ARCHIVED -  Telecom Decision CRTC 99-2

Telecom Decision

Ottawa, 4 March 1999

Telecom Decision CRTC 99-2

MTS COMMUNICATIONS INC. - MECHANISM TO RECOVER FUTURE INCOME TAX EXPENSE

File No.: 8678-C12-02/98

SUMMARY

In this Decision, the Commission denies a request by MTS Communications Inc. (MTS) to pre-collect its future income tax expense from its basic residential local subscribers. However, the Commission approves a pre-collection option whereby MTS will be permitted not to make some or all of the future rate reductions, mandated under the price cap formula. The Commission expects that the rate reductions mandated by the price cap formula will primarily apply to business rates. Any such rate reductions that are not made by MTS will accumulate in a deferral account with interest. The deferral account will be used to mitigate future rate shock to basic residential local subscribers, when MTS incurs income tax expense.

I INTRODUCTION

A. Background

1.Prior to its privatization in 1997, the Manitoba Telephone System obtained an advance income tax ruling from Revenue Canada dated 10 October 1996 concerning the deductibility, for income tax purposes, of contributions to a new employee pension trust fund. Upon privatization, the Manitoba Telephone System was continued as a share capital corporation under the name Manitoba Telecom Services Inc. (Manitoba Telecom). From that point on, Manitoba Telecom and its subsidiaries, including MTS Communications Inc. (MTS), became taxable corporations. MTS was allocated part of the tax benefit in the amount of approximately $359 million in income tax deductions. These tax deductions eliminated the income tax liability for 1997 and produced an income tax loss carry-forward [i.e., additional tax deductions (ATDs)] to offset future income tax liability for several years.

2.By letter dated 31 March 1998, MTS filed an application proposing, among other things, to implement rate revisions and to introduce an exogenous factor relating to its future income tax expense in the company's price cap formula.

3.MTS proposed that an exogenous factor for 1998 be implemented only at the level of the total basket of capped services. It also proposed implementing eight annual exogenous adjustments, commencing 1 January 1999, that would provide for the gradual recovery of future tax expenses. These exogenous adjustments would be incorporated both at the level of the total basket of capped services and at the level of the Basic Residential Local Service (Residential) Sub-Basket.

4.In Telecom Order CRTC 98-467, dated 12 May 1998, the Commission determined that it would be premature and inappropriate to proceed with MTS' proposed 1998 exogenous factor adjustment in light of the significance of the issues associated with MTS' proposal. The Commission stated that it would establish a public process to examine MTS' proposed exogenous adjustments for future income taxes.

B. Proceeding

5.On 29 May 1998, the Commission issued MTS Communications Inc. - Mechanism to Recover Future Income Tax Expense, Telecom Public Notice CRTC 98-12, initiating a proceeding to examine the appropriateness and timing of MTS' proposed exogenous adjustments. MTS was directed to file, by 29 June 1998, evidence regarding its proposal for an exogenous factor adjustment to the price cap index (PCI) and to address, among other matters, the following issues:

(1) the basis of allocating the exogenous event relating to income tax expense between capped and uncapped services;

(2) a detailed description of the mechanism, along with supporting calculations and assumptions, to recover income tax expense from capped services; and

(3) the annual impact on the price cap constraints and the potential impact on residence and business subscribers.

6.On 29 June 1998, MTS filed its evidence which was revised on 17 July 1998. On
21 September 1998, the Consumers' Association of Canada (Manitoba) and the Manitoba Society of Seniors (CAC/MSOS) filed evidence. MTS and CAC/MSOS each filed comments on 24 November 1998 and reply comments on 3 December 1998.

7.On 11 September 1998, the Commission issued MTS Communications Inc. - Mechanism to Recover Future Income Tax Expense: Addition of Winnipeg Public Consultation to the Procedures in Telecom Public Notice CRTC 98-12, Telecom Public Notice CRTC 98-24, announcing that it would hold a public consultation in Winnipeg on 7 November 1998.

8.The public consultation took place before Commissioners David Colville (chairman of the hearing), David McKendry and Martha Wilson. A number of individuals and groups appeared to present their views on MTS' application.

9.In addition to the public consultation, the Commission also received over 200 written comments and 12 petitions with over 1,300 signatures opposing MTS' proposal.

