For Release Upon Delivery STATEMENT OF MICHAEL J. GRAETZ DEPUTY ASSISTANT SECRETARY (TAX POLICY) SUBCOMMITTEE ON SELECT REVENUE MEASURES UNITED STATES HOUSE OF REPRESENTATIVES Mr. Chairman and Members of the Committee: I am pleased to be here today to discuss the recent withdrawal of proposed regulations concerning the treatment under State ratemaking proceedings of consolidated tax savings under the normalization provisions of the Internal Revenue Code (the "Code"). These proposed regulations, which were published in November 1990 and withdrawn in April 1991, attempted to address the question whether the Internal Revenue Code should be interpreted to restrict the ability of State regulators to take into account certain tax savings realized by an affiliated group of corporations ("consolidated tax savings") in setting the rates that they permit public utilities to charge their customers. Background 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 (such as fuel, salaries, postage, etc.), the depreciation of fixed assets during the year (generally allowed on a straightline basis over a 25 to 40 year life), and Federal and State income tax expense for the year. The "return on capital" component of rates is based on the product of the "rate base" (generally the regulatory book value of assets employed to provide utility services) and a weighted average rate of return on debt and equity capital that bondholders and shareholders have invested in those assets. Since 1969 the Internal Revenue Code has conditioned a public utility's ability to use accelerated depreciation for public utility property on specified ratemaking treatment of the tax savings due to the utility's use of accelerated methods of depreciation or shortened depreciation lives. In general, the Code provides that a public utility, may not use accelerated depreciation for public utility property in computing its Federal income tax liability unless the regulators use a "normalization method of accounting" in calculating the utility's tax expense for ratemaking purposes. There are two general ways a utility regulatory commission can account for the benefits of accelerated depreciation, shorter - 2 depreciation lives, and investment credits for public utility property in setting utility rates. One way, flowthrough accounting, treats these benefits as a current reduction in Federal income tax expense in computing the utility's cost of service. Under this method, current operating expenses are reduced, and the Federal tax benefit is immediately flowed through to current utility customers. A second way, normalization accounting, treats these benefits as a reduction in the utility's capital costs. In general, normalization accounting requires a utility to compute its tax expense in determining its cost of service for ratemaking purposes as though it used the same method and period of depreciation that it uses in calculating its depreciation expense for purposes of setting its rates. This typically will be the straight-line method over a much longer life than is used for tax purposes. Thus, under this method, which the Code requires for a utility to be able to use accelerated depreciation on public utility property, regulators must calculate the utility's cost of service in a manner that permits the utility to collect from customers an amount for tax expense that exceeds the utility's actual current tax liability by the amount of the tax savings from accelerated depreciation. - Under normalization accounting, however, regulators may treat the tax savings as cost-free capital. It is not a violation of the normalization rules of the Code for regulators to reduce a utility's "rate base" generally the total amount of capital invested in the utility on which stockholders and bondholders are allowed to earn a return - by the cumulative tax savings from using accelerated depreciation. A utility using normalization accounting may be thought of as treating the reduction in its current tax liability that results from using accelerated depreciation as an interest-free loan from the Treasury; this is accomplished by treating the utility as though it were required to pay to the Treasury the tax that would be due if accelerated depreciation were not allowed, and the Treasury loaned back to the utility without interest - the excess of this amount over the utility's actual tax liability calculated using accelerated depreciation. In effect, normalization accounting operates to determine a utility's rate of return on a reduced rate base, thereby flowing through to customers over the service life of the asset the benefits of reduced capital expenses due to accelerated depreciation. The normalization rules are intended to ensure that the Federal tax savings provided through accelerated depreciation provide cost-free capital to utilities to promote investment and are not used to subsidize current consumption. - The History of the Normalization Requirement - A requirement that utilities use the normalization method of accounting was first added to the Internal Revenue Code in 1969. In 1964, Congress had foreshadowed the 1969 normalization rules by prohibiting Federal regulatory agencies from flowing through the 3 percent investment tax credit then available on public utility property more rapidly than ratably over the useful life of the asset and prohibiting Federal regulators from flowing through any part of the 7 percent investment credit on nonpublic utility property.' The Tax Reform Act of 1969 added section 'Pub. L. No. 88-272, § 203 (e) (1964). When Congress enacted a 7 percent investment tax credit (ITC) in 1962, regulated utilities were granted a credit of only 3 percent. The reduced rate was a compromise between those who argued that utilities should receive the same investment incentives as other businesses and those who argued that, because of their monopoly