TITLE



PACIFIC GAS AND ELECTRIC COMPANY

CHAPTER 10

INCOME AND PROPERTY TAXES

Introduction

1 Scope and Purpose

The purpose of this chapter is to demonstrate that Pacific Gas and Electric Company’s (PG&E or the Company) expense forecast for income taxes and property taxes, and its estimate of deferred tax balances for its generation function, are reasonable and should be adopted by the California Public Utilities Commission (CPUC or Commission). This chapter presents recorded income tax expense and deferred tax reserve balances for 2004[[1]] and develops estimates of the corresponding amounts for 2005, 2006 and 2007. This chapter also discusses prior Commission decisions that provide the guidance for the calculations presented and uses the same tax calculation used in the 2003 General Rate Case (GRC). The tax expense amounts PG&E is requesting are necessary components of the cost of providing generation service to PG&E’s customers in 2007.

2 Summary of Request

PG&E requests that the Commission adopt its 2007 forecast for income tax expense and deferred tax balance. Tax expense is a calculated amount dependent on: (1) expenditure estimates provided by other witnesses in this case; (2) past Commission decisions on how to perform the calculation; and (3) tax laws.

PG&E further requests that the Commission adopt its 2007 forecast for property tax expense.

Table 10-1 at the end of this chapter presents the specific amounts requested for non-nuclear plant and for Diablo Canyon.

3 Support for Request

PG&E’s forecast for income tax expense is reasonable because the Company:

• Accurately reflects the tax laws in its calculation of tax expense;

• Uses Commission-mandated accounting and ratemaking methods; and

• Calculates federal income tax (FIT) and California corporate franchise tax (CCFT) taxable income using appropriate deductions and adjustments equivalent to or forecast from amounts filed in its federal and state tax returns.

PG&E’s request for property taxes is reasonable because it is based on current property tax rates and methods applied to the estimated net plant in service for this proceeding.

Significant Developments Since the Last GRC

Since the 2003 GRC was filed, Congress passed three tax acts. On May 28, 2003, President Bush signed into law the “Jobs and Growth Tax Relief Reconciliation Act of 2003.”[[2]] That legislation included a provision that increases the special depreciation allowance allowed in the first year from 30 percent, as described in the 2003 GRC, to 50 percent for property placed in service after May 5, 2003 and before January 1, 2005.

PG&E has included an estimate of the effect of special depreciation allowance in its forecast of federal deferred taxes in this application. For 2007, there should be no impact on federal tax depreciation for generation due to the special depreciation allowance on additions made in 2007. There should be no affect on state tax depreciation because, as of the date this application, state law has neither conformed to the 30 percent rate nor conformed to the 50 percent rate.

In the 2003 GRC, PG&E described how the increase in federal tax depreciation, the special depreciation allowance, also changed the net present value dynamics of contributions-in-aid-of-construction received from customers; and that the change caused PG&E to reduce the income tax cost component charged on taxable contributions. The increase of special depreciation allowance to 50 percent required an additional adjustment. Accordingly, PG&E filed Advice Letters 2466-G/2386-E with the Commission on June 6, 2003, reducing the income tax cost component charged on taxable contributions from 27 percent to 22 percent for both electric and gas effective August 1, 2003. The tariff sheets attached to Advice Letters 2387-G/2243-E further provide that the income tax cost component charged would return to 34 percent for electric and 35 percent for gas as of January 1, 2005.

In 2004, the President signed two other tax bills only one of which, the “American Jobs Creation Act of 2004” (2004 Jobs Act), has an impact on this filing. The 2004 Jobs Act included a provision that allows a manufacturer’s tax deduction for goods manufactured and produced in the United States. The deduction is computed as a percentage of the net income of a taxpayer derived from the manufacture or production of such good.[[3]] The rate is phased in beginning at 3 percent for 2005 and 2006, 6 percent in 2007-2009, and 9 percent beginning in 2010. Production of electricity qualifies for the deduction; the transmission and distribution of electricity do not.

PG&E has included an estimate of the manufacturer’s tax deduction in its forecast of federal income tax expense in this application. As of the date this application, state law has not conformed to this change.

In the 2003 GRC, the State Board of Equalization (SBE) separately calculated the values of nuclear generation, non-nuclear generation, and transmission and distribution property using different indicators of value and different weightings for each business segment. As described below, the SBE now uses the same methodology in a single system-wide property assessment.

