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1 Q. Please state your name, business address and present position with 2 PacifiCorp (the Company). 3 A. My name is Larry O. Martin. My business address is PacifiCorp, 825 N.E. 4 Multnomah, Portland, Oregon 97232, Suite 1900. My present position is Tax 5 Director. 6 Qualifications 7 Q. Please briefly describe your education and business experience. 8 A. I hold Bachelor of Science in Accountancy and Master of Accountancy in 9 Taxation degrees. I have been a Certified Public Accountant since 1987. My 10 business experience includes over five years with the public accounting firm Ernst 11 & Young (f/k/a Ernst & Whinney); ten years as the senior tax executive with 12 JELD-WEN, Inc., a privately-held multi-national manufacturing firm; and over 13 four years as Director of Tax with PacifiCorp. My experience includes all areas 14 of U.S. corporate income taxation including mergers and acquisitions, tax 15 controversy and issues resolution, compliance, planning, financial accounting and 16 reporting for taxes; and property, sales and use, and international taxes. 17 Q Have you previously testified before this Commission? 18 A. I filed direct and rebuttal testimony in Docket No. 03-2035-03. In addition, I 19 appeared before the Wyoming and Washington state commissions and have 20 previously been involved in proceedings before the SEC and IRS. 21 Q. Please describe your present duties. 22 A. I am responsible for all aspects of the Company's income tax function including: 23 compliance, accounting, financial and management reporting, issues resolution, Page 1 – Rebuttal Testimony of Larry O. Martin 1 and planning. 2 Purpose of Testimony 3 Q. What is the purpose of your testimony? 4 A. I provide testimony in response to the direct testimony of: 5 Ronald J. Binz submitted on behalf of AARP; 6 Michael L. Arndt and Donna DeRonne submitted on behalf of Committee of 7 Consumer Services (CCS); 8 Mary H. Cleveland and David T. Thomson submitted on behalf of Division of 9 Public Utilities (DPU); 10 Richard M. Anderson submitted on behalf of Utah Association of Energy 11 Users (UAE); and 12 Maurice Brubaker submitted on behalf of Utah Industrial Energy Consumers 13 (UIEC). 14 Collectively, the intervening parties (―Intervenor‖ or ―Intervenors‖). 15 My rebuttal testimony supports recovery of the Company's income tax expense 16 during the test period in this case, computed on a stand-alone basis; and will 17 specifically address the correct regulatory tax treatment for bonus depreciation, 18 the production activity deduction, tax advisory costs, avoided costs, and 19 consolidated tax adjustments raised in Intervenors' pre-filed direct testimony. 20 Q. Please outline your testimony. 21 A. My rebuttal testimony first discusses the various proposed tax adjustments to 22 regulatory taxes associated with the consolidated income tax return. Although 23 several different parties have proposed consolidated tax adjustments, each of the Page 2 – Rebuttal Testimony of Larry O. Martin 1 four witnesses sponsoring testimony on this issue is proposing a different type of 2 adjustment. For the reasons described in detail below, all of the proposed 3 adjustments are flawed, inconsistent with past commission treatment of the issue 4 and with sound regulatory principles, expose ratepayers to volatile costs and risks 5 and should be rejected. The next part of my testimony addresses issues raised by 6 Ms. Deronne and Mr. Thomson related to bonus depreciation, followed by a 7 discussion of the production activity deduction, tax advisory costs, and the 8 avoided costs M-1. 9 Consolidated Tax Adjustments 10 Q. Could you summarize the various consolidated tax adjustments proposed by 11 the Intervenors in this proceeding? 12 A. Yes. Mr. Binz proposes sharing of consolidated tax benefits based upon an 13 allocation of the tax benefits of losses to gain companies. Mr. Arndt proposes an 14 adjustment based upon an assertion that because of the existence of consolidated 15 ―income tax savings‖, a stand-alone income tax calculation creates phantom 16 income taxes, the payment of which results in an unfair subsidization of non- 17 regulated companies and violates the merger order. While Mr. Brubaker asserts 18 that he is calculating taxes for regulatory purposes on a stand-alone basis with one 19 exception related to interest deductions at PacifiCorp's parent company, 20 Pacificorp Holdings, Inc. (PHI), this is a distinction without any difference. He 21 too proposes an adjustment based on taxes calculated on a consolidated basis. 22 Finally, Dr. Anderson proposes a consolidated tax adjustment because he asserts 23 that the largest benefit Scottish Power brought to the Scottish Power/PacifiCorp Page 3 – Rebuttal Testimony of Larry O. Martin 1 merger was the tax benefit. He asserts Utah ratepayers should receive this tax 2 benefit because, he argues, Utah ratepayers lost the opportunity to merge with a 3 better merger partner. 4 Q. What are the key issues facing the Commission in its determination of the 5 consolidated tax adjustments issue? 6 A. Although the witnesses have taken several different approaches to their proposed 7 adjustments, there are many technical tax rules, and voluminous testimony, the 8 issue before the Commission is fairly straightforward. None of the consolidated 9 tax adjustment proposals should be adopted because they are inequitable and run 10 counter to long-standing regulatory precedent and past treatment by this 11 Commission. Precedent and past treatment have been adopted to avoid precisely 12 these types of adjustments, which break down the separation of regulated and 13 non-regulated operations, commonly referred to as ―ring fencing, which our state 14 commissions have historically and strenuously maintained in an effort to protect 15 ratepayers. All of the proposed adjustments have at least one consistent key 16 element. All of the proposals seek to take the tax benefit from affiliated 17 companies that are associated with losses which have never been paid for by 18 ratepayers, without taking any of the corresponding expenses and risks. This 19 overreaching is particularly egregious in that all of the proposals seek to take the 20 tax benefit associated with the loan that was used to buy the very goodwill that 21 has been specifically ordered to be excluded from rate base by this Commission. 22 Irrespective of the basis for the proposals, they subject the ratepayers to 23 unacceptable risks of future liabilities and volatile rates. The proposed Page 4 – Rebuttal Testimony of Larry O. Martin 1 adjustments would confiscate a non-regulated asset without compensation, while 2 excluding the underlying causal cost from rate base. 3 Q. Do you agree with the basis for Dr. Anderson's proposal? 4 A. No. Other significant merger benefits were realized. This issue is addressed in 5 the testimony of Don Furman. 6 Q. Do you concur with the testimony of Mr. Arndt that the ownership structure 7 of the Company leads to unfair subsidization of unregulated companies and 8 that there are "phantom taxes" due to consolidated income tax savings? 