ML 160396
ORDER NO. 86711
IN THE MATTER OF THE APPLICATION OF
POTOMAC ELECTRIC POWER COMPANY
FOR ADJUSTMENTS TO ITS RETAIL
RATES FOR THE DISTRIBUTION OF
ELECTRIC ENERGY
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BEFORE THE
PUBLIC SERVICE COMMISSION
OF MARYLAND
______________
CASE NO. 9336, Phase II
______________
Issued: November 13, 2014
I.
Background
The Public Service Commission (“Commission”) instituted this Phase II
proceeding on August 26, 2014, “to resolve any outstanding NOLC issues in this
proceeding and the impact, if any, of the PLR on such issues.”1
In order to place the Net Operating Loss Carry Forward (“NOLC”) issue in
proper perspective it is appropriate to briefly review how this issue first arose in the
Potomac Electric Power Company’s (“Pepco”) previous base rate proceeding, Case No.
9311.2 In that case Montgomery County, Maryland (“MC”) witness Ostrander first
identified Pepco’s NOLC for the record.3 He recommended that the entire amount of
Pepco’s NOLC “be removed from rate base in order to share the NOLC benefit with
customers.”4
1
Mr. Ostrander offered four reasons for his recommendation.5
Mr.
Order No. 86574 at 2. The “PLR” is the Private Letter Ruling Pepco obtained from the Internal Revenue
Service (“IRS”) regarding NOLC issues. The PLR was issued by the IRS on May 22, 2014.
2
The NOLC issue was discussed in Commission Order No. 85724 at pages 15-28, issued in Case No.
9311 on July 12, 2013. It is appended to this Order as Appendix I.
3
Case No. 9311, Order No. 85724 at 15.
4
Order No. 85724 at 16.
5
Order No. 85724 at 16.
Ostrander concluded that “the Commission should require Pepco to obtain an IRS ruling
that its treatment of the NOLC is proper.”6
“Pepco witness Hook countered that removal of any part of the NOLC would
create a federal income tax problem as this would violate the IRS depreciation
normalization rules. Ms. Hook asserted that if these rules are violated, then Pepco would
lose the benefit of accelerated depreciation tax deductions in the future, which would
increase the Company’s tax expense and ratepayers’ cost of service.”7
Office of People’s Counsel (“OPC”) witness Schultz concurred with Pepco that
elimination of the entire NOLC from rate base would violate the normalization rules.
“Mr. Schultz stated that the violation only applies to the NOL that was created as a result
of tax depreciation; if the NOL was due to some other cost, then that debit should not be
included as an offset against the deferred income tax credit.”8 However, Mr. Schultz
went on to conclude that Pepco had not met its burden of proof that a normalization
violation would occur if the NOLC was excluded from rate base so he recommended
that rate base be reduced.9 Mr. Schultz also pointed out that because of the NOL Pepco
would not incur any current income tax expense although the Company reflected a
current tax expense in its cost of service. Consequently, Mr. Schultz concluded that “the
NOLC should be reduced by the amount of taxes in the rate effective period by zeroing
out income tax expense.”10
Staff witness Stinnette stated that “to comply with the tax normalization rules,
6
Order No. 85724 at 17.
Order No. 85724 at 16.
8
Order No. 85724 at 22. “NOL” is Net Operating Loss.
9
Order No. 85724 at 23.
10
Order No. 85724 at 22.
7
2
four elements of a rate case – tax expense, depreciation expense, deferred taxes and rate
base – should all be based upon actual expenses. Ms. Stinnette disagreed that using
projections is appropriate.”11 Ms. Stinnette concluded that Pepco had not “definitively
established” its position to Staff’s satisfaction.
Consequently, Staff recommended
disallowing the Company’s NOLC adjustments at that time and further recommended
that a Phase II proceeding be established for review of Pepco’s NOLC.12
Because no party had provided “a definitive analysis of the NOLC and associated
tax
implications”
the
Commission
acted
cautiously
and
rejected
parties’
recommendations to substantially or totally disallow Pepco’s NOLC ratemaking
adjustments in Case No. 9311.13 Consequently, the Commission directed Pepco to seek
an IRS Private Letter Ruling “that addresses the ratemaking implications of the NOLC…
including the impact on income tax expense… .”14 Finally, the Commission stated that
if Pepco failed to support its position with a PLR within three years that the Commission
would “make an appropriate adjustment” in a future proceeding.15
In the meantime, Pepco filed for another base rate increase, which we docketed
as Case No. 9336 on December 5, 2013. On July 2, 2014, we issued Order No. 86441,
which addressed the issues raised in Pepco’s base rate proceeding. Pepco’s proposed
ratemaking adjustments, “RMA”1, which annualized test year reliability plant closings,
and RMA2, which reflected post-test year reliability plant closings through the hearing
11
Order No. 85724 at 27.
Order No. 85724 at 27.
13
Order No. 85724 at 28. As the PLR makes clear, had the Commission not rejected these
recommendations a normalization violation would have occurred.
14
Order No. 85724 at 28.
15
Order No. 85724 at 28.
12
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date, were accepted by the Commission.16 Because accumulated deferred income taxes
(“ADIT”) are impacted by acceptance of RMA1 and RMA2, we discussed the tax
implications of Pepco’s RMA1 and RMA2, including the impact of Pepco’s NOLC as
well.17
Pepco accounted for its current NOLC tax position by zeroing out the deferred
tax impact for RMA1 and RMA2.18 Although additions to plant increase rate base the
associated ADIT normally lessens this increase somewhat. Because Pepco is in a Net
Operating Loss tax position, it is the Company’s view that to the extent there is an
increase in ADIT associated with RMA1 and RMA2 there is an equal increase in the
NOLC, which equally offsets the ADIT and results in a zero ADIT adjustment.
