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At the Hearing of the Select Revenue Measures Subcommittee of the Committee on Ways and Means, U.S. House of Representatives, Concerning the Internal Revenue Service's Withdrawal of Proposed Regulations Concerning the Treatment of Consolidated Tax Savings Under the Normalization Requirements of the Internal Revenue Code

September 11, 1991

Mr. Chairman, at the outset of this important hearing, I have some observations which I would like to offer on the topic of today's hearings. As stated by Chairman Rostenkowski in his letter requesting the Subcommittee to hold these public hearings, it will be helpful for the Subcommittee to get to the heart of why the I.R.S. withdrew its proposed regulations regarding consolidated tax savings and normalization, so that we can better appreciate the current state of the law given that withdrawal.

First of all, I believe the Service acted correctly in withdrawing the proposed regulations in April of this year, because they were fundamentally flawed. The proposed regulations would have permitted the reduction of a utility's rate base by the amount of the tax saving realized by the utility from filing a consolidated federal income tax return with non-regulated affiliated corporations. Implementation of that portion of the proposed regulations would have been inconsistent with the normalization method of accounting, which has been required of public utilities since 1969.

Let me briefly describe the background of tax

normalization.

Normalization

Normalization is a rate making concept designed to adjust a regulated utility's operating expenses in its test year by eliminating abnormal, non-annual events that are known and certain to change in a regularly recurring manner. Normalization as it applies to income tax expense permits a regulated utility to include in its current cost of service an income tax expense higher than that which it has been required to pay, on the assumption that taxes saved by accelerated depreciation or other tax incentives of a timing nature are merely being deferred. Tax expense computed under normalization is the sum of the utility's current tax expense and deferred tax expense. Essentially, under normalization, rates are set on the basis of the higher income taxes the utility would hypothetically have paid, had it used straight

line depreciation for tax purposes or not had available tax incentives or other tax benefits.

other

The normalization method of accounting for federal income tax purposes was first provided by the Tax Reform Act of 1969. The purpose of normalization was to insure that tax incentives to regulated utilities from accelerated depreciation and the investment tax credit would encourage capital investment, rather than merely reduce the rates paid by ratepayers. Congress was also concerned that flow through of the incentives to ratepayers would decrease federal revenues.

tax

Statutory Provisions

In order to use the accelerated cost recovery system of section 168 for public utility property, a regulated utility must use a normalization method of accounting. The normalization rules are now set out in Code section 168 (i) (9). Those rules provide that to use a normalization method of accounting:

(i) the taxpayer, in computing

its tax expense

account >

method of

for purposes of establishing its cost of service
for ratemaking purposes and reflecting operating
results in its regulated books of
("regulated tax expense"), must use a
depreciation that is the same as, and a >
depreciation period for such property that is not
shorter than, the method and period used to >
compute its depreciation expense for ratemaking
purposes; and

(ii) if the amount allowable as a deduction for tax purposes with respect to the public utility property differs from the amount that would be > allowable as a deduction under the method used to compute regulated tax expense, the taxpayer must make adjustments to a reserve to reflect the > deferral of taxes resulting from such difference.

Section 168(i) (9) (B) of the Code prohibits a taxpayer for ratemaking purposes from using a procedure or adjustment inconsistent with the above requirements. Any procedure or adjustment for ratemaking purposes that uses an estimate or projection of the taxpayer's (1) tax expense, (2) depreciation expense, or (3) reserve for deferred taxes is deemed inconsistent, unless such estimate or projection is also used, for ratemaking purposes, with respect to the other two such items and with respect to the rate base and cost of service.

I.R.S. Notice 89-63

In Notice 89-63, the I.R.S. announced that it planned to develop regulations to provide guidance on the proper application of the above normalization requirements for public utilities that file consolidated returns with non-regulated

affiliates. The I.R.S. indicated that those regulations would address the use by public utilities of "effective tax rates" and "consolidated tax adjustments." Those are procedures that have been used by some regulators in calculating utility income tax expense for ratemaking purposes, which take into consideration the tax deductions and the tax credits of non-regulated affiliates, through consolidated returns.

if

Prior to the issuance of Notice 89-63, the I.R.S. had historically taken the position, as reflected in many private letter rulings, that a public utility would not be in compliance with the normalization requirements of the Code a consolidated tax adjustment was used for purposes of determining regulated tax expense. See, for instance, PLR 8711050. The theory behind the holding of that private letter ruling is that a consolidated tax savings adjustment would improperly reduce the reserve required under Code section 168 (i) (9) (A) (ii) to reflect the deferral of taxes caused by the excess of regulated tax expense over actual tax expense. The reserve is simply the product of the difference between book depreciation and tax depreciation and the federal income tax rate in effect for the year. Introducing a variable such as a consolidated return adjustment that served to reduce the amount of federal income tax liability deferred, would cause the reserve to be inadequate to meet the normalization requirements.