Specific Modification for Income Tax Expense-Retained Plant

In the Competitive Transition Cost Decision,[[4]] the Commission authorized collection of the FAS 109 tax regulatory asset for all book and tax basis flow-through timing differences for fossil and hydro generation plant. The 2003 GRC Settlement Agreement established a 10-year collection period for the remaining balance of the tax regulatory asset.

The tax regulatory asset will have an uncollected balance of $77.5 million as of December 31, 2006. As discussed more fully in Chapter 2 of this exhibit, Generation Ratemaking, PG&E requests that the tax regulatory asset at December 31, 2006, be amortized over six years beginning in 2007. As the regulatory asset is amortized, the appropriate adjustment will be made to the deferred tax reserve.

Exclusive of return on rate base, amortization of the tax regulatory asset increases revenue requirement for retained non-nuclear plant by the amount of the amortization.

In addition, as discussed more fully in Chapter 2 of this exhibit, Generation Ratemaking, PG&E plans to shut down the Hunters Point Power Plan (HPPP) in mid-2006. PG&E is projecting expenditures to decommission HPPP during the 2007 GRC timeframe. It is also projecting some smaller expenditures for decommissioning work at Humboldt Bay Power Plant during this timeframe. For tax purposes, the decommissioning expenses create a flow-through tax benefit in the ratemaking tax calculation.

Calculation Methodology

Tax expense is a calculated amount dependent on: (1) expenditure estimates provided by other witnesses in this case; (2) past Commission decisions on how to perform the calculation; and (3) tax laws. This section provides a brief history of the development of Commission-mandated tax calculations.

In the Economic Recovery Tax Act of 1981, Congress mandated that the tax benefit of certain expenditures made by utilities subject to cost-of-service regulation should be accounted for using a “normalization” method of tax accounting.[[5]] The Commission issued Order Instituting Investigation 24 (OII 24), and later adopted normalization accounting for the specified expenditures.[[6]] Other Commission decisions have ordered “flow-through” tax accounting for other categories of expenditures. Both of these technical terms are explained below.

Where past Commission decisions mandate that expenditures be deducted against taxable income in the ratemaking tax calculation using the same timing that is used to determine book income (revenue less expenditures before tax expense), then the tax expense calculation is merely book income times the tax rate. However, often the timing is different, thus giving rise to a “book tax timing difference.” For example, taxing authorities typically provide depreciation lives and methods shorter and more accelerated than those used for book purposes, resulting in tax depreciation greater than book depreciation in the early years of an asset’s life cycle.

Commission decisions have provided for either normalized or flow-through tax accounting for specific book tax timing differences to determine the amount of tax benefit reflected in the revenue requirement for the utility.

Flow-through accounting uses the amount of the tax return deduction to determine the amount of the tax benefit reflected in the revenue requirement. The tax benefit reflected in the revenue requirement is equal to the cash saved on the return due to the deduction.

In contrast, normalized tax accounting uses the amount of the book expenditure to calculate the amount of the tax benefit reflected in the revenue requirement. In this case, the tax benefit in rates is different from the cash saved due to the tax deduction. This adjustment is referred to as deferred tax expense. Since the tax benefit in rates is different from the cash saved on the return, the normalization tax accounting method usually calls for a rate base adjustment to provide a return on the difference. This accumulated deferred tax expense (deferred tax reserve) adjusts rate base.

In the discussion of adjustments that follows, PG&E specifies when it has used flow-through or normalized tax accounting and indicates if a rate base adjustment has been made in the case of normalization.

Deductions From Taxable Book Income

The following tax adjustments are made to pre-tax book income and are common to the development of the FIT and CCFT taxable income shown in Table 10-1. In addition, adjustments unique to either FIT or CCFT tax laws are addressed later in this chapter.

1 Interest Charge Adjustment

The interest charge adjustment provides a tax deduction for interest on debt used to finance rate base. The deduction, computed from rate base and rate of return information, is shown in Table 10-1 at the end of this chapter. Decision 93848[[7]] ordered flow-through tax accounting for this adjustment; PG&E has used the prescribed accounting in its showing.

2 Fiscal/Calendar Year Property Tax Adjustment

In Decision 84-05-036,[[8]] the Commission recognized the book and tax basis timing differences between property tax accrued for financial reporting purposes and property tax accrued as an income tax deduction. This timing difference is illustrated in Table 10-1. For financial reporting purposes, property taxes are accrued for the period in which they are paid. For income tax purposes, property taxes become deductible on the January 1 lien date. The adjustment to book accrued property tax is shown in Table 10-1. Decision 93848[[9]] provides for flow-through tax accounting for this adjustment, which is the accounting used for this item in this proceeding and in the last GRC.

