BEFORE THE NEW MEXICO PUBLIC REGULATION COMMISSION

Transcription

1 BEFORE THE NEW MEXICO PUBLIC REGULATION COMMISSION IN THE MATTER THE APPLICATION ) PUBLIC SERVICE COMPANY NEW ) MEXICO FOR REVISION ITS RETAIL ) ELECTRIC RATES PURSUANT TO ADVICE ) NOTICE NO.S AND (FORMER ) TNMP SERVICES), ) ) PUBLIC SERVICE COMPANY NEW ) MEXICO, ) ) Applicant. ) ) Case No UT REBUTTAL TESTIMONY IN SUPPORT STIPULATION APRIL, 0

2 NMPRC CASE NO UT INDEX TO THE REBUTTAL TESTIMONY IN SUPPORT STIPULATION WITNESS FOR PUBLIC SERVICE COMPANY NEW MEXICO INTRODUCTION AND PURPOSE... NORMALIZATION AND ASC 0... KROGER PROPOSED ADJUSTMENTS... CEUC PROPOSED ADJUSTMENTS... REASONABLENESS ADIT BALANCES... CONCLUSION... AFFIDAVIT PNM Exhibit MFH-R Resume of Matthew F. Harland PNM Exhibit MFH-R PNM s response to Kroger PNM Exhibit MFH-R Treasury Regulation Section.(l)- PNM Exhibit MFH-R IRS Private Letter Ruling 00 PNM Exhibit MFH-R Internal Revenue Code Section PNM Exhibit MFH-R Treasury Regulation Section.- PNM Exhibit MFH-R IRS Notice - PNM Exhibit MFH-R IRS Private Letter Ruling 00 PNM Exhibit MFH-R IRS Private Letter Ruling 00 PNM Exhibit MFH-0R Comparison of Plant in Service and ADIT Balances

3 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT INTRODUCTION AND PURPOSE Q. PLEASE STATE YOUR NAME, BUSINESS ADDRESS, AND PLACE EMPLOYMENT. A. My name is Matthew F. Harland. I am the Director of Income Tax for PNM Resources, Inc. ( PNM Resources ) and its subsidiaries. I am employed by PNMR Services Company, a wholly-owned subsidiary of PNM Resources. My business address is Alvarado Square, Albuquerque, New Mexico. My educational and professional background is summarized in PNM Exhibit MFH-R. 0 Q. DID YOU FILE DIRECT TESTIMONY OR TESTIMONY IN SUPPORT THE STIPULATION IN THIS CASE? A. I filed direct testimony in this case. I did not file direct testimony in support of the stipulation. 0 Q. WHAT ARE YOUR RESPONSIBILITIES IN YOUR PRESENT POSITION? A. I am responsible for managing the PNM Resources income tax department and its functions. This includes the preparation and filing of all income tax returns, all income tax accounting for both internal and external purposes, all tax planning, and managing all Federal and state income tax audits. These services are provided for PNM Resources and

4 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT all its affiliated companies, including the Public Service Company of New Mexico ( PNM ). Q. HAVE YOU PREVIOUSLY TESTIFIED IN UTILITY REGULATORY PROCEEDINGS? A. Yes, I have previously testified before the New Mexico Public Regulation Commission ( NMPRC or the Commission ) and the Public Utility Commission of Texas ( PUCT ). A summary of the cases in which I have testified is included in PNM Exhibit MFH-R. 0 Q. WHAT IS THE PURPOSE YOUR TESTIMONY IN THIS PROCEEDING? A. My rebuttal testimony addresses the following areas: Normalization of income taxes under Internal Revenue Service ( IRS ) rules and ASC 0 Kroger witness Kevin Higgins discussions and proposed modifications to the stipulation related to income taxes, specifically: The effects of bonus tax depreciation, its effects on net operating losses ( NOLs ) and the Domestic Production Activity Deduction ( DPAD ), and

5 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 the related IRS normalization requirements. CEUC witness Jatinder Kumar s proposed modifications to the stipulation related to income taxes, specifically: The removal from rate base of Accumulated Deferred Income Tax ( ADIT ) asset balances related to Contributions In Aid of Construction ( CIAC ) and LXP write-offs, Capitalized Interest, and the Afton writedown, the addition to the ADIT liability for bonus tax depreciation, its effects on NOLs and the DPAD, the IRS normalization requirements for all the above items, the removal from rate base of ADIT asset balances for EIP Prepaid Tax and EIP refunding costs, other CEUC rate base adjustments which require corresponding adjustments to ADIT that are not included by Mr. Kumar, the flow-through, rather than normalization of state income taxes, and the revised tax calculation provided on schedule of CEUC Exhibit JK-.

6 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 0 NORMALIZATION AND ASC 0 Q. WHAT IS THE PURPOSE THIS SECTION YOUR TESTIMONY? A. In this section of my testimony I discuss the normalization of income taxes and how it affects the cost of service. Both Mr. Higgins and Mr. Kumar propose adjustments to the cost of service which affect the normalization of income taxes. Q. PLEASE EXPLAIN THE TERM PERMANENT DIFFERENCES AS IT RELATES TO THE RECORDING INCOME TAXES. A. A permanent difference is a book/tax difference that will never reverse. Because of differences between the book accounting rules and the tax law, the taxability of some income or expense items will never be the same for book and tax purposes. These items affect the total income taxes paid, not just the timing of those payments. An example of a permanent difference is the DPAD. This is a tax deduction that was created purely by the tax code, as an incentive for domestic manufacturing. For book purposes, there is no such deduction. For tax purposes, deduction permanently reduces taxable income, and correspondingly, cash taxes due. Therefore, tax expense must be decreased by the tax savings resulting from the deduction, because this expense permanently reduces taxes payable to the IRS. The difference between the deduction for tax purposes and the lack of deduction for book purposes is absolute and permanent, not merely related the timing of the deduction that would reverse over time.

