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

Introduction to Electric Industry Taxation

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
State Activities to Promote Electric Industry Restructuring
Electric Industry Taxation
Definition of Taxes
Federal Actions that Affect the Electricity Market

The Public Utility Regulatory Policies Act of 1978 (PURPA)
The Energy Policy Act of 1992 (EPACT)
Private Use Restrictions

Electric Industry Composition

Investor Owned Utilities (IOUs)
Rural Electric Cooperatives
Public Power Systems
Federal Electric Utilities
Independent Power Producers
Power Marketers

Types of Taxes Assessed by States and Localities on Various Electricity Producers
Property Tax
Gross Receipts Tax
Corporate Income Tax
Corporate Franchise Tax (Capitol Stock Tax)
Franchise Fee
Consumption Tax
Sales and Use Tax
Commodity Tax
Payment in Lieu of Taxes (PILOT)
Regulatory or Public Service Fee
Federal Constitutional Issues
Equal Protection Clause Limitations on State Taxation
Due Process Limitations on State Taxation
Commerce Clause Limitations on State Taxation
Supremacy Clause Limitations on State Taxation
Import/Export Clause Limitations on State Taxation
Conclusion

Introduction

As with the telecommunications, natural gas and airline industries, the electric utility industry 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.

State Activities to Promote Electric Industry Restructuring

Restructuring the electric industry requires legislators to address a number of issues. One component of discussions concerning electric industry restructuring is its effect on state and local taxes. Policymakers may want to assess the effect of restructuring on tax receipts and revenue demands in a manner that more fully reflects the new competitive marketplace. This report will give state policymakers historical background about electric industry taxation. It discusses the competitive position of different electric suppliers with different tax burdens, defines the types of taxes traditionally levied upon the electric industry (tax definitions may vary within the states) and gives legislators options to consider during discussions of the changing tax structure in a restructured system. Because each state has unique circumstances, electric industry tax decisions should be made in that context.

Electric Industry Taxation

Taxation of a regulated industry usually differs in several key respects from the taxation of unregulated entities. One of the major differences lies in the predictability of a regulated system revenue stream. For example, a regulated utility has a defined, exclusive service territory that provides a stable and predictable customer base.

As a result, hidden taxes are common in a regulated monopoly industry. Hidden taxes, generally, are taxes levied directly on an industry that then passes them on to the consumer as part of the overall price of the product. Such taxes are not listed as a specific line item on the consumer's bill. For example, if a 6.5 percent gross receipts tax is levied on an investor owned utility (IOU), the IOU may then increase its bill by 6.5 percent, but not show that amount as an incremental line item on the bill. That 6.5 percent is a hidden tax for consumers. Hidden taxes on a regulated monopoly have been an attractive option for policymakers because they allow revenues to be raised with little controversy.

Taxation of the electric industry is unique because many principles of taxation that apply to other industries are not applicable. For example, electric industry taxation differs from taxation of other nonutility industries in rates, assessment methods and valuation methods. The taxes also can vary within the industry based upon the utility's ownership. In addition, there are three separately taxable components to the industry-generation, transmission and distribution. The generation component of the industry is being restructured. At least initially, transmission and distribution are likely to remain regulated monopoly enterprises.

As the electric industry restructures, the participants in the marketplace will change. Therefore, state and local governments should determine how restructuring will affect their tax bases. Governments must determine what revenues may be increased in a competitive environment, what revenues may be reduced and methods they may want to use to address these revenue changes. States may need to reevaluate their tax codes on a regular basis as the electric industry changes.

There has been a complex history of utility industry taxation in the states because each state addresses the issue individually. For example, Ohio assessment rates for utility property are substantially higher than for nonutility property. Investor owned utilities in Ohio annually pay about $1 billion in personal property taxes and gross receipts taxes. At the local level, this results in about $240 million in funding for school districts. In a competitive environment, electric providers will insist on taxation equal to other types of businesses. Given the potential decrease in revenue, including the possibility that some noncompetitive electric generating facilities may close, Ohio has begun to examine the effect restructuring would have on funding for the local education system.

Although there are differences among the states, the types of taxes and fees levied on utilities generally fall into the following categories:

Several of these taxes may be levied in combination. Alabama, for instance, imposes seven taxes on electric utilities-a utility gross receipts tax, a utility service use tax (ranging from 2 percent to 4 percent of gross receipts), a license tax of 2.2 percent of gross receipts, a corporate franchise tax of $10 on each $1,000 of capital stock, a corporate net income tax, a privilege tax on businesses that manufacture and sell hydro power and a property tax. Some states, such as California, assess other environmental charges and fees on utilities in addition to taxes

Types of Taxes Assessed by States and Localities on Various Electricity Producers

Source: Compiled by Edison Electric Institute from Table 74, Detail of Taxes-Electric Department Only Investor-Owned Electric Utilities, EEI Statistical Yearbook of the Electric Utility Industry, 1994, and Federal Energy Regulatory Commission Form 1.

