Under a revised policy statement (Docket No. PL17-1-000), the Federal Energy Regulatory Commission (FERC or the Commission) will no longer allow master limited partnerships (MLPs) that operate interstate oil and natural gas pipelines with cost-of-service-based rates to recover an income tax allowance in their cost of service. The revision, issued March 15, 2018, is a draft revised policy statement to the Commission's 2005 Policy Statement of Recovery of Income Tax Costs and will become effective as of the publication date in the Federal Register. It will affect both oil and natural gas MLP pipelines prospectively.

While the policy change is expected to affect certain MLPs, the revised policy statement will primarily affect cost-of-service-based rates. Market-based rates, committed rates, negotiated rates and certain discounted rates ought not to be affected.

Background

This revision results from a decision by the D.C. Circuit Court (the Court) on July 1, 2016, in United Airlines, Inc. v. FERC, No. 11-1479, 2016 U.S. App. (D.C. Cir. July 1, 2016), in which the Court held that FERC failed to provide sufficient justification for its conclusion that there was no double recovery of taxes for partnership pipelines receiving a tax allowance in addition to the discounted cash flow return on equity. The Court believed that the current FERC methodology in cost-of-service rates permitted a disparity between equity owners in partnership and corporate pipelines. The Court remanded the case to the District Court for FERC to consider how to calculate a return on pretax income with no tax allowance or some other method demonstrating no double recovery.¹

The FERC is tasked with setting rates commensurate with the rate or return expected from investments of similar risk profiles. A partnership pipeline does not incur entity income taxes, the partner does. Conversely, an investor in a corporate pipeline does incur an entity-level tax. This alone, for investments of similar risk profiles, causes a disparity in the return to the investor when both an allowance for taxes is permitted in a partnership pipeline and a discounted cash flow determination on equity determines the pre-tax investor return required to attract investment, regardless of the investor's tax classification. Thus, the return is often greater to the partnership investor as opposed to the corporate investor.

The question of reversal of the Court's previous decision in a prior, landmark case was present throughout the Court's opinion. Rather than reversing the prior decision, the Court justified it, in which a partnership was permitted a tax allowance, by concluding that partners in partnership are taxed on their distributive share of the partnership's items of income, gain, loss, deduction and credit, regardless of cash distributions, while shareholders in corporations are taxed on the dividend (cash) income they receive. This is significant in that it highlights that an income tax allowance is allowable in a partnership setting; an unreasonable return obtained via double recovery of income taxes, however, is not appropriate.

Implications

For FERC-regulated oil and gas pipeline MLPs, research into how their current rates are set will be an immediate need. MLPs should determine if they have an income tax allowance included in rates or whether their rates are set at a market or negotiated rate. If rates are based on a tariff and include an income tax allowance, then understanding how the allowed return on equity (ROE) is determined will be the next step. Further, understanding whether the determination of the allowed ROE is done on an after-tax or pre-tax basis and gathering supporting documentation on that conclusion will be important.

FERC-regulated oil pipeline MLPs that have an income tax allowance in their cost of service will need to reflect the Commission's elimination of the income tax allowance in their Form No. 6, page 700 reporting. The Commission, based on the accumulated data, is expected to incorporate the effects of the revised policy on industry-wide oil pipeline costs in the 2020 five-year review of the oil pipeline index level.

For FERC-regulated natural-gas-pipeline MLPs, the Commission issued Docket No. RM 118-11-000, which proposes to require interstate natural gas pipelines to file an information filing with the Commission. Additionally, the Commission proposes to provide four options for each interstate natural gas pipeline to voluntarily make a filing to address the changes to the pipeline's recovery of tax costs, or explain why no action is needed.

For non-MLP oil and natural gas partnerships, the Commission has indicated an intent to review the income tax allowance issues for such partnerships in subsequent proceedings. Such non-public pipeline partnerships and other pass-through entities should review their cost-of-service and ROE calculations. If there is an allowance for income taxes, and the partnership uses a pre-tax ROE, the partnership should determine what the impact would be if the Commission disallowed the income tax allowance in cost of service for all pipeline partnerships and pass-through entities.

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ENDNOTES

¹ United Airlines, Inc. v. FERC, No. 11-1479, 2016 U.S. App. (D.C. Cir. July 1, 2016) at p. 25