National Conference of State Legislatures

Tax Implications of Electric Industry Restructuring
A Series by the NCSL Partnership on State and Local Taxation of the Electric Industry

December 1997
By Matthew H. Brown and Kelly Hill

14 Page Document

The National Conference of State Legislatures' Partnership on State and Local Taxation of the Electric Industry was formed in 1997 as a forum for those with various roles in restructuring the electric industry. The partners include key state legislators, experienced state legislative staff and sponsors of NCSL's Foundation for State Legislatures who chose to participate in this project.

Contents
Introduction
Federal Actions Affecting the Electricity Market
Franchise Taxes and Net Income Taxes

Main Findings
Income Base and Net Worth
Nexus
Apportionment
Corporate Franchise Tax
Income Tax
Who Pays the Corporate Franchise and Income Taxes?

Electric Industry Composition
Corporate Franchise and Net Income Taxes and Electric Industry Reform: A Hypothetical Example

Taxes Before Restructuring

Franchise Taxes and Income Taxes After Restructuring

Nexus
Apportionment, Tax Revenues and Restructuring

Further Loss of Market for Amalgamated Electric, Gain of Market for First National Power

Effect on State A
Effect on State B

Net Income Taxes and the Holding Company
Options for Policymakers
Notes
Questions for Policymakers

Introduction

As with the telecommunications, natural gas and airline industries, the electric utility in-
dustry is in the midst of a fundamental transformation. Indeed, one no longer can accurately characterize it as solely the utility industry. Wholesale competition is robust today, with dozens of sellers of electricity as a result of the Public Utility Regulatory Policies Act of 1978, the Energy Policy Act of 1992 and the actions of the Federal Energy Regulatory Commission in orders 888 and 889. As shown in figure 1, retail customers in at least a dozen states will be able to choose their electricity providers as the result of legislation or comprehensive regulatory packages enacted in those states. It is not only utilities that now are selling electricity. Electric companies that operated in the retail electricity sales business as state-regulated monopolies for more than 50 years will face competition not only from each other, but also from other companies that previously sold no retail electricity.

In states that reform their electric industry, utilities no longer will be restricted to service territories in which they operate as monopolies. These utilities, whether they be investor owned, public power systems or rural electric cooperatives, may find themselves in competition with each other and with other new electricity providers like power marketers, aggregators or independent power producers. The utilities may begin to sell electricity across service territories and state boundaries to customers that previously had no choice among electric companies. They also may break away from their regulated, vertical structure—where one company owned and coordinated the power generation, transmission, distribution, back office and customer service functions—into separate companies. Some may even sell these functions so that they can focus on just one business activity. The states that are encouraging this restructuring are doing so for different reasons. States with high-cost electricity hope that competition will reduce its cost. States with low-cost power producers often see the potential for growth in their companies’ market share outside their state.

These changes may, indeed, produce benefits. In many states they also will require a reexamination of the tax system that has developed around regulated monopoly businesses. Two similar taxes that are likely to be affected by the greater number of interstate electricity sales and the restructuring of today’s electric utilities are the state or local franchise tax and the income tax.

This paper deals with the direct effects of electric industry restructuring on income and franchise tax revenues. If restructuring fulfills the promise of providing lower rates and greater economic activity, it will lead to economic growth, new investments and a larger franchise and income tax base. These effects on the tax base are difficult to quantify with a useful degree of accuracy and it is not the purpose of this paper to make assertions about the potential effects of restructuring. This paper should be taken in that context.

In a restructured market, franchise and income tax revenues will increase in some places and decrease in others. The objective of this paper is to give state policymakers the tools to understand the effects of electric industry reform on these taxes. It will aid policymakers to participate in an informed debate and enhance their ability to make decisions with information about the franchise and income tax consequences of electric industry reform.

Franchise Taxes and Net Income Taxes

Main Findings

Corporate franchise and income taxes contribute less revenue to state governments than other taxes such as the property tax or the sales tax. Often, however, tax payments from utilities constitute a large percentage of the total corporate net income tax collections. Utility restructuring presents two issues related to these taxes:

• The effect of restructuring on franchise and income tax revenues, and
• The effect of franchise and income taxes on effective competition.