Relying on Commission Order No. 85724 issued in Case No. 9311, neither MC
nor the Commission Staff (“Staff”) challenged Pepco’s tax position related to RMA1
and RMA2.19 However, OPC witness Ramas “recommended that the ADIT Pepco will
record on its books associated with RMA1 and RMA2 …should also be reflected in the
adjusted test year… capped at the projected reduction to the NOL deferred tax asset that
will result from PEPCO’s projected receipt of cash in 2014 associated with its 2013
federal net operating loss.”20
OPC witness Ramas “also asserted that because the
reliability-related plant additions are added to rate base at a terminal value rather than at
an average value, the associated ADIT should also be reflected at a terminal value.”21
16
Order No. 86441 at 8-10 and 10-13 respectively.
Order No. 86441 at 13-19.
18
Order No. 86441 at 14.
19
Order No. 86441 at 14.
20
Order No. 86441 at 14-15.
21
Order No. 86441 at 15.
17
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Furthermore, she argued that “because the recognition of the tax benefit to customers
through the ADIT rate base offset will not exceed the cash benefit Pepco expects to
receive (in 2014), her recommendation will not result in a violation of the IRS
depreciation Normalization Rules.”22
Pepco witness Warren argued that “imputing cost-free capital that Pepco has not
received in the test year is inappropriate.”23
Furthermore, he stated that “OPC’s
recommendation ignores both the accounting and tax allocation practices that have been
consistently applied by all of the PHI companies for many years.”24 Mr. Warren stated
that OPC’s proposal to use the “terminal value” of Pepco’s anticipated 2013 tax
compensation payment (to be received in 2014) “is inconsistent with IRS Tax
Normalization Rules”, particularly the “Consistency Requirement.”25 He stated that this
“requirement mandates that the same regulatory procedure that is used to measure the
items that produce ADIT must be applied to measure the ADIT produced by those
items.”26
Mr. Warren stated that except for reliability plant additions, which are
calculated on a terminal basis, that Pepco computed its rate base as well as its ADIT
balance on a 13-month average basis.
Therefore, to comply with the Consistency
Requirement he asserted that the compensation payment must be computed on a 13month average basis except for the portion related to reliability plant additions.27
“Because violation of IRS Normalization Rules could subject Pepco, and thus its
22
Order No. 86441 at 15.
Order No. 86441 at 16.
24
Order No. 86441 at 16. “PHI” is Pepco Holdings, Inc., Pepco’s parent holding company.
25
Order No. 86441 at 16-17.
26
Order No. 86441 at 17.
27
Order No. 86441 at 17-18.
23
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ratepayers, to substantial adverse tax and rate consequences…” and consistent with its
findings in Case No. 9311, the Commission stated:28
We find, subject to further review, that it is appropriate to accept
RMA1 and RMA2, which incorporates Pepco’s positions regarding the
ADIT and NOLC balances. The IRS issued its PLR Ruling on May 22,
2014, which Pepco filed in Case No. 9311 on June 10, 2014. However,
since the PLR Ruling is not part of the record in this case and because
other parties have not had an opportunity to comment on it, we will
consider its impact on this case, if any, at a later time, which is also
consistent with our Order No. 85724 in Case No. 9311.29
II.
IRS Private Letter Ruling30
On June 13, 2014, Pepco filed a redacted copy of its IRS Private Letter Ruling in
Case No. 9311. The IRS stated as follows:
On its regulatory books of account, Taxpayer [Pepco]
“normalizes” the differences between regulatory depreciation and tax
depreciation. This means that, where accelerated depreciation reduces
taxable income, the taxes that a taxpayer would have paid if regulatory
depreciation (instead of accelerated tax depreciation) were claimed
constitute “cost-free capital” to the taxpayer. A taxpayer that normalizes
these differences, like Taxpayer, maintains a reserve account showing the
amount of tax liability that is deferred as a result of the accelerated
depreciation. This reserve is the accumulated deferred income tax
(ADIT) account. Taxpayer maintains an ADIT account. In addition,
Taxpayer maintains an offsetting series of entries – a “deferred tax asset”
and a “deferred tax expense” – that reflect that portion of those ‘tax
losses’ which, while due to accelerated depreciation, did not actually
defer tax because of the existence of an net operating loss carryover
(NOLC). Taxpayer, for normalization purposes, calculates the portion of
the NOLC attributable to accelerated depreciation using a “with or
without” methodology, meaning that an NOLC is attributable to
28
Order No. 86441 at 18.
Order No. 86441 at 18.
