Many Utilities Collect for Taxes They Never Pay

By David Cay Johnston
The New York Times

Wednesday 15 March 2006

Many electric utility companies across the nation are collecting billions of dollars from their customers for corporate income taxes, then keeping the money rather than sending it to the government.

The practice is legal in most states. The companies say it is smart business.

But some representatives of utility customers say that the practice, which involves using losses from other subsidiaries to reduce taxes owed, is not fair. They say that money that utilities are required to collect for federal and state taxes - typically a nickel on each dollar paid for electricity - should go for just that, or not be included in electric bills.

Otherwise, they argue, these legal monopolies make more than they are authorized to, and other taxpayers have to make up the difference in higher taxes or reduced services.

An examination of regulatory filings by The New York Times shows that companies with electric utilities in at least 26 states have pocketed money intended for income taxes, and that utilities can legally do so in 21 more states.

Because they are legal monopolies, utilities must charge rates set by state regulators. These cover all costs - from buying fuel, to building new power plants, to a virtually guaranteed profit and paying the taxes on that profit.

Normally, customer payments for those taxes eventually find their way to federal and state governments. That is usually the case for independent utilities like Consolidated Edison, which serves the New York area, and American Electric Power, which operates in 11 states from Kentucky to Oklahoma.

But in recent years many utilities have expanded into unregulated businesses, like energy trading and aircraft leasing, while others have been acquired by companies that own other businesses. When those other businesses lose money or create artificial losses through tax planning, those losses can be used to offset income earned by the utilities.

As a result, the parent companies owe less in taxes than their electric customers paid. Sometimes these companies owe nothing, or receive large tax refunds. By not remitting the taxes, the parent companies effectively have more money to invest in their operations or pay to shareholders in dividends.

The ability to intercept tax payments is not limited to electric utilities. Natural gas, water and telephone utilities can use the same techniques. The potential tax benefits are much smaller for gas and water utilities, however. And most telephone companies are no longer regulated as monopolies and their rates no longer include income taxes. (The taxes and fees that phone companies add to monthly bills are not corporate income taxes.)

Among the electric utilities whose customer tax payments are not reaching tax coffers is Pepco, serving four states and the District of Columbia. Pepco collected nearly $546 million from customers to cover its income tax bill for the years 2002 through 2004. Yet the parent Pepco Holdings did not pay income taxes during those years; indeed, it received $435 million in tax refunds.

Pepco says the beneficiaries of those refunds were not the company's shareholders, but utility customers. A vice president, Anthony J. Kamerick, said that without the ability to use taxes embedded in monthly electric bills to help finance its unregulated investments, including new power plants, electric customers would pay higher rates.

Customers paid Xcel Energy, a big utility in 10 Midwest and Western states, at least $723 million to cover taxes from 2002 to 2004. But the money did not go to the government; in fact, the company received cash refunds of $351.4 million.

A spokesman, Ed Legge, said the refunds resulted from a failed energy trading business. "Utility customers did not bear the risk of that business, and they should not benefit either," he said.

Also expressing the utilities' view, Paul L. Joskow, an economist at the Massachusetts Institute of Technology, said, "For the customer, the result is the same." If the utility were a stand-alone company and filed its own tax return, he added, the customer would pay the same for power.

But critics argue that when utilities collect taxes the government never receives, customers do lose.

The Minnesota attorney general, Mike Hatch, said, "Essentially, the utility ratepayers pay the tax twice, once through the utility bill and again through the lost revenue to government that means either higher taxes for them or less government services." Mr. Hatch is trying to require that any taxes included in Xcel bills be paid to the government. Xcel opposes this.

The critics say that while many profitable businesses use losses to minimize their tax bills, utilities are unique because their taxes are built into the bills that customers pay.

