quire 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 Útility Commission set Contel's rates using an actual taxes paid approach. Contel then appealed the commission's decision to the Commonwealth Court of Pennsylvania, which affirmed the commission's position. The Pennsylvania court rejected the conclusion of the private letter ruling that Contel would be in violation of the normalization rules if it followed the commission's orders. Subsequent to the Pennsylvania court's decision, decisionmakers at the Internal Revenue Service and the Treasury were forced to consider whether to maintain the position taken in the private letter ruling which would have treated Contel as in violation of the normalization requirement, and thereby required a disallowance of accelerated depreciation on its public utility property and required the Internal Revenue Service to assess large tax deficiencies against Contel. In May 1989, the Service published a notice to inform utilities and ratemakers that it was developing proposed regulations to address whether the use of consolidated tax adjustments violates the normalization provisions of the code. At that time, the Service also withdrew the private letter ruling issued to Contel. On November 27, 1990, the Service proposed regulations attempting to apply the general policies of the normalization method of accounting to consolidated tax savings. These proposed regulations would have prohibited current flowthrough of consolidated tax savings by denying a utility the use of accelerated depreciation on its public utility property-this is the only sanction permitted under the code-unless the utility's tax expense in determining its cost of service for ratemaking purposes is determined on a stand-alone basis. However, the proposed regulations would not have prohibited the commission from adjusting the utility's rate base to treat the affiliated group's tax savings from filing a consolidated return as costfree capital until the affiliate that had losses becomes profitable. This approach of the proposed regulations generally regards the taxable income that was generated by the utility as serving to permit current use of the offsetting losses or credits of unregulated affiliates and treats the benefits of filing a consolidated tax return as a deferral, rather than a permanent reduction, of tax liability. The normalization requirements of the proposed regulations were similar to those under the code for tax savings from accelerated depreciation. As with statutory normalization of accelerated depreciation, the proposed regulations would not have required ratemakers to adjust the rate base by a utility's share of the affiliate group's consolidated savings, but would have permitted them to do so. The proposed regulations specified a method based on the consolidated return regulations for determining the utility's share of the affiliated group's consolidated tax savings. The proposed regulations also included transition rules that were intended to minimize the effect of the proposed regulations by limiting any sudden changes in utility rates. The Internal Revenue Service received about 100 written comments on the proposed regulations and held a public hearing on February 8, 1991, at which about 30 witnesses testified. Not one person commenting endorsed the basic approach of the proposed regulations. Representatives of public utility commissions argued that the Internal Revenue Service lacked authority under the normalization rules to issue regulations to require the use of a stand-alone approach in computing the utility's cost of service because the normalization rules of the code only apply to accelerated depreciation of public utility property. Ratemakers contended that the Service exceeded its regulatory authority by attempting to dictate the ratemaking treatment of an item, such as consolidated tax savings, that does not necessarily involve either accelerated depreciation or public utility assets. State regulatory authorities indicated that they intended to challenge in court the validity of the regulations if they were finalized. Representatives of public utilities opposed the proposed regulations on the grounds that the normalization rules of the code do not permit any reduction of rate base due to consolidated tax savings. They argued that any reduction of rate base inappropriately allows utility customers to share in the tax benefits associated with the losses of an unregulated affiliate, when the customers do not bear the burden of those losses. On March 29, 1991, the Office of Management and Budget informed the Treasury Department that it had designated any final regulations in this area as a major rule under Executive order 12291. That designation requires the Department to submit the text of final regulations, along with a regulatory impact analysis of the costs and benefits of the rule and of any alternative regulatory approaches, for review by OMB before any final rule can be published in the Federal Register. The Treasury Department is not aware of another circumstance when OMB has designated a tax regulation as a major rule under Executive Order 12291. Performing the kinds of cost-benefit analyses required by the Executive order would be difficult in any circumstances, but in the instant context, such analyses would be particularly forbidding. Moreover, the adverse commentary on the proposed regulations made it clear that neither the State regulatory authorities, nor the affected utilities approved of the approach of the proposed regulations, and for opposite reasons. The State commissions regarded the proposed regulations as overreaching and illegal, while the utilities complained that the proposed regulations did not sufficiently constrain the regulator's discretion. In these circumstances we had little reason to believe that any cost-benefit analysis we performed would be convincing to the affected parties. On April 25, 1991, the Internal Revenue Service withdrew the proposed regulations pending congressional guidance. You have asked about the current state of the law. I have attached to my statement a memorandum to me from the chief counsel of the Internal Revenue Service that describes the Service's cur rent ruling policy concerning whether a consolidated tax adjustment by a regulated utility violates the normalization requirements of the code. Mr. Chairman, we did not view the proposed regulations as a complete or final product. We saw them as a general rule and a framework within which a number of more specific issues could be resolved. We had expected that as a result of comments by the affected parties, the proposed regulations would be revised. Questions have been raised about our legal authority to issue the proposed regulations. The Internal Revenue Service and the Treasury concluded that the code authorizes, but does not require, the Service to issue such regulations. Obviously the Treasury and the Internal Revenue Service also regarded the basic approach of the proposed regulations as appropriate as a matter of policy when they were issued. As I have indicated, the proposed regulations were designed to follow the general structure of the normalization requirements for accelerated depreciation. In essence, this approach views consolidated tax savings resulting from the combination of losses of unregulated affiliates with the income of the regulated utility as enabling the consolidated group to use the losses sooner than if the affiliate were to file its tax return on a stand-alone basis. We concluded that we should not attempt to prohibit regulatory commissions from permitting utility customers to share in the benefits produced by consolidated tax savings through a rate base adjustment that reflects the time value benefit of the more rapid use of the unregulated affiliate's losses or excess credits made possible by the utility's taxable income or tax liability. We also concluded that the losses generated by those assets should not be used to adjust the utility's current tax expense, and the proposed regulations held that the current tax expense of the utility must be calculated as if it had filed a separate return. Mr. Chairman, even when the statutory language is directly applicable and congressional policy is clear, the normalization requirements of the code have proved to be something of a blunt instrument. On the prior important occasion when a State regulatory authority refused to accede to the statutory structure, Congress ultimately was forced to legislate to clarify the rules and forgave over $2 billion in tax liability that would have been due had the Service disallowed accelerated depreciation deductions in the manner contemplated by the statute. In the current context, certain State regulatory commissions made clear their intention to challenge the validity of these regulations if they were finalized and may well have disregarded them in the interval. The Service's ability to sustain disallowances of accelerated depreciation deductions in circumstances where the State commissions refuse to adhere to these proposed regulations is far from certain. And the failure to do so might well erode the Service's ability to enforce normalization requirements where the code speaks clearly as to the congressional policy. Mr. Chairman, if Congress wishes to limit State regulatory commissions' discretion with respect to their treatment of consolidated tax losses by specifying normalization or other ratemaking treatment, we believe that disallowing the filing of a consolidated return by the utility would be a more focused and appropriate remedy than the only sanction available by regulation, which is the disallowance of accelerated depreciation on public utility property. We are prepared to work with this committee should it decide that legislation is appropriate on the consolidated tax savings issue. This concludes my prepared remarks and I will be happy to answer any questions the committee may have. [The prepared statement follows:] 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 |