The franchise tax and corporate income tax are susceptible to changes in the electric industry as a result of the three general factors discussed below.

Income Base and Net Worth

• A decrease in net taxable income will lead to a decrease in tax receipts for the income tax and, depending on its base, for the franchise tax. An increase in net taxable income will lead to an increase in tax receipts.
• For franchise taxes based on the net worth of the taxpayer, a decrease in net worth will lead to a decrease in tax receipts. An increase in net worth will increase tax receipts.

Nexus

• States may not be able to tax many out-of-state electricity providers. It may be more difficult to levy an income tax on out-of-state electricity providers than to levy a franchise tax on out-of-state providers.
  

Apportionment

The increase in interstate sales of electricity will have a major effect on franchise tax and net income tax revenues.

• The allocation and apportionment formula that states use will be an important factor in the effect of electric industry reform on both franchise taxes and corporate income taxes.
• States that are home to utilities that increase their out-of-state market share probably will see an increase in their franchise tax and income tax revenues.
• States that rely heavily on the property and payroll of the taxpayer as a way to apportion income may face income tax revenue losses as a result of restructuring.
• States’ ability to tax some new forms of electricity providers will be determined by whether they tax on a unitary or separate company basis.
• Where change is necessary, it will require state legislation because most of the rules that govern revenue departments’ activities can be found in state statute.

Corporate Franchise Tax

The net income and franchise taxes are often very similar. A corporate franchise tax is a tax imposed on companies that conduct business in the taxing state. In a few states it is used as a substitute for an income tax. Generally, a corporate franchise tax is based on the net worth of the corporation. However, some states impose a corporate franchise tax based on the taxable net income earned by the corporation. Commerce Clause limitations may restrict a state’s ability to impose a franchise tax on an out-of-state business. The tax is considered a general business cost. In some states, an upper limit is set on a single taxpayer’s franchise tax payment; in Illinois, for instance, the franchise tax payment is capped at $1 million.

Income Tax

A corporate income tax is imposed on a corporation’s net income that is earned within a state. As with the franchise tax, commerce clause limitations may restrict a state’s ability to impose an income tax on an out-of-state business. States are afforded great latitude in determining the income earned within their borders. Generally, states compute income by starting with federal taxable income. Some states view each company as a separate trade or business—separate company states—and compute income on a company-by-company basis. Other states regard a trade or business as one entity regardless of the corporate structure and will compute income and apportionment on the unitary business. This income base is further modified to allow or deny other deductions.

Businesses that conduct trade in several states often pay taxes in all the states in which they do business. In the case of both the income and the franchise tax, once the multistate business’s overall income or net worth base is established, the tax is apportioned or allocated among the states. Typically, the apportionment is based upon a combination of factors, including property, payroll and sales. Different states rely more heavily on one or another factor to allocate each tax among states; however, many states rely more heavily on property and sales to allocate the franchise tax. An apportionment formula requires the computation of the percentage of property, payroll and sales within a state or political subdivision as compared to the total for the company. This percentage would be applied to the modified income to determine income earned within a state or political subdivision.

The state (or political subdivision) collects the franchise or income tax revenues, which are deposited directly to the general fund. They are not sent by a formula to political subdivisions of the state, nor are the revenues from the income tax generally designated for one purpose, such as school funding. Corporate income taxes and franchise taxes generally do not comprise a large proportion of states’ total business taxes. In Minnesota, for instance, corporate franchise taxes based on net income comprise about 6.4 percent of total state general fund revenues. However, income tax receipts from utilities often represent a significant portion of total corporate income taxes that states collect, because utilities generally conduct a large proportion of their business inside their home state. Minnesota’s utilities make about 9.5 percent of those total franchise tax payments.

