Opinion ID: 535996
Heading Depth: 1
Heading Rank: 2

Heading: Deferred Tax Reserve Fund

Text: 27 Under cost-of-service pricing, a utility's rates are set to allow recovery of all costs of production. Income taxes are among the costs recoverable. A problem arises when the tax code allows a firm to deduct an expense for income tax purposes sooner than the Commission allows it to charge its customers with the item. Thus, while the federal income tax laws allow immediate expensing of certain intangible drilling costs of a well, they are for regulatory accounting purposes treated as a capital item, and recovered by an annual depreciation charge over the life of the well. In such a case a question arises as to how to time the tax benefit (i.e., the tax reduction resulting from the accelerated, non-conforming deduction of costs for tax purposes). 28 Under the flowthrough method, a utility must pass the tax benefit on to customers in the year received under the tax laws. Under normalization--the method applied to El Paso before the switch to NGPA pricing--the utility spreads the tax benefit over the life of the relevant asset, so that a customer, in any given year of the asset's life, will both bear the burden of depreciation allocable to that year and enjoy whatever tax benefit is associated with that depreciation. This is known as the matching principle. See Public Systems v. FERC, 709 F.2d 73, 76 (D.C.Cir.1983) (Public Systems II ). 29 Normalization thus allows a utility to charge its customers more in tax costs in the early year(s) of an asset's life than the firm pays out in taxes. The tax savings of course are temporary. Assuming no change in rate or other disturbance, the utility must make it up in later years of the asset's life. In the meantime it builds up funds that are reserved for the later taxes. The Commission requires a utility to deduct the amount of the fund from its rate base, in order to reflect the fact that with respect to a certain portion of its rate base the utility has no interest cost. While this has the effect (roughly) of giving customers the benefit of the interest or other earnings on the fund, the Commission has flatly rejected the notion that normalization can properly be analogized to a loan from customers to the utility. See Order No. 144, Regulations Implementing Tax Normalization for Certain Items Reflecting Timing Differences in the Recognition of Expenses or Revenues for Ratemaking and Income Tax Purposes, FERC Stats. & Regs. [1977-1981] p 30,254 at 31,539, Order No. 144-A (Order Denying Rehearing), FERC Stats. & Regs. [1982-1985] p 30,340 (1982), aff'd, Public Systems v. FERC, 709 F.2d 73 (D.C.Cir.1983). 30 In the case of El Paso's gas production assets, the reserve amounted to about $100 million dollars as of October 1, 1983, the date of El Paso's switch to NGPA pricing. See Order on Rehearing, 44 FERC at 61,207. The switch of course wiped out the premise of tax normalization--that the price of natural gas would be tied to historic cost and that El Paso would directly charge its customers the annual depreciation on its gas production assets. Thus the matching principle has ceased to operate as an explicit guide. Both El Paso and its customers claim the tax reserve. California argues also that even if El Paso may keep the fund, its customers should enjoy its earning power as it is gradually drawn down for payment of deferred taxes. 31 FERC originally determined that the fund and its earnings should remain with El Paso. The previous panel remanded on the grounds that FERC had inadequately explained the decision. It left the Commission free to proceed on remand as it saw fit (within the bounds of the law). On remand, the Commission split the baby. While adhering to its original decision on the fund, it ordered that El Paso's customers should receive its earnings so long as it existed. (The Commission assumed it would be drawn down to pay deferred taxes associated with income from the relevant production assets.) See 44 FERC at 61,207. This credit to the customers was to be achieved, as before 1983, by deducting the fund balance from El Paso's rate base. 32 We find the Commission's credit for the fund's earnings not in accordance with law. (The reasons will make apparent why its disposition of the principal is correct.) The fundamental difficulty with the credit of the fund's earnings is that it is not attached to, derived from, or related to any service that El Paso provides or has provided in the periods covered by the PGA filings, i.e., October 1, 1983 and thereafter. It is plain that the credit does not attach to El Paso's transmission service. It does not in any logical sense apply to El Paso's current gas costs: as to those, Sec. 601 of the NGPA, and the Supreme Court's decision in Mid-Louisiana, entitle the pipeline to NGPA rates--not NGPA rates reduced by a credit to adjust for tax controversies related to prior years. Finally, if the credit rests on a Commission view that the rates collected for gas prior to October 1983 were in retrospect too high, then the credit violates the rule against retroactive ratemaking. 