status, utilities did not need incentives to invest and that flowthrough accounting by ratemakers would defeat the purpose of making investment incentives available to utilities. - 3 167 (1) to the Code to limit the use of flowthrough accounting, and, in general, to require utilities that claimed accelerated tax depreciation to use a normalization method of accounting. Congress did not completely prohibit flowthrough accounting in 1969, however. At that time, about half of all State ratemaking authorities were requiring utilities to flow through to current customers the benefits of accelerated tax depreciation.2 Congress was concerned about causing a widespread increase in rates paid by customers of those utilities, and the 1969 legislation was designed to stop the spread of flowthrough accounting to utilities not already using it; utilities using flowthrough were "grandfathered." In structuring the 1969 prohibition, Congress did not attempt directly to prohibit State ratemaking authorities from using flowthrough accounting. Because of federalism concerns and suggestions that such a direct prohibition would raise constitutional issues, Congress instead conditioned a utility's ability to use accelerated depreciation on its use of normalization accounting.' The 1969 Act granted Treasury broad authority in section 167 (1) (5) to issue regulations as needed to carry out the purposes of the normalization rules. In 1971, Congress increased the investment tax credit on public utility property to 4 percent and required utilities to use a normalization method of accounting for the credit as a condition of claiming it with respect to public utility property. In 1981, in connection with the adoption of the ACRS system of depreciation, Congress extended the normalization rules to all utilities by repealing the 1969 grandfather rules. In 1982, Congress expanded Treasury's regulatory authority to prevent the use of ratemaking techniques that are inconsistent 'Indeed, some ratemakers were insisting that utilities, such as the major telephone companies, which had been claiming straight-line depreciation, claim accelerated tax depreciation so that the Federal tax savings could be flowed through to ratepayers. Certain ratemakers were reducing rates by the available Federal tax savings even if a utility did not claim accelerated tax depreciation. "The 1969 normalization requirement grew out of H.R. 6659, which would have prohibited flowthrough accounting by State ratemakers. This direct prohibition was rejected in favor of imposing a loss of accelerated depreciation on utilities because the bill's opponents raised doubts about the constitutionality of prohibiting State regulators from using flowthrough accounting. See, e.g., Statement of Fred P. Morrissey, Commissioner, California Public Utilities Commission, before the Committee on Ways and Means on March 27, 1969, summarized in Summary of Testimony on Treatment of Tax Depreciation by Regulated Utilities, JCS 47-69 at 8 (July 11, 1969). The Treasury Department opined on May 5, 1969, that the direct prohibition was constitutional. See letter from Paul W. Eggers, General Counsel of the Treasury, submitted in response to a question from Congressman Utt to Assistant Secretary Cohen and reprinted in Hearings before the Committee on Ways and means, Ninety-first Congress, First Session on the Subject of Tax Reform, Part 15 of 15 at 5672 (April 24, 1969). 'Although the new ITC normalization rules in section 46(e) (which later became section 46(f)) allowed ratemakers to "share" part of the credit with current and future ratepayers, the rules were not identical to the section 167 (1) normalization rules that were prescribed for accelerated depreciation in 1969. Under the 1971 rules, ratemakers were permitted to reduce the rate base by the amount of the investment tax credit or to flow through the credit over the life of the property. with the statutory normalization requirement.' In 1986, Congress extended normalization accounting to cover the ratemaking treatment of the reduction in corporate income tax rates." Notice 87-82, 1987-2 C.B. 389, 391, requires normalization of contributions in aid of construction (CIACS) received subsequent to the 1986 Act's changes in the method of tax accounting for most CIACS.' In summary, Congress has enacted normalization requirements with respect to the regulatory treatment of three tax benefits: accelerated depreciation and investment tax credits claimed for public utility property and the 1986 reduction in corporate tax rates. Prior to the publication of the proposed regulations concerning consolidated tax savings which are the subject of - "The California regulatory commission had created a technique called the Average Annual Adjustment ("AAA") method, which creatively used certain "estimates and projections" to mimic the effects of a flowthrough method in a way that arguably did not violate the statutory normalization rules. In sections 168 (e) (3) (C) (which later became section 168 (i) (9) (B)) and 46(f) (10), Congress stated that the normalization requirements are not met if the taxpayer uses procedures and adjustments that are inconsistent with the normalization rules. Congress described the AAA method as one procedure or adjustment that violated the new statutory "consistency requirement," and authorized Treasury to prescribe by regulation other procedures and adjustments that would be treated as inconsistent with the normalization rules. See H.R. Rep. No. 97-827, 97th Cong. 2d Sess. at 7-10 (1982). The 1982 legislation also granted relief to eliminate the substantial tax liability of several California utilities that would have been assessed for prior years due to the disallowance of accelerated depreciation and investment credits on the grounds that the State regulatory commission's rules violated the Code's normalization requirements. "By