Corporate Tax Rate Change Implications for Utilities
The 117th United States Congress is now set following two runoff elections in Georgia which have given the Democratic party control over 50 seats in the Senate and the tie-breaking vote through Vice President-elect Kamala Harris. With control of both chambers of Congress and the Presidency, Democrats are now poised to pursue more ambitious policy changes, including a proposed increase to the corporate tax rate. Many utilities are already beginning to model and prepare for the possible legislative changes
The Biden Tax Plan and the Current State of Congress
President-elect Joe Biden’s tax plan proposes several important initiatives, including a corporate tax rate increase from 21% to 28% and a 15% corporate minimum book tax. Some more progressive Democrats, including several who ran in the Democratic presidential primaries, have proposed raising the corporate rate all the way back to 35%, although the political ceiling is likely to be closer to 25% than 28%. Moderate Democrat Joe Manchin has expressed reluctance to raise rates above 24% and his vote will be required for Democrats to reach a majority (unless any Republicans cross the aisle, which is unlikely).
Because the Senate Democratic majority is razor-thin, Democrats will most-likely need to turn to the budget reconciliation process that allows certain legislation to pass with 51 votes (rather than the 60-vote filibuster threshold) for a major economic bill that does not have broad bipartisan support. In the past, the budget reconciliation tool has been used by Republicans to pass Tax Cut and Jobs Act (TCJA) and by Democrats to pass portions of the Affordable Care Act (ACA) during Obama’s administration and welfare reform during the Clinton administration. Using the budget reconciliation process means that proposed tax legislation can be expected in the third or fourth quarter of 2021.
Deferred Income Tax
Due to current financial reporting regulations a corporate tax rate cut will create an immediate effect on reported corporate earnings from deferred tax account revaluations. This is in addition to a higher tax bill. The applicable standard pertaining to the reporting of balance sheet deferred taxes is ASC 740 (formerly FAS 109).
Recall that deferred taxes arise when there is a temporary difference between the balance sheet amounts for assets and liabilities as reported in annual reports versus the tax basis amounts for those same assets and liabilities reported for the IRS. Per the Financial Accounting Standards Board (FASB) guidance, deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are to be valued “using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”
Thus, if a law were passed in 2021 stipulating an increased corporate tax rate effective in 2022 and beyond, the remaining 2021 DTA/DTL balance would need to be revalued at that higher rate for purposes of 2021 balance sheet presentation (along with any additional DTA or DTL amounts arising during 2021). The amount by which a DTA/DTL balance is revalued is also the amount by which 2021 earnings would need to be adjusted.
Open Questions on the Impact to Utilities
In theory, a tax increase raises customer costs while leaving earnings unchanged because costs, including income taxes, are passed through to customers. Regulated companies have the opportunity to earn allowed after-tax ROEs.
A higher tax rate may also expedite cash flows. Because utilities use accelerated tax depreciation, cash flows are accelerated by deferring tax liability (MACRS for eligible assets, bonus depreciation when available). All else equal, a tax increase magnifies the above effects and thus can expedite cash flow. Higher tax rates mean more deferrals.
Adjustment to accumulated deferred income taxes (ADIT) will be material. In the aggregate, ADIT approximates 15% of U.S. electric utility balance sheets, and an increased tax rate means that ADIT is increased proportionally. Regulators generally require that excess ADIT (EDIT) be flowed back to customers. Broadly speaking, this is intended by the tax law to occur no faster than the discharge of ADIT. The text of Public law no. 115-97 (Tax Cuts and Jobs Act of 2017) states that “The excess in the reserve for deferred taxes is reduced over the remaining lives of the property as used in its regulated books of account which gave rise to the reserve for deferred taxes.” Utilities must comply with these normalization requirements in order to qualify for accelerated depreciation in tax filings.
With so many moving pieces governing how the corporate tax rate may or may not change, the only thing that is for certain is uncertainty. The treatment of EDIT will be a big question and utilities should prepare themselves for any number of potential scenarios that may come to pass.
