Appendix — Pacific Telephone & Telegraph Co. v. Public Utilities Commission

Supreme Court brief1978

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78-606 0 ETT ED?

€8- 6 Q 7 OCT 2 1978

Nos. 78- and 78- xen

MISHAEL RODAK, JR., CLERK

IN THE

Supreme Court of the United States

OcToBeR TERM, 1978

THE Pacirric TELEPHONE AND TELEGRAPH COMPANY,

Petitioner,

THE Pusuic UTILITIES COMMISSION OF THE STATE OF

CALIFORNIA, and Ropert BaAtINovicH, VERNON L,

STURGEON, RicHarD D. GRAVELLE, CLAIRE T. Derp-

RICK, and WILLIAM Symons, Jr., the members of

said Publie Utilities Commission, 7 AL.,

Respondents.

GENERAL TELEPHONE COMPANY OF CALIFORNIA,

Petitioner,

Vv.

THE Pusuic UTILITIES COMMISSION OF THE STATE

OF CALIFORNIA, ET AL.,

Respondents.

JOINT APPENDIX FOR PETITIONERS

INDEX

Page

AppenpDIx A

Orders of the Supreme Court of California Deny-

ing Petitions for RevieW 2... .sccrccccsecccacs 1A

Appenpix B

Decision No. 87838 of the Public Utilities Com-

mission of the State of California ............. 3A

Concurring Opinion of Commissioners Gravelle

er are rae a eer ee 70A

Dissenting Opinion of Commissioner Symons .. 71A

Dissenting Opinion of Commissioner Sturgeon . 73A

ApPpenpDIx C

Article VI of the Constitution ................ T5A

The Fourteenth Amendment to the Constitution 75A

Internal Revenue Code of 1954, as amended (26

U.S.C.):

EEE ecks 55 o04-sie genes enan ek ans 75A

SD I cca es puede uscwn agar eee T9A

I ct kas a gal waen nk can bares T9A

oan seg ek va amen 84A

Treasury Regulations on Income Tax (1954 Code)

(26 C.F.R.):

Bt eee rere ee re 85A

AppPEeNbDIx D

Internal Revenue Service Ruling Addressed to

Pacific Telephone & Telegraph ecole Dated

a EE boo hice Gok oe Ke a Reo 95A

Internal Revenue Service Ruling Addressed to

General Telephone Company of California Dated

Se ee EE nos eb i ave bedbatwoeselachusess 116A

AppEenpix E

Internal Revenue Service Rulings Addressed to

Pacific Telephone & Telegraph Company and

General Telephone Company of California Dated

July 27, 1978 and August 9, 1978 .............. 133A

ilnsecetcicin

APPENDIX A

;

APPENDIX A

Order Denying Alternative Writ

S. F. No. 23746

IN THE SUPREME COURT OF THE STATE OF CALIFORNIA

IN BANK

Tue Pacitric TELEPHONE AND TELEGRAPH Company, ETc.,

Petitioner

Vv.

Pusiic Utiuities Commission, Etc., et au., Respondents.

(Firep Jury 13, 1978)

Petition for writ of Review Denrep.

Richardson, J., is of the opinion that the petition should

be granted.

Motion for leave to intervene is dismissed as moot.

/3/ Brrp

Chief Justice

Order Denying Alternative Writ

S.F. No. 23743

IN THE SUPREME COURT OF THE STATE OF CALIFORNIA

IN BANK

GreNERAL TELEPHONE Company oF CALIFORNIA, Etc.

Petitioner,

Vv.

Pusuic Utinities Commission, Erc., er au., Respondents

Petition for writ of Review Dentep.

Richard, J., is of the opinion that the petition should be

granted.

Motion for leave to intervene is dismissed as moot.

/s/ Birp

Chief Justice

APPENDIX B

fala ta

APPENDIX B

Decision No. 87838

September 13, 1977

BEFORE THE PUBLIC UTILITIES COMMISSION

OF THE STATE OF CALIFORNIA

Application No. 53587

(Filed September 19, 1972)

In the matter of the Application of Tug Pactric TELEPHONE

AND TELEGRAPH Company, a corporation, for authority

to increase certain intrastate rates and charges appli-

cable to telephone services furnished within the State of

California.

Application No. 51774

(Filed March 17, 1970)

In the matter of the Application of Tae Pactric TELEPHONE

AND TELEGRAPH Company, a corporation for authority

to increase certain intrastate rates and charges appli-

cable to telephone services furnished within the State of

California.

Application No. 55214

(Filed September 30, 1974;

amended December 13, 1974)

In the Matter of the Application of The Pacific Telephone

and Telegraph Company, a corporation, for telephone

service rate increases to offset increased wage, salary

and associated expenses.

Case No. 9503

(Filed January 30, 1973)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, separations, prac-

tices, contracts, service and facilities of The Pacific

Telephone and Telegraph Company.

Case No. 9802

(Filed November 26, 1974)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, separations, prac-

tices, contracts, service and facilities of the telephone

operations of the Pacific Telephone and Telegraph

Company.

Case No. 9832

' (Filed November 26, 1974)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, costs, separations,

inter-company settlements, contracts, service, and fa-

cilities of Tue Pactric TELEPHONE AND TELEGRAPH Com-

pany, a California corporation; and of all the telephone

corporations listed in Appendix A, attached hereto.

Application No. 51904

(Filed May 15, 1970;

amended July 17, 1970)

In the Matter of the Application of General Telephone

Company of California, a corporation, for authority to

increase its rates and charges for telephone service.

Application No. 53935

(Filed March 28, 1973)

In the Matter of the Application of General Telephone

Company of California, 2 corporation, for authority to

increase its rates and charges for telephone service.

Case No. 9100

(Filed August 4, 1970)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, separations, prac-

tices, contracts, service and facilities of General Tele-

phone Company of California.

Case No. 9504

(Filed January 30, 1973)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, separations, prac-

tices, contracts, service and facilities of the telephone

operations of all the telephone corporations listed in

Appendix A, attached hereto.

Case No. 9578

(Filed July 3, 1973)

Investigation on the Commission’s own motion into the

rates, tolls, rules, charges, operations, costs, separations,

practices, contracts, service, and facilities of GENERAL

TeLEPHONE ComMpPANy or CaLirorniA, a California cor-

poration; and of Tue Paciric TELEPHONE AND TELEGRAPH

Company, a California corporation; and of all the tele-

phone corporations listed in Appendix A, attached

hereto.

(Appearances are listed in Appendix A.)

INDEX

Item

Title

Index

Normalization Accounting and IRC

Section 167(l)(3)(G)

Review of Cases and Background

Treasury Regulation 1.167(1)-(1)(h) (6)

IRC Sections 46(f)(2) and (3)

Assumptions

Evidence

Discussion

Accelerated Tax Depreciation

Investment Tax Credit (ITC)

Imputed Flow-through

Summary of Refunds and Rate Reductions

Pacific

General

Miscellaneous Contentions

Refunds and Reductions

IRS Ruling Request

Exceptions to Proposed Report

Epilogue

Findings

Conclusions

Order

List of Appearances

Table 1 (Pacific AD Refund Computation)

Table 2 (General AD Refund Computation)

Table 3 (Pacific ITC Refund Computation)

Table 4 (General ITC Refund Computation)

Table 5 (Pacific 1968 and 1969 Vintage

Flow-Through)

Appendix A

Appendix B

Appendix C

Appendix D

Appendix E

Appendix F

Table 6 (General 1969 Vintage

Flow-Through) Appendix G

Table 7 (General Adjustments for

Uncollected Revenues) Appendix H

Opinion

This is the latest, and hopefully the final, proceeding on

the long and tortuous road involving the regulatory rate

treatment of accelerated tax depreciation (which includes

asset depreciation range, class life system, salvage value,

and repair allowance) and the Job Development Invest-

ment Credit, now called the Investment Tax Credit (ITC),

for two major California telephone utilities, The Pacific

Telephone and Telegraph Company (Pacific), and General

Telephone Company of California (General). This pro-

ceeding results directly from the remand by the California

Supreme Court in City of Los Angeles v. Public Utilities

Commission (1975) 15 C 3d 680, which annulled that por-

tion of the rate increase granted Pacific in D.83162 dated

July 23, 1974 which related to accelerated tax depreciation

and ITC. (All other matters decided in D.83162 were af-

firmed by the court). This annulment also applied to Gen-

eral because in D.83778 dated November 26, 1974 General’s

accelerated tax depreciation and ITC were treated by this

Commission in the same manner as was Pacific’s in D.

83162.

At the time the above decision was filed by the court,

there was under submission another rate increase proceed-

ing for Pacific, A.55214, in which we issued D.85287 on

December 30, 1975. D.85287 granted a rate increase sub-

ject to refund to provide for any adjustment in the rates

that might be required as a result of the hearings in the

instant proceeding. In addition, at the time this matter

was remanded by the court two rate increase applications,

A.55492 for Pacific and A.55383 for General, were pending.

The accelerated depreciation and ITC issues in those pro-

ceedings were removed for final determination in this pro-

ceeding.

In the remanded matters this Commission had set rates

based on the normalization method of accounting,’ which

involves the computation of rates based on the same me-

thod of depreciation, both for depreciation expense and

federal income tax expense, while the federal income taxes

are actually paid on the basis of a different amount of

(accelerated) depreciation expense. Since accelerated de-

preciation substantially increases the allowable expenses

to the utility, the taxable income, and therefore the federal

income tax expense of the utility, is substantially below

what it would have been had taxes been paid on the rate-

making (straight-line) depreciation basis. The difference

between the amount of taxes computed on a straight-line

depreciation basis and an accelerated depreciation basis is

reflected in a reserve account called the deferred tax re-

serve. This amount, on an average basis, is deducted from

rate base so that the authorized rate of return is not earned

on this sum. The deferred tax reserve accumulates from

year to year disproportionately to revenues, expenses, and

‘Internal Revenue Code (IRC) Section 167(1)(3)(G), which

reads as follows:

‘*(G@) Normalization method of accounting.—In order to use

normalization method of accounting with respect to any pub-

lic utility property

(i) the taxpayer must use the same method of depre-

ciation to compute both its tax expense and its deprecia-

tion expense for purposes of establishing its cost of service

for ratemaking purposes and for reflecting operating re-

sults in its regulated books of account, and

(ii) if, to compute its allowance for depreciation under

this section, it uses a method of depreciation other than

the method it used for the purposes described in clause

(i), the taxpayer must make adjustments to a reserve to

reflect the deferral of taxes resulting from the use of such

different methods of depreciation.’’

rate base as long as the overall plant additions by the

utility continue to grow. To this extent, the taxes set aside

in the deferred tax reserve shall never be paid and amount

to an actual tax saving, rather than only a deferral. (ITC

is defined as a tax credit, thus is a direct tax saving and

not a deferral.)

In the remand of D.83162 the Supreme Court held, inter

alia, that this Commission has the power to implement an

alternative method, e.g., an annual adjustment, of tax ex-

pense treatment for accelerated depreciation and ITC.

This annual adjustment method was discussed but not used

in arriving at the treatment set forth in D. 83162. The Su-

preme Court ordered this Commission to give considera-

tion to this method, as well as other alternatives, including

the possibility of a commensurate adjustment in the rate

of return, and to provide for refunds, if appropriate.

Hearings on this remand were held between March 1,

1976 and July 9, 1976 before Commissioner Robert Batino-

vich and Examiner Philip E. Blecher. The matter was sub-

mitted on the latter date subject to the filing of briefs.

The Proposed Report of the examiner was issued on

January 19, 1977. Exceptions to the Proposed Report were

timely filed by Pacific, General, City of Los Angeles (LA),

and Toward Utility Rate Normalization (TURN). These

exceptions shall be discussed where appropriate.’

Review

D.83162, 83778, and 85287 have exhaustively reviewed

and discussed this tax expense issue from its inception. We

shall not reiterate that discussion, but shall attempt to

confine the review of evidence and discussion of the issues

to those old matters still pertinent here, as well as the

new matters not previously raised. However, we think a

* All transcript corrections requested after the date of submission

by Pacific, General, and LA have been adopted.

10A

brief recounting of three California Supreme Court de-

cisions relating to this issue is warranted.

Case 1: City and Council of San Francisco v, Public

Utilities Commission, et al. (1971) 6 C 3d 119. This case

annulled D.77984, which had provided that Pacific could

use accelerated depreciation with the normalization method

of accounting as defined in IRC Section 167, because this

Commission failed to consider lawful alternatives in the

calculation of federal income tax expense. On page 130 the

court said: ‘*Beecause these methods involve fictitious al-

lowances for tax expense and because they provide results

which in the light of current federal income tax law are

either harsh on the utility or the ratepayers, the Commis-

sion may also consider alternative approaches which strike

a balance between these two extremes.’’ This statement

was quoted with approval in Case 3, infra. Since there has

been no substantive change in the applicable federal tax

statutes, this quotation is as appropriate today as when

made.

Case 2: City of Los Angeles v. Public Utilities Commis-

sion (1972) 7 © 3d 331. A general rate increase for Pacitic

was annulled partly because the Commission computed

taxes on the basis of normalization.

Case 3: City of Los Angeles v. Public Utilities Commis-

sion (1975) 15 C 3d 680. This is the case which remanded

D.83162, et al., for these proceedings. The court stated on

page 684 that the Commission took the action in D.83162

in spite of the court having annulled its previous decision

in this matter for failure to consider lawful alternatives in

the calculation of federal income tax expense (Case 1).

The court further said that the Commission set a rate

which in its own words would create a windfall for the

telephone companies te the detriment to the ratepayers.

Pursuant to the remand in Case 1 the Commission en-

tered D. 80347 dated August 8, 1972 which directed further

L1A

hearings into the tax expense problems. These further

hearings had not yet been held at the time of the decision

in Case 2. In D.80347 we said on page 3: ‘‘For the purpose

of this opinion only we will compute Pacific’s federal tax

expense on the basis of accelerated depreciation with flow-

through.’’ D.80347 thus ordered a substantial refund

amounting to about $176 million, including interest, based

on the flow-through method of computation of the federal

tax expense. D.80347 also set rates which were in effect

through the effective date of D.83162 rates, which was Au-

gust 17, 1974. The hearings held pursuant to Case 1 were

consolidated with A.53587 and resulted in D.83162 where

this Commission again adopted the normalization basis for

computing federal tax expense, which resulted in Case 3.

In D.74917 dated November 6, 1968, prior to the enact:

ment of the Tax Reform Act of 1969 (TRA) effective Jan-

uary 1, 1970, we determined that Pacific was imprudent in

not electing the accelerated depreciation option. For rate-

making purposes we imputed accelerated depreciation with

full flow-through, though Pacific was paying taxes on a

straight-line basis. This procedure was approved in Case

1, TRA allowed utilities to take accelerated depreciation

even though they had not taken it before 1969 only if the

cost of service (which includes federal income tax expense)

was computed on a normalization basis. After the enact-

ment of TRA both Pacific and General reversed their long-

standing opposition to accelerated depreciation and elected

it on a normalization basis. This election has resulted in

the instant proceedings in which we are attempting to

comply with the mandate from our Supreme Court to reach

an equitable determination of this problem.

Pacific and General argue that accelerated depreciation

is allowable only if normalization accounting is used be-

cause neither is eligible under IRC Section 167.1 for flow-

through accounting. If normalization is not used, then the

companies must revert to straight-line depreciation and

12A

the benefits of accelerated depreciation will be lost to both

the utilities and the ratepayers. We have previously agreed

with this position, as has the court in Case 1, though this

result is due only to the intransigence of Pacific and Gen-

eral in not opting for accelerated depreciation when they

had the opportunity. While this Commission deplores the

actions of Pacific and General, we are again compelled to

agree with their interpretation of the tax law. To impute

flow-through now in attempting to redress the balance be-

tween the utilities and ratepayers, we would ultimately

cause the ratepayers substantially higher rates and poorer

service while seriously damaging the financial position of

the companies. This horrendous result has been created

by Congress through the options allowed the utilities in

the tax laws, which have the effect of allowing the regu-

latee to regulate the regulator.

