# Appendix — Pacific Telephone & Telegraph Co. v. Public Utilities Commission > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385005_1873%3A02 ## Record - **Collection:** Supreme Court brief - **Document type:** Appendix - **Published:** January 1, 1978 - **Citation:** 439 U.S. 1052 ## Text ~~“ 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 ; ; 7 | 1A 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 2A 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 a fala ta 3A 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- 4A 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. 5A 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.) 6A 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) 7 10 11 12 13 18 20 28 30 32 34 35 38 40 41 45 47 53 54 Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F 7A 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- 8A 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.’’ 9A 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 ce 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- a 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. se 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- ee 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 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 a a 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 eee eter ae 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 DA 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. 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Se 2 Se eS B «oats. tha S oe eee 2 = = 6 66 a) at ~ BS55,58 2 8 865 + gS SE SES ass nase 8 Bem . 8938388 &S 2S uMNS uN 6S SCHSEE Ba SB BF GF ~ ” 5 ” a 2 re qs ~ o sS a = a 2 a | ° tzs‘9 $ UOTIVZY[VMAON JO S89OXq UT uoTjonpeg Zurosug [wnuuy nIls‘9 SL6l __eorpes = LLG = ‘TE Aoquiadaq ysnoiyL spunjoy [30], u6se'e LL6L Tzs‘9 8e9 8b8's cgo‘e sgs‘zt 082°6 Los‘Oll 608'3s 6IS‘l¥ 9261 oa St b LL6OL S08 9L6T ot 9862 CL6l o 0&3 rL6I ree'9 ¥6S gcl's cse's = «L628 z18‘s 699°S9 £20'% T88‘St ¥L6I 2£02'S PL6L 2868'S €L6l as “- ol6l ae — $ TL61T _ _— 9e2'e¢ ccze Ter‘ i¢ ose'I$¢ I29TS tT $ oes 6 «COCTTZT $= osgs’s & OL6T xipueddy Le eT PE ene alts bi 60A 61A 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. __ gpe'sse — GFnorgy-MopT ogi] aorsseg Jo Bseoxy ut worjonpay FET 1B0X 9PE'es 11s 096‘0T GL8‘IT ShO'eS OLT IT e89‘Ll (8261) 1 FEES 861 9IF'El £62 662'9 $289 et b66'LT et OLUIT c96'TL (2261) _— _ — — n OLTII ec OLTIL nx 0L0'F9 9L-SL6I __Tes‘tss LL6I ‘Tg Jequasveq YyBnoiyy, spunzey [ez0J, ot 3299'S LL61 T8L‘1z 9Lb 922 01 6L0°TT £66 LI ct6'9 co6'TL (L161) ot TI9°S1 9L61 oRs‘sl GL L06°¢ ooF'9 creel cl6'9 £86°S9 (9261) _— _ _— _ « SI69 n S169 60S EF GL-bLET oSt3 961 6FL‘6I 36 162'6 990'0T creel 6b2'E £86'C9 (9261) o30e' el CL6I eee il C3s see’s 9LL'S 6206 6a LST‘39 (e261) ol IFT PL6I esos 09 Lert gcs'T CO8't 6F2'E 106'62 (#161) — 8 _ — ¢ —* — §¢ -— § 6h es F 6ba'e ¢ 8203s £261 (SGNVSNOHWL NI SUVTTITOd) (1) (H) (D) (a) (a) (a) (9) (a) (v) s punjoy 1¥9 x 2 YsnomyL » 89Da . 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AS Sin rc 3 2 ai a> A= US. | * oe — 2 us eS 23 #5 3 ‘ ° x aa 4 a tH b4 — “es es ~ 4S | — ~ — n a m = — rs) sa cm |. ar) © 27, 98 5 - + a, pe Bos g°* se ie ws 3 Se §. Ss | Se (3 S £2 -& “ Ss > tt e ' - 7 8 Cae Ae _ wo ES Bp = — — & ea 6 . 3m 5 aw ee 28 SX ge aees 8 § a & @.2 2. as ae , Ae Fo se 2 B> 8F SHR seta ypos © & S 2) 4 * r= > om OO Vw OF te x = eo ° = § »e EX $9 + Ze ~ - oO gs 2s sd =e 2 8 vw # =z cmt lot ~~ la US S @ a Sa™*mo®* - Sau ts 8 BS S .. S ° ~~ «ww Gy OO =) vo = ue = | Sh =] 92 3 at i Se $5 23 ef — e 252° 6 & 3. ~~ ee HR Rx esse oss 22 q 3 BSB, 9S SRF SOF AA SY . -~ 4 Nn oS Be) +t r=) bs 2 a C) a _ 7 x Ss o = — 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 more equitable and realistic method of normalization than the other proposals and the best available now.”’ Decision No. X states that the actual Federal tax expense bears no direct relation to the increase in deferred tax re- serve, but fluctuates independently of it and cites an exhibit submitted by the taxpayer in a rate case. It believes that the Code or regulations thereunder do not discuss the estimat- ing process and believes that this method uses the same time period for estimating the reserve for deferred taxes and the tax expense for establishing cost of service for ratemaking purposes; and that section 1.167(/)-1(h) (6) of the regulations is satisfied and eligibility is maintained for 101A accelerated depreciation, CLADR system and the CL sys- tem. ; In reviewing the taxpayer’s record in the proceedings, it came to the attention of the Commission that for the 1968 and 1969 vintage plant additions no aecelerated deprecia- tion was ever reflected in taxpayer’s rates. In a previous application of taxpayer, imputed flow-through was pro- posed for the 1968 and 1969 vintage accounts. Decision No. X adopted this imputed flow-through for these years and used it to determine tax expense in each of the three tax- payer’s test year cost of services for ratemaking purposes to compute the reduction in rates and the amount of the refund. The taxpayer became concerned when the Commission’s Decision No. X was issued and therefore requested the present ruling to determine whether the decision would im- pair its eligibility for accelerated depreciation, use of CLADR system under section 1.167(a)-11 of the regulations and the CL system under section 1,167(a)-12. If the deci- sion becomes final and is inconsistent with the Code and regulations thereunder, taxpayer stated it will have enor- mous Federal tax obligations for both past and future years. The request for this ruling is the result of the Com- mission’s decision. The taxpayer states it is following the normalization method of accounting in regard to accelerated depreciation under section 167(l) of the Code and adhering to the nor- malization of tax deferrals resulting from the use of shorter lives for tax purposes than are used for regulatory pur- poses to comply with section 1.167(a)-11(b)(6)(ii) of the regulations for post-1970 public utility property CLADR system and section 1.167(a)-12(a) (4) (iii) for pre-1971 pub- lic utility property CL system. It is the taxpayer’s belief that the average annual ad- justment method is the same as the method proposed by the Commission’s staff several years ago and rejected by the 102A Commission as being inconsistent with section 167(l) of the Code and regulations thereunder. The taxpayer states that the simple average of the reserve for deferred taxes that is excluded from the rate base is greater than the amount of th reserve for deferred taxes excluded from the test year rate base. Therefore, the exclusion of a larger deferred tax reserve covering a different time period than the time period used in determining tax expense for cost of service purposes is precisely what section 1.167(1)-1(h)(6) of the regulations prohibits. The taxpayer further states that when a computation is made of net revenue reduction, it has a bearing on tax ex- pense because of the necessary mathematical relationship between after-tax net revenues and Federal income taxes. The taxpayer believes the Commission’s computation is not how the tax expense under section 1.167(1)-1(h)(6) (i) of the regulations should be computed, otherwise this section of the regulations would have no meaning as far as the amount of the reserve for deferred taxes to be deducted from the rate base is concerned, The taxpayer believes the tax expense as computed under the average annual adjust- ment method does not represent actual or a proper esti- mated tax expense for the test year, any future year, or any average of these years. The taxpayer is also concerned about the Commission’s use of the actual reserve for deferred taxes being used for the calendar years 1973, 1974 and 1975, while using esti- mated figures for all other cost of service items, including tax expense. The deferred tax reserve figures for each of the test years were substantially higher than the original estimated figures, as more property was placed in service than originally estimated. Should the Commission amend its decision to eliminate the four-year forward averaging of the reserve for deferred taxes, the taxpayer states the deferred portion of normal- ized tax expense included in the cost of service for each test ys 4 tke PS A Ae one me Sa yties el Ro o 103A year would still be equa! to the lower estimated figure, while the deferred portion of the normalized tax expense excluded from the rate base would be equal to the higher actual fig- ure. Therefore, the taxpayer believes the amount credited to the reserve and excluded from the rate base should be based on the deferred portion of the tax expense as stated under sections 