City and County of San Francisco v. Public Utilities Com., S.F. 22794

• Decision Date: 26 November 1971
• Docket Number: S.F. 22794,22793
• Citation: 98 Cal.Rptr. 286,490 P.2d 798,6 Cal.3d 119
• Court: California Supreme Court
• Parties: , 490 P.2d 798, 91 P.U.R.3d 209 CITY AND COUNTY OF SAN FRANCISCO, Petitioner, v. PUBLIC UTILITIES COMMISSION et al., Respondents, PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest. CONSUMERS ARISE NOW et al., Petitioners, v. PUBLIC UTILITIES COMMISSION, Respondent, PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest. In Bank

Page 286

98 Cal.Rptr. 286

6 Cal.3d 119, 490 P.2d 798, 91 P.U.R.3d 209

CITY AND COUNTY OF SAN FRANCISCO, Petitioner, v. PUBLIC UTILITIES COMMISSION et al., Respondents, PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest.

CONSUMERS ARISE NOW et al., Petitioners, v. PUBLIC UTILITIES COMMISSION, Respondent, PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest.

S.F. 22794, 22793.

Supreme Court of California,

In Bank.

Nov. 26, 1971.

Rehearing Denied Dec. 23, 1971.

Thomas M. O'Connor, City Atty., Milton H. Mares, Deputy City Atty., and William F. Bourne, San Francisco, for City and County of San Francisco.

Garret Shean, in pro. per.

William M. Bennett, San Francisco, for Consumers Arise Now and others.

Mary Moran Pajalich and Timothy E. Treacy, San Francisco, for respondents.

Warren A. Palmer, San Francisco, as amicus curiae for respondents.

Pillsbury, Madison & Sutro, John A. Sutro, Noble K. Gregory, George H. Eckhardt, Jr., and Richard W. Odgers, San Francisco, for real party in interest.

PETERS, Justice.

These are consolidated proceedings to review Decision No. 77984 of the Public Utilities Commission of the State of California. The decision provides that the Pacific Telephone and Telegraph Company (Pacific) may use accelerated depreciation with the normalization method of accounting as defined in subsection (l)(2)(B) of section 167 of the Internal Revenue Code and that, if it elects to do so, the commission, for rate making purposes, will compute Pacific's tax expense on the basis of straight line depreciation for the purpose of establishing its cost of service and will give recognition to the normalization tax reserve in determining rate base. The decision was made effective immediately. ¹ .

It appears that the general approach employed by the commission for determining what constitutes permissible rates is to determine for a 'test period' the costs and expenses which can be attributed to providing the service, the rate base of the utility (value of property devoted to public use), and the reasonable rate of return to be allowed the utility on its rate base. The 'test period' costs, expenses, and rate base are then adjusted to allow for the effect of various known or reasonably anticipated changes. By adding the adjusted costs and expenses to the rate of return (in recent years between 5 and 8 percent) multiplied by the rate base, as adjusted, the necessary gross revenues are determined, and the rates are then fixed to produce such gross revenues. (See Pacific Tel. & Tel. Co. v. Public Utilities Comm., 62 Cal.2d 634, 643--645, 44 Cal.Rptr. 1, 401 P.2d 353.) Under this system an increase in a cost item will ordinarily be reflected as an increase in the rates, and a reduction in the rate base will produce a reduction in the rates. However, the increase in cost will be reflected in its full amount in the rates, while the reduction in the rate base will be reflected only to the extent of the reasonable rate of return, between 5 and 8 percent of the reduction.

In computing the cost of service for rate making purposes, the utility is allowed to recover its federal income taxes as a cost of business. In computing the federal income tax cost the utility is allowed to deduct depreciation, and the greater the depreciation for tax purposes (all other things being equal) the less the tax liability and the less the necessary rate to recover it.