9 A. No. In fact, the ownership structure of the Company, consolidated tax filings and 10 accounting, and ―ring fence‖ regulatory provisions combine to actually ensure 11 that cross-subsidization of non-regulated entities does not occur. 12 Q. By way of background, will you please describe a consolidated tax return? 13 A. Yes. The Internal Revenue Code (IRC) allows affiliated groups of corporations to 14 file consolidated income tax returns on a combined basis rather than requiring 15 each business to file a separate return. In the case of PacifiCorp, the Company 16 normally ―contributes‖ income to the consolidated group for which it pays its 17 appropriate share of taxes. Fiscal year ended March 31, 2002 is an example of a 18 year when PacifiCorp, on a stand-alone basis, incurred a taxable loss and did not 19 contribute income to the consolidated group. It is important to understand that 20 PacifiCorp's taxable income is computed and reported to the IRS on a separate 21 company basis. This separate company computation is not based upon 22 hypothetical taxable income, but rather is based upon the Company's actual stand- 23 alone taxable income. The consolidated entity then adds together the taxable Page 5 – Rebuttal Testimony of Larry O. Martin 1 income of each company participating in the return and makes limited 2 adjustments at the consolidated level to calculate the taxes owing the federal 3 government. 4 Q. Is it common for companies that are eligible to file a consolidated return to 5 elect to do so? 6 A. Yes. Although filing a consolidated return is ―elected‖ under the IRC, in fact, if 7 corporations meet certain ownership thresholds, the IRS will impose certain 8 limitations on the group irrespective of whether the corporation elects to join in a 9 consolidated tax return. In other words, while the election is voluntary, if the 10 group of corporations chooses not to file a consolidated return, the IRS will 11 nevertheless impose some limitations as if they did. Moreover, many states, 12 including Utah, require ―unitary‖ entities such as PHI to file a consolidated or 13 combined return. Many utilities that are part of a larger holding company system 14 participate in consolidated returns. 15 Q. What are other reasons that companies participate in consolidated returns? 16 A. A key reason entities choose to participate in the filing of consolidated tax returns 17 is because of timing differences. It is critical to understanding this issue and the 18 Intervenors' proposed adjustments to understand that total tax expense is made up 19 of two components, current taxes (the return and liability accrual) and deferred 20 taxes (such as net operating losses (NOL), for example) which will become 21 payable at some later date. Filing a consolidated tax return effects the current 22 taxes payable rather than the total income tax expense. In other words, the 23 benefit, if any, of filing consolidated returns is the effect upon the timing of the Page 6 – Rebuttal Testimony of Larry O. Martin 1 income tax payment, not the total tax liability. While current taxes owed may be 2 reduced (if there are losses to offset gains); deferred taxes are increased and will 3 ultimately become due. For example, charitable contributions disallowed in prior 4 years due to consolidated taxable income limitations, are carried over to reduce 5 the current tax payable in later years. As another example, excess net operating 6 losses from a prior year may be carried forward to reduce current taxes payable in 7 a subsequent year. With very few exceptions (e.g., percentage depletion), if the 8 filing of a consolidated tax return decreases current taxes owing, it will always 9 increase deferred taxes. In other words, filing a consolidated tax return does not 10 create a permanent benefit. Filing a consolidated return also provides 11 administrative economies of scale in the filing of the tax return, as well as the 12 subsequent resolution of issues upon examination by the IRS. 13 Q. How are losses treated in the filing of a consolidated return? 14 A. In a very simple example, when one company with positive income files a 15 consolidated return with another business that has incurred a net loss, the total tax 16 paid by the two firms is reduced, because the net loss of the affiliated business 17 could not otherwise be recognized until later years in which that separate business 18 achieved a profit. 19 Q. In response to PacifiCorp Discovery Request 9.6, Mr. Arndt asserts that tax 20 losses are not assets of the loss company. Please comment on Mr. Arndt's 21 response. 22 A. Contrary to Mr. Arndt's statement, the tax benefits of losses represent an asset to 23 the company which generated the losses. FAS 109 dictates the U.S. GAAP Page 7 – Rebuttal Testimony of Larry O. Martin 1 treatment of such tax benefits for financial reporting purposes, and states in 2 paragraph 18b., ―A deferred tax liability or asset is recognized for the estimated 3 future tax effects attributable to temporary differences and carryforwards." 4 (Emphasis added.) FAS 109 further states in paragraph 17, ―…Deferred taxes 5 shall be determined separately…c. Measure the total deferred tax asset for 6 deductible temporary differences and operating loss carryforwards using the 7 applicable tax rate…‖ Such assets have value to a company and, for example, if 8 done consistent with requirements of the IRC, this asset can continue with the loss 9 company if it is acquired by another company. 10 Q. Is the federal income tax paid by PacifiCorp reduced by its participation in 11 the consolidated return? 12 A. No. Even when a consolidated income tax return is used, each entity's stand- 13 alone tax liability is separately calculated. Accordingly, the Company contributes 14 to the consolidated group its separately calculated share of current income tax. 15 Q. The Intervenors imply however that there is a distinction between how 16 PacifiCorp filed its return before and after the Scottish Power acquisition. Is 17 that implication correct? 18 A. No. PacifiCorp joined in filing a U.S. consolidated income tax return prior to the 19 Scottish Power acquisition effective November 30, 1999, and continues to join in 20 the filing of a consolidated return now, after the acquisition. During the test 21 period for this case, PHI is the parent company. 22 Page 8 – Rebuttal Testimony of Larry O. Martin 1 Q. Is Scottish Power in any way included in the U.S. consolidated income tax 2 return? 3 A. No. Scottish Power income has not been, and is not currently, included in the 4 U.S. consolidated income tax return. Scottish Power has no U.S. income tax 5 liability for which a U.S. tax return would be required. 6 Q. If the federal income tax owed by PacifiCorp is not reduced, then what are 7 the "savings" from filing a consolidated tax return referred to by Mr. Arndt? 8 A. The savings are a timing benefit only. Consolidated tax adjustments made in the 9 PHI consolidated return are deferred items and do not permanently minimize tax 10 expense. Since deferred taxes will ultimately be paid, the only benefit to the 11 company is the time value of money on the tax payment deferred. Over time a 12 consolidated tax return and a stand-alone return for a company the size of PHI or 13 PacifiCorp will yield the same result once all the deferrals have reversed. 