Court rules that FERC policy permitting a tax allowance for pass-through entities may unjustifiably permit “double-recovery” of tax expense.

On July 1, the US Court of Appeals for the District of Columbia Circuit issued an opinion invalidating an oil pipeline partnership’s tax allowance that the Federal Energy Regulatory Commission (FERC) had approved as consistent with established FERC policy. In United Airlines v. FERC, the DC Circuit determined that FERC “failed to demonstrate that there is no double-recovery of taxes for partnership, as opposed to corporate, pipelines.” The court, in turn, ruled that FERC’s policy as applied in the case was arbitrary and capricious in violation of the Administrative Procedure Act. The court vacated that portion of the FERC decision and remanded for further proceedings.

The DC Circuit’s decision and its underlying analysis threaten to upset long-established FERC-permitted rate recovery of tax expense by pass-through entities and may create far-reaching rate implications for affected interstate pipelines and for electric transmission providers that have opted to be treated as partnerships for tax purposes.

Overview of Issue in United Airlines v. FERC

The case before the DC Circuit concerned the cost-of-service governing and rates paid for transportation on common-carrier oil pipeline facilities owned by SFPP, LP. In United Airlines v. FERC, the DC Circuit was faced with determining whether a crude oil pipeline partnership such as SFPP should be permitted to claim an income tax allowance, which accounts for taxes paid by partner-investors that are attributable to the pipeline entity.

Shippers on SFPP’s pipeline claimed that FERC’s tax allowance policy (discussed further below) permits partners in a partnership pipeline to “double-recover” their taxes. The SFPP shippers argued that such double-recovery occurs because FERC’s ratemaking methodology already provides for an after-tax rate of return sufficient to attract investors, and partnership pipelines do not incur entity-level taxes.

Background of FERC Policy

In 2005, FERC issued a Policy Statement on Income Tax Allowances (Policy Statement), which definitively explained when a jurisdictional pass-through entity may claim a tax allowance based on the profits of that entity’s partners or members.[1] In the Policy Statement, FERC concluded that all entities providing jurisdictional services may qualify for an income tax allowance, including partnerships and other forms of pass-through entities.[2] This determination served as a novel approach by FERC that was generated after a 2004 DC Circuit opinion in which the DC Circuit reversed FERC’s prior approach in addressing tax allowances.[3] Previously, FERC only allowed corporate partners of a pass-through entity to claim a tax allowance because they incurred tax liability that non-corporate partners—such as limited liability companies (LLCs) or limited partnerships (LPs)—did not.[4]

After the DC Circuit reversed FERC’s prior approach to addressing tax allowances, FERC issued the Policy Statement to provide guidance as to how FERC would address tax allowances in future proceedings. While FERC determined that the income generated by both corporate and non-corporate entities may qualify for a tax allowance, FERC did qualify the decision by stating that partnerships and other pass-through entities would be permitted an income tax allowance only in proportion to those members or partners that have an actual or potential income tax liability.[5] FERC also explained that to the extent that a partner or other owner of a pass-through interest did not have an actual or potential income tax liability, the tax allowance would be reduced.[6] 

However, in the Policy Statement, FERC changed its tax allowance policy in recognition of the tax liability attributable to partners of a non-corporate entity. Specifically, FERC determined that, just as a corporation has an actual or potential income tax liability on income from the first tier regulated assets it controls, so do the owners of a partnership or LLC on the income from the first tier regulated assets that they control by means of the pass-through entity.[7] In FERC’s view, the first tier income of non-corporate entities may be taxable at that level because the actual investors in the entity hold the specific physical regulated assets that generate the income, and those investors are ultimately taxed on the income that those regulated assets generate.[8] Further, because the investors of a non-corporate pass-through entity are the ones that are individually taxed (rather than the pass-through entity itself), FERC recognized that determining whether a tax allowance should apply might require review of several layers of pass-through ownership to determine where the ultimate actual or potential liability lies.[9] In this vein, FERC concluded that subchapter C corporations always possess actual or potential tax liability because they are subject to a tax on all income. Likewise, subchapter S corporations also qualified because they are pass-through entities where income is recognized and taxed directly to shareholders. Because LLCs are taxed as either subchapter C or subchapter S corporations, FERC determined that they, too, qualified.

