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STATEMENT OF G. STEPHEN ARNOLD

ON BEHALF OF

THE INTERSTATE NATURAL GAS ASSOCIATION OF AMERICA

BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES

September 11, 1991

INTRODUCTION

The Interstate Natural Gas Association of America ("INGAA") is the nonprofit trade association of the interstate gas pipeline transmission industry. Its membership consists of virtually all of the major interstate natural gas transmission companies in the United States. The principal business of its members is the transportation in interstate commerce of natural gas from producing fields to gas distribution companies throughout the nation. I am Assistant Vice President Tax for MidCon Corp., headquartered in suburban Chicago, and I currently serve as Chairman of INGAA's Tax Committee.

INGAA member companies account for approximately ninety percent of all natural gas transported and sold in interstate commerce. They are subject to the jurisdiction of the Federal Energy Regulatory Commission ("FERC") and are regulated public utilities as defined in Section 7701 (a) (33) of the Internal Revenue Code (the "Code"). Consequently, INGAA has a direct and substantial interest in the current state of the law under the "normalization" requirements of the Code concerning the treatment of Consolidated Tax Adjustments ("CTAS"), which include tax losses and tax credits of affiliated companies joining in consolidated federal income tax returns with INGAA member companies.

INGAA POSITION

O

The Normalization Rules of the Code Require that a
Utility Compute its Ratemaking Tax Expense and Rate
Base as if the Utility Filed a Separate Return.

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Allowing CTAS to Affect Cost of Service or Rate Base
Frustrates Federal Tax Policy.

The Legislative History of the Normalization Rules and
IRS Rulings Support Prohibition of any CTAS.

The IRS Has Authority to and Should Issue Regulations
Prohibiting CTAS.

The Withdrawal of IRS Regulations Addressing This Issue has Created Uncertainty That May Cause a Revenue Loss to the U.S. Treasury Unless New IRS Regulations Prohibiting CTAS are Promulgated.

INGAA RECOMMENDATION

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Congress Should Direct Treasury to Issue Regulations
Prohibiting all Forms of CTAS as a Violation of

Normalization.

DISCUSSION

A. Overview of the "Normalization" Concept

1.

"Normalization"

"Normalization" is a mechanism to account for tax benefits related to capital investments that insures that ratepayers and investors in regulated companies are treated equitably. Normalization accounting requires adjustments to the regulatory tax expense and rate base to account for expected future Federal tax liability.1 The accumulation of the differences between regulatory tax expense and actual Federal tax liability creates a deferred tax reserve. The normalization provisions of the Code do not allow a regulated company to avail itself of accelerated depreciation on "public utility property" unless normalization accounting is used. Thus, the potential disallowance of this tax benefit serves as the enforcement mechanism for the normalization concept.

The tax policy rationale for normalization is that the tax benefits enacted by Congress were designed to encourage capital formation. In order to achieve this objective, regulated companies must have the use of the timing benefits of accelerated depreciation over the useful life of the project, rather than flowing them through to ratepayers. The only way to ensure that regulated companies have the use of the timing benefits is to require that these benefits be "normalized" by providing for deferred taxes in setting rates.

The Congressional recognition of the relationship between ratemaking and taxes occurred in the Tax Reform Act of 1969 when the concept of normalization was first incorporated into the Code. At that time Congress was concerned that "[t]he trends of recent years are shifts from straight line to accelerated depreciation and shifts from normalization to flowthrough, often against the will of the taxpayer utilities."2 Congress understood the unique relationship taxes played in the ratemaking process and was concerned that the tax benefits it was enacting were being undermined by being passed through to ratepayers rather than serving as incentives for capital investment. Congress considered limiting tax benefits for regulated utilities but concluded "that, in too many cases, this would place regulated utilities at an unfair competitive disadvantage, both in terms of the sale of their products or services and their attractiveness to equity investors."3

1

In general, rates are determined by a regulatory body by allowing a rate of return on a utility's "rate base," or capital invested in the regulated activity, plus the recovery of expenses, including taxes. Thus, the reduction of rate base, or the reduction in tax expense, will result in less revenue and reduced earnings for the regulated company.

2

Tax Reform Act of 1969, S. Rep. No. 552, 91st Cong., 1st Sess., Pt. 1 at 173 (1969).

