FERC Issues Final Rule Regarding Income Tax Allowances in Rate Setting for Pipelines: MLPs Not Precluded from Tax Allowance

On Wednesday, July 18, 2018, the Federal Energy Regulatory Commission (“FERC” or “Commission”) issued a final rule regarding the application of income tax rate reductions in setting natural gas pipeline rates.  This rule broadly extends the conclusions previously reached by FERC in Opinion 511-C,^[1] in which the Commission considered whether changes to U.S. tax law required SFPP, L.P. to revise its FERC-jurisdictional, cost-based, pipeline rates in light of the D.C. Circuit Court of Appeals’ prior ruling in United Airlines.^[2]  The FERC Order is almost 200 pages long, and our alert discusses only the core substance of the rule; the impact for any specific pipeline may vary depending upon application of the detailed provisions in the Order not discussed herein.

Background

The rule was originally issued in proposed form as part of a Notice of Proposed Rulemaking on March 15, 2018 (the “NOPR”), designed to address the reduction in the corporate income tax rate from 35 percent to 21 percent under the Tax Cuts and Jobs Act of 2017.  (See our prior alert dated March 20, 2018).  In the NOPR, FERC proposed to reduce rates to reflect the drop in corporate rates and also proposed that pipelines organized as master limited partnerships (“MLPs”) no longer recover an income tax allowance in their cost-of-service rates.  The NOPR was followed by a drop in market prices for MLP units by, on average, almost 10 percent and by several MLPs indicating that they would consider switching to corporate form in order to continue to receive an income tax allowance.

The MLP policy change was a result of the July 2016 remand to FERC of a rate case by the D.C. Circuit Court of Appeals in United Airlines.  In that case, the petitioners (shippers on an interstate oil pipeline) asserted that cost-of-service rates should not include an allowance for income tax costs if the pipeline is held by an entity, such as a partnership or LLC, that is transparent for tax purposes and all the income taxes of which are borne by the partners (or, in the case of MLPs, their unitholders).  The petitioners argued that including income tax costs in the partnership’s cost of service was a double recovery if the partnership did not, in fact, bear entity-level tax costs. 

The Court of Appeals remanded the issue to FERC to determine the basis for including an income tax cost recovery in the rates of a partnership, and FERC has had an open inquiry on this point for almost two years.  Multiple stakeholders submitted comments on the issue, asserting that the tax costs of MLP unitholders affect their return on investment in the same manner that the tax costs of a corporation affect corporate shareholders and thus should equally figure into a cost-of-service calculation.

Final Rule 

In the final rule issued last week (the “Final Rule”), FERC adopted the general provisions of the NOPR, with a few key exceptions.  The Final Rule requires all natural gas pipelines with cost-based rates that filed a 2017 FERC Form 2 or Form 2-A (with certain limited exceptions) to make a special one-time report (Form 501-G) that will provide information regarding the pipeline’s return on equity (“ROE”) as calculated before and after the tax-rate drop.  FERC’s implementation guide for Form 501-G^[3] provides a list of when each pipeline’s report is due.  The Final Rule takes effect 45 days after publication in the Federal Register.  Thus, absent a delay in publishing, the new rule would become effective in September 2018, and, per the aforementioned guide, each pipeline’s Form 501-G would be due between 28 and 84 days from such effective date.^[4]

In addition to, and simultaneously with, filing the one-time report, each pipeline, regardless of its entity form as a corporation or partnership, is required to exercise one of the following options:

1. make a limited Natural Gas Act Section 4 rate- reduction filing, reflecting the pipeline’s decrease in corporate income tax rate and, in the case of a pipeline organized as a partnership, eliminating any income tax allowance and accumulated deferred income taxes (“ADIT”) reflected in its current rates;
2. make a commitment to file a general Section 4 rate case in the near future, and if the commitment is to do so by December 31, 2018, FERC will not initiate a Section 5 rate investigation of the pipeline before that date;
3. provide an explanation as to why the pipeline believes no rate change is needed; or
4. provide a statement that the pipeline is taking no further action and not changing its rates. 
   