14 Q. Is the stand-alone calculation of PacifiCorp's tax liability contained within 15 the Company's filing consistent with the calculation and regulatory 16 treatment of income taxes in past Utah rate cases? 17 A. Yes. Both before and after the merger with Scottish Power, the Commission 18 calculated PacifiCorp's income taxes on a stand-alone basis. Principles for 19 regulatory recovery of tax expense recognize that the Company would benefit 20 from reduced current tax cash requirements to the extent of deferred taxes, absent 21 an adjustment. Removal of this potential benefit to a company for deferred taxes 22 is accomplished by requiring a reduction to rate base for the accumulated deferred 23 tax liability. Page 9 – Rebuttal Testimony of Larry O. Martin 1 Q. Intervenors point out that in the merger order the Commission expressly 2 reserved the consolidated tax issue for consideration in a future rate case. 3 How do you understand this stipulated reservation? 4 A. It is true that a number of the parties, including the Company, stipulated in the 5 merger proceeding that consideration of a proposed adjustment related to potential 6 tax savings should be left to a later rate case. However, in doing so, the Company 7 and other parties specifically reserved all factual as well as legal arguments and 8 objections to such proposals in later cases. One specific objection was that stand- 9 alone tax calculations had previously been used by the Commission and therefore, 10 any party challenging such calculation would have to satisfy their burden of proof 11 to warrant a change from Commission precedent. Leaving open the opportunity 12 to consider the issue does not mean that an adjustment is warranted or 13 appropriate. 14 Q. Has such a showing been made in this case? 15 A. No. For the reasons described in greater detail below, Intervenors have offered no 16 compelling reasons to depart from long-standing Commission precedent of 17 calculating income taxes on a stand-alone basis. Instead, they have proposed 18 adjustments that would create substantial risk to ratepayers and violate other 19 important regulatory principles. 20 Q. Before turning specifically to the proposals of the various Intervenors, do you 21 have any general comments regarding Mr. Arndt's proposed adjustment? 22 A. Yes. At page 17, lines 12-17, Mr. Arndt asserts that PacifiCorp has not provided 23 forecasted consolidated federal income tax information for the test period because Page 10 – Rebuttal Testimony of Larry O. Martin 1 the Company does not do such forecasts. This statement is not correct. In fact, 2 PacifiCorp has provided projected, consolidated federal income tax information in 3 response to UIEC 8.6, a response that was also provided (as updated) to the 4 Committee in response to CCS Data Request 35.2. If the Committee had asked us 5 for this information prior to the filing of their testimony, it would have been 6 provided to them. Mr. Arndt's failure to investigate this issue prior to filing his 7 testimony leads him to conclude that the Commission should adopt his adjustment 8 using 2001-2003 fiscal tax year information. In fact, the Company's response to 9 UIEC 8.6 shows that the future taxes are expected to be different than those on 10 which Mr. Arndt's proposed adjustment is based. 11 Q. The proposals of Mr. Arndt and Mr. Binz seem to be based on a similar 12 premise although the calculations and the rationales are somewhat distinct. 13 Each argues that consolidated tax benefits are the result of the existence of 14 both loss and gain companies and that gain companies should therefore 15 receive their respective share of any tax benefit. Do you agree that this is a 16 reasonable approach? 17 A. No. Such an approach would violate the states commission's merger order 18 requirements to keep regulated and non-regulated activities functionally 19 separated. 20 Q. Why is it important to separate PacifiCorp from its non-regulated affiliates? 21 A. The state utility commissions that regulate PacifiCorp have gone to great lengths 22 to ensure adequate separation between PacifiCorp and its non-regulated affiliates 23 in order to protect ratepayers. For example, during the merger, the Idaho, Page 11 – Rebuttal Testimony of Larry O. Martin 1 Washington and Wyoming commissions specifically ordered the Company to 2 separate out non-utility businesses from PacifiCorp and to put into place ―ring 3 fence‖ provisions for the diversified activities. (Idaho Merger Stipulation at ¶ 33, 4 Wyoming Merger Stipulation at ¶ 20; Washington Merger Stipulation at ¶ 27.) In 5 addition, in approving the merger, this Commission placed particular emphasis on 6 merger stipulation provisions designed to keep PacifiCorp separate from other 7 Scottish Power nonregulated activities. 8 PacifiCorp has taken steps, encouraged and approved by its commissions, 9 to maintain separation of its utility operations for the benefit of ratepayers. In 10 2001, PacifiCorp sought approval from FERC and other state utility commission 11 for which it was required to do so to insert PHI into the holding company 12 structure and move PPM and other non-regulated companies to a position of being 13 affiliates of PacifiCorp rather than a subsidiary. The FERC and the commissions 14 approved the reorganization. 15 Even prior to the merger, the Company had also consistently made an 16 interest synchronization adjustment in its general rate case filings to remove the 17 portion of actual interest paid to fund rate base not allowed into rates. 18 Q. Is this careful separation between the utility and its non-regulated affiliates 19 consistent with Intervenors' proposed adjustments? 20 A. No. The Intervenors' adjustments disregard the functional separation between 21 these separate companies that this Commission and others have carefully 22 maintained and would expose ratepayers to greater risks and more volatile rates. 23 Ignoring the separate business functions, risks, expenses and revenues, Page 12 – Rebuttal Testimony of Larry O. Martin 1 Intervenors simply reach out to capture the benefit of the losses generated by the 2 non-regulated entities. Moreover, the proposed adjustments disregard other well- 3 known cost-causation principles that this Commission has embraced. 4 Q. Please explain what you mean by regulatory cost-causation principles. 5 A. Long-standing regulatory principles establish that a Company's rates are ―just and 6 reasonable‖ when they are cost-justified. In determining whether rates are cost- 7 justified, a commission looks for a causal link between the service the company 8 provides ratepayers and the expenses the company incurs to provide that service. 9 The Intervenors' proposed adjustments totally disregard this regulatory principle 10 by seeking to assign to ratepayers the tax benefits of losses generated by affiliated 11 companies when the shareholders or affiliates, not the ratepayers, have paid the 12 expenses associated with generating those losses. 