II ISSUES REGARDING PRE-COLLECTION OF FUTURE INCOME TAX EXPENSE

A. Exogenous Factor

10.In Price Cap Regulation and Related Issues, Telecom Decision CRTC 97-9, 1 May 1997 (Decision 97-9), the Commission stated that an exogenous factor adjustment would be considered for inclusion in the PCI if the exogenous event satisfies the following three criteria:

(1) it is a legislative, judicial or administrative action that is beyond the control of the company;

(2) it is addressed specifically to the telecommunications industry; and

(3) it has a material impact on the Utility segment of the company.

11.In a letter dated 31 December 1997, the Commission stated that exogenous factor adjustments to the PCI provide an appropriate mechanism by which MTS may apply to recover present and future income tax expenses, subject to the criteria stipulated in Decision 97-9.

12.MTS submitted that the Commission's 31 December 1997 letter provided the company with the approval to pre-collect income tax expense through an exogenous factor. MTS noted the Commission's statement that "exogenous factor adjustments to the price cap index provide an appropriate mechanism by which MTS may apply to recover present and future income tax expense...". In MTS' view, this proceeding was initiated to consider an appropriate and timely mechanism of exogenous adjustments to enable recovery of future income tax expense. MTS argued that the only outstanding questions were the timing and the amount of the exogenous adjustment.

13.CAC/MSOS submitted that the exogenous factor was intended to recover new costs in a manner that respects the constraints of the price cap mechanism. In CAC/MSOS' view, it is not appropriate for an exogenous factor to be used to pre-fund or collect funds prior to the expense being incurred.

14.The Commission is of the view that the first criterion for considering whether to allow inclusion of an exogenous factor has been met, since MTS became subject to income tax pursuant to a legislative action beyond the control of the company.

15.Although income tax is not specific to the telecommunications industry, the recovery of tax in this case is specific to MTS as it is the only telephone company that did not have income tax expense taken into account in setting its rates in Implementation of Price Cap Regulation and Related Issues, Telecom Decision CRTC 98-2, 5 March 1998, prior to the implementation of price caps. Therefore, the Commission is of the view that the second criterion has been met.

16.The Commission considers that the impact on the company's Utility segment is material. Therefore, the Commission finds that the third criterion has been met.

17.In view of the above, the Commission concludes that incurring income tax expense by MTS meets the criteria of an exogenous event as defined in Decision 97-9.

B. Pre-collection from Residential Subscribers

1. MTS' Proposal

18.MTS submitted that, in the absence of a mechanism to address its future income tax liability, customers of its basic local residential services could face a monthly rate increase in the future of approximately $9.00 ($7.43 in 2001 and an additional $1.52 in 2002) when MTS incurs actual income tax costs. In MTS' view, this was not a reasonable or a viable option.

19.In order to raise rates to recover its Utility segment future income tax expense in a more gradual manner, MTS proposed a program of exogenous adjustments that would be applied to its PCI calculations over a five-year period commencing 1 January 1999. MTS also proposed corresponding adjustments to the Service Band Limits (SBLs) for the Residential Sub-Basket. MTS considered that its proposal would provide the company with adequate pre-tax funds to address its future tax liability and minimize the potential rate impact to its residential subscribers by providing an average increase of $1.60 per year for five years. In addition, MTS noted that its proposal would permit the company to adhere to the 10% price cap rate constraint on basic local residential rates in bands where the loops are considered essential.

20.In conjunction with the above-noted proposal, MTS proposed a deferred benefit account mechanism, which would accumulate the revenues derived from the exogenous adjustments. MTS proposed that funds accumulated in this account would earn interest at 4.75%. Once MTS actually incurs an income tax expense, funds in this account would be drawn down to recognize the specific tax charges as they become due on the earnings of its Utility segment.

21.MTS was of the view that its proposed program of exogenous adjustments combined with a deferred account mechanism would reduce the impact and preserve pricing protection for its customers, and offer MTS a reasonable opportunity to recover its future income taxes.

22.Furthermore, MTS submitted that pre-tax revenues required to meet its Utility segment income tax expense should be recovered from services that are priced below costs, in particular basic local residential services. MTS considered that recovery from uncapped or competitive services would:

(1) preserve cross-subsidies and maintain basic residential rates below costs;

(2) serve to heighten barriers and reduce competitive entry into the market for uncapped and competitive services; and

(3) be economically inefficient.

