20040319MacMahon Rebuttal.pdf

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BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
CASE NO. IPC-O3-
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPANY FOR
AUTHORITY TO INCREASE ITS INTERIM
AND BASE RATES AND CHARGES FOR
ELECTRIC SERVICE.
IDAHO POWER COMPANY
DIRECT REBUTTAL TESTIMONY
BRUCE E. MACMAHON
Please state your name and business address.
My name is Bruce E. MacMahon and my business
address is 350 N. Mitchell Street, Boise, Idaho 83704.
What is your educational background?
I graduated from Saint Mary s College in
Moraga, California in 1983, receiving a Bachelor of Business
Since that time, IAdministration Degree in Accounting.
have participated in numerous training courses related to
industry, taxation, management and leadership, as well as
developed course material and provided instruction on
technical business taxation topics.I became a licensed
Certified Public Accountant in the State of Idaho in 1987.
I have been an active member of the Tax Committee of the
Edison Electric Institute, Tax Executives Institute, and
served as a board member of the Idaho Society of CPA'
Southern Idaho Chapter, and as a board member of the
Associated Taxpayers of Idaho.
Please outline your business experience.
I have worked in government and industry
since graduating from college in 1983.I initially worked
at the Federal Energy Regulatory Commission as a Financial
Audi tor, taking part in a number of audits of regulated
In 1984 I joinedutili ty companies, including Idaho Power.
the Boise Cascade Corporation as a Tax Analyst and Research
Supervisor until 1996, at which time I joined the Idaho
MACMAHON, Di - Reb
Idaho Power Company
Power Company as the Tax Research Coordinator.In 1999, I
became the Corporate Tax Director for Idaho Power Company
and remained so until November of 2003 when I became Chief
Financial Officer for IDACOMM, Inc.
In your position as Corporate Tax Director
for Idaho Power Company were you responsible for the filing
of the income tax returns for Idaho Power Company wi th the
Internal Revenue Service and the state tax agencies for the
tax years 2001 and 2002?
Yes.
Did you participate in and are you familiar
with the income tax calculations that are presented in Idaho
Power s direct case in this proceeding?
Yes.
Have you reviewed Mr. Holm s testimony as it
relates to the adjustments proposed by Staff for income
taxes?
Yes.
Do you believe that Staff's income tax
proposals are reasonable and should be implemented by the
Idaho Public Utilities Commission for purposes of
determining Idaho Power s revenue requirement in this
proceeding?
No.Staff's approach ignores the computation
of the applicable tax base and instead applies a five-year
MACMAHON, Di - Reb
Idaho Power Company
average ratio to the pre-tax rate case income.This
approach (1) ignores what is uniquely taxable or deductible
under current income tax law,(2) it ignores enacted income
tax rates, and (3) it ignores the distinction between
normalized income tax adjustments and flow-through income
tax adjustments, sweeping away years of carefully maintained
regula tory process, principles, and orders.
Please explain how Idaho Power prepared the
income tax calculations that are presented in its direct
case.
First, current federal income tax is
calculated.The starting point is "income before tax
adjustments (or pre-tax operating income) .Deductible
interest expense computed using rate case concepts (interest
synchronization) is subtracted from pre-tax operating income
to arrive at "net operating income before taxes Federal
income tax temporary and permanent adjustments, known as
book-to-tax " or "1" adjustments, are added or subtracted
from net operating income before taxes to produce what is
commonly known as the federal tax base.The federal tax
base is reduced by the current state income tax deduction to
arrive at federal taxable income.Federal taxable income is
multiplied by the statutory corporate federal tax rate of
35% to arrive at the current federal income tax liability.