lowering the top marginal income tax rate for corporations from 46 percent to 34 percent, the 1986 Act produced an "excess deferred tax reserve" because the deferred tax reserve for accelerated depreciation that was set aside at a rate of 46 percent could now be paid back at the 34 percent rate. Section 203 (e) of the 1986 Act provided that under a normalization method, the excess deferred tax reserve could not be flowed through to reduce the cost of service component of current rates more rapidly than over the remaining regulatory lives of the utility's assets. In 1987 and again in 1989, this Committee revisited the decision to require normalization of the effect of the 1986 change in income tax rates, and on both occasions Congress left in place its 1986 decision that the excess deferred tax reserves should be normalized. A typical CIAC is a utility line that a customer constructs and contributes to the utility, or pays the utility to construct, as a condition of receiving utility services. Prior to 1986, CIACS were generally excluded from the utility's income as nonshareholder contributions to capital under Code section 118 (a). The 1986 Act added section 118 (b), which provides that CIACS received from a customer or potential customer are not covered by section 118 (a). Thus, these CIACS must be included currently in the utility's gross income under section 61. However, notwithstanding the 1986 change in the tax law, most utilities disregard the receipt of a CIAC for ratemaking purposes. Thus, the 1986 Act created a timing difference between ratemaking and tax accounting for CIACS, and Notice 87-82 required that difference to be normalized so that the prepayment of tax on CIACS would be shared between current and future ratepayers. The Notice requires a utility to increase its rate base by the amount of the CIAC or treat the CIAC as a loss of zero-cost capital in computing the return on capital component of current rates. We are not aware of any utilities or ratemakers who have complained about Notice 87-82. - 5 - this hearing the Internal Revenue had published normalization requirements for only one additional item: post-1986 CIACS. Consolidated Tax Savings In recent years, the Treasury and Internal Revenue Service have been asked whether the normalization requirements of the Code apply to restrict the regulatory treatment of the reduction in Federal income taxes resulting from utilities filing a consolidated return with unregulated affiliates. Utilities, like other corporate taxpayers, are permitted to file a consolidated tax return with other commonly controlled corporations. When a consolidated return is filed, the tax liability of the affiliated group generally is determined as if the members of the group were a single corporation. A utility, for example, may thereby shelter its income from current taxation by offsetting tax losses (or excess credits) of other affiliated corporations engaged in unregulated businesses (for example, leasing and gas exploration). If the affiliated corporations did not file a consolidated return, the losses of the unregulated companies generally would not be used to reduce taxes until the later years in which the loss companies become profitable. State ratemaking authorities generally have used two different approaches to determine the tax expense of a utility that files a consolidated return. Under an "actual taxes paid" approach, the tax savings that result from filing a consolidated return are flowed through to utility customers through lower rates that result from including only the utility's share of actual taxes paid in the utility's cost of service. The United States Supreme Court upheld the Federal Power Commission's use of such an "actual taxes paid" approach in 1967, two years before the depreciation normalization rules were first added to the Internal Revenue Code. Federal Power Commission v. United Gas Pipe Line Co., 386 U.S. 237 (1967). Under an alternative "stand-alone" approach, the ratemaking authority determines the utility's tax expense for purposes of setting rates as if the utility had filed a separate return. Thus, for example, under stand-alone accounting, if a utility that has taxable income files a consolidated return with an affiliate whose losses completely shelter that income from current taxation, the utility's cost of service for ratemaking purposes reflects the tax that the utility would have paid if it had filed a separate return. The United States Court of Appeals for the District of Columbia Circuit upheld the Federal Energy Regulatory Commission's use of such an approach in City of Charlottesville v. Federal Energy Regulatory Commission, 774 F.2d 1205 (D.C. Cir. 1985), cert. denied, 475 U.S. 1108 (1986).8 In the 1980s, the Internal Revenue Service issued several private letter rulings holding that the normalization provisions of the Code require regulatory authorities to use a stand-alone approach. One of these rulings was issued to Contel, a utility doing business in Pennsylvania. Notwithstanding this ruling, the Pennsylvania Public Utility Commission set Contel's rates using an "actual taxes paid" approach. Contel then appealed the Commission's decision to the Commonwealth Court of Pennsylvania, The Federal Power Commission (FERC's predecessor) decided in 1972 to abandon consolidated tax savings adjustments in favor of a stand-alone approach. Dismissing as dicta the Supreme Court's statements in United Gas Pipeline about FPC's "duty" to limit the cost of service component of rates to real expenses, Judge Scalia rejected Charlottesville's argument that the "actual taxes paid" doctrine prevented FERC from using a stand-alone method. 774 F. 2d at 1216. In essence, the court held that it was within FERC's ratemaking authority to require either a flowthrough or stand-alone method of accounting for consolidated tax savings. |