City of Los Angeles v. Public Utilities Com.

• Decision Date: 12 December 1975
• Docket Number: S.F. 23215,S,S.F. 23257
• Citation: 542 P.2d 1371,125 Cal.Rptr. 779,15 Cal.3d 680
• Parties: , 542 P.2d 1371 CITY OF LOS ANGELES et al., Petitioners, v. PUBLIC UTILITIES COMMISSION et al., Respondents; PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest. CITY OF LOS ANGELES et al., Petitioners, v. PUBLIC UTILITIES COMMISSION et al., Respondents; GENERAL TELEPHONE COMPANY OF CALIFORNIA, Real Party in Interest. F. 23237 and
• Court: California Supreme Court

Page 779

125 Cal.Rptr. 779

15 Cal.3d 680, 542 P.2d 1371

CITY OF LOS ANGELES et al., Petitioners, v. PUBLIC UTILITIES COMMISSION et al., Respondents;

PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Real Party in Interest.

CITY OF LOS ANGELES et al., Petitioners, v. PUBLIC UTILITIES COMMISSION et al., Respondents;

GENERAL TELEPHONE COMPANY OF CALIFORNIA, Real Party in Interest.

S.F. 23215, S.F. 23237 and S.F. 23257.

Supreme Court of California In Bank.

Dec. 12, 1975.

Burt Pines, City Atty., Los Angeles, Leonard L. Snaider, Deputy City Atty., Leonard Putnam, City Atty., Long Beach, Robert E. Shannon, Deputy City Atty., John Witt, City Atty., San Diego, Robert J. Logan and William S. Shaffran, Deputy City Attys., Thomas O'Connor, City Atty., City and County of San Francisco, and Milton H. Mares, Deputy City Atty., for petitioners.

Richard D. Gravelle, J. Calvin Simpson and Andrew J. Skaff, San Francisco, for respondents.

Albert M. Hart, H. Ralph Snyder, Jr., Santa Monica, O'Melveny & Myers, Allyn O. Kreps, Edward D. Burmeister, Jr., Steven C. Babb, Los Angeles, James A. DeBois, William R. Roche, Pillsbury, Madison & Sutro, Noble K. Gregory, Richard W. Odgers, James B. Young and Francis Kirkham, San Francisco, for real parties in interest.

TOBRINER, Justice.

In these three telephone rate cases the Public Utilities Commission determined, Inter alia, that it lacked legal authority to approve tariffs which would annually adjust telephone rates to take account of changing federal tax expenses. As a consequence, the commission found itself compelled to set a rate which, in its own words, would 'create a windfall for (the telephone companies) to the detriment of the ratepayers.' (Re Pacific Telephone & Telegraph Co. (1974) Cal.P.U.C. (Decision No. 83162; slip opn., p. 63).) The commission took this action in spite of our having annulled its previous decisions in this matter '(f)or failure to consider lawful alternatives in calculation of federal income tax expense.' (City & County of San Francisco v. Public Utilities Commission (1971) 6 Cal.3d 119, 130, 98 Cal.Rptr. 286, 292, 490 P.2d 798, 804.) As we explain, we have concluded that the commission does possess the power to implement an annual adjustment scheme, and we accordingly remand these cases in order that the agency may reconsider its action with knowledge of the full scope of its powers.

In addition to this failure to consider lawful alternatives in the treatment of tax expenses, the petitioning cities assert as grounds for annulment: (1) that the commission authorized an unreasonably high rate of return for the two telephone companies in question; and (2) that the commission erred in promulgating an interim rate pending its rehearing of the General Telephone case. As to the first contention, we have concluded that the commission did not exceed the boundaries of its discretion. (Pub.Util.Code, § 1757.) As to the second contention, we show below that the commission regularly pursued its authority.

1. The background of the present litigation.

Because these cases spring from the relationship between federal taxing authority and public regulatory power, we must review pertinent developments in these two fields.

An extremely significant element of the operating expenses which a rate-setting agency must consider is that of state and federal taxes; ¹ increased tax deductions decrease a utility's tax bill and with it the revenue it must acquire from its ratepayers. These cases turn on two such tax deductions available to General and Pacific, ² accelerated depreciation and the Job Development Investment Credit; ³ both of them enable a public utility to reduce its tax expenses, and the efforts of regulatory bodies to pass the benefits of such reduced tax expenses on to the utilities' ratepayers form the backdrop to the instant cases. ⁴

Such regulatory efforts are of course mandatory for a state agency charged with insuring that '(a)ll charges demanded or received by any public utility . . . shall be just and reasonable' (Pub.Util.Code, § 451) and that '(n)o public utility shall raise any rate . . . except upon a showing before the commission and a finding by the commission that such increase is justified' (Pub.Util.Code, § 454). We therefore examine the background of these cases to determine whether the commission has failed to consider alternative means of dealing with unnecessary tax payments which might be eliminated to the benefit of the ratepayers.

