XIII. Water Division Audit Report
A. Background
San Gabriel has two divisions: the Fontana Division and the Los Angeles County Division. In the last Fontana Division rate case decision, D.04-07-034, we ordered our Water Division to audit, prior to Fontana Division's next general rate case, all sale and condemnation proceeds received by San Gabriel from 1996 onwards. Although D.04-07-034 only pertained to the Fontana Division, the proceeds at issue also included proceeds from the Los Angeles County Division. Additionally, in the last Fontana Division rate case, the City of Fontana raised the issue of whether proceeds received by San Gabriel from condemnation, service duplication, and lawsuit settlements related to water contamination had been properly accounted for. This was also part of the Audit Report.
The major findings of the Audit Report are summarized as follows:
· San Gabriel received $27,811,312 in gain from various transactions during the years 1996 to 2004 from:
Fontana |
Los Angeles |
Total | |
Water contamination (Non-CIAC) |
$ 8,559,863 |
$ 11,081,498 |
$ 19,641,361 |
Service duplication |
$ 2,314,538 |
$ 1,500,000 |
$ 3,814,538 |
Sale on condemnations |
$ 2,520,148 |
$ 709,373 |
$ 3,229,521 |
Sale to private property owners |
$ 507,199 |
$ 618,693 |
$ 1,125,892 |
Total |
$ 13,901,748 |
$ 13,909,564 |
$ 27,811,312 |
· San Gabriel claims that the $27,811,312 proceeds were reinvested in water plant infrastructure in accordance with Section 790.
· Most of the $27,811,312 proceeds do not qualify under Section 790.
· $27,456,307 in net proceeds should be allocated to ratepayers.
· If the Commission accepts San Gabriel's claim that the proceeds qualify under Section 790, San Gabriel did not reinvest the proceeds in Section 790 plant infrastructure.
· $40,855,200 in dividends was paid to shareholders during 1996 to 2004. San Gabriel would not have been able to pay these dividends without the $27,811,312 proceeds received during those years.
San Gabriel asserts that it has accounted properly for the proceeds of all the relevant transactions, has complied with all recordkeeping requirements of Section 790, and properly has reinvested the proceeds in utility plant on which it is entitled to earn its authorized rate of return. It says if the Commission determines that some portion of those transactions and proceeds are not governed by Section 790 or the gain on sale OIR decision (D.06-05-041), the disposition of proceeds should depend on the relative risks and burdens borne by shareholders and ratepayers.
In 1995, the California Legislature adopted the Water Utility Infrastructure Improvement Act to address the challenge facing California's investor-owned water utilities to invest in new infrastructure, plant, and facilities to comply with increasingly strict safe drinking water laws and regulations, to develop new and existing sources of supply, and to replace or upgrade existing infrastructure, plant, and facilities. Pub. Util. Code § 789.1(a)-(e).
In Phase II of Rulemaking (R.) 04-09-003, we are examining the regulatory treatment of gains that result from the disposition of property as a result of condemnation, sales under threat of condemnation, and proceeds from inverse condemnations. We will defer judgment on the regulatory treatment and the application of Section 789-790 to these proceeds to that proceeding.
We now turn to the Audit Report.
Overall, the Audit Report addresses $27,811,312 in proceeds San Gabriel received from four categories of transactions during the years 1996 to 2004 in both the Company's operating divisions. By far the largest portion of this total was proceeds from contamination claims not classified as CIAC - $8,559,863 in the Fontana Division and $11,081,498 in the Los Angeles County Division. In both instances, the contamination proceeds at issue were above the amounts reimbursed to the Company for the costs to design, build, and operate wellhead treatment facilities; all of those reimbursements were recorded as CIAC rate base adjustments (for capital) or used to reduce customer revenue requirements (for O&M expenses). Another $2,314,538 in Fontana Division and $1,500,000 in Los Angeles resulted from service duplication claims. Lesser totals resulted from sales in connection with condemnations and sales to private property owners, respectively.
The Audit Report claims that, contrary to San Gabriel's contention, most of the proceeds at issue did not qualify under Section 790 - that is, they were not the proceeds of sales of real property. To whatever extent the proceeds did qualify under Section 790, the Audit Report asserts that San Gabriel failed to reinvest those proceeds in accordance with the statutory requirements. The Audit Report recommends that all of the $27,811,312 in proceeds from the four classes of transactions except for $355,005 in retired plant - a total of $27,456,307 in net proceeds - plus an unspecified amount of interest should be allocated to ratepayers.
Noting that San Gabriel paid more than $40 million in dividends from 1996 to 2004, the Audit Report argued that San Gabriel could not have paid those dividends without the $27,811,312 in proceeds that were the focus of the staff audit. The dividend payments contradict San Gabriel's claim that those proceeds were reinvested in Section 790 plant. The Audit Report recommends that even if the proceeds qualify under Section 790, the net proceeds of $27,456,307 must be allocated to ratepayers.
2. Applicability of Gain on Sale
Rulemaking D.06-05-041 in R.04-09-003
On May 25, 2006, the Commission issued its opinion regarding allocation of gains on sale of utility assets. (D.06-05-041.) In that decision, we adopted a process for allocating gains (and losses) on sale received by certain electric, gas, telecommunications, and water utilities when they sell utility land, assets such as buildings, or other tangible or intangible assets formerly used to serve utility customers. In D.06-05-041, we deferred the issue of gains resulting from condemnation, sales under threat of condemnation and inverse condemnation. That phase is currently underway and we defer determining this issue in this proceeding until we have articulated our broader policy.
