that happen to be affiliated with utilities will be placed in a competitive disadvantage vis a vis corporations that are not affiliated with utilities. 3.CTA's Violate the Consistency Requirement Code Section 168(i)(9)(B) specifically prohibits the use of inconsistent estimates and projections. Thus, as stated in the Code, the same estimate or projection that is used for tax expenses must also be used for depreciation expense, rate base and the deferred tax reserve. Use of a consolidated tax adjustment, whether by cost of service adjustment or rate base adjustment, cannot satisfy this requirement. This is so because the investment in non-utility property that resulted in tax losses of affiliates is not included in the rate base of the utility, and is not included in the depreciation expense paid by the utility customers. The purpose of accelerated depreciation and investment tax credit in the Code is to spur economic growth through increased capital investment. While it is appropriate to use the tax savings of a utility as zero-cost capital for financing the utility's property, thus benefitting the utility's customers, it is not appropriate tax policy to create the fiction that utility property is financed in part by the tax savings generated by non-utility businesses operating in a competitive market place. The Service dealt with this issue in Private Letter Ruling 8904008, and reached the same conclusion. In that ruling, which has not yet been revoked, the Service held that the use of consolidated tax savings derived from losses of non-regulated affiliates to reduce rate base violates normalization rules. Reducing rate base without allowing consistent adjustments to expenses in cost of service constitutes the use of a procedure which is inconsistent for purposes of Section 168(i)(9)(B)(i). The provision in the proposed regulations with regard to the rate base would have had the effect of allowing just such an inconsistency.. NEED FOR GUIDANCE Consumers believes that Federal tax policy established by Congress, as expressed repeatedly in Committee reports accompanying the passage of, or amendments to, the normalization provisions, is clear. Congress established accelerated depreciation and investment credit to promote adequate capital formation for both utility and non-utility companies alike; it added the normalization provisions to ensure that this important federal tax policy would be respected in utility ratemaking proceedings. To allow consolidated tax adjustments through a narrow interpretation of the normalization provisions would permit this important national tax policy to be thwarted with respect to non-utility investment in a manner that is, ironically, unquestionably barred with respect to utility investment. Congress should establish and control Federal tax policy in this important area. This Subcommittee should take the steps necessary to ensure that the Service has the guidance it needs to require compliance with the normalization provisions, by prohibiting consolidated tax adjustments and placing utilities on a "stand alone" basis with respect to their income tax expense. CONCLUSION CMS Energy and Consumers are pleased to have the opportunity to present their statement before this Subcommittee. We understand that there is a great deal of interest in this issue and widespread concern regarding the impact on particular companies, consolidated groups, and the utility industry as a whole. Consumers is a member of the Edison Electric Institute and the American Gas Association. These associations, among others, also are testifying with respect to the concerns of the utility industry, and we urge this Subcommittee to give careful consideration to that testimony. We urge this Subcommittee to provide whatever guidance is necessary to direct the Service to adopt regulations prohibiting the use of consolidated tax adjustments as violative of the normalization requirements. M991tal.05 Hearing on Treatment of Consolidated Tax Savings Under IRC Normalization Requirements September 11, 1991 Coopers & Lybrand is an international accounting and consulting firm that counts among its clients numerous companies that provide regulated services. Included in this group are providers of telecommunications, electric, gas, steam, water and waste water services. This testimony has been prepared under the leadership of Woody Sharpe, representing Coopers & Lybrand's utilities tax industry group. It is not presented on behalf of any particular client. Rather, our firm is extremely interested in seeing that sound policy considerations prevail as this Subcommittee explores the treatment of consolidated tax savings under the Internal Revenue Code's (IRC) normalization requirements. ("Consolidated tax savings" is here understood to mean the use of losses of a utility's unregulated affiliates to reduce the regulated utility's tax expenses or rate bases.) Our testimony centers on a single, overriding aspect of normalization -- the necessity for a "regulatory stand-alone" tax computation when a regulated utility files a consolidated tax return with unregulated affiliates. The stand-alone concept holds that the income tax expense paid by utility ratepayers should be determined as if the utility were a separate company and, accordingly, that such tax expense take into consideration only expenses and revenues that are provided by ratepayers. Any benefits that result from losses or deductions of non-regulated affiliates that are included in a consolidated tax return would not reduce regulated tax expense under the stand-alone concept, because the ratepayers did not bear any of the cost that generated the losses or deductions. Moreover, we believe that this