5 Permanent vs. Temporary Differences

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1 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET NO in rates. It follows that the interest saved because of such tax benefits should also be 2 tied to the underlying expense. Therefore, if the underlying expense and tax benefits are 3 not included in rates, neither should be the interest savings resulting from the tax 4 benefits. 5 Permanent vs. Temporary Differences 6 Q. PLEASE GIVE AN EXAMPLE OF A TEMPORARY BOOK/TAX DIFFERENCE. 7 If the Company purchases a software package for $1,500, and that software will be used 8 for 5 years, it would amortize the cost of that software over a five-year period. Each 9 year, $300 of that cost would be included as an expense on the books of the Company. 10 For tax purposes, though, assume that software is amortizable over three years. Each 11 year, $500 of that cost would be included as an expense on the tax return of the 12 Company. Therefore, each year, the Company would have a book/tax difference 13 between the expense reported on the books and the expense reported on the tax return. 14 However, over the five-year period, $1,500 would be expensed for both book and tax 15 purposes. Therefore, even though the recognition of the expense differs in any one 16 year, it is equal over the life of the asset. Because the difference creates no permanent 17 difference between book and taxable income, it is referred to as a temporary difference. 18 Q. DOES THE FACT THAT THE SOFTWARE CAN BE DEDUCTED FASTER FOR TAX 19 PURPOSES AFFECT THE RATEMAKING IMPACT OF THE EXPENSE? 20 No, it does not. In this case, $300 would be included in determining rates, even though 21 in the test year the Company may have deducted $500 (in years 1-3) or $0 (in years ). The tax expense in the cost of service will be calculated based on that $500. This 23 expense is made up of the current portion (the amount actually calculated on the tax 24 return) and the deferred portion (the amount related to the book/tax difference for that 25 year). 26 Q. WHY IS THIS SO? 27 Calculating income taxes in this manner matches the income tax expense with the 28 deduction reported on the books. It does not benefit or penalize the Company in any 29 single year for temporary differences between the GAAP rules of accounting and the 30 IRC. For ratemaking purposes, it ensures that no matter what year is chosen as a test 31 year, the impact on the customer would be the same. In all cases, the customers get the

2 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET No tax benefit of the expense they fund, no more and no less. This concept is known as 2 normalization of income tax expense. 3 Q. IS THE NORMALIZATION OF INCOME TAXES REQUIRED BY THE COMMISSION? 4 Yes, it is. P.U.C. SUBST. R (b)(1)(D) states that Federal income taxes must be 5 normalized if they are to be considered reasonable and necessary expenses included in 6 the cost of service. 7 Q. DOES THE CTSA VIOLATE THIS NORMALIZATION REQUIREMENT? 8 Yes, it does. The CTSA does not differentiate between permanent and temporary 9 book/tax differences. It only takes into account taxable income reported on the 10 consolidated tax return. By allocating the benefit of current losses of unregulated 11 affiliates to the utility, it effectively treats the temporary differences of those unregulated 12 affiliates as if they were permanent differences, and flows them through to customers. 13 There is no recognition that some of these losses were created by temporary differences 14 which will reverse over time. 15 Interest Synchronization 16 Q. PLEASE EXPLAIN INTEREST SYNCHRONIZATION. 17 As discussed earlier in this testimony, the debt return component embedded in the total 18 return on rate base can be viewed as the recovery of interest expense on the long-term 19 debt necessary to fund the Company. In the tax calculation, the deduction of this 20 interest expense is known as synchronized interest expense. It is so named because it 21 represents the implied interest expense on debt that is recovered, dollar for dollar, with 22 no profit component, from customers as the debt component of total return on rate base. 23 Q. HOW COULD A CTSA DISRUPT THIS INTEREST SYNCHRONIZATION? 24 If the interest credit CTSA calculation is used, it determines the interest purportedly 25 saved by the consolidated group as a result of that filing, due to the offsetting of losses 26 from some members against the income of others. A portion of this interest savings is 27 then allocated to the utility to reduce its recoverable income tax expense. Even though it 28 is used to offset income tax, the adjustment represents interest, as evidenced by the 29 name "the interest credit method." Because this adjustment is a reduction to interest 30 expense with no corresponding reduction to the debt component of return on rate base, 31 it disrupts, or "un-synchronizes" interest expense

3 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET NO Alternative Minimum Tax 2 Q. PLEASE EXPLAIN THE ALTERNATIVE MINIMUM TAX. 3 In the calculation of AMT, taxable income is increased or decreased for certain 4 adjustments, and the resulting Alternative Minimum Taxable Income ("AMTI") is taxed at 5 20%. If this tentative AMT is more than the tax at the statutory rate, the AMT is paid. If 6 it is less, the regular tax is paid. In general, if AMT is paid in one year, the excess of the 7 AMT over the regular tax can be carried forward to reduce the tax in a subsequent year 8 where the regular tax exceeds AMT (subject to a minimum of the AMT liability in that 9 year. The effect of AMT can be threefold. First, it will reduce the current tax benefit 10 realized from marginal losses to 20%, rather than 35% in years where the group pays 11 AMT. Second, it will increase the tax paid as a percentage of taxable income in years 12 where the group pays AMT. Last, in years where the AMT credit is utilized to reduce 13 taxes payable, it will decrease the tax paid as a percentage of taxable income. 14 Q. DOES THE CTSA RECOGNIZE THE EFFECTS OF THE ALTERNATIVE MINIMUM 15 TAX? 16 No, it does not. The CTSA analyzes taxable income per the consolidated tax returns. It 17 does not analyze the actual tax liability on those returns. The CTSA assumes that tax is 18 paid at the statutory rate of 35%. If AMT is paid, the marginal cash tax benefit of 19 offsetting a dollar of continuing losses should be calculated at 20%, rather than 35%. 20 Fair Sharing 21 Q. DOES THE CTSA RESULT IN THE FAIR SHARING OF THE BENEFIT OF FILING 22 CONSOLIDATED TAX RETURNS? 23 No, it does not. PURA (a) requires, in certain circumstances, that a "fair share" 24 of the benefit of filing consolidated tax returns be allocated to the utility. The CTSA 25 allocates all of the benefit to the income companies in the group, and none to the loss 26 companies. As stated above, the income companies have incurred absolutely no 27 additional expense underlying this benefit. All they have done is agree to be included in 28 the consolidated filings. The loss companies, on the other hand, have incurred all the 29 expenses generating the benefit. Yet, under the CTSA, they are allocated none of the 30 benefit resulting therefrom. This is patently unfair. It permanently confiscates 100% of 31 the benefit from the companies that incurred the expenses and took on the risk 32 associated with that benefit, and gives it to the companies that have done nothing