In most cases, utility ratepayers should receive 100% of the gain from depreciable property such as buildings. Ratepayers and shareholders, however, will split the gain from non-depreciable property such as land and water rights. We said, though ratepayers bear most of the risk associated with such property, a 67% - 33% allocation is a fair and reasonable outcome, partly to compensate for some financial risk borne by the utility, and partly as an incentive to utility management to manage its assets wisely.
The decision provides interpretation of the Water Utility Infrastructure Act 1995, § 789 et seq. We found that the Legislature intended the Act to give water companies certainty on how to allocate gains on sale, and to limit Commission flexibility in allocating such gains. We said the statute does not limit our ability to impose record keeping requirements on the water companies to ensure they give notice of planned sales and of how they would invest proceeds from the sale of formerly used and useful utility property in new infrastructure, and we imposed such requirements. We also discussed the treatment of proceeds attributable to property purchased with funds that did not come from the water company, such as developer funds and contamination litigation proceeds.
We said "unless otherwise stated, we also intend the answers to the generic gain on sale questions to apply to water utilities." (D.06-05-041, p. 12.) And we concluded "that incidence of risk is the best determinant of how to allocate gains and losses on sales." (Id., p. 26.) We found that the Uniform System of Accounts (USOA) accounting categories, while necessary to ensure that utilities maintain their books in a consistent manner, do not control gain on sale allocation. (Id., p. 41.) We reviewed the Infrastructure Act in great detail, but did not resolve all issues. We said contamination proceeds do not involve sales of real property, so the Infrastructure Act does not apply, nor are such proceeds gains on sale; such proceeds are outside the scope of that proceeding. (Id., p. 69.)
San Gabriel took a prominent role in commenting on condemnation gains and involuntary conversion gains. It referred to two types of condemnation for which it contends the utility should receive the proceeds. First, utilities routinely sell property as a result of condemnation or under the threat or imminence of condemnation by a city or other governmental agency. Second, water utilities may also receive proceeds from inverse condemnation under the "Service Duplication Law," Pub. Util. Code § 1501 et seq. Such condemnations occur when the government constructs water facilities that duplicate the facilities of a private water utility. Under § 1503, the private utility is entitled to compensation for the reduction in value of its property even where the government does not physically acquire the utility property. In both cases, San Gabriel contends the proceeds should be treated as sales proceeds, and the gain or loss passed to utility shareholders. San Gabriel claims such treatment is consistent with the USOA, generally accepted accounting principles (GAAP) and federal and California income tax rules.
San Gabriel seeks too much. We have consistently maintained that accounting provisions do not control the ratemaking policies which we may determine to be reasonable and necessary; nor are income tax rules controlling. We noted in D.06-05-041 that we had received a great deal of comment on the condemnation (including sale under threat of condemnation) issue; we found the issue requires further consideration. We deferred consideration of this issue to a second, narrowly focused phase of R.04-09-003 proceeding. (Id., p. 77.)
When private parties seek to purchase easements or real property in connection with planned improvements, San Gabriel determines if the property is no longer necessary or useful to the company for public utility service. The 24 sales to private parties in the Fontana Division during years 1996 to 2004 mainly involved release of easements or rights of way with lines damaged, threatened, or rendered unusable or hazardous by grading and construction operations. The Water Division agrees these properties were no longer necessary or useful and that the $507,199 San Gabriel received from property sales to private owners is governed by Section 790. We, also, agree.
When a government agency informs San Gabriel that a public improvement project requires acquisition or condemnation of San Gabriel's property, San Gabriel's normal practice is to work out a reasonable settlement and a voluntary sale. San Gabriel documented the circumstances of all ten such transactions between San Gabriel and the City of Fontana, the City of Rialto, or Caltrans, (as well as a minor access agreement with the County of San Bernardino), that were entered into during the years 1996-2004.
We received a great deal of comment on the condemnation (including sale under threat of condemnation) issue in R.04-09-003, our Gain on Sale rulemaking. In D.06-05-041, we determined that the issue requires further consideration and, perhaps, briefing. We therefore defer consideration of this issue to a second, narrowly focused phase of that proceeding. That phase is currently underway and we defer determining these issues in this proceeding until we have articulated our broader policy in R.04-09-003.
California law treats a government agency's duplication of the service or facilities provided by a privately-owned water utility as a taking of the property of the private utility to the extent it renders the private utility's property useless, inoperative, or reduces its value, and provides for payment of just compensation. (Pub. Util. Code § 1501 et seq.) San Gabriel argues that in past cases, even if the public agency did not physically acquire any of the utility's property, the Commission has directed the utility to account for such payments as proceeds of a sale. San Gabriel Valley Water Co. v. Montebello (1978) 84 Cal. App.3d 757, and Re San Gabriel Valley Water Co., D.92112 (hereinafter Montebello).
The amount in controversy is $2,314,538. San Gabriel claims that these service duplication proceeds qualify under Section 790. DRA and the Audit Report conclude that the $2,314,538 does not qualify as Section 790 proceeds because it was not the result of the sale of real property. There was no real property sale between San Gabriel and the City of Fontana. The settlement agreement with the City did not provide for any transfer of title or interest of property or rights to the City. Instead, the settlement paid San Gabriel just compensation under inverse condemnation by service duplication under § 1501 et seq.