Added to the test year's current federal income tax were
MACMAHON, Di-Reb
Idaho Power Company
federal deficiencies paid in 2003 for Idaho Power s 1998-
2000 Internal Revenue Service examination.
Second, current Idaho, Oregon, and other state
income taxes are computed.The starting point for each
calculation is the federal tax base.From that point
various state tax adjustments are made to arrive at the
s ta te tax base.For Idaho, the federal deduction for bonus
depreciation is added back.The result is the Idaho state
income tax base, which is multiplied by 5.9%.The 5.9% rate
is Idaho s statutory corporate tax rate of 7.6% multiplied
by Idaho Power s state of Idaho apportionment factor of 78%,
which is consistent with the methodology set forth in
Commission Order 17499 (p. 13).The resulting Idaho state
tax is reduced by Idaho Power s current Idaho Investment Tax
Credit to yield the current Idaho state income tax
liability.For Oregon, a depreciation adjustment is also
added back.The result is Oregon s tax base, which is
multiplied by .3%.The 3% is Oregon s statutory corporate
tax rate of 6.6% multiplied by Idaho Power s state of Oregon
apportionment factor of 5%.The result is the current
Oregon state income tax liability.The other states
calculation starts with the same base as Idaho multiplied by
a blended rate of .1%.
Third, the provision for deferred income taxes is
computed by multiplying the normalized temporary book-to-tax
MACMAHON, Di-Reb
Idaho Power Company
differences from the current income tax calculation by the
applicable statutory income tax rate.The resulting
deferred income tax expense is also the net annual change to
the accumulated deferred income taxes component of rate
base.
Finally, the investment tax credit component of
income tax expense is computed by combining the current year
amortization of federal and Idaho deferred investment tax
credi ts with the current year deferral of Idaho investment
tax credi t earned.
Are you familiar with the terms
normalization " and "flow-through" as those terms are used
to reflect income tax adjustments in public utility revenue
requirement cases?
Yes.
Please provide to the Commission a definition
of normalization and flow-through as those practices would
be reflected in Idaho Power s revenue requirement.
These two terms refer to two distinct methods
of computing income tax expense in a regulatory proceeding.
Using a normalization method to compute income tax expense
simply means that all of the income tax costs related to
items in the current period will be computed, whether paid
in the current year or paid later.This method creates
deferred income tax expense and the associated accumulated
MACMAHON, Di-Reb
Idaho Power Company
deferred income tax liability that is subtracted from rate
base.The flow-through method of computing income tax
expense will take into account only those taxes that will be
paid in the current year, and does not create deferred
income tax or add to accumulated deferred income taxes on
the balance sheet.
Unless a book-to-tax adjustment is permanent, it is
considered temporary, meaning that the item will reverse in
a future period.A normalized book-to-tax difference is a
temporary difference that for accounting purposes adjusts
current income tax expense and has an equal offset in
deferred income tax expense, thus the net effect to total
book income tax expense is zero.A flow-through book-to-tax
difference is also a temporary difference that adjusts
current income tax expense, but does not have an offsetting
deferred income tax expense amount.
For example, if a flow-through adjustment is a
deduction, current income tax is reduced and with no
deferred income tax offset, book income tax expense is lower
than if the adjustment were normalized.Flow-through is a
regulatory accounting concept only.Generally Accepted
Accounting Principles ("GAAP"), under Financial Accounting
Standard Board Statement No. 109 ("FASB 109"), require that
deferred income taxes be recognized for all temporary
differences.
MACMAHON, Di-Reb
Idaho Power Company
In its test year regulatory income tax expense
calculations, Idaho Power identified both its normalized and
flow-through book-to-tax adjustments.The total system
flow-through adjustments in the test year are a net $21.
million deduction.This net deduction reduces current
income tax expense by $8.3 million.
Is Idaho Power considered a flow-through
company for Idaho ra temaking purposes?
Yes, Idaho Power is a flow-through company
for ratemaking purposes.The only temporary book-to-tax
differences that receive normalized accounting treatment are
those provided by federal law.
Please describe the normalized treatment
specified by federal law.
Temporary differences created by federal
accelerated and bonus depreciation and contributions-in-aid-
of-construction (CIAC) are excluded from flow-through
treatment by federal law (Internal Revenue Code ~168 (f) (2)
and Notice 87-82 respectively).A violation of the
normalization requirements in the federal tax law would
trigger a repayment obligation to the federal government of
previously accumulated deferred income taxes and the
forfei ture of accelerated tax depreciation methods to Idaho
Power in the future. Accordingly, the Company has provided
for deferred income taxes on these items in its regulatory
MACMAHON, Di-Reb
Idaho Power Company
income tax expense at the federal statutory income tax rate.