4 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET No Conclusion 2 Q. HAVE YOU INCLUDED A CONSOLIDATED TAX ADJUSTMENT IN THE FEDERAL 3 INCOME TAX SCHEDULES INCLUDED IN THE RATE FILING PACKAGE? 4 No, I have not. For the reasons discussed above, I do not believe that is appropriate to 5 include a CTSA in this proceeding. If a CTSA is deemed appropriate, I believe that the 6 appropriate fair share allocated to TNMP should be zero. 7 Q. HAS THE PUC PREVIOUSLY ORDERED A CONSOLIDATED TAX ADJUSTMENT 8 FOR TNMP? 9 No, it has not. 10 Q. HAVE YOU INCLUDED A CONSOLIDATED TAX ADJUSTMENT CALCULATION AS 11 AN EXHIBIT TO YOUR TESTIMONY? 12 Yes, I have designated Confidential Exhibit MFH-2. This exhibit contains highly 13 sensitive confidential information. It will be made available only upon execution of a 14 confidentiality agreement in accordance with a Protective Order entered in this 15 proceeding. Again, I believe the fair share of the benefit to be allocated to TNMP is 16 zero, and that no adjustment should be made in this case, for the reasons I have 17 described as well as those presented by Mr. Gee and Mr. Warren. That said, in order to 18 more fully present the issue, I have included Confidential Exhibit MFH-2 to illustrate 19 calculation of a CTSA that does address some of the shortcomings of the interest credit 20 model as it has been proposed in recent cases. 21 Q. PLEASE DESCRIBE THE CALCULATION IN YOUR EXHIBIT. 22 I have calculated an adjustment based on the last 15 years of taxable income from the 23 consolidated tax returns, as adjusted by IRS exams and amended returns, of which 24 TNMP was a member. TNMP was included in the TNP Enterprises return through June , when that group terminated as a result of the acquisition by PNM Resources. 26 From June 2005 through 2008 (the last return filed) TNMP has been included in the 27 PNM Resources return. I have reflected the effect of loss carryovers that would apply 28 had the companies filed on a separate company basis. I have done the calculations on 29 an annual, rather than a cumulative basis. I have limited the annual adjustments to the 30 amount of tax shield provided by TNMP in that year. I have indicated which years the 31 relevant group was in AMT or had an effective rate that differed from the statutory rate, 32 and have calculated the actual cash tax benefit of the utilization of losses in those years

5 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET No using the appropriate rate. For all other years, the tax benefit is calculated at the 2 statutory rate in effect for that year. I have reduced the CTSA benefit by 50%, to 3 represent a fairer sharing of that benefit between the income and loss companies within 4 the consolidated group. I have not grossed-up the adjustment, because it represents the 5 time value of money, or interest, rather than Federal income tax. I have included totals 6 for the periods both before and after the acquisition by PNM Resources. I have only 7 included losses that were realized during the period which TNMP was part of the 8 applicable consolidated group. I believe this is a better measure of the benefit that has 9 inured to the present group, although it remains my judgment that none of this benefit 10 was realized by TNMP and therefore TNMP"s fair share is zero. 11 V. SFAS 109 -ACCOUNTING FOR INCOME TAXES 12 Q. PLEASE DISCUSS SFAS Statement of Financial Accounting Standard ("SFAS") 109 is the pronouncement that 14 governs the accounting requirements for income taxes under Generally Accepted 15 Accounting Principles ("GAAP"). It requires the recording of income taxes payable (or 16 receivable) during the current year, as well as deferred taxes payable (or receivable) in 17 future years. The deferred taxes result from differences between a company's book 18 income and taxable income which are temporary in nature, and will reverse over time. 19 Q. IS THE TAX ACCOUNTING OF REGULATED ENTERPRISES SPECIFICALLY 20 ADDRESSED IN SFAS 109? 21 Yes, it is. SFAS 109 states, in paragraph 29, that: A deferred tax liability must be recognized for both temporary tax benefits that have been flowed through to rate-payers, and the equity component of AFUDC A deferred tax asset or liability must be established for any change in tax laws or tax rates If the tax effect of the above items will be recovered or returned to rate-payers through rates, then a regulatory asset or liability is recorded to reflect that future revenue or expense pursuant to paragraphs 9-11 of SFAS 71. This regulatory asset or liability is also a temporary difference for which deferred taxes must be recognized (i.e. it must be grossed-up for tax)