Since 1954, the federal government has permitted straight line or accelerated depreciation in determining federal income tax liability. Straight line depreciation provides for essentially uniform annual write-offs of a depreciable asset over the life of the asset. Accelerated depreciation provides for larger allowances as expenses than straight line depreciation during the early years of the life of the asset but during later years the depreciation expense attributable to the asset will ordinarily be less than if the straight line method had been used. Because of the relation between depreciation and tax liability, it would follow in theory that accelerated depreciation would result in lower tax liability or tax expense in the early years as compared to straight line depreciation but that in subsequent years the tax liability would exceed that had straight line been used and thus lead to higher rates. In theory there would be lower rates in the earlier years under accelerated depreciation but higher rates in later years. However, in Practice, the tax saving of the earlier years, although in a sense repaid in the subsequent years, does not result in higher taxes and rates in the later years because the utilities tend to increase their investment in plant and equipment every year so that the increased depreciation due to acceleration in any year will more than offset any reduced depreciation due to the effect of accelerated depreciation as to older assets. ²

Apparently all utilities other than Pacific and General Telephone have used accelerated depreciation in computing and paying their federal income taxes. The commission has in the past required the utilities using accelerated depreciation to pass on the tax savings to the consumer in the form of lower rates (in computing the cost of service for the purpose of fixing rates, the actual tax liability was used rather than the greater tax liability that would have been due had straight line depreciation been used for tax purposes). This passing on to the consumer of the tax savings is called 'flow-through.'

Pacific and General Telephone, unlike other utilities, have refused to use accelerated depreciation in filing their income tax returns. On November 6, 1968, in Decision No. 74917 the commission determined that Pacific's management was imprudent in not electing to take accelerated depreciation for income tax purposes. The commission concluded that it could not compel Pacific to take the accelerated depreciation on its federal income tax return, but it held that for purposes of rate making Pacific would be treated as if it had obtained the tax saving of accelerated depreciation and that the saving would be flowed-through to the consumers in the form of lower rates. (Imputed accelerated depreciation with flow-through.) Notwithstanding this, Pacific continued to determine its federal tax liability using straight line depreciation.

In section 441 of the Tax Reform Act of 1969, Congress amended section 167 of the Internal Revenue Code to limit the use of accelerated depreciation by utilities in determining income tax liability. Subsection (l)(2) provides: 'In the case of any post-1969 public utility property, the term 'reasonable allowance' (for depreciation) as used in subsection (a) means an allowance computed under--

'(A) a subsection (l) method (straight line depreciation (see Int.Rev.Code, § 167, subs. (l)(3)(F))),

'(B) a method otherwise allowable under this section (such as accelerated depreciation) if the taxpayer uses a normalization method of accounting, or

'(C) the applicable 1968 method, if, with respect to its pre-1970 public utility property of the same (or similar) kind most recently placed in service, the taxpayer used a flow-through method of accounting for its July 1969 accounting period.' ³ (Italics added.)

Subsection (l)(3)(G) defines normalization: 'In order to use a normalization method of accounting with respect to any public utility property--

'(i) the taxpayer must use the same method of depreciation to compute both its tax expense and its depreciation expense for purposes of establishing its cost of service for ratemaking purposes and for reflecting operating results in its regulated books of account, and

'(ii) if, to compute its allowance for depreciation under this section, it uses a method of depreciation other than the method it used for the purposes described in clause (i), the taxpayer must make adjustments to a reserve to reflect the deferral of taxes resulting from the use of such different methods of depreciation.'

The commission permitted argument by interested parties in this matter. However it refused to accept any evidence and struck evidence previously received (some correspondence between Pacific and the Internal Revenue Service).

The commission found that it had in its 1968 decision imputed to Pacific for tax purposes accelerated depreciation with flow-through pointing out that Pacific had an option to use accelerated depreciation; that Pacific had used straight line depreciation in its income tax returns through the year 1969, and that under the Tax Reform Act of 1969 could accelerate depreciation for tax purposes only if it normalized. The commission concluded that it would now declare that it intended to use normalization of taxes in setting Pacific's rates so that Pacific could commence acceleration under subsection (l)(2)(B) with regard to its 1970 taxes.

The majority opinion reasoned that the commission could not continue the existing method of imputing accelerated depreciation. The commission said of its 1968 ruling: 'The imputation of accelerated depreciation with flow-through did not deprive Pacific of its property without due process because there was then no legal restriction against Pacific's changing to accelerated depreciation with flow-through and paying essentially those income taxes that had been allowed in the decision. ( ) That no longer is the case. If we now were to attempt to impute accelerated depreciation with flow-through for setting rates in this proceeding, the law clearly would preclude Pacific from actually using accelerated depreciation in filing its federal income tax returns. We thus would be assuming lower taxes than Pacific would be required by law to pay. * * * Since accelerated depreciation with flow-through is no longer an option available to Pacific under federal law, it would now be futile to consider the relative merits of flow-through and normalization.' (Italics added.)

We have concluded that the...