Thus, we are forced to again consider the question of

maintaining eligibility for accelerated depreciation on a

normalized basis. The primary reference for this purpose

is Treasury Regulation 1.167(/)-(1)(h)(6).* It delineates

when the normalization method of accounting is not used,

and concomitantly, when it is used. If these criteria are

not met, then accelerated depreciation in its entirety will

be disallowed creating a huge tax liability for Pacific and

General, which will be met with an equally huge deferred

’ This regulation, as far as pertinent, reads as follows:

‘*(6) Exclusion of normalization reserve from rate base. (i)

Notwithstanding the provisions of subparagraph (1) of this

paragraph, a taxpayer does not use a normalization method of

regulated accounting if, for ratemaking purposes, the amount

of the reserve for deferred taxes under section 167(1) which

is excluded from the base to which the taxpayer’s rate of re-

turn is applied, or which is treated as no-cost capital in those

rate cases in which the rate of return is based upon the cost

of capital, exceeds the amount of such reserve for deferred

taxes for the period used in determining the taxpayer’s tax

expense in computing cost of service in such ratemaking.’’

13A

tax reserve account, which is paper only, as the monies

credited to the deferred tax reserve have already been

spent.

The same proposition prevails for ITC. Since ITC be-

came effective in December 1971, General and Pacific have

elected ratable (service-life) flow-through (Option 2).‘

This means that the amount of plant investment in the

taxable year shall be apportioned on its expected service

life for ratemaking purposes.

Neither Pacific nor General was eligible for ITC Option

3° (see Case 1, page 130), which allows full flow-through

of the tax savings in the year in which the benefit occurred.

* IRC Section 46(f) (2), which reads as follows:

‘*(2) Special rule for ratable flow-through.—lIf the taxpayer

makes an election under this paragraph within 90 days after

the date of the enactment of this paragraph in the manner

prescribed by the Secretary or his delegate, paragraph (1)

shall not apply, but no credit shall be allowed by section 38

with respect to any property described in section 50 which is

public utility property (as defined in paragraph (5)) of the

taxpayer——

‘*(A) Cost of service reduction.—If the taxpayer’s

cost of service for ratemaking purposes or in its regulated

books of account is reduced by more than a ratable por-

tion of the credit allowable by section 38 (determined

without regard to this subsection), or

‘*(B) Rate base reduction.—If the base to which the

taxpayer’s rate of return for ratemaking purposes is ap-

plied is reduced by reason of any portion of the credit

allowable by section 38 (determined without regard to

this subsection ).’’

5 IRC Section 46(f) (3), which reads as follows:

‘*(3) Special rule for immediate flow-through in certain cases.

—In the case of property to which section 167(l)(2)(C)

applies, if the taxpayer makes an election under this para-

graph within 90 days after the date of the enactment of this

paragraph in the manner prescribed by the Secretary or his

delegate, paragraphs (1) and (2) shall not apply to such

property.’’

14A

Thus, ITC for Pacific and General will be disallowed in

its entirety if the taxpayers’ cost-of-service for ratemak-

ing purposes is reduced by more than a ratable portion of

the credit allowed or if the base to which the taxpayers’

rate of return for ratemaking purposes is applied is re-

duced by more than a ratable portion of the credit.

ASSUMPTIONS

. This discussion and ensuing decision reflect the assump-

tions set forth below:

(1) Tax Reduction Act becomes effective on January

1, 1970.

(2) As a result of Case 1 and D.80347, Pacifie’s rates

from January 1, 1970 to August 17, 1974 have been

promulgated on a flow-through basis. Since these

rates are final they cannot now be amended by any

action of this Commission. Therefore (a) any

action taken in respect to Pacific’s rates will apply

from August 17, 1974 until the effective date of

the rates set in D.85287, which is January 5, 1976;

(b) the rates set in D.85287 are subject to refund

and any action taken in this decision shail adjust

those rates accordingly; and (c) any action taken

here shall apply prospectively to the rates to be

set in pending A.55492 of Pacific.

(3) General’s rates for test year 1970 in D.79367 (ef-

fective December 12, 1971) and thereafter have

been subject to refund. Therefore (a) any action

taken on accelerated depreciation here shall apply

to the rates collected by General from December

12, 1971; (b) although ITC was not in existence

in test year 1970 used in D.79367, any action taken

on ITC shall apply from December 12, 1971, as

General has been taking ITC since it has been

available; and (c) any action taken here on ITC

15A

and accelerated depreciation shall apply prospec-

tively to the rates to be set in pending A.55383

of General.

(4) Neither Pacific nor General has the option to elect

accelerated depreciation on a flow-through basis

under IRC Section 167, et seq. (Case 1.)

(5) Both Pacific and General must use a normalization

method of accounting to maintain eligibility for

accelerated depreciation under IRC Section 167,

et. seq.

(6) Neither Pacific nor General has the option to elect

ITC on a flow-through basis (Option 3) under IRC

Section 46, et seq.

(7) Normalization accounting for accelerated depre-

ciation reduces financial risk and increases cash

flow compared to the flow-through treatment for

accelerated depreciation.

(8) Both Pacific and General were guilty of imprudent

management in their original determination to pay

federal income taxes on a straight-line deprecia-

tion basis. (Cases 1 and 3.)

(9) The quantification of a rate of return reduction

because of the increased cash flow and decreased

risk and vulnerability of normalization accounting

is difficult and judgmental.

Tue EvipENcE

Various alternative methods presented at the hearings

may be summarized as follows:

General’s Proposals

1. Three-Year Reserve and Tax Adjustment Method.

This is a variation of a previously proposed three-year

pro forma method which, it was argued, was disqualified

16A

under Treasury Regulation 1.167(/)-(1)(h)(6) because it

used a deferred tax reserve balance that exceeded the

amount of such deferred tax reserve for the period used in

determining the taxpayers’ tax expense. The current pro-

posed method remedies this defect because it considers the

additional tax expense for the same period as the deferred

tax reserve. It is based on the assumption that the federal

income tax will increase in proportion to growth after the

test year. The method of computation is as follows:

At test year the Commission should find a reasonable

federal income tax (before ITC) and a reasonable

normal growth rate. (General recommends using the

compound growth in main stations for the three pre-

ceding years.) The test year tax expense would then

be increased by applying the growth factor to the in-

trastate federal income tax (before ITC) for three

years into the future and averaging. The test year

federal tax expense would then be deducted from the

three-year average to determine the additional tax

expense to be included in the test year. This amount

would then be multiplied by the net-to-gross multiplier

to represent the intrastate change in revenue require-

ment related to the additional tax expense that must

be considered for the same period as the deferred tax

reserve as determined in the three-year pro forma

method.

2. Annual Reserve and Tax Adjustment. This is an adap-

tation of the annual or year-to-year adjustment method

(which the Supreme Court discussed in Case 3), which has

the same disadvantage as the pro forma method because

of its use of an out-of-period deferred tax reserve. The cur-

rent adaptation of this method makes an annual adjust-

ment for the increase in reserve and also brings the addi-

tional tax expense forward for the same time period. The

additional tax expense is determined in the same manner

as in the three-year reserve and tax adjustment method,

i7A

but the rates would only be adjusted one year at a time.

The federal income tax before ITC, plus a normal growth

rate, would be determined by the Commission and each

year’s calculation wouid be based upon the prior year’s

calculation until a new test year was established.

3. The Deferred Tax Reserve as No Cost Capital. This

method is used by applying the amount in the deferred tax

reserve as a component of the capital structure with zero

cost assigned to it. Rate base is not reduced by the amount

of deferred tax reserve. The effect is to lower the cost of

capital and rate of return found reasonable in general rate

proceedings.

Pacific’s Proposal

Annual Ratemaking Plan. Pacific would annually tender

an estimated full intrastate cost of providing telephone

service, keeping as constant ali the ratemaking adjustments

previously adopted in the latest general rate decision and

the last authorized rate of return. No new adjustments or

change in authorized rate of return would be permitted but

all other elements of cost-of-service would be considered.

This is a slightly simplified annual rate case, which every-

one agrees is permitted under the existing tax laws.

Staff’s Proposals *

1. Pro Forma Annual Adjustment. Gross revenue re-

quirement reductions are determined by annual adjust-

ments in the deferred tax reserve for the test year and

each of the next three years. The average of these four

years’ reductions is then applied as a gross revenue re-

duction in test year rates.

2. Rate of Return Adjustment—Reduced Risk. The au-

thorized rate of return upon which test year gross revenue

* Staff refers to the Utilities Division of the Commission.

18A

requirements are based is reduced in order to recognize

the reduction of financial risk resulting from the cash flow

generated by the tax savings froin accelerated depreciation

and ITC on a normalization accounting basis.

3. Midpoint Flow-Through Applied to a Normalization

Rate Base. In addition to the normalized treatment of de-

ferred tax reserve, one-half of the difference in gross reve-

nue requirements between normalization (for accelerated

depreciation) and ratable flow-through (for ITC) and a

full flow-through of each is reflected in rate reductions.

4. Normalization with Amortization of Deferred Tazes.

This is similar to the method of adjusting the expense and

rate base for contributions in aid of construction. The

gross revenue requirements are reduced by the reduction

in rate base in the amount of the average deferred tax re-

serve for the test year, but the deferred tax reserve is also

amortized (using the straight-line depreciation rate) by

a sum also reflected in a reduction in gross revenue re-

quirements and rates.

. Rate of Return Adjustment—Cost-Free Funds. This

is substantially equivalent to General’s no-cost capital

proposal.

The City and County of San Francisco’s (SF) Proposal

SF recommends full flow-through, or in the alternative,

a rate of return reduction contingent upon a favorable IRS

ruling on eligibility, but in the event of an unfavorable

ruling, rates to be then reset on a full flow-through basis.

The purpose of this theory is to provide the companies

with an incentive to obtain a favorable tax ruling, or alter-

natively, to amend the existing law to avoid the loss of

eligibility.

Se RS Oa em

19A

The City of Lus Angeles’s (LA) Proposal

LA recommends a rate of return reduction up to a maxi-

mum of two percentage points,’ while continuing the nor-

malization treatment of tax expense. This reduction is to

be quantified after considering three factors:

(1) Analysis of the financial risk reduction of a nor-

malization as compared to a flow-through company

due to the greater cash flow generated, the re-

duction of the need for outside financing, the re-

duction of the cost of embedded debt, the improve-

ment in interest coverage, and the generally fa-

vorable effect on the cost of new capital and evalu-

tion of the utility’s securities generally. (This

position is supported by the city of San Diego.)

(2) The previously found imprudent management in

failure to elect accelerated depreciation to avoid

rewarding the utilities for their imprudence.

(3) Reflection of the phenomenon of inverse attrition,

which is the opposite of the allowance for attrition

that the Commission has used in the past as a

regulatory tool where there is a projected dimi-

nution of the rate of return. Here, since the nor-

malized tax reserve grows at a markedly greater

rate than the other components of the utility’s

operations, the authorized rate of return would be

exceeded in subsequent years because no reduc-

tion in rate base occurs between test years. The

inverse attrition allowance set in the test year

will reduce the rate of return in the future. (This

is a step beyond the continuous surveillance me-

7 For test year 1975-76, the staff calculates that the rate of re-

turn for Pacific would be 2.17 percentage points higher on a

flow-through basis than on a normalization basis.

20A

thod now in use, which only applies to earnings

in excess of the authorized rate of return.)

LA recommends that ITC be treated in the same manner.

Toward Utility Rate Normalization’s (TURN) Proposal

Turn proposes another method of compensating for the

reduced risk of normalization by reducing the rate of re-

turn. It is caleulated by discounting to present value the

money which is accumulated in the deferred tax reserve

and the measurement of that time value upon the rate of

return allowed in addition to the normalization treatment.

The method also applies to ITC using a three-year forward

averaging amount (test year and two following years).

In the beginning this method would produce a refund in

excess of the refund produced by full flow-through.

OruHer Positions

Citizens Action League (CAL). CAL supports a greater

sharing of the benefits of accelerated depreciation with

ratepayers than exists under normalization accounting,

pine urges ieiunds be paid in cash rather than as a bill

credit.

Continental Telephone Company of California. This com-

pany would be affected by our decision here only if a re-

fund of toll revenues collected by Pacific should be ordered.

The Los Angeles Urban League. This organization seeks

equal opportunities for blacks and other minorities in all

sectors of our society and is concerned over a decision ad-

verse to Pacific which would be disastrous to Pacific’s mi-

nority hiring, firing, and promotion practices under Pa-

cific’s scenario of service and construction reductions.

Los Padrinos, Inc. This is a nonprofit charitable and

educational corporation of predominantly Spanish-sur-

named employees of Pacific. It is also concerned about the

Z1A

serious economic consequences depicted by Pacific’s wit-

nesses and urges the Commission to adopt an alternative

which will preserve Pacific’s eligibility for tax benefits.

The National Association for the Advancement of Col-

ored People (NAACP). NAACP is a civil rights organiza-

tion with the principal purpose of eliminating racial dis-

crimination in every facet of American life. It urges the

Commission to allow Pacific the full tax advantage of ac-

eelerated depreciation and ITC to preserve the employ-

ment of ethnic minorities and aid in employing the large

number of unemployed black persons.

The Pacific Telephone Employees for Women’s Affirma-

tive Action, Southern California. This is an organization

dedicated to aiding Pacific in achieving its affirmative ac-

tion goals relating to women and urges action similar to

the other above-mentioned groups.

Discussion

One of the major difficulties in the resolution of these

cases is the length of time that has transpired between the

onset of the problem and its latest submission for resolu-

tion. In Case 1 the court recognized then (in 1971) that

one extreme or the other in the solution would be harsh to

either the utilities or the ratepayers. That proposition has

now been exacerbated by the passage of years and many

millions of dolla:s of increase in the deferred tax reserve.

Now, in the event of the loss of eligibility for the tax

benefits flowing from accelerated depreciation and ITC,

Pacific estimates its total potential tax liability here from

1970 through the end of 1976 at $764 million, while Gen-

eral estimates its comparable liability at $223 million, or

together almest $1 billion in potential tax liabilities. This

is without regard for any rate refunds, ongoing rate re-

ductions, and other costs that might be attributable to a

retroactively assessed tax liability, such as the need for

raising additional funds for plant investment, the dete-

22A

rioration in financial position, the necessity for increased

interest rates and returns on debt and equity, and a myriad

of other problems involved, not the least of which are the

staggering rate increases that are foreseeable as the bot-

tom line in such a scenario. We are seeking to resolve this

dilemma in a middle ground, perhaps pleasing to no one,

but finally disposing of this problem by more suitably level-

ing the interest of the utilities and the ratekeepers. Eligi-

bility is the first issue to be determined. To render a de-

cision which attempts to resolve these cases without regard

for this issue might create problems for these utilities,

their ratepayers, the Commission, and the Courts that even

exceed (both in scope and complexity) the problems that

we are attempting to resolve in this decision. In the final

analysis a loss of eligibility to the utilities would not only

create service problems (though certainly not of the scope

described by Pacific’s) but would create staggering finan-

cial problems to be ultimately borne by the ratepayers

whose interests we are attempting to redress. We believe

that eligibility for these tax benefits should be maintained

and proceed on this basis.

ACCELERATED Tax DEPRECIATION

The parties recommend various positions which encom-

pass the entire spectrum of possibilities from maintaining

the status quo with normalization to a method which would

refund more money than would be available under flow-

through. While the alternatives submitted are plentiful, all

are substantially variations on two themes: (1) reduction

of rate of return; and (2) some form of reflecting the in-

crease in the deferred tax reserve in order to further re-

duce the rate base (the annual adjustment method).

The utilities would prefer to maintain the status quo

though Pacific condescended to advocate what amounts to

an annual rate case, merely holding the rate of return and

any other test year adjustments constant while delving

EEE ee

23A

into the entire cost of service each year, a solution that

will solve nothing while adding to the specter of regulatory

lag.

General was somewhat more generous by offering addi-

tional variations on the annual adjustment, while offsetting

the increased deferred tax reserve with increased federal

tax expense.