The Commission has not normalized these items for state of
Idaho income tax purposes, thus the state effect of the
adjustment is flowed through to current income tax expense.
Please explain the event that Mr. Holm refers
to as being the cause of the 2002 tax benefit.
The tax benefit that Mr. Holm refers to was
the result of an accounting method change adopted in Idaho
Power s 2001 federal income tax return.
Please explain to the Commission why Idaho
Power made this accounting method change for tax purposes.
In early 2002, the IRS issued certain
technical changes in Revenue Procedures 2002-9, 2002-19, and
2002-54, and Announcement 2002-17 that made the method of
accounting change under Internal Revenue Code ~263A and
associated Treasury Regulations possible for Idaho Power
2001 tax return.
Idaho Power is required to capitalize certain
Sectionindirect costs under Internal Revenue Code ~263A.
263A requires the capitalization of all direct costs and
those indirect costs, known as "mixed service costs , that
directly benefit or are incurred by reason of the production
In its business, Idaho Power produces self-of property.
constructed assets (plant), and electricity (inventory) for
sale to its customers.
MACMAHON, Di-Reb
Idaho Power Company
The IRS ruled in Technical Advice Memoranda 9527003
that electricity is inventory for tax purposes.This
ruling, plus the changes to ~263A, allowed Idaho Power to
allocate some of its mixed service costs to inventory, which
then became immediately deductible, due to electricity
unique nature of real-time production and consumption. The
Company applied with the Internal Revenue Service to change
its method of accounting for capitalizing mixed service
costs with its 2001 federal income tax return, which it
filed in September 2002.Idaho Power followed the automatic
accounting method change procedures authorized in Revenue
Procedure 2002-9 to properly apply for the change in method.
Idaho Power changed its previously allowable method
of accounting to a new allowable method using the simplified
service cost method of ~1. 263A-1 (h) with the production
based allocation ratio in ~1. 263A-1 (h) (5) to determine its
future capitalizable mixed service costs for inventory and
self-constructed assets.
How did this accounting method change cause
such a large benefit in 2002?
When a taxpayer changes its method of
accounting for an item, it must compute the effect the
change would have had on prior tax years had the method been
utilized.This is done pursuant to ~481 (a) of the Internal
Revenue Code.A "~481 (a) adjustment" will either result in
MACMAHON, Di - Reb
Idaho Power Company
a decrease (negative) or an increase (positive) to the
taxpayer s taxable income.Idaho Power s adjustment was
negative.The adjustment was computed by applying the new
method to the mixed service costs incurred by Idaho Power
during the years 1987-2000.Following Revenue Procedure
2002-19, Idaho Power was allowed to recognize its negative
~481 (a) adjustment in the tax year of change, 2001, thus
creating a one-time single-year tax deduction, which was
recorded on the Company s books in 2002.
As the individual responsible for the filing
of Idaho Power's income tax returns in the year 2002 for the
tax year 2001 did Idaho Power amend any prior tax returns
when it filed its 2001 income tax returns in 2002?
No, for income tax and accounting purposes
the one-time ~481 (a) adjustment created by the method change
is considered a 2001 adjustment, therefore no prior year
returns were amended, nor would the tax authorities allow
them to be amended for this purpose.
Does the 2003 test year include any benefits
related to the method change?
Yes, the 2003 test year regulatory income tax
expense includes a total system $14.3 million flow-through
tax deduction.The deduction reduced current income tax
expense by $5.6 million.Had Idaho Power not initiated the
method change, customers would not be realizing this benefit
MACMAHON, Di-Reb
Idaho Power Company
in the 2003 test year.
Could you please describe your understanding
of the proposals for income tax adjustments that the Staff
has made in this proceeding?
Certainly.Staff has proposed to compute
Idaho Power's income tax expense by using an average ratio
of Idaho Power s actual above-the-line income tax expense as
a percentage of actual pre-tax book income for each of the
past five years added together and then divided by five.