7 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. WHY ARE PERMANENT DIFFERENCES RECORDED AND ACCOUNTED FOR DIFFERENTLY FROM TEMPORARY DIFFERENCES? A. Because permanent differences never reverse over time, they affect the total tax paid over time, not just the timing of the payments. Therefore, book income tax expense must be adjusted for the change in tax expense related to these permanent differences. The accounting treatment for permanent differences is the same whether the flow-through method is used or whether taxes are fully normalized. Temporary differences, on the other hand, are book/tax differences that reverse over time. Therefore, they affect only the timing of tax payments, and not the total income tax payable over time. 0 0 Q. PLEASE EXPLAIN THE TERM TEMPORARY DIFFERENCES AS IT IS USED ABOVE. A. A temporary difference is a difference between book income and taxable income that arises in one tax year and reverses in later years. A temporary difference results in no change in total tax expense payable over the life of the underlying item. A temporary difference only affects the timing of the payment of such tax liability. The use of accelerated depreciation for tax purposes is an example of an accounting practice that gives rise to a temporary difference between book income and taxable income. Although depreciation on a given asset can only equal the asset s cost and can only be taken over the life of the asset, the timing of the depreciation deduction will differ when different depreciation methods are allowed for book and tax purposes. Assume accelerated

8 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT depreciation is used for tax purposes but a straight-line method is used for calculating book income. In this case, taxable income will be less than book income in the early years of the life of the asset, because the depreciation deduction for tax purposes is accelerated, or front-end loaded. Correspondingly, taxable income will be greater than book income in later years, when the straight-line book method results in a higher depreciation deduction than that used for tax purposes. Over the life of the asset, the cumulative amounts deducted for depreciation will be the same for book and tax purposes, and the total income tax expense will be the same for both. 0 Q. WHAT TWO METHODS MAY BE USED IN ACCOUNTING FOR TEMPORARY DIFFERENCES? A. Historically, two methods have been utilized by regulated utilities to account for the tax effect of temporary book/tax differences the flow-through method, which is theoretically flawed and prohibited by the IRS, and the preferred and theoretically correct normalization method. 0 Q. PLEASE DESCRIBE THE SHORTCOMINGS THE FLOW-THROUGH METHOD. A. The flow-through method simply adjusts the total tax expense in any given year by the cash tax-savings or costs resulting from the temporary differences, both originating and

9 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 reversing, in that year. In other words, taxable income for book and tax both reflect the current taxable income as reported on the tax return. Because temporary differences affect only the timing of tax payments, and not the total amount of the income tax liability, in any one period the flow-through method results in a mismatching of book income and expense items and the tax expense resulting therefrom. This is because certain pre-tax items are recognized for book but their tax effect is not, and vice versa. The inclusion in the cost of service of tax expense based on current taxable income rather than on book income results in a mismatch of tax expense and recoverable expenses for ratemaking purposes as well. If the temporary differences result in a net reduction in current taxable income and, correspondingly, the tax expense included in the determination of rates, current ratepayers would benefit unjustly at the expense of future ratepayers. If a net increase in current taxable income results, it would be the current ratepayers that were adversely affected. On a theoretical basis, therefore, the flowthrough method is not the preferred method of calculating income tax expense because it does not correctly match tax expense with the underlying pre-tax income and expense items in any one period. 0 Q. PLEASE DESCRIBE THE BENEFITS THE NORMALIZATION METHOD. A. The normalization method correctly recognizes that temporary book/tax differences do not result in a change in total tax expense, but rather in the timing of the payment of that expense. Therefore, tax expense is calculated based on the income and expense

10 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 calculated on a book basis, not on a tax basis. This methodology correctly matches the tax expense with the underlying income from which it stems. The difference between the normalized tax expense, calculated on a book basis, and the cash taxes payable, calculated on a tax basis, is recorded as ADIT, because it represents tax expense accrued in the current period, but payable in a future period. In other words, ADIT represents the cash tax savings that result from temporary book/tax differences in current and prior periods, which must be paid in future periods. For ratemaking purposes, this temporary cash savings is a cost-free source of capital to the utility. The inclusion of the ADIT liability in the cost of service as a reduction to rate base assures that customers receive the benefit of this cost-free capital. 0 Q. CAN ADIT BE AN ADDITION TO RATE BASE, RATHER THAN A REDUCTION? A. Yes, it can. Certain temporary book/tax differences increase, rather than decrease, taxable income. An example is interest expense that is required to be capitalized and depreciated for tax purposes, but is deducted for book purposes. In this case, the cash tax payable actually exceeds the tax expense recorded for book purposes, but this excess will be returned to the Company over time. In such a case, an ADIT asset, rather than a liability, would be created. The theory and treatment is the same, however, for both ADIT assets and liabilities their inclusion in rate base accounts for the difference between recoverable income tax expense and cash taxes paid.