The staff basically recommended full flow-through but

as a concession to compromise supported a rate of return

reduction based on reduced risk only for future rates and

a refund based on full flow-through for the rates subject

to refund. LA recommended a maximum two percentage

point rate of return reduction for the current test year

1975-1976 for Pacific, although it supports flow-through as

the only proper ratemaking approach.

For General’s test year the rate of return difference be-

tween flow-through and normalization was .14 percentage

points in test year 1970, 1.39 in test year 1974, and 1.58 in

test year 1976. (Staff Exhibit 45.) For Pacific, the perti-

nent years and comparable differences are as follows: Test

year 1973, 1.52 percentage points; test year ending June

30, 1976, 2.17. (Staff Exhibit 46.) The flow-through basis

always produces a higher rate of return because the

greater the dollar amount of depreciation differential is he-

tween straightline and accelerated depreciation, the smalier

the correlative federal tax expense is for the flow-through

company, and the greater the earned rate of return.

While we agree that full flow-through is the proper and

best ratemaking method, we shall not consider it further

because both Pacific and General would be ineligible for

accelerated depreciation and ITC if rates were set on a

flow-through basis. We must look to some other alternative,

proposed or encompassed in the entire range of possible

alternatives.

24A

All the variations on the theme of increasing the de-

ferred tax reserve provide readily estimable items for the

purpose of computing the necessary numbers to determine

the gross revenue requirements and rates. On the other

hand, the reduction in rate of return is subjective, highly

judgmental, and most difficult of quantification, as all the

parties concede. If we were to adopt reduction in rate of

return, what number would we adopt? How is this number

to be determined? Is the difference in rate of return be-

cause of reduced risk merely a function of the dollar differ-

ence, as suggested by LA’s witness? (Exhibit 22, page 16.)

If not, what other factors are used to compute the actual

number? If we adopt reduction in rate of return based on

the dollar differences, as computed by the staff, what jus-

tification is used to differentiate this return from the re-

turn based on normalization accounting? Do we reason

that the entire reduction in rate of return is caused by the

risk reduction, as we did in D.85627 (Southern California

Gas Company)?

In D.83540, the decision on petition for rehearing in

D.83162, we stated on page 4: “The impact of normalization

upon risk, and hence upon rate of return, was taken into

account in the Commission’s deliberations and was one of

the factors which caused us to reduce the equity return

authorized for Pacific below that authorized for other Cali-

fornia utilities of similar capital structure. The impact or

normalization on Pacific’s risk was not specifically discussed

because it was not disputed; all parties, including Pacific,

conceded that the authorization of normalization reduces

risk below that which would otherwise result. This uncon-

tradicted evidence was taken into account in fixing rate of

return.” To now say that we shall again reduce rate of re-

turn in D.83162 when we already conceded that it was taken

into account in setting the original rate of return would be

unfair as the reduced risk would be reflected twice in rate

of return. We believe it fairer to use a variation of the

25A

annual adjustment proposed, which we will call the “aver-

aged annual adjustment”.

The theory of this method is simple: Because the increase

in the deferred tax reserve is deduced from rate base, the

authorized rate of return on the smaller rate base pro-

duces less revenue. The smaller amount of net revenues

will then produce less tax expense since the taxable income

will be decreased. Essentially, the total of the reduction in

net revenues and the decreased tax expense, together with

the adjustment for uncollectibles, amounts to the total gross

revenue reduction.

General’s expert witness testified (Exhibit 3, page 10):

“If the deferred tax reserve is determined as of a time

subsequent to the test period, tax expense for ratemaking

purposes must be determined as of the same time.” This

principle is embodied in General’s first alternative (pages

13 and 14, above), which remedies the alleged defect of the

old pro forma method, which did not take into account tax

expense for the same period used to calculate the reserve.

(General’s opening brief, page 16.) General’s opening brief,

page 16, describes the methodology, as follows: “. . . the

deferred tax reserve is averaged three years into the future

in the same fashion as pro forma normalization, and in ad-

dition, federal income tax expense is also averaged for the

same three-year period by which test period tax expense

and rate based is adjusted. The necessary correlation of the

reserve and tax expense provided in the cited Treasury

Regulation is thereby achieved (Exhibit 3, page 16).” This

is exactly the methodology for the averaged annual ad-

justment.

General believes it fair to assume growth in the tax ex-

pense every year. The actual federal tax expense bears no

direct relation to the increase in deferred tax reserve, but

fluctuates independently of it. (Exhibit 36, Pacific; Exhibit

27, General.)* TR 1.167(/)-(1)(h)(6) does not discuss rev-

*In addition, the effective actual tax rate has been generally

declining.

26A

enue growth, nor the direction of federal tax expense, but

only the time frame for two specific items. We think it

equally fair to assume a tax expense for the averaged an-

nual adjustment that decreases as the deferred tax reserve

increases in each year to accurately reflect only the increase

in deferred tax reserve in the same period of tax expense.

Thus, we will hold constant all items of cost-of-service not

or dependent on the increase in deferred tax reserve.

The computation starts with the test year figures. Using the

latest available estimates, we will compute the reduction in

net revenues resulting from the increased deferred tax re-

serve in each of the next three years, compute the resulting

decrease in tax expense in each corresponding year, then

average the deferred tax reserve and federal tax expense

for the four-year period. These averaged annual adjust-

ment figures for deferred tax reserve and federal tax ex-

pense will then be used in the current test years for the

pending rate cases. For past years, the total of the decrease

im net revenues and decrease in federal tax expense ® will

be deducted from the gross revenues computed under nor-

malization accounting, and the difference shall be refunded.

Tables 1 and 2 (Appendices B and C) show the method and

results for Pacific and General, respectively. Total refunds

through December 31, 1977 for Pacific are $110,785,000 and

for General are $40,230,000. The current rate reduction is

$31,609,000 for Pacifie and $6,571,000 for General,’ based

on current test years and estimates for three succeeding

years. The refund amounts contain interest at the rate of 7

pereent per annum through December 31, 1977 from the

time the rates were originally authorized and collection be-

gan. The deferred tax reserve amounts used are actual

through 1976 and estimated thereafter.

® A smali factor shall be added a i

‘tor s -d as appropriate to compensate for

decreased uncollectibles and franchise taxes. , :

'°This amount may be adj i

» adjusted for more current es i

A.55492 for Pacific. pia aaa

27A

Pacific’s opening brief (pages 42 and 43) indicates that

cust-of-service must include the total tax expense * for the

test period and the succeeding “pro forma” priod. This

means the tax expense for each of the future years will

have to be estimated. While Pacific agrees that the regula-

tions do not cover how tax expense must be estimated, it

indicates that the same method used to estimate future de-

ferred tax reserve must be used to estimate future tax ex-

pense or the procedure would be suspect and subject to

IRS disapproval. No authority is cited nor is any specific

method of estimating proposed, nor does the IRC and the

treasury regulations direct or discuss the estimating proc-

ess. We believe our method is direct, simple, and in full

compliance with the applicable federal law. Eligibility will

be maintained since the federal tax expense for cost-of-

service purposes is computed for the same period as the

deferred tax reserve. While we agree that it uses a book-

keeping fiction, it is no more fictitious, no more illogical,

and no more unreasonable than the fictitious theory of

normalization. In San Francisco v PUC (1971) 6 C 3d 119,

130-131, the court said “Both of the extreme methods (nor-

malization and flow-through) involve a fictitious charge of

federal tax expense. . . Since a fictitious figure must be used

under either method it is not improper for the commission

to use an additional fictitious factor to limit the harsh re-

sults. Insofar as the compromise would impose a lesser

burden on Pacific than is permissible consistent with due

process (lesser than the burden under imputed accelerated

depreciation with flow-through), Pacific is not in a posi-

tion to make due process objections.” We adopt this reason-

ing here.

The averaged annual adjustment is actually a form of

annual ratemaking. It is not objectionable because it uses

11 General’s e.ception to the Proposed Report makes this same

point. Our discussion applies equally to this exception.

28A

assumed constants, as these are used in an ordinary test

year projection, whether or not we are considering the de-

ferred tax reserve and the tax expense in an isolated man-

ner. If the test year is 1970 and the rates remain in effect

until the next test year, which is 1974, we have assumed

that the cost-of-service has remained constant for the years

1971, 1972, and 1973. This may be unrealistic, but clearly

permissible under our authority and the law. On a normali-

zation basis, we will do the same. We will compute the de-

ferred tax reserve and the tax expense on a normalized

basis for the test year, and thereafter until the next test

year those items and all other elements of cost-of-service

are deemed constant. We see no difference in taking the

deferred tax reserve and computing the tax expense and

the rates based on those two items (and their variables) for

years subsequent to the test year and averaging them back

into the test year. Though the method is different, the

principle is identical to the ordinary test year principle.

Nor is this subject to the objection that this is a flow-

through subterfuge. Everything and every method pro-

posed by any party, including normalization as used by

the companies here, is a method of flow-through. Normali-

zation, according to Pacific, saves the ratepayers a great

deal of money compared to straight-line depreciation, and

there is no question that it does. But it does not approach

the only sensible and realistic method of setting rates—

using the actual tax expense as the cost-of-service tax ex-

pense. The method being adopted here is a more equitable

and realistic method of normalization than the other pro-

posals and the best available now.

ITC

While we agree with the Supreme Court that the effect

of accelerated depreciation and ITC is identical the laws

and regulations respecting them differ substantially. Thus,

the specific delineation of permissible ratemaking policies

in regard to maintaining ITC eligibility as set forth in IRC

29A

Section 46, supra, requires a ratemaking treatment for ITC

differing from that accorded accelerated depreciation.

There is no question that utilities which did not elect

accelerated depreciation with flow-through prior to the ef-

fective date of TRA were ineligible to elect Option 3 (im-

mediate flow-through of ITC when it became effective in

December, 1971. In D.85627 (Southern California Gas Com-

pany (SoCal)), we imposed a rate of return reduction be-

cause of the reduced risk and increased cash flow generated

in part as a result of SoCal’s election of Option 2 for the

years 1975 and 1976, when ITC was increased for those

years from 4 to 10 percent for utility plant additions and

from 7 to 10 percent for transmission plant additions.” It

is our position that ITC eligibility was not affected by

D.85627. However, the Internal Revenue Service (IRS), in

response to a request from SoCal, issued an alleged ruling

(Exhibit 52) of which we were notified by letter dated No-

vember 22, 1976. In this alleged ruling the IRS concludes

that ITC will not be available to SoCal for federal income

tax purposes when the benefits to be derived therefrom are

treated for raternaking purposes in the manner provided

in D.85627 (as affirmed by D.86117). Our Supreme Court

has granted a writ of review on SoCal’s appeal of D.85627

and 86117 and has heard oral argument on the matter.

While the IRS ruling is not the final determination of this

issue, we believe tiiat a rate of return reduction is not war-

ranted in this proceeding in any event. We also, in this

proceeding, reject the concept of a permanent reduction in

rate of return for past as well as future rates, as recom-

mended by some of the parties.

We do not believe a rate of return reduction to be any

more of a subterfuge for accomplishing flow-through than

any of the other methods presented here nor are we reject-

* This increase in ITC was extended through 1980 in the bill

signed into law on October 4, 1976.

30A

ing it for that reason. In a full rate case, all the elements

of cost-of-service are considered in the process of arriving

at a reasonable rate of return. Here, all the parties advo-

cating this method base it solely on the number of dollars

of desired refund, and not vice versa. In this proceeding,

where we are addressing ourselves to changes in the level

of ITC which may be expected to occur beyond the test

year, we prefer a more precisely ascertainable result.” For

these reasons we are adopting for the purposes of ITC

and eligibility thereunder the only method that appears to

encompass all the factors we desire, the annual adjustment.

Sometime prior to the first day of each year after (and in-

cluding) the test year, we shall recalculate the ITC for the

coming year on the basis of the best estimates then avail-

able and shall adjust the rates accordingly at the begin-

ning of the year to provide for the full year-to-year growth

in the annual amount of ratable flow-through (Option 2).

The difference in tax expense between that occurring on the

test year because of Option 2 and that estimated for the

adjustment year would be computed on the most recent

estimate for eligible plant additions. The intrastate factor

would be applied and the charge would be converted to rev-

enue requirement by the proper net-to-gross multiplier and

applied as an adjustment to decision rates for the year fol-

lowing the test year. Thereafter, we shall delete the ear-

liest year t . use the next year to establish the tax expense

difference, and adjust the then current rates.’* For Pacific,

the refund obligation through December 31, 1977 for ITC

is $51,231,000 and the approximate current rate reduction

is $23,346,000 (Table 3, Appendix D). For General, the

18 This reasoning applied equa!'y to accelerated depreciation.

‘* Annual adjustments may also be implemented when a Com-

mission decision becomes effective after the beginning of the first

annual adjustment period. The first annual adjustment will merely

be incorporated in any such decision.

SN ee ee

31A

comparable figures are $15,649,000 (gross) and $4,771,000

(Table 4, Appendix EF).

We are rejecting all the other proposed treatments for

varying reasons, principally that they either cause or tend

to raise doubts about eligibility, or do not adequately re-

dress the balance between the ratepayers and the utilities.

Imputep FLow-THrRovucH or ACCELERATED DEPRECIATION

In reviewing the record of this proceeding it has come to

our attention that certain old vintage plant additions were

not previously considered in the ratemaking process. We

shall discuss Pacific and General separately.

Pacific

In D.74917 dated November 6, 1968 we imputed flow-

through of accelerated tax depreciation for 1967 vintage

plant using a 1967 test year. In D.77984 dated November

24, 1970 (test year 1970) the normalization treatment for

accelerated depreciation was ordered for Pacific. When this

decision was annulled the rates reverted to those set in

D.74917 (test year 1967). In D.80347 dated August 8, 1972

rates were increased using 1970 vintage plant additions to

determine the flow-through of accelerated depreciation or-

dered there. The rates set in this final decision were effec-

tive until August 17, 1974, the effective date of the rates

set in D.83162. The net effect of this history is that no

accelerated depreciation for 1968 and 1969 vintage plant

additions was ever reflected in Pacific’s rates, even though

our Supreme Court approved the imputed flow-through of

accelerated depreciation.

In Exhibit 32 in A.53587 (and the A.51774 rehearing),

this imputation was proposed for the two years in ques-

tion. We shall adopt this recommendation. Further, we

shall continue this imputation through Pacifie’s test years

1973 in D.83162 and 1974-1975 in D.85287 and shall order

here an ongoing reduction in pending A.55492 (test year

32A

1975-1976) for this flow through item. These amounts are

as follows:

Flow-Through of 1968 and 1969

Vintage Plant Additions

(Table 5, Appendix F’)

(Dollars in Thousands)

1.83162 (Test Year 1973) 8/17/74 to 1/4/76

D.85287 (Test Year 1974-75) 1/5/76 to 12/31/77

Ongoing reduction (TY 1975-76) A.55492

SumMarY OF Paciric Rerunps AND

———

$24,158

Rate Repuctions THroven DecemsBer 31, 1977

(Dollars in Thousands)

REFUNDS

Accelerated Tax Depreciation

(Table 1, Appendix B)

ITC (Table 3, Appendix D)

Flow-Through of 1968 and 1969 Vintage

(Table 5, Appendix F’)

ToTraL Rerunbs

Rate Repuctions (A. 55492)

Accelerated Tax Depreciation

(Table 1, Appendix B)

ITC (Table 3, Appendix D)

Flow-Through of 1968 and 1969 Vintage

(Table 5, Appendix F)

ToraL Rare Repuctions

ToraL RerunpsS AND Rate Repuctions

$110,785

51,231

43,570

$205,586

$ 31,609

23,346

5,539

$ 60,494

$266,080

33A

General

A similar situation exists for General but it is limited

to 1969 vintage plant additions. In D.75873 dated July 1,

1969 we imputed flow-through of accelerated depreciation

for 1968 vintage plant using a 1968 test year. In D.79367

dated November 22, 1971 increased rates were ordered us-

ing the normalization treatment of accelerated depreciation

beginning with 1970 vintage plant additions. Thus, 1969

vintage plant additions were never reflected in General’s

rates, all of which have been subject to refund since

D.79367.

