Transcript Panel on Accounting for Income Taxes: Rate-regulated Utilities FAS 71 Exceptions to FAS 109 David J.

Panel on Accounting for Income Taxes:
Rate-regulated Utilities
FAS 71 Exceptions
to FAS 109
David J. Yankee
Deloitte Tax LLP
April 23, 2007
Caveats
• The views expressed do not necessarily
represent Deloitte & Touche LLP or Deloitte
Tax LLP policy.
• The outcome of any specific matter depends
upon the specific facts and circumstances in
which the matter arises.
• The views expressed cannot be relied upon as
accounting or tax advice.
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2
Agenda*
• Effective Tax Rate Items
• Income Taxes and Ratemaking
• Normalization v. Flow-through Accounting
• Changes in Tax Rates – Excess Deferred Income
Taxes
• Allowance for Funds Used During Construction
• Investment Tax Credit
*Normalization requirements to be addressed in a separate session
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Effective Tax Rate Items
• Permanent differences
• Credits
• Temporary differences with:
– Flow-through accounting
– Historical tax rates
– After-tax accounting
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4
Basic Principles of the
Tax Provision
Balance Sheet
Current Taxes Receivable or Payable
Deferred Tax Asset or Liability
Income Statement
Current Tax Expense or Benefit
Deferred Tax Expense or Benefit
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Basic Principles of the
Tax Provision – Regulated Utilities
Balance Sheet
Current Taxes Receivable or Payable
Deferred Tax Asset or Liability
Regulatory Assets Related to Income Taxes
Regulatory Liabilities Related to Income Taxes
Deferred Investment Tax Credits
Income Statement
Current Tax Expense or Benefit
Deferred Tax Expense
Amortization of Investment Tax Credits
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The Ratemaking Formula
and Its Components
Rate base
x Allowed rate of return
=Required return
(i.e., operating income)
+Operating expenses
=Revenue requirement*
*Total amount which must be collected in rates for the
utility to recover its prudently incurred costs and earn a
fair return
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Tax-on-tax Gross-up Formula –
Federal Items and Allowed Equity Return
• Required revenue is the total amount which must be collected from
customers in rates in order for the utility to recover its costs,
including the allowed equity return.
• Allowed equity return must be grossed-up for taxes:
Equity Return
1 – Tax Rate*
=
Gross-up for Equity
Return and Taxes
*Based on combined statutory federal/state tax rates
• Example:
Allowed Equity Return = $3,000,000
$3,000,000 / (1 – 40%) = $5,000,000
Note – Adjustments to income tax expense (e.g., flowthrough, flow-backs, ITC amortization) must also be
considered.
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Rate Base Formula
Plant in service
Net plant and additions to rate
base
- Accumulated depreciation
Net plant in service
+ Construction work in progress*
+ Plant held for future use*
-
Deferred tax liability**
-
Accumulated deferred ITC
(Option 1 Company)
+ Fuel inventories
- Customer deposits
+ Material and supplies
- Regulatory liabilities
+ Inventories and prepayments
- Other reserves
+ Regulatory assets
Total rate base
+ Deferred tax asset**
+ Cash working capital
Net plant additions to rate base
*Often excluded from rate base
**Unless treated as no-cost capital
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Rate Base Components –
Income Taxes
• Accumulated Deferred Federal Income Taxes –
represents the deferred federal income taxes
resulting from tax normalization and is
considered a source of interest-free funds
(i.e., cost-free capital) provided by the U.S.