11 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. IS THERE A REQUIREMENT THAT NORMALIZATION METHOD BE USED IN THE DETERMINATION UTILITY RATES? A. Yes, there is. The Internal Revenue Code ( IRC or the Tax Code ) mandates that, in determining rates using a cost of service methodology, regulated utilities must use the normalization method, not the flow-through method, to calculate the Federal income tax expense related to all utility plant-related temporary differences. Utilities that do not use the required normalization method lose the use of accelerated depreciation for tax purposes. The normalization method correctly recognizes that temporary book/tax 0 differences, by their nature, reverse over time. As a result, they affect only the timing of tax payments, and not the overall tax expense paid to the Internal Revenue Service or other taxing authorities (collectively or singularly, the IRS ). Accordingly, normalization accounting does not adjust the total tax expense in any year for temporary differences, but rather creates separate tax provisions for the amount of tax currently payable and tax amounts that have been deferred to other years as a result of the existence of temporary differences. The only adjustments made to total tax expense are for permanent book/tax differences, as they result in an overall increase or decrease in taxes due. As noted above, the Tax Code mandates that for cost of service purposes, regulated utilities use normalization accounting for temporary tax savings arising from accelerated 0 depreciation and other plant related temporary book/tax differences. Additionally,

12 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT unregulated companies are required by Generally Accepted Accounting Principles ( GAAP ) to normalize all temporary book/tax differences. Q. WHAT IS THE PENALTY FOR VIOLATING THIS NORMALIZATION REQUIREMENT? A. A normalization violation would result in the loss of the ability to use accelerated tax depreciation on all public utility property held by the utility. This would result in a substantial increase in rates, as customers would no longer enjoy the large rate base reduction resulting from depreciation ADIT. 0 Q. WHICH ACCOUNTING METHOD HAS PNM USED TO DETERMINE INCOME TAX EXPENSE IN THE ILLUSTRATIVE COST SERVICE? A. In NMPUC Case No. ( Case No. ), PNM proposed full tax normalization (for state as well as Federal tax purposes) for its electric operations for all new temporary differences. The Commission approved this methodology in that case and it has been consistently used by PNM in every subsequent rate proceeding. PNM used the same full normalization methodology in its original filing in the current case and in the illustrative cost of service. 0

13 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 Q. WHAT IS ASC 0 AND HOW DOES IT IMPACT COST--SERVICE STUDIES? A. ASC 0 addresses the inter-period allocation of income tax expense. Effective January, 0, PNM adopted SFAS, the predecessor to SFAS 0 and, ultimately, ASC 0. GAAP generally, and ASC 0 specifically, requires the normalization of income taxes, and that the deferred income taxes resulting from temporary book/tax differences be accounted for using the liability ( ADIT ) method. Under this method, deferred income tax expense (the tax on temporary book/tax differences that will be paid in the future) is computed using the tax rates expected to be in effect when the deferred taxes reverse. 0 KROGER PROPOSED ADJUSTMENTS Q. PLEASE EXPLAIN BONUS DEPRECIATION. A. Bonus depreciation is an acceleration of depreciation deductions in excess of normal (MACRS) tax depreciation. It was enacted as a temporary provision in the Internal Revenue Code to stimulate the economy and encourage businesses to buy or build property. The bonus depreciation available to the Company when this case was filed was enacted in the Economic Stimulus Act of 00. This Act allowed an immediate deduction of 0% of the cost of eligible property in the year placed in service. It applied to assets placed in service in 00 and 00. Assets placed in service after 00 were to be depreciated using normal MACRS rates. On September, 00, the Small Business

14 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Jobs Act retroactively extended bonus depreciation for 00. On December, 00, the Tax Relief, Unemployment Insurance and Job Creation Act of 00 modified and extended bonus depreciation. Under this Act, for eligible assets placed in service between September, 00 and December, 0, tax depreciation is allowed for 00% of the cost of the asset. For 0, the bonus percentage reverts to 0%. Thereafter, normal MACRS rates are to be used. 0 Q. WHAT IS THE DIRECT EFFECT BONUS DEPRECIATION ON A COST SERVICE CALCULATION? A. Because bonus depreciation provides an additional acceleration of tax depreciation, it has the direct effect of increasing the ADIT liability for depreciation included in rate base, because the deduction is available earlier for tax purposes than for book purposes. The total deduction for depreciation is still the same for book and tax purposes over time, so bonus depreciation is only a temporary book/tax difference and does not reduce total tax expense recoverable in rates. 0 Q. ARE THERE ANY OTHER EFFECTS BONUS DEPRECIATION ON A COST SERVICE CALCULATION? A. Yes, in the case of PNM, there are. First, for capital intensive businesses such as utilities, bonus depreciation can result in such large tax deductions that the company has negative

15 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT taxable income. This situation is referred to as a Net Operating Loss. When this happens, the company cannot realize the cash benefit of all of the deductions, because it cannot reduce its tax payments below zero. The NOL may be carried forward to use against taxable income in future periods. Because the deductions cannot be utilized in the current period, but can be utilized in future periods, the NOL is a temporary book/tax difference for which an ADIT asset must be recorded. The sum of the ADIT liability created by the bonus depreciation and the ADIT asset created by the NOL represents the cash tax benefits actually received by the company. This is illustrated in the simple example below: NOL c/f created NOL c/f utilized Description Year Year Total at end of year Taxable Income Book Income 0,000 0,000 0,000 Bonus Depreciation (,000) - (,000) Taxable Income before NOL (,000) 0,000,000 NOL carry forward (utilized),000 (,000) - Taxable income -,000,000 Tax Payable at 0% Cash Taxes due without Bonus,000,000,000 Cash Taxes paid with Bonus -,000,000 CASH SAVINGS FROM BONUS,000,000,000 ADIT at 0%

16 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT NOL ADIT Asset,000 (,000) - Bonus ADIT Liability (,000) - (,000) Incremental ADIT (,000) (,000) ADIT BALANCE (,000) (,000) (,000) Comments ADIT is equal to the cash tax benefit of offsetting the $0,000 book income. ADIT is equal to the cash tax benefit of offsetting $,000 of book income with the NOL c/f. ADIT balance is equal to the total cash tax benefit of the $,000 bonus depr received over the two years. As can been seen in the example, the ADIT balance (the sum of the Bonus ADIT liability and the NOL ADIT asset) equal the actual cash benefit from the bonus depreciation at any point in time. The second possible effect of bonus depreciation is actually a result of the NOL, if any. The DPAD is a permanent book/tax difference in the calculation of taxable income which reduces tax expense. By statute, the DPAD is limited to current taxable income. 0 Therefore, if the company incurs a NOL because of bonus depreciation, it loses the DPAD deduction. There are no carryover provisions for the DPAD, so if it is lost in any year, it is lost permanently. In any year that the company has no taxable income, either because of a current year NOL, or a carryover of NOL from a previous year, it loses the DPAD. This elimination of the DPAD results in an increase in the recoverable income tax expense from customers because it increases taxable income.

