Discussion
of Issues
Issue 1:
Should the Commission propose the amendment of Rule
25-14-004, F.A.C., Effect of Parent Debt on Federal Corporate Income Tax?
Recommendation:
Yes. The Commission should propose the amendment of
Rule 25-14.004, F.A.C., as set forth in Attachment A. The Commission should certify
the rule as a minor violation rule. (Sapoznikoff, Cicchetti, Guffey)
Staff Analysis:
Currently
the rule considers the debt of a parent company invested in a regulated,
subsidiary utility. Following adoption of the rule in 1983, regulatory theory
and practice, accounting principles, finance theory, economic theory, corporate
structure, and legal rulings have evolved. FERC uses the stand-alone approach,[4] and Florida is one of only a
handful of states that still use a consolidated approach. Consequently, use of
consolidated parent company data to set utility rates is no longer generally
accepted and the method in the recommended amendments has become the prevailing
national standard over time. The Commission is tasked with setting fair, just,
and reasonable rates. That not only means that customers should only pay for
their actual cost of service, but also that utilities be allowed to recover
their actual revenue requirements. By imputing a parent’s debt, the current
rule results in an inaccurate revenue requirement which ultimately results in artificially
low rates that can increase the frequency of requests for rate increases. The
current rule is the only instance in which the Commission does not use actual
cost of service in determining revenue requirements and setting rates. Accordingly,
the time has come to make a change. Staff recommends that the rule be amended
as set forth in Attachment A. Below is a detailed discussion of staff’s
recommended amendments to the rule.
Rule 25-14.004, F.A.C., Determination of
Total Corporate Income Tax
The
initial paragraph of the current rule is unnumbered and requires that when a
regulated utility is a subsidiary of one or more parent companies and files a
consolidated tax return with a parent company, the subsidiary’s income tax must
be adjusted to reflect the income tax expense of the parent debt that may be
invested in the equity of the subsidiary. Under the current rule, the tax
benefits associated with the parent company’s interest expense are attributed
to the subsidiary utility. This inappropriately lowers utility rates, distorts
price signals, and contributes to the inefficient allocation of resources.
Under the recommended amendments to Rule 25-14.004, F.A.C., the Commission
would use only the interest expense inherent in the
capital structure of the regulated utility to compute income tax expense,
rather than reducing the tax expense in accordance with the parent’s capital
structure.
The
recommended amendments to the unnumbered introductory paragraph require that
the income tax expense of a regulated utility be determined using only its
income, regardless of any parent-subsidiary relationship that may exist. This
policy is referred to as the stand-alone approach. The stand-alone approach
sets utility rates as if the subsidiary utility were an independent entity.
With regard to income tax expense, the stand-alone approach ensures that the
revenue requirement is based upon operations of the regulated utility and that
the tax benefits associated with the debt are both an expense of the regulated utility
and borne by that utility’s customers. The stand-alone approach is different
from the current rule in that by not considering the income of the parent
company invested in the subsidiary there are no cross-subsidies between
regulated and non-regulated operations, which contributes to a more accurate
picture of the utility’s financial health.
Overall,
staff recommends changing Commission policy on how to determine the income tax
expense of a regulated utility that is a subsidiary of one or more parent
companies to align the rule with the current national standard.[6] FERC uses the stand-alone
approach reflected in the recommended amendments to the rule,[7] and Florida is one of only a
handful of states that still use a consolidated approach.
If
the Commission votes to approve the recommended policy change, the recommended
amendments to subsections (1) through (4) and the addition of subsection (5) are
necessary to reflect the change in the process of making tax determinations from
incorporating parent debt to only using the tax expense of the regulated
utility. Staff’s recommendations for the amendment of each subsection of the
rule is below.
Subsection (1)
Subsection
(1) of the current rule addresses how to calculate the income tax effect of the
parent’s debt when there is only one parent company.