13 Q. Could the Commission adopt the Intervenors' proposals without violating 14 the cost-causation principle? 15 A. No. As currently proposed, the Intervenors' adjustments inequitably take all or 16 most of the benefit of the tax losses and none of the corresponding burdens or 17 business risk. In other words, if the Intervenors' adjustments were adopted, the 18 shareholders or affiliates would absorb all of the costs, and the ratepayers would 19 receive the related tax benefits. However, if the Commission permitted the 20 Company to include the expenses of the non-regulated companies associated with 21 generating the losses and the amount of the losses in the Company's revenue 22 requirement, than it might be equitable and consistent to share the tax benefits 23 associated with the losses with ratepayers. Page 13 – Rebuttal Testimony of Larry O. Martin 1 Q. Are you advocating such a result? 2 A. No. The Company believes that the Commission's current policy to carefully 3 separate regulated and non-regulated operations and expenses is fair and 4 consistent with regulatory principles and regulation and best protects ratepayers. 5 If the Commission were to include non-regulated costs and tax benefits in setting 6 utility rates, it would presumably have a duty to examine the reasonableness of 7 the parent corporation's decisions that have an effect on the tax position of the 8 non-utility affiliates. This would greatly expand the oversight of the Commission, 9 while it nevertheless lacks jurisdiction over regulating the affiliates' operations. 10 This could lead to volatile utility rates that would rise or fall inversely with 11 affiliate earnings. While the Intervenors' methods find a benefit in the current 12 years, when loss companies begin to generate a profit, these methods would begin 13 raising the rates of ratepayers. I will discuss these increased risks in greater detail 14 later in my testimony. 15 Q. Mr. Brubaker asserts that the basis for his adjustment is the financing 16 structure used in the Scottish Power/PacifiCorp merger. His adjustment 17 would take the tax benefits associated with the deductions of just one affiliate 18 (PHI) to reduce the PacifiCorp tax calculation for regulatory purposes. Does 19 this limitation change any of the previous testimony? 20 A. No. This proposal equally violates cost causation principles and runs afoul of the 21 requirements of separation from the merger order. Just as in the case of the other 22 affiliates in the corporate group, the tax losses at PHI were created by expenses 23 (interest paid on the loan associated with the acquisition adjustment) never borne Page 14 – Rebuttal Testimony of Larry O. Martin 1 by ratepayers, indeed, the losses are created by expenses this Commission has 2 insisted will never be borne by ratepayers. 3 Q. Can the Commission adopt Mr. Brubaker's proposal without violating or 4 compromising the stand-alone tax computation? 5 A. No, by virtue of his adjustments, his proposed computation is no longer a stand- 6 alone computation. Although Mr. Brubaker makes a novel assertion that stand- 7 alone computations can be preserved while simultaneously adjusting for the tax 8 benefit of an affiliate's interest expense, this position is without merit. The tax 9 benefit at issue arises from an entity's losses. For purposes of determining these 10 losses, interest expense is no different than any other cash expense incurred in the 11 operations. 12 Q. How did Scottish Power acquire PacifiCorp and when was it completed? 13 A. Scottish Power established a U.S. holding company, NA General Partnership 14 (NAGP) to acquire and hold PacifiCorp shares, which previous to the acquisition 15 were publicly traded. As NAGP's shares were not publicly traded, Scottish 16 Power's publicly-traded shares were used in exchange for PacifiCorp shares in a 17 type ―B‖ reorganization under IRC §368. Scottish Power then transferred this 18 equity stock ownership in PacifiCorp to NAGP in exchange for debt and equity in 19 NAGP totaling $6.6 billion. Upon conclusion of the transaction on November 30, 20 1999, NAGP owned all of the outstanding shares of PacifiCorp. 21 Q. What changes have occurred in the U.S. structure since the acquisition? 22 A. Corporate reorganizations were approved by FERC and state utility commissions 23 in order to meet merger commitments discussed above with the express purpose Page 15 – Rebuttal Testimony of Larry O. Martin 1 of creating better ringfencing between regulated and non-regulated affiliates. 2 After these reorganizations, PHI became the parent company when NAGP was 3 merged into PHI effective December 1, 2003. 4 Q. You mentioned that ratepayers have never and, according to Commission 5 order, should never finance the costs associated with the acquisition 6 adjustment. What do you mean by the acquisition adjustment and how is it 7 related to the deductions at the PHI level? 8 A. As explained in detail in testimony filed by the Company and other parties in the 9 merger proceeding, when Scottish Power merged with PacifiCorp, it bought the 10 equity at PacifiCorp and paid more than net book value for those assets. The 11 amount paid above the net book value of the assets is referred to as an acquisition 12 premium, acquisition adjustment or goodwill. This goodwill is recorded on the 13 financial books and records at PHI, not at PacifiCorp. In the merger order, the 14 Commission ordered that the goodwill could not be included in rate base for 15 ratemaking purposes and that ratepayers should not pay the costs associated with 16 the goodwill. In compliance with that order, PacifiCorp has never attempted to 17 recover any of the goodwill premium from ratepayers. The loan at PHI, which 18 creates the interest deductions that Mr. Brubaker would apply to the calculations 19 of PacifiCorp's taxes for ratemaking purposes, was used to acquire the goodwill 20 associated with the merger which is on the books of PHI. Mr. Brubaker's one- 21 sided adjustment takes the tax benefits associated with the interest deductions for 22 the loan that services the goodwill asset but would not take the costs which create 23 the tax benefits, e.g. the goodwill. This adjustment blatantly violates regulatory Page 16 – Rebuttal Testimony of Larry O. Martin 1 cost-causation principles. For consistency, Mr. Brubaker should also propose that 2 goodwill be included in the rate base at PacifiCorp to make the adjustment 3 evenhanded. However, such a proposal would be directly counter to the merger 4 order. 5 Q. But isn't the tax benefit associated with the loan at PHI permanent as 6 Intervenors appear to assert and therefore different from the adjustment 7 proposed by Mr. Arndt and Mr. Binz? 8 A. That is absolutely false. As I discussed above, the interest deductions at PHI 9 create a NOL, which as cited above from FAS 109, is a deferred tax item. Not 10 surprisingly, Intervenors' proposed adjustments make no provision for 11 compensating PHI (or any other non-regulated loss company) for the loss of this 12 future benefit. If the adjustment by Mr. Arndt and Mr. Binz is adopted, 13 PacifiCorp's current taxes would be artificially reduced, but its deferred taxes 14 would be increased by an equal amount. Later, the current cash flow benefit will 15 become an increased tax payment when the NOL reverses. Also not surprisingly, 16 Intervenors' proposed adjustments make no provision for this future increased 17 expense. 