Tax Reform and the Regulated Distribution Utility: A Regulatory Summary

Apr 15, 2019

Source/Author : : Julie Lieberman

Access to the complete study : https://bit.ly/2Df8aiF

Published at : October 11th, 2018

 

Overview of Tax Implications Because taxable utilities are capital intensive companies with substantial depreciable assets, they have historically incurred large deferred tax liabilities for timing differences arising from accelerated depreciation allowed by the tax code and book depreciation expense.

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The utility receives revenue recovery in its authorized revenue requirement at a rate equivalent to the statutory tax rate applied to income. However, a significant portion of the statutory tax liability may be deferred and actual taxes the utility pays are often significantly less. The deferred tax liability captures the cumulative differences between book and tax deductions and is unwound over the life of the assets that generated the timing difference. Because the revenue requirement provides an earnings stream to compensate for taxes on a book basis, the amount of tax that is deferred in a liability provides additional funds to the taxable company in the early years of an asset that will later be required to meet future tax expenses ratably over the remaining life of the asset. As a result, regulated utilities have historically benefitted by carrying large accumulated deferred income tax liabilities (“ADIT”), which contribute to operating cash flows and are typically carried as no-cost capital. Moody’s estimates that roughly 13% of the sector’s funds from operations have historically been comprised of these deferred tax benefits. With the new tax law, not only are regulated utilities bringing in less cash due the effect of the lower tax rate in its cost of service (i.e., recovering tax expense at a rate of 21% rather than 35%), they also have significant deferred tax balances, representing over-collected future taxes based on the higher rate, which must be dealt with. Lower tax rates will also slow the recognition of future tax benefits, such as NOLs and tax credits. The rate with which overstated deferred liabilities are refunded to customers will have significant credit implications for utilities. Regulatory Research Associates, an offering of S&P Global Market Intelligence, estimates that $91.4 billion of excess deferred income taxes (“EDIT”, approximately 43% of 2017’s deferred tax liability balance) will be returned to ratepayers nationwide. This averages roughly $1.7 billion of EDIT per regulated investor-owned utility.

Normalization Rules require that EDIT that arises from differences between federal tax and book depreciation or tax credits is “protected.” This is also known as the “average rate assumption” method and requires that EDIT is used to reduce revenue requirements no quicker than would occur from the reversal of book/tax differences in accordance with the original amortization schedule. Any reduction in revenue requirements quicker than this method would be a normalization violation. All other federal timing differences which result in a deferred tax liability, are not protected by the IRS normalization rules, and the rate at which these excess balances are returned to ratepayers are at the discretion of the regulator.


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