Opinion ID: 1356002
Heading Depth: 2
Heading Rank: 4

Heading: income tax expense

Text: {11} Zia claimed $700,000 in income tax expenses. The Commission, using its imputed capital structure, determined that Zia would have been able to deduct $497,000 of the taxes in fictitious interest payments on the 46% imputed debt. As a result, the Commission awarded Zia $391,000 in income tax expenses. Zia complains, however, that while it must in reality pay a high amount of federal taxes on its income, the imputed debt creates false tax savings in the form of a deduction equal to the amount of interest. The savings resulting from this deduction ($309,130) exists only in the hypothetical world of the imputed capital structure. Zia claims the imputed tax savings is contrary to law. We agree. While it is reasonable for the Commission to evaluate the utility in terms of an imputed capital structure for purposes of developing a pattern for comparison with other similarly situated companies, it is not reasonable to carry the imputation of capital structure to the point where the rate is evaluated without consideration of actual taxes paid. We see no reason to depart from case law which has held for many years that a regulatory body cannot arbitrarily disallow federal taxes that a company has paid or is obliged to pay, by assuming a tax savings under a capital structure which does not exist. See General Tel. Co. v. Michigan Pub. Serv. Comm'n, 78 Mich.App. 528, 260 N.W.2d 874, 878 (1977) (citing Public Serv. Comm'n v. Indiana Bell Tel. Co., 235 Ind. 1, 130 N.E.2d 467, 480 (1955)). One leading case is In re Diamond State Tel. Co., 51 Del. 525, 149 A.2d 324, 328-329 (1959), which held a utility commission could not arbitrarily disallow legitimate actual tax expenses on the theory of reforming the company's capital structure. {12} Whereas the use of an imputed capital structure in determining the rate of return appropriately balances the interests of ratepayers and investors and equalizes a management structure that is more beneficial to investors, the refusal to use actual tax expenses determining the rate of return is improper. In other words, the Commission would have been punishing Zia for exercising its management prerogative in making the company more secure for its investor. Once the Commission has established a reasonable rate of return which balances investor and ratepayer interests, it is unnecessary to deny actual tax expenses reasonably incurred because it would shift the balance too far in favor of ratepayers. Zia points out that, even though the Commission determined that 9.15% was a reasonable rate of return, the disallowance of tax expenses reduces the actual rate of return to 7.33%. Cf. General Tel. 1982, 98 N.M. at 757, 652 P.2d at 1208 (deducting 41% from the rate of return the commission had determined to be just and reasonable would nullify the commission's finding concerning the necessary rate of return). The problem was summarized in General Telephone Co. v. Public Utilities Commission, 174 Ohio St. 575, 191 N.E.2d 341, 344 (1963): There is no tax advantage [in an imputed capital structure] because the federal income tax law does not permit the deduction of hypothetical interest in computing income tax. The federal law allows for the deduction of only the amount of interest actually paid. To argue that this is a tax advantage is to assert, in simple words, that it is a tax advantage for a company to be allowed, as expense for income taxes, an amount less than the amount of taxes which it is actually required to pay under the law. It is evident that there is no tax advantage here, but rather a disadvantage which results in the [company's] annual dollar return to which it is entitled being reduced arbitrarily and either its statutory rate base, which has been determined and agreed upon, being reduced arbitrarily and unlawfully, or the annual fair rate of return which the commission has held it is entitled to receive being reduced arbitrarily and unlawfully. {13} In past utility cases, this Court has said that the Commission has an obligation to allow a utility expenses that are necessary in providing utility service, that benefit ratepayers, and that are prudently incurred. See General Tel. 1982, 99 N.M. at 6, 653 P.2d at 506 (noting [t]he Commission could not disallow prudent expenditures for essential telephone services since the telephone company [was] required to provide these services even if a loss resulted). In an analogous situation, this Court reviewed the decision of the Public Service Commission in denying recovery to a sole proprietor for tax expenses. Moyston v. New Mexico Pub. Serv. Comm'n, 76 N.M. 146, 157, 412 P.2d 840, 847 (1966) (stating all parties agreed that income taxes imposed on an incorporated public utility are properly deductible as expenses for rate-making purposes). In Moyston, this court held that the Commission's denial to a sole proprietor of a deduction for actual taxes which were higher than hypothetical taxes because she had not incorporated denie[d] to the owner of the utility the right to select whether or not the operation is by a corporation or by a proprietorship, by reason of the denial of an allowance of state and federal income taxes. Id. at 158, 412 P.2d at 848. Similarly, the Commission's denial of recovery for Zia's tax expenses denies Zia the decision whether to operate at 100% equity, a decision clearly left to Zia by this Court's opinion in Mountain States 1954, 58 N.M. at 278, 270 P.2d at 696-97. It is plain that a higher federal income tax expense results from the lack of an interest expense deduction. The lack of debt in the capital structure would result in no interest expense. Thus, we conclude that the disallowance of this expense was arbitrary.