Opinion ID: 1961637
Heading Depth: 2
Heading Rank: 3

Heading: Synchronization of NET and AT&T Interest.

Text: An important component of NET's operating expenses chargeable to ratepayers is its income tax expense. In calculating taxable income, NET deducts its interest payments from gross income. On the theory of compensating fully for the effect of the parent-subsidiary relationship of AT&T and NET, the Commission adopted an interest-allocation adjustment which it has denoted interest synchronization. To accomplish that adjustment, the Commission calculated the income tax interest deduction corresponding to the amount and cost rate of NET capital structure debt. (See pt. III(A) of this opinion). Next, a portion of AT&T's interest deduction was allocated to NET, since a portion of NET's equity is financed by AT&T debt on which interest is paid. [32] The Commission's application of this adjustment to the present case resulted in an additional $2,091,000 of deductible interest attributable to NET over its claimed $8,537,000 interest expense. As a result, the Commission reduced NET's income tax expense by $1,040,000, thereby reducing the revenue requirement by $2,225,000. NET apparently does not contest the basic theory behind the Commission's interest-synchronization adjustment, a theory this Court recognized and upheld in the 1978 NET Case, 390 A.2d at 30. Instead, NET challenges the Commission's application of the adjustment in two specific respects: first, that the Commission's inclusion in rate base of plant financed through job development investment tax credit (JDITC) when calculating NET's interest deduction for income tax purposes results in overstating that interest expense and thereby renders NET ineligible for the tax credit because of I.R.C. § 46(f); second, that the Commission failed to consider pertinent differences between Maine and federal income tax law in applying interest synchronization to the state income tax. 1. The Commission's Treatment of JDITC. In 1971, Congress enacted provisions for an investment tax credit. [33] I.R.C. §§ 38, 46. One purpose of the credit is to stimulate investment in new plant and equipment by providing as a credit against tax liability a statutory percentage of the investment in qualifying property during the tax year. [34] In determining the allowable deduction for interest expense, the Commission multiplied rate base by the combined weighted costs of debt to NET and AT&T. In effect, by doing so, the Commission treated the tax-credit funds, which were obtained interest-free, as if they had been partially obtained from debt instruments in the same proportion as debt is present in the doubly leveraged capital structure of NET. That is so because of the presence of JDITC-financed plant in NET's rate base. NET asserts that the Commission's methodology results in a violation of I.R.C. § 46(f) that will render NET unable to take the investment tax credit. Since JDITC plant has no associated interest cost, NET claims that the Commission violated I.R.C. § 46(f)(2)(A) & (B), set forth in text below, by failing to recognize that NET's rate base includes interest-free JDITC-financed plant. [35] This failure, NET argues, will cause it to lose its eligibility for JDITC. The Commission contends that inclusion of JDITC-financed plant in rate base is permissible under I.R.C. § 46(f)(2) and that such treatment is consistent with the language and legislative history of section 46 and with the applicable treasury regulations. Accordingly, it argues that NET's eligibility for investment tax credit is unaffected. In enacting section 46 of the Internal Revenue Code, Congress placed certain limitations on the use of JDITC when that credit is amortized, as here, over the life of the associated investment. See Treas.Reg. § 1.46-6(a)(3) (1979). [36] Section 46(f) of the Code was designed to prevent regulatory agencies from defeating the credit's intended purposestimulation of investmentby flowing through to ratepayers the entire savings which result from the credit. See H.R.Rep.No.533, 92d Cong., 1st Sess., reprinted in [1971] U.S.Code Cong. & Ad. News 1825, 1839; S.Rep.No.437, 92d Cong., 1st Sess., reprinted in [1971] U.S.Code Cong. & Ad.News 1918, 1943. Section 46(f)(2) thus specifically provides that no credit shall be allowed in two circumstances: (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 portion 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 applied is reduced by reason of any portion of the credit allowable by section 38 (determined without regard to this subsection). Hence, subdivisions 2(A) and 2(B) permit a limited flow through to consumers of the benefits accrued through use of the credit. [37] As long as cost of service is not reduced by more than a ratable portion of the credit and as long as rate base is not reduced by any of the credit, the utility remains