In Exhibit 5-R in A.53935 (and the A.51904 rehearing),

this imputation was proposed for 1969. We shall adopt this

recommendation and shall continue this imputation from

December 12, 1971 (the effective date of D.79367) through

test years 1970 (D.79367), 1974 (D.83779), and 1976

(D.87505).

However, in Table 6 of Exhibit 2, General claimed credit

for refunds and rate reductions already made as a result

of the annulment of D.78851 of Pacific.’® In D.83778 dated

November 26, 1974 we said, on page 41:

“The refunds already made by General are attributable

to the annulment of Decision No. 78851 while the settle-

ment revenue losses to General are attributable to the

annulment of that decision and also to the difference

between Pacific’s rates authorized in Decision No.

80347 and Pacific’s annulled rates.”

Failure to give General credit for these sums would

amount to requiring double refunds. Since this would be

inequitable, we are offsetting the losses already incurred

** This claim was also made in General’s exceptions to the Pro-

posed Report.

34A

against the refunds and rate reductions required of Gen-

eral by this decision.”

Summary OF GENERAL Net Totat Rerunps

AND Rate Repuctions THrovuGH DercemBer 31, 1977

(Dollars in Thousands)

REFUNDS

Accelerated Tax Depreciation

(Table 2, Appendix C) $34,987

ITC (Table 4, Appendix E) , 15,363

Flow-Through of 1969 Vintage

(Table 6, Appendix G)

a. D.79367 (TY 1970) 12/12/71 to 12/20/74 9,244

b. D.83779 (TY 1974) 12/21/74 to 7/17/77 7,245

e. D.87505 (TY 1976) 7/18/77 to 12/31/77 670

Tota, Rerunps $65,440

Rate Repuctions (D.87505)

Accelerated Tax Depreciation

(Table 2, Appendix C) $ 6,571

ITC (Table 4, Appendix E) 4,771

Flow-Through of 1969 Vintage

(Table 6, Appendix G) 1,311

Tota, Rate Repvuctions 12,653

Tota, Rerunps anp Rate Repvuctions $78,093

**In applying the credit, reductions are treated separately for

1971, 1972, and 1973 (from 1/1/73 to 9/22/73 only) and com-

pared to refunds computed for those years, in accordance with

the principle used by General in Exhibit 2, Table 6. Reductions

in refunds are made first to the imputed flow-through refunds, then

any remaining reduction is credited to ITC, and finally and re-

maining reduction is credited to accelerated tax depreciation. (See

Table 7, Appendix H.)

+ 5 tea inte ai ein

ee eee eee ee ee ee

35A

SERVICE

Pacific has depicted a service and employment scenario

of horrendous proportions in the event it loses eligibility

for accelerated depreciation and ITC, and assuming a back

tax payment of $764 million, rate refunds of $73 million

and an ongoing rate reduction of $62.6 million. In 1972 and

1973, however, Pacific refunded $176 million together with

a rate reduction of $90 million and had no significant em-

ployee layoffs, no deterioration in service and no adverse

effects on earnings.

Because the eligibility of both companies is unaffected in

our judgment, we foresee no meaningful change in the

operations and quality of service, number of employees,

level of earnings, impairment of financial integrity, or

other deleterious consequences as predicted by Pacific.

Thus, the companies are put on notice that any deviation

from their current service indices, objectives, standards,

and our General Order No. 133 shall be monitored and,

when appropriate, punished to the fullest extent of the

law. For these purposes, we particularly emphasize Pa-

cific’s 1976 Service Objective List admitted as Exhibit 43

in its pending A.55492 as exemplary of the service stand-

ards expected, together with the ultimate determination,

in the same proceeding, of the acceptable level of held

primary orders.

MIsceLLANEOUS CONTENTIONS

Pacific and General have discussed many other points,

some pertinent, some not. We shall briefly discuss due

process, actual results of operations, confiscatory rates,

retroactive ratemaking, credit for revenues authorized but

uncollected, and settlement adjustments.

Pacific relies heavily on the case of West Ohio Gas Com-

pany (No. 2) v Public Utilities Commission (1935) 294 US

79. There the regulatory agency had, in setting a rate in

1933, chosen to rely exclusively on data from 1929, ignor-

36A

ing available revenue and expense data from 1930 and

1931. The court said this was an unconstitutional proce-

dure. Our situation here is easily distinguishable, as we

are taking into account the actual deferred tax reserve and

ITC amounts for the past years and computing the func-

tional variables from that actual number. Our Supreme

Court in Los Angeles v PUC (1975) 15 C 3d 680, has al-

ready found this procedure to be proper since the tax ex-

penses and reserves under accelerated depreciation vary

abnormally with respect to the other components of a

utility’s finances. The court said on page 703, ‘‘Simply to

recognize this fact is not to deny due process.”’

Further, the actual results of Pacific’s operations indi-

cate a financial picture much brighter than depicted by

Pacific. It is true that the dividend on common stock has

not been increased since 1961, as Pacific alleges, but that

is a Management decision which is not directly related to

its per share earnings or any other indicia of financial

progress. In 1961 Pacific had 104 million common shares

outstanding while at the end of 1975 it had over 168 million

such shares and contemplates over 181 million at the end

of 1976. Thus, the total dividends paid now are approxi-

mately two-thirds greater than in 1961, to over $202 mil-

lion in 1975. Further, the earnings per share increased

from $1.46 in 1970 to $1.82 in 1975 and $2.06 in 1976, all on

an increased number of outstanding shares. There has been

an increase in the number of employees, an increase to

earned surplus from 1972 to 1975 of the staggering sum of |

$245 million, and an increase in construction budget from

1971 to 1974 of $225 million. And this was all accomplished

while refunding $176 million with an ongoing rate reduc-

tion of $90 million per year. In this be confiscation, let

there be more of the same. Ir view of these facts, Pacific’s

arguments regarding confiscatory rates are untenable and

rejected.

Neither do we agree with Pacific’s position that the im-

position of a penalty for imprudence would constitute im-

37A

proper retroactive and punitive ratemaking since this pro-

cedure has already been approved by the Supreme Court

(6 C 3d 119). Penalties for imprudence, like penalties for

civil or criminal wrong, have nothing to do with rates;

they are punishment. But we are not imposing a penalty

here; we are determining the proper basis for setting rates.

Pacific has suggested that it is appropriate, in the event

the Commission orders a refund in this matter, to deduct

from the amount of refund the revenues previously au-

thorized but not collected because it has failed to earn its

authorized rate of return. If rate of return has not been

earned, the remedy for that, as clearly set forth by the

court in 15 C3 680, is to seek rate relief, which both com-

panies have done and are presently doing. Further, this

recommendation would guarantee the authorized rate of

return. Because it is axiomatic that this Commission does

not guarantee the return, but merely provides an oppor-

tunity to earn it, the requested credit would be inapposite.

Since our action will not render Pacific ineligible, we

need not answer its argument that this would unduly bur-

den interstate commerce, particularly as no evidence on

this point was tendered.

The rates to be filed by the utilities pursuant to this or-

der will, of course, reflect settlement payments between

utilities. However, we will not authorize any retroactive

settlement adjustments associated with refunds resulting

from this order.

REFUNDS IN THE Form or Stock

It was suggested in the event a refund was ordered that

it be accomplished via the issuance of capital stock of Pa-

cific and General. The companies introduced a great deal of

material setting forth the problems involved with this idea.

The major potential problems are with the Securities &

Exchange Commission, the difficulty of issuing minute

fractional shares for small refunds to ratepayers, the large

38A

cost of such a program, and the Commission’s authority

to order such a securities issue. No party supported this

concept in its present form. We shall not order it.

REFUNDS AND ReEpDUcTIONS

Refunds in the past have been made in direct proportion

to the billing of the various customers without regard to

class of service. In this case it was suggested that refunds

be made only to residential customers on the theory that

since business customers include telephone service cost as

part of their cost of doing business, they are being paid by

the consumer for tle cost of the phone service. A refund

theoretically would then create a windfall for the business

phone customers since no refunds by the business custom-

ers would be made to its customers. It can also be argued,

however, that the amount of any refund to the business

customer would be used to reduce the cost of business for

the period in question and thereby would be reflected in

lower or stable prices. In our opinion there is no evidence,

one way or the other, in this proceeding to support either

view.

Another suggestion was to refund to all customers on a

per capita basis, meaning that the total amount of the re-

fund wouid be divided by the total number of customers

of the company and the same dollar amount refund would

be given to each customer whether residential or business.

Since the number of residential customers is much greater

than business customers, and as residential revenues ap-

proach 50 percent, it is apparent that individual business

customers on average pay much greater monthly revenues

to the phone compauies than the individual residential cus-

tomers. This proposal, for example, would have the effect

of giving the city of Los Angeles, General Motors, and ev-

ery individual the same amount of refund. In the case of

the residential customers, their refunds might well exceed

their monthly bills.

39A

Pacific and General will be directed to file proposed re-

fund plans. Approval, disapproval, or modification of the

proposed plans will follow by subsequent Commission

order.

The ongoing prospective rate reductions ordered herein

shall be reflected in rates for all current subscribers by a

uniform proportional reduction in the recurring basic ex-

change primary service rates. To insure that rates for

competitive services are not reduced (since those rates are

generally priced as nearly as possible at full cost) we are

directing that only rates for basic exchange primary serv-

ice be reduced. With respect to central office centrex serv-

ice the reductions shall be made on the trunk rate per

station.

IRS Rvuuine Request

The companies have suggested that any proposed action

changing the method of normalization now being used

should allow the continuance of existing rates, either by

putting the rates aside in a trust fund, as suggested by the

Supreme Court, or keeping them subject to refund as at

present, until such time as a ruling can be rendered by the

IRS regarding the retention of eligibility under the method

adopted by this Commission for treating the tax expense

problems. This is based on the theory that if the IRS dis-

approves the proposed treatment the present method of

accelerated depreciation shall continue in effect, or an-

other proposed method may be submitted for a ruling. But

the companies’ requests provide no incentives to obtain

an expenditious advance IRS ruling, and might lead to

further delay in the implementation of the refunds con-

templated in this order. Moreover, General’s expert wit-

ness Nolan indicated that there are some instances where

the IRS will nct issue an advance ruling, nor does the IRS

necessarily advise in advance that it will not issue such

a ruling. The supplicant merely waits and hopes. Nolan

also said that the more difficult the problem, the more

40A

likely the IRS is to avoid issuing an advance ruling. We

have here a case of first impression under the tax laws,

and we think an advance ruling within a reasonable time is

not probable. Moreover, the opportunities for such action

by the utilities have been ample in the past, yet they took

no such action. For these reasons we think that their pro-

posals are inappropriate.

Exceptions To Proposep Report

We shall discuss here, where necessary, the exceptions

that have not been discussed elsewhere in this opinion.

Pacific

Pacific’s exceptions generally fall into two categories:

1. Since D.83162 was issued in August 1974, its earnings

have been below the authorized rate of return and it is ©

improper to order refunds and rate reductions in such cir-

cumstances. We have already discussed this point else-

where, and concluded otherwise. There is nothing suffici-

ently meritorious in Pacific’s exceptions in this area that

have not been raised, discussed, and disposed of by this

Commission, or our Supreme Court.

2. Pacifie’s eligibility for accelerated tax depreciation

and ITC is endangered by the proposed treatment of these

benefits.

(a) Accelerated Tax Depreciation. Pacific complains of

the use of recorded data for historical periods, but in its

brief cited the West Ohio Gas case (supra) as requiring

the recognition of such data. Its position is inconsistent

and varies with the direction the wind is blowing. Further,

there is no prohibition in proper ratemaking or the IRC

sections in question which bar this procedure.

Pacific also complains of the failure to use the pro rata

requirements in Treasury Regulation 1.167(1)-1(h) (6) (ii).

It overlooks the discussion on page 3 of Exhibit 16 spon-

41A

sored by staff witness John Quinley, where the use of the

pro rata percentage of 46.33 is shown. Mr. Quinley explains

the offsetting working cash adjustment which produces a

combined effect of 50 percent as the proper figure to be

used in determining the average deferred tax reserve and

its ultimate revenue effect. Footnote 4, Table 1, Exhibit

16, reflects this combined effect, as does Footnote 4, Table

i, Exhibit 10-A (sponsored by Pacific), which uses the

identical percentage as its Table 1 is identical to Table 1

of Exhibit 16.

The other exceptions with respect to accelerated depre-

ciation have been either mentioned or explained elsewhere

and merit no further discussion.

(b) Investment Tax Credit. Pacific cites proposed

treasury regulations allegedly relating to its interpretation

of our ITC treatment. These proposals in our judgment do

not effect the validity of our treatment and have no force

or effect, in any event, being mere proposals. We reiterate

that our treatment of [TC is akin to an annua] ratemaking

procedure. We see nothing in law or logic that prohibits

this treatment.

General

The thrust of General’s exceptions relates to the alleged

ineligibility for accelerated depreciation which would occur

as a result of the treatment of that subject in the Proposed

Report. General alleges that the total tax expense must be

considered for the same period for which the deferred tax

reserve is estimated, and the Proposed Report considers

only the reduction in tax expenses. This is not the case, as

the reduction in tax expense for years after the test year is

used to reduce the test year tax expense used in the suc-

ceeding year. The effect is to reduce each succeeding year’s

tax expense, but the entire tax expense is used for the

appropriate period. General also alleges that the proposed

method is exactly like the old pro forma method, except

42A

for the time period. That is correct, because the failure to

consider the deferred tax reserve for the same period as the

tax expense is the alleged defect of the old pro forma

method regarding eligibility. The Averaged Annual Adjust-

ment remedies this defect by considering the two required

items separately for the same period. While the effect is

the same as pro forma, we are specifically complying with

the existing tax laws by using a proper method to compute

the revenue requirement. It must also be noted that this

method complies exactly with the method (though not the

assumptions) recommended by General and its witnesses.

We have already discussed and decided the other major

exception : the double refund effect for revenues author-

ized but not collected because of Pacifie’s prior refunds.

There is no retroactive ratemaking involved here since

all General’s rates since November 22, 1971 have been sub-

ject to refund. The fact that ITC was not previously con-

sidered does not make it res adjudicata, nor does it prevent

this Commission from reflecting its effect where possible.

That is what we are doing by this decision.

LA objects to the failure of the Proposed Report to de-

cide the constitutionality of the relevant tax laws under the

Tenth Amendment to the U.S. Constitution. We already

decided that question in the affirmative in D.83778 and see

no reason to go into the matter again.

We have previously discussed, directly or indirectly, all

the other matters raised in LA’s exceptions.

TURN

TURN filed two exceptions, one relating to its proposed

method of determining the amount of refunds (discussed

earlier), and the other relating to the effective date of the

Proposed Report. We see no need to consider its exceptions.

meter. i obaie she. Meds ap ETE

43A

EPILoGuE

We desire to discuss the wisdom of using the tax laws

for the purpose of providing a capital subsidy (in this in-

stance, phantom taxes) from the taxpayers (in this in-

stance, the ratepayers) to a special interest group (in this

instance, state-regulated utilities). This occurs because

every dollar of taxes that the utilities pay is obtained in

rates from the ratepayer, even when the utilities can defer,

and perhaps never pay the taxes collected in rates. The

regulators must essentially order two dollars to be paid

to the utility by the ratepayer for each dollar in taxes

avowedly to be paid by the utility. This seems to us to be

a wasteful use of resources as well as a legally sanctioned

subsidy to the utility from the ratepayer without the lat-

ter’s consent. The money is not being contributed by in-

vestors in the usual manner, but is being contributed in

the form of rates by the ratepayer on a two-for-one basis

and not on a one-for-one basis, as it the case for traditional

investment capital. The funds are being obtained from the.

ratepayers under the guise of taxes, while Congress has

decreed that the money so collected as taxes need not be

used as taxes by the utilities, but may be used by the

utilities for whatever purposes they desire. There is no

restriction on the use of these funds in the tax laws. The

taxes collected, but not paid, in essence amount to a direct

capital subsidy which the utilities may use as unrestricted

capital. Nothing is paid to the ratepayers for this invest-

ment use of the ratepayers’ money as would be paid to

traditional investors. Thus, this is free capital, and this

is occurring in a free enterprise system which traditionally

rewards venture and investment capital!! Here, the con-

verse is true. The ratepayers are actually being penalized

instead of being compensated for this subsidy. Their money

is being involuntarily contributed on a two-for-one basis,

and no return is forthcoming on any basis. We think this

is grossly unfair and should be more forcefully presented

by the utilities, by the regulatory agencies, and by con-

444

sumer organizations. Congress has created a situation

where in California both the utilities and the ratepayers

feel they are being whipsawed by these tax laws and the

actions of this Commission in attempting to be fair to all

sides. This Commission believes that it has a legal duty to

balance the interests of the utilities and the ratepayers

and is attempting to do so, but finds itself more frequently

hamstrung by the actions of Congress where it appears

that the interests of the utility ratepayers are not ade-

quately considered, for whatever reason.

