On January 6, 2017, Texas utility companies organized as pass-through entities, including partnerships, received welcome news regarding their ability (1) not to elect to be treated as a corporation eligible to be included in a consolidated return, regardless of whether such inclusion would be advantageous to ratepayers, and (2) to include in rates an income tax allowance (ITA) on behalf of its partners.
A regulated public utility company is entitled to charge just and reasonable rates to its customers that are sufficient to cover its expenses and a reasonable return on its rate base sufficient to attract capital.1 To establish a utility company’s reasonable and necessary operating expenses, the utility’s actual or anticipated expenses are determined for a test year and then adjusted, if necessary, for known and measurable changes.2 Allowable expenses include, but are not limited to, operating expenses, depreciation expense, federal income taxes and employee post-retirement benefits.3
Most states use a “stand-alone” method for calculating the amount of income taxes properly includible in a regulated utility company’s rates.4 This method calculates taxes based on the regulated revenues and operating costs of the utility itself, disregarding the utility’s unregulated activities or the activities of its parent or other affiliated companies.5 The stand-alone method is used so that the taxes included in utility rates are based solely on the costs of providing the regulated utility’s service borne by ratepayers.6
Filing a consolidated federal income tax return allows affiliated corporations to offset the profits of some members of the affiliated group with losses of other members, thereby lowering their collective tax liability.7 If the consolidated tax liability were used in setting utility rates, however, the tax expense recoverable from ratepayers would reflect the costs of providing both regulated and unregulated utility services. Even though ratepayers would not bear the cost of the unregulated activities, they would benefit from the impact of those costs on the consolidated tax liability. Some have argued that not using consolidated tax reporting can result in amounts collected for taxes in a utility’s rates exceeding the income taxes the parent actually pays to the taxing authorities, thereby creating inequitable treatment for utility customers.8
Oncor Electric Delivery Co. LLC v. Public Utility Commission of Texas, et al.
On January 6, 2017, in Oncor Electric Delivery Co. LLC v. Public Utility Commission of Texas, et al., ratepayers argued that Oncor—an electric transmission and distribution utility company, treated as a partnership for federal income tax purposes—could have saved millions of dollars by electing to be treated as a corporation and filing a consolidated return with its affiliated companies, rather than calculating its federal income taxes on a stand-alone basis.9 The Texas Supreme Court, however, affirmed Oncor’s argument that it had the right to collect income tax expenses computed on a stand-alone basis from ratepayers under the Public Utility Regulatory Act (PURA), ruling that even though Oncor could have elected to be taxed as a corporation, it did not have to elect to be taxed as a corporation. The court explained that PURA § 36.060(a) only applies to a utility company that is a member of an affiliated group, not a utility company that could be an eligible member of such a group by filing an election to be treated as a corporation. Accordingly, the court determined that Oncor’s decision to be treated as a partnership, foregoing the tax savings that it could have realized by filing a consolidated tax return, must be respected.
Furthermore, the court concurred with the Public Utility Commission calculating Oncor’s tax expense as if it were a corporation—despite the utility being treated as a partnership for federal income tax purposes. The court, citing Suburban Utility Corp. v. Public Utility Commission of Texas, explained that a utility company structured as a subchapter S corporation could include, as reasonable and necessary expenses in a ratemaking proceeding, the income taxes payable by its shareholders on the utility company’s taxable income, because such income taxes paid by shareholders of a pass-through entity are “inescapable business outlays and are directly comparable with similar corporate taxes which would have been imposed if the utility operations had been carried on by a corporation.”10
United Airlines v. Federal Energy Regulatory Commission
The issue concerning the proper income tax allowance to be collected on behalf of a partnership comes at an interesting time given the recent ruling of the U.S. Court of Appeals for the District of Columbia in United Airlines v. Federal Energy Regulatory Commission.11 Concerned that allowing a pipeline partnership to include an income tax allowance on behalf of its partners, on the facts before it, potentially enabled that partnership to “double recover” its taxes when coupled with the allowed rate of return. The U.S. Court of Appeals remanded the case to enable the Federal Energy Regulatory Commission (FERC) to either demonstrate that the income tax allowance and rate of return did not produce a “double recovery” or to provide additional justification for its long-standing policy of allowing a partnership to include an ITA on behalf of its partners.12 In response, on December 15, 2016, FERC issued a Notice of Inquiry to solicit comments on any methods by which it can avoid double recovery of income taxes from its income tax allowance and rate of return policies for pass-through entities.13 On January 4, 2017, FERC extended the initial comment period until March 23, 2017, and the reply comment period until May 2, 2017. It is clear that FERC is not wedded to any particular approach and seeks a wide range of data-driven approaches to address the ITA issue.