D.C. Circuit Sends Tax Allowance for Partnership Pipelines Back to FERC

Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000. JULY 7, 2016 SIDLEY UPDATE D.C. Circuit Sends Tax Allowance for Partnership Pipelines Back to FERC On July 1, 2016, the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) sided with pipeline shippers (Shippers) who challenged the Federal Energy Regulatory Commission (FERC) policy of including an income tax allowance in the transportation rates of pipelines organized as limited partnerships. In its decision in United Airlines v. FERC, No. 11-1479 1 , a D.C. Circuit panel of Judges Sentelle, Griffith and Kavanaugh vacated three FERC orders related to rate filings by SFPP, an interstate petroleum products pipeline, finding that FERC acted arbitrarily and capriciously because it “ha[d] not adequately justified its tax allowance policy for partnership pipelines.” Depending on how FERC rules on the issue on remand, its decision could have a significant impact on the rates of interstate oil and gas pipelines that are organized as limited partnerships. United Airlines is the third D.C. Circuit decision in the past dozen years regarding the income tax allowance in transportation rates of oil and gas pipelines organized as limited partnerships rather than corporations. The D.C. Circuit previously considered FERC’s tax allowance policy for partnership pipelines in BP West Coast Products, LLC v. FERC, 374 F.3d 1263 (D.C. Cir. 2004), and ExxonMobil Oil Corp. v. FERC, 487 F.3d 945 (D.C. Cir. 2007). In BP West Coast Products, the D.C. Circuit held that it was unable to “conclude that FERC’s inclusion of the income tax allowance in SFPP’s rates is the product of reasoned decisionmaking.”2 Three years later in ExxonMobil, the D.C. Circuit “held that FERC’s policy of permitting partnership pipelines to receive a tax allowance was ‘not unreasonable’ in light of ‘FERC’s expert judgment about the best way to equalize after-tax returns for partnerships and corporations.’”3 It is this “reasoned decisionmaking” (or lack thereof) that Shippers challenged in United Airlines, but Shippers’ challenge was based on grounds not at issue in ExxonMobil or BP West Coast Products. Many practitioners thought, and FERC argued, that the income tax allowance for partnership pipelines had been settled in ExxonMobil. While acknowledging the result of that decision, however, the court in United Airlines found that ExxonMobil had “implicit[ly] reserve[ed]” a separate question, namely, “whether the combination of the discounted cash flow return on equity and the tax allowance results in double-recovery of taxes for partnership pipelines . . .”4 Finding that FERC “failed to demonstrate that there is no double-recovery 1 Slip op. at 25 (D.C. Cir. Jul. 1, 2016) available here. 2 374 F.3d at 1288. 3 487 F.3d at 953. 4 Slip op. at 19. SIDLEY UPDATE Page 2 of taxes for partnership, as opposed to corporate, pipelines,” the court vacated FERC’s orders and remanded the case to FERC for further proceedings consistent with its opinion. 5 Notwithstanding its holding, the court made clear that, on remand, FERC is free to continue to provide partnership pipelines with an income tax allowance if it either (1) provides a sufficient explanation that its current policy does not result in double-recovery of taxes for such pipelines, or (2) takes another approach to assure there is no double-recovery, e.g., by “remov[ing] any duplicative tax recovery for partnership pipelines directly from the discounted cash flow return on equity,” or “eliminating all income tax allowances and setting rates based on pre-tax returns.”6 Citing ExxonMobil, the court observed that “FERC has a justifiable basis for its attribution of partner taxes to the partnership pipeline,” because “‘investors in a limited partnership are required to pay tax on their distributive shares of the partnership income, even if they do not receive a cash distribution,’” whereas “‘a shareholder of a corporation is generally taxed on the amount of the cash dividend actually received.’”7 Thus, “allocation of partner-level taxes to a partnership pipeline may not result in a ‘phantom tax’ of the type we rejected in BP West Coast.” Nevertheless, if FERC elects on remand to continue providing a tax allowance to partnership pipelines, it must “ensure parity between equity owners in partnership and corporate pipelines.”8 It remains to be seen, of course, how FERC will deal on remand with the income tax allowance for partnership pipelines. Among other questions is whether FERC will distinguish partnership pipelines whose limited partnership interests are held solely by corporations from those whose interests are held by both corporations and individual taxpayers. With respect to pipelines whose partnership interests are held solely by corporations, FERC may provide a sustainable rationale for concluding that a tax allowance is appropriately included in a partnership pipeline’s cost of service. Although such pipelines incur no income taxes at the entity level, their income is distributed entirely to corporate partners, which pay corporate-level income taxes in the year such distributions are made. Thus, for income tax allowance purposes, FERC may conclude that partnership pipelines whose interests are held solely by corporations should be entitled to the same income tax allowance as corporate pipelines. Until this issue is finally resolved, however, the exposure for partnership pipelines remains since the regulated entity pays no income taxes. If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or Eugene R. Elrod Partner eelrod@sidley.com +1 202 736 8206 Kenneth W. Irvin Partner kirvin@sidley.com +1 202 736 8256 Lorrie M. Marcil Partner lmarcil@sidley.com +1 202 736 8273 William A. Williams Partner bill.williams@sidley.com +1 202 736 8767 Lauren C. Freeman Associate lfreeman@sidley.com +1 212 839 6792 Sidley Energy Practice Sidley has a diversified and global Energy practice. We represent clients in virtually every aspect of the energy industry, including upstream oil and gas developers, oilfield service companies, natural gas pipelines, crude oil and refined product pipelines, electric utilities, merchant electric transmission companies, independent power producers, alternative energy developers, suppliers and 5 Id. at 19, 25. 6 Slip op. at 24. 7 (citations omitted) 8 Id. SIDLEY UPDATE Page 3 contractors, energy trading companies, and the financial institutions that serve companies in all of these industry segments. Our energy practice encompasses all types of transactional, litigation and regulatory matters. To receive Sidley Updates, please subscribe at www.sidley.com/subscribe. BEIJING ∙ BOSTON ∙ BRUSSELS ∙ CENTURY CITY ∙ CHICAGO ∙ DALLAS ∙ GENEVA ∙ HONG KONG ∙ HOUSTON ∙ LONDON LOS ANGELES ∙ MUNICH ∙ NEW YORK ∙ PALO ALTO ∙ SAN FRANCISCO ∙ SHANGHAI ∙ SINGAPORE ∙ SYDNEY ∙ TOKYO ∙ WASHINGTON, D.C. 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