1.167(/)-1(h)(1)(i) and (iii) of the regula- tions. The taxpayer further states that if the larger actual amount of the reserve is excluded from the rate base then the actual tax expense must be included in the cost of serv- ice for ratemaking purposes, otherwise the exclusion of the larger actual amount of the reserve for deferred taxes, without the use of the actual tax expense, would be in vio- lation of section 1.167(l)-1(h) (6). In regard to the question of being eligible for the contin- ued use of accelerated method of depreciation for its post- 1969 public utility property when the Commission has or- dered imputed flow-through treatment with respect to the taxpayer’s 1968 and 1969 vintage accounts, taxpayer states that it computes depreciation allowance for its 1968 and 1969 vintage accounts for both its regulated books of ac- count and tax purposes on the straight line method in ac- cordance with section 167(/)(1)(A) of the Code. Also, the imputed flow-through method of accounting for the 1968 and 1969 vintage accounts does not prevent the use of the accelerated methods of depreciation for its post-1969 public utility property. The taxpayer cites section 1.167(1)-1(d) (2)(ii) of the regulations, and believes that the phrase, ‘‘with respect to the property’’ means the normalization requirements with respect to the property on which accel- erated depreciation is claimed. The taxpayer believes the normalization method of accounting need not be followed for all property as a condition to using accelerated depre- ciation for post-1969 public utility property. In regard to the question of being eligible to continue the use of the CL system for pre-1971 property, the taxpayer states the Commission’s treatment of the 1968 and 1969 104A vintage accounts relates only to accelerated depreciation and does not reflect any adjustment of the shorter lives for the property under the CL system than are being used in computing tax expense and depreciation expense in the cost of service for ratemaking purposes. The taxpayer therefore believes the Commission’s imputed flow-through of acceler- ated depreciation for the 1968 and 1969 vintage accounts does not impair its eligibility to use the CL system with respect to these vintage accounts. Section 167(1)(1)(A) of the Code provides that in re- gard to pre-1970 public utility property, the term ‘‘reason- able allowance’’ ineans; (i) a subsection (1) method or; (ii) the applicable 1968 method for such property. Section 167(/)(2)(B) of the Code provides that the tax- payer may use an accelerated method of depreciation if it uses a normalization method of accounting. Section 167(/)(3)(Q) of the Code provides that to use a normalization method of accounting with respect to public utility property, the taxpayer must use the same method of depreciation to compute both its tax expense and depreci- ation expense for purposes of establishing its cost of serv- ice for ratemaking purposes and for reflecting operating results in its regulated books of account. It then has to use, for computation of its Federal income tax liability, a method of depreciation other than that used for tax ex- pense and depreciation expense and to make adjustments to a reserve to reflect the deferral of taxes resulting from the use of these different methods of depreciation. Section 167{/)(3) (Hl) of the Code provides that to use a flow-through method of accounting with respect to any pub- lie utility property, the taxpayer must use the same method of depreciation, (other than a subsection (1) method), to compute its Federal income tax liability and to compute its tax expense for purposes of reflecting operating results in its regulated books of account. 105A Section 1.167(a)-11(a)(1) of the regulations provides an optional election of an asset depreciation range and class life system for determining the reasonable allowance for depreciation of designated classes of assets placed in serv- ice after December 31, 1970. Section 1.167(a)-11(b)(6) (ii) of the regulations provides that, for purposes of normalization, a taxpayer that has public utility property, for which no guideline life was pre- scribed in Rev. Proc. 62-21, shall use the period for depre- ciation for computing tax expense for ratemaking purposes and in its regulated books of account, that is the period for computing the depreciation expense for ratemaking