Energy #24 – Hydro One’s Phantom Taxes

Hydro One is planning to collect more than $1.5 billion ($2.0 billion in rates) for taxes it will never pay.   The Ontario Energy Board seems poised to let them do that.

This has created a bit of a controversy.

As a former tax lawyer with knowledge of the case, I have been asked numerous times to explain this issue.

All right, already.  Here is my explanation.

Caveat #1:  I have represented the School Energy Coalition, a major customer group, throughout the process described below, and weighed in on the issues.  In this article, I am trying to keep my views out of it, and just describe the various aspects of the problem without taking a position.

Caveat #2:  The specifics of the issue are in fact quite complicated.  This article simplifies as much of it as possible, without changing the fundamental factors at play.  If you are a tax specialist, this article is not going to help you understand the details.

There are three components to address.  First, there is the interaction of the relevant tax rules, and how that plays out.  Second, there is the application of the fundamental rate-making principle, which controls cost recovery by the utility.  Third, there is the somewhat unusual process that has unfolded so far to deal with this issue.

The Phantom Tax

Companies that are owned at least 90% by a province or a municipality are not subject to normal (i.e. federal) income tax.  They are exempt from that tax.   But, Ontario electric utilities in that situation are subject to an identical amount of tax levied by the Ontario government (called PILs, which stands for “payments in lieu of taxes”).

Hydro One was one of those exempt companies, because it was owned by the Province of Ontario.   It paid the same amount of taxes as other companies, but it paid them all to Ontario.

Then they did an IPO, and more than 40% became owned by others, mostly pension funds and mutual funds.

Once they decided to do that (but before they completed it), two things happened.

First, they became subject to federal income tax (plus the related Ontario income tax), just like any other company.

Second, they ceased to be subject to Ontario PILs, but on the way out the door they had to pay a “departure tax” to the province of $1.5 billion.

The way it works is that when you leave one set of tax rules (the PILs rules) to go to another (the feds), you are treated as having sold all of your assets for fair market value for both purposes.

For PILs, this means you pay an extra tax.  Some depreciation deductions you have taken in the past are reversed and taxed, and any gain over the original cost of assets is a capital gain, also taxed.

Let me give you an example.  Assume Hydro One paid $1 million for a substation in 2006.  It has taken $500,000 in deductions for depreciation (called capital cost allowance) in calculating its Ontario PILs since then.  Now the substation is worth $1.3 million, and is treated as sold at that price.  The $500,000 of depreciation deductions taken to date were obviously not necessary (its value didn’t decline), so are recaptured and taxed fully.  Half of the additional gain of $300,000 is taxed, so $150,000 is added to taxable income.  In total, tax is paid on $650,000.

When you do that with all of Hydro One’s assets, you get a total departure tax bill of about $1.5 billion, payable to the Ontario government.

Hydro One wanted to write a cheque for that tax, of course, but didn’t actually have $1.5 billion lying around.  Its shareholder – that very same Ontario government – stepped in and gave them $1.5 billion for some new shares, which allowed Hydro One to give that $1.5 billion back to the government as a tax.  Before these transactions, Hydro One was 100% owned by the province.  After these transactions, Hydro One was still 100% owned by the province.  Both Hydro One had exactly the same amounts of money before and after these transactions.  Nothing had been changed, but the tax had been “paid”.

In fact, government officials expressly justified those transactions to the Legislature (Standing Committee at pages 419-420) on the basis that the money was just going around in a circle, and there was no net impact to Hydro One or the province.

On the other side, the federal income tax applies only on the increased value of the assets after the pretend sale at fair market value.  This means that Hydro One gets to take much larger depreciation deductions going forward than it would have otherwise had available.

The effect of those higher deductions is that, for about the next twenty years, Hydro One will not actually have to pay federal (or related Ontario) income tax.  The total amount of tax it will be able to avoid is – wait for it – about $1.5 billion.

(The two amounts – the departure tax and the future avoided taxes – are not identical for various technical reasons, but they are close, because they are calculated using mostly the same inputs.)

So, the underlying foundation of this problem is that Hydro One paid a $1.5 billion tax, but got it right back from the province, so it wasn’t out of pocket.  At the same time, Hydro One became subject to future federal taxation, but will avoid the first $1.5 billion of those taxes.

All good, right?

The Ratemaking Paradigm

Rates for electricity transmitters and distributors (Hydro One is both) are set on the basis of recovery of the costs incurred to transmit or distribute electricity.

Most costs are calculated the same way for accounting purposes as for rates purposes.  However, the longstanding rule for tax costs is that the accounting amount is not used.  Instead, the utility forecasts the actual taxes it will pay in the year, and that is the amount that it recovers through rates.