concept extends equally to the tax benefits of disallowed or non-regulated costs, which are incurred by the entity in which the utility operation resides. The legislative history of the normalization rules, the statute itself, long-standing administrative practice, economic considerations and logic all support this computational approach. As such, any consideration, either for tax expense or rate base purposes, of tax characteristics associated with underlying items of income or expense not themselves considered in ratemaking constitutes a normalization violation. Despite what we believe is the reasonableness of these established standards, however, a series of recent events has called into question the treatment of consolidated tax savings under the normalization rules. The most notable of these have been the Commonwealth Court of Pennsylvania's 1988 Continental Telephone Company of Pennsylvania decision, 548 A.2d 344 (Pa. Cmwith. 1988), the Internal Revenue Service's revocation of letter rulings in this area, and the ostensible reason for today's hearing: the IRS's proposed -- and subsequently withdrawn --regulations concerning consolidated tax savings. In announcing the withdrawal of those controversial regulations, the IRS stated that it was awaiting Congressional guidance before taking any further action. We respectfully suggest that this guidance take the form of instructions to the IRS that it expeditiously reissue revised regulations in this area, and that these regulations clarify that the normalization rules of §168(1)(9) require a regulatory stand-alone tax computation to be used when determining a regulated utility's tax expense. We do not believe that legislation is required, since the IRS clearly has authority to issue regulations in this area (see IRC §168(i)(9)(B)(iii)). Timely guidance is an absolute necessity, and the IRS can address the matter most expeditiously. Today, the guidance that exists with respect to the use of consolidated tax savings is subject to different interpretations. In this environment, utilities and other interested parties are faced with a degree of uncertainty that is unsettling. The likely outcome of this situation will be increased litigation, as both utilities and the ratemaking bodies seek to clarify the statute in court. This uncertainty also will have a chilling effect on business planning for regulated utilities, since it will be difficult to predict how a particular ratemaking body will treat the consolidated tax adjustment in the future. Differences between state utility commissions, which already exist and almost certainly will be exacerbated under the current state of affairs, could lead to dramatically different treatment of otherwise similar utilities. We expect that utilities with several non-regulated affiliates will restructure their nonregulated activities to minimize the impact of the consolidated tax adjustment -- which likely will entail mergers, an outcome that only increases "soft costs" without adding any real economic benefit. Most important, if commissions adopt a strict taxes-paid standard and a stand-alone rule is not promulgated by the IRS, utilities might well be driven out of any business potentially involving start-up losses. Ultimately, this could yield a distinct competitive disadvantage in a global marketplace. Moreover, there are basic questions of equity that consolidated tax savings present. Public utility commissions may be anxious to seize upon the benefits of filing a consolidated tax return to lower rates when an unregulated affiliate incurs losses. However, there is no precedent -- and we believe little likelihood -- that utilities would be permitted to increase their rates to reflect the additional tax expense incurred in filing a consolidated tax return when unregulated affiliates become profitable. Our position, that the IRS should rectify this situation by speedily issuing guidance requiring the stand-alone computation, is thus based on a number of compelling considerations, developed at length in the pages following. I. The Legislative History Supports the Stand-Alone Approach In our view, the history of normalization clearly prohibits the "flowing through" to ratepayers of the benefits of accelerated depreciation attributable to other than "public utility property." Further, this history describes a system for the preservation of tax incentives that premised on the assumption that ratemaking will be conducted on a regulated stand-alone basis. As a consequence, any ratemaking that contradicts that assumption -- whether or not caused by accelerated depreciation -- deprives a utility of the level of capital presumed by the normalization rules and, therefore, ought to be deemed violative. Over the years, the IRS has recognized this principle in numerous revenue rulings which, explicitly or implicitly, incorporate this premise. This body of administrative material has become well accepted as the state of the law in this regard. The sole reason for the existence of the depreciation normalization rules is to secure for utilities the benefit of a Congressionally provided capital incentive: accelerated depreciation. The significant controversies generated over the application of these rules bear testimony to the complex inter-relationship between the ratemaking process and the preservation of this incentive. While normalization's purpose remains as critical as ever, changes in the structure of the utility industry and in the nature of regulation have rendered the original mechanism imperfect, at best. The depreciation normalization rules provide, in general, that public utility property will be eligible for accelerated depreciation only if a normalization method