6 DIRECT TESTIMONY OF MATTHEW F. HARLAND PUC DOCKET No Q. WHAT IS THE NET EFFECT OF SFAS 109 ON THE COST OF SERVICE 2 CALCULATION? 3 The recording of the deferred taxes and the regulatory assets and liabilities related to the 4 above paragraph of SFAS 109 have no effect on the revenue requirement of the 5 regulated enterprise, as long both the deferred taxes and the SFAS 109 regulatory 6 assets and liabilities are included in rate base, as the amounts exactly offset each other. 7 Such is the case in this filing, where the SFAS 109 regulatory asset is offset by ADFIT. 8 A. TEXAS FRANCHISE (MARGIN) TAX 9 Q. HOW IS TEXAS FRANCHISE ( MARGIN) TAX CALCULATED ON SCHEDULE II-E-2? 10 The tax included in the test year cost of service is calculated based on the current law. 11 The tax is calculated at a rate of 1% of taxable margin, defined as the lesser of 70% of 12 total revenues or total taxable revenues minus the larger of taxable cost of goods sold or 13 compensation expense. As the cost of service does not include the necessary level of 14 detail to determine taxable cost of goods sold, the 70% of revenues is used as the best 15 estimate of taxable margin. The tax is calculated at 1% of 70% of total revenues 16 (excluding intra-company revenues). The tax calculation is shown on WP111-E VII. CONCLUSION Q. PLEASE SUMMARIZE YOUR CONCLUSIONS. Schedules II-E-3 through II-E-3.26, relating to Federal income taxes, are in compliance with the prescribed Rate Filing Package and are in accordance with the substantive rules of the Commission. All adjustments to ADFIT, regulatory assets, and tax expense are reasonable and appropriate. TNMP's "fair share" of any consolidated tax savings found to exist pursuant to PURA (a) is zero

7 PUC Docket No Exhibit MFH-1 Page 1 of 3 MATTHEW F. HARLAND. CPA EDUCATIONAL AND PROFESSIONAL SUMMARY Employment: PNMR Services Company: Director of Income Tax, 2008-Present Senior Manager, Corporate Tax Projects, PNM Resources, Inc.: Senior Manager, Corporate Tax Projects, Public Service Company of New Mexico: Senior Manager, Corporate Tax Projects, Manager of Tax Planning, Senior Tax Analyst, KPMG Peat Marwick: Income Tax Senior Accountant, Income Tax Staff Accountant, Education: Master of Accountancy: New Mexico State University, Las Cruces, NM, 1986 Bachelor of Arts in Economics: Pomona College, Claremont, CA, 1983 Continuing Professional Education: Tax and Accounting CPE as required by the New Mexico State Board of Public Accountancy, 1989-Present Certification: Affiliations: Certified Public Accountant, New Mexico, 1989-Present American Institute of CPAs, Tax Section, 1994-Present Edison Electric Institute, Tax Committee, 2008-Present Tax Executives Institute, 2008-Present 305

8 PUC Docket No Exhibit MFH-1 Page 2 of 3 Testimony in Regulatory Proceedings: Nature of Proceeding Regulatory Body Docket Number In the Matter of the Application of Public Service Company of New Mexico for Revision of its Retail Electric Rates pursuant to Advice Notice No.s 397 and 32 (former TNMP Services). NMPRC UT In the Matter of the Transfer of NMPRC UT Public Service Company of New Mexico's Unamortized Accumulated Deferred Investment Tax Credit of its Gas Utility. (Private Letter Ruling) In the Matter of the Application of NMPRC UT Public Service Company of New Mexico for Revision of its Retail Electric Rates pursuant to Advice Notice No In the Matter of the Applications of NMPRC UT Public Service Company of New Mexico and New Mexico Gas Company, Inc. for the Abandonment, Purchase and Sale of the Gas Utility Assets and Services and for Related Authorizations and Variances. In the Matter of the Application of NMPRC UT Public Service Company of New Mexico for Revision of its Retail Electric Rates pursuant to Advice Notice No In the Matter of the Petition of NMPRC UT Public Service Company of New Mexico for a Revision to its Rates, Rules, and Charges pursuant to Advice Notice No.s 755 and 756. In the Matter of the Petition of NMPRC UT Public Service Company of New 306

9 PUC Docket No Exhibit MFH-1 Page 3 of 3 Mexico for a Revision to its Rates, Rules, and Charges pursuant to Advice Notice No.s 721 and 722. Application of Texas New-Mexico PUCT Power Company for Authority to Change Rates. Application of Texas New-Mexico PUCT Power Company to Adjust Carrying Charges pursuant to P.U.C. Subst. R Application of Texas-New Mexico PUCT Power Company to Establish a Competitive Transition Charge pursuant to P.U.C. Subst. R (n). 307

10 PUC Docket No Exhibit MFH - 2 This document has been designated Confidential and/ or Highly Sensitive to be filed with the Commission under Confidential Cover pursuant to P.U.C. ^ PROC. R (d). 308

11 PUC Docket No AFFIDAVIT STATE OF NEW MEXICO COUNTY OF BERNALILLO BEFORE ME, the undersigned authority, on this day personally appeared Matthew F. Harland, who, upon proving his identity to me and by me being duly sworn, deposes and states the following: "My name is Matthew F. Harland. I am of legal age, a resident of the State of New Mexico, and have never been convicted of a felony. I certify that the foregoing direct testimony and exhibits, offered by me on behalf of Texas-New Mexico Power Company, are true and correct and based upon my personal knowledge and experience." MATTHEW F. HARLAN SWORN TO AND SUBSCRIBED before me, Notary Public, on this day of August, 2010, to certify which witness my hand and seal of office. SEAL: } ^. OFFICIAL SEAL Jo Ann Dicker { t ^" At \ ^ :^,: NOTARY PUBLIC ( STATE OFeNEW xjco 11 My Commiss^ors Expires: ff^pi ^^(f`(^ ^ Printed Name,_)^C> My Commission expires 309

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13 PUC DOCKET NO BEFORE THE PUBLIC UTILITY COMMISSION OF TEXAS APPLICATION OF TEXAS-NEW MEXICO POWER COMPANY FOR AUTHORITY TO CHANGE RATES PREPARED DIRECT TESTIMONY OF JAMES I. WARREN ON BEHALF OF TEXAS-NEW MEXICO POWER COMPANY AUGUST 26,

14 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No TABLE OF CONTENTS 1. INTRODUCTION I II. PURA AND "STAND ALONE" TAX COMPUTATIONS 2 III. THE ECONOMIC EQUITIES OF "STAND ALONE" 7 IV. "STAND ALONE" IS THE STANDARD IN THE BUSINESS 9 MARKETPLACE V. "STAND ALONE" IS THE STANDARD IN THE REGULATORY 12 MARKET PLACE VI. CONCLUSION

