The following is an article by Kimberly Johnston and Michael J. Reno, a national tax partner and a national tax administrator, respectively, with Ernst & Young LLP in the Americas Power & Utilities division.
Organizations of all sizes are considering the impact of potential policy changes as part of a Biden administration. One such change proposed by President-Elect Joe Biden is to increase the U.S. corporate tax rate by 7 percentage points from 21% to 28% with a minimum tax of 15% on corporate profits for companies with an income of $ 100 million or more.
While a comprehensive tax plan is unlikely to pass if Republicans retain a majority in the U.S. Senate, executives and regulators must use this time of uncertainty to assess the impact of potential tax rate changes, especially given the financial pressures of COVID-19 moratoriums and collectibility risks affect utility companies owned by investors.
The Impact of the TCJA on Regulated Utilities
Estimates derived from the 2017 SEC 10-K annual filings show that the 14 percentage point reduction in corporate tax rate set under the Tax Cut and Employment Act (TCJA) of 2017 resulted in utilities owned by investors significant regulatory liability balances totaling approximately $ 90 billion that will be refunded to customers.
The TCJA was issued very quickly. As a result, public service commissions made an effort to win contracts to account for the cumulative deferred income tax balances (EADIT) associated with the reduction in the tax rate and to respond to consumer inquiries about how and when the tax law change would account in installments. Commissions and regulated utilities have settled agreements to return the TCJA tax benefit to customers. In doing so, the prescribed federal tax normalization laws (the “protected” part) specified in the TCJA were complied with and amortization approaches for EADIT balances were negotiated, which are up for discussion and case law (the “unprotected” balance).
These TCJA ratemaking settlements were not without controversy. The results varied across the utilities sector, with the unprotected portion of EADIT credits being returned to customers over a period of one year, three years, ten years, or the remaining life of the utility.
In addition, the TCJA has established a regulated trade or business division that states that regulated utilities and regulated gas pipelines are not subject to the interest expense cap or eligible for immediate expense for qualifying property.
The Biden tax plan
Unlike the TCJA, where utilities had to reimburse their customers for lower tax benefits, a Biden tax plan that would increase the corporate tax rate by 7 percentage points could result in utilities charging customers more energy services, although that would ultimately depend on the Effects of all elements of the tax plan, as well as the use of tax revenue. And while a significant rate hike would be less likely in the near future if control of the Senate wasn’t changed, it is still a good time to plan for a future rate change.
If corporate tax rates were to rise, regulated utilities would likely need to set up a regulatory asset. Essentially, customers would return EADIT credits to the utility company. Assuming that the financial health of the regulated utilities sector has not changed significantly since the adoption of the TCJA, it is estimated that a 7 percentage point increase in isolation would be roughly half the resulting approximation of US $ 90 billion. Dollar corresponds to the 14 percentage point reduction under the TCJA.
It is uncertain how a minimum book revenue-based tax for ratemaking purposes would apply – e.g. B. whether the proposed minimum tax of 15% would lead to a credit to be monetized in the future, similar to the traditional alternative minimum tax treatment as a deferred tax item.
In addition, the TCJA-regulated utility spin-off and federal normalization laws are expected to be maintained in any comprehensive tax bill.
Considerations for an expected rate increase
A carefully thought-out strategy of creating guides to respond to increases in corporate tax rates for commissioners, client advocacy groups and investor-owned utilities will position both investors and clients for better results. Here are six important considerations:
TCJA ratemaking consistency: Utility executives can evaluate whether to use the TCJA ratemaking approaches if a tax rate increase is decided or deviate from the TCJA approach due to significant socio-economic changes arising from the COVID-19 pandemic and extreme weather conditions. While the regulatory asset may be depreciated in accordance with previous methods agreed in TCJA-related engagements. However, it can be beneficial to re-examine whether a deviation leads to a better result for suppliers and customers.
Novel approaches to rate making: Certain utility companies have introduced novel commission rate-making approaches to use a portion of the TCJA tax break for investments in hurricane recovery as an alternative mechanism for the benefit of interest payers. In the event of a change in the tax rate, possible approaches could be to offset the newly established regulatory asset from a tax increase against the remaining regulatory liability balance of the TCJA and to create a comprehensive amortization plan that takes both changes into account simultaneously and at the same time includes a ratemaking method with the best result . Another option is to continue to write off TCJA’s regulatory liability in line with the previously agreed order.
COVID-19 relief: The commissions have issued COVID-19 ratemaking orders that allow regulated utility companies to cover additional operating costs to ensure safe and reliable energy supplies during the pandemic. Assessing both the ongoing COVID-19 settlement arrangements and an expected tax rate increase as regulatory assets to be borne by customers can offer opportunities to provide both energy bill relief for customers and financial stability for utilities. Utilities are already working with customers on alternative financing plans to provide relief during the economic downturn caused by the pandemic. Such remedial actions can be beneficial when customers are faced with increased energy tariffs due to changes in tax policy.
Federal tax normalization: In recent months, in response to the TCJA, the U.S. Treasury Department has issued guidance on normalizing federal taxes. The guidelines contain limited mandatory tax rules for the treatment of EADIT in determining energy costs for customers. Federal normalization laws and recent guidelines provide options for determining the ratemaking treatment of EADIT balances due to changes in tax rates. The US Treasury Department stated in the guidelines that it recognizes different industry practices in rate-making treatment of net operating losses in the interest base and that it honors agreed orders. In addition, the most recent guidance allows utilities to use the alternative method of federal normalization if the regulated utility uses FERC compound rates.
Excess accumulated deferred tax assets: The unprotected portion of the EADIT credit remains the subject of negotiations between utility companies and commissions. The negotiations resulted in amortization times for changes in the return rate of only one year and as long as over the remaining life of the supply object. The benchmarking and scenario planning of the various TCJA settlements in the US in relation to the treatment of the unprotected portion of EADIT will have a significant impact on the outcome of a tariff change in setting utility income requirements.
Prepare now: While it is very uncertain whether a corporate tax rate hike will have enough support to become law or what the timing would be, commissions and utilities now have an opportunity to prepare accordingly.
The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of the global EY organization.