Treasury to the utility
– ADFIT balances deducted from rate base, or
– ADFIT balances included in the capital structure
of the utility at zero cost when computing the
rate of return
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Rate Base Components –
Income Taxes
• Accumulated Deferred Investment Tax Credit
– The accounting and ratemaking treatment for ITC is
largely dictated by former Internal Revenue Code (IRC)
Sections 46(f)(1) and 46(f)(2)
– The IRC permits sharing of ITC benefits between utility
investors and customers either
 Option 1 - As ADITC rate base reduction, with no
amortization through operating expenses (i.e., income
tax expense), or
 Option 2 - Through amortization of ITC “above-the-line”
as a reduction in operating expenses (i.e., income tax
expense). No rate base reduction. Option 2 deferred
ITC should earn at least the overall cost of capital if
included in the capital structure
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Normalization v. Flow-through
• Normalization – the reflection in ratemaking of a tax benefit
commensurate with the level of depreciation expense being
recovered from ratepayers
– Accrual-basis accounting for interperiod tax allocation
(i.e., deferred taxes)
 Current and deferred provisions and liabilities
• Flow-through – the reflection in ratemaking of a tax benefit
commensurate with the level of depreciation expense being
deducted on the tax return
– Cash-basis accounting for interperiod tax allocation
 Current tax provision/payable only
– Exception to comprehensive interperiod tax allocation
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Normalization v. Flow-through
Characteristics and Impacts
• Over the life of an asset, the amount of income
tax expense and the amount of rate recovery
are the same
• The methods differ on an annual basis as to the
amount of tax expense included in rates and,
thus, the amount recognized in the income
statement
• Sharing of tax benefits
– Between utilities and ratepayers
– Between generations of ratepayers
• Regulatory promise for future rate recovery
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13
Plant-related Book/Tax Differences
• Types
– Basis
 Overhead allocations, AFUDC, repairs
– First- and last-year placed-in-service conventions
– Method
– Life
– Salvage value
– Removal costs
• Normalization requirements – protected v. unprotected
differences
– Vary based on asset’s placed-in-service date
• State tax effects
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Flow-through Items
Regulatory Asset Calculation
Temporary difference flowed through
x Enacted tax rate
x Gross-up (tax-on-tax) factor
Regulatory asset
Dr. Regulatory Asset
Cr. Deferred Tax Liability
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Prior Flow-through
•
Book/tax differences for which deferred taxes were not originally provided
(or recovered in rates)
–
Interest-free government loan from government to taxpayer is in the hands of
ratepayers until it is repaid (i.e., when the future liability becomes due)
•
Scope and extent varies on a company-by-company, commission-bycommission basis
•
Change from state to FERC regulation
•
Resulted in lower revenue requirement and lower effective tax rate as
favorable book/tax differences originated
•
Results in higher revenue requirement and higher effective tax rate as
book/tax differences reverse
•
Prior to adoption of SFAS No. 109 – resulted in understated deferred tax
liabilities
•
Adoption of SFAS No. 109 – recognition of deferred tax liabilities and
regulatory asset as well as tax-on-tax gross-up
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Regulatory Assets – Examples
• FERC Account 182.3 – Other Regulatory Assets
• Non-tax-related examples
– Loss on reacquired debt
– Unrecovered fuel or purchased power costs
– Rate case expenditures
– Stranded asset costs
• Tax-related regulatory assets – SFAS Nos. 71 and 109
– Prior flow-through
 Tax-on-tax effect
– AFUDC-equity
 Tax-on-tax effect
– Increase in tax rates
 Tax-on-tax effect
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Flow-back of Prior Flow-through
• Basis differences reverse over the book lives of an asset
• Measure the reversing (temporary) basis difference as
the difference between:
– Book depreciation (i.e., book basis, book life, book
method)
– Tax straight-line depreciation (i.e., tax basis, book life,
book method)
• Remaining book/tax depreciation difference is
normalized:
– Tax straight-line depreciation
– Tax depreciation (i.e., tax basis, tax life, tax method)
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Effective Tax Rate Reconciliations
Line Item Descriptions
• Depreciation
• Tax over book depreciation
• Flow-through
• Flow-back of prior flow-through
• Accelerated depreciation flow-through
• Amortization of regulatory income tax asset
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Flow-through
Effective Tax Rate – Case Study #1
Assumptions
Tax-related regulatory asset = $1,000
Tax rate = 40%
Gross-up factor = 1.67 (rounded)
What is the amount of temporary differences for which deferred
taxes have not been recovered through rates?