23.MTS submitted that delay in collecting its future income tax expense beyond 1999 would hamper its ability to deliver its current services as well as introduce new and innovative services, and as such, would place the company at a competitive disadvantage relative to its competitors. MTS emphasized the importance of having the flexibility to price its existing capped services in order to respond to competition and maintain an appropriate balance in its margins.

24.Finally, MTS submitted that there is an expectation from the financial community that the company requires an effective mechanism to recover its future income tax expense. MTS was of the view that addressing the future recovery of its income taxes should commence prior to MTS actually incurring an expense. In support, MTS provided a submission prepared by RBC Dominion Securities which concluded that "a positive ruling by the CRTC would significantly benefit clients and stakeholders by reducing uncertainty towards cash flows and earnings".

2. CAC/MSOS' Position

25.CAC/MSOS was of the view that MTS' proposal to pre-collect for a future expense which has neither been paid nor incurred contravenes current accounting and regulatory principles. CAC/MSOS submitted that the principle of matching cost recognition with cost incurrence has been recognized as an essential component of both the regulatory and accounting processes. CAC/MSOS submitted that regulated companies are entitled to an opportunity to earn a return on capital invested by them and to recover costs reasonably and prudently incurred.

26.CAC/MSOS also stated that the MTS proposal violates the concept of inter-generational equity because it asks current subscribers to bear costs which should be properly borne by future ratepayers.

27.CAC/MSOS noted that, if MTS were allowed to pre-collect its income tax expenses, the company would lose all incentives to operate in an efficient and cost effective manner and as such, would enjoy an enormous pricing advantage over its competitors.

28.CAC/MSOS submitted that MTS' future tax liability is based on projections of events expected to occur approximately three years into the future. CAC/MSOS submitted that MTS was seeking to collect from consumers before the magnitude and timing of this future expense is known.

29.CAC/MSOS noted that, as competition in the local market evolves, market forces may limit increases to amounts below those permitted under the price cap regime and, as such, pre-collection would enable MTS to build up funds that will cushion its transition to a fully taxable status. However, CAC/MSOS also stated that MTS would be pre-collecting taxes from its most captive subscribers (i.e., basic local residential subscribers) in a period when local competition is limited.

30.CAC/MSOS stated that, in the event that MTS was allowed to pre-collect, MTS' proposed return of 4.75% on pre-collected funds in the deferral account was too low because this rate was most likely below the cost of capital of most residential customers.

3. Conclusions

31.In past decisions, the Commission has recognized and allowed income tax expense to be included in the calculation of a company's revenue requirement only when it is incurred. The Commission's practice has been not to grant increases to subscribers' rates unless the income tax expense being incurred increases a company's revenue requirement. The Commission considers that these accounting and regulatory principles should continue to apply unless special circumstances would justify the Commission deviating from them.

32.With respect to MTS' concerns regarding competitive issues, the Commission notes that MTS' proposal would allow it to pre-collect from its basic local residential subscribers, who are its most captive subscribers, during the infancy period of local competition. The Commission is of the view that pre-collection from captive subscribers would provide MTS with an unfair competitive advantage, as it could allow the company to cross-subsidize other competitive services.

33.With respect to MTS' concerns regarding rate shock, the Commission recognizes that waiting to recover income tax until the company incurs it could result in a potentially large monthly increase to basic local residential subscriber rates. In this regard, rate shock is a special circumstance which could warrant deviation from previously established regulatory and accounting principles.

34.The Commission is mindful that pre-collection of future income tax expense would serve to mitigate MTS' rate shock concerns for residential subscribers. In this regard, the Commission is of the view that the mechanism to recover future income tax expense set out in Part IV of this Decision would provide MTS with the opportunity to mitigate its rate shock concerns.

35.With respect to MTS' concerns regarding expectations from the financial community, the Commission considers that the mechanism outlined in Part IV of this Decision should provide sufficient assurance that MTS will be provided an opportunity to recover its future tax liability.

36.In view of the above and in light of the uncertainty regarding the timing and magnitude of the increase of income taxes for MTS' Utility segment, the Commission considers that no increases to basic local residential subscriber rates as proposed by MTS should be granted in these circumstances. Therefore, the Commission denies MTS' proposal to include an exogenous factor adjustment to the Residential SBL in order to pre-collect for its future income tax expense.