As
parent debt is not a consideration in the recommended amendments, the recommended
amendment of subsection (1) deletes the prior language in its entirety. In its
place the recommended rule language of subsection (1) sets forth the method of
determining state corporate current income tax of the regulated, subsidiary
utility. This amount is calculated by multiplying the
regulated utility’s state taxable income before state and federal income taxes
by Florida’s corporate income tax rate, plus or minus any applicable tax
adjustments or credits in accordance with applicable state income tax laws and
regulations.
Subsection (2)
Subsection
(2) of the current rule addresses how to calculate the income tax effect of the
parent’s debt when there is more than one parent company.
As
parent debt is not a consideration in the recommended amendments, the
recommended amendment of subsection (2) deletes the prior language in its
entirety. In its place, the recommended rule language of subsection (2) sets
forth the method of determining the federal taxable income of the regulated,
subsidiary utility after state corporate income tax. This amount is calculated by
deducting the state corporate income tax amount calculated pursuant to the
recommended amendment of subsection (1) from the regulated utility’s federal
income before taxes.
Subsection (3)
Subsection
(3) of the current rule addresses what is included in the capital structure of
the parent and notes that it is a rebuttable presumption that “a parent’s
investment in any subsidiary or in its own operations shall be considered to
have been made in the same ratios as exist in the parent’s overall capital
structure.”
As
parent debt is not a consideration in the recommended amendments, the recommended
amendment of subsection (3) deletes the prior language in its entirety. In its
place, the recommended rule language of subsection (3) sets forth the method of
determining the federal current corporate income tax of the regulated,
subsidiary utility. This amount is calculated by multiplying the federal
taxable income after state taxes (which amount was calculated
pursuant to the recommended amendment of subsection (2)), by the federal
corporate income tax rate, plus or minus any applicable tax adjustments
or credits in accordance with applicable federal income tax laws and
regulations.
Subsection (4)
Subsection
(4) of the current rule addresses how to calculate the parent debt adjustment
using debt ratio and debt cost of the parent, the statutory tax rate applicable
to the consolidated entity, and the equity dollars of the regulated subsidiary,
excluding its retained earnings.
As
parent debt is not a consideration in the recommended amendments, the
recommended amendment of subsection (4) deletes the prior language in its
entirety. In its place, the recommended rule language of subsection (4) clarifies
that applicable temporary adjustments to taxable income multiplied by the
respective federal and state corporate income tax rates, plus or minus any
applicable tax adjustments or credits in accordance with applicable federal and
state income tax laws and regulation, shall be used in determining federal and
state income tax expenses for the regulated utility.
Subsection (5)
The
current version of the rule does not contain a subsection (5). The recommended
amendment of the rule adds subsection (5), which states that total income tax
expense for the regulated utility will be determined by adding the amounts
calculated pursuant to the recommended amendments of subsections (1), (3), and
(4) of the rule.
Stakeholder Comments
All
stakeholders who commented, except for OPC, support the recommended amendments
to Rule 25-14.004, F.A.C. OPC’s objections to the recommended amendment of the
rule fall into two main categories. First, OPC opposes the recommended amendment
of the rule because it alleges the stand-alone method will inappropriately
increase rates and result in double-leverage. Next, OPC alleges that precedent
disallows the stand-alone method contained in the recommended amendments to the
rule. As discussed below, staff disagrees with OPC’s comments.
The recommended amendments align the rule
with current national standards and will not inappropriately increase rates or result
in double leverage.
While
there will be a rate impact associated with the recommended amendments, not
amending the rule also has rate impacts and the recommended amendments make
certain that appropriate revenue requirements are being set based on actual cost
of service to customers. In essence, the parent-debt adjustment (recognizing
double leverage) perverts the calculation of return on equity (ROE). In a rate
proceeding, the Commission determines the appropriate ROE and capital structure
(i.e., the appropriate debt and equity ratios), which reflect the utility’s
cost of obtaining funds. The parent-debt adjustment imputes the tax deduction
associated with parent company debt to the regulated utility. However, because
the regulated utility did not incur the parent’s interest expense, the
regulated utility cannot claim that expense on its taxes and reduce its costs. Therefore,
there is no tax benefit to the regulated utility from the current rule and
application of the parent-debt adjustment only serves to set artificially low
rates at the expense of accurate revenue requirements.