15 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No INTRODUCTION 2 Q. PLEASE STATE YOUR NAME AND BUSINESS ADDRESS. 3 A. My name is James I. Warren. My business address is 1700 K Street, N.W., Washington, 4 D.C Q. BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY? 6 A. I am a tax partner in the law firm of Winston & Strawn LLP ("Winston"). 7 Q. PLEASE DESCRIBE YOUR CURRENT RESPONSIBILITIES AT WINSTON. 8 A. I am engaged in the general practice of tax law. I specialize in the taxation of and the 9 tax issues relating to regulated public utilities. Included in this area of specialization is 10 the treatment of taxes in regulation. 11 Q. ON WHOSE BEHALF ARE YOU SUBMITTING THIS TESTIMONY? 12 A. I am submitting this testimony on behalf of Texas-New Mexico Power Company ("TNMP" 13 or the "Company"). 14 Q. PLEASE DESCRIBE YOUR PROFESSIONAL BACKGROUND. 15 A. I joined Winston in September of For the five years prior to that time, I was a 16 partner in the law firm of Thelen Reid Brown Raysman & Steiner LLP and resident in its 17 New York office. Before that, I was affiliated with the international accounting firms of 18 Deloitte & Touche LLP (October September 2003), PricewaterhouseCoopers 19 LLP (January September 2000) and Coopers & Lybrand (March June ) and the law firm Reid & Priest LLP (July December 1997). At each of 21 these professional services firms, I provided tax services primarily to electric, gas, 22 telephone. and water industry clients. My practice has included tax planning for the 23 acquisition' or transfer of business assets, operational tax planning and the 24 representation of clients in tax controversies with the Internal Revenue Service ("IRS") at 25 the audit and appeals levels. I have often been involved in procuring private letter 26 rulings or technical advice from the IRS National Office. On several occasions, I have 27 represented one or more segments of the utility industry before the IRS and/or the 28 Department of Treasury regarding certain tax positions adopted by the federal 29 government. I have testified before several Congressional committees and 1 313

16 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO I subcommittees and at Department of Treasury hearings regarding legislative and 2 administrative tax issues of significance to the utility industry. I am a member of the New 3 York, New Jersey and District of Columbia Bars and also am licensed as a Certified 4 Public Accountant in New York and New Jersey. I am a member of the American Bar 5 Association, Section of Taxation where I am a past chair of the Committee on Regulated 6 Public Utilities. 7 Q. HAVE YOU TESTIFIED IN ANY REGULATORY PROCEEDINGS? 8 A. Yes I have. I have testified regarding tax, tax accounting and regulatory tax matters 9 before a number of regulatory bodies including the Federal Energy Regulatory 10 Commission and the utility commissions in Florida, Arkansas, Louisiana, Nevada, 11 Delaware, West Virginia, New Jersey, the District of Columbia, the City of New Orleans, 12 New York, Connecticut, Ohio, California, Maryland, Pennsylvania, Missouri, Illinois, 13 Kentucky, Vermont and Texas. 14 Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND. 15 A. I earned a B.A. (Political Science) from Stanford University, a law degree (J.D.) from 16 New York University School of Law, a Master of Laws (LL.M.) in Taxation from New York 17 University School of Law and a Master of Science (M.S.) in Accounting from New York 18 University Graduate School of Business Administration. 19 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY? 20 A. The purpose of my testimony is to support the computation of income tax expense 21 contained in the direct testimony of Matthew F. Harland filed on behalf of the Company 22 in this proceeding. Specifically, I will explain why his "stand alone" computation is 23 completely in accord with the requirements of PURA. 24 II. PURA AND "STAND ALONE" TAX COMPUTATIONS 25 Q. GENERALLY, WHAT IS A"STAND ALONE" TAX EXPENSE COMPUTATION? 26 A. A "stand alone" tax computation is a tax computation that is calculated by reference to 27 the items of income and expense that are used to develop a utility's rates. 28 Q. WHY IS A "STAND ALONE" TAX EXPENSE COMPUTATION APPROPRIATE? 2 314

17 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO A. The end result of a rate case is to establish the amounts a utility can charge for the 2 provision of its services. The development of this charge is based on the utility's costs to 3 deliver the regulated service. Unlike most expenses, income tax is not an observable 4 phenomenon. One can observe the compensation a company will pay to its employees 5 based on the number of employees and their salaries - that is, without regard to other 6 items of income and expense. The same is true for the vast preponderance of other 7 costs a utility incurs. Almost uniquely, income taxes must be entirely derived from other 8 items income and expense. In other words, unlike virtually all other expenses, income 9 tax expense cannot be calculated until all other elements of revenue and expense are 10 established. And because the costs used to establish utility rates are those necessary to 11 the provision of the regulated service, then the only way to calculate the quantity of 12 income tax expense that can be attributed to the provision of the regulated service is by 13 calculating it by reference to the revenues and expenses related to the provision of the 14 regulated service - that is, those items included in the establishment of the utility's cost 15 of service. 16 Q. DOES PURA BEAR ON THIS SITUATION? 17 A. It does. PURA provides: 18 The regulatory authority may not consider for ratemaking purposes: 19 (1) an expenditure for legislative advocacy, made directly or indirectly, including 20 legislative advocacy expenses included in trade association dues; 21 (2) a payment made to cover costs of an accident, equipment failure, or negligence 22 at a utility facility owned by a person or governmental entity not selling power in this 23 state, other than a payment made under an insurance or risk-sharing arrangement 24 executed before the date of loss; 25 (3) an expenditure for costs of processing a refund or credit under Section ; or 26 (4) any other expenditure, including an executive salary, advertising expense, legal 27 expense, or civil penalty or fine, the regulatory authority finds to be unreasonable, 28 unnecessary, or not in the public interest. 29 The Supreme Court of Texas long ago concluded that the prohibited "consideration" of 30 the costs referenced in the above provision extends to consideration of the tax 31 consequences of those costs. In GTE-Southwest, Inc.,' the Court held that PURA ' 901 SW2d 401 (1995)