C. Canadian Institute of Chartered Accountants Handbook Section 3465

37.In its comments, MTS noted that, in accordance with Generally Accepted Accounting Principles (GAAP) and specifically Section 3465 of the Canadian Institute of Chartered Accountants Handbook, it will be obliged to recognize the benefits resulting from the remaining balance of its income tax loss carry-forward as an asset in its financial statements in the year 2000. Pursuant to the same section, MTS also noted that it will be required to record income tax expense commencing in January 2000. However, in its reply comments, MTS stated that the method of accounting for its income taxes is irrelevant when considering the appropriate mechanism to recover income tax.

38.In reply comments, CAC/MSOS questioned why MTS omitted to document the requirements of Section 3465 during the evidentiary portion of the proceeding. In addition, CAC/MSOS noted that, when MTS adopts Section 3465 by booking income taxes and recording the benefit of the remaining balance of its loss carry-forward as an asset on its balance sheet, the Commission must still determine the appropriate regulatory accounting treatment for this asset. CAC/MSOS stated that, during the evidentiary portion of the proceeding, MTS failed to advise the Commission or interested parties that it was seeking a determination of the appropriate regulatory accounting procedure.

39.The Commission notes that the requirements of Section 3465 were announced in December 1997 and provided for a transition period prior to required implementation on 1 January 2000. Under these new requirements, in the year 2000, MTS will be required to reflect income tax expense on its income statement and record an asset on its balance sheet that reflects the benefit of the remaining balance of its loss carry-forward.

40.The Commission notes MTS' submission that it will not be required to record income taxes until 2000 and that the method of accounting for income tax is irrelevant when considering a mechanism for recovery.

41.The Commission agrees with CAC/MSOS that, when MTS adopts Section 3465, the Commission will still have to determine the appropriate regulatory accounting treatment for this asset. In any event, the Commission concludes that the appropriate regulatory treatment regarding the implementation of Section 3465 is beyond the scope of this proceeding.

D. Alternative Proposal - Uniform Province Wide Rate

42.In its final comments filed 24 November 1998, in an effort to address concerns that MTS' basic local residential rates might become amongst the highest in the industry, MTS proposed, in the alternative, a uniform monthly rate of $21.00 for basic residential local service across its serving territory. Under this alternative proposal, MTS' monthly rates for basic local residential service would increase to $21.00 effective 1 January 1999, and would remain frozen for the remainder of the price cap period.

43.In its reply comments, CAC/MSOS was of the view that the alternative proposal was presented outside the evidentiary process. CAC/MSOS also stated that the alternative proposal endorses the pre-collection of income taxes before they are incurred. In addition, CAC/MSOS submitted that MTS' alternative proposal violates the 10% price cap constraint in the Residential Sub-Basket where loops are considered essential.

44.The Commission agrees with CAC/MSOS that the proposal was presented outside the evidentiary stage of the proceeding. The Commission notes that MTS' alternative proposal endorses pre-collection of future income tax expense through increases for basic local residential subscribers. As a result of the determinations in Section B above (i.e., not to allow increases to basic local residential subscriber rates to pre-collect future income tax expense), a decision on MTS' alternative proposal is not necessary.

III ALLOCATION OF ADDITIONAL TAX DEDUCTIONS

45.MTS proposed that the $359 million tax benefit arising from its 1997 contribution to the company's new pension plan be allocated between its Utility and Competitive segments on the basis of gross telephone plant in service.

46.MTS was of the view that gross telephone plant in service is a reasonable proxy of the historical salary expense that caused the creation of the ATDs. Moreover, MTS noted that, unlike current salaries and wages expense, allocating the ATDs using gross telephone plant in service provides the greatest benefit to the consumer as it allocates the majority of the ATDs to the Utility segment.

47.CAC/MSOS did not object to the company's proposed allocation of the tax benefits between the Utility and Competitive segments.

48.The Commission considers that generally the most appropriate approach to allocating ATDs is on a cost-causal basis. In MTS' case, the Commission considers that, given that the source of the tax benefit was a pension fund contribution, one appropriate method for allocating the ATDs between the Utility and Competitive segments would be on the basis of applicable salaries and wages.

49.However, in light of the difficulty of obtaining information on historical salaries and wages and the year-over-year stability of the assignment of gross telephone plant in service, the Commission considers MTS' proposal to be reasonable.

