Legal Insights

Pennsylvania Supreme Court Overturns Longstanding Practice of Excluding State Income Tax Deductions and Accumulated Deferred Income Taxes (ADIT) from Public Utilities’ Distribution System Improvement Charge (DSIC) Calculations

July 26, 2021
By: Devin T. Ryan

On July 21, 2021, the Pennsylvania Supreme Court issued its 5-2 decision in McCloskey v. Pa. PUC, 2021 Pa. LEXIS 3071 (Pa. 2021) (“McCloskey”), a consolidated appeal of two Commonwealth Court rulings concerning the proper calculation of public utilities’ Distribution System Improvement Charges (“DSICs”). See McCloskey v. Pa. PUC, 219 A.3d 1216 (Pa. Cmwlth. 2019) (involving the electric utilities Metropolitan Edison Company, Pennsylvania Electric Company, Pennsylvania Power Company, and West Penn Power Company); McCloskey v. Pa. PUC, 219 A.3d 692 (Pa. Cmwlth. 2019) (involving the water utility Newtown Artesian Water Company). 

The DSIC is an important mechanism that allows public utilities to timely recover the costs of repairing and replacing infrastructure between base rate cases “in order to ensure and maintain adequate, efficient, safe, reliable and reasonable service.”  See 66 Pa. C.S. § 1353(a). There are statutory caps (subject to change by the Pennsylvania Public Utility Commission (“PUC”)) on the amount that utilities can recover using the DSIC:  5.0% of the amount billed to customers for electric, natural gas, and wastewater utilities, and 7.5% of the amount billed to customers for water utilities. See 66 Pa. C.S. § 1358(a)(1)-(2). Therefore, the proper calculation of the DSIC is critical, as it affects the amount of infrastructure repair and replacement costs that the public utilities can timely recover without exceeding the caps.

In McCloskey, the Supreme Court reversed how the DSIC has been calculated by utilities since its inception in 1996, which likely will reduce the calculated percentage change in the quarterly DSIC filings between base rate cases. Specifically, the Court affirmed the Commonwealth Court’s decisions, finding that the recently enacted Section 1301.1(a) of the Public Utility Code requires state income tax deductions and accumulated deferred federal income taxes (“ADIT”) associated with DSIC-eligible plant additions to be included in the DSIC calculation. As a result, the Court remanded the matter to the PUC so that state income tax deductions and ADIT can be reflected in the DSIC calculations of the utilities at issue. 

The case centered around the statutory interpretation of Section 1301.1(a) of the Public Utility Code and statutes related to the DSIC. The Supreme Court broke down Section 1301.1(a) into its four separate sentences as follows:

 (a) Computation. -                 

[Sentence 1] If an expense or investment is allowed to be included in a public utility’s rates for ratemaking purposes, the related income tax deductions and credits shall also be included in the computation of current or deferred income tax expense to reduce rates. 
 
[Sentence 2] If an expense or investment is not allowed to be included in a public utility’s rates, the related income tax deductions and credits, including tax losses of the public utility's parent or affiliated companies, shall not be included in the computation of income tax expense to reduce rates. 
 
[Sentence 3] The deferred income taxes used to determine the rate base of a public utility for ratemaking purposes shall be based solely on the tax deductions and credits received by the public utility and shall not include any deductions or credits generated by the expenses or investments of a public utility’s parent or any affiliated entity. 
 
[Sentence 4] The income tax expense shall be computed using the applicable statutory income tax rates.

McCloskey, at *14-15 (quoting 66 Pa. C.S. § 1301.1(a)). 

The Supreme Court held that the language in Section 1301.1.(a) was unambiguous and applied to “public utility’s rates,” which includes the DSIC. Id. at *15-18, 47. In reaching that holding, the Court rejected several arguments that Section 1301.1(a) should only apply to base rates and not the DSIC. Id. at *18-47.

Principally, the PUC and the electric utilities advocated that Section 1301.1(a) needs to be read as a whole and observed that the third sentence of Section 1301.1(a) uses the term “rate base,” which indicates that “the General Assembly intended for Section 1301.1(a) to apply to base rate cases only and not to DSIC procedures.” Id. at *18-20. Indeed, as noted by the PUC and electric utilities, the legislative history reveals that Section 1301.1 was enacted to eliminate consolidated tax adjustments (“CTAs”) in base rate proceedings. Id. at *20-21. However, “[r]egardless of whether DSICs were an intended target of the General Assembly in enacting Section 1301.1,” the Court determined that “the words employed in the first sentence plainly encompass DSICs, which provide for ‘expense[s] or investment[s] . . . to be included in a public utility’s rates for ratemaking purposes.’” Id. at *23-24 (quoting 66 Pa. C.S. § 1301.1(a)). To the extent that Section 1301.1(a) should not apply to the DSIC, then the General Assembly “can simply add a phrase clarifying that intent.” Id.