eligible for the credit. See Public Service Co. of New Mexico v. Federal Energy Regulatory Commission, 653 F.2d 681, 684-85 (D.C.Cir. 1981). As explained above, the Commission's methodology for calculating the interest expense treats the entire rate base, which includes JDITC, as though it were financed conventionally in the same proportions as the capital structure. NET contends that such treatment runs afoul of the proscription in subsection 46(f)(2)(B) that rate base not be reduced by reason of the credit. In support of its argument, NET relies on certain language in the Senate and House Reports which accompanied the Revenue Act of 1971 and in Treas.Reg. § 1.46-6(b)(3)(ii) (1979), one of the regulations implementing section 46(f). The Senate Report states in pertinent part: In determining whether or to what extent a credit has been used to reduce the rate base, reference is to be made to any accounting treatment that can affect the company's permitted profit on investment by treating the credit in any way other than as though it had been contributed by the company's common shareholders. For example, if the `cost of capital' rate assigned to the credit is less than that assigned to common shareholders' investment, that would be treated as, in effect, a rate base adjustment. S.Rep.No.437, 92d Cong., 1st Sess., reprinted in [1971] U.S.Code Cong. & Ad.News 1918, 1946. [38] Section 1.46-6(b)(3)(ii) (1979) of the treasury regulations explains in different terms what is meant by a rate base reduction: In determining whether, or to what extent, a credit has been used to reduce rate base, reference shall be made to any accounting treatment that affects rate base. In addition, in those cases in which the rate of return is based on the taxpayer's cost of capital, reference shall be made to any accounting treatment that affects the permitted return on investment by treating the credit in any way other than as though it were capital supplied by common shareholders to which a `cost of capital' rate is assigned that is not less than the taxpayer's overall cost of capital rate (determined without regard to the credit). What is the overall cost of capital rate depends upon the practice of the regulatory body. Thus, for example, an overall cost of capital rate may be a rate determined on the basis of an average, or weighted average, of the costs of capital provided by common shareholders, preferred shareholders and creditors. (Emphasis added.) The Senate Report (as well as somewhat similar language in the House Report) can be read as suggesting that all JDITC must be treated as if it were attributable to common equity. However, the emphasized provision of the treasury regulation quoted above merely requires that the cost-of-capital rate assigned to JDITC be not less than the utility's overall cost-of-capital rate determined without regard to the credit. According to the regulation, the overall cost of capital may be determined on the basis of a weighted average of the various costs of capital supplied by shareholders and creditors, implying that JDITC may be properly treated as though it were ordinary capital consisting of both common equity and leveraged investment or debt. After recognizing the apparent inconsistency between the treasury regulations and the quoted passages in the legislative reports, the Courts of Appeals for the Eighth Circuit and the District of Columbia have held that treating JDITC as if it were ordinary capital did not operate as a prohibited rate base adjustment under I.R.C. § 46(f)(2)(B). Union Electric Co. v. Federal Energy Regulatory Commission, 668 F.2d 389 (8th Cir. 1981); NEPCO Municipal Rate Committee v. Federal Energy Regulatory Commission, 668 F.2d 1327 (D.C.Cir.1981); Public Service Co. of New Mexico v. Federal Regulatory Commission, 653 F.2d 681, 687 (D.C.Cir.1981). We agree. Independent review of the legislative history and of IRS regulations interpreting section 46(f)(2) convinces us that the cited federal decisions are correct. The legislative history of the Revenue Act of 1971 shows that Congress intended that both investors and consumers of regulated utilities should share the benefits of the tax credit. The House Report states: In restoring the investment credit for public utility property of regulated companies, the committee has given careful consideration to the impact of this credit on ratemaking decisions. Although there are many different ways of treating the credit for ratemaking purposes, your committee, in general, believes that it is appropriate to divide the benefits of the credit between the customers of the regulated industries and the investors in the regulated industries. H.R.Rep.No.533, 92d Cong., 1st Sess. 24, reprinted in [1971] U.S.Code Cong. & Ad. News 1825, 1839. To the same effect is S.Rep.No.437, 92d Cong., 1st Sess. 36, reprinted in [1971] U.S.Code Cong. & Ad. News 