******************************************************** NOTICE ******************************************************** This document was converted from WordPerfect to ASCII Text format. Content from the original version of the document such as headers, footers, footnotes, endnotes, graphics, and page numbers will not show up in this text version. All text attributes such as bold, italic, underlining, etc. from the original document will not show up in this text version. Features of the original document layout such as columns, tables, line and letter spacing, pagination, and margins will not be preserved in the text version. If you need the complete document, download the WordPerfect version or Adobe Acrobat version, if available. ***************************************************************** Before the Federal Communications Commission Washington, D.C. 20554 In the Matter of ) ) Maryland Cable Partners, L.P. ) Complainant ) ) v. ) ) City of Bowie, Maryland ) Respondent ) ) Appeal of an Order to Set Basic Service) and Equipment Rates ) MEMORANDUM OPINION AND ORDER Adopted: March 11, 1998 Released: March 18, 1998 By the Deputy Chief, Cable Services Bureau: I. INTRODUCTION 1. Pursuant to Section 76.944(b) of the Commission's rules, Maryland Cable Partners ("Maryland Cable"), a franchised cable operator serving the City of Bowie, Maryland ("City"), has filed an Appeal from a local rate order ("Second City Order") issued by the City as the local franchising authority. The issue is whether Maryland Cable can recover the statutory tax rate from subscribers in its permitted rate of return on equipment and installation. The City filed an Opposition and Maryland Cable submitted a Reply. Maryland Cable also filed a Petition for Stay, which is moot because this Order resolves the case on its merits. II. BACKGROUND 2. Under the Communications Act, the Commission reviews appeals of rate orders issued by local cable franchising authorities ("LFA"). When considering appeals, the Commission will not conduct a de novo review, but instead will sustain the LFA's decision as long as it did not act unreasonably in applying Commission regulations. If the Commission reverses an LFA's decision, it will not substitute its own judgment, but will remand the case to the franchising authority with instructions to resolve it consistent with the decision. 3. Pursuant to the Cable Television Consumer Protection and Competition Act of 1992 ("1992 Cable Act"), the Commission established standards for setting the rates for installation and lease of equipment used by subscribers to receive the basic service tier. A cable operator that does not face effective competition is subject to these standards and must file FCC Form 1205 with its local franchising authority ("LFA"). Form 1205 determines the costs of equipment and installation and allows the operator to collect a reasonable profit, or rate of return. Commission regulations presume this rate of return to be 11.25%, and allow an operator to adjust, or "gross-up," the number to account for federal and state income taxes. The gross-up for taxes is determined by the statutory corporate tax rate. Even when the operator does not pay income taxes directly, as in the case of a partnership or Subchapter S Corporation, Commission rules permit this adjustment. In these cases, however, the gross-up calculation requires an additional step to ensure that subscribers do not reimburse the partnership for taxes paid by the partners on their distributions. Under our regulations, the gross-up for partnerships only allows compensation from subscribers for those taxes attributable to earnings retained in the business and that can be used to provide service to subscribers. Distributions to partners are not earnings retained in the business, so even though partners pay taxes on their distributions, the partnership may not recover these taxes as part of their gross-up. 4. Application of the Commission's gross-up methodology and the concept of tax normalization often results in a disparity between how much an operator actually pays in taxes and how much it is reimbursed through use of the statutory tax rate. The incurring of an income tax liability and the timing of the payment are often not the same. In some years, a cable operator will pay more in taxes than the statutory tax rate. Prior to the adoption of the Cost Order, operators sought to recover the extra amount, but the Commission rejected this in the interest of uniformity and regulatory ease. Conversely, an operator will sometimes pay less taxes than the statutory rate, but may still recover that rate through the gross-up of the rate of return. The gross-up calculation can affect an operator's rates even in those years when an operator pays no taxes. This possibility is the central issue in Maryland Cable's Appeal. III. FACTS AND PLEADINGS 5. This is the second time we have addressed the City's rejection of Maryland Cable's use of the statutory tax rate in its gross up calculation. Maryland Cable submitted its Form 1205 on February 23, 1995 for rates effective on May 1, 1995. The City rejected the Form 1205 for the