A major issue confronting all states that impose an income tax or a franchise tax that is based on net income, in addition to constitutional limitations, is the statutory limit that Public Law 86-272 imposes upon a state’s ability to levy an income tax on a business that conducts operations in a multistate environment. Public Law 86-272 provides that a state cannot impose an income tax on a business if the company’s activities within the state are limited to mere solicitation of sales. This higher standard to which the income tax is held could make it more difficult to impose an income tax on out-of-state electricity sales, although this has not been tested in the courts. Scholars disagree as to the reach of PL86-272. Specifically, many scholars believe PL86-272 only provides protection to sellers of tangible personal property. If this is true, an issue arises as to whether or not electricity is tangible personal property. States are divided on the nature of electricity as tangible personal property. This issue typically has been addressed for sales tax purposes. The corporate franchise tax is not subject to this higher standard.

Who Pays the Corporate Franchise and Income Taxes?

Corporate Franchise and Net Income Taxes and Electric
Industry Reform: A Hypothetical Example

The following example illustrates how utilities and others in the electric industry pay the income and franchise taxes and how these payments could be affected by restructuring of the electric industry. Any solutions described in the example should be considered only as illustrative and not as recommendations for policy actions. Questions for state policymakers are interspersed with the example. The answers to these questions will help policymakers determine how to address this issue in their individual states. Below, examples A, B and C describe the relationship between income and franchise taxes and restructuring.

Taxes Before Restructuring

Consider Amalgamated Electric, Rural Power and City Power, three electricity providers in State A’s newly competitive electric marketplace. Until recently, these three organizations operated in their own service territories, selling power to customers that had little choice but to buy from them. With passage of State A’s new legislation allowing competition among electricity providers, these three utilities now are competing with each other, with a power marketer that has begun doing business in the state and with a utility—First National Power—that has a power plants in State B, but none in State A. First National Power also has restructured its company, and is considering the merits of establishing a holding company in State C. State C has no corporate franchise or income tax. Both Amalgamated Electric and First National Power have an identical net income of $100 million and a net worth of $1 billion.1 First National Power captured 20 percent of the competitive electric market in State A.

Since State B also passed legislation to allow competition in the electric industry, Amalgamated Electric is selling to customers in its market and has done well enough that it has taken 10 percent of the competitive electric market in State B. The power marketing company—Marketer Inc.—has captured an additional five percent of the competitive market in State B. Both states A and B have corporate net income taxes on utilities. State C has no corporate income tax.

State A figures its corporate income tax on the basis of Amalgamated Electric’s revenues minus its expenses. Like the difference between book and tax values for property, Amalgamated Electric’s taxable income is different from the income that it shows in its annual or quarterly report for book purposes.

State B figures its corporate franchise tax partly on the basis of a taxpayer’s net worth—or, essentially, the market value of its outstanding stock—and partly on the basis of the taxpayers’ net income.

Since Amalgamated Electric began operation as a regulated monopoly, it has paid income tax on the basis of 100 percent of its net income because it made all its sales in State A and because 100 percent of its property and payroll also were located in that state. Similarly, because State B allocates the corporate franchise tax on the basis of the taxpayers’ property and sales, and because First National Power’s sales and property have long been almost exclusively in State B, nearly 100 percent of First National Power’s franchise tax payments have gone to State B. Until the new restructuring laws in States A and B, the income tax situation was relatively simple.

Franchise Taxes and Income Taxes After Restructuring

Nexus

Amalgamated Electric has also lost some market share to The Marketer Inc. and to First National Power. Neither of these companies located offices in State A. In attempting to tax these out-of-state providers, State A encounters a nexus problem.

Nexus is the minimum connection the taxing state must have with the corporation or the activity being taxed to collect taxes from that corporation or activity. To legally uphold its taxing authority, a state’s interpretation of nexus cannot violate the Due Process Clause or the Commerce Clause of the U.S. Constitution. The concept of nexus was litigated in the 1992 case, Quill Corporation v. North Dakota, 504 U.S. 623 (1992) in the context of the mail-order catalog business. In that decision, the U.S. Supreme Court ruled that some kind of physical presence was necessary to support imposition of sales and use tax collection responsibility. Physical presence generally refers to having property or people in the state, either directly or through certain kinds of agency relationships. Similar issues of jurisdiction are likely to arise in states that open their electric industry to competition.