Source: National Rural Electric Cooperative Association, 1996 data.

To have a common understanding of the kinds of taxes imposed on the electric industry, it is useful to define those taxes. Although the definitions can vary by state, the following definitions will be applied in this series.

Property Tax

A property tax is imposed on the value of real or personal property located within the taxing jurisdiction. Some states have their own, often unique, definition of real and personal property. Whether property is defined as real or personal may determine whether it is subject to tax, how it will be classified and valued for assessment, how assessments are equalized and at what rate it will be taxed. Some states tax real property only and other states tax both real and personal property. The real and personal property of regulated utilities typically is centrally assessed by a state agency, generally the state's department of revenue. However, in some other states, utility property is assessed locally.

Gross Receipts Tax

A gross receipts tax generally is a levy applied to total revenues from a company's sales without the benefit of any deductions. The tax is imposed directly on the seller based upon total revenue receipts and is considered a general business cost. It differs from a sales tax in that it is a tax on the selling company rather than on the purchaser. However, the gross receipts tax usually is passed to the customer indirectly in the form of increased energy cost.

Corporate Income Tax

A corporate income tax is imposed on the net income of a corporation earned within a state. In the case of multi-state companies, 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 a single entity regardless of the corporate structure and will compute income and apportionment on the unitary business.

Corporate Franchise Tax (Capital Stock Tax)

A corporate franchise tax is a tax imposed on companies that conduct business in the taxing state. Generally, a corporate franchise tax is based on the net worth of the corporation. The tax is considered a general business cost. However, some states impose a corporate franchise tax based on the net income of the corporation. Commerce Clause limitations arising under Article 1, Section 8 of the U.S. Constitution may restrict a state's ability to impose a franchise tax on an out-of-state business.

Franchise Fee

Franchise fees are paid as part of a service agreement between state and local governments and a utility company. Service agreements outline the terms under which utility companies provide service to customers in a specific service territory. As part of a service agreement, state and local governments impose a franchise fee. Franchise fees work much like a gross receipts tax. Specifically, a franchise fee usually is calculated on a percentage of the revenues derived from sales of electricity to customers in the franchise territory. A franchise fee generally is imposed in lieu of licenses or permits that otherwise would be required.

Consumption Tax

A consumption tax is a tax on the consumption of an item or service by an end consumer. A consumption tax can be a set amount for each unit consumed or produced or it can be based on a percentage of the total cost of purchasing the items or services. Some states limit the tax to specific types of commodities, while other states impose the tax regardless of how the item or service is produced.

Sales and Use Taxes

A sales tax is a tax imposed on the retail sales price of tangible personal property purchased for use or consumption in the taxing state. Sales and use taxes are counterparts. States that tax sales also impose use taxes at the same rates. The use tax was designed to capture revenues on purchases not subject to the state sales tax, namely purchases by out-of-state vendors that are not responsible for collecting tax on interstate transactions. If a sale is subject to the state sales tax, it generally would not be subject to the state use tax, and vice versa.

Sales tax is withheld and remitted by the seller of goods, while the use tax is remitted by the consumer. State sales and use taxes generate significant tax revenues for the states. States may impose their sales and use taxes on the sale of electricity. This tax is collected from the customer by the electric supplier and passed to the state. Historically, states have exempted many energy and nonenergy items from state sales and use taxes. But electric suppliers are responsible for sales taxes assessed on their purchases (such as office equipment, vehicles or other nonexempted supplies).

Commodity Tax

A commodity tax is a tax imposed on the delivery of a commodity to an end consumer for use within a state. The tax is usually a rate per unit (e.g. kilowatt hour) rather than a tax based upon income or gross receipts. The tax normally is imposed on the company that makes final delivery to the end consumer within a state. Typically, a commodity tax is imposed on and included in the price of such items as gasoline, oil, electricity, natural gas, cigarettes and alcohol.

Payment in Lieu of Taxes (PILOT)

A payment in lieu of taxes or transfer to the general fund is a cash payment or comparable free services made by a utility to the local government jurisdiction in which it is located. In the case of public power systems, for example, the utility is not subject to local property taxes because it is owned by the municipality. Often, the local government will establish an annual payment or transfer in lieu of receiving property tax revenues. There may be a formula for computing the payment, or the amount may be negotiated each year. Some jurisdictions differentiate between payments that are computed by formula or set by contract (payments in lieu of taxes), and payments that are determined on an annual basis (transfers to the general fund), but typically these two terms are used interchangeably.

Regulatory or Public Service Fee

A regulatory or public service fee is imposed on utilities to cover the costs of regulatory activities. This fee is based on the gross receipts of a utility. The rate of the tax is significantly less than a standard gross receipts tax. Most states set an upper limit on a regulatory fee.

Federal Constitutional Issues

When examining the implications restructuring may have on state and local taxation, state policymakers should be aware of the federal constitutional issues that may arise because a state's ability to impose a tax is restricted by constitutional and statutory limitations. The major constitutional issues concerning a state's ability to impose taxes relate to the Equal Protection Clause, the Due Process Clause, the Commerce Clause, the Supremacy Clause and the Import/Export Clause protections.

