2007 NASUCA Annual Meeting Excess Deferred Income Taxes and IRS's NOPR: Who shouldbenefit" Anaheim,

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2007 NASUCA Annual Meeting Excess Deferred
Income Taxes and IRS's NOPR Who should benefit?"
Anaheim, CANovember 13, 2007

• Bente Villadsen

The comments are those of Bente Villadsen and not
necessarily reflective of The Brattle Groups
position
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Key Concept Normalization Method of Accounting

• Normalization Method Requires
• Ratemaking tax expense use depreciation no more
  accelerated than ratemaking depreciation
• Difference between ratemaking tax and paid tax
  is added to reserve ADFIT
• The accounting treatment prevents immediate
  flow-through to utility ratepayers of tax
  reduction due to accelerated tax depreciation

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The Issue

• Utilities use different depreciation schedules
  for tax and regulatory purposes
• Deferred Tax Liability, Regulatory
  Deferred Tax Account
• Two Scenarios
• Utility own asset throughout its useful life
• Utility sell asset during its useful life
• Does the transfer of tax benefits to ratepayers
  violate normalization accounting and hence
  prevent the use of accelerated depreciation?
• IRS 2003 proposal NO (withdrawn)
• IRS Private Letter Rulings - YES

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Key Concepts Normalization and No Sale of Assets

• Accumulated Deferred Income Taxes
• Created through accelerated tax depreciation of
  assets
• Regulatory depreciation period is matched to the
  useful life of the asset
• Utilities regulated on a stand alone basis
  collect taxes based on revenues and expenses - -
  rather than based on the taxes paid
• The balance in the Deferred Tax Account as well
  as in associated Regulatory Account increases
  then decreases to end up at zero at the end of
  the assets useful life
• Many jurisdictions apply the Deferred Tax Account
  as an offset to rate base (zero-cost capital)

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Several Deferred Tax Issues

• ADFIT Accumulated Deferred Income Taxes that are
  due to differences in book and tax depreciation
• EDFIT Excess Deferred Income Taxes due to
  changes in tax rates
• ADITC Accumulated Deferred Investment Tax
  Credits - - accrue due to legislative initiatives
  that afford special tax treatment to some
  investments

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Typical Development in Regulatory ADFIT and
Deferred Income Tax Accounts
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Sale of Previously Regulated Asset

• At the date of sale, a balance may exist in the
  deferred tax liability and regulatory deferred
  tax account
• Need to consider impact on

Utilities
Ratepayers
Regulatory Policy
Tax Payers

• Unfortunately, a change in regulatory regimes
  usually reduces the welfare on one or more
  parties

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Viewpoints

• The balance was collected from ratepayers in
  excess of the taxes paid and should be returned
  to ratepayers
• The balance was collected as part of normalized
  expenses and is owed to the tax authorities the
  amount becomes a current liability at the date of
  sale
• Less attention has been paid to the impact on
  taxpayer or the regulatory environment

The second point is the accounting treatment
for ADFIT but not necessarily for EDFIT or ADITC
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Key Issues Utilities, Ratepayers, Taxpayers, and
Regulation

• Utility Perspective
• During its tenure, ratepayers received benefit
  from the asset in proportion to its life and
  incurred associated expenses return of capital
  and obligations from its use
• The deferred tax liability is a loan from tax
  authorities who is paid at the date of sale
• For deferred income taxes that accrue due to
  differences in tax and book depreciation (i.e.,
  not related to investment tax credits or changes
  in tax rates) this view is consistent with the
  notion that rates are established to provide the
  company an opportunity not a guarantee to
  recover its reasonable costs of providing utility
  service and earn its authorized rate of return

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Key Issues Utilities, Ratepayers, Taxpayers, and
Regulation - - Continued

• Ratepayer Perspective
• Ratepayers provide a return of and on capital
  invested
• The deferred tax liability is a loan from
  ratepayers (usually in return for a reduction in
  rate base) and following a sale the loan needs to
  be repaid
• This view is consistent with the notion that
  regulation transfers the risk of utility assets
  from owners to ratepayers
• Utility/Ratepayer Perspective
• The allocation of the deferred income tax
  balance cannot be separated from the allocation
  of risk
• Conceptually, ADFIT, EDFIT, and ADITC may be
  different

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Key Issues Utilities, Ratepayers, Taxpayers, and
Regulation - - Continued

• Taxpayer impact
• Assume 140,000 in deferred tax and 7-year
  amortization
• Utility Income before Taxes
• 1,000,000 if no flow through
• 1,000,000 - 140,000/7 976,667 under flow
  through
• Utility Taxes
• 1,000,000 x 35 350,000 if no flow through
• 976,667 X 35 341,833 under flow through
• Impact on Taxpayers
• 350,000 - 341,833 8,167 (less tax revenue)

Such flow through is a reduction to revenues.
Both the courts and IRS have ruled that the
return of collected taxes cannot be considered an
expense
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Key Issues Utilities, Ratepayers, Taxpayers, and
Regulation - - Continued

• Regulatory Policy
• Consistency is important
• Flow through leads to differences in treatment
  across regulated and unregulated entities
• Current uncertainty leads to differences across
  jurisdictions
• Not all deferred taxes are necessarily created
  equal
• Investment Tax Credits Consider the purpose of
  legislation
• Substantial funds at issue for both ratepayers
  and utilities
• large deferred tax balances
• normalization method of accounting is essential
  to most companies with large infrastructure

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Conclusions

• IRS proposed/withdrawn rule making and the
  recently issued private letters are inconsistent
  and leave regulators, ratepayers, and utilities
  without guidelines
• The allocation of the balance at the date of
  sale cannot be separated from the allocation of
  risk among the utility and ratepayers and other
  ratemaking issues
• Separate consideration needs to be given to each
  type of deferred income tax balance

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Additional Reading

• Internal Revenue Service, Internal Revenue
  Bulletin 2006-5, January 30, 2006
• Daily Tax Report, Speakers Oppose Accounting
  Rule Change, Say Ratepayers Would Lose Benefit
  Unfairly, Daily Tax No. 66, April 6, 2006
• Private Letter Rulings
• Department of the Treasury, Internal Revenue
  Service, Application of Normalization Accounting
  Rules to Balances of Excess Deferred Income Taxes
  and Accumulated Deferred Investment Tax Credits
  of Public Utilities Whose Generation Assets Cease
  to be Public Utility Property, Federal Register,
  March 4, 2003 (26 CFR Part 1)
• David M. Wise, Phantom Taxes The Big Payback,
  Public Utilities Fortnightly Magazine, July 1996
• Robert P. Knickerbocker and Florence K.S. Wise,
  Is There a Phantom Tax Menace When Electric
  Utilities Divest Plants?, Public Utilities
  Fortnightly Magazine, November 1999
• A. Lawrence Kolbe, William B. Tye, and Miriam
  Alexander Baker, Conditions for investor and
  customer indifference to transitions among
  regulatory treatments of deferred income taxes,
  Rand Journal of Economics, 1984.