Regulatory asset
$1,000
Divided by gross-up factor
÷ 1.67
Plant-related deferred tax liability
600
Divided by enacted tax rate
÷ 40%
Plant-related book/tax difference
$1,500
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Flow-through
Effective Tax Rate – Case Study #2
Assumptions (unrelated to prior page)
Effective tax rate flow-back = $1,000
Tax rate = 40%
Gross-up factor = 1.67
What is the amount of plant-related book/tax differences reversing in
the current year for which deferred taxes had not previously been
recovered through rates?
Effective tax rate flow-back
$1,000
Divided by enacted tax rate
÷ 40%
Plant-related book/tax difference
$2,500
What is the amount of reduction to the tax-related regulatory asset?
Change in plant-related deferred tax reserve
Gross-up factor
Change in regulatory asset
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$1,000
x 1.67
$1,670
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Tax Rate Changes
Overview
• SFAS No. 109 requires use of enacted tax rates
• Other factors
– Normalization requirements
– Regulators
• Federal rate changes
• State rate changes
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Changes in Tax Rates
SFAS No. 109, Paragraph 27
Deferred tax liabilities and assets shall be
adjusted for the effect of a change in tax laws or
rates. The effect shall be included in income from
continuing operations for the period that includes
the enactment date.
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Annual Computation of DTLs/DTAs
SFAS No. 109, Paragraph 18
• The objective is to measure a deferred tax
liability or asset using the enacted tax rate(s)
expected to apply to taxable income in the
periods in which the deferred tax liability or
asset is expected to be settled or realized.
• If there is a phased-in change in tax rates,
determination of the applicable tax rate
requires knowledge about when deferred tax
liabilities and assets will be settled and realized.
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Excess Deferred Federal Income
Taxes (EDFIT) - Overview
• Deferred taxes provided at tax rates in excess of the current
statutory tax rate
–
Pre-1979
48%
–
1979-1986
46%
–
1987
40%
–
1987-93
34%
–
Post-1993
35%
• Reduction in rates charged to ratepayers (as a reduction of
ratemaking income tax expense) as the book/tax depreciation
differences giving rise to the deferred tax liability reverse
–
Average rate assumption method - Act Section 203(e) of TRA of 1986
–
Reverse South Georgia method - Rev. Proc. 88-12
• Impact of turnaround on effective tax rate (decrease)
• Adoption of SFAS No. 109
– Regulatory liability
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Reduction in Tax Rates
Regulatory Liability Calculation – Part I
Previously recorded DTL
<Temporary differences at new tax rate>
“Excess” deferred taxes
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Reduction in Tax Rates
Regulatory Liability Calculation – Part II
Excess deferred taxes
x Gross-up (tax-on-tax) factor
Regulatory liability
Dr. Deferred Tax Liability (Reduction due to Rate Reduction)
Dr. Deferred Tax Asset (on Regulatory Liability)
Cr. Regulatory Liability – Excess Deferred Taxes
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Regulated Enterprises
SFAS No. 109, Paragraph 29
•
29. Regulated enterprises that meet the criteria for application of FASB
Statement No. 71, Accounting for the Effects of Certain Types of Regulations,
are not exempt from the requirements of this Statement. Specifically, this
Statement:
a. Prohibits net-of-tax accounting and reporting
b. Requires recognition of a deferred tax liability (1) for tax benefits that
are flowed through to customers when temporary differences originate
and (2) for the equity component of the allowance for funds used during
construction
c. Requires adjustment of a deferred tax liability or asset for an
enacted change in tax laws or rates.
•
If, as a result of an action by a regulator, it is probable that the future
increase or decrease in taxes payable for items (b) and (c) above will be
recovered from or returned to customers through future rates, an asset or
liability is recognized for that probable future revenue or reduction in
future revenue pursuant to paragraphs 9-11 of Statement 71. That
asset or liability also is a temporary difference for which a deferred
tax liability or asset shall be recognized.
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Regulatory Liabilities
SFAS No. 109, Paragraph 125
• The general standards of SFAS No. 71 require
recognition of a regulatory liability when a
deferred tax asset is recognized if it is probable
that a future reduction in revenue will result
when that deferred asset is realized.