30
The redacted copy filed in Case No. 9311 by Pepco with the Commission on June 13, 2014 is attached
to this order as Appendix II and is incorporated into the record in this case. (See Case No. 171 in Case
No. 9311) We also incorporate into this record the confidential PLR filed by Pepco on June 10, 2014, in
Case No. 9311. (Docket No. 170)
29
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accelerated depreciation to the extent of the lesser of the accelerated
depreciation or the NOLC.31
The IRS also noted that in Case No. 9311 Pepco normalized the tax benefits
attributable to accelerated depreciation in computing its income tax expense element of
the cost of service, which this Commission accepted. The IRS noted that Pepco argued
that its ADIT balance should be reduced by the amount it calculated did not actually
defer tax due to the presence of the NOLC, as represented in the deferred tax account,
which the Commission authorized. The IRS also noted one party (OPC) recommended
that if the Commission allowed Pepco to reduce its ADIT balance as proposed, then
Pepco’s income tax expense element of the cost of service should be reduced by this
amount, (which this Commission rejected). Further, the IRS noted that Pepco proposed
that no additional ADIT should be reflected for its reliability plant addition adjustments
(similar to RMA1 and RMA2 in Case No. 9336) because any additional book and tax
depreciation produced by considering these assets would increase Pepco’s NOLC and
there would be no net impact on ADIT, which the Commission also accepted.32
The IRS stated that in Order No. 85724 issued in Case No. 9311 this
Commission (referred to as “Commission B” in the redacted PLR) reduced rate base by
Pepco’s ADIT account, modified by the Company’s NOLC. The IRS stated that the
Code “makes clear that the effects of an NOLC must be taken into account for
31
PLR-148310-13 (“PLR”) at 2. “The ‘with or without’ method, sometimes known as the ‘last dollar’
method, treats the accelerated depreciation in excess of book straight line depreciation as the last dollars
deducted in any given tax year.” Pepco Reply at 8.
32
PLR at 2-3.
7
normalization purposes.”33
However the IRS also stated as follows:
Section 1.167(1)-1(a)(1) of the Income Tax Regulations provides
that the normalization requirements for public utility property pertain
only to the deferral of federal income tax liability resulting from the use
of an accelerated method of depreciation for computing the allowance
for depreciation under section 167 and the use of straight-line
depreciation for computing tax expense and depreciation expense for
purposes of establishing cost of services and for reflecting operating
results in regulated books of account. These regulations do not pertain to
other book-tax timing differences with respect to state income taxes,
F.I.C.A. taxes, construction costs, or any other taxes and items.34
According to the IRS:
Because the ADIT account, the reserve account for deferred taxes,
reduces rate base, it is clear that the portion of an NOLC that is
attributable to accelerated depreciation must be taken into account in
calculating the amount of the reserve for deferred taxes (ADIT). Thus,
the order by Commission B is in accord with the normalization
requirements. The “with or without” methodology employed by
Taxpayer is specifically designed to ensure that the portion of the NOLC
attributable to accelerated depreciation is correctly taken into account by
maximizing the amount of the NOLC attributable to accelerated
depreciation. This methodology provides certainty and prevents the
possibility of “flow through” of the benefits of accelerated depreciation to
ratepayers. Under these facts, any method other than the “with and
without” method would not provide the same level of certainty and
therefore the use of any other methodology is inconsistent with the
normalization rules.35
Addressing the imputation of incremental ADIT on account of the reliability
plant addition adjustments, the IRS stated that increasing Pepco’s ADIT account “by an
amount representing those taxes that would have been deferred absent the NOLC
increases the ADIT reserve account (which will then reduce rate base) beyond the
33
PLR at 6.
PLR at 4.
35
PLR at 6. Emphasis added by the Commission.
34
8
permissible amount.”36 The IRS further stated the OPC’s proposed reduction to Pepco’s
tax expense to reflect the tax benefit of Pepco’s NOLC “would, in effect, flow through
the tax benefits of accelerated depreciation deductions through to rate payers even
though the Taxpayer has not yet realized such benefits” … and “would violate the
normalization provisions.”37
Finally, the IRS ruled as follows:
1. Under the circumstances described above, the reduction of Taxpayer’s rate
base by the full amount of ADIT account balances offset by a portion of its
NOLC-related account balance that is less than the amount attributable to
accelerated depreciation computed on a “with or without” basis would be
inconsistent with the requirements of § 168(i)(9) and § 1.167(l)-1 of the
Income Tax regulations.
2. The imputation of incremental ADIT on account of the reliability plant
addition adjustments described above would be inconsistent with the
requirements of § 168(i)(9) and § 1.167(l)-1.
3. Under the circumstances described above, any reduction in Taxpayer’s tax
expense element of cost of service to reflect the tax benefit of its NOLC
would be inconsistent with the requirements of § 168(i)(9) and § 1.167(l)-1.38
Based upon the foregoing, it is clear that Commission Order No. 85724, issued in
Case No. 9311 is in accord with the IRS normalization requirements.39 Furthermore, to
the extent Pepco’s NOLC, computed using a “with and without” method, is based upon
“the deferral of federal income tax liability resulting from the use of an accelerated
method of depreciation” Pepco’s NOLC must offset and thus reduce its net ADIT
amount included in rate base, thereby increasing the Company’s rate base.40 However,
36
PLR at 6.
PLR at 6.
38
PLR at 7.
39
PLR at 6.
40
See the PLR at 4 and 6.
37
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to the extent that Pepco’s NOLC is related to “other” federal tax deductions, which do
not involve accelerated depreciation, or is the result of book-tax timing differences with
respect to state income taxes, then the Commission has discretion to determine whether
such NOLC-related amounts should, or should not, be used to offset Pepco’s ADIT in
rate base.41
III.
NOLC Amounts Not Governed by IRS Normalization Rules
A. Pepco’s Position
Pepco stated that its total NOLC deferred tax asset (“DTA”) included in its 13-
month average rate base on a Maryland jurisdictional basis is $78.5 million of which
$74.1 million is federal and $4.4 million is state.42 According to Pepco, $60.3 million of
the federal NOLC is a result of accelerated/bonus tax depreciation deductions in excess
of book straight line depreciation calculated on a “with or without” basis. Therefore,
$13.8 million of the federal NOLC is due to “other” deductions not covered by the
normalization rules as is the $4.4 million state NOLC.43 Furthermore, Pepco stated that
RMA1 and RMA2 included an $11.1 million NOLC, $11.0 million federal and $0.1
million state. Pepco stated that the entire federal amount is “protected” because “all of it
relates to the excess of accelerated tax over book straight line depreciation.”44
Therefore, the Total NOLC Pepco has included as an offset to its ADIT balance in this
41
See PLR at 4. See also the Initial Brief of Montgomery County at 4 where MC specifically recognizes
that this is a matter of Commission discretion.
