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FAQ – Tariff Methodology for the Setting of Pipeline Tariffs – IDMS 46306

Frequently Asked Questions: Tariff Methodology for the Setting of Petroleum Pipeline Tariffs

2nd June 2010

Answers and guidance to Frequently Asked Questions are provided as per the following outline. Glossary of Terms and Abbreviations C - Claw-back adjustments CPI - Consumer Price Index D - Depreciation. The charge (normal depreciation and amortisation on

the write-up) for the tariff period under review E - Expenses. Maintenance and operating expenses for the tariff period

under review. F - Approved revenue addition to meet debt obligations RAB - Regulatory Asset Base T - Tax. Flow-through and notional tax options WACC - Weighted Average Cost of Capital

FAQ – Tariff Methodology for the Setting of Petroleum Pipeline Tariffs – IDMS 46306 of 28

RAB Question 1 Why are assets re-valued?

Answer 1.1 Regulation 4(6)(e)1 stipulates that the value of the regulatory asset base

(RAB) is to be on an inflation-adjusted base. The inflation adjustment is

calculated by trending the original cost on an annual basis with the CPI to

give the trended original cost (TOC). The TOC value therefore reflects the

nominal value of the regulatory asset base (RAB).

1.2 The return on the RAB is calculated in real terms on the nominal value of

the RAB.

1.3 The result of applying a real return on a nominal RAB is that tariffs become

back-loaded. Back-loading of tariffs implies that tariff levels will increase in

real terms over time. This approach ensures that tariffs do not deflate in real

terms as the asset ages but keep up with the trend of inflation. (This is also

discussed in 4.1.)

1.4 The back-loading of tariffs also reflects the economic reality of prices

generally becoming inflated over time and will therefore counter the effect of

huge price increases when new assets replace old assets.

1.5 The way to calculate the TOC value of the RAB (inclusive of depreciation

and amortisation of the write-up) is demonstrated in Table 1.5 below. This

table is also published on the NERSA website.

1 see Government Notice R342, Government Gazette No. 30905 of 4 April 2008.


Table 1.5: Calculation of TOC value of RAB (inclusive of depreciation and amortisation of the write-up)

Trending of asset value (TOC)

Formula for year 2

(column "C")

A B C D E F G H I J K

1 Tariff period 0 1 2 3 4 5 6 7 8 9 10 2 Remaining asset useful life 10 9 8 7 6 5 4 3 2 1 3 Depreciated original cost b/f +B3-B4 100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 4 Depreciation (historic) +$B$3/$B$2 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00

5 Depreciated original cost (V-d) RAB bal c/f +C3-C4 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00

6 7 Inflation write-up balance 8 Inflation write-up bal b/f +B12 0.00 4.50 8.20 11.03 12.93 13.81 13.60 12.21 9.55 5.51

9 Current period inflation write-up +B13*$A$9 5.00% 5.00 4.73 4.41 4.05 3.65 3.19 2.68 2.11 1.48 0.78

10 Write-up balance on which WACC should be earned =SUM(C8:C9) 5.00 9.23 12.61 15.09 16.58 17.00 16.28 14.32 11.03 6.29

11 Amortisation of write-up +C10/C2 0.50 1.03 1.58 2.16 2.76 3.40 4.07 4.77 5.51 6.29

12 Write-up bal net of amortisation carried forward =C10-C11 4.50 8.20 11.03 12.93 13.81 13.60 12.21 9.55 5.51 0.00

13 TOC closing balance (c/f) =C5+C12 100.00 94.50 88.20 81.03 72.93 63.81 53.60 42.21 29.55 15.51 0.00

14 TOC opening balance (b/f) balance to inflate +B13 100.00 94.50 88.20 81.03 72.93 63.81 53.60 42.21 29.55 15.51

15 Total amount on which WACC should be earned =+C3+C10 105.00 99.23 92.61 85.09 76.58 67.00 56.28 44.32 31.03 16.29


Question 2 Why is the TOC not applied to the working capital component of the RAB-formula?

Answer 2.1 Working capital resets itself each year and therefore there is an automatic

annual adjustment for inflation in the components of working capital.

2.2 If a multi-year tariff application is submitted, the working capital (W) should

be inflated with the forward looking CPI assumptions.

Question 3 Why is a deferred tax liability deducted and a deferred tax asset added to the RAB in

the RAB formula?