The income tax is unique among taxes that involve the nexus issue in that states must meet a higher nexus standard to establish nexus over a company or a transaction. Indeed, it can be difficult to establish nexus over a company in the new electric marketplace. Public Law 86-272 states that mere solicitation of sales is not sufficient to establish nexus. This narrower definition of nexus is meant to allow the free flow of commerce among states, without requiring a seller based in one state to pay income tax to the multiple states in which it has customers. In the case of electricity sales, it may mean that out-of-state power marketers or out-of-state utilities will not often be subject to income taxes in the state in which they are selling electricity. Until Public Law 86-272 is tested in the courts, it will not be certain that it will apply to electricity sales.

In the hypothetical example of Western Power and The Broker Inc. selling to customers in State A, it is unlikely that State A will be able to collect a corporate income tax on either Western’s or The Marketer Inc.’s sales in that state.

Although the standard for establishing nexus is not as high for a franchise tax that is based on net worth, many of the same nexus concerns apply. It may not always be possible to assert nexus on out-of-state companies in order to levy a franchise tax.

Apportionment, Tax Revenues and Restructuring

States’ methods of apportioning income or net worth among themselves, for multi-state utilities, will affect the amount of income or franchise tax they collect from these multi-state companies. The example below is simplified in an effort to explain the influence of different apportionment formulas, and the effect of the loss or gain of market share on state or local tax revenues.

Now that Amalgamated Electric has captured 10 percent of State B’s market, but lost 20 percent of the market in its own state to First National Power. State A’s and State B’s tax situation will be as follows.

Both State A and State B assess income taxes on Amalgamated Electric based on a formula2 that includes:

• The property that Amalgamated Electric has in State A,
• The payroll that Amalgamated Electric has in State A, and
• The sales that Amalgamated Electric makes in State A.

State A levies a 10 percent income tax on taxable income. State B levies a 1 percent franchise tax on net worth of the taxpayer.

In Amalgamated Electric’s case:

• Property in State A: 100 percent.
• Payroll in State A: 100 percent.
• Sales in State A: 90 percent (the remainder are in State B, as a result of retail wheeling).
• Average: 96.6 percent.

The average of these three is 96.6 percent, so State A will be able to collect income taxes on 96.6 percent, or $96.6 million of Amalgamated Electric’s income. Its income tax revenue from Amalgamated will be $9.66 million.

State B collects a franchise tax via a formula that looks at:

• Property located in State B,
• Sales that take place in State B.

In First National Power’s case:

• Property: First National Power maintains 100 percent of its property in State B;
• Sales: First National Power makes 70 percent of its sales in State B.

Therefore, State B will be able to collect a franchise tax on 85 percent ($850 million) of First National Power’s net worth. Its franchise tax revenue from First National Power will be $8.5 million.

By focusing on a large sales force and offices located within its borders, State A may be able to assert nexus over First National Power. Its tax collections from First National Power will not make up for its losses from Amalgamated Electric.

• Property: First National Power maintains 1 percent of its property in State A.
• Payroll: First National Power maintains 2 percent of its payroll in State A.
• Sales: First National Power makes 20 percent of its total sales in State A.

State A will be able to tax 7.66 percent ($7.66 million) of First National Power’s income, making its income tax revenue from First National Power $766,000.

Further Loss of Market for Amalgamated Electric, Gain of
Market for First National Power

Effect on State A

If First National Power takes 40 percent of Amalgamated Electric’s market share, State A will collect some additional income tax revenue from First National Power, but will lose income tax revenue from Amalgamated Electric.

Amalgamated Electric:

• Income: $80 million, with reduced sales in-state.
• Property: 100 percent in State A.
• Payroll: 100 percent in State A.
• Sales: 90 percent of Amalgamated’s sales are in-state, but its total sales are reduced.
• Average: 96 percent.

