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Issue Brief

Electricity Industry Restructuring Threatens to Give Private Utilities Billions of Dollars in Tax Windfalls

January 2000

Summary: Investor-owned utilities (IOUs) enjoy a unique federal tax benefit called "excess deferred income taxes". These excess deferred taxes are taxes collected from the ratepayer, but not immediately paid to the federal Treasury. These tax payments, which are "deferred" presumably to be remitted to the Treasury at a later date, have become a tax windfall for IOUs as the electric utility industry moves to retail competition. Under many state deregulation plans, some existing capital assets owned by IOUs are being sold or spun off into subsidiaries. The deferred taxes on these assets (that have been paid by the ratepayer but not yet submitted to the U.S Treasury) should be returned to the ratepayer. However, some private utilities are attempting to turn existing deferred tax accounts into profit centers either by keeping the reserve in their entirety or their earning on the reserve. (As of 1996, there was over $57 billion held by investor-owned utilities in accumulated excess deferred income tax accounts.) Congress must ensure that any federal electricity legislation earmark the entire benefits of deferred income tax balances associated with deregulated assets and ensure that they be returned directly to the ratepayer –not transferred to the shareholder in the form of profits.

Background: The accelerated depreciation provisions of the Federal tax code allow investor-owned utilities to depreciate their facilities faster for corporate income tax purposes than for regulatory ratemaking purposes. The result is that IOUs are able to collect hundreds of millions of dollars from ratepayers each year for Federal income tax payments that never find their way to the U.S. Treasury. For example, in any given year, for every $10 a utility may collect for Federal income tax expenses only $8.50 may actually be paid to the Treasury. In theory, the differences between taxes collected (under regulatory accounting) and taxes actually paid (under tax accounting) are eventually equalized and paid to the Treasury. The reality is quite different. The annual differences in taxes collected and paid are "excess deferred taxes" and earmarked for future payment. However, rather than balancing out as deferred taxes are supposedly completely repaid over time, the amount of deferred taxes IOUs have on hand has grown continuously from $132 million in 1954 to almost $57 billion as of 1996. This huge amount of cash on hand provides the IOUs a multi-billion, interest-free loan at ratepayer expense that costs the Treasury more than $5 billion annually.

Changing Circumstances: In addition to this long-standing and costly tax privilege from which IOUs benefit, many IOUs are now attempting to take advantage of rapid changes in the industry, ambiguities and conflicts in state and federal law, the secret nature of the Internal Revenue Service’s (IRS) "private letter ruling" process, and insufficient regulatory oversight to turn these accumulated deferred taxes into windfall profits for shareholders. Others are acting responsibly and honoring their obligation to ensure that tax expenses are not over-collected and that they are properly dispersed to either the federal Treasury or ratepayers. Two activities associated with restructuring, the end of rate regulation and the divestiture or transfer of assets, are providing circumstances for opportunistic utilities to inappropriately increase shareholder returns at the expense of consumers.

According to a 1999 study for APPA by MSB Energy Associates’ on Major Tax Subsides to Investor-owned Electric Utilities and the Cost to the U.S. Treasury, IOU's had over $56.7 billion in accumulated deferred income tax (ADIT) reserves as of 1996. They also have several billions of dollars in excess deferred income taxes (EDIT) resulting from a 1986 decrease in the corporate tax rate and Unamortized Investment Tax Credits (UTIC) not yet restored to ratepayers.

Notwithstanding that the deferred excess taxes were collected from ratepayers, some IOUs have begun to argue that earnings on ADIT reserves should go to shareholders. In addition, IOUs are claiming that entire EDIT and UTIC balances should be transferred to shareholders upon deregulation even though they are over-collected taxes that will never be paid to the IRS. As a result, some stranded cost recovery and asset disposition proceedings prompted by state retail competition programs have included decisions regarding the treatment of deferred taxes that are adverse to the interests of ratepayers.

There is a lack of sufficient understanding, public policy, and/or enforcement mechanisms at the state and federal levels to ensure an appropriate disposition of these deferred taxes. Moreover, regulators and consumer advocates do not have the resources to adequately address the situation. These issues are governed by an obscure and highly technical section of the Internal Revenue Code whose understanding requires specific interdisciplinary expertise. Large accounting and consulting firms that have been retained by the IOUs employ most of the individuals possessing such expertise.

In addition, the IRS’ private letter ruling process provides the IOUs with inherent procedural advantages over regulators and consumers, starting with the process’ confidential nature. The process also allows the IOU requesting the ruling to effectively see the ruling in advance and terminate the process if it appears the IRS is going to issue the "wrong" answer. Once the IOU has obtained a favorable private letter ruling, that ruling can be used with regulators to support the IOU’s efforts to secure a deferred tax windfall.

Recognition of this issue has begun to increase. Last November, the National Association of Regulatory Utility Commissioners adopted a resolution calling on the IRS to provide general regulatory guidance regarding the treatment of excess deferred taxes and unamortized investment tax credits when assets are sold or divested.

APPA Position: Deferred tax windfalls violate the principals of equity, regulation, normalization, and deregulation. Specifically such windfalls:

  • violate the basic tenet of cost-of-service rate regulation, which is that rate-regulated utilities are permitted to recover their costs, but not in excess of their costs;
  • are contrary to the underlying tenets of normalization, which seek to achieve intergenerational equity among ratepayers, not transfer wealth from ratepayers to shareholders; and
  • violate the letter and intent of stranded cost recovery, which is to provide an equitable remedy intended to allow recovery of utility investment, not to permit utility retention of funds collected from ratepayers to pay taxes.

Regulatory and Congressional Action Requested: The Department of the Treasury and the Internal Revenue Service should make clear through regulation and revenue rulings that deferred tax windfalls are not consistent with the policies underlying tax normalization, and are not required under the tax normalization provisions of the Internal Revenue Code. Moreover, APPA calls on Congress to exercise careful oversight of this issue and take action as necessary to ensure that deferred excess taxes are properly accounted and do not benefit shareholders of private utilities at the expense of ratepayers and the federal Treasury. Lastly, the Federal Energy Regulatory Commission and state public service commissions must assert their prerogatives as entities charged with establishing "just and reasonable" rates to deny any attempts to secure deferred tax windfalls by private utilities as the industry moves to restructure.

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