first time on February 27, 1996, arguing that Maryland Cable failed to justify its use of the 34% federal and 7% state tax rates since Maryland Cable had paid no taxes. The City ordered Maryland Cable to recompute and resubmit its Form 1205 and to refund the amounts attributable to the gross-up. Maryland Cable appealed the decision to the Bureau, which held that the City unreasonably set Maryland Cable's federal and state tax rates at zero and had not acted in accordance with Commission rules or within the scope of its regulatory authority. The Bureau remanded the case to the City. The City sent Maryland Cable a request for information and, on March 11, 1997, conducted a public hearing on the appropriate tax rates for computing the permitted equipment and installation rates. 6. On May 6, 1997, the City once again rejected Maryland Cable's use of the statutory tax rate, explaining, as in the first order, that Maryland Cable failed to justify its gross-up since it paid no taxes during the relevant period. The City interpreted the Bureau's remand to hold that the City was simply required to explain its reason for a 0% rate, not that the City could not use a 0% rate. The City asserts in its Opposition that the Commission did not explicitly reject the use of the 0% rate, but only remanded the case to the City. Maryland Cable disagrees, arguing that, in fact, the Bureau did find that a 0% rate was unreasonable and that the City failed to explain how it could be upheld. 7. The City contends that Maryland Cable paid no taxes, so it should not recover them from subscribers. The City relies primarily on Section 76.922 of our regulations, which allows the recovery of federal and state taxes as "external costs experienced by the cable system." The City argues that the costs must be "experienced" before an operator may account for them, and taxes not paid are not experienced. The City also cites the instructions for Form 1205, which state that a cable operator may "recoup a return on investment that is adjusted ('grossed up') to account for your payment of federal and state income taxes." The City alleges that Maryland Cable is being unjustly enriched: "[A] cable operator which does not pay taxes ... should not reap a windfall in its rates at the expense of individual subscribers, who would be charged for a cost not incurred." 8. Maryland Cable responds that the Commission's regulations and Form 1205 both require all cable operators to adjust their rate of return by using statutory rates. The operator states that the use of the statutory tax rate is based upon investment retained in cable operations, not upon whether a cable operator or its partners actually paid federal or state income tax, and regardless of whether a cable system operates at a profit or loss in the applicable tax year. Maryland Cable argues, "The rate-of-return adjustment in Form 1205 has nothing, absolutely nothing to do with a cable operator's actual income, but rather reflects the level of investment in the equipment basket and the tax rate that is used is based solely on the level of investment retained in cable operations." If this were not so, Maryland Cable argues, the Commission's rules would unfairly penalize cable operators organized as non-taxpaying entities for reinvesting earnings in cable operations, because their rate of return could never equal that permitted for cable operators organized as corporations. Maryland Cable asserts that, under the City's theory, cable operators organized as partnerships would only be able to adjust their rate of return for taxes by distributing all their earnings to the partners. This would leave no incentive to reinvest the earnings in operations, facilities upgrades, and expanded services. 9. Maryland Cable challenges the City's use of the external cost recovery language in Section 76.922(d), which adjusts an operator's service rates (as opposed to its equipment rates) on a quarterly basis. Maryland Cable argues that, "[T]he treatment of external costs to adjust service rates as provided by this section has absolutely nothing to do with the calculation of permissible rates for equipment. IV. DISCUSSION 10. Maryland Cable has correctly applied the statutory tax rate in its rate of return calculation. In the Cost Order, the Commission recognized that cable companies reflect varied structures, including corporations, Subchapter S corporations, partnerships, and sole proprietorships. Regardless of the form, the Commission determined that regulated cable companies should be able to recover income taxes from subscribers by adjusting their permitted rate of return. The rate of return is presumed to be 11.25%. Adjusting ("grossing-up") for income taxes increases that amount, which in turn increases the permitted charges for equipment. In the Cost Order, the Commission specifically rejected proposals that would allow operators to include only taxes actually paid, not an amount based on the statutory tax rate. The Commission determined that such an approach would not be consistent with principles of tax normalization as traditionally applied to regulated industries. 