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decided: September 26, 1988.


Appeals from the Orders of the Pennsylvania Public Utility Commission in the case of Pennsylvania Public Utility Commission v. Continental Telephone Company of Pennsylvania, Nos. R-850044, R-850044C001, R-850044C002, R-850044C003, R-850044C004 and R-850083; and in the case of Pennsylvania Public Utility Commission v. Quaker State Telephone Company, Nos. R-850045 and R-850045C001.


D. Mark Thomas, with him, Charles E. Thomas, Thomas & Thomas, for petitioners.

Billie E. Ramsey, Assistant Counsel, with her, Bohdan R. Pankiw, Deputy Chief Counsel, and Daniel P. Delaney, Chief Counsel, for respondent.

Daniel Clearfield, Assistant Consumer Advocate, with him, Sally Strauss, Legal Assistant, for intervenor, Consumer Advocate of Pennsylvania.

Charles D. Gray, Assistant General Counsel, with him, Paul Rodgers, General Counsel, for amicus curiae National Association of Regulatory Utility Commissioners.

President Judge Crumlish, Jr., and Judges Craig, MacPhail, Doyle, Barry, Colins and McGinley. Opinion by Judge Craig. President Judge Crumlish, Jr. did not participate in the decision of the case.

Author: Craig

[ 120 Pa. Commw. Page 27]

Two telephone utilities, Continental Telephone Company of Pennsylvania and Quaker State Telephone Company, appeal from orders of the Pennsylvania Public Utility Commission (PUC or commission) that approved rate increases for the utilities but allowed them to recover in rates only a portion of the federal tax expenses that they claimed in their rate filings.

The sole issue raised by the utilities on this appeal is whether the PUC erred as a matter of law by recognizing tax savings that they realized because of their participation in a consolidated tax return of their parent corporation, in view of the utilities' claim that the PUC order is contrary to a private letter ruling issued by the federal Internal Revenue Service (IRS), after the appeal to this court, stating that such a reduction of their federal income tax expense would cause them to be in violation of certain provisions of federal tax law requiring public utilities to normalize benefits they realize from making use of accelerated depreciation provisions of the tax law.

[ 120 Pa. Commw. Page 28]

"Normalization" is a ratemaking concept designed to adjust a utility's operating expenses in its test year by eliminating abnormal, non-annual events which are known and certain to change in a regularly recurring manner. As applied to the effect of accelerated depreciation on public utility income tax expenses, normalization permits the utility to include in its current rate calculations an income tax expense higher than what the utility has actually paid, on the theory that the taxes saved by accelerated depreciation are merely deferred. Under sections 167(l) and 168(e)(3) of the Internal Revenue Code, 26 U.S.C. §§ 167(l) and 168(e)(3), normalization means that utilities employing rapid depreciation of certain of their assets, for tax purposes, must compute their federal income tax expense for ratemaking as if they were employing a straight-line method of depreciation, and they must enter the difference between the large deductions actually taken and the lower straight-line deductions into a deferred taxes account, rather than passing these savings on to customers. Ratepayers realize some benefit from the deferral of taxes because the utility's rate base is reduced by the amount of the adjustment to the deferred tax reserve. See Barasch v. Pennsylvania Public Utility Commission, 507 Pa. 496, 500 n.1, 505-06, 491 A.2d 94, 95 n.1, 98 (1985) (Barasch/Penn Power) and 26 C.F.R. § 1.167(l)-1(h)(6).

The policy behind requiring normalization of deferred tax expense is to provide incentives for capital formation by channeling the benefits of accelerated depreciation to the company, rather than to the ratepayers. Although the taxes deferred are credited to a reserve for taxes, those funds are available for any proper business purpose, and, in theory, they will be used to finance new capital expenditures until higher taxes fall due. Of course, if the ratemaking process passed the benefits of

[ 120 Pa. Commw. Page 29]

    accelerated depreciation through to the ratepayers, the described incentives would be negated. Barasch/Penn Power, 507 Pa. at 505 and n.6, 491 A.2d at 98 and n.6.