1918, 1945. To hold that Congress intended that JDITC be treated exclusively as if it were common equity supplied by shareholders would be inconsistent with one of the dominant themes of the legislative history, namely, that the benefits of the tax credit be shared by both investors and consumers. Under the Commission's interest-synchronization method, both the shareholders and the ratepayers benefit from the credit. The utility gets interest-free capital and the ratepayers receive lower rates as a result of the interest deduction and concomitant lower cost of service. [39] The Commission's position is that if JDITC were treated as if it were common equity, the revenue requirement of NET would be thereby artificially inflated and the ratepayers would derive no benefit from the JDITC. NET challenges the Commission's assumption that, in the absence of JDITC, the capital otherwise supplied by the credit would be replaced by a balanced combination of equity and debt. Implicit in NET's argument is the assumption that if JDITC did not exist it would be replaced entirely by equity capital supplied by common shareholders. When confronted with a case involving similar divergent assumptions regarding capital acquisition, the Court of Appeals for the District of Columbia decided as follows: As a matter of economic theory, the competing theories advanced by FERC [the Federal Energy Regulatory Commission] and [the utility] raise questions that are undoubtedly complex. The question before this court, however, is not. The function of this court is not to speculate on the manner in which a utility would finance investment in a world devoid of the investment tax credit. Since no issue of statutory interpretation is presented, the question before this court is simply whether the factual assumption relied on by the Commission in applying the statute is arbitrary, capricious, or an abuse of discretion. We hold that it is not. The assumption of capital acquisition relied on by FERC is supported by reasonable economic theory. Textbook economics suggests that an enterprise is likely to establish a target capital structure, and make individual financing decisions that are consistent with the maintenance of that target. See E. Brigham, Financial Management Theory and Practice 512 (2d ed. 1979). If this is true, then, in the absence of ADITC, additional capital needed to finance the investment property would be generated from all capital suppliers, in approximately the same proportion as previously existing in the capital structure. Since existing proportions of debt and equity in all likelihood reflect an established target capital structure, it is reasonable to assume that, in order to maintain that target, the ADITC portion of the rate base would be financed with similar proportions of debt and equity. 653 F.2d at 689-90 (footnote omitted). The Commission's assumption that, in the absence of JDITC, NET would finance its plant by ordinary means with a combination of equity and debt in the same proportion as it exists in the capital structure is reasonable. The Commission's treatment of JDITC in this case is not inconsistent, therefore, with the intended purpose of section 46(f). That the treasury regulations are intended to permit JDITC to be treated like ordinary capital in the determination of the interest expense tax deduction is clear from the following prefatory comments accompanying the 1979 amendments to Treas.Reg. § 1.46-6: Section 1.46-6 (originally proposed as § 1.46-5) implements section 46(f). That provision lists the circumstances for disallowing an investment tax credit. Public comments suggested that the definition of `rate base reduction' contained in § 1.46-6(b)(3) of the proposed regulations was inconsistent with the legislative history of section 46(f). The Committee reports accompanying section 105 of the Revenue Act of 1971 indicated that investment tax credits must be treated as capital contributed by the common shareholders of regulated companies and must be assigned the same cost of capital rate as all other capital provided by common shareholders. The proposed regulations merely required that a credit be assigned a cost of capital rate not less than the company's overall rate of return. The committee reports also state that the limitations of section 46(f) were intended to achieve two goals: a sharing of benefits between consumers and investors and a limitation on Federal revenue losses. Under certain circumstances, the common shareholder equity rule would deny consumers any of the benefits of a credit and could force ratemaking authorities to set rates higher than the rates that would have been established had no credit been available. Under such circumstances, Federal revenue losses would not be merely limited to the amount of the credit, but would be reduced to an amount less than the credit. Congress did not