August 1, 2012 by FCS GROUP
By Chris Gonzales, Project Consultant, FCS Group
Is your utility taking full advantage of the deductions and exemptions specified in the Revised Code of Washington (RCW) and the Washington Administrative Code (WAC)? Given that the tax rules applicable to utilities in the State of Washington are complex and can change over time, it is relatively easy to overpay or underpay taxes – because tax reporting is an annual issue with potentially compounding impacts, it is in your utility’s best interest to verify that it is paying the correct amount of tax to the state.
Key deductions allowable under state law include:
- Sales for Resale: RCW 82.16.050 (2) provides a Public Utility Tax deduction for revenue derived from the sale of commodities (e.g. water, electricity) to another agency for resale within this state. Note that the agency purchasing the commodity cannot deduct its payments.
- Irrigation Sales: RCW 82.16.050 (7) provides a Public Utility Tax deduction for revenue derived from irrigation through an irrigation system. Note that this deduction applies to irrigation for agricultural, landscaping, or other purposes.
- Jointly Provided Services: RCW 82.04.432 allows a deduction for amounts that an agency pays to another agency for wastewater transmission, treatment, and disposal. Note that this deduction is based on the actual expense, and not the revenue that is raised to cover the expense.
- Sales to Political Subdivisions: RCW 82.04.4291 allows a Business & Occupation (B&O) Tax deduction for revenue derived from political subdivisions (cities, counties, towns, school districts, fire districts, and other special purpose districts). Thus, revenue from services that would otherwise be taxed at the B&O rate would be deductible to the extent that they are from political subdivisions.
- Interdepartmental Charges: WAC 458-20-201 provides a deduction for revenue received from a utility’s own departments.
Be careful when taking potentially overlapping deductions – for example, if you deduct revenue from your parks department as irrigation revenue, you cannot deduct it again as interdepartmental revenue. Similarly, if you are deducting your payments to another agency for wastewater treatment, you have to adjust what you deduct for political subdivision revenue so that it does not include the share attributable to treatment expenses.
A number of utilities have historically overpaid taxes in the areas discussed above; however, there have also been some areas where utilities have underpaid: connection charges (which were historically exempt under a law that expired in July 1993), stormwater revenues (which became taxable when stormwater management became an enterprise activity), wholesale water purchases, and municipal utility taxes (the Washington State Department of Revenue has ruled that they are a “cost of doing business,” and revenue raised to pay them is taxable). Given that wastewater revenues are subject to different tax rates for sewage collection and related business activities, the split between those functions is another potential area of overpayment or underpayment. The first step in determining an appropriate split is to allocate wastewater asset costs between these functions.
- Collection: Includes sewer mains that are assigned to collection.
- Other: Includes sewer mains assigned to transmission, lift stations, and treatment plant assets.
While it is generally easy enough to separate treatment plant assets and lift stations from sewer mains, the process of separating mains between collection and transmission functions is not as straightforward. Several different methodologies have been used over the years, with the most recent methodology resulting from a 2001 trial between the City of Spokane and the Washington Department of Revenue. This methodology defines a pipe with no upstream junctions except for side sewers (such as laterals) as a “collection” pipe; other pipes (such as interceptors) are assigned to “transmission.” Side sewers, to the extent that they are located in the public right-of-way and maintained/depreciated by the utility, would also be included in this consideration as “collection” pipe – side sewer pipe lengths can be estimated based on an assumed length of pipe per service connection.
So which “asset costs” should be used in this allocation? Original cost may be desirable as the simpler and more readily available option, but it may result in a lower allocation of costs to transmission and treatment because those facilities are often built prior to extending laterals and side sewers to serve new customers (also, transmission mains tend to be larger and more expensive per foot to construct than collection mains). Using estimated replacement cost could address this issue by converting all asset costs to a common basis, but it is more complex to derive and may face increased scrutiny by auditors. If your utility has an asset management plan that estimates asset replacement costs, it could serve to inform and justify a replacement-based allocation.
The next step is to allocate the wastewater utility’s annual expenses between functions as a proxy to revenue. Depending on the level of detail that you have available, you can either allocate expenses to functions directly or use the percentages derived based on the allocation of assets. For example, treatment plant expenses would be fully allocable to treatment; pumping costs would generally be allocable to transmission. Note that if you pay another agency for wastewater treatment and deduct those expenses on your tax returns, you should not consider those payments in this allocation of expenses. Asset-related expenses such as maintenance, depreciation (if your utility funds depreciation through rates), and debt service can be allocated based on the underlying assets – however, as these expenses can vary significantly from year to year, it is important to review the allocation of expenses regularly.
A quick review of your utility’s excise tax worksheets and supporting records can provide insight into whether or not there is a potential liability or refund opportunity for your utility.
Questions to consider include:
- At what level of detail are revenues being reported? If the revenue lines are grouped together at a high level (“metered sales”), your utility might be paying taxes on revenues that it could be deducting, such as revenue from irrigation customers, political subdivisions, and other internal departments.
- Are wastewater revenues split between collection and transmission for tax purposes? If so, when was the split last updated? The asset allocation can be updated during system plan updates, but the allocation of expenses should be updated annually so that the split of revenue is based on current costs.
- If your utility is a city utility in a city that imposes a utility tax, how is the tax revenue accounted for? If the tax is embedded in your rates and reported as taxable revenue, no further action would be needed. If it is itemized separately on the bill, the revenue may go straight to the general fund and not appear in utility revenue reports – in this case, you should confirm that it is being included on your tax returns.
Based on the currently accepted definition of “collection” versus “transmission,” a number of cities, towns, and special purpose districts have initiated audits with the Department of Revenue and received refund checks ranging in size from $20,000 to over $600,000. Here are some things that you should know about an audit:
- Per WAC 458-20-230 (2), tax assessments must generally be made within four years from the close of the calendar year in which the tax was incurred. This means that if you were to initiate an audit this year, it would consider payments made as far back as January 1, 2008.
- The scope of the audit cannot be limited, and it will consider both refunds from overpayments and liabilities from underpayments. As a result, an audit may result in either a net refund or a net assessment with interest and penalties as applicable.
Though there are potential risks involved with initiating a refund request, there may be value in doing so if you estimate the potential for a significant refund. Even if you decide not to pursue a refund, you can modify your reporting practices looking forward to save money or reduce liabilities in the future. Based on the information that you have available (or could obtain within a reasonable amount of effort), you can be selective in choosing which deductions to take – it may also be worth considering potential modifications to your utility billing system and/or accounting practices to more easily take advantage of certain deductions in the future.