42
Pepco Phase II Brief at 11. (Unless otherwise stated, all references to Briefs and Reply Briefs are to the
parties Case No. 9336 Phase II Briefs and Replies.)
43
Pepco Brief at 11. Pepco discusses its view of the accounting for deferred taxes at pages 6-8.
Montgomery County and OPC appear to disagree with Pepco’s calculations as to the portion of the NOLC
covered by the normalization rules; however, due to our ruling, the discrepancy is immaterial.
44
Pepco Brief at 12.
10
case is $89.6 million.45
Pepco stated that, for 2009, 2011 and 2012, it claimed tax deductions each year
that exceeded its taxable income, which resulted in a net operating loss.46 Since the
NOLs could not be carried back to previous tax years (and thereby generate an
immediate tax deduction) the NOLs are carried forward creating NOLCs. Pepco stated
that the consequence of this is that some portion of the deductions it claimed on its tax
returns in those years did not produce a cash benefit but that those deductions may be
used within the next 20 years to offset taxable income.47
According to Pepco, “the Commission must address the fundamental regulatory
issue of whether or not it makes economic sense to impute in rate base the impact of
cost-free capital [ADIT] when that capital is not available because there is insufficient
taxable income [due to the Company's NOL’ tax position].”48
Pepco argued that the propriety of reducing its rate base by its ADIT balance “is
entirely dependent on the premise that the offset represents the level of cost-free capital
the Company receives.”49 Therefore, Pepco concluded that offsetting the ADIT balance
by its NOLC balance “is the only way to reflect economic reality in the rate setting
process.”50 Pepco stated that a NOLC essentially represents “suspended tax deductions”
that will produce cost-free capital in the future when the NOLCs are used to reduce
Pepco’s tax liability.51 “At that time, the additional cost-free capital, in other words, the
45
$74.1 + $4.4 + $11.1 = $89.6
Pepco Brief at 5. Pepco also shows estimated 2013 losses through September 30 on its Attachment 1.
47
Pepco Brief at 5.
48
Pepco Brief at 1-2.
49
Pepco Brief at 7.
50
Pepco Brief at 7.
51
Pepco Brief at 4-5.
46
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incremental ADIT, will be available to reduce rate base and ultimately, customer
rates.”52
Pepco argued that the proposals of some parties to compute its rate base as if
there was no NOLC and as if all of its tax deductions are currently usable “imputes to
Pepco an amount of cost-free capital that it simply does not possess.”53 Pepco asserted
that “any proposal which leaves in the deferred tax credits reducing rate base where an
interest free loan has not been realized would be the equivalent of arbitrarily disallowing
a portion of the Company’s investment in plant in service.”54 Pepco concluded that “if
the Commission’s intention is to properly reflect in Pepco’s rate base the level of costfree capital it actually possesses, then it needs to do nothing other than what it has
already done.”55
B. OPC’s Position
OPC stated that the PLR “is consistent with the position of Mr. Schultz” in Case
No. 9311 that “only the NOLC amount related to accelerated depreciation would need to
comply with the normalization rules.”56 OPC stated that the “PLR did not address that
portion of the NOLC which was in excess of the amount of accelerated depreciation.”57
Although Pepco takes the position that rate base should not be reduced because
cost-free capital due to ADIT is not produced when there is a corresponding NOLC,
OPC says this position is fallacious. OPC stated that it is uncontradicted that “ratepayers
52
Pepco Brief at 5-6.
Pepco Brief at 3.
54
Pepco Brief at 14.
55
Pepco Brief at 8.
56
OPC Brief at 3-4. See also footnote (“FN”) 11 on page 4. However, the PLR completely contradicted
Mr. Schultz’s recommendation in Case No. 9311 to reduce Pepco’s tax expense element of the cost of
service to reflect the tax benefit of the NOLC. See Order No. 85724 at 22 and the PLR at 3.
53
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are providing funds for income taxes even though the Company will not pay any income
taxes.”58 OPC stated that as a result Pepco has the use of these funds until a tax payment
is actually due. Rather than the Company receiving a unilateral benefit, OPC argues that
to the extent Pepco has this cash flow ratepayers should be credited in the form of a
deferred tax offset to rate base.59
OPC stated that it is clear from the PLR that providing cost-free capital to the
Company and preventing these benefits from being flowed through to ratepayers are
important policy considerations underlying the normalization requirements that apply to
the tax benefits associated with accelerated depreciation. However, OPC argued in the
context of traditional utility ratemaking no comparable policy considerations are
applicable.60 Consequently, OPC concluded that Pepco’s receipt of funds for income
taxes that it does not presently have to pay without an offset to rate base would be “an
inappropriate violation of the fundamental matching principle.”61 For this reason, OPC
recommends that an adjustment to the rate increase approved in Order No. 86441 in
Case No. 9336 should be made by reducing rate base by that portion of Pepco’s NOLC
that “is not due to accelerated depreciation.” OPC recommends reducing rate base by
$70,298,153, although OPC states that the exact calculation may require additional
information.62
57
OPC Brief at 2, emphasis by OPC. Technically speaking the PLR also did not address state income tax
deductions related to accelerated depreciation.
58
OPC Brief at 5.
59
OPC Brief at 5.