Specifically, Staff has developed a hybrid income
tax rate concept by taking each of the last five years
including the test year and averaging the ratio of total
income tax expense (current tax, deferred tax, and ITC) for
each year over the total pre-tax book income for each year.
The resulting ratio for each year was added up and divided
by five to arrive at an average ratio that applied to the
previous five years.This average ratio was applied to
regulatory pre-tax income and labeled "current tax
Staff's hybrid ratio was used to value the current
change in normalized temporary differences for deferred
income tax expense, without regard to the beginning balance
in accumulated deferred income taxes having been previously
established using enacted tax rates.
This hybrid ratio was used by Staff to compute the
net-to-gross tax multiplier to set new revenue requirement
MACMAHON, Di-Reb
Idaho Power Company
to a pre-tax revenue value, without regard to the actual
income taxes the Company will pay on these new revenues.
Additionally, Staff has taken Idaho Power s 1998-
2000 Internal Revenue Service examination deficiency payment
included in the test year income tax expense and reduced it
by two-thirds on the theory that the payment is for a three-
year settlement and should be amortized accordingly.
Please explain your understanding of the
computations that Staff made utilizing their five-year
hybrid tax ratio.
As I previously discussed, Staff has averaged
Idaho Power s above-the-line effective income tax rate for
the previous five years rather than looking to the statutory
income tax rates that Idaho Power is subject to.Staff then
used their average rate to recompute current and deferred
income tax, and reset the net-to-gross multiplier.
Staff has taken a very simplistic view of the income
tax calculations in the test year.It would appear that
their primary motivation for developing the five-year
average rate is to take advantage of Idaho Power
abnormally low effective income tax rate in 2002.The cause
of the low income tax rate was a non-reoccurring deduction
for an accounting method change adopted in the 2001 federal
income tax return.When I removed the benefit for the non-
reoccurring deduction from the 2002 effective income tax
MACMAHON, Di-Reb
Idaho Power Company
rate and recomputed the five-year average ratio it came out
to 39.19%.This happens to be extremely close to Idaho
Power s federal and state combined statutory income tax rate
of 39.10%.
Mr. Holm stated in his testimony that by
using an average effective income tax rate Staff is
...
looking forward ins tead 0 f backward.Do you agree?
No.By using this five-year hybrid ratio of
income tax expense to pre-tax book income, Staff is looking
backward to seize a portion of a non-reoccurring flow-
through deduction claimed in the 2001 income tax return and
then assumes that it could somehow be repeated to set future
rates.
Is Staff's proposed computation an
appropriate way to compute income tax expense for revenue
requirement purposes in this proceeding?
No.As a theoretical method of reimbursing
income tax expense, the Staff's computation bears no direct
relationship to the income taxes a company will pay in the
future, unless every single variable that produced the ratio
in the past five years could somehow repeat itself in
single year, which is quite impossible.Staff's approach
confuses the basic formula for computing income tax expense:
the income tax base times the currently enacted income tax
ra tes .The Commission s approved method has always been to
MACMAHON, Di-Reb
Idaho Power Company
compute the applicable tax base (taxable income) and then
apply the currently enacted income tax rates to that base.
As I have previously stated, Staff's approach ignores the
computation of the applicable tax base and instead applies a
five-year average ratio to the pre-tax rate case income.
This approach (1) ignores what is uniquely taxable or
deductible under current income tax law,(2) it ignores
enacted income tax rates, and (3) it ignores the distinction
between normalized income tax adjustments and flow-through
income tax adjustments, sweeping away years of carefully
maintained regulatory process, principles, and orders.
An example is helpful to illustrate this point.
Assume Idaho Power earns $100 in Year 1 and claims a $5
repair allowance deduction on its income tax return, paying
federal income tax of $33.25 ($95 x 35%).The effective tax
ratio is 33.25%, while the statutory tax rate remains at
35% .
Assume further that Idaho Power makes $150 in year 2
and claims another $5 repair deduction on its annual income
tax return, paying federal income tax of $50.75 ($145 x
35%) .If the Commission were to use the prior year
effective tax ratio to reimburse the Company for its Year 2
income tax expense, the Company would receive only $49.