FERC’s policy has also addressed concerns that some actions should disqualify a pass-through entity from claiming a tax allowance for income generated by its partners or members. Namely, FERC addressed

  • situations where a pass-through entity issues partnership distributions that exceed the partnership book income,
  • circumstances where a partnership’s deductions of losses offset any income generated by the partnership in a particular year, and
  • instances where income or expenses are allocated among a pass-through entity’s partners in a proportion that differs from the partner’s actual ownership share of the pass-through entity.

In each case, FERC determined that such actions do not disqualify the pass-through entity from claiming a tax allowance for the income generated by its partners.

DC Circuit Opinion in United Airlines v. FERC

In United Airlines, the DC Circuit determined that FERC may only permit an income tax allowance when FERC has provided a reasoned basis justifying the allowance; FERC is not permitted to allow a blanket income tax allowance for all partnership pipelines. Turning to the allowance that FERC’s policy provided to SFPP, the DC Circuit concluded that FERC failed to provide a sufficient justification for its conclusion that there is no double-recovery of taxes for partnership pipelines receiving a tax allowance in addition to the discounted cash flow return on equity.

In support of its conclusion, the DC Circuit relied on three undisputed facts: First, a partnership-owned pipeline incurs no taxes at the entity level, unlike a corporate pipeline. Second, a discounted cash flow return on equity determines the pre-tax investor return required to attract investment. Third, a partner in a partnership-owned pipeline will receive a higher after-tax return than a shareholder in a corporate pipeline if permitted to receive a tax allowance. Collectively, the court found that these facts support the conclusion that granting a tax allowance to partnership pipelines results in inequitable returns for partners in those pipelines as compared to shareholders in corporate pipelines.

Drawing on the US Supreme Court’s 1944 mandate in Federal Power Commission v. Hope Natural Gas Co., the DC Circuit found that such inequitable returns violate the Supreme Court’s conclusion that “the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.” This violation occurs because, in the DC Circuit’s view, a pipeline organized as a partnership carries a similar level of risk as one organized as a corporation.

The DC Circuit remanded the issue to FERC and directed FERC to consider mechanisms for which FERC can demonstrate that there is no double-recovery.

Industry Implications

The DC Circuit’s opinion in United Airlines will impact ratemaking and cost-of-service computations far beyond the transportation service provided by SFPP on its crude oil pipeline system. Indeed, the presence of such a large number of FERC-jurisdictional entities organized as pass-through entities necessarily suggests that the DC Circuit’s rejection of FERC’s tax allowance policy will create industry-wide impacts. The open questions for the industry are whether FERC’s decision on remand will justify granting income tax allowances to both pass-through and taxable entities, or if FERC will conclude that it cannot justify granting similar tax allowances to entities in taxable and pass-through structures, or if FERC attempts to identify some other means of permitting tax recovery.

Interstate pipelines subject to regulation under the Natural Gas Act and the Interstate Commerce Act will unquestionably be impacted by the DC Circuit’s opinion and FERC’s response to the court’s mandates. Pipeline entities are often organized as pass-through entities such as LPs. The court’s decision raises questions concerning the justness and reasonableness of existing rates for those pass-through entities that receive an income tax allowance and compute return on equity based on a discounted cash flow methodology. In addition, the court’s decision also raises questions concerning future rates proposed by those entities.

Electric transmission developers organized as pass-through entities could face similar challenges to the justness and reasonableness of their rates under the Federal Power Act if they use cost-based rates. FERC has in the past allowed transmission developers organized as pass-through entities to receive an income tax allowance, even though the parent companies or partners in the development entity have the tax liability, not the development entity. This concern does not arise for pass-through entities authorized to charge negotiated rates for transmission capacity, such as many merchant transmission developers. But many electric transmission projects currently under development, including those selected through Order No. 1000 regional transmission planning, are expected to charge cost-based rates. To the extent pass-through entities have been selected to build such projects, this decision creates a risk that their rates could be found unjust and unreasonable if they receive an income tax allowance. Similarly, to the extent that an FERC-regulated entity that charges cost-of-service rates is held in a real estate investment trust (REIT) structure (within which a REIT is typically immune from certain income taxation), FERC policies developed on remand might result in the loss of the tax allowance portion of a REIT-owned entity’s rates.