60
We discuss the normalization versus flow-through issue in the decision section.
61
OPC Brief at 6.
62
OPC Brief at 6.
13
In its Reply, OPC argues Pepco has ignored traditional ratemaking principles that
“mandate” adjustments to Order No. 86441 as recommended by OPC.63 OPC states that
Pepco’s refusal to reduce rate base for the NOLC in excess of accelerated depreciation
would result in treating uncontradicted tax benefits of the NOLC as a nullity. Pepco’s
rationale is no “cost-free” capital is produced; however, for accounting purposes Pepco
presumes all of its tax deductions reduce its tax liabilities, which OPC states increases
ADIT under traditional ratemaking principles and should reduce rate base. OPC states
that a fundamental flaw of Pepco’s economic argument is that “while the generation of
cost-free capital is the controlling principle of the IRS normalization requirements there
is no such doctrine applicable to utility ratemaking.”64 OPC argues that for ratemaking
purposes the reduction in rate base for the deferred tax liability is a quid pro quo for the
deferral of income taxes.”65 Furthermore, OPC argues that in fact Pepco is receiving a
cash benefit due to the NOLC because ratepayers are providing funds for income taxes
even though the Company will not (currently) pay any income taxes. OPC argues that
Pepco thus has the use of these funds until a tax payment is actually due.66 OPC
concludes that Pepco’s proposal to use the NOLC to offset any deferred income tax
reduction to rate base and also collect for income taxes it does not currently have to pay
results in “a unilateral benefit to the Company.”67 OPC also states that there is “no basis
for Staff’s conclusion that the PLR provides guidance on the issues which are the subject
63
OPC Reply at 1.
OPC Reply at 2.
65
OPC Reply at 2-3.
66
OPC Reply at 3.
67
OPC Reply at 3.
64
14
of Phase II of this case, and Staff’s conclusion and recommendations in this regard
should be rejected.”68
C. Montgomery County’s Position
Montgomery County, Maryland (“MC”) stated that in Case No. 9336 the
Company’s rate base included NOLC amounts that are depreciation-related and nondepreciation-related on both a state and federal income tax basis.69 On a “positive note”
MC stated its agreement with Pepco on the “Maryland Jurisdictional” NOLC amount of
$89.5 million that Pepco claimed it included in rate base in Case No. 9336, consisting of
$78.5 million for the September 30, 2013 test year ending 13-month average balance and
$11.1 million associated with RMA1 and RMA2.70 However, MC stated that there
“remains significant disagreement between Montgomery County and Pepco regarding
the amount of NOLC related to non-depreciation-related tax issues.”71
MC stated that to “be consistent with Pepco’s argument regarding NOLC, it
makes neither ‘economic’ nor ‘common sense’ for Pepco to be able to recover income
tax expenses in a rate case when it never actually pays income taxes to the IRS.”72 MC
noted that in Case No. 9311 its witness, Mr. Ostrander, stated that, at best, the tax
normalization rules would only apply to the depreciation-related NOLC and not an
NOLC related to other matters.73 MC recommended that the Commission remove from
rate base the state and federal tax portion of the non-depreciation-related NOLC as well
68
OPC Reply at 7. OPC also cites the PLR at page 4; OPC Reply at 6.
MC Brief at 8.
70
MC Reply at 2. Due to rounding, the figure is $89.6 million. Id., footnotes 1 and 2.
71
MC Reply at 2.
72
MC Reply at 11.
73
MC Brief at 6.
69
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as the state tax portion of the depreciation related NOLC because removal of these
NOLC amounts would not result in a tax normalization violation according to the PLR.74
Furthermore, MC asserted that Pepco has admitted that a state tax NOLC is not required
under federal or Maryland state tax codes. MC argued that there is “no legal precedent
or regulatory-related reason to unduly increase rate base and related customer rates for
the impact of state tax on a depreciation-related NOLC, and Pepco has never provided a
reasonable argument to support inclusion of these amounts in rate base.”75
Montgomery County admitted that it “recognizes the calculation of income tax
expense at a statutory federal tax rate of 35% (regardless of any actual tax payments to
the IRS) is a long-standing ratemaking policy of the Maryland Public Service
Commission.”76 However, MC asserted that this policy “should be balanced by also
excluding non-depreciation-related NOLC and state NOLC from rate base, because
Pepco should not be allowed to have its cake and eat it too.”77 In its Reply MC revised
its recommendations and now recommends that the Commission only “allow Maryland
Jurisdictional depreciation-related NOLC of $8,696,593 in rate base, and exclude federal
non-depreciation-related NOLC in a range of $76,296,997 to $86,654,424, and exclude
state-related NOLC ranging from $4,549,521 to $9,170,126.”78
D. Staff’s Position
Staff stated that the PLR provides “sufficient guidance” regarding Pepco’s
74
MC Brief at 3-4.
MC Brief at 9. See also FN22 at page 9.
76
MC Reply at 11.
77
MC Reply at 11.
78
MC Reply at 13-14.