When
the current rule is applied, the utility does not collect the actual cost of
providing utility service. Consequently, the utility may seek rate increases
more frequently incurring additional rate case expense. The
recommended amendments will make certain that revenue requirements are not artificially
reduced, as is the case under the current rule. This should lessen the
frequency with which utilities seek rate increases as the rates set using the
recommended amendments to the rule will be based on actual cost of service to
customers. Moving away from the parent debt adjustment and
adopting the stand-alone approach is also beneficial to rate payers. Setting
rates on a stand-alone basis ensures only the costs associated with the
provision of utility service are charged to customers.
Under [the] stand-alone
methodology, a regulated entity's income tax allowance is based on the income
and deductions specifically attributable to the regulated entity's
jurisdictional cost of service and the income tax allowance does not
incorporate potentially offsetting losses and deductions of the parent owner
not reflected in the regulated entity's jurisdictional cost of service.
Trailblazer Pipeline Co., LLC,
166 F.E.R.C. P61141, 61674, 2019 WL 830962, at *10 (FERC Feb. 21, 2019) (citing
City of Charlottesville v. Fed. Energy
Reg. Comm’n, 774 F.2d 1205, 1215 (1985), cert. den’d, 475 U.S. 1108
(1986)).
While
some cases have described the stand-alone approach as relying on a
“hypothetical” calculation, using the parent debt adjustment artificially
decreases the regulated utility’s tax expense and lowers the regulated
subsidiary’s revenue requirement. While the parent debt adjustment approach
lowers rates, it results in a revenue requirement based upon tax benefits
associated with debt that is neither an expense of the utility nor borne by the
utility’s customers. If taxes are allocated in a manner other than on a
stand-alone basis, utility customers may pay rates that reflect costs or
benefits of other nonregulated members of the consolidated group.
In
its written comments, OPC alleges that staff’s concern that application of the
rule results in “double leverage” is unfounded. However, contrary to OPC’s
allegations, the cases that advance a parent-debt adjustment do so for
double-leverage. See, e.g., New England
Tele. & Teleg. Co. v. Pub. Utils. Comm’n, 390 A.2d 8, 28-47 (Me. 1978).
Double leverage occurs when a subsidiary enjoys its own leverage (use of debt
instead of all equity capital) plus the leverage factor of its parent company
(which also uses some debt instead of all equity capital). See id. at 41.
OPC
asserts that while the rule states it is to calculate the income tax expense to
be used in Commission proceedings to establish revenue requirements or
addressing over-earnings, the rule is essentially a “consumer protection rule”
and “is not really based on an income tax issue.” OPC asserts the rule “is a
protection from affiliate transaction abuse” in that “it keeps customers from
being forced to subsidize the parent’s income tax expenses by having to pay a
taxable equity return on the amount of debt that makes up the parent and
grandparent investment in the equity recorded on the regulated utility’s
books.” However, staff disagrees with OPC’s assessment as to the purpose and
nature of the rule.
The
plain language of the rule states it addresses the calculation of the income
tax expense in proceedings to establish revenue requirements or address over-earnings.
The rule is part of the section of the Florida Administrative Code in which the
Commission lists rules related to policy determinations affecting the rates,
charges, and tariffs of all companies subject to its rate-setting jurisdiction.
Moreover, a parent company issuing debt to invest in a regulated subsidiary is
not “affiliate transaction abuse.” In fact, a parent company issuing debt to
invest in a regulated utility subsidiary could be of vital importance, in the
public interest, and should not be penalized.
How
much equity a regulated utility has in its capital structure is an issue in
every rate case. In cases in which the leverage formula is not used, all
parties have the opportunity to provide expert testimony regarding the
appropriate capital structure and equity ratio. A utility’s required return on
equity is a function of the risk to which capital is exposed, not the source of
the funds.
