DUQUESNE LIGHT SAYS ANY ADJUSTMENT TO RATE BASE IS INCONSISTENT WITH NORMALIZATION.

SUMMARY: Gary L. Schwass, chief financial officer, Duquesne Light Company, Pittsburgh, has commented that any adjustment to rate base to reflect consolidated tax savings ultimately affects the cost of service tax expense of a regulated utility and, therefore, is inconsistent with the normalization method of accounting. Schwass believes that final regulations should hold that such rate-base treatment violates the normalization requirements of sections 167(l) and 168(i)(9).

Duquesne Light Company submits the following comments in response to the Notice of Proposed Rulemaking and Notice of Public Hearing (PS-107-88) regarding normalization as it applies to tax benefits resulting from tax consolidation of non-regulated subsidiaries.

Duquesne, a Pennsylvania corporation, provides electric service for approximately 573,000 customers within an 800 square mile area in Allegheny and Beaver counties in Southwestern Pennsylvania and also sells electricity to other utilities.

The proposed regulations have a direct bearing on the manner in which rates are set for regulated utilities. Thus, Duquesne has a direct and substantial interest in the outcome of this rulemaking process. We concur that COST OF SERVICE consolidated tax savings adjustments to regulated tax expense violate normalization requirements. However, we also believe that RATE BASE consolidated tax savings adjustments which indirectly adjust regulated tax expense and/or the reserve for deferred taxes violate normalization requirements. In this regard, we strongly disagree with the proposed regulation and we urge reconsideration of the position taken by the Treasury.

In addition, we believe that the proposed regulations pose a serious threat to utility diversification options. Potential adverse effects include:

o Utilities that have relied on IRS Private Letter Rulings, which provide that giving recognition to tax benefits from unregulated subsidiaries would violate normalization requirements, will be unfairly impacted. The proposed regulations clearly will penalize the companies who relied in good faith on such rulings in making the economic determination to diversify.

o Shareholders who bear the risk associated with the unregulated activity will be unfairly deprived of the associated tax benefits.

We thank you for this opportunity to express our views on the proposed legislation and we respectfully submit the following analysis.

The rate base reduction contemplated by the proposed regulations is difficult to reconcile with the consistency requirements of IRC Section 168(i)(9)(B)(ii). That section provides that it is a violation of the normalization rules if a procedure or adjustment is used in computing tax expense, depreciation expense or the deferred tax reserve unless such procedure or adjustment is also used for the other two items and with respect to rate base. The legislative history of this provision clearly shows that it does not establish new law but is a mere statutory continuation of the law under existing regulations. See H.R. Rep. No. 827, 97th Cong., 2d Sess. 9 (1982) and S. Rep. No. 643, 97th Cong., 2d Sess. 9 (1982). An adjustment, such as that contained in the proposed regulations, which reduces rate base but which is not also used in determining the other items violates this explicit requirement. Furthermore, the reduction in rate base in the proposed regulations violates the consistency requirements of the Code.

The proposed regulations are premised on the presumption that tax benefits arising from consolidation of non-regulated entities are similar to the tax benefits of accelerated depreciation. The Explanation of Provisions states:

"Consolidated tax savings are similar to the deferred taxes arising from the allowance of accelerated depreciation on public utility property in that the temporary tax savings available to the utility is cost-free capital from the time it is collected from ratepayers until the time the affiliate becomes profitable."

The statement is incorrect in stating that consolidated tax savings constitute cost-free capital collected from ratepayers. Rates for utility services are determined based on the utility recovering its prudently incurred costs and earning an allowed return on rate base. A utility's rate base is not comprised of any components that create a consolidated tax benefit. Any tax benefit arising from the filing of consolidated income tax returns results because federal tax law allows consolidated taxable income to be computed by combining members' taxable income and losses, not because ratepayers have infused capital.

The intent of the normalization concept is to ensure that capital formation incentives contained in the Code accrue to the benefit of the taxpayer who has made capital investments in property. To allow the benefits associated with these incentives to accrue to anyone else must be considered a normalization violation. Allocation of tax benefits to a ratepayer is wrong if the ratepayer receives tax benefits from property in which he has made no investment, paid no costs and bears no risk.

Moreover, consolidated tax benefits are not analogous to tax benefits (deferred taxes) from accelerated depreciation. Accelerated depreciation is a device enacted as the result of the congressional decision to encourage capital investment. Normalization was enacted to prevent regulators from shifting that benefit to ratepayers, thereby defeating the intent of Congress.

In contrast, consolidated tax benefits do not constitute, in any sense, a source of government-supplied capital. Over seventy years ago, at the time consolidated returns were first the subject of legislation (Section 240 of the Revenue Act of 1918), the stated primary purpose of consolidation was that, ". . . the principle of taxing as a business unit what in reality is a business unit is sound and equitable and convenient both to the taxpayer and to the Government". Sen. Rep. No. 617, 65th Cong., 3rd Sess., Page 9. This primacy of economic substance over structural form has persisted through the years and has been recognized as the continuing rationale for allowing the filing of consolidated returns.

The provision of a permanent rate base reduction attributable to the situation described above constitutes the economic equivalent of a cost of service reduction. Since the proposed regulations themselves prohibit a cost of service reduction, a permanent rate base reduction should likewise be prohibited.

The notice of proposed rulemaking invited comments on the proper normalization treatment of expenses not included in cost of service. Examples of these items include the cost of an abandoned plant, plant construction costs or any other cost a ratemaking authority considers to be imprudent.

We believe the final regulations should prohibit the reduction of regulated tax expense by the tax benefits resulting from items not included in cost of service. The tax effect of any cost a ratemaking authority considers to be imprudent should be prohibited by the final regulations from reducing regulated tax expense. Such a reduction of tax expense is a normalization violation.

Although these tax benefits are applicable to the utility, they, like the consolidated tax benefits of unregulated entities, are not paid for by the ratepayers. Therefore, they should not be used to reduce tax expense in setting rates. The use of the tax benefits associated with utility costs not included in the cost of service constitutes a violation of the normalization rules. See Code sections 167(l) and 168(f)(2) and (i)(9).

Utility companies have made substantial investments as well as diversification decisions based on prior interpretations of the normalization rules by the IRS. As recently as 1989, in Ltr 8904008, the IRS ruled that the utility would "not be in compliance with the normalization rules of Secs. 167(l), 168(f)(2), and 168(i) if it uses the commission's proposed consolidated tax savings adjustment. . . . The introduction of a variable, such as the parent company's tax benefits resulting from its affiliates' tax losses, would create an excess deferred tax reserve, which would reduce the ratebase to an amount less than that needed to meet normalization requirements." Accordingly, if the regulations are adopted as proposed, we strongly recommend an effective date of no earlier than January 1, 1992. To make the effective date earlier would unfairly penalize those utility companies who have made large capital investments based on these prior interpretations.

CONCLUSION

Duquesne Light Company appreciates the opportunity to present its views on the proposed regulations that would provide guidance on the application of the normalization requirements of Code sections 167(l) and 168(i)(9) as they relate to utility companies that file consolidated Federal income tax returns. It is our view that any adjustment to rate base to reflect consolidated tax savings ultimately affects the cost of service tax expense of the regulated utility, and is therefore inconsistent with the normalization method of accounting. Final regulations should hold that such rate base treatment violates the normalization requirements of Code Sections 167(l) and 168(i)(9).

Sincerely,