The recent decision by the U.S. Court of Appeals for the District of Columbia Circuit in United Airlines Inc., et al., v. Federal Energy Regulatory, Case No. 11-1479, July 1, 2016 (United Airlines) will likely reignite a debate at the Federal Energy Regulatory Commission (FERC) on an issue the FERC attempted to resolved in 2005, i.e., whether a FERC regulated entity, that is a pass-through entity for tax purposes – an entity that does not itself pay tax on its income but rather passes-through that income to its owner or investors, such as a partnership or a limited liability corporation (e.g., a generator with a reliability must-run contract) – can receive a tax allowance in its cost-of-service rates?
In 2005, FERC addressed this issue stating that pass-through entities can receive a tax allowance "provided that an entity or individual has an actual or potential income tax liability to be paid on that income from those assets [of the pass-through FERC regulated entity.]” FERC concluded, “[t]hus a tax-paying corporation, a partnership, a limited liability corporation, or other pass-through entity would be permitted an income tax allowance on the income imputed to the corporation, or to the partners or the members of pass-through entities, provided that the corporation or the partners or the members, have an actual or potential income tax liability on that public utility income. Policy Statement on Income Tax Allowance, 111 FERC ¶ 61,139 at P 32 (2005)(Policy Statement.)
Applying the Policy Statement, FERC said that SFPP, L.P.was entitled to a tax allowance. In 2007, the same panel of the District of Columbia Circuit as in United Airlines (Senior Circuit Judge Sentelle, joined by Circuit Judges Kavanaugh and Griffith) rejected challenges to the SFPP decision (and in the process as the court recognized, reviewed “the Commission’s [FERC’s] reasoning and conclusions in the Policy Statement.”) ExxonMobil Oil Corporation v. Federal Energy Regulatory Commission, 487 F.3d 945, 951 (D.C. Cir. 2007)(ExxonMobil).
Since that time, FERC has applied its policy in a wide variety of circumstances, see e.g., RITELine Illinois, LLC, et. al., 137 FERC ¶ 61,939 at P 132 (2011) (RITELine Illinois and RITELine Indiana, builders of large scale transmission “will be pass-through entities for federal income tax purposes and will not be liable for the payment of any income taxes. Although the RITELine Companies, as limited liability companies, will not be subject to federal income tax, the tax obligations incurred through their operations will be passed through to and reported on the tax returns of their corporate parents. For ratemaking purposes, the Commission treats pass-through entities, such as the RITELine Companies, as though they are corporations and allows them to receive an income tax allowance for the tax liability ultimately paid by their parents.”)
Now almost 10 years later, that same panel has remanded a FERC decision, from a later SFPP rate case, that granted SFPP a tax allowance, thereby calling into question the application of FERC’s Policy Statement. Procedurally, the court said its ExxonMobil decision did not resolve the issue of a tax allowance for a pass-through tax entity; specifically whether the combination of (i) the discounted cash flow return on equity and (ii) the tax allowance results in (iii) a double recovery of taxes for partnership pipelines (and other pass-through entities such as limited liability companies with cost-based rates.)
Substantively, the court said FERC did not demonstrate that a double recovery did not exist. Further, the court expressed a concern that because of the tax allowance partnership pipelines would receive higher returns than a corporate pipeline.
Based on the following three facts to which the court said the parties did not disagree, the court (i) concluded that “granting a tax allowance to partnership pipelines results in inequitable returns for partners in those pipelines as compared to shareholders in corporate pipelines” and (ii) remanded for further consideration. Id. First, unlike a corporate pipeline, a partnership pipeline incurs no taxes, except those imputed from its partners, at the entity [pass-through] level. Second, the discounted cash flow return on equity determines the pre-tax investor return required to attract investment, irrespective of whether the regulated entity is a partnership or a corporate pipeline. Third, with a tax allowance, a partner in a partnership pipeline will receive a higher after-tax return than a shareholder in a corporate pipeline, at least in the short term before adjustments can occur in the investment market. Slip Op. at 22
On remand, the court suggested several options. FERC could impute partner taxes to the partnership pipeline entity, but as the court said “it [FERC] must still ensure parity between equity owners in partnership and corporate pipelines.” Id. at 24. Further, FERC “might be able to remove any duplicative tax recovery for partnership pipelines directly from the discounted cash flow return on equity” an option FERC suggested at oral argument. Id. Finally, the court said FERC could consider the possibility of eliminating all income tax allowances and setting rates based on pre-tax returns, an option FERC previous considered (and rejected). Policy Statement at P 31.