17 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. ON PAGES - HIS TESTIMONY, MR. HIGGINS DISCUSSES PNM S ORIGINAL FILING IN THIS CASE, WHICH USED A DECEMBER, 0 TEST PERIOD. HE STATES THAT THE FILING INCLUDED THE EFFECTS BONUS DEPRECIATION THROUGH DECEMBER, 00, BUT NOT THEREAFTER. IS HIS STATEMENT CORRECT? A. Yes, it is. Because bonus depreciation was not extended for 00 and 0 until well after the original case was filed, the filing did not include bonus depreciation for those periods. The filing reflected the law for bonus depreciation as of the filing date. 0 Q. MR. HIGGINS GOES ON TO STATE THAT AS A RESULT, PNM S INITIAL FILING OVERSTATES THE COMPANY S REVENUE DEFICIENCY BECAUSE THE COMPANY S FILING DID NOT REFLECT THE IMPORTANT TAX BENEFITS CONVEYED BY BONUS DEPRECIATION. IS HIS CONCLUSION CORRECT? A. No, it is not. PNM projected the effects of bonus depreciation for the years 00 and 0 and included them in the response to Kroger s th set of interrogatories, attached as PNM Exhibit MFH-R. This calculation indicates that if all the effects of bonus 0 depreciation were included in the cost of service for the year ended December, 0, the revenue requirement would actually increase by $. million for PNM North and $ thousand for PNM South.

18 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 Q. HOW COULD THE INCLUSION THE TAX BENEFIT FROM BONUS DEPRECIATION RESULT IN A REVENUE REQUIREMENT INCREASE? A. The inclusion of the ADIT liability created by the bonus depreciation alone, decreases rate base and decreases the revenue requirement, as one would expect. However, as discussed above, there are two other effects that must be accounted for in the cost of service. First is the fact that the inclusion of bonus depreciation forces PNM into a NOL position, and the NOL ADIT asset must be included in rate base. The second is that the NOL eliminates the DPAD otherwise includible as a permanent book tax deduction which otherwise would reduce recoverable income tax expense. In PNM s case, for the 0 test year, the sum of these two adjustments increases the revenue requirement, and outweighs the reduction created by the bonus depreciation ADIT. The net effect of these three adjustments results in the approximately $. million net increase to the revenue requirement noted above. Q. DOES MR. HIGGINS ACKNOWLEDGE THE EXISTENCE THE NOL? A. Yes, he does, but he ignores its effects in his suggested modifications to the stipulation. 0 Q. WHAT ARE THE CONSEQUENCES IGNORING THE NOL? A. First, the Company would be unfairly penalized because the ADIT included as a reduction to rate base would overstate the cash benefit actually received from bonus

19 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT depreciation. The inclusion of the bonus depreciation ADIT liability but not the 0 offsetting NOL ADIT asset would essentially treat the Company as if it had realized the entire benefit of the bonus depreciation in the years in which it was earned, when in reality a substantial portion of that benefit is required to be deferred, to be realized by the Company in future years. The reason that ADIT is included in the cost of service as a reduction to rate base is to compensate customers for the cash benefit, or cost-free capital, that the Company has received due to differences in the book and tax treatment of certain expenses. By not including the NOL ADIT, an addition to rate base, this benefit is greatly overstated. Second, excluding the NOL ADIT asset from rate base while including the bonus depreciation ADIT liability would constitute a violation of the IRS normalization rules. 0 Q. PLEASE EXPLAIN WHY THE EXCLUSION THE NOL ADIT WOULD CONSTITUTE A NORMALIZATION VIOLATION. A. Treasury Regulation.(l)-(h)()(iii), included as PNM Exhibit MFH-R specifically addresses this situation. It states: If, however, in respect of any taxable year the use of a method of depreciation other than a subsection (l) method for purposes of determining the taxpayer's reasonable allowance under section (a) results in a net operating loss carryover (as determined under section ) to a year succeeding such taxable year which would not have arisen (or an increase in such carryover which would not have arisen) had the taxpayer determined his reasonable allowance under section (a) using a subsection (l) method, then the amount and time of the deferral of tax

20 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT liability shall be taken into account in such appropriate time and manner as is satisfactory to the district director. IRS Private Letter Ruling ( PLR ) 00, attached as PNM Exhibit MFH-R clarifies that a tax calculation with and without accelerated depreciation is utilized to determine the total ADIT effect required to be normalized. To the extent that accelerated depreciation creates an NOL, the ADIT must be included in rate base. NOL ADIT constitutes a normalization violation. Excluding this 0 Q. WHAT IS THE PENALTY FOR VIOLATING THE IRS NORMALIZATION REQUIREMENTS? A. As discussed above, if a utility incurs a normalization violation, it is no longer eligible to use accelerated depreciation for tax purposes. This would result in a very large increase to rate base, and revenue requirements, because the rate base reduction from ADIT related to such depreciation would be eliminated. 0 Q. DOES MR. HIGGINS ACKNOWLEDGE THE ELIMINATION THE DPAD RESULTING FROM BONUS DEPRECIATION AND THE ASSOCIATED NOL? A. No, he does not. In fact, on page 0 of his testimony, he refers to PNM s response to Kroger -(c) when discussing the effect of the NOL, but nowhere does he acknowledge Although not strictly binding authority on taxpayers other than the one applying for the ruling, Private Letter Rulings issued by the IRS reflect their position on the issues discussed in the ruling.