What this Commission proposes and strongly supports,

in lieu of this hidden subsidy and no-cost capital contribu-

tion to the utilities by the ratepayers (we mean at no cost

to the utilities), is the elimination of the income tax upon

regulated utilities to be replaced with a gross receipts tax

(or, for energy and water utilities, a per unit of consump-

tion tax), as a surcharge to all billings paid by the rate-

payers, to be collected by the utilities and paid directly to

the IRS. This surcharge would be indicated as such on the

utility bills and would not be included in the utility cost-

of-service. It could easily be structured to provide reve-

nues to the treasury equivalent to that now being paid as

income taxes by the utilities. It would eliminate the rate-

payers’ involuntary and hidden subsidy to the utilities be-

cause what they pay in gross receipts tax is what the IRS

gets on a dollar-for-dollar basis. If the utilities desire to

obtain funds from the ratepayers for the purpose of ex-

pansiun and investment, let it be done forthrightly by di-

rect subsidy so the ratepayers will have knowledge and the

opportunity for input. Let the ratepayers share in what-

ever benefits might accrue to the utility as the result of any

such investment by the ratepayers. We see no reason why

the ratepayers, in their role of capital investors, should not

share in the fruits of their investment. We believe the tax

laws are not the proper medium for the creation of invol-

untary investment capital. Tax law gimmickry should not

tilt or distort the balance necessary between state-regu-

lated utilities and ratepayers.

ee er ee a

$800 ADB den Tae

45A

The gross receipts tax would simplify the job of Con-

gress in levying taxes and simplify the job of the regula-

tory ayencies in setting rates, while preserving the rights

of both the utility and the ratepayers. It would create

faster rate relief on the part of regulatory agencies and

maintain the utilities on a solid financial basis, instead of

requiring everyone involved in setting rates to go through

a series of contortions and distortions to attempt to com-

ply with or legally avoid the effect of the existing tax laws

and the concommitant uncertainty and delays,

FUNDINGS

1. Pacifie and General were imprudent in failing to se-

lect accelerated depreciation when that option was avail-

able under the federal tax laws. This imprudence denied

the companies the option to elect flow-through accounting

for ITC and accelerated depreciation purposes.

2. Flow-through of the tax benefits accruing under ac-

celerated depreciation and ITC is the best method of

handling these benefits for the purpose of balancing the

interest of the ratepayers and the companies for ratemak-

ing purposes.

3. Pacific and General are ineligible to elect flow-

through accounting for accelerated depreciation and ITC

for ratemaking purposes pursuant to IRC Section 167, et

seq. and Treasury Regulation 1.167, et seq. Normalization

accounting is the most appropriate method available to

Pacific and General. Under the normalization method we

are adopting for ratemaking purposes, tax depreciation

expense for ratemaking purposes will be computed on a

straight-line basis while federal taxes will be computed on

an accelerated depreciation basis. The difference between

the two tax computations will be accounted for in a de-

ferred tax reserve. The average sum of the test year de-

ferred tax reserve and the deferred tax reserve for the

46A

tiiree next subsequent years shall be deducted from rate

base in the test year. As a result of each of the deductions

from rate base federal tax expense will be recomputed on

the same basis in the test year for the test year and the

three corresponding subsequent years, thus matching the

estimated tax deferral amount for each period with the

estimated federal tax expense for the same period. This

method complies with Treasury Regulation 1.167(1)-(1)

(h)(6) and is normalization accounting.

4. For ITC we shall make an adjustment prior to the end

of each calendar year (or as soon thereafter as possible)

for the rates to be set beginning January 1 of the next

calendar year taking into account at that time the growth

in the amount of ITC estimated for the next immediate

future calendar year as compared to the last test year (or

last preceding year), and recomputing federal tax expense

and gruss revenue requirements based on that new esti-

mate for each year between rate cases. This method com-

plies with the requirements of ratable (service life) flow-

through selected by the utilities under IRC Section 46.

o. The methods described in Findings 3 and 4 are an

attempt to more accurately reflect in rates the abnormal

growth in these reserves compared to th. other compo-

nents of cost-of-service used in computing rates.

6. The methods adopted in this order as deseribed in

Findings 3 and 4 comply with the mandate of the Califor-

ma Supreme Court set forth in City of Los Angeles v Pub-

lic Utilities Commission (1975) 15 C 3d 680.

7. The methods deseribed in Findings 3 and 4 fairly bal-

ance the interests of the ratepayers and the utilities and

avoid harsh results to either as a result of the tax benefits

accruing under accelerated depreciation and ITC,

8. The amount to be refunded by Pacific to its ratepayers

under the method described in Finding 3 for accelerated

depreciation is $110,785,000, including interest at 7 per-

SN ee ee ee

en ee

47A

cent per annum from the date of the respective orders en-

tered from which refunds are being required, as set forth

in Table 1. The current rate reduction under this method

is $31,609,000.

9. The gross amount to be refunded by General to its

ratepayers under the method described in Finding 3 for

accelerated depreciation is $40,230,000, including interest

at 7 percent per annum from the date of the respective

orders entered from which refunds are being required, as

set forth in Tables 2 and 7. The current rate reduction un-

der this method is $6,571,000.

10. The amount to be refunded by Pacific to its ratepay-

ers under the method described in Finding 4 for ITC is

$51,231,000, including interest at 7 percent per annum

from the date of the respective orders entered from which

refunds are being required, as set forth in Table 3. The

current rate reduction under this method is $23,346,000.

11. The gross amount to be refunded by General to its

ratepayers under the method described in Finding 4 for

ITC is $15,649,000, including interest at 7 percent per

annum from the date of the respective orders entered from

which refunds are being required, as set forth in Table 4.

The current rate reduction under this method is $4,771,000.

12. The maintenance of eligibility under the federal tax

laws to allow Pacific and General to use accelerated depre-

ciation and ITC is beneficial to both the ratepayers and the

utilities and is an important goal of this Commission in

this decision.

13. It is reasonable to order a uniform proportional re-

duction in the recurring basic exchange primary service

rates. With respect to central office centrex service it is

reasonable to make the reductions on the trunk rate per

station.

14. It is reasonable to impute flow-through of 1968 and

1969 vintage plant additions for Pacific and 1969 vintage

48A

plant additions for General, as the Supreme Court has pre-

viously approved this procedure in San Francisco v. PUC

(1971) 6 C 3 119, and accelerated depreciation of these

vintages has never been reflected in rates.

15. A gross receipts tax surcharge would abolish the

“two-for-one” collection of income taxes from the ratepayers

in rate setting for utilities and would allow lower utility

rates since the gross receipts tax would allow a dollar-for-

dollar collection of taxes paid by the utilities to the federa!

government.

16. As long as plant investment of the utility continues

to expand, the deferred tax reserve is actually a tax saving

and not a tax deferral.

17. It is unfair and unreasonable to use the tax laws to

create investment dollars flowing from the ratepayers to

the utilities on which the ratepayers do not receive any re-

turn.

18. The gross receipts tax surcharge would eliminate the

involuntary capital contribution incurred by the ratepayers

and would abolish the windfall to the utilities by allowing

them to collect taxes from the ratepayers which they may

never have to pay.

19. The investment tax credit is a tax saving and not a

tax deferral.

20. A gross receipts tax surcharge will prevent the dis-

tortion of the tax laws to create subsidies from the rate-

payers to the utilities in the setting of rates.

21. In computing the refunds and rate reductions com-

puted herein, this Commission has used recorded figures,

where available, for the periods in question.

22. The reduction and refunds of rates authorized by this

decision are justified and reasonable, and the present rates

as they differ from those prescribed therein, are for the

future unjust and unreasonable.

ee Oe ee

49A

23. No revenue adjustments for settlements by Pacific

and General with interconnecting carriers will be allowed

for the refund period.

24. The amount to be refunded by Pacifie to its ratepay-

ers pursuant to Finding 14 is $43,570,000, including interest

at 7 percent per annum from the date of the respective or-

der entered from which refunds are being required, as set

forth in Appendix F. The current rate reduction under this

method is $5,539,000.

25. Because of revenues authorized, but not collected,

General is entitled to credit for certain sums refunded and

lower rates set due to San Francisco v PUC (1971) 6 C 3

119 and D.78851 of Pacific. It is reasonable to offset these

amounts against the other refunds required herein, on an

annual basis only, first reducing the imputed flow-through

of accelerated depreciation under Finding 14, then the ITC

refund, and lastly, the accelerated tax depreciation refund.

26. The net amount to be refunded by General to its tax-

payers, pursuant to Findings 14 and 25, is $17,159,000, in-

cluding interest at 7 percent per annum from the date of

the respective orders entered from which refunds are be-

ing required, as set forth in Appendix G. The current rate

reduction under this method is $1,311,000.

27. As a result of Finding 25, the refunds due from Gen-

eral, pursuant to Findings 9 and 11, are reduced to the net

sums of $34,453,000 (Finding 9) and $13,828,000 (Find-

ing 11).

28. The total net refunds due from Pacific and General,

and the total current and/or ongoing rate reductions re-

quired respectively, are summarized in the tables on page

32 (for Pacific) and page 34 (for General).

CONCLUSIONS

1. The methods described in Findings 3 and 4 maintain

the eligibility of the utilities to use accelerated depreciation

50A

and ITC and comply with the requirements of the Internal

Revenue Code relating to Pacific and General.

2. This Commission does not guarantee the utility the

rate of return authorized in rate proceedings, but merely

provides an opportunity to earn that return.

3. The method described in Finding 3 for accelerated de-

preciation for Pacific and General is a normalization method

of accounting.

4. The method contained in Finding 4 for ITC complies

with the ratable (service life) flow-through option of ITC

under IRC Section 46.

5. The imputation of flow-through of the accelerated tax

depreciation benefits for 1968 and 1969 vintage plant addi-

tions for Pacific and 1969 vintage plant additions for Gen-

eral is a proper ratemaking procedure and does not affect

eligibility under the TRA of 1969.

6. The rates being set herein are not confiscatory.

7. The offset allowed General due to the revenues au-

thorized, but not realized, is a proper ratemaking proce-

dure.

8 There is no retroactive ratemaking ordered in this

decision.

Order

Ir Is Onverev that:

1. The Pacifie Telephone and Telegraph Company shall

refund the sum of $205,586,000 (computed as of December

31, 1977), being the total of the amounts due under the

recomputation of accelerated depreciation with normaliza-

tion, investment tax credit on the service life flow-through

basis, and accelerated depreciation for 1968 and 1969

vintage plant addition on a flow-through basis, as deter-

mined herein pursuant to Findings 3, 4, and 14. This

th i ll

a tt en

51A

amount includes interest at the rate of 7 percent per year

from the respective effective dates of the rates being re-

funded.

2. General Telephone Company of California shall re-

fund the sum of $65,440,000 (computed as of December 31,

1977), being the net total of the amounts due under the

recomputation of accelerated depreciation with normaliza-

tion, investment tax credit on the service life flow-through

basis, accelerated depreciation for 1969 vintage plant addi-

tions on a flow-through basis, and certain offsets thereto,

as determined herein pursuant to Findings 3, 4, 14, and

25. This amount includes interest at the rate of 7 percent

per year from the respective effective dates of the rates

being refunded.

3. The Pacific Telephone and Telegraph Company and

General Telephone Company of California shall prepare

and file refund plans for all current (at the time of filing

of the plan) subscribers. This pian shall be filed within

thirty days after the effective date of this order. This plan

must be approved by an order or resolution of the Com-

mission.

4. The methods described in Findings 3, 4, and 14 shall

be applied to all future rates of The Pacific Telephone and

Telegraph and General Telephone Company of California.

5. The filings required for the continuous surveillance of

earned rate of return as previously ordered in D.83540

and D.83778 are no longer required.

6. The Pacific Telephone and Telegraph Company shall

reduce{current rates by the sum of $60,494,000 (computed

as of Pecember 31, 1977), being the total of the reductions

due under the recomputation of accelerated depreciation

with mormalization, investment tax credit on the service

life flow-through basis, and accelerated depreciation for

1968; and 1969 vintage plant additions on a flow-through

52A

basis, as determined herein pursuant to Findings 3, 4,

and 14.

7. General Telephone Company of California shall re-

duce current rates by the sum of $12,653,000 (computed

as of December 31, 1977), being the net total of the reduc-

tions due under the recomputation of accelerated deprecia-

tion with normalization, investment tax credit on the serv-

ice life flow-through basis, accelerated depreciation for

1969 vintage plant additions on a flow-through basis, and

certain offsets thereto, as determined pursuant to Find-

ings 3, 4, 14, and 25.

8. The Pacific Telephone and Telegraph Company and

General Telephone Company of California shall prepare

and file tariffs reflecting such reductions on a uniform pro-

portional basis on recurring basic exchange primary ser-

vice rates, and with respect to central office centrex service

the reductions shall be made on the trunk rate per station.

Such tariffs shall be filed within thirty days after the effec-

tive date of this order and shall not become effective until

approved by order or resolution of this Commission.

9. Pacific and General shall not recompute intercompany

EAS or other settlement amounts between themselves or

with other independent companies as a result of the refunds

or rate adjustments ordered herein except for busniess

done on or after the effective date of this order.

10. In the event the refund plans and tariffs required

to be filed by this order are effective after December 31,

1977, the amounts shown in Ordering Paragraphs 1, 2, 6,

and 7 shall be recomputed to the appropriate effective date

of the refund plan or tariff filing, with interest as computed

in Ordering Paragraphs 1 and 2.

The effective date of this order shall be twenty days after

the date hereof.

53A

Dated at San Francisco, California, this 13th day of

September, 1977.

Rosert Batinovicu

President

Ricwarp D. GravELLe

Cuame T. Deprick

Commissioners

I will file a written dissent.

/s/ Vernon L. Srurcron

Commissioner

I will file a dissent.

/s/ WiuiaM Symons, Jr.

Commissioner

I will file a coneurrence.

/s/ Ricuarp D. Gravette

Cerririep as a True Copy

OF THE ORIGINAL

/s/ H. L. Farmer

Assistant Executive Director

Public Utilities Commission

State of California

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Oe é He Re ete on

fee fr bu wet elite dl Mrs

FUN al alt al Sl it I ON le adh RE Nt echt OS hd a to dls ne

. cat

Appendix A

List oF APPEARANCES

Applicants: Robert M. Ralls and Robert Dalenberg, Attor-

neys at Law, for The Pacific Telephone and Telegraph

Company; John Robert Jones, A. M. Hart, and H.

Ralph Snyder, Jr., Attorneys at Law, for General Tele-

phone Company of California.

Interested Parties: Thomas M. O’Connor, City Attorney,

and Robert Laughead, for City and County of San

Francisco; Robert W. Russell and Manuel K roman, for

Department of Public Utilities & Transportation, City

of Los Angeles; George R. Gilmour, Attorney at Law,

for TURN; James F. Crafts, Jr., Attorney at Law, and

Del Williams, for Continental Telephone Company;

Louis Possner, for City of Long Beach; John W. Witt,

City Attorney, by William S. Shaffran, Deputy City

Attorney, for City of San Diego; Alexander Googooian,

City Attorney, for City of Bellflower; Burt Pines, City

Attorney, by Leonard L. Snaider, Deputy City Attor-

ney, for City of Los Angeles; Jack Krinsky, for Ad

Visor, Inc.; Dina G. Beaumont, for Communications

Workers of America; Thelma Garcia, for Pacifie Tele-

phone Women Employees for Affirmative Action;

Joseph J. Salazar for Los Padrinos, Ine.; William M.