pur- poses and for reflecting operating result in its regulated books of account. The normalization method of accounting shall have the same definition as stated in sections 167(/) (3)(G) of the Code and 1.167(1)-1(h). Section 1.167(a)-11(b) (6) (ili) of the regulations provides that if a taxpayer fails to normalize the tax deferral, the election to apply this section to such property shall termi- nate as of the beginning of the taxable year for which the taxpayer fails to normalize the tax deferral. Section 1.167(a)-12(a) of the regulations provides an elective class life system for determining the reasonable allowance for depreciation of certain classes of assets for taxable years ending after December 31, 1970. This applies to assets placed in service before January 1, 1971. Section 1.167(a)-12(a) (4) (iii) of the regulations provides that, for purposes of normalization, a taxpayer that has public utility property, for which no guideline life was pre- scribed in Rev. Proc. 62-21, shall use the period for depre- ciation for computing tax expense for ratemaking purposes and in its regulated books of account, that is the period for computing the depreciation expense for ratemaking pur- poses and for reflecting operating results in its regulated books of account. The normalization method of accounting 106A shall have the same definition as stated in section 167(/) (3)(G) of the Code and section 1.167(/)-1(h). Section 1.167(a)-12(a) (4) (iii)(¢) of the regulations pro- vides that if a taxpayer fails to normalize the tax deferral, the election to apply the CL system shall terminate as of the beginning of the taxable year for which the taxpayer fails to normalize the tax deferral. Section 1.167(/)-1(a)(1) of the regulations provides that the use of a method of depreciation other than a subsection (7) method (which includes the straight line method) is not prohibited by section 167(l) for any taxpayer if the tax- payer uses a normalization method of regulated accounting. This section also states that the normalization method of accounting with respect to public utility property pertains only to the deferral of Federal income tax liability result- ing from the use of an accelerated method of depreciation for computing the allowance for depreciation under section 167 of the Code and the use of straight line depreciation for computing tax expense and depreciation expense for pur- poses of establishing cost of service and for reflecting operating results in the regulated books of account. This section of the regulations also provides that under section 1.167(/)-1(h) (6), the same time period is used io determine, for cost of service purposes, the amount of the deferred tax reserve resulting from the use of an accelerated method of depreciation and the reserve amount that may be excluded from the rate base in determining the cost of service. Section 1.167(1)-1(d)(2)(ii) of the regulations provides that under section 167(/)(2) of the Code, in the case of post- 1969 public utility property, the term ‘‘reasonable allow- ance’? means a subsection (1) method or a methed of de- preciation otherwise allowable under section 167 if with respect to the property the taxpayer uses a normalization method of regulated accounting. 107A Section 1.167(/)-1(h)(1)(i) of the regulations describes the normalization method of accounting, such as was de- scribed under section 167(1)(3)(G) of the Code. Section 1.167(/)-1(h) (2) of the regulations provides that when a taxpayer uses a normalization method of accounting he must credit the amuwnt of deferred Federal income tax to a reserve for deferred taxes. Section 1.167(1)-1(h)(4) (ii) of the regulations provides that where a taxpayer did not use the flow-through method of regulated accounting for its July 1969 regulated ac- counting period or thereafter (including a taxpayer who uses a subsection (/) method to compute its depreciation under section 167(a) of the Code and to compute its tax expense for reflecting operating results in its regulated books of account) it will be presumed that the taxpayer is using the same method of depreciation to compute both its tax expense and its depreciation expense for purposes of establishing its cost of service for ratemaking purposes with respect to its post-1969 public property. Section 1.167(1)-1(h)(6)(i) of the regulations provides that a taxpayer