33 1. Transmission service. It hardly seems worth arguing that El Paso's gas production facilities do not contribute to its provision of gas transmission service, but the Commission's order (at least in form) pretends otherwise. The credit is given customers by deducting the fund from the rate base. But with the switch to NGPA pricing, the only investments in that rate base are ones relating to gas transmission. As the Commission noted in another case: To the extent that the Mid-Louisiana decision requires [a natural gas company's] production to be priced under the NGPA, the decision simply results in removal of [its] production plant from the rate base so it is nonjurisdictional for purposes of this rate proceeding. Consolidated Gas Supply Corp., 24 FERC p 61,283 at 61,584 (1983). 34 It would seem to go without saying that the Commission cannot simply lop money out of a company's jurisdictional rate base in order to dole out a credit intended to solve some problem extraneous to the rate base. Not surprisingly, the very FERC regulations establishing the mechanism of a rate base adjustment for deferred tax reserves require that the tax reserve adjustments to rate base be related to jurisdictional assets. See 18 C.F.R. Sec. 154.63a(b)(2)(ii) (Such rate base reductions or additions must be limited to deferred taxes related to rate base, construction or other jurisdictional activities.); see also Order No. 144, FERC Stats. & Regs. [1977-1981] p 30,254 at 31,558 (1981) (rate base adjustments must aris[e] from construction-related timing differences and from other jurisdictional activities). This requirement is not just a technical accounting principle. It ensures that the tax benefits flowing from a given asset accrue only to customers who also bear the costs associated with that asset. 35 In explaining its rate base adjustment, the Commission acknowledged that accounting principles required discontinuance of the rate base credit once the relevant facilities were out of the rate base. (It did not refer explicitly to its override of Sec. 154.63a(b)(2)(ii).) But it asserted that [t]he relevant point is that El Paso has the use of cost-free capital generated from past rates. Order, 43 FERC at 61,748. Although the presence of cost-free capital was relevant while a pipeline's gas was priced under cost-of-service principles, it loses meaning under the shift to NGPA prices. Accordingly, we cannot be certain what the Commission intends by the phrase. Whatever the explanation's meaning, it cannot possibly turn a production-related deferred tax fund into something transmission-related. 36 Indeed, in its first pass at the issue, the Commission expressed concern that applying the fund (or its earnings) to El Paso's rates would effectively enable El Paso to cross-subsidize its transmission services with the funds. El Paso Natural Gas Co., 33 FERC p 61,099 at 61,210 (1985). The remark was an odd one, as El Paso had never shown any desire to offer such a subsidy. But the underlying point, that the fund was completely unrelated to El Paso's transmission service, was clearly correct. No reason appears why current users of El Paso's transmission service, who may take no El Paso gas at all, should receive credits based on earlier El Paso gas service. 37 2. Current gas supplies. In enacting the NGPA, Congress took away from the Commission the power to determine just and reasonable rates for wellhead sales of gas (including, under Mid-Louisiana, intracompany wellhead transfers). Instead it set ceiling prices itself. Section 601 addresses the downstream impact of the wellhead ceilings, entitling a natural gas company to pass on NGPA-complying costs. (Sec. 601(b)(1) states that amounts paid that comply with Title I of the NGPA shall be deemed just and reasonable for Natural Gas Act purposes, and Sec. 601(c)(2) states that the Commission may not deny a pipeline recovery of amounts deemed just and reasonable under Sec. 601(b)(1), subject to exceptions not relevant here). 15 U.S.C. Sec. 3431 (1988). Thus, if the rate El Paso is passing on to customers is a lawful rate under the NGPA, the Commission is powerless to reduce it. 38 Although El Paso's only jurisdictional transactions are its provision of gas or transmission service, the Commission asserts that its credit has no impact on El Paso's receiving NGPA prices for NGPA sales. Commission Brief at 25 (quoting Order on Rehearing, 44 FERC at 61,206). This seems utterly fictional. If the credit does not relate to transmission, which is plain enough, it must relate to gas. As El Paso points out, the Commission [may not] pick the pipeline pocket but point to the producer pocket as still full. Initial Brief of Petitioner El Paso at 22. 39 California argues both that the NGPA pricing scheme allows the Commission to distribute the fund (and its earnings) to customers and that it requires it to do so. The two arguments coalesce. Both start with the proposition that the deferred tax fund is derived from customer charges and that the Commission's tax normalization regulations contemplated its use for future tax payments. Thus, according to California, if El Paso keeps the fund, it is really charging the customers an add-on to the NGPA prices. 40 Since El Paso's switch to NGPA pricing, it has passed on to its customers no more than the ceiling prices that Congress set. On its face, therefore, El Paso has been complying with the NGPA. Rather than end the inquiry there, however, California's argument would engage us in an analysis of El Paso's costs after its switch to NGPA pricing. However, it is precisely such an inquiry which Congress sought to foreclose by adopting ceiling prices which were wholly divorced from the traditional historical-cost methods applied by the Commission in implementing the [Natural Gas Act]. Mid-Louisiana, 463 U.S. at 333, 103 S.Ct. at 3032-33. Simply because these funds were collected in contemplation of future tax liabilities does not authorize us or the Commission to embark anew on the cost-based analysis that Congress sought to avoid through passage of the NGPA. 41 California is therefore reduced to arguing that until October 1983 El Paso was merely a custodian of the tax funds, Initial Brief of Petitioner California at 46, so that when it uses or retains them after the switch to NGPA it is really charging for them (or for its current tax costs) during the post-switch period. In fact, however, the fund was generated from past rates which have long since been finally approved as just and reasonable and collected. As the Commission noted, 44 FERC at 61,205, just because El Paso may draw on these funds to pay future costs does not mean that the funds should be treated as having been collected in the period in which they are spent. Moreover, the argument appears to rest on the notion that under normalization accounting customers enjoy an equitable interest in a utility's deferred tax account, a notion that the Commission and this court have both rejected. See Order No. 144, FERC Stats. & Regs. [1977-1981] p 30,254 at 31,539 (1981); Public Systems v. FERC, 709 F.2d at 86 n. 30. California's approach not only plays games with the ordinary meaning of words but invites a wholesale destruction of the rule against retroactive ratemaking. 42 California notes that in a case sustaining normalization prior to Order No. 144, this court rested its affirmation on the concept that there would be no permanent tax savings accruing to producers but not to the benefit of customers. American Public Gas Ass'n v. FPC (APGA ), 567 F.2d 1016, 1042 (D.C.Cir.1977). Moreover, the court said that the legitimacy of the Commission's method depended on the assumption of its being applied consistently in the future; if it adopted another method, the producers could indeed achieve a tax 'savings' that is permanent and would not inure to the benefit of consumers. Id. But the APGA decision will not support the inferences California would draw. The statement quoted was obviously not made in contemplation of Congress's later enactment of the NGPA. Nor could it have meant that the validity of tax normalization depends on its indefinite continuation, regardless of changing circumstances. Tax normalization sought to match the timing of a customer's contribution toward a cost with enjoyment of any offsetting tax benefit. In the pre-1983 period El Paso's rates did just that. Enactment of the NGPA, however, mooted the whole question to which normalization was an answer. The logic of California's argument in fact requires that if the NGPA had completely deregulated wellhead prices, 6 the Commission would have to keep soldiering on with stray remnants of the prior learning. APGA cannot have intended that. 43 Finally, California's windfall argument overlooks the reality that every pre-1983 purchaser received the full tax benefit associated with every expense that it bore. El Paso's enjoyment of the deferred tax reserve is a windfall only if one assumes that the accounting system used by the Commission for regulatory purposes (i.e., capitalizing intangible drilling expenses and providing for periodic recovery through depreciation charges) was the one true way. In fact, however, that method was simply one policy choice out of several. Congress in its tax provisions allowed an immediate tax benefit for certain types of investment in order to encourage them. The Commission might itself have similarly allowed immediate recovery of the drilling expenses. Had it done so, the two accounting systems would have matched, and El Paso would have recovered the entire cost of the items in the first year. Compared to that scenario, cessation of the historic cost system has given the customers a windfall. The reason we would reject any such argument by El Paso is simply that we take as given, as the baseline for reasoning, the accounting system that the Commission happened to employ for regulatory purposes in the period of historic costing. Similarly, if FERC had formerly employed the flow-through method of passing on tax breaks to consumers, followed by an El Paso switch to NGPA pricing, we would allow no current adjustment in its rates to offset the customers' windfall of receiving the entire tax break from assets of which they would have paid for only a part. We must take the prior system as given, for to do otherwise would open the door to endless retroactive ratemaking. As that principle would foreclose El Paso from claiming (under either of the above hypotheticals) that complete cessation of the system in 1983 gave its customers a windfall, so it prevents the customers from claiming that cessation of the prior system conferred a windfall on El Paso. 44 3. Retroactive ratemaking. To the extent that the Commission's credit is intended to implement a Commission perception that, in light of the October 1, 1983 switch, El Paso's prior rates were unjust or unreasonable (FERC makes no such claim), it would violate the rule against retroactive ratemaking. 