21 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT PNM s responses to Kroger -(b), -, and -, which specifically discuss both the elimination of the DPAD and its effect on the revenue requirement. 0 Q. WHAT ARE MR. HIGGINS PROPOSED MODIFICATIONS TO THE STIPULATION? A. Mr. Higgins proposes that the stipulation be modified in one of two ways.. The revenue requirement should be adjusted downward to take into account bonus depreciation (but not the NOL or DPAD) at the outset, or. A regulatory liability could be established in which the annual benefits of bonus depreciation for 00-0 accumulate for eventual crediting to customers. Q. WHICH APPROACH DOES MR. HIGGINS PREFER AND WHY? A. He prefers the second approach. He gives two reasons. First is that he believes that the Stipulation covers a multi-year period and does not have a clearly delineated test period. Second, he incorrectly contends that under his second approach it makes sense to calculate annually the revenue requirement reduction associated with the increase in accumulated deferred income tax associated with bonus tax depreciation as this benefit is realized by the Company. 0

22 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 Q. DO YOU AGREE WITH MR. HIGGINS JUSTIFICATIONS? A. No. I strongly disagree. There are two fallacies in the rationale Mr. Higgins offers for his proposal. The first fallacy is that PNM will realize the full revenue requirement reduction as a result of bonus depreciation. PNM has shown that when all effects of bonus depreciation are considered, including the resulting NOL and elimination of DPAD, there is actually a revenue requirement increase in the 0 test year. Just accumulating the revenue requirement decrease resulting from the bonus depreciation ADIT but not taking into account the other effects is one-sided and improper. Second, he states that his methodology reflects the tax benefits as they are received by the Company. This also is incorrect. The Company will not receive the actual cash benefit of the deductions that go into the NOL until that NOL is utilized to reduce taxable income in future periods. PNM does not receive the cost-free capital which is created by the bonus depreciation but deferred by the NOL until the NOL is utilized in future years. By creating a regulatory liability, and having it earn a carrying charge equal to Company s approved rate of return, Mr. Higgins is treating these benefits as if they were actually realized in the year they arise (even though they cannot be fully utilized), rather than in the later year when they are actually utilized to reduce taxable income. 0 Q. WOULD IMPLEMENTATION MR. HIGGINS SECOND PROPOSAL OVERSTATE THE BENEFIT FROM BONUS DEPRECIATION? 0

23 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT A. Yes, it would. The standard normalization ratemaking treatment of ADIT (both assets and liabilities) in the cost of service model already correctly accounts for the benefits received by the Company as a result of temporary book/tax differences. By including all the effects of book/tax differences, it correctly calculates both the benefit received and the timing of that benefit. To add to this mechanism an additional regulatory liability would in effect pass these benefits back to customers a second time. This is unfair to the Company because it greatly overstates the benefits received. 0 Q. DOES MR. HIGGINS FIRST PROPOSAL, TO REDUCE THE STIPULATED REVENUE REQUIREMENT FOR BONUS DEPRECIATION, CONSTITUTE A NORMALIZATION VIOLATION? A. Yes, it does. As discussed above, because the proposal does not include the effect of the NOL ADIT asset in the calculation, it returns the benefit stemming from utility plant temporary book/tax differences to customers before such benefit is actually realized by PNM. This is a normalization violation. 0 Q. DOES MR. HIGGINS SECOND PROPOSAL, TO CREATE A REGULATORY LIABILITY, CONSTITUTE A NORMALIZATION VIOLATION? A. Yes, it does, for these reasons. First, as is the case with his first proposal, the second proposal does not include the effect of the NOL ADIT asset in the calculation of the

24 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT incremental revenue requirement, which constitutes a normalization violation. Second, this proposal violates the consistency requirement in the normalization requirements of Internal Revenue Code ( IRC ) Section (i)()(b), attached as PNM Exhibit MFH-R. 0 Q. PLEASE EXPLAIN THE NORMALIZATION CONSISTENCY REQUIREMENT. A. The consistency requirement provides that ADIT related to public utility property must be calculated based on the same period as that on which other rate base items and expenses related to the property are calculated. In other words, if you calculate ADIT as of //0, then you must calculate plant in service as of the same date, and recoverable depreciation as of that date also, as well as recoverable income tax expense. It is clearly a violation of this rule to calculate an ADIT benefit for 00, 0, 0, and 0 and return these benefits to customers without also recalculating and including the revenue requirement effect of 00, 0, 0, and 0 plant in service, recoverable depreciation expense, and recoverable income tax expense. Q. DOES THE FACT THAT MR. HIGGINS PROPOSES TO PASS THESE BENEFITS THROUGH TO CUSTOMERS, INDIRECTLY AS A REGULATORY LIABILITY, RATHER THAN AS ADIT OR TAX EXPENSE, REMOVE THE NORMALIZATION VIOLATION?

