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Subject to specific exceptions for cases where consolidated tax savings had previously been flowed through to customers, the proposed regulations would not have permitted any tax savings from prior years to be flowed through to customers or to be treated by regulatory commissions as cost-free capital. These provisions 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 commenter endorsed the basic approach of the proposed regulations.

Representatives of public utility commissions argued that the Service lacked authority under the normalization rules to issue regulations to require use of a stand-alone approach in computing cost of service, because the normalization rules of the Code apply only 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. The ratemakers maintained that if Congress had intended to treat consolidated tax adjustments as a violation of normalization, it would have done so explicitly and would have adopted a different statutory penalty for violating normalization -- something other than the loss of accelerated depreciation on utility property. State regulatory authorities indicated that they intended to challenge in court the validity of the regulations if 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 enjoy the tax benefits associated with losses of an unregulated affiliate when the customers did not bear the burden of those losses.

On March 29, 1991, the Office of Management and Budget ("OMB") 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 the 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 the final rule can be published in the Federal Register.10

1oAs provided in section 3 (d) of Executive order 12291, the Analysis is required to contain the following information:

1.

2.

3.

4.

A description of the potential benefits of the rule, including any beneficial effects that cannot be quantified in monetary terms, and the identification of those likely to receive the benefits;

A description of the potential costs of the rule, including any adverse effects that cannot be quantified in monetary terms, and the identification of those likely to bear the costs;

A determination of the potential net benefits of the rule, including an evaluation of effects that cannot be quantified in monetary terms;

A description of alternative approaches that could substantially achieve the same regulatory goal at lower cost, together with an analysis of their potential benefits and costs and a brief explanation of the legal reasons why such alternatives, if proposed, could not

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Furthermore, the designation of the final regulations as a "major rule" under Executive order 12291 automatically makes any final regulations a "significant regulatory action" under Executive order 12498. That designation would have required the final regulations to be described in the published Regulatory Program of the U.S. Government."

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 these Executive orders would be difficult in any circumstances, but in the instant context such analyses would be particularly forbidding. First, the factual variations are manifold. For example, tax savings resulting from the filing of consolidated tax returns by affiliated groups that include a regulated utility may or may not be due to the use of specific tax incentives, such as accelerated depreciation or deduction of intangible drilling costs, and may vary in their relationship to the provision of utility services. Second, the costs and benefits may be different in different sections of the country and will depend, at least in part, on the State regulatory process relating both to consolidated tax savings and other

5.

be adopted; and

Unless covered by the description required under item 4. above, an explanation of any legal reason why the rule can not satisfy the requirements set forth in section 2 of the Executive order:

Administrative decisions shall be based on adequate information concerning the need for and consequences of regulatory action;

Regulatory action shall not be undertaken unless the potential benefits to society from the regulation outweigh the potential costs to society;

Regulatory objectives shall be chosen to maximize the net benefits to society;

Among alternative approaches to any given regulatory objective, the alternative involving the least net cost to society shall be chosen; and

Agencies shall set regulatory priorities with the aim of maximizing the aggregate net benefits to society, taking into account the condition of the particular industries affected, the condition of the national economy, and other regulatory actions contemplated for the future.

11That description must include:

1.

2.

3.

4.

An identification of the problem to be solved;

A statement of the need for a Federal solution to the problem;

A summary of the approach taken by the rule; and

A tabular presentation of the currently projected monetary costs and benefits of the rule, as well as that of potential alternative approaches to the rule, including transfer costs and benefits resulting from the rule. (OMB has indicated to the Treasury Department that a narrative description of costs and benefits associated with a final regulation might be acceptable in lieu of a tabular monetary analysis in certain cases.)

issues.12

Third, this issue raises important issues of both Federal-State relations and utility ratemaking regulatory policy that are difficult, if not impossible, to quantify and about which the Internal Revenue Service and the Office of Tax Policy claim no special expertise. Finally, 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 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 regulators' 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.

Current State of the Law

Attached as an Appendix to this statement is a memorandum to me from Abraham N.M. Shashy, Jr., Chief Counsel, Internal Revenue Service, that describes the Service's current ruling policy concerning whether a consolidated tax adjustment by a regulated utility violates the normalization requirements of the Internal Revenue Code. It is the position of the Service that, in the absence of regulations specifically prohibiting consolidated tax adjustments, these adjustments can be made without violating the normalization requirements of the Code. Therefore, if requested in an appropriate circumstance, the Service would rule that these adjustments do not violate the normalization requirements of the Code, provided that the adjustments are applied only to the extent of current ratemaking tax expense and not to the deferred tax reserve applicable to accelerated depreciation on public utility property.