San Gabriel contends these proceeds are treated under the California Code of Civil Procedure and under state and federal tax laws as inverse condemnation damages and, pursuant to Pub. Util. Code § 1501, et seq., as an involuntary sale of property. San Gabriel reads the Montebello case as one in which the Commission instructed San Gabriel to account for the damage award proceeds in a service duplication case the same as the proceeds of a sale and allocating all gain to the Company, even though no physical property changed hands. San Gabriel asserts that it has consistently accounted for all compensation from condemnations, including inverse condemnations, in accordance with this Commission's directive, i.e., as a sale of real estate. Accordingly, irrespective of whether the service duplication damages judgment is classified as Section 790 proceeds, the Audit Report is wrong in concluding that the $2.3 million judgment the City of Fontana paid San Gabriel should be allocated to ratepayers or treated as CIAC.
We will also defer the determination of what to do with the proceeds resulting from inverse condemnations. This issue is before us in R.04-09-003 and we will defer judgment on how to deal with these types of condemnations to that proceeding.
On November 10, 1998, San Gabriel entered into a settlement with the County of San Bernardino (County) where the County agreed to pay San Gabriel compensation for damaging San Gabriel's property by contamination from the County's Mid-Valley Sanitary Landfill. San Gabriel reported that it received, for the period 1998 to 2004, $8,559,863 from the County. These proceeds are comprised of the following:
Compensation for damages from 3/1/97 to 12/31/99 $4,052,449
Costs to construct Plant F-10 remediation facilities 3,996,455
Delay in restoring Plant F-10 to full service 455,959
Additional damages (addendum agreement) 55,000
Total $8,559,863
In addition, the County promised to pay San Gabriel for the actual costs to operate and maintain the Plant F-10 facilities after they were completed. For the period May 2000 to December 2004, San Gabriel incurred $1,242,057 in actual operating and maintenance costs, and the County reimbursed the costs entirely. Those reimbursed expenses were recognized in the last Fontana GRC. Although they were included in test year expense estimates, they were offset by the inclusion of estimates for the reimbursed revenue, and therefore revenue neutral for ratemaking purposes.
Of the $8,559,863 proceeds received from the County, $4,107,449 ($4,052,449 plus $55,000) represented compensation for damages resulting from water contamination from the County's Mid-Valley landfill. San Gabriel reported no plant assets had to be retired because of the water contamination. San Gabriel, however, did not consider these proceeds as CIAC, and thus, recorded these proceeds into a miscellaneous surplus account.
San Gabriel documented through its job orders that it cost $2,618,291 to construct the treatment facilities for Plant F-10. The Water Division reviewed Plant F-10 construction work orders and determined that San Gabriel was correct. In the last Fontana GRC, D.04-07-034 classified the $2,618,291 as CIAC for ratemaking purposes, and accordingly reduced rate base by the same amount. Although, San Gabriel intends to continue classifying the $2,618,291 as CIAC for ratemaking purposes in the current Fontana GRC, the Water Division found that San Gabriel has not adjusted its accounting records to record the reimbursement as CIAC.
There is an excess of $1,834,123 ($3,996, 455 plus $455,959 received in settlement minus $2,618,291 costs) in proceeds earmarked for Plant F-10 treatment facilities, which San Gabriel received, but did not use for building Plant F-10 treatment facilities. San Gabriel claims that any excess proceeds were reinvested in Section 790 plant infrastructure.
Excluding $2,618,291 of costs to build Plant F-10 treatment facilities from $8,559,863, there is an excess of $5,941,572 that San Gabriel received in the settlement. San Gabriel claims to have reinvested all excess proceeds in Section 790 plant infrastructure.
The Audit Report states that San Gabriel deposited the water contamination proceeds into its general bank account and then commingled these proceeds with all other funds received by San Gabriel. San Gabriel did not set up a memorandum account to track the proceeds received against funds spent. The Water Division was not able to track the spending of the proceeds against funds spent because San Gabriel could not provide appropriate documentation of how it accounted for the funds, segregated them, or otherwise tracked the money. Even if the contamination proceeds qualified under Section 790, without a means of tracking the proceeds to the invested infrastructure by the use of a memorandum account, or by some other equivalent record-keeping system, the Water Division concludes that San Gabriel has not met its burden of showing that it complied with Section 790 by reinvesting the $8,559,863 water contamination proceeds in plant infrastructure. DRA, the City, and the District all support allocating the entire $8,559,863 to CIAC, with no deduction for litigation expenses or taxes.
San Gabriel not only disagreed with the demand that all contamination gains should be allocated to the ratepayers, but asserted that all gains should be allocated to the shareholders.
San Gabriel argues that water rights are real property under California law, and that the County effected a taking of San Gabriel's water rights by rendering them useless due to the contamination that resulted from the County's landfill operations. This amounts to an inverse condemnation and is no less a sale of real property within the meaning of Section 790 than was the assignment of groundwater contamination damage claims approved by the Commission as a Section 790 sale in the recent Southern California Water Company case concerning the Charnock Basin. (Re Southern California Water Company, D.04-07-031.) Therefore, San Gabriel claims the proceeds received from the settlement of its groundwater contamination claims against the County qualify as a sale of real property, and are subject to reinvestment in utility plant pursuant to Section 790.