Answer 3.1 A deferred tax liability represents a temporary return of capital on which no

return is allowed and therefore it is deducted from the RAB. As the licensee

starts repaying the deferred taxation to the Receiver of Revenue, the

deduction from the RAB reduces.

3.2 A deferred tax asset represents additional capital investment. The NERSA

tax formula (paragraph 7.3 of the Tariff Methodology for the Setting of

Petroelum Pipeline Tariffs – hereinafter ‘the Methodology’) assumes the

cash “to be received” from the fiscus, but the actual cash flow benefit from

the fiscus materialises only in later years and therefore a return would be

allowed on this investment. Deferred tax assets arise mostly as a result of

assessed taxation losses not utilised and carried forward.

3.3 The deferred taxation liabilities and assets are not trended.


WACC

Question 4

Why is a real WACC and not a nominal WACC applied?

Answer 4.1 As explained under question 1, Regulation 4(6)(e) stipulates that the value of

the RAB has to reflect an inflation-adjusted value. Because the nominal value

of the RAB is used, a real rate of return is used (as reflected in the real

weighted average cost of capital - WACC). This requirement is also stipulated

in section 28(3)(c) of the Petroleum Pipelines Act 2003 (Act No. 60 of 2003).

4.2 Inflation is added to the asset base (RAB) and is therefore “taken out” of the

nominal return (WACC). Nominal returns on real assets would constitute a

double count of CPI and thus “real returns” are used.

Question 5 What is to be understood by the following two statements? i) Section 28(3)(c) of the Petroleum Pipelines Act 2003 (Act No. 60 of 2003):

(3) The tariffs set or approved by the Authority must enable the licensee to-

(c) make a profit commensurate with the risk

and

ii) Section 4(6) of the Regulations made in terms of the Petroleum Pipelines Act (see Government

Notice R432, Government Gazette No. 30905 of 04 April 2008):

(6) The allowed revenue to be derived from tariffs contemplated in sub-regulation (2) must

include:

a) reasonable operating expenses

b) reasonable maintenance expenses

c) depreciation expenses

d) reasonable working capital


e) reasonable real return on the regulatory asset base which should be

determined on the assets’ inflation-adjusted cost less accumulated

depreciation; and

f) other applicable obligations.

Answer 5.1 The reasonable return relates to the return earned by the licensee on the RAB

and not to the return earned by an equity investor on the RAB. Sub-regulation

(2) refers to an “efficient licensee” and not an equity holder as an entity different

from the licensee.

5.2 In view of the fact that the regulation does not stipulate that the “profit

commensurate with risk” is to be earned in each year, it is taken that the “profit”

(return) is to be earned over the total life of the asset. This profit relates to the

profit of the licensee on the RAB and not to the profit of an equity investor as a

separate construct.

5.3 The actual return that will be earned by the equity investor each year is a

function of the capital structure of the licensee. If the funding structure of the

licensee requires the debt funding to be repaid earlier or faster than the life of

the asset, it is viewed that the equity holder has chosen to become a “patient

capital” investor. The “patient capital” investor will therefore wait for the debt

capital to be repaid before the full return on equity can be earned.

5.4 Figure 5.4(i) and figure 5.4(ii) below demonstrate the effect on the annual

returns on equity under the following two scenarios (patient capital investor):

a) debt tenure of 10 years; and

b) debt tenure of 25 years


Figure 5.4(i): ROE per annum (debt = 10 years) ROE per annum (10 years debt)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1 2 3 4 5 6 7 8 9 10 11

Years

RO

E %

Notional TAX with Deferred Tax adjusted to RAB Required ROE Flow-through actual tax

ROE per annum (10 year debt)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Years

RO

E %

Notional TAX with Deferred Tax adjusted to RAB Flow-through actual tax Required ROE


Figure 5.4(ii): ROE per annum (debt = 25 years)

ROE per annum (25 years debt)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1 2 3 4 5 6 7 8 9 10 11

Years

RO

E %

Notional TAX with Deferred Tax adjusted to RAB Required ROE Flow-through actual tax

ROE per annum (25 year debt)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Years

RO

E %

Notional TAX with Deferred Tax adjusted to RAB Flow-through actual tax Required ROE Note 1. Once the debt has been paid off, the equity starts “catching up” (around years

6-8) and the actual return to equity is at higher levels. The higher levels of


equity returns reflect the “catching up” of returns that should have been

earned in previous years but were forfeited because of having to pay off debt

(“patient capital”).

2. The conversion of the RAB to a nominal value (TOC) and the subsequent real

WACC that is to be earned on the nominal value result in the “addition” of CPI

values to the asset base that do not match the “reduction” of the value of the

return in earlier years, because the return is calculated in real terms. The

returns in earlier years are lower as it takes time for the TOC effect to catch

up with the real return effect. Over the life of the asset, the return equalises

out.

3. Note that a minimum debt level of 30 per cent is assumed as per paragraph

5.5 of the Methodology.

WACC – Beta

Question 6

Why is a beta derived from international companies used in relation to the conditions

of the local market?

Answer

6.1 There are no suitable comparative companies listed on the local markets.


Question 7 What are the criteria for selecting the betas of specific companies as a proxy for local

companies?

Answer 7.1 In 2008/9 when the decision on proxy companies was taken, companies were

chosen that:

a) operate in the pipeline industry (or at least partly in the pipeline industry);

b) are smaller in size as they are considered to be more on par with the

South African companies;

c) have a high debt ratio to try and represent the start-up business of a

potential new entrant to the market as well as an existing operator who is

embarking on huge investments (under such circumstances companies

normally reflect high debt ratios);

d) have higher operating margins to more closely represent the higher

inflation environment in the South African market at the time.

Note 1. Some of the companies selected also appeared on the list of companies

utilised by Transnet in their tariff application for 2008/9.

2. The criteria for selecting companies will be determined by the outcome

of the beta study which is currently being undertaken by NERSA.


Question 8 When are adjustments to the industry beta allowable?

Answer 8.1 In the past, the following aspects were considered for adjusting the beta of a

company:

a) size of a company relative to the size of companies on the

Johannesburg Stock Exchange (JSE)

b) construction and start-up requirements

c) instruments available for obtaining capital

d) private versus state-owned entities.

8.2 Decisions regarding the above aspects were taken by NERSA after assessing

the company at the time of making a tariff determination. Decisions were

taken by applying regulatory discretion and judgement. Direction will be

obtained on how to quantify such decisions relative to other players in the

industry as part of the beta study which is currently being undertaken by

NERSA.

Question 9 At what frequency and over which period was data on the beta value of proxy

companies collected? Has a statistical correction factor been applied to the values of

the beta?

Answer 9.1 The tariff Methodology stipulates that the beta value that will be applied in

tariff determinations has to be a beta that has been determined and published


on NERSA’s website 12 months prior to a tariff determination. (NERSA has

published the value of the beta as part of the RfD for the Transnet 2008/9

tariff determination.)

9.2 At the time of publishing the beta value, no comments from any stakeholder

were received on the frequency of data, the period over which data had been

collected or the application of a correction factor. These areas have only

recently been discussed within the industry and are in the process of being

attended to as part of the beta study that is currently being undertaken by

NERSA.

Question 10 Why is Zacks used as a supplier of beta data on proxy companies?

Answer 10.1 A wide variety of sources is used for the determination of betas in the South

African market. The following suppliers seem to be popular :

• Zacks

• McGregor

• Bloomberg

• Cadiz Financial Risk Services

• Reuters / Factiva

10.2 At the time of selecting a supplier, the Zacks website was found to have

sufficient data on the proxy companies and data could be obtained without

subscription.

10.3 The Methodology of determining the beta values by the respective suppliers

was not challenged and the value of the betas was taken at face value.


10.4 A decision about which supplier to use for providing beta values will be based

on the outcome of the beta study currently being undertaken by NERSA.

WACC – The Market Return (MR)

Question 11

What are the criteria for using either of the following two market indices: the All Share

index or the Financial and Industrials?

Answer

11.1 In practice there is no index that accurately measures the total return of the

market portfolio. The lack of availability of weekly or monthly return data for all

asset classes requires the use of equity indices as a proxy for the market.

11.2 The All Share index is considered to be biased towards particular sectors and

therefore the Financial and Industrial indices have been considered as a more

appropriate measure for the petroleum pipeline industry.

11.3 The decision on which market index to use will be determined by the outcome

of the beta study currently being undertaken by NERSA.

Question 12 Why is a post-tax market return (MR) used for determining the MRP?

Answer

12.1 The market returns (MR) as represented by the various JSE indices reflect

earnings after taxation has been provided for (i.e. data is presented on an

after-tax basis). In South Africa there is currently no dividend tax paid as

secondary tax on companies (STC) on dividends is paid by the company and


not shareholders. The earnings attributable to shareholders are therefore

presented on an after-tax basis (income tax and STC).

12.2 No adjustment for Capital Gains tax is made as it is assumed that the equity

return holders will hold the investment to maturity and therefore the total

return index (TRI) is used.

12.3 There are flaws and challenges inherent in converting the “post-tax” market

return (MR) as a basis and converting it to a “pre-tax” market return (MR) by

grossing it up with the tax rate. This method is thus not used by NERSA.

12.4 As the Allowable Revenue formula treats Taxation as a separate “operational”

item (T), the WACC calculations are ALL performed on a post-tax basis.

WACC – The Risk-free rate (Rf)

Question 13 Why is the post-tax Risk-free rate (Rfpost-tax) used and not the pre-tax Risk-free rate

(Rfpre--tax)?

Answer 13.1 The tariff Methodology consistently treats all values on a post-tax real basis

because Tax is treated as a separate item (T) in the formula to determine

allowable revenue. In this way the impact of all tax-related matters (burdens as

well as benefits) is reflected separately and all tax-related WACC components

are treated on a post-tax basis.

13.2 In the taxation formula – notional and “new” flow-through tax – all components

which do not carry a tax deduction are grossed up to allow for the tax shield.

The tax which is needed to be provided for is therefore included in the tax

allowance.


Question 14 Why are government bonds with a maturity of ten years or longer used?

Answer 14.1 In selecting a government security as an acceptable proxy for the risk-free rate,

thought was given to the maturity of the security and the possible influences on

the market risk premium (MRP) to be used in the WACC calculation.

14.2 In the South African environment one of the following two common approaches

is normally used. The maturity of the risk-free instrument is matched to:

• the profile of the cash flows (life of the asset); or

• an assumed investor horizon of seven to ten years.

14.3 An investor in pipeline infrastructure normally has a long-term investment

horizon of at least ten years. A maturity of less than ten years is considered to

be subject to short-term fluctuations in the economic environment which could

impact on the volatility and validity of this measure for the industry if taken over

a short term.

14.4 Longer term investment instruments are also more in line with the 25-year

market return (MR) data used in calculating the WACC.


WACC – Cost of debt (Kd)

Question 15

Why is the real cost of debt (Kd) used and not the nominal cost of debt?

Answer 15.1 The inflation adjustment in the cost of debt (Kd) is “taken out” as this is

“replaced” with the trending of the full value (V-d) of the original cost to give the

nominal value (TOC) of the RAB.

15.2 Nominal returns on real assets would constitute a double count of CPI and

therefore “real returns” are used.

Question 16

Under what scenario will equity investors be in a position to earn their full return as

embedded in the Ke portion of the WACC?

Answer

16.1 The reasonable return relates to the return on the asset for the licensee and not

for the equity investors. The actual return that will be earned by the equity

investor is a function of the capital structure of the licensee as was explained

under question 5. If the funding structures of the licensee require the debt

funding to be repaid earlier or faster, it is viewed that the equity holder has

chosen to become a “patient capital” investor. The “patient capital” investor will

wait for the debt capital to be repaid before he receives his required return.

16.2 The conversion of the asset base (V-d) to a nominal value (TOC) and the

subsequent conversion of WACC into real WACC results in the “addition” of

CPI to the asset that does not “match” the “reduction” of the rate in earlier

years. Therefore the returns in earlier years are lower as it takes time for the

TOC effect to catch up with the real return effect. Once the catch up has taken


place (around years 6-8), the return will be superior (See graphs in question 5

above).

Question 17 Does the post-tax WACC not allow the entity enough allowable revenue to pay back

its debt which is payable in nominal terms because the WACC (Ke & Kd) is provided

for only on a post tax real basis?

Answer 17.1 No. The tax shield in the Kd is provided for in the tax formula where the post-

tax Kd is grossed up with the tax shield portion of the Kd. This ensures a pre-

tax Kd is provided for in the allowable return to match the payment of the

financing costs in nominal values. (See formula in paragraph 7.3 of

Methodology.)

17.2 In Tables 17.3(i) and 17.3(ii) below the calculation of tax (as per the tax formula

in the tariff Methodology) is demonstrated. For each component which is

taxable, a gross-up at the existing tax rate is performed. Tax allowances are

therefore provided for in these grossed-up balances and will be included in the

total balance of the allowable revenue.

17.3 As can be seen from Table 17.3(i), the grossing up of balances also applies to

the cost of debt (Kd) to ensure the tax shield on the Kd is properly accounted

and provided for.


Table 17.3(i): Treatment of WACC with Notional Tax

Allowable Revenue = (RAB x WACC) + E + T + D + F ± C. RAB WACC E D (historic)

D (amortisation of write-up)

T taxation) Total

allowable revenue

WACC = [Rf + (MRP*beta)*eq] + [Kd*debt] Ke Kd WACC Gearing 51% 49% Transnet NERSA decision (returns %) 9.52% 3.47% 6.56% Transnet NERSA decision value (R million) 105.00 5.10 1.78 6.88 3.00 4.00 0.20 14.08 NPBT excl tax allowance = { (RAB*WACC) + E + D + F ±C} - {E + D(historic) }.

0.00 0.00 0.00 (3.00) (4.00) (7.00) NPBT excl tax allowance 5.10 1.78 6.88 0.00 0.00 0.20 0.00 7.08 Taxation (gross up and notional tax) 1.98 0.69 2.68 0.00 0.00 0.08 2.75 2.75 Add back tax deductions 0.00 0.00 0.00 3.00 4.00 0.00 0.00 7.00 Total revenue including notional tax 7.08 2.48 9.56 3.00 4.00 0.28 2.75 16.84

All these WACC components are

not deducted to arrive at a taxable income before tax allowance. They first become grossed up. By grossing up and then adding a notional tax allowance, they all effectively become pre-tax. The applicant therefore receives the tax which he is going to pay to the fiscus.

These components are tax deductible and there-fore do not need a tax shield.

The argument sometimes is that the amortisation of the write-up (effectively to counter for the "loss" of CPI

in the conversion of nominal rates to real rates) is affecting the after-tax returns. This component is also awarded a tax shield in the calculation and the applicant receives the tax allowance it needs to pay the fiscus. There is obviously a time delay.


Table 17.3(ii): Treatment of WACC with flow-through tax

Allowable Revenue = (RAB x WACC) + E + T + D + F + C RAB WACC E

D & wear & tear

(historic)


T(taxation) Total

allowable revenue

WACC=[Rf+(MRP*beta)*eq]+[Kd*debt] Ke Kd WACC Gearing 51% 49% Returns % 9.52% 3.47% 6.56%

Returns (R million) 105.00 5.10 1.78 6.88 3.00 4.00 0.20 14.08

NPBT excl tax allowance={(RAB*WACC)+E+D(historic & write-up)+F+-C}-{E+wear & tear allowance (historic) +Kd(nominal)} 0.00 (5.88) 0.00 (3.00) (10.00) (13.00) NPBT excl tax allowance 5.10 (4.10) 6.88 0.00 (6.00) 0.20 0.00 1.08 Taxation (gross-up and notional tax) 1.98 (1.59) 0.39 0.00 (2.33) 0.08 (1.87) (1.87) Add back tax deductions 0.00 5.88 0.00 3.00 10.00 0.00 0.00 13.00 Total revenue including flow- through tax with tax shield on Kd

7.08 0.19 7.27 3.00 1.67 0.28 (1.87) 12.22

All these WACC components (except Kd) are

not deducted to arrive at a taxable income before tax allowance. By grossing up and then

adding a notional tax allowance, they all effectively become pre-tax. The applicant

therefore receives the tax which he is going to pay. Tax shield on Kd not given.

These components are tax deductable and therefore do not need a tax shield.

The argument is sometimes that the amortisation of the write-up (effectively to counter for the "loss" of CPI in the conversion of nominal rates to real rates) is affecting the after-tax returns. This component is also awarded a tax shield in the calculation.


Question 18 Why is Vanilla WACCreal (pre-tax Kd and post-tax Ke) not used instead of grossing up the

post-tax Kd to ensure that the tax shield of the Kd is provided for in the before tax allowable

revenue?

Answer 18.1 Vanilla WACC is a calculation where the cost of equity (Ke) is post-tax and the cost of

debt (Kd) is pre-tax.

18.2 The taxation component for the cost of debt is “given” to the investor by allowing the

“tax shield” in the calculation of taxation allowance (T) as is demonstrated in the

above Table 17.3(i) and Table 17.3(ii).

18.3 The Vanilla WACCreal results in a higher return relative to the notional or flow-through

(with tax shield) options and therefore it is not utilised by NERSA. This is

demonstrated in the published model in the TAB “flow-through Vanilla” where the

return achieved is 15.5 per cent which is higher than the 15 per cent required return.

EXPENSES

Question 19 When will the claw-back be applied?

Answer 19.1 In the tariff application following the release of audited financial statements of the

applicant.


TAX

Choice between two different tax approaches

Question 20 How is the tax calculated under the following scenarios?

• Flow-through tax

• Notional tax

Answer Flow-through tax 20.1 Section 7.2 of the Methodology states that it is the actual tax paid by the entity and

this is allowed as a tax allowance.

20.2 This would not be a beneficial option for the licensee to choose as it does not award

the tax shield of the Kd nor does it award the benefits of accelerated wear and tear or

deferred taxation.


Table 20.1: Formula and example to determine the tax when a flow-through approach is followed

Formula and example for paragraph 7.2

Tax={(NPBT excl tax allowance)/(1-Tr)}*Tr NPBT excl tax allowance = {(RAB*WACC)+E+D(historic & write-up)+F+-C}-{E+wear & tear allowance (historic) +Kd(nominal)}

Ke a 5.10 Kd(real) b 1.78 WACC c=a+b 6.88

E d 3.00 D (historic) e 4.00

D (write-up) ee 0.20

Wear and tear allowance eee 10.00

F f 0 C [Claw-back excluding tax claw-back] g -

Allowable revenue before tax allowance h=c+d+e+ee+f+g 14.08 Tr j 28%

Kd (nominal) n 5.88 NPBT excl tax

allowance={(RAB*WACC)+E+D(historic & write-up)+F+-C}-{E+wear & tear allowance (historic)

+Kd(nominal)} Note that interest is deducted as a actual tax calculation is performed

k=h-d-eee-n

(4.80)

Allowable revenue pre-tax 14.08 Tax={(NPBT excl tax allowance)/(1-

Tr)}*Tr l={k/(1-j)}*j (1.87)

Total allowable revenue m=h+l 12.22 Test tax rate l/(k+l) 28%


The penalty for choosing the flow-through option is demonstrated in Table 20.2 below: Table 20.2: The effect of using flow-through tax-


D & wear and tear (historic)


T(taxation) Total

allowable revenue


Returns (R million) 105.00 5.10 1.78 6.88 3.00 4.00 0.20 14.08

NPBT excl tax allowance={(RAB*WACC)+E+D(historic & write-up)+F+-C}-{E+wear & tear allowance (historic) +Kd(nominal)} 0.00 (5.88) 0.00 (3.00) (10.00) (13.00) NPBT excl tax allowance 5.10 (4.10) 6.88 0.00 (6.00) 0.20 0.00 1.08 Taxation (gross-up & notional tax) 1.98 (1.59) 0.39 0.00 (2.33) 0.08 (1.87) (1.87) Add back tax deductions 0.00 5.88 0.00 3.00 10.00 0.00 0.00 13.00 Total revenue including flow-through tax with tax shield on Kd

7.08 0.19 7.27 3.00 1.67 0.28 (1.87) 12.22


Notional tax: 20.3 The calculation is to be done by using the formula as demonstrated in Table 20.3. Table 20.3: Formula and example to determine the

tax when a notional tax approach is followed

Tax = { (NPBT excl tax allowance) / (1-Tr)}*Tr

NPBT excl tax allowance={(RAB*WACC) + E + D(historic & write-up) + F ± - C} - {E + D(historic) }

Ke a 5.10 Kd(real) b 1.78 WACC c=a+b 6.88 E d 3.00 D (historic) e 4.00 D (write-up) ee 0.20 F f 0 C [Claw-back excluding tax claw-back] g -

Allowable revenue before tax allowance h=c+d+e+ee+f+g 14.08

Tr j 28%

NPBT excl tax allowance = { (RAB*WACC) + E + D + F ± C} - {E+D(historic)} [Note interest and amortisation of write-up is not deducted to allow tax shield.]