Bennett, attorney at law, for Consumers Arise Now,

and himself; Diamantes P. Katsikaris, for Independent

Taxpayers Union of California, Inc.; Timothy J. Samp-

son, for Citizens Action League; and John Mack, by

Ballard W. Brooks, for Los Angeles Urban League.

Commission Staff: Timothy Treacy, Attorney at Law, J. D.

Quinley, and K. K. Chew.

‘3 o> ees “4

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TABLE 3

NoTES

INTRASTATE OPERATIONS

THE Paciric TELEPHONE AND TELEGRAPH COMPANY

13 Adjusted as 10/4 times amounts shown in Exhibit 10-A, Table

3 for 1977 in order to approximately reflect the 10% Investment

‘1 A 55492 test year data adjusted to most recent estimates. 1978

Credit available under the Tax Reform Act of 1976.

*Column (C) minus Column (B). Note duplication of amounts

reduction, Column (G).

for 1974, 1975, and 1976.

®* Column (G) adjusted as per Exhibit 40, Computation Method

* Effects of state income tax and uncollectibles (.039 « Col. (D)

for T.Y. 1973 and .043 «& Col .(D) for T.Y. 1974-75 and 1975-76).

2. Interest added at the rate of 7% per year for 1974-77.

* Exhibit 10-A, Table 3, Column (D) in adjustment year.

1° [1).85287 rates effective 1-5-76. One-half 1977 included.

? Exhibit 10-A, Table 3, Column (A).

? Exhibit 10-A, Table 3, Column (D).

> Column (D) .92307 [(D x .48/1 — .48].

*° 2.83162 rates effective 8-17-74 to 14-76.

7 Columns (D) + (E) + (F).

#2 Average of two calendar years.

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Appendix G

Page 1 of 2

TABLE 6

GENERAL TELEPHONE COMPANY OF CALIFORNIA INTRASTATE OPERATIONS

COMPUTATIONS OF REFUNDS AND ONGOING REVENUE REDUCTION DUE TO IMPUTED FLOW-THROUGH

OF ACCELERATED TAX DEPRECIATION FOR VINTAGE YEAR 1969 PLANT ADDITIONS

Refunds by Decision and

Additional Net

Federal Tax Effect of

Year's Rates Effective

Additional

Other Gross Gross Revenue

Federal

Revenue

Accelerated Tax

Depreciation— First Year

Income Tax

Reduction

Vintage Year

Revenue

1969 2 1969 Additions ® Reduction ¢ Effects ° Reduction ® Year Refund 7

19702

66A

(B) (C) (D) (E) (F) (G) (H)

(DOLLARS IN THOUSANDS)

(A)

$ 1,811 $ 3,963 $2,152 $1,986 $353 $4,491

1970

11,001 12,055 1,054 973 209 2,236

1974

14,410 621 573 128 1,322

Total Refunds Through December 31,

13,789

1976

$17,159

1,311*

$ 1,311

1977

1978

Annual Ongoing Reduction

67A

TABLE 6

NoTES

GENERAL TELEPHONE COMPANY OF CALIFORNIA

INTRASTATE OPERATIONS

1 Exhibit 5-R in A.53935 and A.51904 Rehearing, Table I, Col-

umn (a) Tax Depreciation « 48% X intrastate factors of .891

for T.Y. 1970, .873 for T.Y. 1974, and .855 for T.Y. 1976.

* Exhibit 5-R, Table I-A, Column (a), Tax Depreciation x 48%

X intrastate factors as in Footnote 1, above.

3 Column (B) minus Column (A).

* Column (C) X .92307 ((C) & .48/1 — .48).

5 Effects of state income tax and uncollectibles (.1645 « Col. (C)

for T. Y. 1970, .1990 « Col. (C) for T.Y. 1974, and .20695 x

Col. (C) for T.Y. 1976).

*(C) + (D) + (EB).

7 Column (H) adjusted as per Exhibit 25, Table A-A-2. Interest

added at the rate of 7% per year for 1971-77.

5 —D.79367 rates effective 12-12-71 to 12-20-74.

® 1.83779 rates effective 12-21-74 to 7-17-77.

101P).87505 rates effective 7-18-77. Test year data adjusted to

most recent estimates.

11 Adjustments for revenues not collected are shown on Table 7.

68A

Appendix H

TABLE 7

GENERAL TELEPHONE COMPANY OF CALIFORNIA

INTRASTATE OPERATIONS

ADJUSTMENTS TO TABLES 2, 4, AND 6

FOR REVENUES NOT COLLECTED

Gross Revenue Reductions

Line 12-12-71 to 1-1-73 to

No. Item 12-31-71 1972 9-22-73

(A) (B) (C)

(Dollars in Thousands)

1 Total Revenues Not Collected’ $ 846 $12,601 $4,372

2 Line 1 Adjusted to 12-31-77

Refund Levels” 1,313 18,889 5,963

Refund Offset by Line 2

Imputed Flow-Through 377 7,616 5,476

Investment Tax Credit 35 1,299 487

Liberalized Tax Depreciation 291 5,486 —

Remaining Revenues Not

Collected * 393 2,994 a

a Oe CO

1 Exhibit 2, Table 6, line 15 (adjusted for D.83778 refunds).

? Adjusted by including interest to match refund amounts,

3 Line 2, less lines 4, 5, and 6, divided by interest factor.

70A

ComMISSIONER Ricuarp D. GravELLE, CoNCURRING.

ComMISSIONER CiatrE T. Deprick, CoNCURRING.

We concur.

Today’s decision, while attributed to this Commission, is

not really ours. We are merely the instrument of delivery.

This decision was spawned by the Bell System; nurtured by

Congress; brought through adolescence by the efforts of

our staff, the cities of San Francisco, Los Angeles, San

Diego, and TURN; shaped into maturity by the California

Supreme Court; and finally left to us for mere refinement.

The entity most responsible for the result of the order as it

stands is the Court, which clearly mandated us to achieve a

balance between utility and ratepayer which we have finally

done. We have also protected eligibility by carefully re-

maining within the confines of the tax laws and regulations.

No one, however, should be confused on the latter point. The

ultimate verdict on the validity of this decision will have to

be made in the United States Supreme Court and the sooner

that is accomplished the better off all participants will be.

San Francisco, California

September 13, 1977

/s/ Ricuarp D. GravELLE

Ricuarp D. GravELLe, Commissioner

/s/ Cuatre T. Deprick, Commissioner

Criatre T. Deprick, Commissioner

doe eA a he obs) eek ee

iat as tite ih att:

71A

Paciric TeLePHone & TevecrapH Company

GENERAL TELEPHONE ComMPaANny oF CALIFORNIA

Re: Accelerated Depreciation and Investment Tax Credit

ComMIssiIoneR WILLIAM Symons, JR., Dissenting

California stands to lose at least a billion dollars, with

nothing to gain, as the Public Utilities Commission major-

ity again plays brinkmanship with the United States Gov-

ernment. There is no need to recklessly risk eligibility for

such enormous sums in federal tax deferrals and federal

tax forgiveness.

Congress enacted the federal tax laws, and in order to

qualify for specific federal tax benefits, it is realistic to ex-

pect that the intentions of Congress be respected. Eligibility

under the federal tax laws makes it possible for the com-

munication companies in California to use accelerated de-

preciation and to receive investment tax credit. To have the

federal government forego the collection of these taxes is

most beneficial to both the utilities and the ratepayers. To

risk these tax benefits so needlessly is bad regulatory ad-

ministration. Loss of eligibility through 1976 as a conse-

quence of California Public Utilities Commission action

means that Pacific Telephone will have to pay taxing au-

thorities in Washington, D.C., retroactive tax bills of $764

million. General Telephone will have to pay $223 million.

Loss of eligibility into the future will cost our communica-

tion system and ratepayers additional hundreds of millions

of dollars in taxes.

I cannot support a decision which fails to take the oppor-

tunity to resolve the ‘‘eligibility’’ issue before the Commis-

son decision is finalized and ‘‘set in concrete’’. Assurance

on the issue of eligibility is proceduraly feasible if we were

to follow the recommendation of the Administrative Law

Judge in this case. The order as originally drafted deferred

any effective date until 180 days. This was done to allow

the utilities a reasonable period to obtain a ruling on eli-

72A

gibility from the U.S. Internal Revenue Service. Ratepayer

interest would have been protected by adequate accounting,

refund, and interest provisions.

But today’s majority strikes out that simple safeguard.

In doing so they ignore the fact that last year’s schemes,

which the majority recklessly imposed on the state’s largest

electric utility and the state’s largest gas utility, are in

grave danger of causing millions of dollars in unnecessary

tax liabilities to fall upon those companies. (See Majority

and Minority Opinions: A. 54946 Southern California

Edison Company, D. 86794, December 21, 1976; rehearing

based on adverse tax attorney opinion, D. 87828, September

7, 1977; and A. 55676, Southern California Gas Company,

D. 85627, March 30, 1976, together with adverse IRS ruling,

dated November 22, 1976; California Supreme Court de-

cision pending, in Case SF 23495.)

In light of these danger signals, it is imprudent of the

Commission not to exhaust available consultive procedures

and thus safeguard the state against the catastrophic con-

sequences of ineligibility.

Instead, the majority lectures Congress on legislative

goals. Acting as a school marm to Congress, the majority

tells the national legislature that federal tax credits and

deferrals may be used to lower monthly utility bills, but

may not be used to stimulate job development or acceler-

ated capital investment. Such homey advice is interesting

but what the California ratepayer will have to worry about

is the bottom line. What will he and the California utility

companies have to pay to Washington, D.C., after the IRS

has cut through the verbiage of this decision and applied

the law?

San Francisco, California

September 13, 1977

/s/ Witutam Symons, JR.

Wim Symons, JB.

73A

Commissioner Vernon L. Srurceon, Dissenting

The inconsistent and cavalier manner in which the ma-

jority treats the key issue of eligibility for accelerated de-

preciation warrants my strong dissent. The majority recog-

nizes, as it must, that our regulatory treatment of aeceler-

ated depreciation and the investment tax credit (ITC) must

preserve General’s and Pacific’s eligibility for these tax

saving methods. The majority, in one of its few realistic

comments on the question, states that:

‘‘Eligibility is the first issue to be determined. To ren-

der a decision which attempts to resolve these cases

without regard for this issue might create problems for

these utilities, their ratepayers, the Commission, and

the Courts that even exceed (both in scope and com-

plexity) the problems that we are attempting to resolve

in this decision.’’ (Mimeo p. 19)

After recognizing and elaborating upon the importance

of eligibility, the majority then, incredibly, moves quickly

to jeopardize that eligibility by adopting a regulatory ac-

counting scheme whose compliance with the standards of

normalization established by the Internal Revenue Code

and Treasury Regulations must be considered a matter of

speculation. While the majority states confidently (Finding

No. 3) that ‘‘This method complies with Treasury Regu-

lation 1.167(1)-(1)(h)(6) and is normalization accounting,’’

they admit (at Mimeo p. 41) that ‘‘We have here a case of

first impression under the tax laws... .’’

The Examiner’s Proposed Report took a sensible ap-

proach to the eligibility question by setting an effective date

180 days after the entry of the order. Had a majority of

the Commission had the wisdom to adopt such an approach,

Pacific and General would have not only the time but the

incentive to seek an expeditious IRS ruling. The majority

correctly points that ‘‘expeditious’’ is not an adjective fre-

quently associated with IRS rulings (as it is not with deci-

74A

sions of this Commission). However, even if no such ruling

were issued within the 180 days following the entry of the

order, what harm would occur? Under the Examiner’s ap-

proach, the order would simply be final at that time. If a

ruling was issued, the Commission would then have the

opportunity to modify the order if necessary.

It is doubtful that any of the majority would, in the han-

dling of their own federal income taxes, make a decision in-

volving a risk of substantial tax liability in which their

position rested on a legal position which they knew to be a

‘‘case of first impression under the tax laws.’’ Today, how-

ever, they have asked Pacific, General and their ratepayers

to do just that.

/3/ Vernon L. SturGEon

Vernon L. Sturceon

Commissioner

San Francisco, California

September 13, 1977

—~ Sores Po ee ee ee ee

cet

APPENDIX C

75A

APPENDIX C

Article VI of the Constitution:

* * * This Constitution, and the laws of the United

States which shall be made in Pursuance thereof; and

all Treaties made, or which shall be made, under the

Authority of the United States, shall be the Supreme

Law of the Land; and the Judges in every State shall

be bound thereby, any Thing in the Constitution or

Laws of any State to the Contrary notwithstanding.

** @

The Fourteenth Amendment to the Constitution:

* * * nor shall any State deprive any person of life,

liberty or property, without due process of law * * * *

Internal Revenue Code of 1954 (26 U.S.C.):

SEC, 46. Amount or CrepIr.

(f) [as amended by See. 105(c), Revenue Act of 1971, P.L.

92-178, 85 Stat. 503, See. 302(a), Tax Reduction Act of 1975,

P.L. 94-12, 89 Stat. 40, and Sec. 1906(b)(13)(A), Tax Re-

form Act of 1976, P.L. 94-455, 90 Stat. 1834] Limitation IN

Case or Certain Reautatep ComPpaANIEs.—

(1) GeneraL RuLE.—Except as otherwise provided in

this subsection, no credit shall be allowed by section 38 with

respect to any property described in section 50 which is

public utility property (as defined in paragraph (5)) of the

taxpayer—

(A) Cost or service rEDUCcTION.—If the taxpayer’s

cost of service for ratemaking purposes is reduced by

reason of any portion of the credit allowable by section

38 (determined without regard to this subsection) ; or

(B) Rate Base repuction.—If the base to which the

taxpayer’s rate of return for ratemaking purposes is

76A

applied is reduced by reason of any portion of the

credit allowable by section 38 (determined without re-

gard to this subsection).

Subparagraph (B) shall not apply if the reduction in the

rate base is restored not less rapidly than ratably. If the

taxpayer makes an election under this sentence within 90

days after the date of the enactment of this paragraph in

the manner prescribed by the Secretary, the immediately

preceding sentence shall not apply to property described in

paragraph (5)(B) if any agency or instrumentality of the

United States having jurisdiction for ratemaking purposes

with respect to such taxpayer’s trade or business referred

to in paragraph (5)(B) determines that the natural domes-

tic supply of the product furnished by the taxpayer in the

course of such trade or business is insufficient to meet the

present and future requirements of the domestic economy.

(2) SPECIAL RULE FOR RATABLE FLOW-THROUGH.—If the

taxpayer makes an election under this paragraph within 90

days after the date of the enactment of this paragraph in

the manner prescribed by the Secretary, paragraph (1)

shall not apply, but no credit shall be allowed by section 38

with respect to any property described in section 50 which

is public utility property (as defined in paragraph (5)) of

the taxpayer—

(A) Cost oF SERVICE REDUCTION.—If the taxpayer’s

cost of service for ratemaking purpeses or in its regu-

lated books of account is reduced by more than a rat-

able portion of the credit allowable by section 38 (de-

termined without regard to this subsection), or

(B) Rate BASE REDUCTION.—If the base to which the

taxpayer’s rate of return for ratemaking purposes is

applied is reduced by reason of any portion of the

credit allowable by section 38 (determined without re-

gard to this subsection).

77A

(4) Limiration.—

(A) In GenreraLt.—The requirements of paragraphs

(1), (2), and (9) regarding cost of service and rate

base adjustments shall not be applied to public utility

property of the taxpayer to disallow the credit with

respect to such property before the first final determi-

nation which is inconsistent with paragraph (1), (2), or

(9) (as the case may be) is put into effect with respect

to public utility property (to which this subsection ap-

plies) of the taxpayer. Thereupon, paragraph (1), (2),

or (9) shall apply to disallow the credit with respect

to public utility property (to which this subsection ap-

plies) placed in service by the taxpayer—

(i) before the date that the first final determina-

tion, or a subsequent determination, which is in-

consistent with paragraph (1), (2), or (9) (as the

case may be) is put into effect, and

(ii) on or after the date that a determination

referred to in clause (i) is put into effect and be-

fore the date that a subsequent determination

thereafter which is consistent with paragraph (1),

(2), or (9) (as the case may be) is put into effect.