($150 x 33.25%).The Company would be left short by $0.
($50.75 - $49.88).The overall effect of Staff's approach
MACMAHON, Di-Reb
Idaho Power Company
when applied within the context of the current rate
proceeding has an effective decrease to revenue requirement
in the millions of dollars.Clearly, this is a significant
issue to Staff's case.
Staff has suggested that blending the rates
between years "
...
provides a more realistic basis for tax
expense over time Do you agree?
As noted above, the effective tax ratio has
relevance only inside a single year, due to its
interdependence upon book income as its denominator.Since
it would be a mathematical impossibility to have a test year
mirror all the conditions that gave rise to the previous
year s tax ratio, let alone five previous years ratios
averaged together, there is no possibility of accurate or
even reasonable income tax recovery.
Mr. Holm also notes that the adjustments that
historically have gone into Idaho Power s calculation of
taxable income can be either stable or change dramatically,
year over year.Mr. Holm concludes that because of this
reality, the Company s effective income tax rates vary from
This is only half true.The other half isyear to year.
that book income is also varying widely from year to year,
and as previously noted, has been generally lower than the
test year operating income due to drought conditions.A low
book income with large flow-through deductions for the
MACMAHON, D i - Reb
Idaho Power Company
method change and repair allowance in the tax calculation
has resulted in unprecedented low tax ratios.
Is Staff's amortization of the Internal
Revenue Service tax deficiency payment appropriate?
Staff's proposal is not consistent withNo.
Commission Order 17499 (p. 24) where the Commission ordered
that income tax contingencies would not be allowed in
determining the test year regulatory income tax expense but
that any income tax deficiencies actually paid in the test
year should be included in regulatory income tax expense.
Idaho Power has settled and paid tax deficiencies in its two
previous audit cycles that were not in test years (1993-95,
paid in 1998 and 1996-97 paid in 2000) and has not included
these deficiencies in the 2003 test year in accordance with
the Commission s previous order.The test year tax expense
includes only the amounts paid in the current test year, at
100%, not 33%.
Would Staff's hybrid income tax ratio
proposal violate the requirements of the Internal Revenue
Code as it relates to normalization vs. flow-through?
By applying Staff's five-yearYes, it would.
hybrid tax ratio to deferred income taxes, Mr. Holm has
caused the current year change for accelerated depreciation
to be valued at something other than the statutory rate.
This violates the normalization requirement of Internal
MACMAHON, Di-Reb
Idaho Power Company
Revenue Code ~168 (f) (2) .
Please explain the effect of the use of
Staff's hybrid tax ratios on the Company s deferred income
tax balances.
Mr. Holm reduced deferred income tax expense
by using Staff's five-year hybrid tax ratio on the current
year change to temporary differences, while disregarding the
fact that the beginning balance in accumulated deferred
income taxes has been recorded using statutory income tax
ra tes .Setting aside the resulting issue of triggering a
normalization violation, another deficiency in the Staff'
proposal is that the accumulated deferred income taxes would
need to be recomputed using the five-year hybrid tax ratio.
Following Staff's proposal, the recomputed reserve for
deferred income taxes would increase the Company s rate base
by approximately $53 million as the net deferred tax
liability balance would drop due to the application of the
lower rate.
Does Staff's use of a net-to-gross tax
multiplier that is based upon their proposed five-year
hybrid tax ratio adequately reimburse Idaho Power for the
income taxes it will pay on the new revenue received from
cus tomers?
No.By using the five-year hybrid tax ratio,
Staff is assuming that the same ratio of average income tax
MACMAHON, Di-Reb
Idaho Power Company
to average pre-tax book income will apply to the new revenue
deficiency dollars paid by customers.The federal and state
governments will not recognize this ratio when Idaho Power
income tax returns are filed that contain these new revenue
Instead, the governments will apply the statutorydollars.
income tax rates to these new revenue dollars.Staff'
proposal leaves the Company far short of the cash needed for
its real income tax liabilities.
Does this conclude your direct rebuttal
testimony in this case?
Yes, it does.
MACMAHON, Di - Reb
Idaho Power Company