75
16
NOLC-related accounting practices “to conclude that Pepco’s accounting method is
appropriate for use when determining how to treat the NOLC for ratemaking
purposes.”79 Staff further stated:
Specifically, in ratemaking terms, the IRS has concluded that in a
given test year the maximum ADIT that may be used to offset NOL,
thereby reducing rate base, is equivalent to the NOL for the period under
consideration. Reduction of rate base by any carryover would effectively
increase the ADIT reserve account “beyond the permissible limit”. The
amount of this carryover or NOLC may only be used when this item
actually offsets taxes during the period under review. Since Pepco
correctly accounted for the NOLC in Case No. 9336 and the Commission
adopted Pepco’s adjustments, there is no need to change these
adjustments or to add carrying costs to the original adjustments.80
E. Pepco’s Reply
Addressing OPC’s point that Pepco’s customers are paying income tax expense
even though the Company is not currently paying income taxes, Pepco states in its Reply
that “OPC is correct in its assertion that the difference between Pepco’s total income tax
expense on its regulatory books and what it pays in income taxes ought to reduce rate
base.”81 Moreover, Pepco states that it does not matter whether Pepco pays no income
tax expense or simply something less than the income tax the Company reflects for
ratemaking purposes because this “differential is, after all, what creates deferred taxes –
and Pepco reduces its rate base by its ADIT balance.”82 Pepco states that regulatory
income tax expense is based on regulatory income and not tax return income, which “is
the essence of normalization tax accounting” and which has been used by this
79
Staff Brief at 6 and 8.
Staff Brief at 8.
81
Pepco Reply at 6.
82
Pepco Reply at 6.
80
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Commission for many years.83 Pepco argues that its regulatory tax expense will not
change, as a result of tax deductions that cannot currently be used due to its NOLC
because regulatory tax expense is computed by reference to regulatory income and not
tax return income.84
Pepco argued that OPC’s assertion that customers are funding the Company’s
NOLC if rates are not reduced by the benefit of NOLC is fallacious. Pepco states that
reflecting the NOLC for customers through an immediate reduction in rates would
provide customers with a tax benefit that Pepco has not yet obtained and which it may
not be able to use for years.85 Furthermore, Pepco argued reducing rates for the NOLC
would “contravene the Commission’s long-standing tax accounting policy which is to
normalize, rather than to flow through, the tax impacts of differences between tax and
regulatory reporting.”86 Pepco concluded that if its net ADIT balance did not reflect – as
an offset to ADIT – the NOLC deferred tax asset (“DTA”), “the rate base offset would
not accurately reflect Pepco’s true economic position.”87 Additionally, Pepco argued
that both OPC and MC “misinterpreted” the “with or without” method and have
“grossly” overstated their proposed reductions to rate base. Pepco asserts that if either of
their adjustments is adopted the normalization rules would be violated as expressed in
the PLR, which “would cause significant economic damage to the Company and its
customers.”88
Pepco concludes that the NOLC represents a lack of cost-free capital
83
Pepco Reply at 7.
Pepco Reply at 7.
85
Pepco Reply at 7.
86
Pepco Reply at 7.
87
Pepco Reply at 8.
88
Pepco Reply at 14.
84
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being provided to the Company from either the government or customers.89 Pepco noted
that there are regulatory precedents for its position citing a Federal Energy Regulatory
Commission (“FERC”) opinion and several state commission opinions.90
F. Commission Decision
In Order No. 85724, issued in Case No. 9311, we directed Pepco to obtain a PLR
from the IRS regarding NOLC ratemaking issues raised in that case.91 Because the IRS
did not issue the PLR until May 22, 2014, which Pepco filed in June, we stated in Order
No. 86441 in this (Case No. 9336) proceeding that “we will consider its impact on this
case, if any, at a later time.”92 By Order No. 86574, issued on August 26, 2014, we
instituted these Phase II proceedings to consider NOLC issues and the impact of the PLR
on those issues.
The IRS has made clear that to the extent Pepco’s NOLC is attributable to federal
accelerated depreciation tax deductions, calculated on a with or without basis, that the
NOLC must be taken into account in calculating the amount of ADIT that is subtracted
from rate base.93 However, the IRS also stated that where ADIT is generated due to
something other than accelerated depreciation federal tax deductions (“other” federal tax
deductions and all state tax deductions) that the IRS normalization rules do not require
that an NOLC balance offset the ADIT balance. Thus, the question before us is whether
NOLC balances should be used to offset these ADITs, and thereby increase rate base, to
89
Pepco Reply at 8. The IRS concurred. PLR at 2.
Pepco Reply at 5-6.
91
Order No. 85724 at 28.
92
Order No. 86441 at 18.
93
PLR at 6.
90
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the extent the IRS normalization rules do not require such an outcome. Determination of
this issue is dependent upon our historic ratemaking practices and an examination of the
competing views of the “matching principle” put forth by the parties.
Pepco’s position is that ADITs do not create a source of cost-free capital when it
is in a NOL position due to NOLCs because it cannot use the deferral in such instances.
Pepco drew the analogy of a “rain check” in this situation. Since ADIT is deducted from
rate base because it provides a source of cost-free capital, Pepco concludes that where it
cannot take advantage of this source presently (the deferral is deferred) due to its NOLC,
the NOLC balance must be used to offset the ADIT balance. Pepco calculated its rate
base consistent with this view and the Commission accepted it in this case, subject to
further review. Staff now supports Pepco’s position.
Conversely, OPC and MC maintain that because Pepco is receiving payment of
income taxes through its cost of service even though Pepco does not presently have to
pay income taxes due to its NOLC, that to the extent the Company has this cash flow,
ratepayers should be credited in the form of a deferred tax offset to rate base.
To begin with, Pepco has properly noted that this Commission has for years
utilized normalization accounting for ratemaking purposes. MC acknowledges this fact.
It is this difference between the total income tax expense on a utility’s regulatory books
and what it actually pays in income taxes that creates deferred taxes, which can be
accumulated and result in an ADIT balance. All parties agree that it is these ADITs that
create cost-free capital for a utility. In the usual situation it is the entire gross ADIT
20
balance that creates cost-free capital, which is then deducted from rate base. However,
Pepco is at present in a NOLC position.
