Opinion ID: 2332363
Heading Depth: 1
Heading Rank: 2

Heading: allocation of american telephone & telegraph interest

Text: As we have seen with respect to the accelerated depreciation issue, an important component of New England's operating expenses, which must be paid by its ratepayers, is its federal income tax expense. One of the calculations New England must make in order to determine its taxable income, and corresponding federal tax liability, is to deduct its interest payments from gross income. Thus, a large interest expense benefits New England's ratepayers by substantially reducing its tax liability and operating expenses. New England claims that its interest expenses must be limited to only interest that it pays on debt issued by New England itself. However, the Commission's calculation of New England's interest expense included not only interest payments on its own debt, but also an allocation of American Telephone & Telegraph's interest expense. We hold that the Commission's interest allocation adjustment was reasonable and its findings, with respect thereto, supported by substantial evidence, with one exception, which requires remand. Before proceeding to the legality of the Commission's actions in this case, an explanation of the method by which New England pays its federal income tax is necessary. The Internal Revenue Code, I.R.C. §§ 1501 et seq. allows affiliated corporations to file income tax returns on a consolidated basis. Accordingly, New England joins with American Telephone & Telegraph and other members of the Bell System in filing a consolidated return, in which the taxable incomes of the profit companies and the negative taxable incomes of the loss companies are totalled. Because the taxable incomes of some companies may be offset by the tax losses of other companies in the affiliated group, the effect is to lower the overall federal taxes paid to the federal government by the Bell System as a whole below the amount of taxes which would be paid if each of the companies filed a separate return. The Bell System then pays the corporate tax rate of 48% on the net consolidated income of the entire group. American Telephone and Telegraph acts as an agent for its subsidiaries and, pursuant to an agreement among the members of the system, allocates the tax liability among the various companies according to a prearranged formula. The profit companies are essentially charged the amount they would have paid if they had filed a separate return, i. e., 48% of taxable income. AT&T then directs them to distribute the money to two different recipients. The profit company might be directed to pay part or all of the money directly to the federal government to satisfy the System's federal income tax liability on the consolidated return. In the alternative, American Telephone & Telegraph might direct the balance of the money to be paid to one of the tax loss companies, in the amount of 48% of its negative taxable income. Thus, the tax loss companies are compensated in the amount by which their losses reduced the System's overall tax liability. In effect, American Telephone & Telegraph collects 48% of the sum of all positive taxable incomes, which is the amount the individual companies would have collectively paid if all members of the System had filed separate returns. But, because the consolidated return system also includes tax loss companies, the actual payments to the federal government total less than 48% of all positive taxable incomes. The tax savings so realized by filing a consolidated return are kept in the System and distributed to only those companies which contributed negative taxable incomes to the consolidated return. Thus, American Telephone & Telegraph is collecting more in income taxes from its profit making subsidiaries than are necessary to meet the System's consolidated tax liability. Yet, the profit companies are not allowed to participate in such tax savings generated by use of the consolidated return. One method used by regulatory agencies to account for what is perceived to be an inequitable distribution of the tax savings among all the members of the consolidated system involves the application of an effective tax rate. We recently affirmed the Commission's application of an effective tax rate in Mechanic Falls Water Co. v. Public Utilities Commission, Me., 381 A.2d 1080 (1977). An effective tax rate is generally determined by dividing the total consolidated tax liability, before credits, by the sum of the positive taxable incomes. Although various methods may be used to compute an effective tax rate, id. at 1095, n. 26, the general purpose is to allocate to the utility in question its proportionate share of the tax liability on the consolidated return. The resulting percentage figure (usually expected to be below 48%) is the rate which, if multiplied by the taxable incomes of the profit companies, would produce just enough money to meet the consolidated system's actual federal tax bill, and no more. This effective tax rate is then used instead of the 48% federal corporate tax figure to determine the utility's federal tax expense for ratemaking purposes. [12] In this case, however, the Commission decided not to use the effective tax rate method to allocate to New England the savings resulting from the use of a consolidated return. As we have seen, the effective tax rate is a method to distribute the tax savings resulting from the existence of tax loss companies, with negative taxable incomes, in the consolidated return. The method chosen by the Commission in this case was designed to allocate to New England one particular item which contributed to the consolidated system's tax savings, i. e. interest paid on debt issued by American Telephone & Telegraph itself. The Commission reasoned that because New England's ratepayers