This makes a big difference, since usually the accounting provision for taxes is much higher than the actual taxes payable.  (The reasons for that are not important here.)

On the face of it, this would mean that Hydro One would not include any amount in its costs for taxes until it actually becomes taxable again, i.e. in about twenty years.  Rates would be lower by more than $2 billion over that time frame (since taxes have to be grossed up to be recovered in rates…don’t ask me to explain that math).

There is a second rule, and that is that costs incurred for reasons other than transmission or distribution of electricity are not recoverable in rates.  That, of course, stands to reason:  why would customers pay for costs that are not related to the service they are buying?

For example, it is well accepted that the $1.5 billion departure tax cannot be recovered in rates.  The departure tax happened because the shareholder wanted to do an IPO.  It had nothing to do with the service being provided to customers.

The other side of that argument – as Hydro One argued – is that the federal tax savings are also unrelated to providing the service to customers.  They also arise because of something the shareholder did to benefit the shareholder.

Thus, Hydro One argued that it should be able to calculate the taxes it collects in rates as if nothing had happened, i.e. pretend that it had not gone public, and it did not have the twenty year tax shelter.  It would, on their theory, collect taxes each year as if it were going to pay them as usual, but then just keep the money.

The Four Theories of the Case

Not everyone agreed that Hydro One should be able to recover $1.5 billion in taxes that it would not actually pay.

There were basically four ways of looking at the problem:

  1. Prepayment.  The payment of the $1.5 billion departure tax was a prepayment of federal taxes that would otherwise have been payable over the next twenty years.  Collecting phantom taxes each year in rates effectively collects the departure tax from customers over time.  This approach can be used to argue against collecting the taxes in rates (the departure tax is not normally recoverable from customers) or to argue in favour of collecting phantom taxes (Hydro One is being kept whole, and the customers are losing nothing).
  1. Standalone.  The departure tax was unrelated to the service to customers, but so are the future federal tax deductions.  Neither should impact rates.  This was Hydro One’s basic argument.  It supports ignoring the extra deductions, and thus collecting the phantom taxes in rates.
  1. Windfall.  The departure tax was not actually paid, since it was immediately returned to Hydro One and there was no change in anyone’s economic position.  Therefore, the normal rule should apply, which is that actual tax payable should be collected from customers in rates.  In effect, there is a windfall, and as between the customers and the shareholders it should go to the customers.  The last time there was a similar situation, when the electricity distributors first became subject to Ontario PILs tax in 1999, this is the basic rule that was followed.  Any windfall tax benefit went to the customers.
  1. Split the Benefit. There is a $1.5 billion tax benefit available from this set of transactions.  It should be split in some rational and fair manner between the customers of Hydro One, and its shareholders.

The Process That Has Unfolded to Date

This tax question arose initially in the Hydro One Transmission rate case for 2017, the first after the IPO.  The arguments described above were all made, at considerable length.  The general consensus emerged that no-one understood it completely.

Really?!

In a long and carefully reasoned decision, the OEB took the fourth approach, splitting the tax benefit between customers and shareholders.

That portion of the Hydro One Transmission decision was written by Peter Thompson, a Board member and a former lawyer for customer groups over almost fifty years.   Although all three Board members agreed with his analysis, and the decision is actually rendered on behalf of all three, Mr. Thompson’s writing style is distinctive.  Thus, notwithstanding the protocol that no-one discusses who wrote what part of any decision, Mr. Thompson’s tens of thousands of pages of submissions and arguments over the years make his authorship obvious.

In the Board’s analysis, the $1.5 billion of tax benefits should be divided into two parts.

The part that relates to the depreciation previously deducted, but not ultimately needed, represents deductions that have already been taken by Hydro One to arrive at past rates.  Those deductions are now available again under the federal act, but the customers have already had the benefit of those deductions once before.  To give them the benefit again would be double counting, and unfair, so that part of the tax benefit goes to the shareholders.

The part that relates to assets being more than their original cost – the pure capital gain – is nothing more than a windfall.  That part of the tax benefit goes to the customers, under the normal rules for tax windfalls.

(There was a second and more complicated breakdown, based on ownership of Hydro One shares as between the province and third parties, but in the end only the first breakdown was included in the calculation of the split.)

An apoplectic Hydro One appealed everywhere they could:  both the internal appeal process at the OEB (called a Motion for Review), and the external appeal to Ontario Divisional Court.  For that much money – about $900 million lost in the split of benefits – it stood to reason that they would appeal.  They have no real downside, so why not give it a try.