18 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO prohibits the Commission from reflecting the tax benefits attributable to 2 disallowed costs in the setting of rates. In effect, the Court supported the "stand alone" 3 calculation of tax expense. 4 Q. SO IS IT YOUR CONTENTION THAT MR. HARLAND'S TAX EXPENSE 5 COMPUTATION IS CONSISTENT WITH PURA AND THE SUPREME 6 COURT'S DECISION IN GTE-SOUTHWEST? 7 A. Yes it is. 8 Q. IS TNMP PART OF A GROUP OF CORPORATIONS THAT FILES A CONSOLIDATED 9 FEDERAL INCOME TAX REUTRN? 10 A. Yes it is. TNMP files as part of the PNM Resources Inc. ("PNMR") and Subsidiaries 11 consolidated tax group. The Company has filed as part of a consolidated group for 12 many years. For most of the past 15 years, it filed as part of a group the common parent 13 of which was TNP Enterprises. Since the acquisition of TNP Enterprises by PNMR in 14 June of 2005, the Company has filed as part of the PNMR consolidated group. 15 Q. IS FILING AS PART OF A CONSOLIDATED TAX GROUP AN UNUSUAL 16 SITUATION? 17 A. No. In fact, based on my more than 30 years experience in taxes, I would say it is the 18 norm for businesses of any substantial size. In fact, know of no company whose stock is 19 publicly traded that does not file as part of a consolidated group. This encompasses 20 groups that include utilities as well as those that do not include utilities. In short, 21 consolidated filing is not confined to utilities and it is the usual tax filing posture of large 22 business enterprises. 23 Q. WHY DO AFFILIATED GROUPS OF CORPORATIONS FILE CONSOLIDATED TAX 24 RETURNS? A. The major reason is that it allows a business enterprise owned by a single owner to structure itself for legal and business purposes without having to take into account federal tax implications. For example, if it is important to insulate one specific operation from another (for instance, for legal liability or regulatory reasons), the two operations can be conducted in separate corporations filing a consolidated tax return with virtually the same federal tax consequences as if it they were divisions of the same corporation

19 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO However, were they divisions, they would not have achieved their legal and regulatory 2 goals. The consolidated return mechanism allows structural flexibility without imposing a 3 tax cost. 4 Q. WHAT ARE SOME OF THE TAX CONSEQUENCES OF FILING AS A MEMBER OF A 5 CONSOLIDATED GROUP? 6 A. Just as would be the case were the separate corporations to be divisions of a single 7 corporation, sales from one member to another member do not produce immediately 8 taxable gains or losses. Tax losses of one member can offset taxable income of another 9 member. Capital losses of one member (which can only be deducted against capital 10 gains) can offset capital gains of another member. There are numerous other 11 consequences, but these illustrate the point. 12 Q. WHAT DOES PURA STATE WITH REGARD TO UTILITIES INCLUDED IN GROUPS 13 THAT FILE CONSOLIDATED TAX RETURNS? 14 A. PURA has been interpreted to require that the tax expense of a utility that is a 15 member of a consolidated income tax group reflect its "fair share" of the savings 16 produced by consolidated filing. 17 Q. WHAT DO WE KNOW ABOUT HOW ONE IDENTIFIES THE EXISTENCE OF A 18 CONSOLIDATED TAX SAVINGS AND HOW ONE MEASURES THE "FAIR SHARE" 19 MENTIONED IN THE STATUTE? A. For the past dozen or so years, this Commission has ascertained the existence of a consolidated tax savings, quantified it and apportioned it using the "interest credit" method. Generally speaking, this method defines a tax savings by comparing the tax posture each consolidated group member is in as of the inquiry date to the posture it would have been in had it always filed separate tax returns. If there is a savings, it is attributable to the ability of the member to use its tax losses against the taxable income of other group members in excess of its ability to use its tax losses against only its own taxable income. This savings is viewed as a time value benefit - that is, filing on a consolidated basis is presumed to have accelerated the ability of a "better off' group member to use its tax losses than it would have had it filed separately. The value of the acceleration is measured by applying the utility's long term debt rate to the accelerated 5 317

20 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO tax benefit. This value is then allocated to all of the group members who were not better 2 off for having filed on a consolidated basis. 3 Q. DOES THIS MEAN THAT THE VALUE OF THE SAVINGS ENJOYED BY THE 4 "BETTER OFF" COMPANIES IS TRANSFERRED FROM THEM TO THE "NON- 5 BETTER OFF" COMPANIES? 6 A. Effectively that is precisely what occurs under the interest credit method. 7 Q. IS THE INTEREST CREDIT METHODOLOGY THE ONLY METHOD OF IDENTIFYING 8 A CONSOLIDATED TAX SAVINGS AND MEASURING A "FAIR SHARE?" 9 A. Clearly it is not. In its GTE-Southwest decision which I referenced previously, the 10 Supreme Court concluded that the Commission was not compelled to include the tax 11 losses of non-regulated affiliates when determining a utility's "fair share" of consolidated 12 tax savings. 13 Q. DO YOU INTERPRET THIS DECISION TO MEAN THAT MR. HARLAND'S "STAND 14 ALONE" TAX EXPENSE CALCULATION NOT ONLY COMPLIES WITH PURA BUT WITH AS WELL? 16 A. I do. In fact, I would go further than that. I would assert that Mr. Harland's tax expense 17 calculation is in greater harmony with both those provisions than is the use of the 18 interest credit method. 19 Q. HOW IS MR. HARLAND'S CALCULATION MORE HARMONIOUS WITH PURA THAN IS THE INTEREST CREDIT METHOD? A. By limiting his calculation of income tax expense exclusively to the consideration of those items of income and expense included in the ratemaking process, his income tax calculation is scrupulously observant of PURA By contrast, the interest credit method adjusts tax expense on account of income and expenses that occur in nonregulated group affiliates. These are clearly completely unrelated to the provision of regulated service. This source of an interest credit adjustment can be confirmed by simply performing a sensitivity analysis. When performing an interest credit calculation, select a loss affiliate and vary its level of expenses. The result of the interest credit calculation will change in lockstep with this variation. Thus, interest credit adjustments clearly constitute "consideration" of those unrelated items