Equal Protection Clause Limitations on State Taxation

The Equal Protection Clause of the 14th Amendment to the U.S. Constitution provides that no state shall deny to any person within its jurisdiction equal protection under the law. The Equal Protection Clause prohibits discrimination among taxpayers within the same classification. The Equal Protection Clause does not prevent a state from treating one class of individuals or entities differently from others. Discriminatory taxation is permitted under the Equal Protection Clause if the discrimination is rationally related to a legitimate state purpose.

Due Process Limitations on State Taxation

The 14th Amendment to the U.S. Constitution provides that no state can deprive anyone of life, liberty or property without due process of law. This limitation has been interpreted to mean that no state may levy any tax unless there is "some definite link, some minimum connection, between the state and the person, property or the transaction it seeks to tax" (Miller Bros. Co. vs. Maryland, 347 U.S. 340, 344 [1954]). This minimum connection is commonly referred to as nexus. The U.S. Supreme Court (the Court) has stated that the due process test is "whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state" (Wisconsin vs. J.C. Penney Co., 311 U.S. 435 [1940]). Furthermore, the Court ruled that "purposeful availment of an in-state market by an out-of-state company will satisfy the due process nexus requirement (Quill Corp. vs. North Dakota 504 U.S. 623 [1992]).

The due process limitation has been litigated extensively in the state tax area. A review of the Court's case law on the issue of nexus reveals that some physical presence in the taxing state is required to justify a tax. However, issues of intangible property and economic presence have been hotly debated in recent years. Typically, any due process challenge related to a state tax is coupled with a Commerce Clause argument.

Commerce Clause Limitations on State Taxation

The Commerce Clause provides that Congress shall have the power to regulate commerce between the states. The purpose of the Commerce Clause is to promote a national and international economy that is insulated from impediments by the states. The Commerce Clause has been used to declare unconstitutional any tax that imposes an undue burden on interstate commerce.

The mere fact that a state imposes a tax that affects interstate commerce is not, per se, a violation of the Commerce Clause. Since Congress has not yet addressed the issue, Supreme Court decisions have been used to define the parameters of the Commerce Clause. The Court uses a four-pronged test to determine the constitutionality of a tax affecting interstate commerce. A state tax will survive scrutiny under the Commerce Clause if: 1) substantial nexus exists, 2) the tax is fairly apportioned, 3) the tax does not discriminate against interstate commerce and 4) the tax is fairly related to the services and benefits provided by the state. What constitutes "substantial nexus" under the Commerce Clause requirement remains a matter of considerable controversy and litigation between taxpayers and state governments.

Supremacy Clause Limitations on State Taxation

Article 6 of the Constitution provides that "This Constitution, and the laws of the United States … shall be the supreme law of the land." This provision is commonly referred to as a Supremacy Clause. The Supremacy Clause embodies the doctrine of immunity, which is used to prohibit direct state taxation of the federal government and its agencies. The Supreme Court has considered the Supremacy Clause's effect on numerous state taxes. In U.S. vs. New Mexico, 455 U.S. 720 (1982), the Court ruled on the constitutionality of a sales tax on the sale of tangible personal property to a government contractor. The Court held that immunity is appropriate only "when the levy falls on the United States itself, or an agency or institution so closely connected to the government that the two cannot realistically be viewed as separate entities" (U.S. vs. New Mexico, 455 U.S. 738 [1982]). The court found that the legal incidence of the tax fell on the contractor rather than the federal government, even though the federal government bore the cost of the tax.

Import/Export Clause Limitations on State Taxation

Article 1, section 10, clause 2 of the U.S. Constitution provides that "no state shall, without the consent of the Congress, lay any imposts or duties on imports or exports, except what may be absolutely necessary for executing its inspecting Laws; and the net Produce of all Duties and Imposts laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Control of the Congress." Generally, the Import/Export Clause prohibits states from imposing taxes on imports and exports. Under the Court's decision in Michelin Tire Corp. vs. Wages, 423 U.S. 276 (1976), a nondiscriminatory tax on goods may be sustained where the tax is imposed on an import that no longer is in transit or where the tax is imposed on an export before it has physically begun transit to a foreign destination (Michelin Tire Corp. vs. Wages, 423 U.S. 295 [1976]).

Conclusion

Some flexibility in state policies may be necessary to accommodate the changing electric industry. States have begun to modify those policies in anticipation of electric industry restructuring and in response to the restructuring of other utilities. For example, New Jersey was one of the first states to take action to change its tax code. New Jersey eliminated the gross receipts and franchise tax collected by the electric, gas and telecommunication utilities and replaced it with a corporate business tax.

As states explore tax issues in more depth, they will be better equipped to determine which taxation options are appropriate to meet their needs. They then can be prepared to implement those taxes in the new system.