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 payback will prove most difficult for those companies that, by virtue of their disproportionate investment in nuclear plant, have argued most vociferously for stranded-cost recovery. Indeed, stranded nuclear investment stands as a primary legacy of tax normalization.
Consider the extreme example of the Long Island Lighting Co. (LILCO) and its Shoreham nuclear plant.
LILCO abandoned Shoreham in 1989 after it was fully constructed at a cost of $5.4 billion and ready for operation. During construction, LILCO capitalized virtually all Shoreham-related costs for rate purposes, including financing and overhead costs. However, on its income tax books, LILCO had also expensed most of Shoreham's construction-related financing expenses and some of Shoreham's overhead costs. Moreover, LILCO never recognized the equity component of AFUDC (allowance for funds used during construction) as income for tax purposes. Finally, LILCO took investment tax credits for its Shoreham investment, without passing them along to ratepayers. Thus, Shoreham generated huge losses for tax purposes while generating income for ratemaking purposes. It took reimbursement for over $100 million in average annual imputed federal income-tax costs, even though its actual federal income tax costs were virtually nonexistent (see Table).
The disparity between the tax and book treatment of Shoreham-related expenses and income (yielding $875 million in excess tax reimbursements over seven years) caused a growing disparity between Shoreham's tax basis and its rate-base value. By 1989, when Shoreham was abandoned, its tax basis was only $1.8 billion, only a third of its $5.4-billion unadjusted rate base. When LILCO wrote off Shoreham, the net balance of ratepayer Shoreham-related ADFIT advances exceeded $1 billion.4 In other words, LILCO had collected more than $1 billion in federal tax-expense reimbursements over and above actual tax expenses.
The Argument for Ratepayer Recovery
Had Shoreham gone into service in the 1980s, its tax basis would now be depreciated close to zero. LILCO would be looking at a 20-year, $50-million annual after-tax cash crunch to reimburse ratepayers for their earlier ADFIT advances (see Chart).5
Other utilities with similarly disproportionate investment in nuclear plant have experienced similar reversals, or will in the future.6 In other words, they must now begin to pay back the tax advances they have been receiving from ratepayers.
First of all, this obligation to pay back prior deferrals must take center stage in the stranded-cost debate. Some treat this obligation as a liability that utilities owe to the Internal Revenue Service (IRS). But utilities have operated as a cost-plus industry; to the extent that they have been reimbursed by ratepayers above incurred costs they should owe restitution to their customers.
Second, utilities should not be permitted to retain ADFITs for their own benefit without an appropriate quid pro quo. Much of the restructuring debate has focused on moving generation assets out of rate base, into unregulated subsidiaries or divisions of utility companies. Unchecked, this shifting of assets could inequitably deny ratepayers recovery of their ADFIT advances.
When the telephone industry restructured, telephone carriers procured IRS private letter rulings that ADFITs could accompany assets transferred to unregulated operations instead of being refunded to the ratepayers who had advanced them.7 These rulings were based on a very rigid technical construction of governing statutes and regulations. State regulators should take steps to ensure that history does not repeat itself with electric industry ADFITs.
Third, ADFITs are easier to give than to receive. The IRS has rejected all efforts by state regulators to flow ADFITs through to ratepayers faster than utilities recover the cost of associated plant from ratepayers, or to permit ratepayers to recover any ADFITs associated with disallowed plant.8 At the same time, however, the IRS has approved a plan that permits a troubled utility to improve its common equity by, in essence, absolving it of its ADFIT obligation to ratepayers (specifically, its ADITCs). The IRS has also proved receptive to plans that permit shareholders to retain the benefits of ADFIT. So, although regulators cannot accelerate ratepayer recovery of ADFIT advances or flow the ADFIT benefits associated with deregulated assets through to ratepayers, they can allow utilities to renege on paying back ADFITs.
Fourth, ADFITs may be better to give than to receive. Although the issue requires further study, ADFITs might be the ideal currency with which to redeem true generation sector competition (em a currency worth more in the hands of the utilities than ratepayers:
s ADFITs act as an interest-free, long-term loan from ratepayers to shareholders. The discounted value of their anticipated payback to ratepayers is less than their stated balance sheet amounts.
s Although ratepayers have historically benefited because ADFITs reduced rate base, the shift to performance- and market-based ratemaking undermines the value of that benefit.
s Most important, the value of utility ADFIT obligations forgiven by ratepayers is probably not taxable income to utilities.