21 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No Q. 2 A. HOW IS MR. HARLAND'S CALCULATION HARMONIOUS WITH PURA ? Mr. Harland's calculation implicitly concludes that the affiliates that produce tax losses 3 are equitably entitled to the cash tax benefit those losses produce when the cash is 4 generated. This conclusion is precisely the same one reached by this Commission in 5 the GTE-Southwest case - that is, not considering affiliate tax losses in the tax expense 6 computation appropriately discharges the "fair share" mandate of PURA Q. WHY WAS THIS COMMISSION CORRECT IN ITS TREATMENT OF AFFILIATE TAX 8 LOSSES IN ITS GTE-SOUTHWEST ORDER? 9 A. The conclusion that an affiliate that produces a tax loss which is used on a consolidated 10 tax return to reduce the group's tax liability is appropriately assigned the benefit of that 11 tax loss when it produces the benefit is compelling. Its logic is overwhelmingly 12 supported by the underlying economic equities. Further, the predominant practices of 13 businesses in this country and the prevailing practice of regulators outside of Texas 14 attests to its widespread recognition. 15 III. THE ECONOMIC EQUITIES OF "STAND ALONE" 16 Q. YOU MENTION UNDERLYING ECONOMIC EQUITIES ABOVE. TO WHAT 17 UNDERLYING EQUITIES ARE YOU REFERRING? 18 A. I am referring to the fact that the imposition of a consolidated tax savings adjustment 19 ("CTSA") such as that derived from the interest credit method is premised on non- 20 substantive distinctions that should not support differences in regulatory outcomes. 21 Q. CAN A CTSA BE IMPOSED UPON A UTILITY THAT OPERATES AS A 22 PARTNERSHIP? 23 A. No it cannot. In Docket No this Commission properly determined that a utility 24 that operates in a partnership form is not subject to the provisions of PURA This must be so because a partnership - and, hence, such a utility - cannot, under the 26 tax law, be a member of a consolidated tax group. Since a CTSA is only relevant to 27 members of a consolidated tax group, the basic concept of a CTSA cannot be applicable 28 to a partnership. 29 Q. IS THIS A NOVEL PROPOSITION? 7 319

22 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No A. Not really. If all the operations of a consolidated tax group were "collapsed" by 2 liquidating all of the members into the ultimate parent so that all operations, including the 3 provision of utility services, became divisions of a single corporate entity, the same 4 conclusion must be reached. In such a structure, there is no consolidated tax return filed 5 so, again, PURA would be inapplicable and the concept of a CTSA inapposite. 6 Q. DOES OPERATING IN PARTNERSHIP OR DIVISIONAL FORM NECESSARILY 7 ALTER THE ECONOMICS OF A UTILITY'S UNDERLYING BUSINESS? 8 A. No it does not. 9 Q. CAN YOU PROVIDE SIMPLE EXAMPLES OF HOW THIS MAY BE SO? 10 A. Yes I can. Assume that a consolidated group consists of a parent company (P), a 11 wholly-owned utility subsidiary ( U) and a wholly-owned non-regulated subsidiary (NR). 12 Such a structure would look as follows: % 100% 15 NR According to recent Commission precedent, using such a structure, U would be subject to the imposition of a CTSA. However, if U converted to a limited liability company ("LLC") and P transferred 1% of its interest in U to NR, then U would be a partnership for tax purposes. Such a structure would appear as follows: U 99% P 1% NR 100%

23 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO Using such a structure, U would not be subject to the imposition of a CTSA because U 2 would not be a member of the P consolidated group. Alternatively, if the entire group 3 was collapsed either by liquidating U and NR into P or simply by converting U and NR 4 into LLCs (entities which would be completely disregarded for tax purposes), the 5 structure would appear as follows: U P NR 9 For tax purposes, U and NR would be considered divisions of P. There would be no 10 consolidated return because P is the only corporation reporting for tax purposes. Again, 11 using such a structure, U would not be subject to the imposition of a CTSA. 12 Q. DOES IT MAKE ANY ECONOMIC SENSE TO DISTINGUISH BETWEEN THE THREE 13 STRUCTURES DEPICTED ABOVE? 14 A. In my opinion, it does not. In theory, two utilities having precisely identical assets, 15 serving identical customer bases, operating in identical fashions and having identical 16 cost structures could charge very different rates for the provision of exactly the same 17 services. To me such a dichotomy is unjustifiable. 18 IV. "STAND ALONE" IS THE STANDARD IN THE BUSINESS MARKETPLACE 19 Q. YOU MAKE REFERENCE TO THE PREDOMINANT PRACTICES OF BUSINESSES. 20 PLEASE EXPLAIN THIS REFERENCE A. I have been a tax practitioner since that is, for over 30 years. During this period of time, I have seen, reviewed and drafted many tax sharing agreements and policies. Tax sharing agreements and policies are the arrangements by which the members of a consolidated income tax group are charged or credited for their respective income tax obligations. In short, they govern the flow of cash among members of the consolidated group relating to income taxes. It is to the mechanisms employed in these arrangements that I refer