Under the Motion to Review process, the OEB establishes a new panel of Board members to review the previous decision.  The test is whether there is a material error in the original decision that, if corrected, would result in a different outcome.   For example, did the Board in making the original decision misunderstand the facts, or misapply the law or the OEB’s policies?

The practice has developed that the OEB first determines whether the motion is really serious, called the “threshold test”, and ask parties to make submissions on that question.  In an unusual step, the review panel on the motion determined that it would not ask for input on that issue, and made a preliminary determination that the threshold test had been met.  This appeared to some to be a statement that the review panel thought Hydro One had a good case to succeed on their appeal.

(There are some who allege that “the fix was in” with respect to the review panel, i.e. that somehow the government wanted the original decision to be changed.  I might as well deal with that directly.  The possibility that OEB cases are predetermined based on backroom activities is remote at the best of times.  In this case, it is even more unlikely.  When Hydro One filed its appeal, there was a Liberal government in place.  Between then and the issuance of the review decision, a new PC government was installed.  For the “fix” to “be in”, those two governments would both have had to be influencing the OEB, sequentially, and in the same direction.  This is not credible.)

After seeing extensive written submissions, and then hearing oral argument by the parties, the review panel concluded that the original decision was wrong.  While the analysis in the review decision was not very comprehensive, it appears that the review panel accepted the arguments of Hydro One, i.e. that the departure tax was actually paid, and that the future tax deductions arose out of the same transaction.  As a result, they represented a real transaction (rather than a windfall), not related to the provision of services to customers, and the customers should not get the benefit of the tax savings.

However, instead of simply deciding the issue on that basis, the review panel decided to send the case back to the original panel, to change its decision to be consistent with the findings of the review panel.

That’s where the matter stood this morning, awaiting decision by the original panel.

The Procedural Twist

This turn of events created an interesting procedural anomaly.  Two of the three members of the original panel – the Chair Ken Quesnelle, and the person who wrote the tax section of the decision, Peter Thompson – had come to the end of their terms as Board members.  Under the rules, they could no longer be appointed to new Board panels, but they could continue to deal with matters with which they were already seized at the time their appointments ended.

What this meant is that the full original panel – Quesnelle, Thompson, and continuing Board member Emad Elsayed – could complete the case by rendering a revised decision.

In a surprising move, the Board instead determined that a new panel would be formed, dropping Thompson and adding Cathy Spoel, one of the members of the review panel, but retaining Quesnelle and Elsayed.

This has created two problems.

First, the Chair of the OEB can generally determine who is on any panel for any matter.  However, Mr. Quesnelle cannot be appointed to a new panel, because he is no longer a Board member.  Thus, the new panel appears to be improperly constituted.

Second, the decision of the review panel was to send the matter back to the original panel, which had already heard the evidence, and thus was in the strongest position to render the final decision.  A new panel would not be able to take the original panel’s place, because it would not have heard the evidence.  This would not be implementing the review panel’s decision.

Since the “new” original panel was decided on, no further action appears to have been taken (until today – see below).  It is not known whether this problem will affect the final resolution of this matter, or whether the legal issues with the panel’s composition will give rise to legal challenges from customer groups or others.

Today a Procedural Order was issued by the new original panel telling parties what they wanted.  It did three interesting things.

  • The proceeding has a new “matter” number. This is not consistent with the original panel making the decision, but it is probably not a big deal.
  • The new original panel stated that the threshold question was not answered by the review panel. Only part of it was answered, and the question of whether the errors were enough to change the decision was not yet decided.
  • The new original panel decided that further evidence is not required, but submissions are required on the issues of whether, assuming the review decision is correct, the tax decision should be changed.

Hydro One is expected to make submissions on this issue on November 20th.  Customer groups and other stakeholders will make their submissions on December 4th, and Hydro One will have an opportunity to reply on December 18th.

Conclusion

Whatever happens with the last-minute procedural twist, the likely result is pretty clear, despite the ambiguity suggested by the new original panel.  As it originally requested, Hydro One may well be allowed to collect $1.5 billion in taxes – about $2 billion in additional rates – from customers for taxes it will not actually pay.

Now you know why that is, and how it happened.

Don’t you feel better?

If you want to follow the arguments and the decision on this issue, you can see them when filed here.

  • Jay Shepherd, November 6, 2018
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About Jay Shepherd

Jay Shepherd is a Toronto lawyer and writer. This site includes a series on energy issues, plus some random non-fiction on matters of interest. More important, it includes the Lives series, which bridge the gap between fiction and non-fiction, and now some short stories. Fiction is where I'm going, but not everything you want to say fits one form. I am not spending any time actively marketing what I write, but by all means feel free to share if you think others would enjoy reading this stuff.
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