2.2. Complainants
In 1979, Castlerock was organized to develop a subdivision of approximately 140 homes on a portion of the Markham Ranch. The subdivision, sited between Markham Lane and Corral de Tierra Creek, was styled "Phase 1 of the Palma Grove."
Bruce B. Breiholz, at the initial Castlerock Board of Directors' meeting October 12, 1979, had purchased 128 shares of Castlerock stock and had been elected corporate secretary. From 1986 to 1990, Breiholz was Castlerock's president. In a 1990 restructuring of Castlerock, Salvatore T. Palma became Castlerock president, and Breiholz transferred his Castlerock stock to Palma. In partial consideration for this transfer, a 50% interest in 12 acres of the Castlerock property was transferred to Monterey Palisades, Ltd., an entity of which Breiholz was a general partner.
Prior to October 1986, in general, when a developer applied to a public utility for a service extension to provide water or sewer service to a new area, the developer paid the utility contributions in the form of money or property, which were termed CIAC. These contributions were exempt from federal income tax and consequently had no effect on either the utility's ratemaking or its federal income tax.
In October 1986, Congress passed Public Law 99-514, the Tax Reform Act of 1986. This Act changed matters by requiring utilities to include CIAC in income for federal taxation purposes. As a result, unless the CIAC was "grossed-up" to account for the taxable effect of the contribution on the utility, the CIAC would not be adequate to compensate the utility for its construction costs, thereby requiring the utility, and ultimately its ratepayers, to absorb the shortfall.
Subsequently, the Commission instituted Investigation (I.) 86-11-019 to determine "methods to be used to establish the proper levels of expense for ratemaking purposes for public utilities and other regulated entities due to changes resulting from the Act." The investigation resulted in D.87-09-026, Re Tax Reform Act of 1986 (1987) 25 CPUC 2d 299, which allowed utilities to gross-up the amount of a developer's CIAC. The gross-up would make the total amount of the developer's contribution income neutral, thus mitigating the ratemaking effect of including the CIAC in the utility's taxable income. We considered five possible methods that had been proposed during the investigation. We concluded that two of the proposals were appropriate responses to the problem posed by the federal tax law change.1 We adopted Method 5 for most utilities, but allowed small water companies (such as Cal Utilities and Toro) and small telephone companies to use Method 2.2 Both methods further our goal of ensuring that the collections from the developer are revenue neutral to the utilities. This objective is reflected in D.87-09-026, Conclusion of Law 12, which provides:
If a utility is not in a taxable position in the year that it receives a contribution or refundable advance, there is no tax liability. The tax gross-up received from the contributor under Method 2 or Method 5 should then be refunded to the contributor. If a utility collects a gross-up using an incremental tax rate that is more than its incremental rate, as determined on a ratemaking basis, the difference between what was and what should have been collected should be refunded to the contributor.
Following a protracted permitting process, the Castlerock subdivision was approved. On February 23, 1988, Toro and Cal Utilities signed water and sewer main extension construction contracts respectively with Castlerock. Adcock signed for Toro and Cal Utilities, and Breiholz signed for Castlerock. Form E of the Toro and Cal Utilities tariffs' contracts were used. Each contract was for a non-refundable contribution of the facilities to be installed. Attached to each contract was a copy of each utility's respective Tariff Rule 15 on file with the Commission.
1 In D.87-09-026, we numbered the five proposals and referred to them by their numerical designations. The parties used those designations in this proceeding, and for convenience we will continue to use them in this decision. 2 Method 2 provides for complete gross-up by the contributor at the utility's incremental federal tax rate. That is, the contributor pays to the utility the amount of the contribution, as well as an amount equal to the utility's total federal tax liability on the contribution and the gross-up amount. Method 5 likewise requires the contributor to gross-up the contribution, but requires payment only of the net present value of the tax amount at the time of the contribution. We adopted uniform state-wide discount rates and pre-tax rates of return to make implementation of Method 5 consistent and easy to administer. In 1988, the year at issue here, Cal Utilities selected Method 2; Toro selected Method 5.
