line depreciation for tax purposes or not had available other tax incentives or other tax benefits. The normalization method of accounting for federal income tax purposes was first provided by the Tax Reform Act of 1969. The purpose of normalization was to insure that tax incentives to regulated utilities from accelerated depreciation and the investment tax credit would encourage capital investment, rather than merely reduce the rates paid by ratepayers. Congress was also concerned that flow through of the tax incentives to ratepayers would decrease federal revenues. Statutory Provisions The In order to use the accelerated cost recovery system of section 168 for public utility property, a regulated utility must use a normalization method method of accounting. normalization rules are now set out in Code section 168 (i) (9). Those rules provide that to use a normalization method of accounting: operating account > method of (i) the taxpayer, in computing its tax expense and a > (ii) if the amount allowable as a deduction for tax purposes with respect to the public utility property differs from the amount that would be > allowable as a deduction under the method used to compute regulated tax expense, the taxpayer must make adjustments to a reserve to reflect the > deferral of taxes resulting from such difference. for Section 168 (i) (9) (B) of the Code prohibits a taxpayer ratemaking purposes from using a procedure or adjustment inconsistent with the above requirements. Any procedure or adjustment for ratemaking purposes that uses an estimate or projection of the taxpayer's (1) tax expense, (2) depreciation expense, or (3) reserve for deferred taxes is deemed inconsistent, unless such estimate or projection is also used, for ratemaking purposes, with respect to the other two such items and with respect to the rate base and cost of service. I.R.S. Notice 89-63 In Notice 89-63, the I.R.S. announced that it planned to develop regulations to provide guidance on the proper application of the above normalization requirements for public utilities that file consolidated returns with non-regulated affiliates. The I.R.S. indicated that those regulations would address the use by public utilities of "effective tax rates" and "consolidated tax adjustments." Those are procedures that have been used by some regulators in calculating utility income tax expense for ratemaking purposes, which take into consideration the tax deductions and the tax credits of non-regulated affiliates, through consolidated returns. if Prior to the issuance of Notice 89-63, the I.R.S. had historically taken the position, as reflected in many private letter rulings, that a public utility would not be in compliance with the normalization requirements of the Code a consolidated tax adjustment was used for purposes of determining regulated tax expense. See, for instance, PLR The theory behind the holding of that private letter ruling is that a consolidated tax savings adjustment would improperly reduce the reserve required under Code section 168 (i) (9) (A) (ii) to reflect the deferral of taxes caused by the excess of regulated tax expense over actual tax expense. The reserve is simply the product of the difference between book depreciation and tax depreciation and the federal income tax rate in effect for the year. Introducing a variable such as a consolidated return adjustment - that served to reduce the amount of federal income tax liability deferred, would cause the reserve to be inadequate to meet the normalization requirements. The Proposed Regulations In November of 1990 the I.R.S. issued proposed regulations to provide guidance on the application of the normalization requirements of the Code to utility companies filing consolidated federal income tax returns with their unregulated affiliates. Those regulations provided that, to comply with the normalization requirements, a utility's ratemaking tax expense would have to be determined as though it filed a separate return for purposes of cost of service. However, the proposed regulations also provided that it generally would not violate the normalization requirements to exclude from rate base a utility's share of the tax savings attributable to the filing of a consolidated return. The I.R.S. held a public hearing in February of this year in which the proposed regulations were widely criticized by both the utility industry and by many public service commissions. The I.R.S. withdrew the proposed regulations in April of this year, pending Congressional guidance. The Effect of the Withdrawal of the Proposed Regulations As a result of the withdrawal of the proposed regulations, taxpayers and public utility commissions are now in a quandary as to what is the proper treatment of consolidated tax savings under the normalization requirements of the Code. Without guidance as to whether ratemakers can adjust for consolidated tax savings, many utilities may be reluctant to make capital investments. In light of the important role that public utilities play in our country's economic well-being, this Subcommittee should not hesitate to provide proper guidance. That guidance should confirm that the normalization method of accounting requires that cost of service and rate base of a utility filing a consolidated return be determined wholly on a stand alone basis; without without regard to the non-regulated consolidated tax savings. The tax characteristics consolidation properly should benefit benefit the shareholders who have borne the risk of the investment. Shifting those benefits away from shareholders would clearly increase the costs to public utilities of capital formation. Important federal tax policies are served when the normalization method of accounting is scrupulously implemented. Business tax incentives provided under the Code, whether they be in the form of accelerated depreciation, mineral depletion, low income housing credits, or other forms, are designed to encourage