18 Q. You assert that the Intervenors' proposed adjustments run counter to the 19 provisions of the merger order. Mr. Arndt claims the opposite is true; that in 20 fact calculating taxes on a stand-alone basis violates the merger order by 21 causing PacifiCorp ratepayers to indirectly subsidize non-regulated 22 operations and/or pay for the acquisition premium. Is his analysis sound? 23 A. No, and in fact, Mr. Arndt's calculation results in non-regulated operations Page 17 – Rebuttal Testimony of Larry O. Martin 1 subsidizing the regulated operations – a property taking. Simply put, tax expense 2 is the result of a math equation. Tax expense or benefit is always a percentage of 3 some other operational income or expense item. For a dollar of revenue, 35 cents 4 of tax is incurred. For a dollar of eligible expense, 35 cents of tax benefit is 5 earned. The tax cannot be separated from its underlying source or cause. In this 6 case, there is no tax benefit without incurring the expense related thereto. 7 Calculating taxes on a stand-alone basis ensures that the tax expense or benefit 8 remains with the entity which earned the revenue or incurred the expense. 9 Q. How would Mr. Arndt's proposal result in a property taking? 10 A. As mentioned previously, the tax benefit related to the interest deduction of a non- 11 regulated entity is an asset of that entity. Adopting Mr. Arndt's proposal, or that 12 of the other Intervenors irrespective of the basis for their position, would mean the 13 Company would take the asset of a non-regulated entity without compensation. 14 The asset is permanently assigned to the gain companies because none of the 15 Intervenors has proposed an adjustment in subsequent years for PacifiCorp to 16 ―pay back‖ the tax benefit it used to the loss company when that loss company 17 could use that benefit in later years. That results in a taking. Conversely, if the 18 Intervenors do not really intend that the tax benefit be permanently assigned from 19 year to year, then mechanisms would need to be put into place for gain companies 20 to ―pay back‖ losses to loss companies when they can be used in subsequent 21 years. This would result in volatile customers rates and mismatches between 22 generations of ratepayers. 23 Page 18 – Rebuttal Testimony of Larry O. Martin 1 Q. Are the proposed adjustments a workable solution? 2 A. No. Intervenors are proposing to take a tax benefit without any cost to the 3 Company, leaving the non-regulated entity treated unfairly. Absent compensation 4 to the non-regulated entity, such an action would create a liability to the non- 5 regulated entity when it later has taxable income against which it would otherwise 6 offset its losses. In accounting terms, the proposed adjustment is out of balance 7 (in other words, a credit to the loss entity with no corresponding debit). 8 Q. The SEC recently reviewed this issue. How does that review relate to this 9 case? 10 A. The SEC recently reviewed the same issue as raised in this proceeding. While the 11 regulatory oversight of the SEC is different than that of the state commissions, 12 their analysis offers some useful information to this case. 13 Q. Specifically what was the purpose of the SEC review? 14 A. The purpose of the SEC review was to ensure compliance under the Public 15 Utilities Holding Company Act of 1935 (PUHCA). This Act specifically requires 16 the SEC to investigate and guard against holding companies taking advantage of 17 their subsidiary companies. As part of this review, the SEC Staff reviewed the tax 18 sharing agreement and tax cash flows. The SEC found that the current tax sharing 19 agreement met their requirements and was consistent with this regulatory charge. 20 Q. What is the conclusion of the SEC regarding tax payments to PHI? 21 A. PHI and its U.S. affiliates are making tax payments within the group in the same 22 fashion as done prior to the SEC PUHCA review. The focus of the SEC is on 23 cash tax payments, not the total tax expense. The SEC PUCHA review resulted in Page 19 – Rebuttal Testimony of Larry O. Martin 1 no change to total tax expense. PUHCA rules recognize that a legitimate, non- 2 abusive use of funds at a public utility holding company is payment of interest 3 expense on acquisition indebtedness. Accordingly, the SEC has allowed PHI to 4 retain cash tax payments in order to satisfy PHI's liability for the acquisition of 5 PacifiCorp. Pursuant to SEC rules, the SEC had to have found that the debt had a 6 relationship to the acquisition or the SEC would not have permitted this particular 7 feature of the tax allocation agreement to remain. 8 Q. Mr. Arndt refers to the tax sharing agreement at PacifiCorp as a document 9 designed to "enrich the non-regulated companies at the expense of 10 PacifiCorp's captive ratepayers." Please respond. 11 A. This allegation is completely false. The SEC PUHCA Staff were complying with 12 their mandate to enforce the provisions of PUHCA, and in the case of taxes, this 13 includes Rule 45. Rule 45 provides the conditions, definitions, requirements and 14 reporting required of affiliated companies subject to the provisions of PUHCA, 15 which includes PHI and its affiliates. Rule 45(c) was adopted under Section 12 of 16 PUHCA to regulate tax allocation agreements because they could involve implicit 17 loans, extensions of credit or indemnities1 and because they had been used by 18 holding companies to exploit utility companies through the misallocation of 19 consolidated tax return benefits.2 The SEC reviewed, provided input and 1 Adoption of Amendment to Rule Governing Allocation of Consolidated Income Taxes Among Member Companies of Registered Holding Company Systems, Rule U-45(b)(6), Holding Co. Act Release No. 12776 (January 12, 1955). 2 Allocation of Consolidated Federal Income Tax Liability By Registered Holding Companies and their Subsidiaries, Holding Co. Act Release No. 21767 (October 29, 1980) (―Rule 45(c) Proposing Release‖). Page 20 – Rebuttal Testimony of Larry O. Martin 1 ultimately found that the tax allocation agreement effective April 1, 2004 was 2 consistent with its statutory charge. 3 Q. Are there any risks associated with adopting the Intervenors' proposed 4 adjustments? 