Fifth, if deregulation necessitates writing down nuclear generation plant to market value, regulators should offset any resulting shareholder obligation for "stranded assets" against ADFITs (see sidebar). This offset could also be applied to ADFITs associated with transmission and distribution plant, if the need should arise.
To argue the stranded-asset issue without putting ADFIT on the table is not only one-sided,
but ignores a solution that could benefit all parties. t
David Wise is president of WiseEnergy Inc. in Maplewood, NJ. He is a former senior attorney for Consolidated Edison Co. of New York and also spent four years as a trial attorney in the Tax Division of the Department of Justice. Mr. Wiseis incoming chair of the Federal Energy Bar Association's Tax Developments Committee.
Using ADFITs to Redeem Stranded Assets
Let's assume that nuclear utility XYZ has a net book value (i.e., original cost less depreciation) of $2.5 billion, a basis for income-tax purposes of $0, a market value under deregulation of $500 million, and ADFITs to the tune of $1 billion. XYZ's balance sheet for utility plant, at original cost, would look something like this:
Electric
Other that nuclear $6 billion
Nuclear plant $4 billion
Total: $10 billion
Less Accumulated Depreciation $3 billion
Net utility plant: $7 billion
Total: $7 billion
Capitalization and Liabilities
Capitalization
Shareholder Equity $2 billion
Long-term Debt $3 billion
ADFIT $2 billion
Total: $7 billion
If ratepayers pay 75 percent of XYZ's $2 billion in stranded-asset costs through ADFIT advances, and shareholder equity pays the rest, XYZ's balance sheet would look like this:
Electric
Other than nuclear $6 billion
Nuclear plant $0.5 billion
Total: $6.5 billion
Less Accumulated Depreciation $1.5 billion
Net utility plant: $5 billion
Total: $5 billion
Capitalization and Liabilities
Capitalization
Shareholder Equity $1.5 billion
Long-term Debt $3 billion
ADFIT $0.5 billion
Total: $5 billion
1. According to the Energy Information Administration's Composite Balance Sheet for Major U.S. Investor-owned Electric Utilities from 1990 through 1994, 1994 industry ADFITs totaled over $107 billion. One might reasonably assume that half this amount represented customer advances for ADFITs. ADITCs totaled another $12.7 billion.
2. The normalization requirements are contained in IRC secs. 167(I)(accelerated depreciation), 16(i)(9)(accelerated cost recovery system), and 46(f)(investment tax credit).
3. For the sake of convenience, the term ADFIT will include ADITCs.
4. In its aftermath, the Shoreham settlement has continued to generate large decommissioning costs, interim carrying costs, and other associated expenses that LILCO deducted for tax purposes but has capitalized for ratemaking purposes. As a result, LILCO has booked another $850 million of Shoreham-related ADFITs between 1990 and 1994. That means that LILCO has enjoyed a positive Shoreham-related ADFIT cash flow (i.e., tax reimbursements in excess of tax payments) approaching $2 billion.
In this author's opinion, the rights and obligations between shareholders and ratepayers connected with this accumulated $2 billion ratepayer advance (em and with the associated $2-billion tax obligation for embedded LILCO capital gains arising from the ratepayer bailout of LILCO's Shoreham-related debt (em had never been fully sorted out. A recent article notes that the $2-billion tax obligation now marks the principal impediment to the proposed public takeover of LILCO. "Lilco Deal Faces Huge Tax Liability," New York Times, June 2, 1996. Curiously, the connection between this capital gains liability and the ADFITs has so far escaped public debate.
5. For the sake of clarity, the sidebar does not deal with the issue of excess ADFITs from the reduction in the maximum marginal corporate income tax rate in the Tax Reform Act of 1986, from 46% to 34%. With that rate reduction, pre-1987 accruals of deferred taxes exceeded the amount needed to pay back taxes at the lower, post-1986 rate.
6. Utilities with a more balanced capital investment spread can (and do) effectively defer this reversal perpetually by continuing to make new capital investments subject to accelerated depreciation.
7. Priv. Ltr. Ruls. 8920025, 8836052.
8. See, e.g., Priv. Ltr. Ruls. 96-13-004, 95-47-008, 95-52-007, 93-12-007, and 90-41-051.
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