The following is a contributed article by Kimberly Johnston and Michael J. Reno, a national tax partner and a national tax managing director, respectively, with Ernst & Young LLP in the Americas Power & Utilities sector.
Businesses of all sizes are contemplating the impact of potential policy changes under a Biden Administration. One such change proposed by President-elect Joe Biden is a 7 percentage point increase to the U.S. federal corporate income tax rate, from 21% to 28%, with a 15% minimum tax on corporate profits for corporations with $100 million or more in book income.
While the passage of a comprehensive tax plan is unlikely if Republicans keep a majority in the U.S. Senate, utility executives and regulators need to use this time of uncertainty to evaluate the impact of potential tax rate changes, especially considering COVID-19 financial pressures, disconnect moratoriums, and collectibility risks impacting investor-owned utilities.
The TCJA impact on regulated utilities
Estimates derived from 2017 annual SEC 10-K filings indicate that the 14-percentage-point reduction in the corporate tax rate enacted under the 2017 Tax Cuts and Jobs Act (TCJA) resulted in investor-owned utilities establishing significant regulatory liability balances, totaling approximately $90 billion to be refunded back to customers.
The TCJA was enacted very quickly. As a result, public service commissions scrambled to get orders in place to account for the excess accumulated deferred income tax (EADIT) balances associated with the reduction in tax rate and to respond to consumer inquiry regarding how and when the impacts of the tax-law change would factor into rates. Commissions and regulated utilities entered into ratemaking settlements to refund the TCJA tax benefits back to customers, complying with the prescribed federal tax normalization laws set forth in the TCJA where required (the "protected" portion) and negotiating amortization approaches on EADIT balances subject to discussion and adjudication (the "unprotected" balance).
These TCJA ratemaking settlements were not without controversy. Outcomes varied across the utility sector, with the unprotected portion of EADIT balances being returned to customers over periods ranging from one year, three years, ten years, or the remaining life of the utility property.
Additionally, the TCJA established a regulated trade or business carve-out, which specified that regulated utilities and regulated gas pipelines are not subject to the interest expense limitation nor eligible for the immediate expensing of qualified property.
The Biden tax plan
Unlike under the TCJA, where utilities had to refund lower tax-rate benefits to customers, a Biden tax plan that would increase the corporate tax rate 7 percentage points could result in utilities charging customers more in energy delivery services, although that ultimately would depend on the effects of all elements of the tax plan, as well as how the tax revenue raised is spent. And even though a significant rate hike in the near future would be less likely unless there is a change in control of the Senate, it nevertheless is a good time to plan for any future rate change.
If corporate tax rates were to increase, regulated utilities would likely need to establish a regulatory asset. Essentially, customers would return EADIT balances to the utility. Assuming the financial posture has not significantly changed for the regulated utility sector since the passage of the TCJA, it is reasonable to estimate that an increase of 7 percentage points considered in isolation would be roughly equal to half of the $90 billion approximation seen as a result of the 14-percentage-point reduction under the TCJA.
It is uncertain how a minimum tax based on book income would come into play for ratemaking purposes — e.g., whether the proposed 15% minimum tax would give rise to a credit to be monetized in the future, similar to the traditional alternative minimum tax treatment as a deferred tax item.
Additionally, it is anticipated that the TCJA regulated utility carve-out and the federal normalization laws will be retained in any comprehensive tax bill.
Considerations for an anticipated rate increase
A carefully thought-out ratemaking strategy to respond to a corporate tax rate increase among commissioners, customer advocacy groups, and investor-owned utilities will position both investors and customers for better outcomes. Here are six key considerations to contemplate:
TCJA ratemaking consistency: Utility executives may evaluate whether to adopt the TCJA ratemaking approaches if a tax rate increase is enacted or deviate from the TCJA approach given the major socioeconomic changes stemming from the COVID-19 pandemic and extreme weather conditions. While amortization of the regulatory asset could be applied in a manner consistent with prior methodologies agreed upon in TCJA-related orders, it might be beneficial to reassess whether deviation will lead to a better outcome for the utilities and customers.
Novel ratemaking approaches: Certain utilities have entered into novel ratemaking approaches with commissions to redeploy a portion of TCJA tax benefits to hurricane recovery investments, as an alternate mechanism to benefit ratepayers. If there is a tax-rate change, possible approaches could include netting the newly established regulatory asset from a tax increase against the remaining TCJA regulatory liability balance and re-establishing a comprehensive amortization schedule that accounts for both changes simultaneously, while also incorporating a ratemaking method with the best outcome. Another option is to continue amortizing the TCJA regulatory liability consistent with the prior agreed-upon order.
COVID-19 relief: Commissions have issued COVID-19 ratemaking orders allowing regulated utilities to recover incremental operational costs to ensure safe, reliable energy during the pandemic. Evaluating both ongoing COVID-19 ratemaking settlements and an anticipated tax-rate increase as regulatory assets to be borne by customers may present opportunities to provide both energy bill relief to customers and financial stability to utilities. Utilities are already working with customers on alternative financing plans to provide relief during the economic downturn as a result of the pandemic, and such relief measures may be advantageous if customers face increased energy rates as a result of tax policy changes.
Federal tax normalization: Over recent months, the U.S. Treasury has issued federal tax normalization guidance in response to the TCJA. The guidance includes limited prescribed tax rules pertaining to the treatment of EADIT in setting customer energy rates. The federal normalization laws and recent guidance present options for determining the ratemaking treatment of EADIT balances arising from tax-rate changes. The U.S. Treasury indicated in the guidance that it acknowledges varied industry practices on the ratemaking treatment of net operating losses in the rate base and would respect agreed-upon orders. In addition, the recent guidance permits utilities to adopt the federal normalization alternative method if the regulated utility uses FERC composite rates.
Excess accumulated deferred tax balances: The unprotected portion of the EADIT balances remains subject to negotiation among utilities and commissions. Negotiations resulted in amortization periods to flowback rate changes as quickly as one year and as prolonged as over the remaining life of the utility property. Benchmarking and scenario planning of the varied TCJA settlements across the U.S. on the treatment of the EADIT unprotected portion will significantly impact the outcome of a rate change to setting utility revenue requirements.
Prepare now: While it is very uncertain whether a corporate tax rate increase will have enough support to become law, or what the timing would be, commissions and utilities do have the opportunity now 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.