25 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 A. No, it does not. Treasury Regulation.-(b)(), attached as PNM Exhibit MFH-R, addresses such indirect reductions to cost of service. Basically, it states that merely changing the form of a normalization violation does not eliminate the violation. To determine whether such indirect method is a normalization violation, the IRS will examine all the facts and circumstances of the case, including, but not limited to, the record in the proceeding, the orders, opinions, and any dissenting views in the case, and the effect of the decision when compared to the direct violation. When the record and facts indicate that an alternative method used yields the same result as a method which would violate normalization (as they do with Mr. Higgins proposal), then the indirect method is also deemed violate normalization. Q. IF MR. HIGGINS PROPOSALS ARE NOT ADOPTED, WOULD CUSTOMERS LOSE OUT ON ANY BENEFITS BONUS DEPRECIATION REALIZED BY PNM? A. No, they will not. Customers will receive the all the benefits of bonus depreciation actually received by PNM both in the Capital Additions Rider and any subsequent rate case. This is ensured because the ADIT reduction to rate base in those proceedings will Treas. Reg..- specifically addresses Investment Tax Credit normalization. However, its intent can be extrapolated to normalized depreciation, as the ITC normalization regulations were drafted subsequent to the depreciation normalization regulations. Several PLRs, including, PLR 00, for example, determine that the additional details in determining what is and isn t public utility property that are included in the ITC normalization regulations apply to the determination of the same for depreciation purposes, even though the details are not included in the depreciation normalization regulations.

26 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT reflect the actual cash-flow benefit that PNM has received up to that time from all temporary book/tax differences, including bonus depreciation. 0 CEUC PROPOSED ADJUSTMENTS Q. BEFORE YOU ADDRESS CEUC S SPECIFIC PROPOSALS, WHAT IS YOUR GENERAL IMPRESSION MR. KUMAR S TESTIMONY? A. Mr. Kumar s testimony and exhibits contain numerous errors stemming from an apparent lack of understanding of IRS requirements related to income tax and the calculations in the illustrative cost of service relating to those requirements. He also disregards this Commission s actions and decisions in other cases on the very same issues. Often, Mr. Kumar presents his opinion as fact, without providing any support for his position. His approach seems to be to eliminate any ADIT account which increases rate base and to include any ADIT account that reduces rate base. IRS Normalization Requirements Q. ON PAGE HIS TESTIMONY, MR. KUMAR STATES THAT INCOME TAX REGULATIONS REQUIRE ACCOUNT,, AND ADITS TO BE USED AS A RATE BASE REDUCTION. I AM NOT AWARE ANY TAX REGULATION WHICH REQUIRES THE ADDITION ACCOUNT 0 TO

27 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT THE RATE BASE. IS HIS STATEMENT ABOUT THE INCOME TAX REGULATIONS CORRECT? A. Absolutely not. Neither the normalization statutes nor the IRS regulations promulgated thereunder refer to FERC account numbers not to,,, or 0. Rather, the normalization requirements dictate that all ADIT related to regulated utility depreciable assets must be normalized and included in rate base. The rules do not differentiate ADIT by the FERC account in which it is recorded nor by whether the account balance is an addition or deduction from rate base. 0 Q. MR. KUMAR CONTENDS THAT HE DID NOT REMOVE ALL 0 ADIT ACCOUNTS FROM RATE BASE. IS THIS STATEMENT CORRECT? A. Technically, it is correct. Practically, however, it is not. Mr. Kumar has proposed to remove of the accounts and $,, of the $,0,0 identified as 0s on schedule of CEUC Exhibit JK-, leaving only $,, or less than one-half of one percent, remaining. Of the two such accounts remaining in rate base, only one, ROW Reserve, had a debit balance. It appears that Mr. Kumar merely chose to remove essentially all of the ADIT accounts that he incorrectly believes were not subject to the normalization rules and that increased rate base.

28 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. HAVE THE ADIT ACCOUNTS THAT MR. KUMAR PROPOSES TO EXCLUDE FROM RATE BASE BEEN INCLUDED IN PRIOR PNM CASES LITIGATED OR SETTLED BEFORE THIS COMMISSION? A. Yes, they have. I am aware of no instances in which the any of the ADIT accounts in question were excluded from rate base unless the underlying rate base item was also so excluded. This includes both litigated and settled cases. 0 Q. IF THE ADIT ASSETS THAT MR. KUMAR PROPOSES TO ELIMINATE WERE SO ELIMINATED, HOW WOULD THE BOOK/TAX DIFFERENCES THAT CREATED THAT ADIT BE TREATED IN THE COST SERVICE? A. Those book/tax differences would have to be flowed through to customers as a book/tax difference that increases taxable income and, correspondingly, increases recoverable income tax expense. Either the flow-through or the normalization method must be used to account for these book/tax differences. They cannot simply be ignored in the cost of service, as Mr. Kumar proposes. 0 Q. WOULD CUSTOMERS BENEFIT FROM THIS FLOW-THROUGH TREATMENT? A. No, they would not. The increase to recoverable income tax expense could far outweigh the benefits of reducing rate base. Additionally, flow-through accounting mismatches the

29 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT timing of tax expense and the book income that creates it. In other words, it creates inter- generational inequities whereby customers in one period will unjustly benefit at the expense of customers in other periods. Normalization accounting matches the tax expense with the book income which creates it, and does not unfairly benefit or penalize customers in any one period. Finally, such flow-through treatment is in violation of the IRS normalization requirements. The result of such a violation would be catastrophic to customers. 0 Removal of CIAC ADIT and LXP Write-off ADIT from Rate Base Q. MR. KUMAR PROPOSES TO REMOVE FROM RATE BASE THE ADIT BALANCES RELATED TO CIAC AND LXP POLICY WRITE-FS. WHAT IS HIS REASONING FOR THIS? A. Mr. Kumar s justification of such a removal is not clear. In his discussion on the LXP Policy Write-offs on page of his testimony, he states: PNM has not demonstrated the LXP Policy write-off provides any benefits to its jurisdictional customers. Further, he states: Also, if PNM included the write-offs as a part of Plant in Service or as other Rate Base item, which should also be excluded. 0 Q. IS MR. KUMAR CORRECT THAT LXP WRITE-FS PROVIDE NO BENEFIT TO CUSTOMERS?