San Gabriel's argument is without merit. Its contamination lawsuit was a claim for damages; the settlement damage payment was not a sale of real property nor did it result in a sale.
In the case before us there is no sale of water rights (or any other property). San Gabriel's ratepayers have paid maintenance, depreciation, and return on facilities made useless by the contamination. Following Southern California Water Co., we could award all the gain from damages received from contamination suits to the ratepayers, but we believe the better course is to allocate the net proceeds between ratepayers and shareholders.
In D.06-05-041 we found that contamination proceeds were not sales of property and hence outside of the scope of that proceeding. As a result, there is no overriding policy guidance regarding how to treat these proceeds and the allocation between ratepayers and shareholders must be done on a case by case basis. That being said, the reasoning articulated in D.06-05-041 and D.06-12-043 regarding the allocation of risks and gains is a useful analysis.
We acknowledge that the property damaged was owned by the shareholders of the utility and they deserve compensation for the damages to this property. However we also acknowledge that ratepayers were also harmed by the damages to these utility properties and that they, too, should receive benefits of these awards for damages. We also seek to create a strong incentive for the utility to aggressively pursue compensation for contamination and believe that allocating 33% of such damage awards or settlements to shareholders provides just such a strong incentive.
This allocation, 67% to ratepayers and 33% to shareholders mimics the allocation of gain on sale of real property that was determined in D.06-05-041 and D.06-12-043. We find that, in this case, the risk analysis associated with contamination is similar to that of real property and thus believe that a similar allocation of the net proceeds is warranted. San Gabriel shall book the 67% of the proceeds of contamination to CIAC, resulting in a corresponding reduction in the rate base of the utility upon which it earns a return.
Section 851 provides, in relevant part:
No public utility...shall sell...any part of its...property necessary or useful in the performance of its duties to the public...without first having either secured an order [or] obtained a resolution from the commission authorizing it to do so....Every sale...made other than in accordance with the [order or] resolution from the commission authorizing it is void....Nothing in this section shall prevent the sale...by any public utility of property that is not necessary or useful in the performance of its duties to the public....
San Gabriel's position is that it is not required by Section 851 to obtain Commission approval for the various sales of real property, including facilities and easements, to government agencies by condemnation or under threat or imminence of condemnation or to private property owners, because in each case San Gabriel had acted pursuant to an engineering memorandum prepared by a San Gabriel engineer documenting the status of the property as "no longer necessary or useful to the company in the performance of its obligations as a public utility."
San Gabriel argues that once a government agency elects to condemn the utility's property, and adopts a resolution finding the agency's planned use more necessary than the utility's, the agency's finding of necessity is not rebuttable, and the only remaining issue normally will be the amount of compensation to be paid. Neither the Company nor the Commission has the ability or authority to prevent such an involuntary sale, and the condemning authority has no need to obtain the Commission's permission to take the utility's property. San Gabriel contends that neither the Audit Report nor any of the parties refuted San Gabriel's showing of the impracticality and futility of applying Section 851 to sales under threat of condemnation as if condemnation was not impending. The Commission should look realistically at these situations and understand that the Commission does not have the legal ability to stop or delay a direct or inverse condemnation action by invoking Section 851.
DRA reads Section 851 to mean that utilities must first gain Commission authorization before selling, leasing, or disposing of any of its property that is either necessary or useful in the performance of its duties to the public. Without such authorization, such transactions are void. DRA says it is unacceptable to classify a property as "no longer, necessary or useful" to satisfy Section 790 simply because it is being threatened by imminent condemnation. Many of the properties sold under threat of condemnation were necessary or useful up to the point of the condemnation proceeding. The very fact that San Gabriel received condemnation proceeds for this property reflects the reality that the property had value at the time of condemnation. Thus, DRA concludes that since San Gabriel sold properties that were still necessary or useful, San Gabriel should have complied with Section 851 prior to sale.
We need not decide whether or not the property sold under threat of condemnation was necessary or useful. No party is seeking to void the transactions. Section 851 is not applicable to this proceeding. It is the allocation of gain from the condemnations that concerns us.
San Gabriel deposited the sales proceeds in a general checking account and claims the proceeds were later reinvested in Section 790 plant infrastructure. San Gabriel, however, did not track these proceeds in a memorandum account. DRA contends that without a means of tracking the proceeds to the invested plant infrastructure by the use of a memorandum account, or by some other equivalent record keeping system, San Gabriel has not met its burden of showing that it complied with Section 790 when it reinvested in plant infrastructure the $507,199 gain from sales to private properly owners.
San Gabriel treated its condemnation proceeds as it did its property sale receipts by depositing them in a general checking account, and thus commingled them with other cash deposits not related to condemnations. The Water Division reviewed job cost sheets and work authorizations, journal entries, and general ledger postings which San Gabriel claimed would support its investments into plant infrastructure during 1996-2004. The job cost documents disclosed the amounts actually spent on these projects, but did not indicate the funding sources. Some of the projects commenced at a time before San Gabriel even received the proceeds. San Gabriel paid for these projects from its general checking account, where funds came from a variety of sources.