11. The City incorrectly demands that Maryland Cable calculate its permitted rate of return using its actual tax experience. The proper statutory tax rate for Form 1205 is determined solely in reference to an operator's adjusted return on investment amount, without regard to either profitability or taxes actually paid. For non-C corporations like Maryland Cable, if the amount of retained earnings is greater than $75,000 but less than $10 million, the statutory federal corporate tax rate of 34% applies. The relevant Maryland statutory corporate tax rate is 7%. Even though Maryland Cable paid no taxes and made no distributions in 1994 or 1995, it still may adjust its rate of return using these rates. 12. The City's reliance on Section 76.922 of the Commission's regulations is misplaced. That section outlines the adjustments made to an operator's service rates, not its equipment and installation rates. While service rates and equipment rates combine to constitute an operator's maximum permitted rate, they are unbundled for purposes of individual calculation. Section 76.922 allows recovery for external costs, including state and local taxes, but this recovery only applies to taxes "applicable to the provision of cable television service." Determination of external costs does not affect an operator's permitted rate of return on its equipment basket. 13. The City also cites Section 623(b) of the Communications Act to support its position. Section 623(b) directs the Commission to prescribe cable rates, taking into account factors like "direct costs (if any) of obtaining, transmitting and otherwise providing signals carried on the basic service tier." The City states that Congress used the phrase "if any" to emphasize that costs must exist before the Commission may take them into account, and costs do not exist if they are not incurred. Additionally, Section 623(b)(2)(C)(v) directs the Commission to prescribe rates which take into account the "allocable portion of ... any other fee, tax, or assessment of general applicability imposed by a governmental entity applied against cable operators or cable subscribers." The City argues that a tax must be "imposed" before it can be included in rates, and no tax has been imposed on Maryland Cable. The City's argument is erroneous because the absence of actual taxation may have nothing to do with an operator's actual customer equipment cost experience. For instance, operating losses may arise from an operator's unregulated or non-cable activities. In such situations, the City's approach would match the consequences of unprofitable and unrelated operations to customer equipment circumstances, which, by virtue of a statutory rate of return and dollar-for- dollar indemnification of operating expenses, would lead to a substantial distortion. Such inconsistency violates the matching principle under Generally Accepted Accounting Procedures (GAAP), which requires a proper matching of revenues and corresponding expenses. As previously noted, in some years an operator may recover more in taxes than it pays, but in other years it may recover less. A gross-up methodology, based on normalization of taxes, recognizes that the incurring of an income tax liability and the timing of the payment are often not the same. Contrary to the City's arguments, the use of the statutory rate in a normalized tax scheme does take into account the direct costs of providing service and the generally applicable taxes imposed by governments. 14. The City incorrectly interpreted its regulatory latitude when it stated in the Second City Order: "Although the Federal Communications Commission Cable Services Bureau has determined to use a uniform rate for whatever reason, regardless of the business form of the operator, the [City] believes that it is appropriate to use the actual taxes paid by the operator." Franchising authorities must adhere to the mathematical principles underlying the benchmark approach of regulating rates, as established by the Commission, in their determination of rates for basic service and associated equipment. The applicable principle here is the application of statutory income tax rates to the permitted rate of return that are outlined in the Cost Order and the Instructions to Form 1205, as discussed above. The City has not reasonably applied the Commission's regulations. We remand the decision for further consideration consistent with the terms of this Order, particularly regarding the recognition of the statutory tax rate. V. ORDERING CLAUSES 15. Accordingly, IT IS ORDERED that Maryland Cable's appeal of the City's local order IS REVERSED AND REMANDED to the City for resolution in accordance with the terms of this Memorandum and Order. 16. IT IS FURTHER ORDERED that Maryland Cable's petition to use statutory tax rates on FCC Form 1205 IS GRANTED. 17. IT IS FURTHER ORDERED that Maryland Cable's Petition for Stay IS DENIED as moot. 18. This action is taken by the Deputy Chief, Cable Services Bureau, pursuant to authority delegated by  0.321 of the Commission's rules. 47 CFR  0.321. FEDERAL COMMUNICATIONS COMMISSION John E. Logan Deputy Chief, Cable Services Bureau