Conclusion

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 might be revised. For example, comments suggested that the rules for determining the utility's deemed share of the consolidated tax savings of the affiliated group merited change, such as by taking into account, where appropriate, tax sharing arrangements among the regulated and unregulated affiliated corporations. The comments we received on the proposed regulations also identified other issues to be considered, such as situations where there are several unregulated affiliates and situations where regulated and unregulated activities are performed within a single corporation.

Notwithstanding contentions to the contrary in comments on the proposed regulations, the Internal Revenue Service and the Treasury concluded that the Code authorizes, but does not require, the Service to issue regulations prohibiting ratemaking procedures -- such as adjusting tax expense to reflect consolidated tax savings -- that it finds to be inconsistent with the policies behind the normalization rules. Section

12As Emil Sunley, Deputy Assistant Secretary of Treasury, reported to this Committee more than a decade ago: "While the [normalization] tax rules prescribe accounting rules, they do not authorize an inquiry into the motivation for regulators choosing a particular rate of return. This means there are limits as to how far the tax rules can be enforced in the regulatory process." Hearings before the Subcommittee on Oversight of the House Committee on Ways and Means, 96th Cong., 1st Sess., 515 (March 28, 1979).

168 (i) (9) (B) (iii) authorizes Treasury by regulations to "prescribe procedures and adjustments" that "are to be treated as inconsistent" with the normalization rules. See also Section 167(1)(5).13 Thus, we determined that we had adequate legal authority to issue these 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. On balance, we decided to propose regulations that would limit regulators' discretion in accounting for consolidated tax savings, notwithstanding Congress's failure to address explicitly the issue of consolidated tax adjustments in 1969 or thereafter, and even though the Supreme Court in 1967 had approved such ratemaking offsets.

As I have indicated, the proposed regulations were designed to follow the general structure of 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. This measure of the utility's contribution may be captured in a rate base adjustment, which provides the utility's ratepayers with a benefit reflecting the time value of the more rapid use of the unregulated affiliates' losses or excess credits made possible by the utility's taxable income or tax liability.14 Under the proposed regulations, the unregulated affiliates would have been no worse off than they would be had the utility not been part of the consolidated group. Since the utility's cost of capital reflects the activities of its unregulated affiliates, there seemed to be no reason to allocate the benefits resulting from the accelerated use of their losses or excess credits entirely to the unregulated affiliates, as would be the result if rate base reductions were prohibited. Thus, we concluded that we should not attempt to prohibit

13 Certain comments argued that the kind of rate base reduction permitted in the proposed regulations violates the statutory consistency rules of section 168 (i) (9) (B) (i). paragraph provides that the normalization requirements are not met "if the taxpayer, for ratemaking purposes, uses a procedure or adjustment which is inconsistent with" the requirements of section 168 (i) (9) (A). In particular, these comments argued that rate base reduction effectively allows losses of affiliates to be taken into account for purposes of computing rate base when they are not taken into account in computing depreciation expense, tax expense, and deferred tax expense, and that this violates the "estimate or projection" consistency rule of section 168 (i) (9) (B) (ii).

The

We do not find this reading of the statute persuasive. practice of taking affiliates' losses into account does not involve an "estimate or projection" of rate base as Congress used those words in section 168 (i) (9) (B) (ii). The term "estimate or projection" as used in the statute clearly was intended to be narrower than the term "procedure or adjustment," and to refer to assumed changes in a particular account or item between a test year and the subsequent years covered by a rate order. See S. Rep. No. 643,, 97th Cong., 2d Sess. 7 (1982). Indeed, there is no evidence that the enactment of the consistency rules in 1982 was intended to extend normalization requirements to consolidated tax savings.

14Even when the tax savings are generated from a transaction that does not automatically "reverse" (i.e., where the tax loss incurred by the unregulated affiliate does not simply represent a timing difference), the component of no-cost capital in the utility's rate base will be reduced when the unregulated affiliate earns income.

regulatory commissions from permitting utility customers to share in the benefit produced by consolidated tax savings through a rate base adjustment. However, because the assets that generated the tax loss are not utility property, we concluded that the losses generated by those assets should not be used to adjust the utility's current tax expense. If they were so used, the shareholders would be subsidizing the cost of the service provided by the utility. For this reason, the proposed regulations held that the current tax expense of the utility should be calculated as if it had filed a separate return.

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 as contemplated by the statute.15 In the current context, certain State regulatory commissions made clear their intention to challenge the validity of these regulations if 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 the proposed regulations is far from certain, and the failure to do so might erode the Service's ability to enforce normalization requirements where the Code speaks clearly as to the congressional policy.

Finally, 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, 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 -- the disallowance of accelerated depreciation on public utility property. We are prepared to work with this Committee should it decide legislation is appropriate on the consolidated tax savings issue.

This concludes my prepared remarks. I will be happy to answer any questions that the Committee may have.

15See H. Rep. No. 97-987, 97th Cong., 2d Sess. (1982) and the discussion at note 5, supra.