DRA contends that without a means of tracking the proceeds to the invested plant infrastructure by the use of a memorandum account, or by some other equivalent record keeping system, San Gabriel has not shown it has complied with Section 790 by reinvesting in plant infrastructure $2,520,148 of gain from condemnation proceeds.
DRA contends that even if the service duplication proceeds were Section 790 proceeds, San Gabriel deposited the $2,314,538 into its general bank account and commingled these proceeds with all other funds. San Gabriel claims that these proceeds were later reinvested in Section 790 plant infrastructure, but San Gabriel had not established a memorandum account to track proceeds received or funds spent. In DRA's opinion there is no proof the proceeds were set aside or otherwise segregated so that they could be properly tracked. Without a means of tracking the proceeds to the plant infrastructure by the use of a memorandum account, or by some other equivalent record keeping system, DRA concluded San Gabriel has not shown it has complied with Section 790 by reinvesting in plant infrastructure $2,314,538 of service duplication proceeds.
San Gabriel maintains that the $8,559,863 of water contamination proceeds are Section 790 proceeds, and claims to have reinvested those proceeds in Section 790 plant infrastructure. To support this, San Gabriel provided a list of completed job orders as evidence of its reinvestment in plant infrastructure in compliance with Section 790.
The Water Division reviewed the job orders, and noted that the dates of the orders ranged from 1996 to 2002, which corresponds to the time San Gabriel received the contamination proceeds. There were, however, no indications that any of the job orders were directly funded by the proceeds, nor were any of the job orders for contamination-related purposes. The job orders were primarily for general improvements: installation of equipment such as fire hydrants, valves, and piping.
San Gabriel does not deny that it commingled all proceeds from the four categories of gains, nor does it deny that it did not record the gains in memorandum accounts. But it strenuously asserts that every penny received was invested in plant, and it provided confirming documents.
We have reviewed San Gabriel's job orders and find that San Gabriel has clearly established that it has maintained detailed records sufficient to document its investment in utility plant of the net proceeds of property sales, contamination recovery, condemnations, and involuntary conversions. Absent guidance or orders from the Commission, San Gabriel provided what it considered appropriate to comply with Section 790. Therefore, to the extent Section 790 is applicable to the proceeds at issue, San Gabriel has reinvested those proceeds in water system infrastructure necessary or useful in performance of its duties to the public, and those proceeds should remain in San Gabriel's rate base.
C. Accounting Classifications
The proceeds of all four classes of transactions were deposited in San Gabriel's general bank account, and invested in what the Company considered to be Section 790 utility property. The Audit Report concluded that San Gabriel's recordkeeping for net proceeds from sales and condemnations was inadequate, because it did not protect against commingling of those proceeds with other Company funds and so did not ensure that all proceeds were invested in utility plant. Apparently the Audit Report would require an accounting system to ensure that the very same dollars received in proceeds are reinvested in the water system infrastructure - a concern which is both meaningless and unusual.
San Gabriel treated not only sales to private parties and to governmental agencies but also involuntary conversions by condemnation, service duplication, and contamination as sales of real property for accounting, tax, and ratemaking purposes. The proceeds were listed in San Gabriel's federal and state income tax returns.
The outstanding accounting issues are limited to deciding whether San Gabriel should be required to amend its general ledger and prior years' financial statements. We find that because neither of the requested accounting changes would have any ratemaking consequences but would impose costs and difficulties on the Company, we will not require them.
The need for tracking derives from the requirement of Section 790(a) that "[f]or purposes of tracking the net proceeds and their investment, the [utility] shall maintain records necessary to document the investment of the net proceeds . . . ." San Gabriel's method of tracking the proceeds of various transactions was to deposit the proceeds in the Company's general bank account and invest it in utility property. San Gabriel's documentation tracked the investment of the proceeds by job numbers, referring to utility plant investments made within one year, and exceeding in each case the amount of the proceeds.
The Audit Report contends that because San Gabriel did not establish a memorandum account in which to record proceeds of sales and condemnations, it was unable to determine whether the funding for plant infrastructure came from such proceeds or from operations. Further, out of concern that commingling the proceeds with other cash allows a utility to apply them for non-Section 790 purposes and then replenish the account with other funds, the Audit Report recommended that the Commission require that all such proceeds be deposited into a special bank account restricted to Section 790 investments.
The Audit Report exalts form over substance. Although a memorandum account would be easier to review than San Gabriel's method, we had not required San Gabriel to utilize one for Section 790 proceeds. The records San Gabriel did keep were adequate to show the receipt of funds and the expenditure of funds. Those records are in evidence which we have reviewed and find adequate. We had no trouble following the money trail. The Audit Report standard that the exact dollars received must be the ones expended on Section 790 plan is meaningless. Nor is it reasonable to have San Gabriel open separate bank accounts for Section 790 proceeds. We should not add workload and costs to no benefit. While Section 790 does not require a memorandum account, San Gabriel does not oppose establishing a memorandum account for Section 790 purposes on a going-forward basis. We will require one.
The Audit Report includes an analysis of San Gabriel's cash flows (including both Los Angeles and Fontana Divisions) over the years from 1990 to 2004, concluding that San Gabriel would have had a cash shortage after paying dividends but for the cash gains described above. The Audit Report contends that payment of over $40 million in dividends during the years from 1996 to 2004 calls into question the investment in Section 790 plant and asserts instead that those proceeds were used to pay dividends. This is one of the bases for the Audit Report's recommendation that $27.5 million plus interest be allocated to ratepayers.