paid part of the interest on American Telephone & Telegraph's issued debt, they should be entitled to have those interest payments deducted from New England's taxable income, thereby reducing its federal income tax expense for ratemaking purposes. The Commission's interest expense allocation basically follows the theory behind its double leveraging adjustment, but is not necessarily dependent upon our approval thereof. American Telephone & Telegraph owns 86% of New England's common equity, which comprises 55% of New England's capital structure. Therefore, 47.3% (86% × 55%) of New England's capital structure and, therefore, its rate base is financed by American Telephone & Telegraph capital. Because 25% of American Telephone & Telegraph's own capital structure consists of long term debt, with an interest cost of 6.5%, [13] the Commission determined that 11.8% (25% × 47.3%) of New England's capital structure is financed by debt issued by American Telephone & Telegraph. The Commission reasons that when New England's ratepayers supply revenues which are used to provide American Telephone & Telegraph with a return on its equity investment in New England, 25% of that return is being used by American Telephone & Telegraph to pay the interest on its own debt. The Commission maintains that New England's ratepayers are entitled to an interest deduction on that portion of American Telephone & Telegraph debt which they indirectly finance. The Commission calculated that 11.8% of New England's $214,615,000 rate base or $25,324,570 was attributable to American Telephone & Telegraph debt on which New England's ratepayers were paying interest at a rate of 6.5%. Therefore, New England's ratepayers paid approximately $1,650,000 in interest on American Telephone & Telegraph debt during the test year. The Commission then added this allocated interest expense to the interest expense on debt issued by New England itself to determine New England's total interest expense for ratemaking purposes. Thus, the Commission reduced New England's federal income tax expense to reflect the contribution made by its ratepayers to interest payments on American Telephone & Telegraph issued debt. New England challenges the Commission's allocation of interest expense on American Telephone & Telegraph's issued debt on a number of grounds. We deny its appeal on this issue, holding that the Commission's actions constituted reasonable ratemaking practice and were generally supported by substantial evidence in the record. [14] Rather than calculate an overall effective tax rate, a number of commissions have focused upon allocating a parent corporation's interest expense to a subsidiary utility as a means of distributing the tax savings when a consolidated return has been filed. A common method to allocate the interest expense on debt issued by the parent is to adopt a higher hypothetical debt ratio for the utility and to calculate its debt expense thereby. Notably in Bell Telephone cases, hypothetical debt ratios have been used with some frequency for the purpose of allocating to particular operating companies the income tax savings which are produced by consolidated income tax returns. 1 A. Priest, Principles of Public Utility Regulation 54 (1969). A number of commissions follow an adjustment recommended by an accounting committee of the National Association of Railroad and Utility Commissions (NARUC). [15] The NARUC adjustment use[s] the cost of debt and debt ratio of the Bell System rather than the debt ratio and operating expenses of a particular operating company. Re Chesapeake & Potomac Telephone Company, 4 P.U.R. 4th 1, 40 (Dist. of Col.Pub.Serv.Comm. 1974). Similarly, some cases use the debt ratio of the utility's parent or the consolidated system to determine the utility's proper interest expense for federal tax purposes. [16] Finally, a few cases state that they are allocating part of the parent's interest expense to the subsidiary utility, but are unclear as to the precise method followed. [17] In this case the Commission stated that it preferred not to use a hypothetical debt ratio, but to use the actual debt ratio of the Company adjusted for that specific portion of New England Telephone's equity which is financed by American Telephone and Telegraph Company debt. Re New England Telephone and Telegraph Co., ___ P.U.R. 4th ___, ___ (Me.Pub.Util.Comm.1977). Thus, the Commission chose to follow a method used by the New York Public Service Commission in Re New York Telephone Company, 84 P.U.R. 3d 321 (N.Y.Pub.Serv. Comm.1970). [18] In that case the New York Commission concluded, Since NYT's ratepayers pay the cost of (i. e., the return on) NYT's equity, a part of which AT&T converts into debt in its own capital structure, . . . the company's ratepayers deserve the tax benefits of the related AT&T deduction for interest on the debt. Id. at 345. The New York Commission then rejected the NARUC and imputed debt ratio approaches and calculated New York Telephone's share of American Telephone & Telegraph's interest deductions by the same method used by the Commission in this case. This method is essentially an application of a double leveraging formula for purposes of determining the utility's proportionate share of interest deductions associated with debt issued by the parent, upon which the utility's ratepayers indirectly make the interest payments. [19] Neither the Commission nor our own research brought to our attention any other case in which a double leveraging type approach was used to allocate interest expense to a subsidiary utility for deduction from taxable income. However, the theory behind the double leverage formula here, i. e., to account for interest paid by New England's ratepayers on that debt issued by American Telephone & Telegraph which is used to fund American Telephone & Telegraph's equity investment in New England, finds support in a number of cases. In Southwestern Bell Telephone Company v. State Corporation Commission, supra n. 16, the Kansas Supreme Court affirmed that state's commission's use of the consolidated system's debt ratio to allocate interest expense to the operating company. The Court noted that when the parent company and its subsidiaries elect to file a joint income tax return, they have disregarded their separate entities for income tax purposes. At least they have for tax purposes combined their income and expense. It is evident also that the parent company has used long term indebtedness, on which the interest is deductible from income as expense, with which to buy the common stock of its subsidiaries whose income tax is paid by its consumers as a chargeable expense. Id. at 543 (emphasis added). [20] It appears to be accepted regulatory practice to allocate the interest deduction on debt issued by American Telephone & Telegraph to a subsidiary whose ratepayers indirectly pay the interest on such debt through the return to American Telephone & Telegraph on its investment in the subsidiary. In fact, a Minnesota District Court held that the Minnesota Public Service Commission erred when it refused to adjust the utility's federal tax expense to reflect interest deductions on debt issued by American Telephone & Telegraph. Re Northwestern Bell Telephone Company, 9 P.U.R. 4th 427, 440-43 (Minn.Dist.Ct.1975), aff'd Northwestern Bell Telephone Company v. State, 253 N.W.2d 815 (Minn.1977). The Minnesota Supreme Court affirmed, stating: [T]he district court was endeavoring to adequately account for Bell's actual tax liability under the consolidated return. A number of cases have considered the effect of this method of tax reporting. [citations omitted] These cases hold generally that when a consolidated return is filed, the subsidiary should not be allowed to receive credit for more than its proportionate share of the consolidated tax liability. . . [citation omitted] The district court properly limited Bell to a deduction from operating income of only its proportionate share of the consolidated AT&T tax liability. Id. at 821. Accordingly, we are satisfied that the Commission may reasonably adjust New England's federal tax expense to reflect an allocation of American Telephone & Telegraph's issued debt upon which New England's ratepayers pay the interest. (Cases relied upon by New England, [21] are in the clear minority, and fail to persuade us on this point). We also find that the Commission's method for determining the appropriate allocation of American Telephone & Telegraph's interest expense to New England was reasonable. As we have seen earlier, double leveraging is a viable ratemaking concept to account for the parent-subsidiary relationship in some cases. It may be reasonably used in this case by the Commission to trace the source of the money used to pay the interest debt issued by American Telephone & Telegraph. When New England and American Telephone & Telegraph filed a consolidated return, they submitted themselves to treatment as a single entity for federal tax purposes. In such a situation the Commission may allocate American Telephone & Telegraph's interest expense so as to provide New England's ratepayers with the benefit of the interest deduction resulting from their own rate payments. We hold that the Commission's allocation of American Telephone & Telegraph's interest expense in this case was a reasonable ratemaking adjustment. After we have determined the reasonableness of the Commission's allocation of American Telephone & Telegraph's interest expense, the only remaining question is whether it is supported by substantial evidence. New England argues that no witness recommended the recomputation of its federal income taxes on the basis of the double leverage formula. However, the testimony of staff witness, Mr. Bruce M. Louiselle, indicated that the double leverage approach was a valid alternative. Moreover, the Commission generated a considerable record on the interest allocation issue, which demonstrates its familiarity with the basic issues and concepts involved. The testimony and exhibits incorporated into the record on this issue provide a sufficient foundation for the Commission's actions. The Commission is not required to follow only methodologies suggested by the witnesses before it. To bind the Commission to only those ratemaking techniques to which the witnesses testify would be an impermissible attempt to limit the discretion entrusted to it by the Legislature. The Commission must exercise its own expertise and skill in the setting of rates; and, we may not interfere with its decisions if they are reasonable and supported by substantial evidence. We have found the Commission's interest allocation to be reasonable in this case. We also find it to be supported by substantial evidence in the record, with one exception. As we note in our discussion of the Commission's double leverage adjustment with respect to rate of return, the record with respect to American Telephone & Telegraph's cost of debt appears weak. The Commission appears to have adopted the 6.5% figure used in its double leverage adjustment, which, in turn, was adopted from Mr. Kosh's suggested double leverage calculation which uses a 6.5% cost for American Telephone & Telegraph's debt. However, there appears to be no explanation concerning the origin of the 6.5% figure and our search of the record has been unsuccessful in this respect. Therefore, we affirm the Commission's interest allocation adjustment, on the condition that it make a finding supported by the evidence in the record as to the cost of American Telephone & Telegraph's debt, and that it incorporate such finding into its calculation of the interest allocation.