We agree with Pepco that what MC and OPC advocate is to flow through to
ratepayers, rather than normalize, the impact of differences between tax and regulatory
accounting. MC was rather succinct when it stated that “Pepco should not be allowed to
have its cake and eat it too.”94 Moreover, the IRS was quite clear that “the effects of the
NOLC must be taken into account for normalization purposes” although the IRS clearly
limited its Ruling to “the portion of an NOLC that is attributable to accelerated
depreciation”.95 Thus, we find that including the entire NOLC balance as an offset to the
gross ADIT amount, thereby reducing the net ADIT balance to be subtracted from rate
base, is consistent with the normalization accounting practices of this Commission.
More specifically, we note that ADITs are subtracted from rate base because they
represent cost-free capital for the utility, which every party agrees. However, when a
utility is in a NOL or NOLC tax position, any new or additional deferred income taxes
that are generated do not actually defer tax because the tax obligation is already zero and
thus there are no new tax obligations to presently defer.
Consequently, no additional cost-free capital is created.
The IRS concurs.96
In this regard we find the
statement of the Texas Public Utilities Commission in Gulf States Utility Co. cited by
Pepco to be cogent:
94
MC Reply at 11.
PLR at 6.
96
“Taxpayer maintains an ADIT account. In addition, Taxpayer maintains an offsetting series of entries –
a “deferred tax asset” and a “deferred tax expense” – that reflect that portion of those ‘tax losses’ which,
while due to accelerated depreciation, did not actually defer tax because of existence of an net operating
loss carryover (NOLC).” PLR at 2.
95
21
To the extent that a utility has unutilized NOL carry forwards, its
tax liability will be reduced in the future. Therefore, if the [Texas]
Commission is going to include deferred income taxes as a reduction to
rate base, which it should, the Commission should likewise include
known reductions to those deferred taxes. Consequently, NOLs should
be included as an offset in the calculation of the deferred income tax
balance included in rate base.97
Moreover, it should be emphasized that ratepayers will benefit prospectively as taxes are
avoided, thus reducing the cost of service, to the extent Pepco does not have to pay taxes
due to its NOLC and again as future reductions in the NOLC balance result is a lesser
subtraction from the ADIT balance.
Furthermore, we find that our decision is consistent with the PLR. As Staff
noted, “[c]entral to the reasoning of the IRS PLR is the principle that the benefits of
accelerated depreciation should flow to the taxpayer (Pepco)”.98 Although the IRS
stated that its ruling does not pertain to state income taxes, we find the reasoning of the
IRS – that accelerated depreciation tax benefits are to be retained by the Company – is
consistent when applied to state income taxes in respect of accelerated depreciation. We
do note that, given Pepco’s on-going NOLC situation, in future proceedings it might be
appropriate to account for it in some other fashion, possibly whether to exclude forwardlooking plant adjustments in rate base.
For the reasons stated herein, we find that Pepco has appropriately accounted for
its NOLC in Case No. 9336. Therefore, no adjustment to rate base shall be made.
97
Pepco Reply at 5 citing Gulf States Utilities Co., Docket No. 8702, 17 Tex. P.U.C. Bull., 703 (Tex. PUC
May 2, 1991).
98
Staff Brief at 5.
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IV.
Pepco’s September 2013 and September 2014 Tax Remittances
A. OPC’s Position
OPC raised two issues in this case concerning the tax compensation payments
Pepco has and would receive from PHI from the consolidated 2012 and 2013 tax returns
filed with the IRS.99
First, OPC asserted, as it did previously, that the September 2013 cash payment
Pepco received from PHI for a portion of its 2012 NOL should be reflected on a
“terminal” (100%) basis rather than treated as if it were received ratably as Pepco
proposed and the Commission accepted in Order No. 86441. OPC points out that this
would be consistent with the reliability plant additions, which are reflected on a terminal
basis.100 OPC applied the same logic to the September 2014 cash payment for Pepco’s
2013 taxes. OPC stated “even though the September 2014 cash payment will be made
after the test year, the ADIT offset associated with RMA1 and RMA2 should be matched
to the method (terminal value) and period (adjusted test year) in which the reliabilityrelated plant additions are being included in rate base.”101 The payments reduce Pepco’s
NOLC balance, thereby increasing the associated net ADIT balance, which reduces rate
base. OPC’s proposed rate base reductions are $629,000 for the 2013 payment for the
2012 tax year and $18,025,000 for the projected 2014 payment for the 2013 tax year.102
B. Pepco’s Position
Pepco opposed reflecting its 2014 tax compensation payment associated with its
99
OPC Brief at 6-9.
OPC Brief at 7-8.
101
OPC Brief at 8.
102
OPC Brief at 8.
100
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2013 NOLC in this case. Pepco asserted “it is improper to reflect the effect of the tax
compensation payment until that compensation payment is made.”103 Pepco argued that
the deductions that created the loss “do not produce any benefit to the Company prior to
that payment” because it does not have cost-free capital until the cash is in hand. Pepco
stated that the 2014 tax compensation payment will not be received until almost a full
year after the test period. Additionally, Pepco pointed out that the tax sharing agreement
works both ways and that if Pepco had taxable income in a year when the consolidated
group pays no tax it would not be required to make a tax payment until the tax return is
filed.104
C. Staff’s Position
Staff stated that the Commission should reflect Pepco’s 2013 tax refund in rates
in a manner similar to RMA8, which reflected the 2012 tax refund (received in
September 2013) on a ratable basis. Staff noted that the Commission found that the
2012 refund reflected tax benefits related to items that are reflected on an average testyear basis in addition to reliability related plant.