San Gabriel strongly objected to the allegation that the gains were paid out as dividends. It maintains it always had reinvested the net proceeds in utility plant consistent with Section 790. It refers to legal counsel memoranda giving instructions to reinvest the net proceeds in utility property, and notes that the Company consistently used the net proceeds as its primary source of capital for new projects. San Gabriel's expert testified that the Company's dividends originate from net income, and demonstrated that San Gabriel has had adequate accumulated earnings for all of the dividends it paid during the period identified in the Audit Report.
San Gabriel's expert said that the Company had a consistent dividend policy to pay dividends equaling about 6% of average common stock equity. The only exception was in 1999, when a special dividend of $4,960,800 was paid from the Company's unrestricted accumulated net earnings, not from proceeds received during that year from the County of San Bernardino which had been directly invested in construction projects. He analyzed San Gabriel's cash flows over the years 1990 to 2004 and concluded that the Company had more than sufficient cash flow from its operations alone to pay shareholder dividends, aggregating $51,026,400, over the 15-year period.
We have independently analyzed San Gabriel's retained earnings, and, assuming no Section 790 issue, we would find that the Company's annual earnings, excluding capital gains and extraordinary items, have been sufficient to pay its annual cash dividends. But the Section 790 issue is the crux of the problem.
During the period 1996 through 2004 San Gabriel paid dividends of $40.9 million. During the same period San Gabriel received $27.8 million in gains from sales, contamination, etc. During that same period, after making its investments in plant which included the $27.8 million gain, San Gabriel had approximately $41.0 million available to pay dividends.2
The audit report concludes the approximately $27.8 million gain was not entirely Section 790 funds to be invested in plant for the account of San Gabriel, and that the ratepayers in the Fontana Division were entitled to $13,343,000 million of that gain. Had San Gabriel sequestered the ratepayers' portion of the gain it would have fallen that amount short in its dividend payment. Rather than dividends of $40.9 million the maximum dividend would have been about $27.6 million. A slightly different analysis of the numbers shows that San Gabriel would have had a cash shortage of $43,088,611 after $51,026,400 in dividends during the years 1990 to 2004, if not for the fact that San Gabriel had received cash of $39,287,285, comprised of $35,179,336 in Other Net and $4,107,949 in Sale of Property Rights. Other Net plus sale of Property Rights include $27,811,312 in gains proceeds that San Gabriel received during 1996 to 2004 from contamination lawsuit settlements, service duplication, sale on condemnations, and sale to property owners. Of the $51,026,400 dividends paid during 1990 to 2004, $40,855,200 was paid during 1996 to 2004. San Gabriel would not have been able to pay $40,855,200 in dividends without the $27,811,311 cash inflow from gains proceeds which included $13,901,748 from the Fontana Division.
From this DRA contends that unless San Gabriel can explain how $40,855,200 in dividends can be paid to shareholders without using the $13,901,748 of Fontana Division proceeds, these proceeds were used for paying shareholder dividends. By using those proceeds to pay dividends, DRA believes San Gabriel had no intention to reinvest the $13,901,748 of Fontana Division proceeds in Section 790 plant infrastructure within the required eight-year period; Section 790 requires that the net proceeds and interest that is not invested after the eight-year period must be allocated solely to ratepayers. Therefore, DRA, the City, and the District recommend that San Gabriel allocate to Fontana Division ratepayers $13,901,478 in net proceeds, plus interest.
We agree with DRA that San Gabriel could only pay $40.9 million in dividends by using the gain proceeds. But San Gabriel's dividend payment did not affect its ability to serve. No harm was done. Section 790 is satisfied if the gain on sale of real property is invested in infrastructure. It is sufficient that the amount of gain can be tracked into utility infrastructure, by company "records necessary to document the investment of the net proceeds...." (Section 790(a).) To the extent that Section 790 applies to this case, we have found that San Gabriel's records meet the test of Section 790. DRA's recommendation is denied.
D. Allocation of Proceeds
The Audit Report, adjusted as shown in Ex. 64, identified the following proceeds and net proceeds (after retirements) from transactions relating to the Fontana Division:
Proceeds |
Net Proceeds | |
Proceeds of contamination claim |
$ 8,559,863 |
$ 8,559,863 |
Service duplication judgment |
$ 2,314,538 |
$ 2,314,538 |
Sales under threat of condemnation |
$ 2,520,148 |
$ 2,421,727 |
Sales to private parties |
$ 507,199 |
$ 431,004 |
Condemnation proceeds |
$ 22,500 |
$ 22,500 |
More proceeds of contamination claim |
$ 26,114 |
$ 26,114 |
TOTAL |
$ 13,950,362 |
$ 13,775,746 |
San Gabriel invested all the net proceeds in new plant necessary or useful for utility service. That new plant is included in the rate base on which San Gabriel has an opportunity to earn a return, except for the $2,618,291 investment in wellhead treatment facilities at Plant F-10, which the Commission already has deducted from rate base as CIAC (D.04-07-034). Thus, the present allocation of net proceeds from the various transactions is, in effect, $11,161,455 to shareholders and $2,618,291 to ratepayers.