3 Operating Expense Adjustments

In Decision 88-01-061,[[10]] the Commission recognized the significant changes introduced by the Tax Reform Act of 1986 (TRA 86). Many of the changes require taxpayers such as PG&E to make miscellaneous adjustments to book income to compute taxable income. For example, 50 percent of the business meal expense included in book income must be eliminated in the computation of taxable income. Another adjustment is made for the Internal Revenue Code (IRC) Section 179A deduction for natural gas vehicles created by the National Energy Policy Act of 1992. Clearing account book depreciation related to vehicles is also removed as an operating expense adjustment because under PG&E’s charge-back accounting for these costs, vehicle depreciation is included in operating expenses, but is not tax deductible. Other miscellaneous tax adjustments to pre-tax book income are shown in Table 10-1. Decision 93848[[11]] provides for flow-through tax accounting for this adjustment, which is the accounting used for this item in this proceeding. In addition, clearing account book depreciation related to vehicles is removed as an operating expense adjustment.

4 Vacation Pay Adjustment

Decision 88-01-061[[12]] discussed the income tax effect of book and tax basis timing differences related to the cost of vacation pay. For financial reporting purposes, the liability is measured by the amount of vacation pay earned. For tax purposes, vacation pay is deductible only to the extent that economic performance has occurred during the year, or will occur by March 15 of the year following the year of the book accrual. Economic performance occurs when an employee actually takes vacation. This timing adjustment to pre-tax book income is shown in Table 10-1. Decision 88-01-061 provides for normalized tax accounting for this adjustment, which is consistent with the accounting used for this item in this and the 2003 GRC. Since the tax effect is normalized, deferred tax expense is calculated for this item.

5 Capitalized Software Adjustment

Section 167(f)[[13]] of the IRC requires taxpayers to capitalize and depreciate certain software acquired in the open market. Section 174 of the IRC provides that some portion of the cost of certain self-developed software may be deducted currently. As in the 2003 GRC, PG&E has used flow-through tax accounting treatment for the amounts that are deductible under Section 174 and normalized tax accounting treatment for amounts that are capitalized under Section 167(f).

Decision 93848[[14]] provides for flow-through tax accounting for this adjustment; the normalized tax accounting used in this case for the Section 167(f) portion of the adjustment is the tax accounting used in Decision 88-01-061 for depreciable tax basis placed in service since 1986. Since this tax effect is normalized, deferred tax expense is calculated for this item.

Development of CCFT Taxable Income

CCFT taxable income is computed in accordance with the statutory requirements of the California Revenue and Taxation Code (R&TC). The starting point for the calculation is pre-tax book income. Pre-tax book income is uniquely calculated for the tax computation. For example, book depreciation and decommissioning costs are not included in pre-tax book income. Other excluded items include the allowance for funds used during construction (AFUDC) income and interest expense.

Tax adjustments that are common to both FIT and CCFT are combined with tax adjustments that are unique to CCFT to compute CCFT taxable income from pre-tax book income. The tax adjustments that are common to both FIT and CCFT are discussed in Section E above. Tax adjustments that are unique to CCFT taxable income are discussed below.

1 CCFT Capitalized Interest Adjustment

Decision 88-01-061 discussed the requirement to capitalize interest in the tax basis of new construction. The Commission recognized timing differences between the amount of interest capitalized in book basis through the debt portion of AFUDC and the amount of interest capitalized in tax basis through compliance with Section 263A of the IRC. California conformed to the requirements of IRC Section 263A through R&TC Section 24422.3. The net unrecovered difference between book basis AFUDC debt and CCFT basis in Section 24422.3 interest capitalized is shown in Table 10-1 at the end of this chapter.

As in the 2003 GRC, PG&E used normalized tax accounting for this adjustment, which complies with Option 3 of Decision 88-01-061. Since this tax effect is normalized, deferred tax expense is calculated for this item.

2 CCFT Depreciation Adjustment

The R&TC specifies the tax depreciation deductibility rules for PG&E. These rules are based on the Asset Depreciation Range (ADR)[[15]] and Class Life System (CLS)[[16]] methods of depreciation. The depreciation deduction shown in Table 10-1 maximizes the deduction permitted by law for the plant activity forecast in this GRC. Decision 93848 provides for flow-through tax accounting for this adjustment, which is consistent with the accounting used for this item in this proceeding.

