC. NW Natural anticipates that until such time that customers receive the direct benefit of this regulatory liability, the balance, net of the additional gross-up for income taxes, will continue to provide an indirect benefit to customers by reducing the utility rate base which is a component of customer rates. It is not yet certain when the final resolution of these regulatory proceedings will occur, and as result, this regulatory liability is classified as long-term.

As noted in the 2017 Form 10-K, Note 9, the determination to exclude all assets placed in service after September 27, 2017 from bonus depreciation was provisional as provided for under Staff Accounting Bulletin (SAB) 118. During the third quarter, the Internal Revenue Service and Treasury issued Proposed Regulations addressing additional first year tax depreciation under the TCJA. These Proposed Regulations, while not definitive, indicate the IRS' initial interpretation that additional first year bonus depreciation was available for regulated utility assets placed in service after September 27, 2017 but before January 1, 2018. On the basis of these proposed regulations, NW Natural revised the provisional estimate of deferred taxes and income taxes payable. NW Natural recognized increases to prepaid income tax of $7.3 million, deferred income tax liability of $4.0 million, and regulatory liability of $3.3 million during the third quarter of 2018.

Utility rates in effect include an allowance to provide for the recovery of the anticipated provision for income taxes incurred as a result of providing regulated services. As a result of the newly enacted 21% federal corporate income tax rate, NW Natural recorded an additional regulatory liability in 2018 reflecting the estimated net reduction in the provision for income taxes. This revenue deferral is based on the estimated net benefit to customers using forecasted regulated utility earnings, considering average weather and associated volumes, and includes a gross-up for income taxes. As of September 30, 2018, a regulatory liability of $7.2 million, including accrued interest, was recorded to reflect this estimated revenue deferral.