Since 1954, section 167 of the Internal Revenue Code has given business taxpayers several options in computing depreciation deductions from their federal taxes. Thus the utilities in the instant case may, like other businesses, assume that their depreciable assets wear out at an even rate and deduct the same amount of depreciation for each year of useful life; such an assumption is known as 'straight-line' depreciation. Another option, first made available by 1954 amendments to the Internal Revenue Code is 'accelerated' depreciation (Int.Rev.Code of 1954, § 167(b)(2)--(4)); using this method the enterprise takes deductions as if the asset in question depreciates more rapidly in the earlier years of its life and more slowly thereafter. ⁵ A taxpaying utility using accelerated depreciation would deduct the same Total amount of depreciation over the useful life of the asset as a taxpayer using straight-line methods, but accelerated depreciation permits the largest part of this total to be deducted in the early years of the asset's life.

If one thinks of a single piece of depreciable equipment, such as a desk or typewriter, over the long run it would make no difference which system of depreciation were employed since the utility could write off no more than the total value of the asset in any case. That which holds true for a single asset, however, does not do so for an enterprise considered as an evolving whole. (Bonbright, Principles of Public Utility Rates (1961) pp. 218--223; see Alabama-Tennessee Natural Gas Co. v. Federal Power Comm'n (5th Cir. 1966) 359 F.2d 318, 328.)

Ratemakers have discovered that if the total enterprise is either expanding or stable, the use of Accelerated depreciation does not merely defer taxes, but eliminates them entirely. (See F.P.C. v. Memphis Light, Gas and Water Div. (1972) 411 U.S. 458, 460, 93 S.Ct. 1723, 36 L.Ed.2d 426; Note, The Effect on Public-Utility Rate Making of Liberalized Tax Depreciation under Section 167 (1956) 69 Harv.L.Rev. 1096, 1102.) This effect occurs because in the later years of an asset's life (when its value as a depreciation deduction has been used up), its place is taken by a New piece of equipment, which replaces it as a deduction in income tax calculation. This replacement effect means that the higher depreciation taken in early years does not have to be paid for by lower depreciation in later years; The tax never catches up. The result is a net tax savings to any utility using accelerated depreciation. ⁶ For a rate-setting agency the comprehension of this counter-intuitive fact has important implications. If the Public Utilities Commission in setting rates were to assume that tax deductions for depreciation under both the straight-line and accelerated methods would yield the same result in the long run, it would, in fact, award the utility a rate windful. For it would have set rates as if the utility would incur tax expenses Which it would never have to pay.

In 1960 the California Public Utilities Commission after studying this problem issued a report indicating that it would pass on to ratepayers any savings effected by the adoption of accelerated depreciation and suggesting that the utilities' managements elect this method. (Commission Investigation Regarding Rate Fixing Treatment for Accelerated Amortization and Depreciation for all Utilities, 57 Cal.P.U.C. 598.) ⁷

Pursuant to this recommendation '(a)pparently All utilities other than Pacific and General Telephone have used accelerated depreciation.' (City and County of San Francisco v. Public Utilities Commission, supra, 6 Cal.3d 119, 124, 98 Cal.Rptr. 286, 288, 490 P.2d 798, 800; emphasis added.) Because 'Pacific and General Telephone, unlike other utilities . . . refused to use accelerated depreciation . . . (o)n November 6, 1968, in Decision No. 74917 the Commission determined that Pacific's management was imprudent' in not electing the option and 'concluded 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 (passed on) . . . to the consumers in the form of lower rates. (Imputed accelerated depreciation with flow-through.)' (Id.) ⁸

In 1969, however, Congress amended the Internal Revenue Code. ⁹ The amendments, some of a highly technical nature, provided that utilities which had not taken accelerated depreciation before 1969 could do so subsequently only if they 'compute(d) their cost of service, which includes federal imcome taxes, as if they were using straight-line depreciation. This method, referred to as 'normalization,' ¹⁰ was designed to avoid giving the present customers of a utility the benefits of tax deferral attributable to accelerated depreciation. If a utility used accelerated depreciation in determining its actual tax liability, the difference between the taxes actually paid and the higher taxes reflected as a cost of service for retemaking purposes was required to be placed in a deferred tax reserve account. See Amere Gas Utilities Co., 15 F.P.C. 760.' (F.P.C. v. Memphis Light, Gas & Water Div., supra, 411 U.S. 458, 460, 93 S.Ct. 1723, 1725, 36 L.Ed.2d 426.) After the passage of these laws Pacific and General reversed their longstanding opposition to accelerated depreciation and began to take the larger deductions it authorized; they contended, however, that if the commission passed on to the ratepayers any of the savings thereby achieved, 'degradation of service...