Washington Watch: When the Tax Man Cometh, FERC Follows

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“A tax loophole is something that benefits the other guy. If it benefits you, it is tax reform.”
— Russell B. Long

As I write this column, the cherry blossoms are in full bloom, prompting some locals to skip work and join tourists in the annual pilgrimage to see the billowing, pink cherry trees encircling the Tidal Basin. Like many others, I’m also working on my taxes and trying to determine how the recent tax changes impact me. But by the time you read this, the cherry blossoms will be long gone and, with luck, my tax forms will be filed. Speaking of taxes, as the result of several related orders, the U.S. Federal Energy Regulatory Commission (FERC) will no longer permit pipelines owned by master limited partnerships (MLPs) to recover an income tax allowance in their cost-of-service rates and will examine the impact of recent corporate tax reductions on pipeline rates. These proceedings could lower the rates of oil and interstate natural gas pipelines.

Let’s begin by explaining what prompted FERC to act. Back in 2008, an oil pipeline (SFPP, LP), which transported refined petroleum products, filed some rate changes with the commission. Shippers (including large airlines) argued that the rates should be lower, primarily because the pipeline was an MLP.

To understand the argument, you need a little background information. To begin, partnerships don’t pay income taxes; instead, the partners individually are responsible for taxes based on their share of partnership proceeds. An MLP is a limited partnership that is publicly traded and, as such, is afforded the tax benefits of a partnership and the liquidity of publicly traded securities.

In contrast to partnerships, corporations pay income taxes. Accordingly, when developing a pipeline’s cost-of-service rates, FERC has historically included a tax allowance in the pipeline’s cost-of-service. Without the tax allowance, the pipeline would be forced to pay taxes, but have no way to recover the tax cost; it would lose money, forcing investors to shy away. Over the years, more and more pipelines changed their ownership structure from corporations to partnerships, often MLPs. Yet FERC continued to provide partnership pipelines with a tax allowance, as long as the partners had a tax liability, in order to encourage capital formation and investment.

So what was the shipper’s beef in the oil pipeline proceeding? In wonk-speak, it involves the way FERC designs rates so that the regulated entity can attract capital investment. In particular, the commission uses the discounted cash flow (DCF) methodology to estimate a potential investor’s return (i.e., the money received from an investment), adjusted for the time value of money.

Because investors must pay income taxes on any earnings received from the partnership, the DCF must be high enough to cover the investor’s tax costs and provide a reasonable after-tax return on equity. And there’s the rub: the pipeline shippers argued that providing a tax allowance and using a DFC analysis essentially provided the MLP pipeline with a double recovery of income tax costs.

Eventually, SFPP’s rate proceeding made its way through the FERC administrative litigation process and ultimately landed at the DC Circuit. In 2016, the court, in United Airlines, Inc. v. FERC, 827 F.3d 122 (D.C. Cir. 2016), agreed with the shippers and remanded the case to FERC to explain why the tax allowance did not grant partnership pipelines a windfall.

In December 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act. Significantly, the new law slashed the federal corporate income tax rate from 35 percent to 21 percent. As a result, the new federal tax rates are much lower than those in effect when FERC approved pipeline rates years ago. In short, the tax reduction coupled with the United Airlines decision led to calls for FERC action to reduce pipeline rates. In mid-March, FERC responded by issuing several companion orders.

“It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the tax rates.”
— John F. Kennedy

One, on remand from the DC Circuit, FERC denied an income tax allowance to SFPP, the refined petroleum products pipeline. This is a harbinger of things to come at FERC, especially because FERC contemporaneously issued a Policy Statement (Docket No. PL17-1-000) finding that an impermissible double recovery results from granting an MLP pipeline both an income tax allowance and a return on equity based on a DCF analysis.

There are several implications for pipelines: 1.) all partnership pipelines seeking to recover an income tax allowance will need to address the double recovery concern, and 2.) oil pipelines organized as MLPs must reflect FERC’s elimination of the MLP income tax allowance in their annual Form No. 6.