3 Tax Reform Act of 1969, H.R. Rep. No. 413, 91st Cong., 1st Sess., at 133 (1969).

The attractiveness of regulated companies to investors was emphasized over twenty years later when in the September 17, 1990 issue of Creditweek, Standard & Poor's stated in reaction to the IRS regulation project that "[r]ate cuts due to tax consolidation can only be viewed as negative to utility credit quality, no As a precaution, bondholders should be aware of utilities or utility parents that incur meaningful tax

matter how modest

In addition, Congress was concerned about a revenue loss from the flow through of tax benefits to ratepayers. In 1969, the House Ways and Means Committee Report explained this point as follows:

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[F]lowing through the tax deferral to the
customers of a utility
results in a
doubling of the Government's loss of revenue
from the use of accelerated methods of
depreciation for tax purposes.
This is
because the current tax reduction reduces the
rates charged to customers, which in turn
reduced the utility's taxable income and
therefore reduces its income tax

Your committee has determined that the likely
revenue loss from wholesale shifts to
accelerated depreciation and flow through is
unacceptable . . .

The normalization rules of the Code were strengthened in the Economic Recovery Tax Act of 1981 and most recently in the Tax Reform Act of 1986. Current Code Section 168 (i) (9) (B) (ii) requires that consistency and symmetry exist between rate base, tax expense, depreciation and deferred taxes. In addition, broad regulatory authority is granted under Section 168 (i) (9) (B) (iii) to the IRS to prescribe additional procedures and adjustments that are inconsistent with normalization.

2. IRS Interpretations of the Normalization
Concept

The IRS issued both public and private rulings during the 1980's prohibiting cost of service and rate base adjustments.' In these rulings, the IRS consistently interpreted the policy of the normalization requirements to prohibit such CTAS. Indeed, the IRS explicitly held that rate base adjustments "to the deferred tax reserve would have the same effect as the kind of adjustment to the reserve that is prohibited. 116 and that such an adjustment would violate the "consistency with respect to the assumptions used for the computation of tax expense, depreciation expense, deferred taxes, and rate base of the regulated company. 17 These rulings are premised on the "stand-alone" or "separate company" method which has set the framework of the IRS policy on normalization over the years.

3. Regulators' Interpretations of the
Normalization Concept

The FERC and most other regulatory agencies have recognized the soundness of ratemaking policy based on The Federal Power Commission ("FPC"), the

normalization.

4

losses from nonutility ventures."

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H.R. Rep. No. 413, supra note 3, at 132.

See, e.g., Rev. Rul. 81-16, 1981-1 C.B. 17; Priv. Ltr. Rul. 84-28-079 (Apr. 11, 1984); Priv. Ltr. Rul. 85-23-067 (Mar. 13, 1985); Priv. Ltr. Rul. 85-25-086 (Mar. 27, 1985); Priv. Ltr. Rul. 85-25-156 (Mar. 29, 1985); Priv. Ltr. Rul. 85-29-024 (Apr. 18, 1985); Priv. Ltr. Rul. 86-43-052 (July 29, 1986); Priv. Ltr. Rul. 87-11-050 (Dec. 15, 1986); Priv. Ltr. Rul. 88-01-041 (Oct. 10, 1987); Priv. Ltr. Rul. 89-04-008 (Oct. 24, 1988); Priv. Ltr. Rul. 90-45-014 (Aug. 9, 1990).

6

Priv. Ltr. Rul. 89-04-008 (Oct. 24, 1988).

7

Id.

predecessor of the FERC, protected utilities' retention of tax benefits by advocating regulation of utilities on a stand-alone basis, holding that none of a pipeline's affiliated companies' activities should be taken into account when the FPC engaged in ratemaking calculations." The FPC further refined the standalone methodology in the Southern California Edison Co. case by developing the benefit/burden test, which provided that ratepayers could only reap the benefits of CTAS if they bore the burden of paying the expenses that generated the tax savings." The FERC's support for normalization was affirmed in City of Charlottesville v. FERC, 10 where Judge Scalia found and upheld, as logically sound, the FERC position that rejected cost of service adjustments related to CTAS.