Of
the utilities providing comments, DEF, FPL,
FCG, FPUC, PGS, and TECO
agree with staff’s rationale for the recommended amendment of the rule. FPL and
its affiliates note the rule’s effect is that the “parent company’s debt is
imputed to the benefit of customers even though customers are not obligated to
pay rates reflecting the interest expense on the parent’s debt in rates” which may
result in the need to file requests for “more frequent and costly base rate
increases, which will further increase rates paid by customers.” They assert
that “to mitigate this costly and time-consuming potential that rates should
reflect the taxes associated with only the items that are included in the cost
of service and net operating income directly attributable to them.” TECO’s
comments generally adopt those submitted by FPL and its affiliates.
DEF
agrees that “the better approach is to compute the regulated utility’s tax
expense on a stand-alone basis without making the adjustment currently called
for in the Rule.” DEF asserts that the stand-alone approach “provides a match
between capital structure interest and the tax effect considered in the
regulated utility’s cost of service.” Because capital structure is always
determined in a base rate proceeding, DEF contends that the “Commission is
assured that the capital structure has been properly set.”
There is no precedent disallowing the
stand-alone method.
In
its oral and written comments, OPC argues “there is no basis to change a
40-year old consumer protection rule that has survived challenges in the
Florida Supreme Court, the United States Treasury Department and the United
States Congress.” OPC further argues that the Commission has twice considered
and denied repeal of the rule. OPC states the rule is “a fundamental bedrock
principle of Florida utility regulation that has been applied to keep Florida
customer utility rates low for 45 years.”
Staff
believes there is no indication that the rule was designed with consumer
protection in mind nor that the recommended amendments to the rule would harm
consumers. Just because the rule has survived challenges does not mean it has
been endorsed as the only or proper way to assess tax liability. In fact, as
discussed in more detail below, the cases to which OPC cites support the stand-alone
method contained in the recommended amendments to the rule.
Florida
Supreme Court precedent does not preclude the stand-alone method.
OPC
asserts the current version of the rule was unequivocally upheld by the Florida
Supreme Court in General Tele. Co. of
Fla. v. Fla. Pub. Serv. Comm’n, 446 So. 2d 1063 (Fla. 1984). OPC further
argues General Telephone supported
the Court’s prior decision in Citizens of
Fla. v. Hawkins, 356 So. 2d 254 (Fla. 1978), which OPC alleges stands for
the proposition that “the regulated utility’s tax deductible debt may cause
customers to overpay on the income tax component imbedded in their rates.” As
explained below, staff believes OPC has misconstrued the holdings of those
cases.
Citizens of Fla. v. Hawkins,
356 So. 2d 254 (Fla. 1978), was the first Florida Supreme Court case to address
the Commission’s computation of the income tax for a regulated entity that was
a subsidiary and filed a consolidated return with a parent company. At that
time, the Commission did not have a rule on that matter, but traditionally used
what was referred to as a “subsidiary approach” rather than a “consolidated
approach.” The “subsidiary approach” was described as using “an allowance for
federal income tax expense equal to the hypothetical tax which would have been
paid if [the subsidiary] had filed a separate federal income tax return.” Hawkins, 356 So. 2d at 259. In Hawkins, OPC argued that use of the
“subsidiary approach” resulted in double-leverage as the regulated entity was
able “to receive an allowance for income tax expense greater than the actual
income tax liability for which it would be properly responsible under [the]
consolidated return.” Id.
In
Hawkins, the Commission noted that
OPC did not object to using the “subsidiary approach” to calculate the cost of
capital and, accordingly, it would be consistent also to do so in determining
tax effect. Id. However, unable “to
discern a rationale for a rule of consistency” and finding that the
Commission’s order “nowhere identified a record basis for preferring...the subsidiary
approach over a calculation on the consolidated approach,” the Court held that
“each [tax] determination must be based on specific independent findings
supported by competent substantial evidence” and that “what evidence there is
in the record supports the consolidated approach as being more accurate.” Id. at 259-260 (citations omitted).