   

If, pursuant to options 1 or 2, a pipeline makes a limited NGA Section 4 rate reduction filing that results in an ROE of 12% or less, FERC will offer protection from a required rate change in the form of a three-year moratorium on an NGA Section 5 rate investigation of the pipeline. 

Importantly, in stark contrast to the provisions of the NOPR, instead of flatly denying an income tax allowance to MLPs, FERC states that if a pass-through entity files a proposal to reduce its rates to reflect the new, lower corporate tax rate but does not propose to eliminate its tax allowance, the Commission will consider whether to initiate a rate case subject to its commitment to the 3-year moratorium.  In this regard FERC noted that a pass-through entity claiming a tax allowance may submit an Addendum to the FERC Form No. 501-G that includes an income tax allowance.  Moreover, to the extent a pipeline elects to make the optional limited NGA  Section 4 filing, the pipeline may use either (a) the FERC Form No. 501-G if it proposes to eliminate its tax allowance or (b) the Addendum to the FERC Form No. 501-G if it claims a tax allowance.

Partnerships with Corporate Partners

The Commission stated that it would permit pass-through entities to report an income tax allowance and would encourage pass-through entities to provide any information regarding their particular ownership structure that they consider relevant in assessing any potential double recovery. 

The final regulation issued as part of the Order states clearly that for purposes of determining the tax rate to which a partnership is subject, a partnership, all of whose income or losses are consolidated on the federal income tax return of its corporate parent, is considered to be subject to the federal corporate income tax.  Thus, for example, if the partners in a partnership are all subsidiaries of the same parent entity that is a corporation and report their results for tax purposes on a consolidated tax return with the corporate parent, then FERC will treat the partnership as itself subject to corporate income tax.  

There is no indication in this regulatory provision that the pass-through to a consolidated parent could be applied on a pro rata basis to, for example, partnerships in which some, but not all, of the units are held by corporations or a corporate group.  The FERC policy statement does, however, encourage pass-through entities to provide information in this regard, which might invite filings that make such an argument.

Accumulated Deferred Income Taxes (“ADIT”)

ADIT arises from differences between the method of computing taxable income for reporting to the IRS and the method of computing income for regulatory accounting and ratemaking purposes.  Because of the reduction in the corporate income tax rate, a portion of ADIT liability that was collected from customers will no longer be due to the IRS, and pipelines and their customers have disputed whether such excess ADIT must be returned to customers.  Similarly, if pass-through entities have excess ADIT because of the elimination of the income tax allowance, the treatment or return of such ADIT becomes an issue. 

In the new policy statement, FERC noted that it had received comments on this issue and that, in general, comments from shippers or customers argued that previously accumulated ADIT should be returned to ratepayers, while comments representing pipeline interests argued that ADIT should be eliminated from cost of service.  FERC provides guidance in the Order that responds to the pipelines’ interest:  MLP pipelines (or other pass-through entities) no longer recovering an income tax allowance pursuant to FERC’s post-United Airlines policy may eliminate previously accumulated ADIT from cost of service instead of flowing these balances through to ratepayers.  In reaching this decision, FERC noted that requiring a return to ratepayers would have raised questions under the prohibition against retroactive ratemaking.

Oil Pipelines

As was the case with the NOPR, in the Final Rule, FERC took no action to alter the rates of oil pipelines, which are generally set according to an industry-wide index.  FERC has, however, sought additional information to inform its 2020 five-year review of the oil pipeline index level.  This information will be used in future rate setting for oil pipelines, regardless of whether rates are set annually through FERC indexing or through cost-of-service ratemaking.

Summary

Issuance of the Final Rule has given pipelines in pass-through entities an opportunity to provide additional information to FERC in support of an income tax allowance.  We will continue to monitor developments as they unfold and as we obtain any additional information regarding FERC’s position with respect to income tax allowances for pass-through entities.