3 CCFT Removal Cost Adjustment

The R&TC specifies the cost of removal deductibility rules for PG&E. Removal costs are incurred when plant is physically removed from service (and is deductible for tax purposes when incurred). The cost of removal deduction shown in Table 10-1 is based on the plant retirement activity forecast in this GRC. For financial reporting purposes, such costs are capitalized. Thus, a tax and book basis timing difference is created. Decision 93848 provides for flow-through tax accounting for this adjustment, which is consistent with the accounting used for this item in this proceeding.

4 CCFT Repair Allowance Adjustment

The R&TC specifies the repair allowance deductibility rules for PG&E. The repair allowance deduction relates to all vintages of ADR property and is based on the plant construction activity forecast in this GRC. For financial reporting purposes, such costs are capitalized. Thus, a tax and book basis timing difference is created. Decision 93848 provides for flow-through tax accounting for this adjustment, which is consistent with the accounting used for this item in this proceeding.

Development of Federal Taxable Income

Federal taxable income is computed in accordance with the statutory requirements of the IRC. The starting point for the calculation is pre-tax book income as discussed in Section E above.

Tax adjustments that are common to both FIT and CCFT are combined with tax adjustments that are unique to FIT to compute FIT taxable income from pre-tax book income. The tax adjustments that are common to both FIT and CCFT are discussed in Section E above. Tax adjustments that are unique to FIT taxable income are discussed below.

1 FIT State Tax Adjustment

For FIT return filing purposes, Section 801 of TRA 86 requires taxpayers such as PG&E to deduct CCFT on a privilege year basis (prior year CCFT becomes deductible for FIT purposes when PG&E exercises its franchise privilege to do business in California on the first day of each new year). Thus, CCFT estimated for 2006 (income year) would be deductible for federal income tax purposes on January 1, 2007 (privilege year).

In Decision 89-11-058, the Commission concluded that CCFT is deductible for FIT purposes on a privilege year basis if the amount deducted is on record in a Commission-adopted prior year summary of earnings.[[17]] In this case, the prior year amount for 2006 as shown in the appropriate tables in this chapter’s workpapers becomes deductible for FIT purposes in 2007, also shown in the tables.

The flow-through tax accounting used for this adjustment is consistent with the accounting used for this item in this proceeding and in the 2003 GRC.

2 FIT Capitalized Interest Adjustment

A tax adjustment discussed in Decision 88-01-061 is the requirement to capitalize interest in the tax basis of new construction. The Commission recognized timing differences between the amount of interest capitalized in book basis through the debt portion of AFUDC and the amount of interest capitalized in tax basis through compliance with Section 263A of the IRC. The net unrecovered difference between book basis AFUDC debt and FIT basis in Section 263A interest capitalized is shown in Table 10-1.

The normalized tax accounting used for this adjustment is consistent with the accounting used for this item in this application and in the 2003 GRC and with Option 3 of Decision 88-01-061. Since this tax effect is normalized, deferred tax expense is calculated for this item.

3 FIT Depreciation Adjustment

The IRC specifies the tax depreciation deductibility rules for PG&E. These rules are based on the CLS, ADR, Accelerated Cost Recovery System (ACRS)[[18]] and Modified Accelerated Cost Recovery System (MACRS)[[19]] methods of depreciation. The depreciation deduction shown in Table 10-1 maximizes the deduction permitted by law for the plant activity forecast in this GRC.

Accelerated depreciation under the ACRS and MACRS methods of depreciation is permissible only if the FIT effects of life, method, and salvage timing differences between the book and tax methods of recovering ACRS and MACRS tax basis are normalized. In Decision 93848 and Decision 88-01-061, the Commission approved normalization accounting to enable PG&E to use ACRS and MACRS methods of depreciation.

The normalized tax accounting used for ACRS and MACRS property is the same accounting used in the 2003 GRC, in accordance with Decisions 93848 and 88-01-061. Since the tax effect is normalized, deferred tax expense is calculated as well (See Table 10-1, line 49).

Accelerated depreciation under the ADR and CLS systems of depreciation is permissible regardless of the tax accounting treatment of book and tax basis timing differences in ratemaking. In Decision 93848, the Commission ordered the use of flow-through tax accounting for such timing differences.

The flow-through tax accounting used for ADR and CLS property basis timing differences is the accounting used for this item in this filing and the 2003 GRC in accordance with Decision 93848.