Thus,
contrary to OPC’s suggestions, Hawkins
did not mandate application of the consolidated approach. Rather, the Court
merely held that under the facts of that case, the consolidated approach was
supported by the record evidence. See id.
Thereafter,
the current rule (mandating the consolidated approach) was adopted in 1983.
Although the Florida Supreme Court upheld the validity of the rule in General Tele. Co. of Fla. v. Fla. Pub. Serv.
Comm’n, 446 So. 2d 1063 (Fla. 1984), it was not necessarily a substantive
endorsement. Rather, the Court evaluated whether the rule was “reasonably
related to the purposes of the enabling legislation, and. . . not arbitrary or
capricious.” General Tele., 446 So.
2d at 1067 (quoting Agrico Chem. Co. v.
State, Dep’t of Env. Reg., 365 So. 2d 759 (Fla. 1st DCA 1978), cert. den’d, 376 So. 2d 74 (Fla. 1979)).
While
the Court acknowledged that it had previously “instructed the PSC to apply this
type of adjustment in a ratemaking case,” it qualified that statement by
stating:
There is no single correct
method of dealing with the income tax expense of a subsidiary-utility joining
in the filing of a consolidated return. By choosing this particular method, the
PSC is merely acting within the scope of its discretion.
General Tele.,
446 So. 2d at 1067. Therefore, the recommended amendments to the rule are
within the discretion of this Commission and reflect nationally recognized best
practices.
Moreover,
while General Telephone noted that
the Federal Energy Regulation Commission (FERC) and “at least eighteen
jurisdictions” had adopted the consolidated approach,[12]
that is no longer the case. FERC now uses the stand-alone approach reflected in
the recommended amendments to the rule,[13]
and Florida is one of only a handful of states that still use a consolidated
approach. States that have adopted the stand-alone approach have done so “due
to the increasing structural complexity of regulated utility entities and the
expansion of non-utility activities by subsidiaries.” SFPP, L.P. v.
Public Utils. Comm’n, 217 Cal. App.
4th 784, 795 (2013). In addition, “without the stand-alone treatment of the
regulated entity, the non-utility activities could result in a tax expense or
savings unrelated to the costs of providing utility service.” ARCO
Prods. Co. v. Santa Fe Pacific Pipeline, L.P., Dec.
No. 11–05–045, 2011 WL 2246059 at 8 (Cal. P.U.C. 2011).
United
States Treasury and Congressional inaction do not preclude the stand-alone
method.
OPC
also asserts that inaction by the U.S. Treasury and Congress indicated that the
stand-alone method is improper. OPC states that in 1990, the U.S. Treasury
proposed a regulation that many interpreted “as an indication that the [parent
debt adjustment] could be deemed a consolidated tax savings adjustment and a
normalization violation.” According to OPC, it and the Commission joined in
filing comments at a 1991 IRS hearing on the matter and were in agreement that
the parent debt adjustment was not a consolidated tax savings adjustment or a
normalization violation. According to OPC, of the hundreds of parties (which OPC
asserts included utilities, consumers, and regulatory agencies), no one
supported the regulation. OPC further states that the IRS eventually withdrew
the proposed regulation. OPC advises that Congress also was “concerned about
whether normalization was costing the United States Treasury tax revenue” and
held hearings. According to OPC, it and the Commission testified before
Congress “in support of the rule and the Commission’s practice to recognize the
tax effect of parent company debt in ratemaking.” OPC states that Congress took
no action. OPC does acknowledge that by that time FERC had retreated from a
parent debt adjustment.
OPC’s
reliance on the failure of the IRS to change its consolidated return rule as
validation of the parent debt rule is misplaced. The proposed Treasury regulation
may have resulted in the Commission’s parent debt adjustment rule violating a
normalization method of accounting. However, the failure of the IRS to change
its policy (regarding the flow-through of tax savings arising from the filing
of a consolidated return) does not mean the IRS endorsed the parent debt
adjustment contained in the rule, or that the rule was the proper or only way
for the Commission to determine a subsidiary’s taxes when setting rates.
