Application Martin No: gr9902 Jones Contents

Utilisation of imputation credits

The availability of tax imputation credits requires a modification to the standard CAPM/WACC model to reflect the return to shareholders of tax credits associated with their share dividends. Thus, gamma () is included in the WACC calculation to represent the proportion of franking credits that can, on average, be used by shareholders of the company to offset tax payable on other income. The higher the gamma, the lower the required return to equity holders and therefore the lower the estimated WACC. Consequently, gamma becomes an important parameter in the determination of financial returns.

Epic proposed a range of 25-50 per cent for gamma. Submissions to the Commission did not deal with this issue. The Commission’s Victoria Final Decision and the Draft Regulatory Principles note that the analysis of imputation credits is a controversial issue and that there is considerable debate as to the value that should be ascribed. Ultimately, the Commission’s choice of gamma will be a matter of judgement based on available empirical evidence.

The Commission has considered a range of 40 to 60 per cent appropriate for the average value of Australian input credits and has used 50 per cent for the value of gamma in all its decisions on gas access arrangements to date.

Epic argued in its response to the Draft Decision that applying a gamma of 50 per cent does not take account of the actual value of imputation credits to Epic’s existing shareholders. Epic is of the view that because Epic’s actual (rather than ideal) tax position is used in the Commission’s modelling, consistency requires that the actual value of imputation credits should be used rather than a generic value. Finally, because Epic is 66.7 per cent owned by international shareholders and 33.3 per cent owned by domestic superannuation funds, Epic claims that a gamma of 15 per cent would be more appropriate.⁸⁴

The Commission notes the comments of Dr Martin Lally in his submission to the ORG’s electricity distribution price review. Dr Lally stated that adjusting gamma to account for foreign shareholders’ inability to access franking credits causes inconsistencies with other elements of the cost of equity. Specifically the betas and market risk premium are calculated on the basis that Australia is completely segregated from the international capital market.⁸⁵ According to Dr Lally:

Once we acknowledge the existence of foreign investors, there are three effects to consider: gamma falls, betas may fall and the MRP falls. Lally (1998a) suggests that the net effect of these three factors is to lower the cost of capital for New Zealand firms, and the same may be true of the question here. Thus, the effect of reducing gamma, but otherwise ignoring the presence of foreign investors, is to raise the cost of capital when the overall effect of foreign investors may be to lower it. This does not seem sensible. If the full effects of foreign investors are to be ignored it seems better to ignore foreign investors completely, and therefore employ a gamma value of 1.⁸⁶

The Commission’s view on the relationship between foreign ownership and gamma was clearly stated in its Draft Regulatory Principles.⁸⁷ There is no well founded basis for discriminating in favour of one type of investor or another, and such discrimination may lead to different regulatory outcomes emerging purely on the basis of ownership. An overseas investor may not be able to take advantage of imputation credits and therefore has a zero gamma, but this may well be offset by different CAPM parameters that would be applicable to the foreign investor. The Commission remains of the view that the relevant benchmark for regulatory purposes should be based on an assumption of private Australian ownership.

The implication of the Lally argument is that it is inappropriate to ‘cherry pick’ WACC parameters from a range of different ownership assumptions. Rather, a set of parameters consistent with a single ownership assumption should be used to determine the CAPM benchmark return. If a return based on a range of ownership is considered relevant then the internally consistent CAPM should be used for each type of owner and then averaged. This is research in progress within the Commission. Until it is completed, the Commission has decided to retain the gamma assumption of 50 per cent for its Final Decision for the MAPS.

Effective tax rate

Epic used a corporate tax rate of 36 per cent in its WACC conversion formulae. Because infrastructure owners are permitted to accelerate depreciation for tax purposes, tax depreciation may be significantly higher than economic depreciation. This difference between tax depreciation and economic depreciation means that there is an excess tax allowance for depreciation in the early years of a project or pipeline service, resulting in a considerable deferral of any tax liabilities associated with the project. These deferred liabilities serve to improve early cash flows to the investment and improve the internal rate of return of the project above that indicated by the assumed WACC parameters. This effect results in an effective tax rate for the return on equity (T_e) that is less than the statutory rate (T) assumed by Epic for the CAPM/WACC framework. The effective tax rate that has been derived from the Commission’s cash flow model is approximately 11.3 per cent.

In the CAPM/WACC equations there is an issue as to whether to use the statutory tax rate or effective tax rate. This issue becomes irrelevant in the post-tax regulatory framework adopted by the Commission, as taxes are calculated on an ‘as you go’ basis. This involves using a post-tax WACC directly available from CAPM estimates to reflect the return on assets and to capture the impact of taxes in the cash flows. Such taxes are simply added, along with other capital costs and operations and maintenance costs, to calculate the target revenue requirement for the business. This approach avoids the need for a special conversion formula and handles tax in a very transparent way.

As the post-tax approach provides full compensation for actual tax liabilities as they occur, it avoids the need to calculate a long-term effective tax rate and problems generated by post-tax returns diverging from market rates over time. As far as the business is concerned, the post-tax approach would remove any risks associated with future tax liabilities and provide a return always commensurate with market requirements.

Because the Commission has adopted a post-tax regulatory framework, it is necessary to carry over aspects of historic financial accounts that impact on post-tax returns likely to be achieved in the future. Therefore, it is important that the residual asset value for tax depreciation be transferred to the post-tax framework and that tax depreciation concessions that can be used to offset future taxes are accounted for in regulated revenues.

To the extent that tax depreciation claimed in previous years may not have been fully exhausted in the reduction of tax liabilities, the amount will still be available (as a carried-forward tax loss) to reduce future taxable income. This carried forward tax loss is not recorded in Epic’s statutory accounts and therefore needs to be estimated. Operating profit is recorded on the basis of book depreciation. It differs from taxable profit/loss by the difference between tax depreciation and book depreciation. Hence, taxable profit is estimated by reducing operating profit by the amount by which tax depreciation exceeds book depreciation estimates. For the period up to 31 December 2000 estimated taxable profits were all negative, resulting in an adjusted carried forward accumulated tax loss of $123.8 million.

Identifying available tax concessions (as a carried-forward tax loss) in Epic’s cash flows ensures that Epic receives an allowance for taxes over the access arrangement period in accordance with its (concession-inclusive) tax liability for the period.

Beta and risk

The risks faced by any business can be described as either systematic (non-diversifiable) or non-systematic (diversifiable).