30 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT A. No, he is not. LXP write-offs occur when the cost of a Contribution In Aid of Construction ( CIAC ) project exceeds the reimbursement received by PNM. By writing off this excess, plant is service is reduced, and customers benefit from lower rate base. 0 Q. WHY IS THERE ADIT ON LXP WRITE-FS AND WHY IS IT APPROPRIATE TO INCLUDE IT IN RATE BASE? A. The tax law does not permit a partial write-off of plant assets. Therefore, for tax purposes, the amount written off for book must be capitalized and depreciated. This temporary difference results in an ADIT asset, because the deduction recognized currently for book purposes (the write-off) is not recognized for tax until later years (as tax depreciation). The temporary difference reverses through depreciation over the tax life of the asset, the ADIT effect of which is included in Account. It is appropriate to include the ADIT in rate base because it relates to the book/tax basis difference on utility plant in service which is included in rate base. 0 Q. PLEASE RESPOND TO THE SECOND REASON GIVEN BY MR. KUMAR FOR EXCLUDING THE ADIT RELATED TO THE LXP WRITE-FS. A. I cannot do so because I have no idea what Mr. Kumar meant by the statement: Also, if PNM included the write-offs as a part of Plant in Service or as other Rate Base item, which should also be excluded.

31 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. WHAT IS MR. KUMAR S JUSTIFICATION FOR REMOVING FROM RATE BASE THE ADIT BALANCE RELATED TO CIAC? A. At page of his testimony, Mr. Kumar appears to justify this removal based on the erroneous notion that PNM collects income taxes from the customers who pay CIAC, and that by including CIAC ADIT in rate base, PNM will be recovering the tax twice. 0 Q. DOES PNM CHARGE A CIAC PAYOR FOR INCOME TAXES IN ADDITION TO THE UNDERLYING CIAC? A. No, it does not. Income taxes are not included in the calculation determining the amount of the CIAC required. Mr. Kumar s assertion to the contrary is unfounded. 0 Q. WHY IS THERE ADIT ON CIAC, AND WHY IS IT APPROPRIATE TO INCLUDE IT IN RATE BASE? A. When PNM receives CIAC from a customer, it applies that payment against the cost of the underlying plant asset. This reduces the book basis of the asset by the amount of the CIAC received. For tax purposes, though, the IRS requires that PNM record the receipt of CIAC as taxable income, and pay tax on it when received. Because the CIAC payment has been recorded as taxable income, the tax basis of the underlying asset is not reduced. The difference created by this divergence of tax and book treatments reverses over time,

32 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT as the asset depreciates, because the depreciable basis for tax exceeds the book basis by the amount of the CIAC. Because PNM pays tax up front on receipt, and receives the reversing deductions in future periods, ADIT is recorded. It is appropriate to include CIAC ADIT in rate base because it relates to the book/tax basis difference on utility plant in service which is included in rate base. 0 Q. HAVE CIAC AND LXP WRITE-F ADIT BEEN INCLUDED IN RATE BASE IN PRIOR PNM CASES BEFORE THIS COMMISSION? A. Yes, they have. To my knowledge, CIAC has been included in all PNM cases for all periods in which a tax gross-up was not collected from the contributor. LXP Policy Write-down ADIT has been included in every case since the book/tax difference arose, including PNM s last litigated case, NMPRC Case No UT. 0 Q. IS CIAC ADIT, AND BY ASSOCIATION, LXP WRITE-F ADIT, REQUIRED TO BE NORMALIZED BY THE IRS? A. Yes, it is. IRS Notice -, attached as PNM Exhibit MFH-R, specifically addresses CIAC, and states: Public utility property includes property that is received as CIAC or that is financed or acquired with the proceeds of CIACs. In any such case, the CIAC property is subject to the normalization rules of sections and a utility will be treated for purposes of the normalization rules as if it computed its regulated tax expense by depreciating the related CIAC property in its entirety in the year in which the CIAC is received CIAC 0

33 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 property is depreciated less rapidly in determining Federal income tax liability than in computing regulated tax expense, and taxes are paid before they are taken into account under the regulatory accounting method. This prepayment, or negative deferral, of tax is also subject to the normalization rules, and the utility must make adjustment to the reserve for deferred taxes to reflect the prepayment. The Notice allows only one exception to the normalization requirement for CIACs. When the contributor pays an additional amount to the utility to compensate the utility for the prepayment of tax, known as a tax gross-up, then the CIAC is not required to be normalized. As explained above, this exception does not apply to PNM because PNM does not charge the contributor for income taxes. Further, PLR 00, attached as PNM Exhibit MFH-R, determined that it was a violation of the normalization requirements for CIAC for a commission to require a utility to reverse its CIAC ADIT asset just because the utility had the opportunity to collect a tax reimbursement from the contributor, but did not do so. The determinative factor is whether or not a tax reimbursement was actually collected from the contributor. 0 Removal of Capitalized Interest ADIT from Rate Base Q. WHAT IS MR. KUMAR S JUSTIFICATION FOR REMOVING CAPITALIZED INTEREST ADIT FROM RATE BASE? A. Mr. Kumar states that Capitalized interest is added to Plant in Service and thus PNM earns a return on and return of the Capitalized Interest including the recovery of income