Moreover,
federal tax policy and rate setting by a utility commission are two distinct regulatory
mechanisms. See Federal Power Comm’n v.
United Gas Pipe Line Co., 386 U.S. 237, 243 (1967). The Court noted that a
commission has the power “to limit cost of service to real expense” and that
doing so would not frustrate tax laws. Id.
at 245-47.
Prior
Commission orders do not preclude the stand-alone method.
In
its oral comments, OPC asserts that the Commission had twice previously been
asked to repeal the parent-debt adjustment and had twice rejected that request.
That is not correct. The Commission has never substantively rejected repeal of
the parent-debt adjustment.
In
1987, staff submitted a recommendation to repeal the rule asserting that the
rule was unnecessary and that the litigation process would resolve the tax
matter.
The Commission deferred ruling and requested that staff submit a new
recommendation.
In
1988 the Commission considered the new recommendation which provided argument both
in support of the rule and also in support of its repeal.
Again, the Commission did not affirmatively reject repeal of the rule. Rather,
the Commission order simply stated, “[w]e do not wish to revisit the rule at
this time.”[17]
Moreover,
in contrast to the options previously submitted of either repealing or keeping
the parent debt adjustment, the current recommended amendment of Rule
25-14.004, F.A.C., sets forth an alternative approach which updates the rule to
conform to best practices.
Minor Violation Rule Certification
Pursuant
to Section 120.695, F.S., for each rule filed for adoption, the agency head
shall certify whether any part of the rule is designated as a rule the
violation of which would be a minor violation. Rule 25-14.004, F.A.C., is
currently listed as a minor violation rule by the Commission. This rule is a
minor violation rule because the violation of this rule would not result in
economic or physical harm to a person, cause an adverse effect on the public
health, safety, or welfare, or create a significant threat of such harm.
Violations of Rule 25-14.004, F.A.C., with the recommended amendments would
continue to be minor violations. Therefore, for the purposes of filing the
proposed amended rules for adoption with the Department of State, staff
recommends that the Commission certify Rule 25-14.004, F.A.C., as a minor
violation rule.
Statement of Estimated Regulatory Costs
Section
120.54(3)(b)1., F.S., encourages agencies to prepare a Statement of Estimated
Regulatory Costs (SERC) before the adoption, amendment, or repeal of any rule.
A SERC was prepared for this rulemaking and is appended as Attachment B. As
required by Section 120.541(2)(a)1., F.S., the SERC analysis includes whether the
rule amendments are likely to have an adverse impact on economic growth,
private sector job creation or employment, or private sector investment in
excess of $1 million in the aggregate within five years after implementation.
None of the impact/cost criteria will be exceeded as a result of the
recommended amendments.
The
SERC concludes that the amendments to the rule will likely not directly or
indirectly increase regulatory costs in excess of $200,000 in the aggregate in
Florida within one year after implementation. Further, the SERC concludes that
the recommended rule amendments will not likely increase regulatory costs,
including any transactional costs, or have an adverse impact on business
competitiveness, productivity, or innovation, in excess of $1 million in the
aggregate within five years of implementation. Thus, pursuant to Section
120.541(3), F.S., the recommended amendment of the rule does not require
legislative ratification.
In
addition, the SERC states that the recommended amendments to the rule would
have no impact on small businesses, would have no implementation or enforcement
costs on the Commission or any other state or local government entity, and
would have no impact on small cities or small counties. The SERC states that
there will be no transactional costs likely to be incurred by individuals and
entities required to comply with the requirements.
Conclusion
The Commission should propose the amendment of
Rule 25-14.004, F.A.C., as set forth in Attachment A. Staff also recommends that
the Commission certify the rule as a minor violation rule.
Issue 2:
Should this docket be closed?
Recommendation:
Yes. If no requests for hearing or comments are
filed, the rule should be filed for adoption with the Department of State, and
the docket should be closed. (Sapoznikoff)
Staff Analysis:
If no requests for hearing or comments are filed,
the rule should be filed for adoption with the Department of State, and the
docket should be closed.