24 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No Q. HAVE ALL OF THESE ARRANGEMENTS BEEN IN THE CONTEXTOF GROUPS 2 CONTAINING ONE OR MORE UTILITY COMPANIES? 3 A. No they have not. Many of the groups to which these arrangements applied contained 4 no utility members. 5 Q. WHAT HAS BEEN THE PREVALENT TAX SHARING REGIME THAT HAS BEEN 6 REFLECTED IN THESE ARRANGEMENTS? 7 A. In the vast preponderance of these arrangements, a company that produces a tax loss 8 that is used to reduce the tax liability of the consolidated group is paid for the use of that 9 tax loss contemporaneously with its use on the consolidated tax return. In fact, I can not 10 recall a single instance where this was not the case. 11 Q. WHAT IS THE SIGNIFICANCE OF THIS CONTEMPORANEOUS PAYMENT 12 SCHEME? 13 A. It is entirely consistent with Mr. Harland's tax expense calculation. Moreover, it is 14 inconsistent with the structure of an interest credit CTSA. Its prevalence signifies that it 15 is, at the very least, commercially reasonable to pay a loss affiliate for the use of its tax 16 loss when it produces cash and not to impose a time value charge as is imposed by the 17 interest credit CTSA. Contemporaneous payment is, in my experience, the commercial 18 standard. 19 Q. WHAT DO YOU BELIEVE IS THE BASIS FOR THIS PRACTICE? 20 A. I believe that this practice is the commercial norm because the marketplace recognizes 21 that a company that produces a tax loss which results in a reduction of a group tax 22 liability is economically and equitably entitled to be paid for that loss when tax reduction 23 takes place. This contrasts dramatically with the interest credit premise that the loss 24 company should only be paid when it could have used its tax loss had it not filed as part 25 of a consolidated tax return. Where, in a consolidated tax return, a loss company is able 26 to accelerate the use of its tax loss against the income of an affiliate, the issue distills 27 down to, as between the two companies, which one should be assigned the benefit of 28 the acceleration. 29 Q. WHAT JUSTIFICATION DO LOSS COMPANIES HAVE FOR CLAIMING THE 30 BENEFITS OF ACCELERATING USE OF THE TAX LOSSES THEY PRODUCE?

25 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET No A. Tax losses just don't happen. They reflect underlying economic activity. By far the most 2 important element is that each dollar of tax loss represents a dollar expended or a dollar 3 of liability incurred by the tax loss member. In other words, each loss member suffered a 4 substantive change in its economic position to produce the tax loss. By contrast, no 5 member of the consolidated group producing positive taxable income, including the 6 Company, contributed anything whatsoever to the creation of the tax loss. 7 Q. WHAT ABOUT THE RISKS ASSOCIATED WITH THE UNDERTAKINGS THAT 8 PRODUCED THE TAX LOSSES? 9 A. This point is a critical one. Through the regulatory process, customers are insulated 10 from the risks of non-regulated undertakings. The risk of commercial failure in these 11 undertakings is, therefore, exclusively for the account of the shareholders. It is their 12 wealth, not customer wealth, which is at stake. It is inequitable to strip out the tax 13 consequences of taking on those risks and transferring them to the non-risk-takers. 14 Q. ARE THERE ADDITIONAL ELEMENTS OF THE TAX LOSS MEMBERS' CLAIMS TO 15 THE BENEFITS OF THE TAX LOSSES THEY PRODUCE? 16 A. Yes, there are. It would be extremely unusual for a company to produce tax losses that 17 it can not use. Such a company could easily engage in any one of a number of tax 18 planning techniques to eliminate such "tax inefficiency." For example, it could moderate 19 its deductible expenditures. Ways of accomplishing this include leasing depreciable 20 assets instead of owning them, extracting the benefits of accelerated tax depreciation 21 through lower lease payments. Such a company could organize along alternative lines. 22 It could operate as divisions of a larger corporation or as wholly owned limited liability 23 company (the existence of which are ignored for tax purposes). It could co-venture in 24 partnership form and specially allocate deductible items to a co-venturer that could make 25 efficient use of additional tax deductions in exchange for enhanced ownership terms. 26 Q. WHAT DOES THIS SUGGEST REGARDING THE TAX LOSS MEMBERS' 27 ENTITLEMENT? 28 A. This is not to say that any of the PNMR loss affiliates should have avoided their tax 29 losses. However, the fact that it was within the power of many of the tax loss members 30 to recognize the tax benefits (directly or indirectly) in the absence of the Company's or 31 any other member's taxable income is a further indicia of responsibility. This element of

26 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO control over the recognition of tax benefits supports the notion that the benefit of tax 2 losses is properly assigned to the companies that produced the losses. 3 Q. WHAT, THEN, DO YOU CONCLUDE REGARDING THE APPROPRIATE 4 ASSIGNMENT OF THE BENEFITS OF THE ACCELERATION OF A TAX LOSS? 5 A. 6 The group member that produced the tax loss has by far the higher claim to the benefit than does the group member that generated positive taxable income. The former is an 7 active participant in the production of that benefit. The latter is a mere bystander. The 8 loss member effectively paid for the benefit and, as a consequence, should be assigned 9 the any benefit of accelerated loss utilization. This conclusion is generally accepted in 10 the business marketplace and is embedded in the standard structure of the tax sharing 11 agreements and policies I have seen throughout my career. 12 V. "STAND ALONE" IS THE STANDARD IN THE REGULATORY MARKET PLACE 13 Q. IS THE PRACTICE OF IMPOSING CTSAS ONE THAT IS GENERALLY FOLLOWED 14 IN THE REGULATORY COMMUNITY? 15 A. No it is not. Of the 53 regulatory jurisdictions that I know of (the 50 states, FERC, D.C. 16 and the New Orleans City Council), I am aware of only five jurisdictions that have 17 adopted the systematic imposition of CTSAs. Consequently, CTSAs, as a utility 18 ratemaking policy, represent very much the exception rather than the rule in this country. 19 Q. WHAT ARE THE FIVE JURISDICTIONS THAT CURENTLY IMPOSE CTSAS? 20 A. The five are Texas, Pennsylvania, New Jersey, West Virginia and Oregon. 21 Q. DOES THE PRACTICE IN THESE FIVE JURISDICTIONS INDICATE THAT THE 22 REGULATORS IN THOSE STATES HAVE EXERCISED THEIR DISCRETION IN 23 ADOPTING "PRO-CTSA" POLICIES? 24 A Not in all cases. In Oregon, the legislature enacted a complex structure for determining the tax element of cost of service that is completely unique. It bears little resemblance to CTSAs in the other four jurisdictions, involving, as it does, an allocation of tax based on sales, payroll and property. In any case, the important aspect of the Oregon CTSA is that it is imposed by statute and leaves no discretion to the regulators. Similarly, the Pennsylvania regulators have no discretion with regard to the imposition of CTSAs. In 1985, the Supreme Court of Pennsylvania issued a decision mandating the imposition of