34 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT taxes associated with the return. Therefore, there is no reason to allow additional return on the Capitalized Interest by including the associated ADIT in Rate Base. Q. IS HE CORRECT THAT PNM EARNS A RETURN ON AND A RETURN THE CAPITALIZED INTEREST THAT CREATES THIS ADIT ASSET? A. Absolutely not. The capitalized interest that creates the ADIT asset is not added to plant in service and PNM earns neither a return of nor a return on the capitalized interest. The capitalized interest in question is that required to be capitalized for tax purposes, and not for book and regulatory purposes. For tax purposes, PNM reverses the interest 0 capitalized for book purposes. This creates the ADIT liability, shown on PNM Exhibit TGS-, line 0, directly above the ADIT asset in question, which reduces rate base (Mr. Kumar did not remove the ADIT that is a reduction to rate base). PNM then capitalizes interest as required by the IRS. This capitalization creates the ADIT asset in question. This was explained in PNM s responses to CEUC -, -, and -. Q. EVEN IF CAPITALIZED INTEREST WERE ADDED TO PLANT IN SERVICE AND PNM EARNED A RETURN AND RETURN ON THE BALANCE, WOULD THAT JUSTIFY EXCLUDING THE ASSOCIATED ADIT FROM RATE BASE?

35 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT A. No, it would not. With very few exceptions, every ADIT balance has an underlying asset or liability in rate base. The ADIT stems from the difference in the timing of the recognition of these items for book and tax return purposes. To the extent an asset is recovered faster for tax than for books, an ADIT liability is created. To the extent the asset is recovered slower for tax than for book purposes, an ADIT asset is created. Both are includible in rate base, because they account for the difference between the book recognition of the related tax expense and the cash payments of such expense over time. 0 Q. HAS CAPITALIZED INTEREST ADIT BEEN INCLUDED IN RATE BASE IN PRIOR PNM CASES BEFORE THIS COMMISSION? A. Yes, it has. To my knowledge, it has been included in all PNM cases subsequent to the enactment of the statute under which such capitalization is required, including PNM s last litigated rate case, NMPRC Case No UT. Removal of Afton Write-Down ADIT from Rate Base Q. WHAT IS MR. KUMAR S JUSTIFICATION FOR REMOVING FROM RATE BASE THE ADIT RESULTING FROM THE AFTON WRITE-DOWN? A. He states that the ADIT should be excluded because PNM has not shown that the write-down was beneficial to customers 0

36 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT 0 Q. IS HIS REASONING CORRECT? A. No, it is not. As stated in PNM s response to CEUC - c), to which Mr. Kumar refers on page of his testimony, the write-down benefitted customers because customers were not required to provide a return of or a return on the amount written down. However, the fact that the write-down benefitted the customer is not the reason that the ADIT must be included in rate base. The ADIT must be included rate base because the book write-down of Afton created a book/tax difference in the depreciable basis of Afton. This occurs because partial write-downs are not allowed for tax purposes. The difference will reverse over time, as tax depreciation exceeds book depreciation by the amount of the write-down, the ADIT effect of which is included in Account. Because Afton is included in rate base, so too must be the associated ADIT. 0 Q. WOULD THE ELIMINATION THE AFTON WRITE-DOWN ADIT CONSTITUTE A NORMALIZATION VIOLATION? Yes, it would. PLR 00, attached as PNM Exhibit MFH-R, concluded in a similar situation that if an asset is predominantly used in a public utility activity, then all the costs, including the portion disallowed by the commission, constitutes public utility property and is subject to the normalization rules. Clearly, Afton is predominantly used in a public utility activity, and, as with the asset in the PLR, all maintenance and operations costs of Afton are included in the cost of service. Therefore, I conclude that it would be a normalization violation to exclude the ADIT asset in question from rate base.

37 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT Q. HAS THE AFTON WRITE-DOWN ADIT BEEN INCLUDED IN RATE BASE IN PRIOR PNM CASES BEFORE THIS COMMISSION? A. Yes, it has. It was included in NMPRC Case No UT, PNM s only rate case subsequent to the write-down. 0 Removal of EIP Related ADIT from Rate Base Q. WHAT IS MR. KUMAR S RATIONALE FOR EXCLUDING THE EIP RELATED ADIT FROM RATE BASE? A. His rationale is completely unclear, other than he is intent on excluding costs. He states that he is not excluding the EIP Acquisition Premium from rate base, but excludes the ADIT. The acquisition premium is not even the source of the ADIT. Rather, the source is the rate base reduction for the Unamortized Gain on EIP, shown on line of PNM Exhibit TGS-. The bulk of the ADIT results from a book/tax basis difference in EIP that created a book/tax difference in the gain when EIP was sold. The remainder results from refinancing costs which were deducted for book but required to be capitalized and amortized for tax purposes, similar to capitalized interest. Q. SHOULD THE EIP ADIT BE INCLUDED IN RATE BASE?

38 REBUTTAL TESTIMONY IN SUPPORT STIPULATION NMPRC CASE NO UT A. Yes, it should. It relates to a rate base reduction which is included in rate base, and therefore it too should be included. 0 Q. HAS EIP ADIT BEEN INCLUDED IN RATE BASE IN PRIOR PNM CASES BEFORE THIS COMMISSION? A. Yes, it has. To my knowledge, the EIP Prepaid Tax has been included in all PNM cases subsequent to the EIP sale-leaseback transaction by which it was created, including PNM s last litigated rate case, NMPRC Case No UT. The EIP refinancing cost ADIT has been included in every case subsequent to the IRS examination which resulted in it having to be capitalized for tax purposes, including in NMPRC Case No UT. Bonus Depreciation, NOL ADIT, and DPAD Deduction Q. ARE THE EFFECTS BONUS DEPRECIATION INCLUDED IN THE ILLUSTRATIVE COST SERVICE? A. Yes, the effects of bonus depreciation are included in the illustrative cost of service to the extent allowed at June 0, 00. In other words, the ADIT effects of the bonus depreciation are included. The illustrative cost of service was prepared using the books and records as of June 0, 00. As of January, 00, bonus depreciation had