7 The Commission made no such claim either in its opinions below or in its brief before us. 45 With limited exceptions inapplicable here, 8 the Natural Gas Act allows the Commission only to change rates prospectively. Where the Commission takes on the burden of showing that prevailing rates are unjust or unreasonable, Sec. 5(a) of the Act allows it only to determine the just and reasonable rate ... to be thereafter observed. 15 U.S.C. Sec. 717d(a) (1988) (emphasis added). 9 46 Here the Commission has addressed itself to disposition of El Paso's deferred tax fund, which is composed entirely of rate revenue that El Paso has already collected. See above at 17. Refund of such property, or its earnings, would effectively force El Paso to return a portion of rates approved by FERC and collected by El Paso. This kind of post hoc tinkering would undermine the predictability which the doctrine seeks to protect. See Columbia Gas, 831 F.2d at 1141. The Act's limited provision for refunds reflects a congressional determination that parties in the industry need to be able to rely on the finality of approved rates, and that this interest outweighs the value of being able to correct for decisions that in hindsight may appear unsound. 10 The rule against retroactive ratemaking also tends to make this highly regulated market approximate ordinary ones, where, for example, General Motors may not, after a sale, demand another $500 to cover its costs, and a buyer may not demand a refund because he just discovered that a competitor had been offering similar cars for less. The doctrine is, of course, a two-way street. It bars the Commission's retroactive substitution of an unreasonably high or low rate with a just and reasonable rate. City of Piqua v. FERC, 610 F.2d 950, 954 (D.C.Cir.1979); see also Arkansas Louisiana Gas Co. v. Hall, 453 U.S. at 576-79, 101 S.Ct. at 2929-31; Associated Gas Distributors v. FERC, 893 F.2d 349, 354-57 (1989) (disallowing $650 million sought by pipeline in excess of prior charges). 47 We note that in its orders on review here the Commission appeared to justify its baby-splitting position on grounds of equity, saying, for example, that [t]he Commission believes that [its] treatment of El Paso's deferred tax reserve is an equitable solution to an extremely difficult dilemma. 43 FERC at 61,748. Part of this focus may have arisen out of references in our earlier opinion to equitable issues, such as a mention of the need to address difficult issues of equity posed by the transition. 817 F.2d at 862. But our previous decision only remanded the issue to FERC because it had failed to provide a reasoned explanation for what it had done. The court obviously never intended to imbue the Commission with the authority to ignore the law in achieving an equitable result. Whatever hints the Commission may have found in the opinion that the issue was essentially an equitable one were not intended to relieve--and, indeed, could not have relieved--FERC of its duty to follow the law. The Commission had no legal right to reduce El Paso's post-October 1, 1983 rates for gas transmission below levels found to be just and reasonable for that service, or to impair its right under Sec. 601 of the NGPA to recover NGPA-complying amounts for its gas. Accordingly, the Commission's adjustments of those rates were in substance a retroactive adjustment of prior rates based on normalization. The rule against such revision operates sometimes to protect customers from surcharges and at others to protect gas companies from refunds; its equity lies in its steady application regardless of what party is seeking to reexamine the past. 48 Our discussion has not focused separately on the fund or the interest. As noted above, see supra at 1380, we see no basis for distinguishing between the two. Both elements equally lack any relation whatsoever to current transmission service. Similarly, with respect to current gas service, any reduction from current gas prices would undercut the pricing rules of the NGPA regardless of whether the fund or its interest was the source of the reduction. That the amount of the fund was formerly deducted from El Paso's gas production rate base arose solely out of the Commission's intention to match El Paso's then-current gas prices with its then-current gas costs; with the application of NGPA pricing, the gas production rate base has disappeared, and the matching principle, while no longer explicitly operative, points against, not for, any such adjustment. Finally, the rule against retroactive ratemaking prevents the Commission not only from forcing a utility to disgorge the proceeds of rates that have been finally approved and collected, but also from denying a producer the fruits of those proceeds. A contrary result would make the prohibition against retroactive ratemaking a sham, by allowing the Commission indirectly to deny a party the benefits of filed rates despite the prohibition against doing so directly.