• Dr.
Deferred Tax Asset
x
Cr. Regulatory Liability
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x
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Example – Tax Reform Act of 1986
Assumptions:
$100
Temporary difference in plant
$ 46
DTL recorded
$ 34
DTL required (with new tax rate of
34%)
Calculation:
$12
x 1.52
Excess DTL
Gross-up factor (or ÷ 0.66)
Dr. Deferred Tax Liability
Cr. Regulatory Liability
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18
30
Example – Tax Reform Act of 1986
DTL
Temporary Differences
Assets
46
18
Reg. Liability
Net
$100
(18)
$ 82
x 34%
28
$28*
*Deferred tax liability of $34 for $100 depreciation temporary difference less deferred tax
benefit of $6 for settling $18 regulatory liability with ratepayers.
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Regulatory Liabilities – Examples
• FERC Account 254
• Non-tax related examples
– Rate refunds
– Overcollected fuel or gas costs
• Tax-related regulatory liabilities – SFAS Nos. 71
and 109
– Excess deferred taxes
 Tax-on-tax effect
– Unamortized investment tax credit
 Tax-on-tax effect
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Changes in State Tax Rates
• Increases in tax rates for regulated utilities with net
deferred tax liabilities may result in regulatory assets.
• Decreases in tax rates for regulated utilities with net
deferred tax liabilities may result in regulatory liabilities.
• Changes in apportionment factors
– Statutory formula
– Facts
• Impact on tax-on-tax gross-up factors
– Federal items
– State items
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Changes in State Tax Rates
Example – Facts
• Company has 100 percent apportionment in State A.
• During Year 1, State A raises its tax rate from
5 percent to 7 percent.
• The rate increase is effective at the beginning of
Year 3.
• Company has $1,000 of taxable temporary differences
at the end of the Year 1 quarter during which the tax
law is amended.
• Company expects $100 of these temporary differences
to reverse in Year 1 and $200 to reverse in Year 2.
• The federal income tax note is 35 percent.
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Changes in State Tax Rates
Example – Facts
Temporary difference
Year 1
Year 2
Year 3+
$100
$200
$700
Historical tax rate
New state DTL
$1,000
5%
Historical state DTL
New tax rate
Total
$50
5%
5%
7%
$5
$10
$49
64
Additional state DTL
(prior to gross-up)
$14
Gross-up factor
x 1.0752*
Regulatory asset
$15
*1 ÷ (1 - 7%)
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Change in State Tax Rates
Example – Scenario #1
It is uncertain whether the PUC will allow Company to
recover the shortfall in its state DTL in its next rate case.
Dr.
Deferred State Tax Expense
Cr.
Dr.
DTL – State
DTA – Federal
Cr.
14.00
14.00
4.90
Deferred Tax Benefit
Immediate impact on the income statement =
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4.90
$ 9.10
36
Change in State Tax Rates
Example – Scenario #2
The PUC has indicated that it will allow Company to
recover the shortfall in its state DTL in its next rate case.
(Assume that the entries on the previous page have not
been recorded.)
Dr.
Regulatory Asset
Cr.
Dr.
DTL – State
DTA – Federal (on State DTL)
Cr.
15
15
5.25
DTL – Federal (on Reg. Asset)
5.25
Immediate impact on the income statement = $0
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Allowance for Funds Used During
Construction (“AFUDC”)
• When utilities are not allowed to recover in current
rates a return necessary to finance construction
projects during the construction period, they will
generally be allowed to capitalize the financing
costs for future recovery from ratepayers.
– AFUDC represents capitalized interest and equity
costs, which will ultimately be included in rate base
as a component of plant in service, thereby earning a
return and being recovered through depreciation
allowances.
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Allowance for Funds Used During
Construction
• Employed when construction work in progress is not included in rate
base
• Non-cash income item representing composite interest cost of debt and
a return on equity funds used to finance construction. The allowance is
capitalized in the property accounts and included in GAAP income.
• Results in additional GAAP depreciable basis in plant that is not
recognized for tax purposes
• AFUDC–Equity represents an estimate of the after-tax equity costs
associated with construction.