27 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO CTSAs by the Pennsylvania regulators.2 Since that decision, i.e., for the past 25 years, 2 Pennsylvania regulators have had no discretion in this matter. 3 Q. WHAT IS THE PREVALENCE OF "PRO-CTSA" POLICIES IN THOSE STATES 4 WHOSE REGULATORS HAVE THE DISCRETION TO IMPOSE OR NOT TO IMPOSE 5 THE ADJUSTMENT? 6 A. Of the 51 jurisdictions in which regulators have discretion to impose or not to impose 7 CTSAs, besides Texas, only two regulatory bodies ( New Jersey and West Virginia) have 8 seen fit to impose them. That represents a strikingly small minority. 9 Q. ARE YOU AWARE OF ANY RECENT REGULATORY ORDERS IN WHICH A 10 COMMISSION NOT PREVIOUSLY IMPOSING A CTSA CONSIDERED CHANGING 11 ITS POLICY IN THAT REGARD? 12 A. 13 Yes. I am aware of six occasions in the last few years in which this has occurred - in Minnesota, New Mexico, Maryland, Kentucky, the District of Columbia and West Virginia. 14 Q. PLEASE DESCRIBE THE RESULTS OF THESE PROCEEDINGS. 15 A In its order in Northern States Power Company, Docket No. E-002/GR (dated September 1, 2006), the Minnesota Commission rejected outright the proposal to implement a CTSA. In New Mexico, the Commission considered which of two methods of tax computation, "Stand Alone" or "Consolidated Tax Methodology," was preferable. In his recommended Decision dated March 6, 2008, the Hearing Examiner concluded: 20 PNM and, especially, Staff have demonstrated that the stand 21 alone method should be continued because it serves the public 22 interest by being consistent with and promoting the accounting and 23 regulatory principles of cost causation, the benefits/burden 24. equation and prevention of cross subsidization The Commission adopted the Hearing Examiner's conclusion in this regard in a final 27 order dated April 25, More recently, in Maryland, the District of Columbia and 2 Barasch V. Pennsylvania Public Utility Commission, 491 A.2d 94 (Sup. Ct. of PA 1985). 3 Public Service Company of New Mexico, Case No UT, Recommended Decision of the Hearing Examiner, March 6, 2008, pg

28 DIRECT TESTIMONY OF JAMES 1. WARREN PUC DOCKET No Kentucky, the commissions explicitly rejected the imposition of CTSAs (Delmarva Power 2 and Light Company, Order No (December 30, 2009); Potomac Electric Power 3 Company, Formal Case No (March 2, 2010), Kentucky Utilities, Case No (June 30, 2010)). The only exception to the uniform rejection of CTSAs occurred 5 several years ago in West Virginia, a state which had historically imported the tax losses 6 of a utility's corporate parent, but only its corporate parent, into rate setting for the utility 7 subsidiary. The West Virginia Commission expanded this historical adjustment into a 8 full-fledged CTSA.4 In supporting its action, that Commission relied on the "actual tax" 9 notion (not coincidentally, the same notion upon which the Pennsylvania Supreme Court 10 premised its CTSA mandate). This idea turns on the proposition that ratepayers should 11 not be asked to pay more tax than their proportionate share of the tax the consolidated 12 group pays; to do otherwise imposes upon them a fictional (i.e., non-actual) tax expense. 13 In effect, the proposition is that the generation of tax losses by non-regulated affiliates 14 somehow decreases the rate at which positive taxable income is taxed. 15 Q. DOES THE PUCT RELY ON THE "ACTUAL TAXES" CONCEPT TO JUSTIFY ITS 16 "PRO-CTSA" POLICY? 17 A. No it does not. In its GTE-Southwest decision, the Supreme Court addressed the 18 "actual taxes" concept at some length. It concluded that, "the 'actual taxes incurred' 19 language...cannot be applied literally when determining the income tax liability in a 20 ratemaking case." Thus, Texas does not accept the basic rationale that underlies the 21 imposition of CTSAs by both the West Virginia Commission as well as the Pennsylvania 22 courts. In fact, this Commission explicitly stated as much in its recent Order on 23 Rehearing in Docket No ( pg. 6) wherein it stated, "The Commission agrees with 24 the Supreme Court that there is no such thing as actual taxes in a ratemaking 25 proceeding." 26 Q. WHAT DO YOU TAKE FROM THE FACT THAT CTSAS ARE ACCEPTED 27 RATEMAKING IN SO FEW JURISDICTIONS? 28 A. There is a message in the fact that only a handful of regulatory jurisdictions employ 29 CTSAs - and that in only three states have regulators affirmatively chosen to do so. 30 While CTSAs may be superficially attractive mechanisms to lower rates, they cannot Monongahela Power Company and The Potomac Edison Company, Case Nos E-42T and E-D (Commission Order dated May 22, 2007)

29 DIRECT TESTIMONY OF JAMES I. WARREN PUC DOCKET NO stand up to a reasoned analysis. Consequently, there are very few "takers" among this 2 country's utility regulators. Moreover, the recent trend among regulators who are invited 3 to impose CTSAs for the first time is to decline the invitation. 4 V1. CONCLUSION 5 Q. WILL YOU SUMMARIZE YOUR TESTIMONY? 6 A. Yes. Mr. Harland's calculation of the tax expense element of cost of service complies 7 with PURA and with all relevant judicial authorities. It properly reflects the level of tax 8 expense attributable to TNMP's provision of regulated services. The imposition of a 9 CTSA would introduce the tax consequences of extraneous operations into the setting of 10 rates and would contravene economic equity, general commercial practices and the 11 sound judgment of most regulators in this country. 12 Q. DOES THIS CONCLUDE YOUR TESTIMONY? 13 A. Yes it does