5 A. Yes. In the previous proceedings in various jurisdictions, PacifiCorp has sought 6 recovery of audit payments made to the IRS dealing with prior tax years. Parties 7 have argued that because taxes are calculated on a stand-alone basis actual 8 payments to the IRS and later audit payments are irrelevant. Whatever merits 9 there may be to that argument, if the Commission were to adopt any of the 10 Intervenors' proposed tax adjustments, the factual basis for that position would no 11 longer be true. Indeed, if taxes were set for regulatory purposes with specific 12 reference to taxes actually paid to the federal and/or state governments and 13 specific tax deductions of other affiliates, then what actually happens with respect 14 to actual tax payments is entirely relevant to utility ratemaking. In this case, the 15 ultimate benefit, if any, of the various losses of the non-regulated affiliates is not 16 yet known. The Intervenors' adjustments are based only on the filing of the tax 17 return and do not take into the account the subsequent adjustments to the returns 18 (and hence, to the losses) which will occur when the IRS audits the tax years 19 included in his computations. The ultimate liability for these tax years will not be 20 known for several years. If the Commission were to take the benefit of these 21 losses now in setting rates, and the IRS were to later take some or all of the same 22 deduction away, customers should be subject to payments in later years in 23 connection with those IRS audit adjustments. In addition to injecting great Page 21 – Rebuttal Testimony of Larry O. Martin 1 potential volatility into the ratemaking process, these types of later adjustments 2 would create intergenerational mismatches among customers. Moreover, unlike 3 other areas of intervenor testimony, the fact that these tax benefits are far from 4 certain to continue (given the audit is not complete) appears to impose no 5 impediments to seeking to take the benefits. 6 Q. Have other Commissions considered and rejected similar type of 7 consolidated tax adjustments? 8 A. Yes. Mr. Binz proposed the same type of consolidated tax adjustment in the 9 Company's Wyoming general rate case earlier this year. Mr. Arndt's adjustment 10 is similar in the calculation methodology to Mr. Binz's adjustment. The 11 Wyoming Public Service Commission rejected the proposed adjustment. In 12 addition, the Oregon Public Utility Commission was faced with a request for 13 investigation filed by a ratepayer related to upstream tax savings in the 14 PGE/Enron corporate structure. The Commission denied the petition for 15 investigation in Order 03-214, on April 10, 2003. In the Staff Memorandum 16 (incorporated by reference into the Oregon commission's order), Oregon Staff 17 recognized the very same cost causation principles I discussed above: ―If PGE's 18 rates were set in a manner that captured some of Enron's tax losses, PGE's rates 19 would also have needed to reflect the expenses that created those tax savings, and 20 customers would be worse off. Staff's counsel advised that it would be difficult 21 for the OPUC to justify picking and choosing which of Enron's revenues and 22 expenses—including tax savings—to include for purposes of setting Oregon 23 customers' rates. Moreover, such an approach may lead to confiscatory rates.‖ Page 22 – Rebuttal Testimony of Larry O. Martin 1 Incredibly, Intervenors' proposed adjustments in this case ignore this fundamental 2 cost causation premise and seek to take either all or some of the tax benefits and 3 none of the corresponding expenses. 4 Q. Are there other risks associated with the proposed consolidated tax 5 adjustments? 6 A. Yes. There is a greatly increased risk of rate volatility, not just from later 7 potential audit payments but also on a year-to-year basis. As an actual example, 8 in recent years, a loss company in the PHI group had a loss in excess of $21 9 million; the next year, the same company had a loss of only about $2 million. All 10 other things remaining equal, PacifiCorp would have reason to come back to this 11 Commission and file for an increase in rates because the $19 million change to the 12 computation would increase PacifiCorp's tax expense. This is true even though 13 nothing had changed with respect to how services were provided to ratepayers or 14 in the expense of actual services provided to ratepayers. 15 Q. Would the proposed tax adjustments also potentially increase the regulatory 16 burden? 17 A. Yes. Non-regulated entities can make decisions that may or may not be in the 18 best interest of ratepayers that will have a direct impact on the calculation under 19 Intervenors' proposed methodology; yet this Commission has no regulatory 20 oversight over those decisions. Nevertheless, in order to ensure that a reasonable 21 level of loss is shared with PacifiCorp, initially the auditors, and eventually the 22 Commission, would need to review the expenses and associated losses to ensure 23 the accuracy of the actual numbers. For example, if an affiliate had a loan that Page 23 – Rebuttal Testimony of Larry O. Martin 1 generated tax losses, auditors might choose to investigate whether the loan had a 2 reasonable interest expense associated with it. This would greatly expand the 3 auditing and monitoring function of the Commission without any corresponding 4 increase in jurisdiction or oversight to affect those decisions. 5 In addition, tax losses and gains and loss and gain companies would need 6 to be tracked over the historical period used in the adjustment (e.g. here, a 3-year 7 average) in order to set up mechanisms to ―pay back‖ tax benefits associated with 8 losses to loss companies when those amounts could be used in later years. This 9 tracking would need to be done for all companies taking part in the regulated 10 return because PacifiCorp could be a loss company (as it was in FY2002) to 11 which tax payments would be due by other nonregulated companies in subsequent 12 years. 13 Even if a true-up was not made on an annual basis, tracking would still 14 need to take place so that ultimately the tax loss asset could be repaid to the loss 15 company when it becomes necessary. For example, if a non-regulated affiliate 16 had tax losses several years in a row (the benefit of which were assigned to 17 PacifiCorp and/or other gain companies), and that non-regulated affiliate was later 18 sold to a third party, that third party would also generally be buying the tax loss 19 assets of the non-regulated affiliate. At the time of the sale, the gain companies 20 who took the benefit of the losses over time would need to pay back this tax 21 benefit prior to the conclusion of the sale. 22 Q. What conclusions do you draw from the foregoing discussion? 23 A. Stand-alone tax calculations are the best way to mitigate risk and rate volatility Page 24 – Rebuttal Testimony of Larry O. Martin 1 for customers. Moreover, stand-alone tax calculations provide the Commission 2 the best mechanism to insulate ratepayers from audit adjustments, penalties and 3 interest payments from the IRS in later years. For these reasons, the Commission 4 should reject the tax adjustments proposed by Messrs. Arndt, Binz, and Brubaker 5 and Dr. Anderson. 6 Bonus Depreciation 7 Q. In Ms. DeRonne's testimony she proposes that an adjustment be made to the 8 2006 test year accumulated deferred income tax for amounts expended 9 through December 31, 2004 on assets placed in service prior to December 31, 10 2005 to reflect bonus depreciation available under two statutes enacted in 11 2002 and 2003. Please explain bonus depreciation. 