To better digest the potential treatment of EDIT, a new corporate tax rate change can be put in the context of the rate change resulting from TCJA, which mandated the use of the average rate assumption method (ARAM) to reverse protected EDIT. EDIT can be considered in 3 distinct pieces: protected EDIT that already exists under TCJA, protected EDIT that originates after TCJA (post-2017), and unprotected EDIT that was not specifically dictated to use ARAM under TCJA.
For protected EDIT from TCJA, it is worth noting that the mandate to use ARAM does not exist in the actual tax code, but instead is dictated in the TCJA act itself (as was the case in the Tax Reform Act of 1986). It follows that if the tax rate were to increase from 21% in a Biden tax act that language would exist in the act itself to tell companies how to handle any deficient deferred taxes.
For EDIT related to TCJA, an increase from 21% would still be subject to ARAM in the TCJA absent any change in law in the new tax proposal. The obvious question is what to do with the revalued EDIT. Would the EDIT generated by the change from 35% to 21% and the deficient deferred tax generated by the increase from 21% be netted together by remeasuring existed excess down? Normalization standards were defined for passing back benefits of EDIT, keeping cash at the utility. Because an increase from 21% is the inverse, it cannot be assumed that EDIT from a rate decrease and deficient deferred taxes resulting from a rate increase will be treated the same way. Public utility commissions (PUCs) may require utilities to separately collect the new deficient deferred tax as a separate line item, which may or may not have any normalization requirements.
EDIT originating after TCJA (post-2017) would still be technically protected, but it is not clear if this means anything in terms of deficient deferred taxes. Tax records 2018 and later would be set up at the current 21% corporate rate and would now need a new regulatory asset to recover the difference between 21% and the new higher rate. It is not clear if this would be considered protected and if the Biden Tax Act would have provisions to specify how these deferred taxes are collected. PUCs will not want to fund these deficient deferred taxes immediately because ratepayers would see a spike in rates all at once. It may be left up to commissions to decide if the deficiency is to be collected over the life of the asset, over a set specific period (e.g. 30 years), or some other collection method.
Finally, unprotected EDIT is the largest unknown of the group. Under TCJA, a hodgepodge of methods were used, as the act left it up to commissions and the utilities themselves to decide how EDIT would be given back. Some companies decided to give back the EDIT immediately, some over ARAM, and others over a period of years. Given what we know about current trends, we can expect an accelerated passback of EDIT due to the strain of COVID. Companies want to reduce rate-shock and be more customer friendly, and one of levers they have to do this is to give back unprotected EDIT more quickly to reduce taxes and cost of service. With a potential rate increase resulting in deficient deferred taxes, it is unclear if the collection period of deficiency will mirror the giveback period of excess. If a utility is giving back excess deferred taxes over a 5 year period, will they also collect deficient deferred taxes over the same 5 years? Will commissions require them to collect over a longer period to reduce the impact to customers? Without a specific ruling in a new tax act, it will be up to commissions and utilities to decide on how they will be collected.
How Lucasys Can Help
With so much uncertainty surrounding the potential tax changes and EDIT treatment, forward-thinking utilities will equip themselves with the tools they need to explore every scenario they are likely to face before they occur. Utilities should be prepared to model tax rate increases and the corresponding impacts on revenues and customer rates. Many utilities will find that strategic opportunities to work with their state commissions to adjust TCJA customer refunds to account for the increased income tax costs, and to schedule out the likely impacts relative to their existing rate mechanisms.
Lucasys has the toolsets to track excess in a simple and configurable way, and the consulting expertise to support your calculations. Change between netting excess and deficient deferred taxes together and tracking them separately with the click of a button. Simulating scenarios for your tax department has never been easier of faster.
Master uncertainty by leveraging industry-leading modeling tools with Lucasys. Whether looking for new software or trying to get the most value out of existing solutions, Lucasys can provide insights into the latest tax issues of the utility industry. To learn more about how Lucasys can help visit https://www.lucasys.com/tax-solutions.