Critics also say utility companies are enriched beyond the limits set by law if they pocket the tax money. "Utilities are entitled to a just and reasonable return," said Myer Shark, a 93-year-old lawyer who sued unsuccessfully to recover $300 million in taxes paid by Minnesota customers of Xcel. "But when they keep the taxes, they are earning an unjust and unreasonable rate of return."

Enron was a pioneer in turning taxes into profit. Since 1997 the company, now in bankruptcy, has collected nearly $900 million from customers of a utility it acquired, Portland General Electric, to cover income taxes. But none of that money reached the federal government from Enron, and only a quirk in the law forced Portland G.E. to pay about $800,000 in income taxes, of which $20 went to the state of Oregon.

Enron could keep the tax money because it created 881 subsidiaries in the Cayman Islands, Bermuda and other tax havens, tax shelters that on paper generated losses for the parent.

The tax benefits are one reason Wall Street these days likes electric utilities, long seen as unexciting investments. Warren E. Buffett, Henry R. Kravis and David Bonderman are among investors drawn to utilities in recent years in hopes of earning returns through parent companies that can be several times those typically approved by state regulators for the utilities themselves.

For decades utilities have been able to delay paying the government the taxes collected from customers; the delayed taxes are known as phantom taxes. But the more recent issue involves taxes the government will never receive because tax rules have not caught up with changes in the ownership structure of utilities.

Three decades ago, said James T. Selecky, a utility-rate consultant to the Minnesota attorney general, "we had true utility companies with very few or minor other operations," so the taxes eventually flowed to the government. But that is no longer true.

Only a few states have mechanisms to prevent pocketing such money. West Virginia and Oregon require that taxes be paid to the government, although the Oregon law, enacted last year, is under attack by utilities there.

In Pennsylvania, the state Supreme Court ruled in 1985 that "fictitious" expenses, such as taxes government never receives, cannot be included in utility rates.

The prospect that a utility could charge for taxes that the government would never receive became a major issue in Oregon when David Bonderman's Texas Pacific Group tried to buy Portland General Electric in 2004.

Texas Pacific specializes in revamping financially troubled companies like Burger King and the clothier J. Crew. Such companies typically have tax losses, but little or no profit to make use of them. If Texas Pacific had acquired Portland General Electric, whose profits are virtually guaranteed and which had $92 million a year of taxes embedded in the bills customers pay, it could have used the losses from its other companies to offset the utility's profit and keep the money paid by customers ostensibly for taxes.

Texas Pacific persuaded Oregon utility regulators to keep most records of the purchase proceedings secret.

When these documents became public, they showed that Texas Pacific expected annual returns greater than 33 percent, three times the expected rate of return for a utility. That revelation generated public and official criticism. The state Public Utility Commission unanimously rejected the Portland purchase a year ago.

In the wake of the controversy, the Oregon Legislature passed a law requiring that taxes on electric bills be turned over to the government and rates adjusted each year to accurately reflect what customers paid and governments collected.

MidAmerican Electric, an Iowa utility holding company controlled by Mr. Buffett, and PacifiCorp, a Scottish-owned electric utility, have been lobbying in Oregon for repeal of the law.

The National Federation of Independent Business's Oregon chapter, with 12,000 members, favors the law. J. L. Wilson, its executive director, said it helped prevent a practice that "just bumps up electric rates."

One way to make sure customers do not pay for taxes that governments never receive would be to require each utility to file its own tax return. That way, taxes would be paid to the government, not to a parent company.

Another solution has been advanced for three decades by Robert Batinovich, a California businessman who promoted innovative approaches to regulation when he was chairman of the California Public Utilities Commission in the 1970's. Mr. Batinovich, now chairman of Glenborough Realty Trust in San Mateo, Calif., suggested exempting regulated monopolies from the corporate income tax. "It's just a disguised consumption tax, just another way to take from the little guy," he said.

But he said that if governments wanted to raise money from regulated utilities, it would be easier just to add a tax, similar to a sales tax, to monthly bills and require that all that money be turned over.