• Journal Entry
Dr. Plant (CWIP)
Cr. Interest expense (debt portion)
Cr. Other income (equity portion)
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100
60
40
39
Allowance for Funds Used During
Construction
• SFAS No. 109 prohibits net-of-tax and after-tax
accounting
• SFAS No. 109 requires recognition of a deferred tax
liability for the equity component recorded in plant
• AFUDC-Equity results in a decrease to the effective
rate in the year recognized (if recorded on an aftertax basis)
• AFUDC-Equity recorded on an after-tax basis results
in an increase to the effective rate in the years that
the asset is depreciated (i.e., reversal of the basis
difference)
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AFUDC-Equity
Regulatory Asset Calculation
AFUDC-Equity capitalized*
x Enacted tax rate
x Gross-up (tax-on-tax) factor
Regulatory asset
Dr. Regulatory Asset
Cr. Deferred Tax Liability
*In CWIP or plant in service
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AFUDC-Equity
Example - Facts
Facts:
• Pre-tax income from operations is $1,000,000
• Tax rate is 40%
• Assume the only potential effective tax rate reconciling item is AFUDC-Equity
• $1,000,000 construction project
–
Started in January 2006
–
Placed into service on January 1, 2007
–
Useful life is 20 years
–
Assume no difference between book and tax depreciation method and
lives.
• AFUDC-Equity:
–
On a after-tax basis, AFUDC-Equity is $75,000 (7.5% after-tax rate)
–
On a pre-tax basis, AFUDC-Equity would be $115,385 (11.5385%)
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AFUDC-Equity – Example
Income Statement
Income Statement
Pre-tax Income from Operations
$1,000,000
Income Taxes (35%)
Income from Operations
(350,000)
$ 650,000
75,000*
Other Income – AFUDC-Equity
Tax on AFUDC-Equity
Book Income
0
$ 725,000
*Net of tax of $40,385 ($115,385 - $40,385 = $75,000)
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AFUDC-Equity – Example
Effective Tax Rate
Effective Rate Reconciliation
Book Income before Taxes
Federal Statutory Rate
Taxes at Federal Statutory Rate
AFUDC-Equity (75,000 x 35%)
Total Income Tax Expense
Effective Tax Rate
$1,075,000
35%
$376,250
(26,250)*
$350,000
32.6%
* AFUDC-Equity recorded on an after-tax basis results in a decrease to the effective
rate in the year recognized.
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AFUDC-Equity – Example
Subsequent Year
• AFUDC-Equity recorded on an after-tax basis
results in an increase to the effective rate in the
years that the asset is depreciated (i.e., reversal of
the basis difference).
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Investment Tax Credit (ITC) – Federal
• Credit for investment in qualified property for the tax year in which
the property was placed in service
–
Enacted, repealed, re-enacted, etc., in the 1960s-1980s
–
Generally tangible personal property and certain real property (excluding
buildings or their structural components)
–
In the later years, taxpayer could elect to receive a reduced credit to
avoid a reduction in depreciable basis
–
Credit was subject to full or partial recapture if the property was
prematurely disposed
• Repealed by the Tax Reform Act of 1986
–
General transition rules applied for property placed in service through
December 31, 1990
 Mandatory reduction in depreciable basis
• Alternative energy investment tax credits
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SFAS No. 109
Investment Tax Credit
5. This Statement does not address:
a. The basic methods of accounting for the U.S. federal investment tax credit (ITC)
and for foreign, state, and local investment tax credits or grants. (The deferral and
flow-through methods as set forth in APB Opinions No. 2 and No. 4, Accounting for the
"Investment Credit," continue to be acceptable methods to account for the U.S. federal
ITC.)
116. The requirements for accounting for investment tax credits are contained in Opinions 2
and 4. In Opinion 2, the Accounting Principles Board (APB) concluded that:
a. The investment tax credit reduces the cost of the related asset, and for that reason,
it should be deferred and amortized over the productive life of the related asset.
b. Display of the deferral in the statement of financial position as a reduction of the
cost of the asset ordinarily is preferable.
c. Display of the deferral as deferred income is also permitted provided that the
investment tax credit is accounted for as a reduction of the cost of the asset, that is,
amortized over the productive life of the asset.
