On December 15, 2016, the Federal Energy Regulatory Commission (FERC) issued a Notice of Inquiry (NOI) in Docket No. PL17-1, seeking comments on how to address any double recovery that may result from its tax allowance and rate of return policies in light of the ruling in United Airlines, Inc. v. FERC, 827 F.3d 122 (D.C. Cir. 2016). See Inquiry Regarding the Commission’s Policy for Recovery of Income Tax Costs, 157 FERC ¶ 61,210 (2016) (citing Composition of Proxy Groups for Determining Gas and Oil Pipeline Return on Equity, 123 FERC ¶ 61,048 (2008); and Inquiry Regarding Income Tax Allowances, 111 FERC ¶ 61,139 (2005)).
In United Airlines, SFPP, L.P.’s (SFPP) Shippers argued that FERC engaged in “arbitrary-or-capricious” decision-making by granting an income tax allowance to SFPP, a master limited partnership (MLP). MLPs are exempt from corporate income tax under the U.S. Tax Code. See 26 U.S.C. § 7704. The Shippers argued FERC granted SFPP double recovery of the partners’ income taxes by granting an income tax allowance when the return calculated by the discounted cash flow (DCF) analysis already incorporates the investor partner taxes.
FERC argued that there was no such double recovery because the DCF analysis imputes the tax burdens of the individual partners to the partnership and that the income tax allowance equalized the after-tax "entity-level" rates of return for partnership and corporate pipelines.
The D.C. Circuit rejected FERC’s argument and found that the policy allowing income tax allowances for partnership pipelines may allow partnerships to unfairly profit from their tax structure, because a partnership does not incur the same income tax burden as a corporation. The D.C. Circuit remanded the proceeding to FERC to consider “mechanisms for which the Commission can demonstrate that there is no double recovery.” 827 F.3d at 137.
FERC issued the NOI in December 2016, seeking comments on whether, and if so how, to address the income tax allowance policy or ROE policy to resolve any double recovery by MLPs and other pass-through entities. Comments were submitted in March and April, 2017.
Several commenters, including the Association of Oil Pipe Lines (AOPL), the Interstate Natural Gas Association of America (INGAA), and SFPP, raised the preliminary issue of whether United Airlines requires FERC to amend its tax and ROE policies. These commenters argued that because the D.C. Circuit did not reject these policies, but rather found that FERC did not provide sufficient justification for its claim that the income tax policy did not result in double recovery for partnerships, FERC could, and should, reaffirm its policy and offer a new, reasoned explanation for its ruling. In contrast, customer groups such as the Liquids Shippers Group and the shippers group led by United Airlines, argued that the United Airlines ruling mandated that FERC change the income tax allowance policy. These commenters argued that if FERC maintained the policy, it would effectively overrule the D.C. Circuit’s decision.
The shipper groups, among others, argued in favor of the D.C. Circuit’s definition of the regulated entity as solely the MLP pipeline, stating that, because MLPs are exempt from corporate income taxes, they should not be permitted to recover those taxes through their rates. They proposed that FERC remove the income tax allowance for MLPs from its tax policy. The pipeline commenters argued that FERC should not revise its income tax allowance policy because MLP pipelines actually do pay income taxes. They argued that the D.C. Circuit narrowly defined the entity subject to FERC’s tax policy as just the pipeline; and that the regulated entity is the MLP pipeline and the individual investors who do incur the tax liability. INGAA argued that the current policy recognized this cost to investors as a cost of service, and that without the ability to recover the tax, MLPs may not be able to obtain the financing necessary to promote their infrastructure projects.
Two analysts, filing comments on their own behalf, took a slightly different approach than the shipper groups. Thomas Horst, who provided the income tax allowance analysis in the underlying SFPP FERC proceeding, and Erin Noakes, a consumer advocate, suggested that proxy groups for the DCF analysis should only include entities with the same corporate structures, i.e. a proxy group of only partnerships or a proxy group of only corporations. Horst recommended that, for partnerships, the DCF analysis should exclude the income tax allowance. If an MLP pipeline is included in the proxy group for a corporate pipeline, then FERC should decrease the MLP ROE by at least 1.4% to compensate for the difference between MLPs and corporations.
In addition to suggesting that FERC issue a revised tax policy, the Natural Gas Supply Association also suggested that FERC initiate investigations under Section 5 of the Natural Gas Act to review pipeline rates and to remove the income tax allowance for MLP pipelines that already include the allowance in their rates. They suggested FERC stagger the investigations, and begin with the pipelines having “the most egregious over-earnings.”
Meanwhile, FERC remains stymied by its lack of quorum to take action on this NOI and cannot issue a formal rulemaking until it regains quorum. Notably, on April 26, the White House unveiled its 2017 budget proposal to, among other things, cut the tax rate for MLPs to 15%. If adopted, this could impact the outcome of this rulemaking. Because the budget proposal is in its nascent stage, with the final impacts on the energy sector uncertain at this time, it is difficult to predict the outcome of FERC’s deliberations on this rulemaking. We will continue to monitor FERC and Congress to see what happens next.