Moreover, pipelines can’t seek rehearing of the policy statement because the pipelines are not “aggrieved” under the law. The policy statement is just that, a generic statement of policy; it does not determine particular issues or rights for any specific pipeline, but merely announces FERC’s intentions for the future. Accordingly, MLP pipelines have been told that their rates will go down, but they cannot seek rehearing from FERC or judicial review by the courts, at least not yet. In contrast, FERC actually reduced SFPP’s costs; it is aggrieved and, therefore, could seek rehearing and appeal.

Nevertheless, one pipeline sought clarification of the policy statement. Dominion Energy claimed that the policy change is unreasonable, especially when applied to an MLP pipeline that is a subsidiary of a corporation. Dominion Energy argued that, under the law, income from an MLP subsidiary pipeline is included in the parent corporation’s federal tax liability. In other words, the parent corporation would lose money because it must pay taxes on the MLP pipeline’s income, but it cannot recover the tax costs. The argument makes sense. Whether FERC agrees is another issue.

Two, FERC concurrently issued in Docket No. RM18-11-000 a Notice of Proposed Rulemaking (NOPR) that addresses the effects of this Revised Policy on the rates of interstate natural gas pipelines organized as MLPs. Based on the Policy Statement and the recent Tax Cuts and Jobs Act that reduced taxes, the NOPR proposes that pipelines: 1.) file a limited NGA section 4 rate case to address tax issues; 2.) commit to filing a general section 4 rate case in the near future; 3.) file a statement explaining why no rate adjustment is needed; or 4.) file a one-time report on the rate effect of the tax reduction. Interested parties may file comments on the NOPR by April 25.

Three, FERC also issued in Docket No. RM18-12-000 a Notice of Inquiry (NOI) — a preliminary rulemaking notice, which precedes a NOPR — seeking comments on the effect of the Tax Cuts and Jobs Act on FERC-jurisdictional rates, particularly, whether, and if so how, FERC should address changes relating to accumulated deferred income taxes (ADIT) and bonus depreciation. Interested parties may file comments on the NOI by May 21.

Four, FERC also instituted a couple of NGA Section 5 investigations, involving Midwestern Gas Transmission Co. (Docket No. RP18-441-000) and Dominion Energy Overthrust Pipeline LLC (Docket No. RP18-442-000). Based on a review of cost and revenue information reported by the pipelines, FERC contends that they may be over-recovering their cost-of-service and, in particular, may be earning an impermissibly large return on equity, which will become even more pronounced given the recent reductions in corporate income tax rates.

As a result, FERC directed each pipeline to file a cost and revenue study based on information for the latest 12-month period available and established an evidentiary hearing to address the issues. Many believe that these two pipelines are just part of the first wave; don’t be surprised, if FERC issues more NGA section 5 investigations.

In sum, the MLP issue poses more problems for pipelines than the corporate tax reduction. The logic underlying FERC’s policy statement might be difficult to assail. But a corporate tax reduction does not necessarily translate into a dollar-for-dollar rate reduction. Rates, as you know, are made like “sausage” and often developed in a “black box.”

Nevertheless, there will be changes. Some have predicted a wave of MLP pipelines transforming themselves into corporations. Whether it’s the anticipated loss of a tax allowance or a possible rate reduction from decreased tax rates, pipelines are likely assessing their options and consulting with their shippers. Speaking of shippers, many natural gas shippers take service under “negotiated” not “cost-of-service” rates. Look for pipelines to provide shippers with incentives to take negotiated rate service. Bottom line, FERC’s recent actions could result in lower pipeline rates.

Washington Watch is a bimonthly report on the oil and gas pipeline regulatory landscape. Steve Weiler is partner at Dorsey & Whitney LLC in Washington, D.C. Contact him at weiler.steve@dorsey.com.

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