San Gabriel states that in calculating net proceeds the Audit Report did not consider the legal and expert consultant costs incurred by San Gabriel in obtaining the proceeds and the income taxes that must be paid. San Gabriel says those factors are especially relevant with respect to the proceeds obtained in settlement of San Gabriel's claims against the County of San Bernardino in the Mid-Valley Landfill contamination case and against the City of Fontana in a service duplication case, and also with respect to the proceeds from sales under threat of condemnation. San Gabriel claims that $1,050,499 in legal costs attendant to these matters were never included in a memorandum account or recovered through rates. The only memorandum account authorized to accumulate such costs, the Water Quality Litigation Memorandum Account, was not established until 2002, after all costs relevant to the proceeds at issue had been incurred.
DRA opposes any reduction of net proceeds for legal costs. It points out that in prior rate cases, legal expenses were included in the determination of San Gabriel's rates. It refers to the Fontana Division rate case, D.04-07-034, which says "San Gabriel analyzed its outside legal costs over a 10-year period to develop an average, normalized estimate applicable to Fontana Division." (p. 22.) In that decision, the Commission adopted San Gabriel's estimate based on a 10-year average. Those ten years included the years in which the legal costs San Gabriel is attempting to utilize as an offset were incurred. Thus, DRA concludes, those costs have already been factored into base rates and have already been recovered. Those legal costs were not deferred on the Company's books in prior years, were not included in a memorandum account for future recovery, and were effectively recovered from ratepayers in base rates. DRA believes that to allow San Gabriel to now offset the net proceeds with legal costs would in effect allow San Gabriel to double recover the legal expenditures. Ratepayers should not be asked to reimburse San Gabriel twice for its litigation expenses.
San Gabriel responds that legal fees and other litigation expenses incurred in achieving a favorable settlement with San Bernardino County were not borne by ratepayers, predated the Commission's authorization of a Water Quality Litigation Memorandum Account, and occurred between rate cases, so the Company bore the entire cost and risk associated with that litigation. Therefore, ratepayers should now pay those costs.
We do not agree with DRA's double recovery theory. With respect to the contamination proceeds, we believe it is appropriate to allow the cost of litigation to be deducted from the awarded damages. The actual gain that resulted from the contamination sales, must account for the litigation expenses incurred to realize that gain. To do otherwise negates the concept of "net" proceeds.
For gains resulting from condemnation, sales under threat of condemnation and inverse condemnation resulting from service duplication we will determine the proper treatment of legal costs at the time we determine the proper ratemaking treatment. It is appropriate to do so at that time because the allocation of the gains may impact the determination as to whether legal costs should be deducted from the proceeds.
The Audit Report failed to deduct income taxes associated with its recommendation to allocate the net proceeds to ratepayers. San Gabriel contends the Audit Report's proposal is flawed because the Company is obligated to pay those income taxes.
All parties agree that San Gabriel has taken advantage of the tax avoidance provision of the IRC to the full extent permissible for its gains from contaminations and involuntary conversions.3 Internal Revenue Service (IRS) code § 1033 provides:
§ 1033. Involuntary conversions
(a) General rule. - If property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted -
(1) Conversion into similar property. - Into property similar or related in service or use to the property so converted, no gain shall be recognized.
(2) Conversion into money. - Into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent hereinafter provided in this paragraph.
(A) Nonrecognition of gain. - If the taxpayer during the period specified in subparagraph (B), for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, or purchases stock in the acquisition of control of a corporation owning such other property, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property or such stock. Such election shall be made at such time and in such manner as the Secretary may by regulations prescribe. For purposes of this paragraph -
(i) no property or stock acquired before the disposition of the converted property shall be considered to have been acquired for the purpose of replacing such converted property unless held by the taxpayer on the date of such disposition; and
(ii) the taxpayer shall be considered to have purchased property or stock only if, but for the provisions of subsection(b) of this section, the unadjusted basis of such property or stock would be its cost within the meaning Section 1012.
The Ninth Circuit has held that:
The purpose of this section relating to non-recognition of gain in the case of involuntary conversion of property due to condemnation is to relieve the taxpayer of unanticipated tax liability arising from the involuntary condemnation by freeing him from liability to the extent that he reestablishes his prior commitment of capital within the statutory period. Filippini v. U.S., C.A.9 (Cal. 1963), 318 F.2d 841, certiorari denied 84 S.Ct. 267, 375 U.S. 922, 11 L.Ed.2d 165.
This section is to be liberally construed to accomplish its purpose. (Davis v. U.S. CA.9 (Hawaii) 1979, 589 F.2d 446.)
It is uncontrovertible that the purpose of the statute being to "relieve the taxpayer of unanticipated tax liability" it follows that San Gabriel, having no tax liability, cannot charge the ratepayers for phantom taxes. The IRS has not challenged the tax liability; nor should we. We find there is no tax liability on the gains San Gabriel achieved from involuntary conversions and contaminations.