The Proposed Regulations

with

In November of 1990 the I.R.S. issued proposed regulations to provide guidance on the application of the normalization requirements of the Code to utility companies filing consolidated federal income tax returns with their unregulated affiliates. Those regulations provided that, to comply the normalization requirements, a utility's ratemaking tax expense would have to be determined as though it filed a separate return for purposes of cost of service. However, the proposed regulations also provided that it generally would not violate the normalization requirements to exclude from rate base a utility's share of the tax savings attributable to the filing of a consolidated return.

The I.R.S. held a public hearing in February of this year in which the proposed regulations were widely criticized by both the utility industry and by many public service commissions. The I.R.S. withdrew the proposed regulations in April of this year, pending Congressional guidance.

The Effect of the Withdrawal of the Proposed Regulations

As a result of the withdrawal of the proposed regulations, taxpayers and public utility commissions are now in a quandary as to what is the proper treatment of consolidated tax savings under the normalization requirements of the Code. Without guidance as to whether ratemakers can adjust for consolidated tax savings, many utilities may be reluctant to make capital investments. In light of the important role that public utilities play in our country's economic well-being, this Subcommittee should not hesitate to provide proper guidance.

That guidance should confirm that the normalization method of accounting requires that cost of service and rate base of a utility filing a consolidated return be determined wholly on a stand alone basis; without regard to the non-regulated consolidated tax savings. The tax characteristics of consolidation properly should benefit the shareholders who have borne the risk of the investment. Shifting those benefits away from shareholders would clearly increase the costs to public utilities of capital formation.

Important federal tax policies are served when the normalization method of accounting is scrupulously implemented. Business tax incentives provided under the Code, whether they be in the form of accelerated depreciation, mineral depletion, low income housing credits, or other forms, are designed to encourage capital formation in selected areas. Where those tax incentives are not available to utility shareholders because of a flow through to ratepayers, the very reason for providing the tax incentives is frustrated.

It is also inequitable to flow through to ratepayers the favorable tax consequences of the risks that the shareholders have assumed in non-regulated areas. Public service commissions are justly vigilant in insulating ratepayers from the risks of unregulated subsidiary ventures of a regulated utility. Therefore, there is no need to shift the tax consequences of such risks, such as net operating losses during a start-up phase, from shareholders to ratepayers through a consolidated tax savings adjustment. The shifting away from shareholders of such tax consequences also would place affiliates of regulated companies at a competitive disadvantage with foreign and domestic unregulated competitors. То the extent we place an additional cost of capital formation and competitive disadvantages on public utilities engaged, through their affiliates, in the search for new or improved energy sources, our country's energy policy suffers as well. Moreover, such an approach would be inconsistent with the policy of the Federal Energy Regulatory Commission of requiring a "stand alone" approach to the treatment of income taxes in determining utility costs.

Therefore, I urge this Subcommittee to take the steps necessary to confirm that to comply with the normalization method of accounting, utilities must not adjust their tax expense or rate base by any amount of non-regulated consolidated tax savings. I will be interested testimony of our witnesses today as it accomplishing this important goal.

to hear the relates

to

Mr. SUNDQUIST. I have a short statement, Mr. Chairman. I want to thank you for calling this hearing on the withdrawal of the proposed regulations on the treatment of consolidated tax savings under the normalization requirements of the code. Given the widespread unfavorable response to the proposed regulations and their subsequent withdrawal, it's imperative that this committee act quickly and decisively to provide the guidance which Treasury has requested for this issue to be resolved.

Now, the current situation leaves the business plans of many diversified utilities in limbo as they cannot determine the value of the tax benefits from their unregulated operations from State to State, or even on a consolidated basis.

This not only disrupts individual operations, but adversely affects our competitiveness in high risk ventures in industries such as telecommunications and energy exploration.

So I look forward, Mr. Chairman, to exploring the intent of Congress in establishing normalization requirements, various tax incentives, and consolidated return elections. I also look forward to exploring the effect of consolidated tax adjustments on competitiveness, on unregulated operations, on financial markets, and on Federal tax receipts.

Thank you, Mr. Chairman.

Chairman RANGEL. Is there any member seeking recognition. [No response.]

Chairman RANGEL. If not, Mr. Secretary, we are anxious to hear your testimony.

STATEMENT OF HON. MICHAEL J. GRAETZ, DEPUTY ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY

Mr. GRAETZ. Thank you, Mr. Chairman.

I will abbreviate my written statement, so I ask that it be included in the record of the hearings.

Chairman RANGEL. Without objection.

Mr. GRAETZ. I am pleased to be here today to discuss the recent withdrawal of proposed regulations concerning the treatment by ratemakers of consolidated tax savings, under the normalization provisions of the Internal Revenue Code.

Public utility rates generally are set under State law to compensate the utility for the costs of providing utility services and to provide the utility's bondholders and shareholders with a fair return on the capital they invest in utility assets. The cost of service component of rates is based on the operating costs incurred by the utility during the year, including depreciation and Federal income tax for the year.

The return on capital component of rates is based on the product of the rate base, and a weighted average return on debt and equity capital that bondholders and shareholders have invested in those assets.

There are two general ways in which a utility regulatory commission can account for the benefits of accelerated depreciation, short depreciation lives and investment credits for public utility property in setting utility rates. One way, flowthrough accounting,

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