X. Only After-Tax Gains Considered
The OIR proposed that any rule we develop here apply only to after-tax gains. In this way, if a sale caused a taxable gain, we would only allocate the net proceeds after taxes were paid.
A. Comments - Taxation
The comments do not address the taxation issue, with one exception. ORA/TURN note that SCE includes the entire pre-tax gain in its "Other Operating Revenue" (OOR) account: "The inclusion of the entire gain in other operating revenue generates a reduction to the utility's taxable income that offsets the tax paid at the time of the gain . . . ."67
SCE states that it believes ORA, TURN and SCE share a mutual understanding and agreement with regard to the treatment of taxes in the allocation of gains and losses. SCE clarifies that tax treatment of gains/losses depends on whether the Commission adopts "flow-through" or "normalized" tax accounting.68
The California Supreme Court in Southern California Gas Company v. Public Utilities Commission, 23 Cal. 3d 470, 475-76 (1979) noted that the Commission's ordinary policy is to require flow-through, or cash-basis, tax accounting:
[T]he commission [has] generally taken the position that rates . . . should reflect only actual costs incurred. As taxes are treated as part of a utility's cost of service, any tax savings should not be retained by the utility but should be immediately passed on to the utility's customers. Accordingly, since 1960 the commission has required utilities to charge as operating expenses only the amount of taxes actually paid. Any savings acquired through the use of accelerated depreciation or the investment tax credit is to be immediately flowed through to the ratepayers.
Where flow-through tax accounting is used, SCE states that the Commission's gain on sale policy should "ensure that any tax benefits or detriments . . . passed along in rates to ratepayers are essentially `recaptured' by ratepayers before allocating the gains or losses to shareholders."69 SCE continues: "To accomplish this [recapture], shareholders' allocated gain or loss should be equal to the pre-tax gain or loss, minus the product of the composite income tax rate times the pre-tax gain or loss."
B. Discussion - Taxation
The rules we develop here apply to after tax gains and losses. While ORA/TURN advocate for a rule that allocates pre-tax gains, allocating gains after-tax makes more sense since taxes reduce or alter the actual gains or losses available for allocation to shareholders and ratepayers.
DRA/TURN assert that the draft decision errs in its discussion of the effect of taxation on gains and losses. We add language to clarify that gains and losses should be allocated to ratepayers on a net after-tax basis that is increased for income taxes paid by ratepayers that were associated with the cost of removal but not allowed as a deduction for income tax purposes. Allocating gains and losses to ratepayers on this basis ensures that any tax benefits or detriments that were previously borne by ratepayers are appropriately reflected into the allocated gain or loss amount. As SCE pointed out in its comments, California ratemaking practices do not utilize full normalization of income taxes. This gives rise to a situation where tax benefits are passed through to ratepayers at a different rate than are charges for depreciation because tax depreciation and book depreciation are not the same. For example, there are certain costs that are not normalized for income tax purposes, such as the cost of removing utility plant. These costs are immediately expensed through depreciation expense for accounting purposes, but are not allowable deductions for income tax purposes. The ratepayers are charged an additional amount to recover the additional income taxes associated with not deducting the removal costs on the utility's income tax return. Once the asset is actually sold, the ratepayer is made whole by receiving the gain on the sale, plus the income taxes that they had paid that were associated with the cost of removal.
The mechanism for the distribution of gains through OOR described by ORA/TURN and SCE derives from D.87-12-06670 and applies to the sales of land and timber. The distribution of the gain through this mechanism depends, among other things, on the amount of time the property was included in rate base. However, SCE's OOR from the sale of non-tariffed products and services is distributed in an entirely different manner through D.99-09-070.71
The distribution of OOR varies widely among the other utilities. It is beyond the scope of this proceeding to specify the precise method for distributing the gains to particular accounts such as OOR; our purpose here is to provide guidelines to help determine the amount of gain to allocate to each of the parties. This decision does not supersede D.87-12-066, nor does it recommend its mechanisms for the distribution of OOR to other utilities. Further, a tax treatment designed for a specific OOR distribution method should not be imposed on all methods. There is nothing in the statements of either SCE or ORA/TURN that would suggest we should apply these rules to anything other than after tax gains.
67 ORA/TURN Comments at 12-13.
68 There are two methods to account for income tax expense for regulatory purposes. Under the flow-through method, the income tax expense recognized for regulatory purposes during a given period is equal to the taxes that are assessed and paid during the period. Under the normalization method, the income tax expense for a given period is based on the net income recognized for regulatory accounting purposes during the period, regardless of when the taxes associated with the accounting income are actually paid. The flow-through method can be viewed as cash-basis accounting, while the normalization method reflects accrual accounting.
69 SCE Reply Comments at 15.
70 26 CPUC 2d 392, 410 (1987).
71 2 CPUC 2d 579, 605 (1999).
