[BETA] Fortnightly

The restructuring debate in the electric industry has focused on nuclear assets at risk for "stranding" under deregulation, while another issue has largely eluded public scrutiny: accumulated deferred federal income taxes (ADFITs). ADFITs represent money that utilities have received from ratepayers to cover federal tax expenses not yet actually recognized and paid. In sheer dollar amounts, ADFITs run well into the tens of billions; the amount might rival the sum of recoverable stranded costs.1 As such, ADFITs might well supply the pot of gold needed to liberate true competition from the ransom of stranded costs.

Under an accounting process called "normalization," the component of utility operating costs represented by federal income tax expenses and recovered by utilities through rates is computed as if the income reportable on the utility's federal return equaled income reported for regulatory purposes (book income). In fact, utilities historically have reported a lower income for tax purposes than book income, because the Internal Revenue Code (Code) permits utilities that use normalization accounting to claim accelerated depreciation and other deductions and credits not recognized for ratemaking purposes. Hence, the federal taxes actually paid by utilities have remained significantly less than the federal tax reimbursements they have received from ratepayers.2 Utilities have been recording the difference on the liability and equity side of their balance sheets to ADFIT (or, in the case of the investment tax credit, accumulated deferred investment tax credits (ADITC)).3 Utilities have not been required to segregate the resulting billions of dollars of ADFIT advances, nor have they been otherwise precluded from using them as operating capital (em merely to reduce rate base by their amount.

Phantom Taxes

ADFITs are monies received by utilities for the benefit of future ratepayers.

The Code has required utilities to use normalization accounting for accelerated depreciation and investment tax credits since the 1960s. Specifically, normalization requires utilities to flow the tax

benefits of accelerated depreciation and investment tax credits through to ratepayers over the useful life of the und erlying assets. Although normalization has been decried by consumer groups as a loop-hole that reimburses utilities for "phantom taxes" (i.e., taxes recovered from ratepayers but not remitted to the IRS), supporters of normalization have defended it on two counts.

First, flowing the entire tax benefit of accelerated depreciation and investment tax credits through to ratepayers immediately rather than over the useful life of the underlying assets would defeat the investment incentive intent underlying the Tax Code's accelerated depreciation and investment tax credit provisions. Second, normalization evenly spreads the tax benefits of utility plant over the life of the plant, thereby preventing today's ratepayers from hogging these benefits to the detriment of future ratepayers. In other words, the payback of excess tax costs after the "reversal" of the tax deferrals (i.e., when utility plant is fully depreciated for tax purposes but continues to be depreciated for regulatory purposes) will not be shouldered by future ratepayers, but by the utilities, ostensibly from the accumulated reserve.

The Legacy of Stranded Assets

For many utilities, the time to pay back those tax deferrals has arrived. The