capital formation in selected areas. Where those tax incentives are not available to utility shareholders because of a flow through to ratepayers, the very reason for providing the tax incentives is frustrated. also inequitable to flow through to ratepayers the favorable tax consequences of the risks that the shareholders have assumed in non-regulated areas. Public service commissions are justly vigilant in insulating ratepayers from the risks of unregulated subsidiary ventures of a regulated utility. Therefore, there is no need to to shift shift the tax consequences of such risks, such net operating losses during a start-up phase, from shareholders to ratepayers through a consolidated tax savings adjustment. The shifting away from shareholders of such tax consequences also would place affiliates of regulated companies at a competitive disadvantage with foreign and domestic unregulated competitors. To the extent we place an additional cost of capital formation and competitive disadvantages on public utilities engaged, through their affiliates, in the search for new or improved energy sources, our country's energy policy suffers as well. Moreover, such an approach would be inconsistent with the policy of the Federal Energy Regulatory Commission of requiring a "stand alone" approach to the treatment of income taxes in determining utility costs. Therefore, I urge this Subcommittee to take the steps necessary to confirm that to comply with the normalization method of accounting, utilities must not adjust their tax expense or rate base by any amount of non-regulated consolidated tax savings. I will be interested to hear the testimony of our witnesses today as it relates accomplishing this important goal. to Mr. SUNDQUIST. I have a short statement, Mr. Chairman. I want to thank you for calling this hearing on the withdrawal of the proposed regulations on the treatment of consolidated tax savings under the normalization requirements of the code. Given the widespread unfavorable response to the proposed regulations and their subsequent withdrawal, it's imperative that this committee act quickly and decisively to provide the guidance which Treasury has requested for this issue to be resolved. Now, the current situation leaves the business plans of many diversified utilities in limbo as they cannot determine the value of the tax benefits from their unregulated operations from State to State, or even on a consolidated basis. This not only disrupts individual operations, but adversely affects our competitiveness in high risk ventures in industries such as telecommunications and energy exploration. So I look forward, Mr. Chairman, to exploring the intent of Congress in establishing normalization requirements, various tax incentives, and consolidated return elections. I also look forward to exploring the effect of consolidated tax adjustments on competitiveness, on unregulated operations, on financial markets, and on Federal tax receipts. Thank you, Mr. Chairman. Chairman RANGEL. Is there any member seeking recognition. [No response.] Chairman RANGEL. If not, Mr. Secretary, we are anxious to hear your testimony. STATEMENT OF HON. MICHAEL J. GRAETZ, DEPUTY ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY Mr. GRAETZ. Thank you, Mr. Chairman. I will abbreviate my written statement, so I ask that it be included in the record of the hearings. Chairman RANGEL. Without objection. Mr. GRAETZ. I am pleased to be here today to discuss the recent withdrawal of proposed regulations concerning the treatment by ratemakers of consolidated tax savings, under the normalization provisions of the Internal Revenue Code. 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, including depreciation and Federal income tax for the year. The return on capital component of rates is based on the product of the rate base, and a weighted average return on debt and equity capital that bondholders and shareholders have invested in those assets. There are two general ways in which a utility regulatory commission can account for the benefits of accelerated depreciation, short depreciation lives and investment credits for public utility property in setting utility rates. One way, flowthrough accounting, treats those 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 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 straightline 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 the utility's rate base-which is generally the total amount of capital invested in the utility on which the stockholders and bondholders are allowed to earn a return-by the accumulated tax savings from using accelerated depreciation. The normalization rules are intended to ensure that the Federal tax savings provided through accelerated depreciation do provide cost-free capital to utilities to promote investment and are not used to subsidize current consumption. Since 1969, 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 which are the subject of this hearing, the Internal Revenue Service had published normalization requirements for only one additional item. State ratemaking authorities generally have used two different approaches to determine the tax expense of a utility that files a consolidated tax return. Under an actual taxes paid kind of 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. Under an alternative stand-alone approach, the ratemaking authority may determine the utility's tax expenses for purposes of setting rates as if it had filed a separate return. Thus, for example, under stand-alone accounting, if a utility that has taxable income files a consolidated tax return with an affiliate whose losses shelter that income from current taxation, the utility's cost of service for ratemaking purposes will reflect the tax that the utility would have paid had it filed a separate return. In the 1980s, the Internal Revenue Service issued several private rulings holding that the normalization provisions of the code re |