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Tax Corner

Fortnightly Magazine - February 15 1995

of affected facilities were free to emit SO2, subject to any other applicable federal, state, and local laws and regulations. After that date the permissible level of such emissions was effectively halved; emissions must be matched on an annual basis by presenting allowance certificates to the Environmental Protection Agency. During Phase 1, affected facilities receive an allowance quota approximating half of their baseline emissions. So it is quite in line with normal tax policy to characterize the Table A allowances not as a gift, but as partial compensation for a "taking" of property by the government.

Utilities can earn extension and bonus allowances by installing scrubbers, but this strategy calls for a significant upfront investment. Of course, as with any other type of capital expenditure, the taxpayer can depreciate the investment over a period of years. But since the installed scrubbers literally create the extra extension and bonus allowances, proper tax policy should allow taxpayers to match any revenues from sales of extension or bonus allowances against the associated installation costs. Current tax treatment puts the utility in an untenable position if it wants to sell these extra allowances soon after receiving them. That utility will incur a large capital gain tax, yet must wait many years to fully depreciate the entire installation cost.

Immediate flow-through also raises questions of intergenerational equity. For either type of allowance, immediate flow-through would cut rates only for the year of sale, while future ratepayers would still incur costs. Immediate flow-through would also create a serious "rate shock" during the second year, when rates would climb back up.

Allegheny Power System and the Chicago Board of Trade have advocated, and the National Association of Regulatory Utility Commissioners has endorsed, legislation to correct this problem. Together we propose to allow selling utilities the option of deferring taxation by applying allowance sale proceeds to reduce the tax basis of the capital investment incurred to reduce SO2 emissions. This proposal would lower the depreciation expense (and, hence, increase income taxes) in each subsequent year over the useful life of the asset. The proposal does not eliminate taxation. It merely defers it. To prevent utilities from "gaming" the system, the gain that qualifies for deferral would be offset by any amounts the taxpayer expends to purchase allowances within two years of the sale.

These arguments should override any tax rule that might otherwise dictate recognition of income when property is converted to cash. The proposal would help achieve the objectives of the CAAA, removing most tax considerations from the decision to use or sell allocated allowances. By writing down the basis of pollution control equipment over time, the proposal would defer tax on the sale transaction and make tax policy more consistent between the "sell" and "use" strategies.

Moreover, our proposal would also even out the year-to-year flow-through of allowance sales proceeds to ratepayers. Flowing through all allowance proceeds to ratepayers in the year of sale risks potentially wild swings in utility bills. No reason exists to think that allowance sales will come in roughly equal amounts over time. In