When consolidated tax returns are used, each subsidiary of a parent corporation calculates its separate income, deductions, tax liability and tax credits on a stand-alone basis, but each subsidiary does not then file a separate federal income tax return or pay the calculated tax to the IRS. Rather, the subsidiary submits its calculations (and, typically, the amount of its stand-alone tax liability, if any) to the parent corporation. As is permitted by sections 1501-1505 of the Internal Revenue Code, 26 U.S.C. §§ 1501-1505, the parent corporation then offsets taxable income generated by some subsidiaries with tax losses and credits generated by other subsidiaries to arrive at a figure representing the taxable income of the consolidated group.

Continental and Quaker State are wholly-owned subsidiaries of Contel Corporation (Contel),*fn1 a holding company with numerous subsidiaries throughout the nation, including both regulated telephone utilities and unregulated companies. The utilities do not dispute that, as a result of consolidated return offsetting of income, the federal income tax return of the parent, Contel, has reflected in recent years an aggregate tax liability that has been significantly less than the sum of the subsidiaries' liabilities computed on a stand-alone

[ 120 Pa. Commw. Page 30]

    basis. Brief of Petitioners p. 14; R.R. 446a.*fn2 Nevertheless, in their rate increase filings before the PUC, the utilities claimed federal income tax expenses equal to the full amount of their stand-alone tax liabilities.

After hearings and the issuance of recommended decisions by Administrative Law Judge Morris Mindlin, the PUC, on February 6, 1986, entered final opinions and orders approving rate increases for Continental and Quaker State. The commission's orders reduced the utilities' claimed federal income tax expenses on the basis of the commission's conclusion that Pennsylvania law requires the PUC to disallow as an expense for ratemaking purposes any federal income tax expense claimed by a utility that the utility does not actually pay to the federal government. The commission acknowledged that, if an adjustment to a utility's claimed tax expense caused a violation of the normalization requirements of the Internal Revenue Code, thereby depriving the utility of the opportunity of benefitting from accelerated depreciation deductions, to the overall detriment of its ratepayers, then the adjustment would be "objectionable."

The reductions to the claimed tax expenses that the PUC adopted were those proposed by the expert witness for the Office of Consumer Advocate (OCA), Thomas S. Catlin.*fn3 Mr. Catlin explained his method of calculating the adjustments as follows:

The first step in my calculations was to compare the taxes which the members of the Contel

[ 120 Pa. Commw. Page 31]

    system would have paid on a separate return basis to the actual consolidated income taxes of the system to determine the savings from consolidation in each year. I then reduced these savings to exclude those amounts resulting from the losses of the regulated companies. I then determined Continental's and Quaker State's share of the net savings in each year based on their tax liability on a separate return basis compared to the tax liability of all members of the system on a separate return basis. Finally, I averaged the tax savings for the years 1981 through 1983 and applied the intrastate factor for income tax deductions to determine my adjustment.

OCA Statement No. 3, p. 41; R.R. 422a.*fn4

The commission expressly preferred the adjustments proposed by OCA over those proposed by the commission's Trial Staff, because OCA's proposals were "effectuated only to the extent of current taxes." R.R. 162a, 271a. That is, the OCA proposal applied the consolidated tax savings adjustment to reduce the amount of current taxes to zero, if the savings were that great, but not beyond zero. The utility's allowance for deferred federal income tax, calculated pursuant to the accelerated depreciation provisions, remained untouched. Even where

[ 120 Pa. Commw. Page 32]

    the consolidated tax savings were greater than the total current taxes, the excess consolidated savings were not applied to reduce the amount of deferred taxes.*fn5 In rejecting the reasoning of the utilities' expert witness -- to the effect that funds earmarked for the payment of federal taxes could not be segregated into "current" and "deferred" accounts -- the commission said:

[ 120 Pa. Commw. Page 33]

Accounting and ratemaking would be impossible if dollars in a common fund could not be labeled and segregated into accounts.

From this view, a reduction to current taxes is not tantamount to a reduction to deferred taxes in the same pool of dollars. And the sequential reduction of current taxes can be validly followed by the addition of provisions for deferred taxes or ITC [Investment Tax Credits]. Therefore, on conceptual grounds, we reject Mr. Charin's reasoning.

R.R. 162a, 270a.*fn6 The commission found support for its conclusion that consolidated tax savings adjustments are not per se violative of the normalization requirements of the Internal Revenue Code in the fact that, although many state regulatory authorities ...

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