IV MECHANISM TO RECOVER FUTURE INCOME TAX EXPENSE

50.In interrogatory MTS(CRTC)31Jul98-112, MTS was requested to provide its views on an approach whereby the company would be allowed to recover only a portion of its future income tax expense from basic local residential subscribers and to offset the remaining amount required against the rate reductions mandated under the price cap regime.

51.In its response, MTS indicated that it would have serious concerns with any restrictions or limitations that would apply to the company, but would not also apply to the other telephone companies. MTS was especially concerned about constraints that would either limit or restrict its ability to implement its local pricing strategy. MTS considered that such constraints were inconsistent with the principles of price cap regulation and the new regulatory regime. MTS argued that pricing flexibility is vital given the introduction of local competition.

52.In response to interrogatory MTS(CRTC)28Sep98-1101c), MTS also expressed its disagreement with any proposal to use mandated rate reductions under the price cap regime that cannot be implemented, due to imputation test constraints, to offset the additional revenues required to address the recovery and payment of future income tax expense.

53.MTS submitted that the issues associated with any company being unable to make rate reductions under the price cap regime due to imputation test constraints are numerous and complex.

54.The Commission notes that MTS, in its evidence, forecast a $40.5 million shortfall in Utility segment pre-tax revenues for the year 2001 based on the company's current financial forecast for that year. As stated earlier, this would translate into an increase of $7.43 to the basic local residential monthly rate in the year 2001 if all of the Utility segment's income tax expense were to be recovered from these subscribers.

55.As stated in Part II of this Decision, no increases to basic local residential rates will be permitted to pre-collect future income tax expenses. Nevertheless, the Commission is mindful of the potential large increases that MTS residential subscribers could face in the future.

56.Accordingly, the Commission considers that the option, described below, could mitigate the potential rate shock to subscribers and the extent to which the 10% constraint on rates in rural areas could be breached when MTS starts to incur income tax.

57.Starting in 1999, the Commission approves a pre-collection option whereby MTS will be permitted not to make some or all of the rate changes mandated under the price cap formula. The Commission expects that the rate reductions mandated by the price cap formula will primarily apply to business rates. To the extent that MTS chooses not to implement any such rate changes required under the price cap formula, the resulting additional revenues will accumulate in a deferral account. When MTS incurs income tax, the funds accumulated in the deferral account will be used to mitigate any rate increases to basic local residential services that may be required to fund income tax expense at that time.

58.If MTS decides not to implement some or all of the mandated rate changes under the price cap formula in a particular year, MTS must include with its 31 March filing, an exogenous factor applicable at the PCI level for that year. This exogenous factor will account for the difference between (i) the Actual Price Index (API) if MTS had implemented the mandated rate changes and (ii) the API for the year. The resulting revenues corresponding to the difference in the APIs is the amount that MTS must accumulate in the deferral account for that year. If the API in (ii) is less than or equal to the API in (i), no amount will be transferred into the deferral account.

59.The Commission notes that, with the possible introduction of an annual exogenous factor to pre-collect income tax expense into the price cap formula, it will be necessary to adjust the PCI each year. Therefore, the current year's PCI will be based on the previous year's PCI excluding the impact of the previous year's exogenous factor.

60.The Commission agrees with MTS' proposal that pre-collected funds, which accumulate in the deferral account, should earn interest based on a short-term rate of 4.75%. On that basis, the Commission finds that it would be appropriate to accrue interest on any amounts in the deferral account at the rate of 4.75% per annum.

61.The Commission is of the view that this option will not hinder MTS' pricing flexibility. Further, this option will also allow MTS to determine the extent to which it can mitigate potential rate shock to residential subscribers' rates by accumulating sufficient amounts in the deferral account.

62.The Commission notes that, if MTS chooses not to utilize the deferral account, or if insufficient funds are accumulated in the deferral account, the Commission may have to address the issue of potential rate shock to local residential subscribers' rates when the company incurs income tax expenses.

63.The Commission also notes that a significant portion of the Utility segment income tax expense will likely have to be recovered from basic local residential subscribers in the future since most residential local services are priced below cost. The extent of this impact will be dictated by MTS' response to the competitive environment at that time.

Secretary General

This document is available in alternative format upon request.