San Gabriel and DRA have presented their methods for calculating net proceeds. To calculate the net proceeds in each class of transaction, the book value, if any, must be deducted. Then legal costs must be deducted to provide the pre-tax net proceeds. Then the applicable income taxes should be deducted. (On the facts of this case we are not deducting taxes.) San Gabriel proposes in late-filed Exhibit 86a, that the appropriate tax factor, combining the effects of federal and state income taxes, is 40.746%. Thus, in San Gabriel's opinion, the net proceeds, net of income tax, are as follows:
Fontana Division |
Excess Proceeds |
Legal Costs |
Net Proceeds |
Net of Tax |
Contamination |
$ 8,559,863 |
$ 8,351,309 |
$ 4,948,485 | |
Service duplication |
$ 2,314,538 |
$616,835 |
$ 1,697,703 |
$ 1,059,569 |
Condemnation sales |
$ 2,421,727 |
$225,110 |
$ 2,196,617 |
$ 1,301,583 |
Private sales |
$ 431,004 |
$ 431,004 |
$ 255,387 | |
Condemnation order |
$ 22,500 |
$ 22,500 |
$ 13,332 | |
Contamination (more) |
$ 26,114 |
$ 26,114 |
$ 15,474 |
San Gabriel observes, if the Commission determines that some percentage of proceeds in one or more of the above categories should be allocated to ratepayers, that percentage should be applied only to the "Net of Tax" amounts.
Looking at the several classes of proceeds, based on the evidence developed in this proceeding we reach the following conclusions:
Sales to private parties: $431,004. San Gabriel fully documented the status of the properties involved as being no longer necessary or useful. These sales were made subject to Section 790 and San Gabriel satisfactorily tracked the receipt of proceeds and their reinvestment in water system infrastructure necessary or useful for utility service. These reinvestments should continue to be recognized as shareholder investments included in rate base.
Sales under threat of condemnation: $2,421,727. We defer determination of the regulatory treatment of proceeds from these sales under threat of condemnation until after our policy determination on the issue of gain on sales under threat of condemnation in Phase II of R.04-09-003. There is no income tax.
Condemnation proceeds: $22,500. This was an involuntary conversion by court-ordered exercise of the power of eminent domain. We defer determination of the regulatory treatment of proceeds from condemnation until after our policy determination on the issue of condemnation in Phase II of R.04-09-003. There is no income tax.
Proceeds of service duplication judgment: $2,314,538. This was an involuntary taking by service duplication resulting in payment by the City of Fontana to San Gabriel pursuant to a court judgment. We defer determination of the regulatory treatment of proceeds from service duplication judgment to Phase II of R.04-09-003. There is no income tax.
Proceeds of contamination claim: $8,559,863 plus $26,114, less litigation costs of $208,554. This was a claim for damages as a result of the destruction in whole or in part of the Company's property and water rights by groundwater contamination from the Mid-Valley Landfill resulting in payment by the County of San Bernardino to San Gabriel pursuant to a settlement. This is not a sale within the meaning of Section 790. For federal tax purposes the Company has considered this the destruction of its property. There is no income tax. The net proceeds of $8,377,923 will be divided 33/67 between shareholders and ratepayers.4
The total allocation of gain to ratepayers is $5,613,208, which should be recorded as CIAC. In D.04-07-034, we had allocated $2,618,291 of that gain to CIAC. The result of this decision is to add $2,994,917 more to CIAC which reduces rate base by an equivalent amount.
E. Ratemaking Effects
The ratemaking effects of the dollars allocated to ratepayers is to add those dollars to CIAC, thereby reducing rate base by that amount. This shall be done for rate base for TY 2006-2007 and going forward. In regard to the rate base utilized to compute the revenue requirement in D.04-07-034, the dollars allocated to ratepayers will be added to CIAC in D.04-07-034, thereby reducing rate base by that amount. The revenue requirement in D.04-07-034 will be recomputed and the difference in rates for the period July 17, 2004 through the effective date of this decision will be refunded to current ratepayers on a cents per ccf of use.
The rate base for this decision is $86,123,679. (Appendix A, p. 1.) The rate base for D.04-07-034 will be recomputed to reduce it by $2,994,582 (Appendix E, p. 2). The revenue requirement for D.04-07-034 will be recomputed to reduce it by $522,200. (Appendix E, p. 2.) The amount of the refund should be calculated to reflect this lower revenue requirement for the relevant time period.
F. Los Angeles County Division
The company shall file an advice letter effective January 1, 2008 to begin refunding these overcollected amounts. Adoption of a refund plan effective January 1, 2008 will help to mitigate the impacts to rates of the inclusion of Sandhill facility in ratebase and minimize the number of rate changes that ratepayers will face. The refund amount shall continue to accrue interest until such time as the amount is fully refunded to customers.
Section 790's applicability to San Gabriel's investments in plant has been decided in this case. However, the details that relate to the Los Angeles County Division ratemaking are not within the scope of this proceeding and only Fontana Division revenues and rates are affected. Accordingly, the parties have addressed only the status and ratemaking treatment of proceeds from surplus property sales and involuntary conversions affecting the Fontana Division. The proper forum for any ratemaking effects in connection with these transactions for San Gabriel's Los Angeles County Division will be the next GRC for the Los Angeles County Division.
2 See Ex. 16, Exhibit A, analysis of cash flows.
3 See, Ex. 48, Attachment 3b; Ex. 6, Attachment A1-2, A1-7.
4 Because $2,618,291 of this gain has been invested in Plant F-10 and recorded as CIAC only an additional $1,674, 697.50 should be added to CIAC.
($8,377,423 ÷ 2) - $2,618,291 = $1,570,421)
($8,377,423 x 67%) - $2,618,291 = $2,994,582)