(B) Dererminations.—For purposes of this para-

graph, a determination is a determination made with

respect to public utility property (to which this sub-

section applies) by a governmental unit, agency, instru-

mentality, or commission or similar body described in

subsection (c)(3)(B) which determines the effect of the

credit allowed by section 38 (determined without re-

gard to this subsection)—

(i) on the taxpayer’s cost of service or rate base

for ratemaking purposes, or

(ii) in the case of a taxpayer which made an

election under paragraph (2) or the election de-

scribed in paragraph (9), on the taxpayer’s cost of

718A

service for ratemaking purposes or in its regulated

books of account or rate base for ratemaking pur-

poses.

graph—

(i) a determination is final if all rights to appeal

or to request a review, a rehearing, or a redetermi-

nation, have been exhausted or have lapsed.

(ii) the first final determination is the first final

determination made after the date of the enactment

of this subsection, and

(iii) a subsequent determination is a determina-

tion subsequent to a final determination.

(5) Pusiic utmtry rropertry.—For purposes of this sub-

section, the term ‘‘publie utility property’? means—

(A) property which is public utility property within

the meaning of subsection (c)(3)(B), and

(B) property used predominantly in the trade or

business of the furnishing or sale of (i) steam through

a local distribution system or (ii) the transportation of

gas or steam by pipeline, if the rates of such furnishing

or sale are established or approved by a governmental

unit, agency, instrumentality, or commission described

in subsection (c)(3)(B).

(6) Ratas_e portion.—For purposes of determining rat-

able restorations to base under paragraph (1) and for pur-

poses of determining ratable portions under paragraph

(2)(A), the period of time used in computing depreciation

expense for purposes of reflecting operating results in the

taxpayer’s regulated books of account shall be used.

(7) REORGANIZATIONS, ASSETS ACQUISITIONS, ETC.—If by

reason of a corporate reorganization, by reason of any other

acquisition of the assets of one taxpayer by another tax-

79A

payer, by reason of the fact that any trade or business 0’

the taxpayer is subject to ratemaking by more than one

body, or by reason of other circumstances, the application

of any provisions of this subsection to any public utility

property does not carry out the purposes of this subsection,

the Secretary shall provide by regulations for the applica-

tion of such provisions in a manner consistent with the

purposes of this subsection.

* 7 * *

SEC. 167. Depreciation.

(a) GeneraL Rute.—There shall be allowed as a depre-

ciation deduction a reasonable allowance for the exhaustion,

wear and tear (including a reasonable allowance for obso-

lescence )—

(1) of property used in the trade or business, or

(2) of property held for the production of income.

* * * ”

(1) [as amended by See. 441(a), Tax Reform Act of 1969,

P.L. 91-172, 83 Stat. 625, and See. 1906(b)(13)(A), Tax

Reform Act of 1976, P.L. 94-455, 90 Stat. 1834] ReasonaBLE

ALLOWANCE IN Case oF Property oF Certain UTiLities.—

(1) Pre-1970 pusirc UTILITY PROPERTY.—

(A) In ceneraL.—lIn the case of any pre-1970 public

utility property, the term “reasonable allowance” as

used in subsection (a) means an allowance computed

under—

(i) a subsection (/) method, or

(ii) the applicable 1968 method for such prop-

erty.

Except as provided in subparagraph (B), clause (ii)

shall apply only if the taxpayer uses a normalization

method of accounting.

80A

(B) FLow-THROUGH METHOD OF ACCOUNTING IN CER-

TAIN CAsES.—In the case of any pre-1970 public utility

property, the taxpayer may use the applicable 1968

method for such property if—

(i) the taxpayer used a flow-through method of

accounting for such property for its July 1969 ac-

counting period, o®

(ii) the first accounting period with respect to

such property is after the July 1969 accounting

period, and the taxpayer used a flow-through

method of accounting for its July 1969 accounting

period for the property on the basis of which the

applicable 1968 method for the property in ques-

tion is established.

(2) Post-1969 puBLIc UTILITY PROPERTY.—In the case of

any post-1969 public utility property, the term ‘‘ reasonable

allowance’’ as used in subsection (a) means an allowance

computed under—

(A) a subsection (/) method.

(B) a method otherwise allowable under this section

if the taxpayer uses a normalization method of ac-

counting, or

its pre-1970 public utility property of the same (or

similar) kind most recently placed in service, the tax-

payer used a flow-through method of accounting for its

July 1969 aeceounting period.

(3) Derinitions.—For purposes of this subsection—

(A) Pusiic utitiry property.—The term ‘‘public

utility property’’ means property used predominantly

in the trade or business of the furnishing or sale of—

(i) electrical energy, water, or sewage disposal

services.

81A

(ii) gas or steam through a local distribution

system.

(iii) telephone services, or other communication

services if furnished or sold by the Communica-

tions Satellite Corporation for purposes author-

ized by the Communications Satellite Act of 1962

(47 U.S. C. 701), or

(iv) transportation of gas or steam by pipeline,

if the rates for such furnishing or sale, as the case Inay

be, have been established or approved by a State or

political subdivision thereof, by any agency or instru-

mentality of the United States, or by a public service

or public utility commission or other similar body of

any State or political subdivision thereof.

(B) Pre-1970 pusiic uTILiry pROPERTY.—The term

‘*pre-1970 public utility property’’ means property

which was public utility property in the hands of any

person at any time before January 1, 1970.

‘*post-1969 public utility property’’ means any public

utility property which is not pre-1970 public utility

property. ;

(D) AppiicaBLE 1968 meTHop.—The term ‘‘appli-

cable 1968 method’’ means, with respect to any public

utility property—

(i) the method of depreciation used on a return

with respect to such property for the latest taxable

year for which a return was filed before August 1,

1969,

(ii) if clause (i) does not apply, the method used

by the taxpayer on a return for the latest taxable

year for which a return was filed before August 1,

1969, with respect to its public utility property of

82A

same kind (or if there is no property of the same

kind, property of the most similar kind) most re-

cently placed in service, cr

(iii) if neither clause (i) nor (ii) applies, a sub-

section (/) method.

In the case of any section 1250 property to which sub-

section (j) applies, the term ‘‘applicable 1968 method’’

means the method permitted under subsection (j)

which is most nearly comparable to the applicable 1968

method determined under the preceding sentence.

(E) AppiicaBLe 1968 METHOD IN CERTAIN casEs.—If

the taxpayer evidenced the intent to use a method of

depreciation (other than its applicable 1968 method or

a subsection (/) method) with respect to any public

property in a timely application for change of ac-

counting method filed before August 1, 1969, or in the

computation of its tax expense for purposes of reflect-

ing operating results in its regulated books of account

for its July 1969 accounting period, such other method

shall be deemed to be its applicable 1968 method with

respect to such property and public utility property of

the same (or similar) kind subsequently placed in

service.

(F) Svussection (1) MetTHop.—The term ‘‘subsection

(1) method’’ means any method determined by the Sec-

retary to result in a reasonable allowance under sub-

section (a), other than (i) a declining balance method,

(ii) the sum of the years-digits method, or (iii) any

other method allowable solely by reason of the applica-

tion of subsection (b)(4) or (j)(1)(C).

(G) NorManizaTION METHOD OF accouNTING.—In

order to use a normalization method of accounting with

respect to any public utility property—

83A

(i) the taxpayer must use the same method of

depreciation to compute both its tax expense and

its depreciation expense for purposes of establish-

ing its cost of service for ratemaking purposes and

for reflecting operating results in its regulated

books of account, and

(ii) if, to compute its allowance for depreciation

under this section, it uses a method of depreciation

other than the method it used for the purposes de-

scribed in clause (i), the taxpayer must make ad-

justments to a reserve to reflect the deferral of

taxes resulting from the use of such different

methods of depreciation.

(H) FLow-THROUGH METHOD OF ACCOUNTING.—-The

taxpayer used a ‘‘flow-through method of accounting’’

with respect to any public utility property if it used

the same method of depreciation (other than a subsec-

tion (/) method) to compute its allowance for depreci-

ation under this section and to compute its tax expense

for purposes of reflecting operating results in its regn-

lated books of account.

(1) Juty 1969 accountING Periop.—The term ‘‘ July

1969 accounting period’’ means the taxpayer’s latest

accounting period ending before August 1, 1969, for

which it computed its tax expense for purposes of re-

flecting operating results in its regulated books of ac-

count.

For purposes of this paragraph, different declining balance

rates shall be treated as different methods of depreciation.

(5) REORGANIZATIONS, ASSETS ACQUISITIONS, ETC.—If by

reason of a corporate reorganization, by reason of any

other acquisition of the assets of one taxpayer by another

taxpayer, by reason of the fact that any trade or business

84A

of the taxpayer is subject to ratemaking by more than one

body, or by reason of other circumstances, the application

of any provisions of this subsection to any public utility

property does not carry out the purposes of this subsection,

the Secretary shall provide by regulations for the ap)lica-

tion of such provisions in a manner consistent with the pur-

poses of this subsection.

(m) Crass Lives.—

(1) In Grenerat.—In the case of a taxpayer who has

made an election under this subsection for the taxable year,

the term ‘‘reasonable allowance’’ as used in subsection (a)

means (with respect to property which is placed in service

during the taxable year and which is included in any class

for which a class life has been prescribed) only an allow-

ance based on the class life preseribed by the Secretary

which reasonably reflects the anticipated useful life of that

class of property to the industry or other group. The

allowance so prescribed may (under regulations prescribed

by the Secretary) permit a variance from any class life by

not more than 20 percent (rounded to the nearest half

year) of such life.

(2) CERTAIN FIRST-YEAR CONVENTIONS NOT PERMITTED.—

No convention with respect to the time at which assets are

deemed placed in service shall be permitted under this sec-

tion which generally would provide greater depreciation

allowances during the taxable year in which the assets are

placed in service than would be permitted if all assets were

placed in service ratably throughout the year and if depre-

ciation allowances were computed without regard to any

convention.

(3) MAakinG or ELECTION.—An election under this sub-

section for any taxable year shall be made at such time, in

such manner, and subject to such conditions as may be pre-

scribed by the Secretary by regulations,

85A

Treasury Regulations on Income Tax (1954 Code) (26 C.F.R.):

§ 1.167(l)-1. Limitations on reasonable allowance in case

of property of certain public utilities.

(a) In general—(\) Scope. Section 167(/) in general pro-

vides L.mitations on the use of certain methods of comput-

ing a reasonable allowance for depreciation under section

167(a) with respect to ‘‘public utility property’’ (see para-

graph (b) of this section) for all taxable years for which

a Federal income tax return was not filed before August 1,

1969. The limitations are set forth in paragraph (c) of

this section for ‘‘pre-1970 public utility property’’ and in

paragraph (d) of this section for ‘‘post-1969 publie utility

property.” Under section 167(/), a taxpayer may always

use a straight line method (or other “subsection (/) meth-

od’’ as defined in paragraph (f) of this section). In general,

the use of a method of depreciation other than a subsection

(1) method is not prohibited by section 167(l) for any tax-

payer if the taxpayer uses a ‘‘normalization method of

regulated accounting’’ (described in paragraph (h) of this

section). In certain cases, the use of a method of deprecia-

tion other than a subsection (/) method is not prohibited

by section 167(/) if the taxpayer used a “flow-through

method of regulated accounting’’ described in paragraph

(i) of this section) for its ‘‘ July 1969 regulated accounting

period’’ (described in paragraph (g) of this section)

whether or not the taxpayer uses either a normalization

or a flow-through method of regulated accounting after its

July 1969 regulated accounting period. However, in no

event may a method of depreciation other than a subsection

(1) method be used in the case of pre-1970 public utility

property unless such method of depreciation is the ‘‘applic-

able 1968 method’’ (within the meaning of paragraph (e)

of this section). The normalization requirements of section

167(l) with respect to public utility property defined in

section 167(1)(3)(A) pertain only to the deferral of Fed-

eral income tax liability resulting from the use of an accele-

rated method of depreciation for computing the allowance

86A

for depreciation under section 167 and the use of straight

line depreciation for computing tax expense and deprecia-

tion expense for purposes of establishing cost of services

and for reflecting operating results in regulated books of

account. Regulations under section 167(/) do not pertain

to other book-tax timing differences with respect to State

income taxes, F. I. C. A. taxes, construction costs, or any

other taxes and items. The rules provided in paragraph

(h)(6) of this section are to insure that the same time

period is used to determine the deferred tax reserve amount

resulting from the use of an accelerated method of depre-

ciation for cost of service purposes and the reserve amount

that may be excluded from the rate base or inciuded in

no-cost capital in determining such cost of services. The

formula provided in paragraph (h)(6)(ii) of this section

is to be used in conjunction with the method of accounting

for the reserve for deferred taxes (otherwise proper under

paragraph (h)(2) of this section) in accordance with the

accounting requirements prescribed or approved, if applic-

able, by the regulatory body having jurisdiction over the

taxpayer’s regulated books of account. The formula pro-

vides a method to determine the period of time during

which the taxpayer will be treated as having received

amounts credited or charged to the reserve account so that

the disallowance of earnings with respect to such amounts

through rate base exclusion or treatment as no-cost capital

will take into account the factor of time for which such

amounts are held by the taxpayer. The formula serves to

limit the amount of such disallowance.

(h) Normalization method of accounting—(1) In general.

(i) Under section 167(/), a taxpayer uses a normalization

method of regulated accounting with respect to public

utility property—

(a) If the same method of depreciation (whether or

not a subsection (/) method) is used to compute both its

87A

tax expense and its depreciation expense for purposes of

establishing cost of service for ratemaking purposes and

for reflecting operating results in its regulated books of

account, and

(b) If to compute its allowance for depreciation

under section 167 it uses a method of depreciation other

than the method it used for purposes described in (a) of

this subdivision, the taxpayer makes adjustments consistent

with subparagraph (2) of this paragraph to a reserve to

refiect the total amount of the deferral of Federal income

tax liability resulting from the use with respect to all of its

publie utility property of such different methods of de-

preciation.

(ii) In the case of a taxpayer described in section

167(/)(1)(B) or (2)(C), the reference in subdivision (1)

of this subparagraph shall be a reference only to such

taxpayer’s ‘‘qualified public utility property’’. See § 1.167

(l)-2(b) for definition of “qualified public utility property”.

(iii) Except as provided in this subparagraph, the

amount of Federal income tax liability deferred as a result

of the use of different method of depreciation under sub-

division (i) of this subparagraph is the excess (computed

without regard to credits) of the amount the tax liability

would have been had a subsection (1) method been used

over the amount of the actual tax liability. Such amount

shall be taken into account for the taxable year in which

such different methods of depreciation are used. If, how-

ever, in respect of any taxable year the use of a method

of depreciation other than a subsection (/) method for

purposes of determining the taxpayer’s reasonable allow-

ance under section 167(a) results in a net operating loss

carryover (as determined under section 172) to a year

succeeding such taxable year which would not have arisen

(or an increase in such carryover which would not have

arisen) had the taxpayer determined his reasonable allow-

ance under section 167(a) using a subsection (/) method,

88A

then the amount and time of the deferral of tax liability

shall be taken into account in such appropriate time and

manner as is satisfactory to the district director.

* * « *

(6) Exclusion of normalization reserve from rate base.

(i) Notwithstanding the provisions of subparagraph (1)

of this paragraph, a taxpayer does not use a normaliza-

tion method of regulated accounting if, for ratemaking

purposes, the amount of the reserve for deferred taxes

under section 167(/) which is excluded from the base to

which the taxpayer’s rate of return is applied, or which

is treated as no-cost capital in those rate cases in which

the rate of return is based upon the cost of capital, exceeds

the amount of such reserves for deferred taxes for the

period used in determining the taxpayer’s tax expense in

computing cost of service in such ratemaking.