does not use a normalization method of regulated accounting if, for ratemaking purposes, the amount of the reserve for deferred taxes which is excluded from the rate base to which the taxpayer’s rate of return is applied exceeds the amount of such reserves for deferred taxes for the period used in determining the taxpayer’s tax expense in computing the cost of service for ratemaking purposes. Section 1.167(1)-1(h)(6) (ii) of the regulations provides that the amount of reserve that may be excluded from the rate base when an historical period is used to determine depreciation for Federal income tax expense for ratemak- ing purposes, is the amount at the end of the historical period. When a future period is used to determine the amount to be excluded, then it is the amount at the begin- ning of the period and a pro rata portion of the amount of 108A any projected increase to be credited or decreased to be charged to the account during the future period. If the amornt of reserve to be excluded is to be made by reference to both an historical period and a future portion of a pe- riod, then the amount of the reserve to be excluded from the rate base for the whole period is the amount at the end of the historical portion of the period and a pro rata portion of the amount of any projected increase to be credited or decrease to be charged to the reserve account during the future portion of that period. The Tax Reform Act of 1969 (1969-3 C.B. 423, 532) changed for tax purposes the method of treatment of accel- erated depreciation allowed regulated utilities. Prior to this Act there were an increasing number of regulated utilities shifting from straight line depreciation to accelerated de- preciation. At the same time regulatory agencies, which had previously permitted the tax deferrals to be normalized, tended to require the flowing-through to the customers of the tax deferrals resulting from the use of accelerated de- preciation. Later, several regulatory agencies imputed ac- celerated depreciation in determining the Federal tax ex- pense of certain public utilities and flowed through the re- sultant fictional tax deferrals, even though the utility was using straight line depreciation and was paying the greater amount of Federal income tax resulting from the use of the straight line method of depreciation. Congress ‘‘froze’’ the situation as of August 1, 1969, re- garding methods of depreciation by enacting section 167 (J) of the Code. The 1969 Act applied the following rules for depreciation in the case of existing property. 1. If straight line depreciation was being taken as of Augusi 1, 1969, then no faster depreciation is permitted as to that property. 2. If the taxpayer was taking accelerated depreciation and was ‘‘normalizing’’ its deferred taxes, as of August 1, 109A 1969, then it must shift to the straight line method unless it continues to normalize as to that property. 4. If the taxpayer was taking accelerated depreciation and flowing through the benefits of the deferred taxes to its customers as of August 1, 1969, then the taxpayer would continue to do so, unless the appropriate regulatory agency permits a change to normalize as to that property. In the case of new property placed in service after 1969, if the taxpayer was flowing-through to its customers the benefits of deferred taxes, then it would stay on accelerated depreciation and flow-through unless the regulatory agency permits it to change to normalization. In all other cases accelerated depreciation is permitted only if the taxpayer normalizes the deferred taxes. The taxpayer is also per- mitted to elect straight line depreciation as to this new property. The question presented whether the taxpayer will re- main eligible for: (1) accelerated depreciation under sec- tion 167(l) of the Code; (2) depreciation based on the CLADR system for post-1970 public utility property; and ‘3) depreciation based on CL system for pre-1971 public utility property cannot be answered until it is determined whether the average annual adjustment method required by the Commission is a proper normalization method of accounting as defined by section 1.167(1)-1(h)(1)(i) of the regulations. Under the Commission’s average annual adjustment method, which takes into consideration [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385005_1873%3A02. Public record. Not legal advice.