In Opinion 4, the APB concluded that:
(1) The essential nature of the investment tax credit is that it reduces the cost of the
related asset, and the method of accounting for it in Opinion 2 is preferable.
(2) The flow-through method to account for the investment tax credit is also acceptable.
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SFAS No. 109
Investment Tax Credit
117. Accounting for an investment tax credit as required by Opinion 2
reduces the cost of the asset to less than its tax basis. The excess of
tax basis over cost for financial reporting will be deductible in future
years when the asset is recovered. Deferred tax accounting for that
temporary difference does not change the accounting for the
investment tax credit required by Opinion 2. The entire amount of the
investment tax credit is still deferred at the outset and subsequently
amortized over the life of the asset. The Board concluded that
accounting for this temporary difference (a) is consistent with the basic
principles of the Board's asset and liability approach to accounting for
deferred income taxes and (b) is not a change in the deferred method
of accounting for investment tax credits under Opinion 2.
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ITC Normalization Requirements
• Normalization provisions require ITC benefits to
be shared:
– Between utilities and ratepayers
– Between generations of ratepayers
• ITC benefit is spread over the regulatory life of
property
• Two main options are available for ratemaking
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Unamortized ITC
Regulatory Liability Calculation
Unamortized ITC
x Enacted tax rate
x Gross-up (tax-on-tax) factor
Regulatory liability
Dr. Deferred Tax Asset
Cr. Regulatory Liability
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50
State ITC
• Investment tax credit is still available in some
states
• Considerations
– Consistent application of the GAAP rules under
APB Nos. 2 and 4
– Application of the normalization requirements
• Book/tax difference
factor
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tax-on-tax gross-up
51
Terminology
Summary
• Normalization
• Flowthrough
• Protected v. unprotected
• Prior flowthrough
• Flowback of prior flowthrough
• ARAM v. Reverse South Georgia Method
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Regulated Utility Effective Tax Rate Items
Summary
• Flow-through
– Flow-back of prior flow-through – straight-line or variable
based on amount of temporary difference reversal
– Originating differences (if applicable) – amount varies with
current capital expenditures and amount of originating
temporary differences
• Allowance for Funds Used During Construction (Equity)
– Current amount capitalized – amount varies with current
equity rate and capital expenditures
– Depreciation of existing balance in plant – straight-line,
but decreasing as vintages become fully amortized
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Regulated Utility Effective Tax Rate Items
Summary
• Excess deferred income taxes
– ARAM method – increasing benefit late in
asset lives as tax depreciation ends and
temporary difference reversal increases
– South Georgia method - straight-line
• Change in state tax rates
• Investment tax credit – straight-line, but
decreasing as vintages become fully amortized
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FAS 71 Exceptions to FAS 109
Circular 230 Statement
Any tax advice included in this written or electronic communication was not intended
or written to be used, and it cannot be used by the taxpayer, for the purpose of
avoiding any penalties that may be imposed on the taxpayer by any governmental
taxing authority or agency.
Limitation on Use
The information contained in this publication is for general purposes only and is not
intended, and should not be construed, as legal, accounting, or tax advice or opinion
provided by Deloitte & Touche LLP or Deloitte Tax LLP to the reader. This material
may not be applicable or suitable for the reader’s specific circumstances of needs.
Therefore, the information should not be used as a substitute for consultation with
professional accounting, tax, or other competent advisors. Please contact a local
Deloitte & Touche LLP or Deloitte Tax LLP professional before taking any action based
upon this information.
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As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each other’s acts or omissions. Each
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In the US, Deloitte & Touche USA LLP is the US member firm of Deloitte Touche Tohmatsu and services are provided by the subsidiaries of Deloitte &
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Copyright © 2007 Deloitte Development LLC. All rights reserved.
Copyright © 2007 Deloitte Development LLC. All rights reserved.
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