of accounting is employed. The definition of "public utility property" has historically been contained in IRC §167(1)(3)(A), and recently was moved to $168(i)(10). Its genesis, however, derives from the definition set forth in former IRC §46(c)(3), enacted as part of §2(b) of the Revenue Act of 1962, P.L. 87-834 (the "1962 Act"). The 1962 Act established an investment tax credit. Much debate preceding this legislation centered around the extent to which it would be useful and appropriate to provide regulated public utilities with any investment incentive at all. The controversy was initiated in President Kennedy's Message on Taxation, issued by Treasury Secretary Dillon on May 3, 1961. This document proposed an investment tax credit to promote capital investment, but proposed that public utilities be excluded from using the credit. In the "Detailed Explanation of the President's Recommendations" contained in Message, the Treasury Department explicitly set forth the rationale for this exclusion (at page 47): Expenditures by public utilities in connection with business activities subject The proposal would, however, apply to enterprises in the transportation field In other words, 1) no incentive was needed due to the generally-imposed utility obligation to serve; and 2) no incentive actually could be provided, even if desirable, since the ratemaking process would dilute or extinguish the benefit by passing it on to ratepayers. In fact, the Revenue Bill of 1961 did exclude property used in a public utility trade or business from qualification as §38 property. The reason given for this exclusion was precisely that expressed by Secretary Dillon: "they are subject to regulations generally designed to limit the rate of return on investment after payment of tax and on the grounds that their growth is largely determined by public requirements." General Explanation of Committee Discussion Draft of Revenue Bill of 1961, prepared for The Committee on Ways and Means by the Joint Committee on Internal Revenue Taxation (September 29, 1961) at page 9. As adopted, the 1962 Act did provide a credit for utilities. However, whereas the generally available credit rate was 7%, the rate available with respect to public utility property was set at only 3%. The rate differential bore testimony to Congress's recognition of the validity of the concerns debated during consideration of the proposed 1961 legislation. The term "public utility property" was, therefore, significant in that it indicated a Congressional understanding that it was only public utility assets that were subject to having their tax benefits diluted or extinguished on account of the ratemaking process, and, more generally, that the ratemaking process would not be affected by events outside the ratemaking arena. It stands to reason that if Congress had believed that the credits generated by non-public utility property might be flowed through to ratepayers, it would have afforded them only a reduced rate of credit as well. The proposition set forth above is supported in a very dramatic way by a provision enacted as part of the Revenue Act of 1964, P.L. 88-272 (the "1964 Act"). Section 203(e) of the 1964 Act responded to the treatment by regulators of the credit made available in the 1962 Act. That section ("Treatment of Investment Credit by Federal Regulatory Agencies") provided as follows: Act Sec. 203(e). It was the intent of the Congress in providing an investment (1) (2) in the case of public utility property (as defined in in the case of any other property, any credit against tax allowed to reduce such taxpayer's Federal income taxes for the purpose of establishing the cost of service of the taxpayer or to accomplish a similar result by any other method. This provision expressed the intent of Congress that the 3% credit be returned to ratepayers only over a period of time and that the 7% credit not be passed through at all. By its terms, this restriction sought to prevent any of the 7% credit generated by regulated public utilities enumerated in §46(c)(3) from being "flowed through" to ratepayers. This provision is consistent with the inference that Congress did not intend or desire that the capital incentive benefits attributable to other than public utility property be provided to ratepayers and its belief that regulated stand-alone ratemaking was the norm. Note that the statute apparently established no penalty for failure to heed this Congressional dictate. In contrast to the current status, the term "public utility property" was, at the time, irrelevant to the crafting of a remedy. The depreciation normalization rules enacted as §441 of the Tax Reform Act of 1969, P.L. 91-172 (the "1969 Act"), resurrected the concept of public utility property with a very few modifications (i.e., COMSAT communications services and transportation of gas or steam by pipeline were added to the enumerated activities). This time around, the purpose of the concept was twofold: 1) again to carve out a group of assets which Congress saw as susceptible to being deprived of certain tax benefits through the ratemaking process, and 2) to prescribe a penalty for this deprivation. The limited nature of the penalty established is curious. It extends only to public utility property. In terms of preserving to corporate taxpayers the capital formation incentive provided by accelerated depreciation, the consideration in ratemaking of accelerated depreciation from non-public utility property is clearly as economically damaging as is its consideration when generated by public utility property. In either case, the stimulative effect is extinguished. The remedy fashioned by the 1969 Act permits the denial of accelerated |