The Supreme Court also rejected the electric utilities’ arguments that such an interpretation of Section 1301.1(a) conflicts with Section 1301.1(b). Id. at *24-26. Specifically, subsection (b) of Section 1301.1 allocates the increased revenue from the elimination of the CTA in subsection (a). Id. at *24-25. Since “Section 1301.1 does not contemplate the reduction of revenue” that would result from applying Section 1301.1(a) to the DSIC, the electric utilities maintained that the statute is ambiguous. Id. at *25. The Court disagreed, reasoning that “while some aspects of Section 1301.1, including subsection (b), highlight[] and address[] the likely increase in revenue resulting from the elimination of the CTA, the first sentence clearly indicates the intent to ‘reduce rates.’” Id. at *26.

In addition, the Court found no conflict between Section 1301.1(a) and the rules for calculating the DSIC charges set forth in Sections 1351 and 1357 of the Public Utility Code. Id. at *26-34. Although the Court recognized that “Sections 1351 and 1357 do not currently include an accounting for income tax deductions and credits,” the mere “absence of a tax adjustment computation in the DSIC proceedings” does not create “a conflict with the requirement for such a computation in Section 1301.1(a).”  Id. at *34. According to the Court, “Section 1301.1 supplements rather than conflicts with the DSIC computations currently set forth in the statute.” Id.

The Supreme Court also denied the PUC’s and electric utilities’ argument that the DSIC’s “earnings cap” under Section 1358(b)(3) of the Public Utility Code “satisfies” Section 1301.1(a)’s requirement that the DSIC account for income tax deductions and credits. Id. at *35-46. The calculation of the “earnings cap” is based on an “earnings report” that looks at “the utility as a whole.” Id. at *45. In contrast, “Section 1301.1’s language directs the inclusion of the ‘related income tax deductions and credits’” that are “related to the ‘expense or investment . . . included in a public utility’s rates for ratemaking purposes.’” Id. (quoting 66 Pa. C.S. § 1301.1(a)). Therefore, the Court “conclude[d] that the earning cap calculation of Sections 1358(b) does not sufficiently account for the income tax deductions and credits related to a specific DSIC expenditure.” Id.

As a result, the matters have been remanded to the PUC so that state income tax deductions and incremental ADIT can be reflected in the DSIC calculations of the utilities at issue. 

Justices Saylor and Mundy dissented. They maintained that Section 1301.1(a) is “sufficiently ambiguous to warrant recourse to the tools of statutory construction,” which support the PUC’s “longstanding position that utilities need not account for accumulated deferred income taxes and state income tax deductions in the central calculation of these specialized rate adjustments.” McCloskey, 2021 Pa. LEXIS 3071, at *47-48 (Saylor, J., dissenting). As Justice Saylor writes, the DSIC was “intended by the General Assembly to serve as a simplified mechanism designed to accelerate investments in infrastructure in lieu of base rate proceedings.”  Id. at *48. Moreover, the “existing statutory protections against utilities’ overearning returns on investments and/or excessive [DSICs] are sufficient and further manifest the legislative intent to maintain the historical approach to the calculation of these charges.” Id. Thus, according to the dissenting justices, the Court should have ruled in favor of the PUC and public utilities.

The Court’s decision will have a substantial impact on public utilities’ ability to use the DSIC to timely recover the costs of necessary infrastructure repair and replacements. The Supreme Court itself noted that prior to the DSIC, “utilities were unable to adjust their rates between base rate cases to recover the costs of these non-revenue producing and non-expense reducing projects, resulting in a regulatory lag of potentially years between the time utilities expended funds for the infrastructure improvements and when they could recoup that amount from customers through increases in the base rates charged.”  McCloskey, 2021 Pa. LEXIS 3071, at *5. These infrastructure improvements continue to be critical, as public utilities have old and aging infrastructure that needs to be repaired or replaced. Yet, by reducing the amount that the DSIC can recover, the Supreme Court’s decision essentially contradicts the DSIC’s purpose—to reduce the “regulatory lag” for utility infrastructure repairs and replacements. Also, as noted by the PUC and utilities in the McCloskey appeal, the DSIC was intended to be a simplified calculation, not one overly complicated by deferred income tax deductions from rate base and accelerated state income tax deductions. Now, the DSIC calculations will become more complex and less streamlined than they have been since 1996, placing additional burdens on public utilities and interested stakeholders. 

In response to the decision, the General Assembly could amend Section 1301.1(a) to clarify that the DSIC is excluded from the statute’s reference to “rate.” Furthermore, interested stakeholders and legislators will need to be mindful that any reference to “rate” in proposed Public Utility Code legislation may encompass the DSIC. For public utilities with PUC-approved DSICs who were not parties in the appeal, the major question is whether the Supreme Court’s decision can only apply to their DSIC calculations prospectively.

This article was prepared by Devin T. Ryan, Principal in the Energy & Utilities Practice Group at Post & Schell, P.C. If you have any questions or wish to discuss the subject of this article, please contact Mr. Ryan at 717.612.6052 or dryan@postschell.com.

Disclaimer: This post does not offer specific legal advice, nor does it create an attorney-client relationship. You should not reach any legal conclusions based on the information contained in this post without first seeking the advice of counsel.