In 1988, however, in Continental Telephone Co. of Pennsylvania V. Pennsylvania Public Utility Commission,11 the Commonwealth Court of Pennsylvania held that cost-of-service adjustments for CTAS were not a normalization violation even though the taxpayer had received a private ruling from the IRS holding to the contrary, 12 In reaction to the controversy created by this case, the IRS commenced the regulations project which is the topic of this hearing.

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1. IRS Proposed Regulations The regulations project that resulted from Continental Telephone decision in 1988 culminated in the promulgation of proposed regulations on November 20, 1990 that attempted to compromise the interests of regulated utilities and ratepayers. The proposed regulations continued the long-standing policy that a regulated company's cost-of-service tax expense must be calculated without regard to tax losses or tax credits of affiliated companies included in a consolidated Federal income tax return with the regulated company (i.e., the "stand-alone" or "separate company" method), but permitted a reduction in rate base for CTAS. The IRS received broad support for its cost of service position at the February 5, 1991 IRS hearing and in written comments from regulated companies, industry associations, accounting and law firms, members of the Taxation Section of the American Bar Association, the American Institute of Certified Public Accountants, and the Tax Executives Institute. consensus of opinion of these groups was that the prohibition on reduction of cost of service by the use of CTAS is supported by long-standing Congressional policy on normalization and was consistent with the numerous IRS rulings on the issue. INGAA endorsed and commended the IRS position on cost-of-service tax expense in its testimony at the IRS hearing.

The

In contrast, the IRS received strong opposition to that part of the regulations which would have permitted rate base to be reduced by CTAS. The objections focused on the consistency requirement in the normalization rules in Code Section 168(i) (9)

8

9

Florida Gas Transmission Company, 47 F.P.C. 341, 362 (1972). Southern California Edison Company, 59 F.P.C. 2167, 2174 See also, Columbia Gulf Transmission Company, 23 F.E.R.C. 61,396 (1983).

(1977).

10

774 F.2d 1205 (D.C. Cir. 1985), cert. denied, 475 U.S. 1108 (1986).

11

548 A.2d 344 (Pa. Commw. 1988).

12

Priv. Ltr. Rul. 87-11-050 (Dec. 15, 1986).

Many

and argued that use of CTAS for this purpose resulted in a deviation from long-established normalization policy. responses also highlighted numerous other technical problems and inconsistencies which were inherent in this section of the proposed regulations. These problems are now moot, however, given the unexpected withdrawal of the proposed regulations on April 25, 1991, and the closing of the regulations project pending Congressional guidance.

2. Reactions to the Withdrawal of the
Regulations

The confusion resulting from the withdrawal of the regulations has encouraged challenges to the Congressional policy on normalization. As recently as June 21, 1991, the Texas Court of Appeals overturned the Texas Public Utility Commission's rejection of CTAS and cited the IRS withdrawal of the proposed regulations as support for its position.13 In that case, the Court of Appeals allowed a CTA against cost of service, contrary to the position taken in the withdrawn IRS regulations.

This case underscores the importance of normalization to equalize the treatment of all taxpayers, regulated and unregulated alike. Congress has enacted many provisions in the Code to provide for capital formation, energy development and other social objectives. Regulators should not be allowed to thwart Congressional tax policy by passing through such benefits to ratepayers. Instead, regulators should address rate of return issues "head on" in the regulatory process. Use of tax benefits as an excuse for rate reductions can place a regulated company with loss affiliates at a competitive disadvantage relative to other regulated companies with no such affiliates. Moreover, a non-regulated affiliate of a regulated company could be at a competitive disadvantage vis-a-vis a similar non-regulated company with no utility affiliation. These results have no economic rationale. Fairness of a rate of return allowed investors of a regulated company should be addressed regulators directly based on capital committed by the stockholders of that regulated company. Tax benefits provided by Congress for a regulated company's unregulated affiliates should not be expropriated by regulators and flowed through to ratepayers.

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CONCLUSION

То eliminate the

confusion generated by the IRS withdrawal of the proposed IRS regulations and to protect Congressionally sanctioned tax benefits and avoid loss of revenue to the Federal Treasury, INGAA urges Congress to direct Treasury to issue regulations prohibiting all forms of CTAS as a violation of normalization.

13

Public Utilities Commission of Texas et al. v. GTE-SW, Doc. No. 3-90-084-CV, Texas Court of Appeals, Third District, June 21,

1991.

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