(ii) For the purpose of determining the maximum

amount of the reserve to be excluded from the rate base

(or to be included as no-cost capital) under subdivision (i)

of this subparagraph, if solely an historical period is used

to determine depreciation for Federal income tax expense

for ratemaking purposes, then the amount of the reserve

account for the period is the amount of the reserve (deter-

mined under subparagraph (2) of this paragraph) at the

end of the historical period. If solely a future period is

used for such determination, the amount of the reserve

account for the period is the amount of the reserve at the

beginning of the period and a pro rata portion of the

amount of any projected increase to be credited or de-

crease to be charged to the account during such period.

If such determination is made by reference both to an

historical portion and to a future portion of a period, the

amount of the reserve account for the period is the amount

of the reserve at the end of the historical portion of the

period and a pro rata portion of the amount of any pro-

PD SR RT OR LO BITES PE ot a Pe LO

89A

jected increase to be credited or decrease to be charged to

the account during the future portion of the period. The

pro rata portion of any increase to be credited or decrease

to be charged during a future period (or the future portion

of a part-historical and part-future period) shall be deter-

mined by multiplying any such increase or decrease by a

fraction, the numerator of which is the number of days

remaining in the period at the time such increase or de-

crease is to be accrued, and the denominator of which is

the total number of days in the period (or future portion).

(iii) The provisions of subdivision (i) of this sub-

paragraph shall not apply in the case of a final determina-

tion of a rate case entered on or before May 31, 1973.

For this purpose, a determination is final if all rights to

request a review, a rehearing, or a redetermination by the

regulatory body which makes such determination have been

exhausted or have lapsed. The provisions of subdivision

(ii) of this subparagraph shall not apply in the case of a

rate case filed prior to June 7, 1974, for which a rate order

is entered by a regulatory body having jurisdiction to

establish the rates of the taxpayer prior to September 5,

1974, whether or not such order is final, appealable, or

subject to further review or reconsideration.

(iv) The provisions of this subparagraph may be illus-

trated by the following examples:

Example (1). Corporation X is exclusively engaged in

the transportation of gas by pipeline subject to the juris-

diction of the Z Power Commission. With respect to its

post-1969 public utility property, X is entitled under sec-

tion 167(/)(2)(B) to use a method of depreciation other

than a subsection (/) method if it uses a normalization

method of regulated accounting. With respect to X the Z

Power Commission for purposes of establishing cost of

service uses a recent consecutive 12-month period ending

not more than 4 months prior to the date of filing a rate

case adjusted for certain known changes occurring within

90A

a 9-month period subsequent to the base period. X’s rate

ease is filed on January 1, 1975. The year 1974 is the

recorded test period for X’s rate case and is the period

used in determining X’s tax expense in computing cost of

service. The rates are contemplated to be in effect for the

years 1975, 1976, and 1977. The adjustments for known

changes relate only to wages and salaries. X’s rate base

at the end of 1974 is $145,000,000. The amount of the re-

serve for deferred taxes under section 167(/) at the end

of 1974 is $1,300,000, and the reserve is projected to be

$4,400,000 at the end of 1975, $6,500,000 at the end of 1976,

‘and $9,800,000 at the end of 1977. X does not use a nor-

malization method of regulated accounting if the Z Power

Commission excludes more than $1,300,000 from the rate

hase to which X’s rate of return is applied. Similarly, X

does not use a normalization method of regulated account-

ing if, instead of the above, the Z Power Commission, in

determining X’s rate of return which is applied to the rate

base, assigns to no-cost capital an amount that represents

the reserve account for deferred tax that is greater than

$1,300,000.

Example (2). Assume the same facts as in example (1)

except that the adjustments for known changes in cost of

service made by the Z Power Commission include an addi-

tional depreciation expense that reflects the installation of

new equipment put into service on January 1, 1975. Assume

further that the reserve for deferred taxes under section

167(/) at the end of 1974 is $1,300,000 and that the monthly

net increases for the first 9 months of 1975 are projected

to be

January PE ib ccna ee eee $ 310,000

Peet Dames Cac Vaeveuiawens 300,000

March = aA oer 300,000

April ee er aa 280,000

May TS Ybaba asa Rromeeaie pater 270,000

June SO ee vee 260,000

ee ee ee Se eee

lek cok a aks Olin BB a Vek ot

ase

91A

July Na sas bewhs whee 1 260,000

August Soars ee ek pesca neremrarege 250,000

UUONNO BOO iscsi cay sudan. 240,000

$2,470,000

For its regulated books of account X accrues such increases

as of the last day of the month but as a matter of con-

venience credits increases or charges decreases to the re-

serve account on the 15th day of the month following the

whole month for which such increase or decrease is accrued.

The maximum amount that may be excluded from the rate

base is $2,470,879 (the amount in the reserve at the end of

the historical portion of the period ($1,300,000) and a pro

rata portion of the amount of any projected increase for

the future portion of the period to be credited to the reserve

($1,170,879) ). Such pro rata portion is computed (without

regard to the date such increase will actually be posted to

the account) as follows:

$310,000 x 243/273 = $ 275,934

300,000 X 215/273 = 236,264

300,000 X 184/273 = 202,198

280,000 X 154/273 = 157,949

270,000 X 123/273 = 121,648

260,000 x 93/273 = _ 88,571

260,000 X 62/273 = —59,048

250,000 X 31/273 = — 28,388

240,000 x 1/273 = 879

$1,170,879.

Example (3). Assume the same facts as in example (1)

except that for purposes of establishing cost of service the

Z Power Commission uses a future test year (1975). The

rates are contemplated to be in effect for 1975, 1976, and

1977. Assume further that plant additions, depreciation

expense, and taxes are projected to the end of 1975 and

92A a

; 93.A

that the reserve for deferred taxes under section 167(/) ’ : ase

is $1,300,000 for 1974 and is projected to be $4,400,000 at ype . a oes hy see

the end of 1975. Assume also that the Z Power Commission 750.000 x 93/365 ve 191.096

applies the rate of return to X’s 1974 rate base of $145,- 630.000 x 1/365 fi 1796

000,000. X and the Z Power Commission through nego- : ; wa ,

tiation arrive at the level of approved rates. X uses a TERR ag

normalization method of regulated accounting only if the ’ $1,291,480

settlement agreement, the rate order, or record of the ft

proceedings of the Z Power Commission indicates that the

Z Power Commission did not exclude an amount repre-

senting the reserve for deferred taxes from X’s rate base

($145,000,000) greater than $1,300,000 plus a pro rata por-

tion of the projected increases and decreases that are to

be credited or charged to the reserve account for 1975.

Assume that for 1975 quarterly net increases are projected

to be

RRs ere $ 910,000

NE Fak tanneries sen 810,000

Be GE Nac venevesneuss 750,000

SE ORIG ok disc cemcvensans 630,000

$3,100,000

For its regulated books of account X will accrue such in-

creases as of thé last day of the quarter but as a matter

of convenience will credit increases or charge decreases to

the reserve account on the 15th day of the month following

the last month of the quarter for which such increase or

decrease will be accrued. The maximum amount that may

be excluded from the rate base is $2,591,480 (the amount of

the reserve at the beginning of the period ($1,300,000) plus

a pro rata portion ($1,291,480) of the $3,100,000 projected

increase to be credited to the reserve during the period).

Such portion is computed (without regard to the date such

increase will actually be posted to the account) as follows:

APPENDIX D

95A.

APPENDIX D

INTERNAL REVENUE SERVICE DEPARTMENT OF THE TREASURY

Index Number 0167.23-00

Washington, DC 20224

Mr. Robert Dalenberg

Vice-President & General Counsel

Pacific Telephone & Telegraph

Company

140 New Montgomery Street

San Francisco, California 94105

Date: 8 June 1978

Taxpayer—Pacifiec Telephone & Telegraph Co.*

State—California

Yommission—California Public Utility Commission

Parent—American Telephone & Telegraph Co.

Representative—Caplin & Drysdale

Decision X—87838, September 13, 1977

Dear Mr. Dalenberg:

This replies to your ruling request dated September 29,

1977, as supplemented, the latest being dated May 3, 1978,

and filed on your behalf by your representatives concerning

your company (taxpayer).

You request a ruling that should Decision No. X of the

Commission, dated September 13, 1977, become final, will

the taxpayer remain eligible for: 1) accelerated depreci-

ation under section 167(/) of the Internal Revenue Code;

2) depreciation based on Class Lives Asset Depreciation

*The comparable ruling issued to General is printed in this

Appendix, infra, pp. 116A-131A.

96A

Range (CLADR) system for post-1970 public utility prop-

erty; 3) depreciation based on the Class Life (CL) system

for pre-1971 public utility property (1968 and 1969 vintage

accounts); and 4) the investment tax credit?

Taxpayer is a state corporation and is a subsidiary of its

parent, which has its principal place of business at 195

Broadway, New York, New York 10007. Taxpayer is sub-

ject to regulation by the Commission with respect to its in-

trastate rates and services. It is a member of a group cf

affliated corporations which files consolidated Federal in-

come tax returns under section 1501 of the Code.

By letter dated December 22, 1977, you have formally

requested that the issues be separated and the first three

issues answered first and the investment tax credit issue

responded to at a later date. Based on your request, we are

replying to the first three issues in this ruling letter and

will reply to the investment tax credit issues at a later date.

Several state utilities, taxpayer not being one of them,

elected accelerated depreciation in the 1950’s and chose to

establish a reserve on their books of account and for rate-

making purposes for the deferred taxes. This was a nor-

malization method of accounting.

In 1960 the Commission determined that the flow-through

method of accounting was to be used in setting rates for

utilities using accelerated depreciation for tax purposes.

Taxpayer did not elect the accelerated method of depre-

ciation, but chose to remain on the straight line method for

tax purposes (until 1970) and in computing depreciation

expense in its regulated books of account. Thus, taxpayer

used a straight line method of depreciation for both its

regulated books of account and for tax purposes for its pre-

1970 publie utility property.

Taxpayer made a timely election to claim depreciation

under the CL system for its pre-1971 public utility property.

Pursuant to section 1.167(a)-12(a)(4) (iii) of the Income

Tax Regulations, the taxpayer has normalized, based on

97A

straight line depreciation, the difference between the longer

book lives (to compute depreciation for book purposes) and

the shorter CL system lives (to compute depreciation for

actual tax purposes). The deferred tax amount is placed in

a reserve account that is deducted from the adjusted rate

base in the computation of the taxpayer’s cost of service for

ratemaking purposes.

Pursuant to the Tax Reform Act of 1969, the taxpayer

made a timely election to use accelerated depreciation to

compute depreciation expense for determining its Federal

income tax, beginning with its 1970 tax return and used the

normalization method of accounting. Therefore, taxpayer

in using an accelerated method of depreciation with respect

to its post-1969 public utility property. As taxpayer was

using the straight line method of depreciation, as provided

under section 167(1)(1)(A) of the Code, for tax purposes

on August 1, 1969, it was not eligible to use the flow-through

method of accounting.

Taxpayer has made a timely election to use the CLADR

system for its post-1970 public utility property. Pursuant to

section 1.167(a)-11(b)(6)(ii) of the regulations, the tax-

payer has normalized the difference between the book lives

(to compute depreciation for book purposes) and the power

limit of the appropriate asset guideline range (to compute

depreciation for actual tax purposes). The deferred tax

amount is placed in a reserve account that is deducted from

the adjusted rate base in the computation of the taxpayer’s

cost of service for ratemaking purposes.

The Commission issued a decision on November 6, 1968,

concerning taxpayer, establishing rates by reducing tax-

payer’s tax expense for the test year 1967 as though it had

used accelerated depreciation on its 1967 tax return. By

computing accelerated depreciation with flow-through, the

Commission gave the ratepayers the benefit of a tax defer-

ral which the taxpayer did not actually realize. With the

taxpayer’s announced use of accelerated depreciation the

98A

Commission issued an interim decision on November 24,

1970, holding that taxpayer’s rates would be established to

reflect its use of accelerated depreciation and the normaliza-

tion method of accounting. On June 22, 1971, the Commis-

sion granted a rate increase to taxpayer based on the in-

terim decision.

_ On November 26, 1971, the state Supreme Court annulled

the interim decision of November 24, 1970, holding that the

Commission had erred in failing to consider lawful alter-

natives to normalization. The court ruled that imputed ac-

celerated depreciation with flow-through was a lawful alter-

native, but remanded to the Commission for consideration

of all alternatives, including normalization and any com-

promise between normalization and imputed accelerated de-

preciation with flow-through. The court then annulled the

Commission’s June 22, 1971 decision and ordered the Com-

mission to reinstate the rates established in the 1968 de-

cision. On July 23, 1974, the Commission issued a decision

granting taxpayer a rate increase based on accelerated de-

preciation with normalization. The Commission adopted

normalization to preserve the taxpayer’s eligibility for ac-

celerated depreciation.

On December 12, 1975, the court annulled that part of the

Commission’s 1974 order relating to the treatment of tax

expense, resulting from the use of accelerated depreciation,

principally because the court disagred with the Commis-

sion’s conclusion that it had no regulatory authority to con-

sider alternate methods of treating the accelerated depre-

ciation. The court remanded for further proceeding relating

to tax expense.

Following additional hearings, the Commission issued

Decision X on September 13, 1977. This decision covers the

tax issues in three separate rate cases using test periods

for: 1) calendar year 1973; 2) fiscal year 7/1/74-6/30/75

and; 3) fiscal year 7/1/75-6/30/76. The Commission or-

dered the taxpayer to make refunds and annual reductions

in rates with respect to these cases.

99A

It seems the Commission had the view that full flow-

through of the tax deferral resulting from using accelerated

depreciation was the proper and best ratemaking method,

but could not consider it as the taxpayer was not eligible

for this method of accounting, since taxpayer was using

straight line depreciation on August 1, 1969.

The Commission had previously taken into account the re-

duced risk accompanying the election of the normalization

method of accounting in determining taxpayer’s rate of

return. The Commission believed it would be unfair to re-

flect the reduced rate twice in the rate of return and, there-

fore, proposed an ‘‘average annual adjustment method.”’

In its presentation of this method, the Commission has at-

tempted to take into aecount section 1.167(1)-1(h)(6) of

the regulations so as to allow the taxpayer to maintain

the election of accelerated depreciation for tax purposes.

Decision No. X states that the theory of the method is

that because the increase in the deferred tax reserve is

deducted from the rate base, the authorized rate of return

on the smaller rate base produces less revenue. The smaller

amount of net revenue will then produce less tax expense,

since the taxable income will be decreased. Essentially, the

total of the reduction in net revenues and the decreased tax

expense, together with the adjusted for uncollectibles,

amounts to the total gross revenue reductions.

In setting rates the Commission’s method uses the tax-

payer’s actual reserve for deferred taxes for the years

1973, 1974 and 1975, and estimated plant additions for the

succeeding three years of each test year and computed the

estimated reserve for deferred taxes for these years. The

simple average of the average annual reserve for deferred

taxes for both pre-1970 public utility property and post-

1969 public utility property for the four year period was

deducted from the rate base, that was adjusted for the test

year depreciation reserve, but not for the additional esti-

mated depreciation reserve for the succeeding three years.

100A

As this computed reserve for deferred taxes was larger

than the test year figure, the subtraction of this amount

from the rat> base resulted in a rate base that was less

than the test year rate base. The taxpayer’s authorized rate

of return was then applied to the reduced rate base to com-

pute the reduced net operating income. This reduced net

operating income was then substituted in the cost of serv-

ice for the larger test year net operating income figure and

certain net-to-gross multipliers were applied to the reduced

net operating income to compute the reduced tax expense

and reduced gross revenues. The reduced tax expense was

then substituted in the cost of service for the larger test

year tax expense for ratemaking purposes. Because of this

lower overall cost of service for ratemaking purposes, the

rates that taxpayer charged its customers are now subject

to refund and rate reduction. The Commission believes the

taxes set aside in the deferred tax reserve shall never be

paid and amounts to a tax savings rather than a tax de-

ferral. The depreciation expense, included in the cost of

service, was left undisturbed.

The Commission believes the normalization method of ac-

counting does not approach the only sensible and realistic

method of setting rates, that is, using the actual tax ex-

pense as the cost of service tax expense. It believes their

annual average adjustment adopted in its Decision No. X

‘‘is a

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