State A will collect income tax on the basis of 96 percent of Amalgamated’s total income, but its collections will decrease because Amalgamated’s total income decreases to $80 million. It collects its 10 percent income tax on the basis of $77.3 million, for net collections of $7.73 million, a reduction of $1.93 million.

First National Power:

• Income with increased sales in Amalgamated Electric’s former territory: $120 million.
• Property in State A: 1 percent.
• Payroll in State A: 2 percent.
• Sales in State A: 40 percent.
• Average: 14.3 percent.

State A now will collect taxes on the basis of 14.3 percent of First National Power’s net income. First National Power now will pay State A on the basis of 14.3 percent of $120 million in income—or $1.68 million in income taxes—an increase of $950,000 in collections from First National Power.

This tax on First National Power’s income will not compensate for the loss of Amalgamated’s income tax revenues. In fact, State A loses $980,000 as a result of its own utility’s loss of market to First National Power. This loss results not only from Amalgamated Electric’s decreased income, but also from State A’s apportionment formula. State A’s formula yields a lower tax base from income taxes from electricity providers that have no property or payroll in the state.

Effect on State B

State B, with a utility that flourishes in a competitive market, gains revenue with First National Power’s success out of state. It now collects revenue from First National Power’s higher net worth. It also gains from use of the same apportionment formula, which relies heavily on First National’s property, which is located in State B, and from First National’s sales.

First National Power:

• Property in State B: 100 percent.
• Sales in State B: 50 percent.

State B will be able to collect corporate franchise tax on 75 percent of First National Power’s net worth, as opposed to previously collecting on 85 percent of its net worth. Even if First National Power’s net worth increases by 15 percent to $1.15 billion, State B will collect its 1 percent franchise fee on $862.5 million of the company’s net worth, resulting in a slight increase of $12.5 million.

Net Income Taxes and the Holding Company

Some electricity providers will alter their corporate structure to make it possible to reduce their total tax bill. If the federal and state legislative laws that govern the structure of utility businesses change as a result of electric industry restructuring, First National Power and many other utilities will be able to alter their corporate structure in ways that heretofore have been impossible.3 Some utilities may choose to form a holding company that has various subsidiaries that perform different functions and meet different tax planning needs.

For example, suppose First National Power forms a holding company, based in State C, with two subsidiaries. State C has no income or franchise tax. The operating subsidiary operates in State B. It runs power plants, power lines and customer service functions. It also operates on a very slim margin of profit. Meanwhile, all payments are remitted to another subsidiary company based in State C. This company is connected to the operating subsidiary through its holding company parent, but it may be very difficult for State B to establish nexus over the profit-making subsidiary. These profits, meanwhile, are not taxed in State C.

State B’s ability to levy a tax on the net income or the net worth of the State C-based subsidiary will lie in State B’s definitions of how it taxes a company. If it taxes companies as unitary corporations, then it levies income taxes based on the net income of the holding company’s combined income and apportionment factors. In this case, State B would be able to tax First National Power’s income.

If State B taxes companies as separate corporations, it may be able to tax only the income of the operating subsidiary over which it has nexus in State B. It will have no ability to tax the profit-generating subsidiary that is based in State C, and cannot claim a connection on the basis of the parent company. Separate reporting states usually have provisions in their laws that allow tax administrators to attach these transfer pricing issues (i.e., if First National Power is artificially shifting its profits to the subsidiary in state C). These provisions are difficult to administer, because they require proving that the formula apportionment does not reflect economic reality. States occasionally do use these provisions, but typically only in extreme cases.

Options for Policymakers

See other papers in this series for details on these possibilities.

Notes

1. These identical net worth and income figures are simplifications made to ease the comparison of the two companies’ tax burdens.
2. States use various formulas to allocate income and corporate franchise taxes. In general, states rely more heavily on property and sales to allocate the franchise tax. Some states, such as Arizona, rely exclusively on sales to allocate taxpayers’ income. Many also weight their formula so that it relies most heavily on sales.
3. The federal government is considering major changes to, or the repeal of, the Public Utility Holding Company Act, which in part governs the structure of investor owned utilities in the United States

Questions for Policymakers: