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BUREAU OF PUBLIC ROADS: THIS IS IN RESPONSE TO YOUR LETTER OF AUGUST 7. THE BASIC QUESTION WHICH THE STATE OF ARKANSAS CLAIM POSES IS WHETHER PAYMENTS IN A CORPORATE COMPLEX WHICH GIVE RISE TO INTERCOMPANY PROFITS UNDER THE CIRCUMSTANCES OUTLINED BELOW MAY PROPERLY BE CONSTRUED AS A "COST OF RELOCATION" SO FAR AS SUCH INTER-COMPANY PROFITS ARE CONCERNED. $272.45 OF THE TOTAL WAS NOT CONSIDERED ELIGIBLE FOR FEDERAL PARTICIPATION. THE AMOUNT WAS. OMITTED FROM THE STATE'S INITIAL CLAIM FOR REIMBURSEMENT AND WAS MADE THE SUBJECT OF A SEPARATE CLAIM IN ORDER TO TEST THE BUREAU'S POSITION. THAT WESTERN ELECTRIC INCLUDES A PROFIT ELEMENT IN ITS BILLINGS FOR MATERIALS PURCHASED BY BELL SYSTEM OPERATING COMPANIES AND THAT THESE "INTERCOMPANY PROFITS" ARE EVENTUALLY RETURNED TO THE BELL SYSTEM COMPANIES THROUGH ACCOUNTING PROCESSES ESTABLISHED UNDER RULES PRESCRIBED BY THE FEDERAL COMMUNICATIONS COMMISSION AND THROUGH THE FILING OF CONSOLIDATED TAX RETURNS UNDER THE INTERNAL REVENUE ACT.

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B-154937, DEC. 16, 1964

TO MR. C. H. SMITH, AUTHORIZED CERTIFYING OFFICER, BUREAU OF PUBLIC ROADS:

THIS IS IN RESPONSE TO YOUR LETTER OF AUGUST 7, 1964, REFERENCE 34 21, CONCERNING A CLAIM BY THE STATE HIGHWAY DEPARTMENT OF ARKANSAS IN THE AMOUNT OF $245 REPRESENTING THE FEDERAL GOVERNMENT'S SHARE OF $272.45 WHICH THE STATE PAID TO SOUTHWESTERN BELL TELEPHONE COMPANY IN CONNECTION WITH THE RELOCATION OF COMPANY FACILITIES INCIDENT TO CONSTRUCTION OF A PORTION OF THE INTERSTATE SYSTEM OF FEDERALLY AIDED HIGHWAYS.

SECTION 123 OF TITLE 23, U.S.C. AUTHORIZES THE USE OF FEDERAL FUNDS TO PARTIALLY REIMBURSE STATES WHERE THEY PAY FOR THE COST OF RELOCATING UTILITY FACILITIES NECESSITATED BY THE CONSTRUCTION OF FEDERALLY AIDED HIGHWAY SYSTEMS. THE BASIC QUESTION WHICH THE STATE OF ARKANSAS CLAIM POSES IS WHETHER PAYMENTS IN A CORPORATE COMPLEX WHICH GIVE RISE TO INTERCOMPANY PROFITS UNDER THE CIRCUMSTANCES OUTLINED BELOW MAY PROPERLY BE CONSTRUED AS A "COST OF RELOCATION" SO FAR AS SUCH INTER-COMPANY PROFITS ARE CONCERNED.

THE AMERICAN TELEPHONE AND TELEGRAPH COMPANY OWNS 100 PERCENT OF THE STOCK OF SOUTHWESTERN BELL AND 99.82 PERCENT OF THE STOCK OF THE WESTERN ELECTRIC COMPANY. SOUTHWESTERN BELL INCURRED ,COSTS" TOTALLING $11,717.77 IN RELOCATING THE FACILITIES HERE INVOLVED. THE STATE PAID THESE ,COSTS.' HOWEVER UNDER BUREAU OF PUBLIC ROADS ESTABLISHED CRITERIA, $272.45 OF THE TOTAL WAS NOT CONSIDERED ELIGIBLE FOR FEDERAL PARTICIPATION, ON THE BASIS THAT IT CONSTITUTED "INTERCOMPANY PROFITS" ON PURCHASES MADE BY SOUTHWESTERN BELL FROM WESTERN ELECTRIC. THE AMOUNT WAS, THEREFORE, OMITTED FROM THE STATE'S INITIAL CLAIM FOR REIMBURSEMENT AND WAS MADE THE SUBJECT OF A SEPARATE CLAIM IN ORDER TO TEST THE BUREAU'S POSITION.

THE BUREAU CONCLUDED, AFTER EXTENSIVE ANALYSIS OF THE PARENT AND SUBSIDIARY COMPANY ACCOUNTING AND BILLING PROCEDURES, THAT WESTERN ELECTRIC INCLUDES A PROFIT ELEMENT IN ITS BILLINGS FOR MATERIALS PURCHASED BY BELL SYSTEM OPERATING COMPANIES AND THAT THESE "INTERCOMPANY PROFITS" ARE EVENTUALLY RETURNED TO THE BELL SYSTEM COMPANIES THROUGH ACCOUNTING PROCESSES ESTABLISHED UNDER RULES PRESCRIBED BY THE FEDERAL COMMUNICATIONS COMMISSION AND THROUGH THE FILING OF CONSOLIDATED TAX RETURNS UNDER THE INTERNAL REVENUE ACT. IT IS, THEREFORE, THE BUREAU'S POSITION THAT SUCH INTERCOMPANY PROFIT DOES NOT CONSTITUTE AN ITEM OF COST TO BELL SYSTEM OPERATING COMPANIES. THIS POSITION WAS FORMALIZED IN A CIRCULAR MEMORANDUM ISSUED ON AUGUST 22, 1962, REQUIRING A CREDIT FOR INTERCOMPANY PROFIT AT 4.69 PERCENT OF THE PRICE OF MATERIALS PURCHASED FROM WESTERN ELECTRIC BY BELL SYSTEM COMPANIES AND INCORPORATED IN FEDERAL-AID PROJECTS AUTHORIZED AFTER SEPTEMBER 1, 1962. THE 4.69 PERCENT RATE WAS THE RATIO OF WESTERN ELECTRIC'S GROSS SALES TO NET PROFIT AFTER TAXES FOR THE CALENDAR YEAR 1961. ON THE BASIS OF WESTERN ELECTRIC'S FINANCIAL STATEMENTS FOR CALENDAR YEAR 1962, THE REQUIRED CREDIT FOR INTERCOMPANY PROFITS WAS RAISED TO 6.99 PERCENT FOR WORK AUTHORIZED ON OR AFTER MAY 1, 1964.

THE GOVERNING STATUTE, 23 U.S.C. 123 DERIVED FROM SECTION 111 OF THE FEDERAL-AID HIGHWAY ACT OF 1956, 70 STAT. 383, AS AMENDED BY SECTION 11 OF THE FEDERAL-AID HIGHWAY ACT OF 1958, 72 STAT. 94, PROVIDES THAT:

"/A) WHEN A STATE SHALL PAY FOR THE COST OF RELOCATION OF UTILITY FACILITIES NECESSITATED BY THE CONSTRUCTION OF A PROJECT ON THE FEDERAL- AID PRIMARY OR SECONDARY SYSTEMS OR ON THE INTERSTATE SYSTEM, INCLUDING EXTENSIONS THEREOF WITHIN URBAN AREAS, FEDERAL FUNDS MAY BE USED TO REIMBURSE THE STATE FOR SUCH COST IN THE SAME PROPORTION AS FEDERAL FUNDS ARE EXPENDED ON THE PROJECT. FEDERAL FUNDS SHALL NOT BE USED TO REIMBURSE THE STATE UNDER THIS SECTION WHEN THE PAYMENT TO THE UTILITY VIOLATES THE LAW OF THE STATE OR VIOLATES A LEGAL CONTRACT BETWEEN THE UTILITY AND THE STATE. * * *

"/B) THE TERM "UTILITY," FOR THE PURPOSES OF THIS SECTION, SHALL INCLUDE PUBLICLY, PRIVATELY, AND COOPERATIVELY-OWNED UTILITIES.

"/C) THE TERM "COST OF RELOCATION," FOR THE PURPOSES OF THIS SECTION, SHALL INCLUDE THE ENTIRE AMOUNT PAID BY SUCH UTILITY PROPERLY ATTRIBUTABLE TO SUCH RELOCATION AFTER DEDUCTING THEREFROM ANY INCREASE IN THE VALUE OF THE NEW FACILITY AND ANY SALVAGE VALUE DERIVED FROM THE OLD CILITY.'

TO IMPLEMENT THESE PROVISIONS THE BUREAU OF PUBLIC ROADS ISSUED ITS POLICY AND PROCEDURE MEMORANDUM 30-4, DATED DECEMBER 31, 1957. WITHOUT REPEATING IN DETAIL THE CRITERIA ESTABLISHED BY PPM30-4 FOR DETERMINING WHAT ITEMS MAY BE REIMBURSED AS COSTS OF RELOCATING UTILITY FACILITIES, IT MAY BE SAID GENERALLY THAT THE UNDERLYING POLICY FOLLOWED IS THAT THE FEDERAL GOVERNMENT WILL PARTICIPATE IN ONLY THOSE COSTS NECESSARY TO PLACE THE AFFECTED UTILITY IN THE SAME FINANCIAL AND PRODUCTIVE SITUATION AFTER RELOCATION AS IT ENJOYED PRIOR THERETO. BUT ALTHOUGH THE BUREAU RELIES UPON VARIOUS PROVISIONS OF THE PPM TO SUPPORT ITS POSITION, WE FIND SUCH PROVISIONS SOMEWHAT VAGUE AND REMOVED FROM THE SITUATION UNDER CONSIDERATION TO BE NECESSARILY CONTROLLING. WE AGREE THAT AMERICAN TELEPHONE'S CONSTRUCTION OF THE PPM HAS CONSIDERABLE MERIT. HOWEVER, WE DO NOT CONSIDER IT NECESSARY TO DECIDE THIS QUESTION AS WE MUST DISAGREE WITH AMERICAN'S ULTIMATE POSITION FOR OTHER REASONS SET FORTH BELOW.

THE POSITION TAKEN BY THE AMERICAN TELEPHONE AND TELEGRAPH COMPANY IS DETAILED IN A DOCUMENT FURNISHED TO THE BUREAU UNDER DATE OF NOVEMBER 2, 1962. THE ESSENCE OF AMERICAN TELEPHONE'S CONTENTIONS RESTS ON THE PROPOSITION THAT THE LAW AND THE IMPLEMENTING INSTRUCTIONS THEREUNDER AUTHORIZE FEDERAL PARTICIPATION IN THE ENTIRE AMOUNT PAID BY A UTILITY IN CONNECTION WITH RELOCATING EQUIVALENT FACILITIES. THEREFORE, SINCE SOUTHWESTERN BELL IS IN AN ORDINARY VENDOR-PURCHASER RELATIONSHIP TO WESTERN ELECTRIC; SINCE THE COURTS HAVE UPON NUMEROUS OCCASIONS RULED WESTERN ELECTRIC'S PRICES TO BE REASONABLE AND APPROPRIATE FOR FULL INCORPORATION INTO SOUTHWESTERN AND OTHER BELL OPERATING COMPANY RATE BASES; AND SINCE WESTERN ELECTRIC PAYS INCOME TAX ON ITS PROFITS ON SALES TO SOUTHWESTERN BELL, AMERICAN TELEPHONE CONCLUDES THAT ANYTHING LESS THAN FULL REIMBURSEMENT TO SOUTHWESTERN BELL FOR THE COST OF MATERIALS PURCHASED FROM WESTERN ELECTRIC FOR A FACILITY RELOCATION PLACES A BURDEN UPON SOUTHWESTERN'S CUSTOMERS RATHER THAN UPON HIGHWAY USERS WHERE IT BELONGS. IN SUPPORT, AMERICAN TELEPHONE CITES A HOST OF COURT DECISIONS AND ABLY PRESENTS AN ANALYSIS OF THE INTRICATE ACCOUNTING PROCESSES AND INCOME TAX TREATMENT BY WHICH THE FULL COST OF PURCHASES FROM WESTERN ELECTRIC IS CHARGED TO SOUTHWESTERN BELL USERS.

WE DO NOT QUESTION THE ANALYSIS WHICH AMERICAN TELEPHONE PRESENTS SO FAR AS IT CONCERNS TRANSACTIONS OCCURRING IN THE ORDINARY COURSE OF ITS BUSINESS. NOR DO WE QUESTION THE FACT THAT IN THE COURSE OF ITS REGULAR BUSINESS AMERICAN IS ENTITLED TO A PROFIT ON WESTERN ELECTRIC SALES TO BELL SYSTEM OPERATING COMPANIES. BUT WE BELIEVE THERE IS A FUNDAMENTAL CONSIDERATION OVERLOOKED IN RELATING THE MATTERS COVERED TO REIMBURSEMENTS FOR THE COST OF RELOCATING A FACILITY. THE TRUE NATURE OF THE RELOCATION SITUATION CAN BEST BE SEEN BY RESORT TO A SIMPLIFIED ILLUSTRATION. FOR PURPOSES OF THE ILLUSTRATION, AS WELL AS FOR THE PURPOSE OF THE FULL CONCLUSIONS REACHED HEREIN, WESTERN ELECTRIC IS TREATED AS A WHOLLY OWNED SUBSIDIARY OF AMERICAN TELEPHONE. WITHOUT DECIDING WHAT MINIMUM PERCENTAGE OF OWNERSHIP IS REQUIRED TO CONSTITUTE SUFFICIENT BASIS FOR SUCH TREATMENT, WE BELIEVE THAT 99.82 PERCENT OWNERSHIP IS SUBSTANTIAL ENOUGH TO CONSTITUTE "WHOLE OWNERSHIP" FOR THE PURPOSES HERE INVOLVED.

WITH AMERICAN TELEPHONE OWNING ALL OF SOUTHWESTERN BELL, ANY RELOCATION OF A SOUTHWESTERN FACILITY IS IN PRACTICAL FACT A RELOCATION OF AN AMERICAN TELEPHONE FACILITY. AND WITH AMERICAN OWNING VIRTUALLY ALL OF WESTERN ELECTRIC, ANY SALE BY WESTERN IS IN PRACTICAL FACT A SALE BY AMERICAN. AS STATED BY THE SUPREME COURT IN LINDHEIMER V. ILLINOIS TEL. CO., 292 U.S. 151, 156 (1934), "* * * THE WESTERN ELECTRIC COMPANY THROUGH THE ORGANIZATION AND CONTROL OF THE AMERICAN COMPANY APPEARS TO BE VIRTUALLY THE MANUFACTURING DEPARTMENT FOR THE BELL SYSTEM * * *.' ANY ASSETS OF EITHER SOUTHWESTERN OR WESTERN ARE ASSETS OF AMERICAN. LET US ASSUME A STATIC SITUATION IN WHICH WESTERN HAS ASSETS CONSISTING SOLELY OF CABLE VALUED AT $900; THAT SOUTHWESTERN HAS ASSETS CONSISTING OF A FACILITY AND $1,000 IN CASH; AND THAT THESE ARE THE ONLY ASSETS WHICH AMERICAN TELEPHONE HAS. COMES NOW A HIGHWAY AND IT IS NECESSARY TO RELOCATE SOUTHWESTERN'S FACILITY. PURSUANT TO SUCH NECESSITY, SOUTHWESTERN PURCHASES WESTERN'S ENTIRE CABLE INVENTORY FOR $1,000 FOR INCORPORATION INTO THE NEW FACILITY. AT THIS POINT, AMERICAN TELEPHONE'S ASSET POSITION IS NOT ALTERED ONE IOTA. THE ONLY CHANGE IS THAT INSTEAD OF HAVING $1,000 AT SOUTHWESTERN AND $900 WORTH OF CABLE AT WESTERN, IT NOW HAS THE CASH AT WESTERN AND THE INVENTORY AT SOUTHWESTERN. NO COST HAS BEEN INCURRED BY THE CORPORATE COMPLEX IN MAKING THIS TRANSFER. (OF COURSE, IN REALITY THERE ARE TRANSPORTATION AND OTHER COSTS INCURRED IN MAKING THE TRANSFER, WHICH COSTS WOULD BE FOR REIMBURSEMENT; BUT THESE ARE OMITTED FOR SIMPLIFICATION.) NOW SOUTHWESTERN INCORPORATES THE CABLE INTO ITS NEW FACILITY. ASSUMING THE NEW FACILITY TO BE IDENTICAL WITH THE OLD WHICH IT REPLACED, THE COST WHICH AMERICAN TELEPHONE MAY BE SAID TO HAVE INCURRED IS THE $900 OF CABLE INVENTORY WHICH IS USED IN ACHIEVING THE RELOCATION. THE PARENT COMPANY HAS REPLACED THE FACILITY TAKEN AND INSTEAD OF HAVING $1,000 IN CASH AND $900 IN INVENTORY, IT HAS ONLY THE CASH. UPON REIMBURSEMENT FOR COST OF THE CABLE USED IN EFFECTING THE RELOCATION, THE PARENT COMPANY WILL BE IN THE SAME FINANCIAL AND PRODUCTIVE POSITION IT ENJOYED PRIOR TO THE RELOCATION.

THE THRUST OF THE PARENT COMPANY ARGUMENT IS THAT IF SOUTHWESTERN BELL IS ONLY REIMBURSED $900 INSTEAD OF THE FULL $1,000 IT EXPENDED, ITS CUSTOMERS WILL BE REQUIRED TO MAKE UP THE DIFFERENCE, SINCE THE COURTS HAVE CONSISTENTLY HELD, IN EFFECT, THAT THE $1,000 CHARGE IS REASONABLE AND APPROPRIATE FOR CONSIDERATION AS A COST TO SOUTHWESTERN. HOWEVER, IT IS ONLY BY REASON OF THE ACCOUNTING TREATMENT ACCORDED THE TRANSACTION THAT SOUTHWESTERN'S CUSTOMERS WOULD BE CALLED UPON TO MAKE UP THIS DIFFERENCE. IF THE PARENT COMPANY WOULD TRANSFER THE $100 PROFIT IT RECEIVES ON WESTERN ELECTRIC'S SALE TO SOUTHWESTERN OR IF WESTERN ELECTRIC WOULD BILL SOUTHWESTERN ONLY THE COST OF INVENTORY SOLD TO SOUTHWESTERN FOR FACILITY REPLACEMENT PURPOSES, SOUTHWESTERN'S CUSTOMERS WOULD NOT BE REQUIRED TO BEAR A COST WHICH IN FACT HAS NOT BEEN INCURRED.

THE QUESTION WHICH EMERGES FROM THE ABOVE ANALYSIS IS SIMPLY THIS: WHERE ONE ENTITY WHOLLY OWNS TWO SUBSIDIARY ENTERPRISES AND ONE OF THE SUBSIDIARIES EARNS FOR THE PARENT A PROFIT ON PURCHASES FROM IT BY THE OTHER, IS SUCH PROFIT SEPARATE AND DISTINCT FROM THE PURPOSE FOR WHICH THE PURCHASES WERE MADE OR MUST THE PROFIT BE CONSIDERED AS A REDUCTION OF THE PURCHASING SUBSIDIARY'S COSTS? ON THE BASIS THAT THE SELLING SUBSIDIARY IS UNRELATED TO THE PURCHASER AND IS ENGAGED IN A COMPLETELY SEPARATE TYPE OPERATION, THE AMERICAN TELEPHONE AND TELEGRAPH COMPANY ARGUES THAT THE PROFIT INVOLVED IS UNRELATED TO THE ACTIVITIES OF THE PURCHASING SUBSIDIARY.

WHILE THE REASONING PRESENTED IS SOUND FOR RATE MAKING PURPOSES OF THE PURCHASING SUBSIDIARY, WE ARE OF THE VIEW THAT TO FOLLOW THIS REASONING IN THE RELOCATION SITUATION UNDER THE FEDERAL-AID HIGHWAY LAWS WOULD GIVE RISE, FOR THE REASONS STATED, TO REIMBURSEMENTS IN EXCESS OF COSTS ACTUALLY INCURRED IN THE RELOCATION OF FACILITIES THEREBY VIOLATING THE INTENT OF THE GOVERNING STATUTE. THE RATE MAKING CASES ARE CONCERNED WITH WHAT IS A REASONABLE PROFIT; HERE THERE IS NO QUESTION OF ALLOWING ANY PROFIT, WHETHER REASONABLE OR NOT. THE OVER-ALL INTENT OF THE STATUTE IS TO REIMBURSE THE STATES FOR ONLY THOSE PAYMENTS MADE BY THEM NECESSARY TO MAKE THE AFFECTED UTILITIES WHOLE AND NO MORE. THE QUESTION REALLY REVOLVES AROUND WHAT IS REQUIRED TO MAKE THE UTILITY IN THIS INSTANCE WHOLE. IT SEEMS AXIOMATIC THAT WHEN WE SPEAK OF MAKING A UTILITY WHOLE WE ARE CONCERNED WITH THE FINANCIAL CONDITION OF ITS OWNERS. AND IT FOLLOWS THAT WHERE THE OWNERS PROFIT FROM A RELOCATION, THEY HAVE BEEN MADE MORE THAN WHOLE.

IN CONSIDERING THE CONSTITUTIONALITY OF THE MONTANA STATUTE AUTHORIZING PAYMENT FOR UTILITY RELOCATIONS NECESSITATED BY HIGHWAY CONSTRUCTION, THE SUPREME COURT OF MONTANA STATED IN JONES V. BURNS, 357 P.2D 22 (1960), AT PAGE 29, THAT:

"IN THE INSTANT CASE, NEITHER THE UTILITIES, THEIR USERS, THEIR STOCKHOLDERS NOR COOPERATIVELY OWNED UTILITIES OR THEIR MEMBERS, WILL RECEIVE ANY DIRECT AND SUBSTANTIAL BENEFIT FROM RELOCATION OF THE UTILITIES' FACILITIES. IT CANNOT BE CONTENDED THAT THE RELOCATION WILL MAKE THE SERVICE TO THE USERS ANY BETTER, OR REDUCE THEIR RATES, OR PROVIDE ANY MORE INCOME FOR THE COMPANY. THE PURPOSE BEHIND REQUIRING RELOCATION OF EXISTING FACILITIES IS TO PROVIDE THE TRAVELING PUBLIC WITH WIDER, STRAIGHTER, AND BETTER HIGHWAYS. IT IS ONLY EQUITABLE THAT THE STATE SHOULD PLACE THE BURDEN OF RELOCATING EXISTING UTILITY FACILITIES ON THOSE WHO WILL DERIVE THE BENEFIT THEREFROM.' WE BELIEVE THIS QUOTE NEATLY SUMS UP THE RATIONALE UNDER WHICH UTILITY RELOCATIONS ARE PAID FOR BY HIGHWAY USERS IN THE FIRST INSTANCE. AND WE BELIEVE, FURTHER, THAT UNDER SUCH RATIONALE IT IS INAPPROPRIATE TO CHARGE HIGHWAYS USERS FOR ANY ELEMENT IN THE NATURE OF PROFIT TO THE OWNERS OF THE UTILITY COMPANIES BEING RELOCATED, WHETHER SUCH PROFIT BE DERIVED THROUGH A SINGLE INDEPENDENT COMPANY OR THROUGH A CORPORATE COMPLEX MADE UP OF INTERMINGLED INTERESTS. IN TERMS OF SUBSECTION (C) OF TITLE 23, U.S.C. QUOTED ABOVE, WE DO NOT BELIEVE THAT ANY PORTION OF THE PAYMENT FOR RELOCATING A UTILITY WHICH CONSTITUTES A PROFIT TO ITS OWNER MAY PROPERLY BE CONSIDERED AS A "COST" ATTRIBUTABLE TO THE RELOCATION.

ACCORDINGLY, ON THE BASIS OF THE PRESENT RECORD, THE CLAIM PRESENTED BY THE STATE OF ARKANSAS MAY NOT BE PAID.

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