12 A. Bonus depreciation was enacted as an incentive for new capital investments. It 13 provides for additional depreciation deductions in the year an asset is placed in 14 service if it meets statutory requirements, generally meaning property with a class 15 life equal to or less than 20 years. As an exception to the normal sunset date of 16 December 31, 2004 for this provision, Congress allowed costs incurred on or 17 before December 31, 2004 to be included in the deduction to the extent the asset 18 was placed in service on or before December 31, 2005. This was done to take 19 into account capital improvements in process during 2004 but which are not 20 completed until 2005. Bonus depreciation is not available for capital expenditures 21 beyond December 31, 2004. 22 Page 25 – Rebuttal Testimony of Larry O. Martin 1 Q. Why wasn't this adjustment included in the original submission for this 2 case? 3 A. The computation of the deduction was complex. Although work had begun at the 4 time of the Company's filing, it had not been completed. 5 Q. Is it appropriate for bonus tax depreciation to be included in the 6 computation of the accumulated deferred income tax liability for the test 7 period? 8 A. Yes. Bonus tax depreciation is another form of accelerated tax depreciation 9 allowable on certain asset additions. The additional depreciation increases the 10 Company's deferred tax liability. 11 Q. Is the bonus depreciation allowance for ratemaking purposes prohibited by 12 Internal Revenue Code (IRC) normalization restrictions? 13 A. No. Normalization under the IRC requires that accelerated tax deductions 14 attributable to life and method differences be allowed in rates no more rapidly 15 than allowed under the tax laws. Additionally, book basis differences are not 16 restricted under IRC normalization rules. As bonus depreciation represents a 17 method difference, the full deduction is allowable for ratemaking purposes, up to 18 the amount determined for tax return purposes. 19 Q. How will the tax effect of bonus depreciation affect rate base in the test 20 period? 21 A. Bonus depreciation increases the deferred tax liability. Accordingly, this 22 deduction will further reduce rate base in the test period. Because the bonus 23 depreciation deduction is entirely related to a method difference, the full impact Page 26 – Rebuttal Testimony of Larry O. Martin 1 of the bonus deduction will reduce rate base. 2 Q. What is the appropriate amount of the bonus depreciation deduction, tax 3 effect, revenue requirement and rate base adjustment for the test period? 4 A. The Company has made an estimate of the amount expended through December 5 31, 2004 for assets that will be placed in service prior to December 31, 2005, 6 thereby qualifying for bonus depreciation. Based upon this estimate, the 7 enhanced depreciation deduction on such asset additions was taken in fiscal year 8 ending March 31, 2005 and in the test period ending March 31, 2006. The 9 Company's total tax expense for the test period remains unaffected (although 10 current and deferred portions may change). The additional bonus depreciation 11 amount is $64.321 million on total Company basis. This figure was provided in 12 the Company's response to Data Request CCS 24.14. 13 Q. Do you have any other comments regarding the proposed adjustment for 14 bonus tax depreciation? 15 A. Yes. To put it simply, the calculation of the amount of bonus tax depreciation 16 that the Company is eligible for is based on two factors (1) the amount of capital 17 dollars actually spent in CY04 and (2) a forecast of the projects that will be 18 completed and placed into service in CY05 on which capital dollars were spent in 19 CY04. Notably, CY04 actual capital spend used to calculate that part of this 20 adjustment includes 9 months of FY05. Likewise, CY05 plant in service 21 projections used in the adjustment includes 9 months of the test year in this case, 22 FY06. The Company's calculation of the proposed adjustment assumes that the 23 amount of plant to be placed into service in CY05 is consistent with the Page 27 – Rebuttal Testimony of Larry O. Martin 1 calculations used in the case for other purposes for the test period (e.g. calculating 2 rate base additions). Accordingly, if the Commission were to adopt the other 3 adjustments proposed by Ms. Deronne and other witnesses to reduce projected 4 plant in service additions to rate base because capital spending is slightly under 5 budget for the first six months of FY05 (or part of CY04), this proposed 6 adjustment will also need to be reduced accordingly. The Committee cannot have 7 it both ways; in other words, they cannot seek the entire tax benefit associated 8 with CY05 plant additions on the one hand, while simultaneously reducing the 9 expense that created the tax benefit over that same period. 10 Production Activity Deduction 11 Q. Both Mr. Thomson (DPU) and Ms. DeRonne (CCS) have identified the newly 12 enacted deduction for production activities as a potential reduction to the 13 Company's federal income tax expense. What is this deduction? 14 A. The recent tax legislation codified the Deduction for Production Activities in IRC 15 §199 (―production activity deduction‖). This provision allows for a deduction 16 against qualified production activities. Qualified production activities include the 17 generation of electricity (but not distribution, transmission, etc.). The deduction 18 for the test period is equal to three percent of the taxable income from generation 19 activities. It is likely that, on a stand-alone basis, the deduction will be available 20 to the Company for its electric generation operations. 21 Q. Why was the deduction not included in the income tax computations filed in 22 this rate case? 23 A. At the time of filing the rate case, the deduction had not yet been enacted. In Page 28 – Rebuttal Testimony of Larry O. Martin 1 addition, because the deduction was added to the Act late in the legislative 2 process, there was little or no information available on how the deduction would 3 be computed. At that time, the deduction was not identifiable. 4 Q. Do you agree that enough information is now known to include the deduction 5 in this case as proposed by Ms. Deronne and Mr. Thomson? 6 A. As stated in the testimony of Mr. Thomson, to date, the IRS has issued very little 7 guidance as to how to interpret and determine the basis for the deduction. That 8 being said, as with other tax matters, corporate tax consultants and professionals 9 are working their way through these issues during this tax season. Subject to the 10 very important caveats discussed below, I believe that the Company's tax 11 department can, exercising its professional judgment with input from qualified 12 consultants, now calculate a reasonable forecast of the amount of the deduction. 13 Like other parts of this case, this forecast requires the company experts to analyze 14 and make calculations based on the information now known, reasonable forecasts 15 of inputs and on their professional experience. 16 Q. Mr. Thomson provided an estimate of the deduction. Ms. Deronne did not 17 provide an estimate but proposed that the Commission order PacifiCorp to 18 do one. What is your calculation of the proposed deduction? 