4 FIT Removal Cost Adjustment

PG&E has an established method of accounting for the costs of removal as incurred. The cost of removal deduction shown in Table 10-1 is based on the plant retirement activity forecast in this GRC. For financial reporting purposes, such costs are capitalized. Thus, a tax and book basis timing difference is created.

The limited flow-through income tax accounting used for the cost of removal is the accounting treatment for this item in this filing and the 2003 GRC, in accordance with Decision 93848.

5 FIT Repair Allowance Adjustment

The IRC specifies the repair allowance deductibility rules for PG&E. The repair allowance deduction relates to all vintages of ADR property and is based on the plant construction activity forecast in this GRC. For financial reporting purposes, such costs are capitalized. Thus, a tax and book basis timing difference is created.

The flow-through tax accounting used for ADR property repair allowance in this filing is the accounting used in the 2003 GRC, in accordance with Decision 93848.

6 FIT Preferred Dividend Adjustment

This adjustment relates to a permanent difference between book and tax basis. Dividends paid on preferred stock issued prior to October 1, 1942, are (with limitations) deductible for federal income tax purposes. Dividends paid on preferred stock issued after October 1, 1942, also qualify, if the preferred stock replaced a bond or other preferred stock that was issued prior to October 1, 1942. This adjustment is forecast in Table 10-1. Decision 93848 provides for flow-through tax accounting for this adjustment, which is the same accounting used in the 2003 GRC.

Development of Property Tax Expense

Estimated property taxes were developed using valuation methods appropriate for cost of service regulated public utilities. The SBE uses the historical cost less depreciation and the capitalized earnings ability valuation methods to determine PG&E's system-wide assessment. Generally, these valuation methods should not result in a valuation significantly different from rate base.

For the test year, forecasts of assessed values are determined by developing a factor based on the relationship between the most current assessment (fiscal year 2004/2005)[[20]] and the taxable historical cost less depreciation for the same period. The resulting factor is applied to the forecasted historical cost less depreciation to determine assessed value. Fiscal period property taxes are calculated by multiplying the assessed values by a composite tax rate. The composite tax rate is computed based on assessment and tax data from the latest known fiscal tax period (fiscal year 2005/2006).

The final expense amount is determined using two fiscal period assessment estimates. For example, 2007 property tax expense is comprised of the last one-half of fiscal period 2006/2007, and the first one-half of fiscal period 2007/2008.

Tables

The following table is provided using the mandated accounting methods described above for PG&E’s generation function:

Table 10-1

Pacific Gas and Electric Company

Income Taxes at Proposed Rates, Year 2007

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[[1]] The 2004 amounts were prepared before PG&E’s tax return for 2004 was filed. Thus, 2004 taxes are estimated based on recorded 2004 book data.

[[2]] Public Law No. 108-027 (May 28, 2003) 117 Stat. 752.

[[3]] The provision uses the term qualified production activities income and defines that as gross receipts, reduced by the sum of: (1) cost of goods sold that are allocable to the receipts; (2) other deductions, expenses, or losses that are directly allocable to such receipts; and (3) a proper share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income. Internal Revenue Code (IRC) §199(c)(1).

[[4]] D.97-11-074; 76 CPUC 2d 627.

[[5]] IRC § 168; 26 U.S.C.A. § 168.

[[6]] D.84-05-036, mimeo p. 46, 15 CPUC2d 42, 61, Conclusion of Law No. 14.

[[7]] D.93848, 7 CPUC 2d 332.

[[8]] D.84-05-036, 15 CPUC 2d 42.

[[9]] D.93848, supra.

[[10]] D.88-01-061, 27 CPUC 2d 310.

[[11]] D.93848, supra.

[[12]] D.88-01-061, supra.

[[13]] The Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66) added Section 167(f) to the IRC, effective for capitalized software purchased after August 10, 1993.

[[14]] D.93848, supra.

[[15]] The ADR system of depreciation determines the CCFT depreciation of property placed in service after 1970.

[[16]] The CLS determines the CCFT depreciation of property placed in service prior to 1971.

[[17]] D.89-11-058, 33 CPUC 2d 495.

[[18]] The ACRS determines tax depreciation of property generally placed in service from 1981 through 1986, and of some post-1986 transition property, supplanting ADR for federal purposes.

[[19]] The MACRS determines tax depreciation of property placed in service after 1986, except for property subject to ACRS rules.

[[20]] For property taxes, the fiscal year runs from July 1 through June 30.

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