k=h-d-e 7.08

Allowable revenue pre-tax h 14.08

Tax = { (NPBT excl tax allowance) / (1-Tr) }*Tr l={k/(1-j)}*j 2.75

l Allowable revenue m=h+l 16.84 Test tax rate l/(k+l) 28.%


The effect of the notional tax formula and the “tax shield” is demonstrated in Table 20.4 below. Table 20.4: The effect of using notional tax


D (histori

c)

D (amortisat

ion of write-up)

T(taxation)

Total allowabl

e revenue


Returns (R million)

105.00

5.10

1.78

6.88

3.00

4.00 0.20

14.08

NPBT excl tax allowance={(RAB*WACC)+E+D+F+-C}-{E+D(historic)}

0.00 0.00 0.00 (3.00) (4.00) (7.00)

NPBT excl tax allowance 5.10 1.78 6.88 0.00 0.00 0.20 0.00 7.08 Taxation (gross-up and notional tax) 1.98 0.69 2.68 0.00 0.00 0.08 2.75 2.75 Add back tax deductions 0.00 0.00 0.00 3.00 4.00 0.00 0.00 7.00 Total revenue including notional tax 7.08 2.48 9.56 3.00 4.00 0.28 2.75 16.84 Note 1. The tax formula for section 7.3 will be added to the Methodology. In the meantime

NERSA is – and has been – applying the formulas as set out above.

Tax – deferred tax (dtax)

Question 21 Why is the deferred tax asset / liability not included in the RAB formula when the flow-

through tax option is chosen?

Answer 21.1 Deferred tax liabilities do not arise relative to the allowable revenue awarded when

the flow-through approach is taken because it is merely a timing issue of when the

tax will be paid and therefore it is not deducted in the RAB formula.


21.2 Deferred tax assets arising from tax losses in earlier years are not added in the RAB

formula to counteract the previously “competitive advantage” enjoyed by the entity

because of this asset class.

Note 1. NERSA has published a model on its website with the intention of

demonstrating the various options and scenarios by way of testing the target

cost of equity by the outcome of the internal rate of return (IRR) of cash flows

to investors.

2. The model published also proves that if deferred taxation assets are not added

back to RAB, the required IRR is not achieved.

3. More notes on the published model are provided as closing remarks at the end

of this section on Frequently Asked Questions.

DEPRECIATION

Question 22 How is depreciation and amortisation of the write-up portion calculated?

Answer

22.1 See example in Question 1 (Table 1.5) above.


CLAW-BACK Question 23

When are claw-backs applied? Answer 23.1 For the tariff period following the availability of audited financial statements of the

applicant.

F-FACTOR

Question 24 How is the F-factor calculated and how will it be recovered?

Answer Details are provided in Section 9 of the Methodology.

Notes on the model published on NERSA’s website. NERSA has published a model on the website with the intention of demonstrating the

various options and scenarios by way of testing the target cost of equity by the outcome of

the internal rate of return (IRR) of cash flows to investors. High level notes pertaining to the

various “worksheet tabs” are presented below:

1. Base case – The model presents a base case scenario using the notional tax

option where no adjustments are made for deferred taxation to the regulatory

asset base (RAB).


2. Notional tax – This is the notional tax option with the deferred taxation adjusted in

RAB. Note that IRR is higher than targeted as the actual tax and deferred tax cash

flows practically lag one year.

3. Flow-through using Vanilla WACC – This represents a flow-through option but

with the cost of debt (Kd) pre tax. This means that the tax shield on the cost of

debt (Kd) is not allowed in the tax calculation as the tax is already included in the

pre-tax rate. Also note that the “achieved IRR” in this option is higher (15.50 per

cent) than the targeted 15 per cent, which is why this option is not followed

.

4. Flow-through actual – This is the flow-through option as defined in the

Methodology (paragraph 7.1) actual payments. As can be seen, the resultant IRR

is below the target IRR of 15 per cent which is a result of the tax shield on cost of

debt not allowed. For this reason NERSA is going to use the “tax formula flow-

through” to calculate the tax allowance under this tax option.

5. Tax formula notional – This demonstrates the tax formula for year 1 of the model

and also demonstrates the tax shield for each component of allowable revenue.

6. Graphs – The model also has “worksheet tabs” comparing, by way of data or

graphs, the differences between the various tax options (flow-through and notional

tax) and tenures of debt (10 years versus 25 years).

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