Further, Staff noted that the
Commission found in the absence of evidence to the contrary that the tax loss was
accrued throughout the year rather than all at once.105 Staff stated that the Commission’s
treatment of the 2012 refund “appears to be consistent with the IRS PLR which notes…
that the tax benefit must first be recognized by Pepco.”106 Staff concluded:
103
Pepco Brief at 14.
Pepco Brief at 16.
105
Staff Brief at 8. See also Oder No. 86441 at 31-32.
106
Staff Brief at 8-9.
104
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If the Commission finds this adjustment appropriate, the
adjustment should be applied to state as well as federal taxes using the
method behind Pepco’s reflection of the 2012 NOL accrual…applied to
Pepco’s 2013 NOL accrual after receipt of any funds due to PHI’s 2013
tax refund. According to Staff, if Pepco’s 2013 tax return is reflected at
such time, there is no need to add carrying costs to this or any other
original adjustment.107
D. Commission Decision
We addressed the issue of Pepco’s 2012 tax compensation payment, which it
received in September 2013 from PHI, in Order No. 86441.108 We noted that if the
payment was reflected when it was received, in September 2013, then only onethirteenth of the payment would have been reflected in the test year. OPC’s proposal to
use the “terminal value” would have meant that 100% of the payment would be reflected
throughout the test period, in other words the payment would be reflected as if received
in whole at the beginning of the test year. We determined that the Company’s proposal
to reflect the tax compensation payment as if received by Pepco ratably throughout the
year struck “ a reasonable balance between Pepco’s initial calculation and OPC’s
recommendation… because in the absence of evidence to the contrary, it is reasonable to
conclude that the tax loss that generated the refund was accrued ratably rather than all at
one time.”109 Furthermore, we found that the tax compensation payment reflected tax
benefits related to other items besides reliability-related plant, “which other items are
also calculated on an average test year basis.”110 OPC has offered no new reason to
depart from our decision and we hereby affirm our decision in Order No. 86441.
107
Staff Brief at 9.
Order No. 86441 at 30-32.
109
Order No. 86441 at 32.
110
Order No. 86441 at 32.
108
25
The second issue to be addressed is the appropriate treatment of Pepco’s 2013 tax
compensation payment, which Pepco was to receive in September 2014, fully two
months after Order No. 86441 was issued. Contrary to OPC’s position, this payment
was not known and measurable during our consideration of Pepco’s rates in this
proceeding. In fact, OPC witness Ramas admitted that her recommendation was based
upon “the projected reduction in the NOL deferred tax asset that will result from the
September 2014 payment.”111 We conclude that the 2013 tax compensation payment
Pepco received in September 2014 should be reflected in Pepco’s next rate case,
calculated consistent with the calculation of RMA 8 in this proceeding. In this way the
payment can and will be reflected on a known and measurable basis. However, we will
require Pepco to increase the adjustment by including carrying costs at its currently
authorized overall rate of return from the date Pepco received the payment in September
2014 through the expected order date in its next base rate case whenever it is filed.112 In
this way an accurate known and measurable adjustment can be made and customers will
receive the full value of the tax compensation payment. Thus, customers will not be
disadvantaged by the timing of Pepco’s rate proceedings. For these reasons we decline
to adjust Pepco’s rate base (and customer rates) in this proceeding for the 2013 tax
compensation payment received in September 2014. Furthermore, we note that making
the adjustment prospectively will avoid any possible issues with the tax normalization
rules from over-projecting the payment or applying it before Pepco has received it.
111
OPC Brief at 8; See also footnote 25. Emphasis by the Commission.
The order date is usually 210 days from the date a utility files a rate case with the Commission. See
Public Utilities Article, Sections 4-203 and 4-204.
112
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V.
Style of Pepco’s PLR Request
OPC and MC have raised concerns that the manner in which Pepco requested its
PLR Ruling was designed to elicit a favorable ruling rather than presenting the issue in
an unbiased manner.113
To begin, we trust that the IRS has the expertise to fully understand the tax issues
presented and the capability therefore to issue an appropriate ruling on an impartial
basis. Further, we note that both OPC and MC participated in the Conference of Right at
the IRS’s offices on May 6, 2014. Additionally, MC and OPC submitted their concerns
with the PLR Request in a letter submitted to the IRS that was included in a follow-up
submission filed with the IRS by Pepco on May 19, 2014.114 Finally, we have reviewed
PLR-148310-13 and it is clear to us that the IRS has issued a ruling that properly reflects
the factual background presented in Case Numbers 9311 and 9336 and its expert opinion
on the application of federal tax law thereto. Consequently, we find that Pepco complied
with our directive in Order No. 85724 in Case No. 9311 to obtain a PLR “that addresses
the ratemaking implications of the NOLC” and that PLR-148310-13 may be
appropriately relied upon to address NOLC issues in Case No. 9336, which we have
done.
IT IS THEREFORE, this 13th day of November, in the year Two Thousand and
Fourteen, by the Public Service Commission of Maryland,
ORDERED: (1) That Order No. 86441 is affirmed;
(2) That Pepco shall make the ratemaking adjustments required in Section IV. D.
113
114
MC Brief at 2-4.
MC Brief at 2-4.
27
of this Order regarding its September 2014 tax compensation payment in its next base
rate case; and
(3) That all motions not previously granted in this case are denied.
/s/ W. Kevin Hughes
/s/ Lawrence Brenner
/s/ Kelly Speakes-Backman
/s/ Anne E. Hoskins
Commissioners*
*Commissioner Harold D. Williams did not participate in this decision.
28