19 A. Based upon regulatory taxable income for the Company's generation activity 20 using the best available information, the forecasted amount of the deduction on a 21 total company basis is $2,493,000 and the tax effect thereof is $872,550. I 22 recommend that the Commission adopt this calculation of the forecasted 23 deduction subject to two caveats. Page 29 – Rebuttal Testimony of Larry O. Martin 1 Q. You mentioned that there are caveats to your recommendation that the 2 Commission adopt the adjustment to include this deduction. What are the 3 caveats? 4 A. First, this deduction should not be allowed to the extent that a ―consolidated tax 5 adjustment‖ of any type as proposed by various Intervenors is allowed in this 6 case. Due to production activity losses outside of PacifiCorp, it is expected that 7 the production activity deduction will be zero on a consolidated tax return basis. 8 In other words, the Company realizes a tax deduction computed on a stand-alone 9 basis that is otherwise unavailable on a consolidated basis. For purposes of this 10 item, the consolidated tax adjustment would work to the detriment of ratepayers. 11 Consistent application of any proposed consolidated tax adjustments, if ultimately 12 adopted, would dictate that this deduction be eliminated. Second, this deduction 13 is based upon revenues requested in this case. Accordingly, computation of the 14 amount of the deduction will need to be revised if the Commission determines 15 taxes should be calculated for regulatory purposes on a stand-alone basis and 16 there are any adjustments to the Company's revenues as filed. 17 Tax Advisory Costs 18 Q. Ms. DeRonne (CCS) proposes an adjustment to reduce tax advisory service 19 costs to the forecasted amount. Do you agree with this adjustment? 20 A. Yes. The Company's tax advisory service costs are forecasted to be $3,040,000 21 in the test period. 22 Page 30 – Rebuttal Testimony of Larry O. Martin 1 Q. Ms. DeRonne further proposes elimination of the full amount of tax advisory 2 service costs if the consolidated tax savings adjustment proposed by Mr. 3 Arndt is not adopted based upon the premise, "If Utah ratepayers do not 4 receive the benefit of the tax advisory services being provided, they should 5 not be included in rates." Do you agree with this proposal? 6 A. Although I agree with the premise, Ms. Deronne's testimony comes to the wrong 7 conclusion. The tax advisory service costs forecasted for the Company are in fact 8 PacifiCorp's portion of the total costs and are not related to consolidated-level tax 9 work. Tax services directly attributable to a non-regulated entity are in fact billed 10 directly to that entity. Services which apply to the entire U.S. group and which 11 cannot be segregated are charged to the respective entities using the three-factor 12 formula. The service costs included in this forecasted amount are, in fact, 13 forecasted for the very kind of compliance related work included in this case for 14 which Ms. Deronne would readily take the associated tax benefits (e.g. bonus 15 depreciation, production activity deduction, etc.). Accordingly, Utah ratepayers 16 are receiving the benefit of these tax advisory services and these costs should be 17 included in rates. 18 Avoided Costs M-1 19 Q. Ms. DeRonne asserts that avoided costs should be eliminated from the case 20 unless the Company provides an explanation and an adequate justification 21 for the item. Should the avoided costs M-1 be eliminated from this case? 22 A. No. Such an elimination would violate normalization because it would return to 23 ratepayers the avoided costs basis adjustment more rapidly than what is permitted Page 31 – Rebuttal Testimony of Larry O. Martin 1 by tax rules. 2 Q. Please explain the avoided costs M-1. 3 A. The 1986 Tax Reform Act adopted an avoided cost interest computation for tax 4 purposes to be used in lieu of the debt AFUDC recorded per books. The tax law 5 codified under IRC §263A capitalizes the financing cost of self-constructed 6 assets, resulting in higher taxable income on the return. The computation 7 determines a ratio based on the Company's interest expense over long-term and 8 interest-bearing liability balances. This rate is then applied to an adjusted annual 9 CWIP amount that reflects self-constructed assets. The CWIP base includes self- 10 constructed assets with a class life of 20 years or more, property with an estimated 11 production period exceeding 2 years and property with an estimated production 12 period exceeding one year with an estimated cost of at least $1,000,000. 13 AFUDC is the book entry of capitalized interest, which is reversed for tax 14 purposes. This reversal decreases taxable income and decreases the tax basis in 15 the property. Avoided cost is the tax entry which increases current taxable 16 income and increases the tax basis in the property. The net of the two different 17 methods of capitalizing interest creates a current book-tax difference to taxable 18 income. The difference in property basis is recovered through tax depreciation. 19 The depreciation on the AFUDC basis difference is not protected by the IRS 20 normalization requirements, but depreciation on the avoided cost basis difference 21 is protected by the IRS normalization requirements. 22 Page 32 – Rebuttal Testimony of Larry O. Martin 1 Should the avoided costs Schedule M addition be included in the Company's filing? 2 A. Yes. The increase projected for the test period is related to the increases in capital 3 additions required to meet demands, as proposed in this case. The avoided costs 4 M-1 are not a new item and the treatment in this filing is the same as past practice. 5 Q. Please summarize your testimony. 6 A. The Commission has historically taken great care to carefully separate PacifiCorp 7 from its non-regulated affiliates in order to protect ratepayers from potential, 8 significant subsequent liabilities, from risk of non-regulated operations losses, and 9 from risk of rate volatility. The Intervenors' proposed adjustments for 10 consolidated tax savings in the various forms ignores this careful separation and 11 imposes great risks onto ratepayers. Moreover, these proposals are inequitable 12 and inconsistent with long-standing regulatory ratemaking principles and practice. 13 The Commission should reject the Intervenors' proposed adjustments for 14 consolidated tax adjustments. The deferred tax liability should be adjusted for 15 bonus depreciation, but the amount may need to be adjusted based upon capital 16 expenditures ultimately allowed in this rate case. The production activity 17 deduction should also be taken in determination of federal income tax expense in 18 this case to the extent that the proposed consolidated tax savings adjustments are 19 not adopted. Tax advisory service costs should be reduced as indicated and 20 should be allowed in this rate case. Consistent with past practice and legal 21 requirements, avoided costs should continue to be accepted as an M-1 adjustment 22 for computing income taxes. 23 Page 33 – Rebuttal Testimony of Larry O. Martin 1 Q. Does this conclude your testimony? 2 A. Yes. Page 34 – Rebuttal Testimony of Larry O. Martin
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