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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