intend to force consumers to subsidize the cost of the investment tax credit. T.D. 7602, approved Mar. 15, 1979, 44 Fed. Reg. 17666, 17666-67 (March 23, 1979). Treasury regulations that implement the congressional mandate in some reasonable manner are entitled to considerable deference, since Congress has delegated to the Secretary of the Treasury, not to this Court, the task `of administering the tax laws of the Nation.' Commissioner v. Portland Cement Co., 450 U.S. 156, 169, 101 S.Ct. 1037, 1045, 67 L.Ed.2d 140 (1981) (quoting from United States v. Correll, 389 U.S. 299, 307, 88 S.Ct. 445, 449, 19 L.Ed.2d 537 (1967) and United States v. Cartwright, 411 U.S. 546, 550, 93 S.Ct. 1713, 1716, 36 L.Ed.2d 528 (1973)). The treasury's explanation and interpretation of section 46(f) afford a reasonable basis for the provisions of section 1.46-6(b)(3)(ii) of its regulations, and those provisions must therefore be deemed controlling. The Commission's treatment of JDITC in this case does not result in a prohibited rate base reduction under I.R.C. § 46(f)(2)(B). NET contends that the Commission's treatment of JDITC also violates I.R.C. § 46(f)(2)(A) (set forth in text above) by impermissibly reducing cost of service by more than a ratable portion of the credit. The treasury regulations define cost of service as the amount required by a utility to provide goods and services, including expenses of operation and maintenance, depreciation, taxes and interest. Treas.Reg. § 1.46-6(b)(2)(i) (1979). NET claims that cost of service is reduced because the Commission, in effect, imputes an interest expense to interest-free JDITC. As in its argument with respect to section 46(f)(2)(B), discussed above, NET assumes implicitly that, in the absence of JDITC, the capital otherwise supplied by the tax credit would be contributed exclusively by common shareholders. Any other treatment, NET argues, will result in a more-than-ratable reduction in cost of service in violation of section 46(f)(2)(A). The Commission assumes that cost of service would remain exactly the same if JDITC did not exist on the ground that NET would finance its plant by ordinary means, including a combination of debt and equity in the same proportion as in the capital structure. Under the Commission's theory, no change in the percentage of debt would occur, and therefore no change would occur in the tax liability used to compute cost of service. Accordingly, the Commission reasons that cost of service remains unaffected by the inclusion of JDITC in the determination of NET's interest deduction in computing its federal income tax obligation. The difference between the positions stems ultimately from the contrary assumptions of the parties regarding capital acquisition in the absence of JDITC. On appeal, our function as a reviewing court is limited to determining whether the Commission's method is reasonable and supported by evidence. As we held above with respect to section 46(f)(2)(B), the Commission's assumption of balanced capital acquisition in the absence of the tax credit is not arbitrary, capricious or an abuse of discretion. Under the Commission's theory, ratepayers bear the same cost of service, excluding the ratable reduction permitted by the statute, as they would pay in the absence of JDITC. See Public Service Co. of New Mexico, 653 F.2d at 691-92. Accordingly, we affirm the Commission's conclusion that its treatment of JDITC did not impermissibly reduce cost of service in violation of I.R.C. § 46(f)(2)(A). The Court of Appeals for the District of Columbia reached the same result in NEPCO Municipal Rate Committee, 668 F.2d 1327, at 1338. In sum, we hold that the Commission's treatment of JDITC does not violate the provisions of either subsection A or subsection B of I.R.C. § 46(f)(2). The Commission's treatment of JDITC in its interest-synchronization adjustment is reasonable and results in a sharing of the benefits of the credit by both investors and ratepayers; it does not impermissibly overstate the interest expense deduction in a way that would deprive NET of a right to investment tax credit. 2. Effect of Interest Synchronization Adjustment on Maine State Income Taxes. On appeal, NET contends that because the Commission multiplied the weighted cost of AT&T debt in NET's capital structure by rate base in computing the interest allocation [40] it treats some AT&T interest, in effect, as deductible for purposes of the State of Maine income tax. Arguing that it is not so deductible under 36 M.R.S.A. §§ 5102(8) & 5211(8) (1978 & Supp.1981-1982), NET urges the Court to remand on this issue. In its brief, the Commission admits that its calculations failed to consider adequately the differences in federal and state income tax laws; in effect, it does not contest NET's argument. Consequently, the case must be remanded to the Commission for reconsideration of this issue.