What the FERC? Making Sense of the Commission’s Recent Tax Actions

This past March, as basketball fans tuned into March Madness, the FERC unleashed some March Madness of its own.

Reversing a longstanding policy, the Commission said it would no longer allow oil and natural gas interstate pipelines organized as master limited partnerships (MLPs) to include income tax allowances in their cost-of-service rates.

The move led to a sharp sell-off of MLPs as investors worried about the impact that loss of income tax allowances would have on MLP profits.  But the story didn’t end there. In the ensuing months, the FERC appeared to soften its position on MLP tax allowances, only to get tough again.

V&E partner David Oelman, the co-head of the firm’s Mergers & Acquisitions and Capital Markets practice group and a board member of the Master Limited Partnership Association (MLPA), and Damien Lyster, a V&E counsel who represents energy industry clients before FERC, sat down to explain the FERC’s recent tax moves and the implications for MLPs. Both have advised the MLPA on pleadings related to the Commission’s income tax allowance policy. Here’s what they had to say.

What did the FERC do on March 15 and in what way did it affect MLPs?

To answer that question, it’s important to first understand how the FERC regulates the rates pipeline operators can charge their customers.

In determining whether a pipeline’s rates are appropriate and fair, for many pipelines the FERC uses a method called ʺcost-of-serviceʺ ratemaking. The FERC allows pipeline operators to charge enough to cover their costs — including taxes — and to also provide a reasonable return on equity (ROE) to their investors.

To figure out ROE, the FERC uses a “discounted cash flow” (DCF) approach. The expected ROE for a pipeline company is equal to the pipeline’s dividend yield plus the expected rate of growth in its earnings per share. The expected rate of growth is based on a combination of analysts’ near-term expectations for growth taken from several sources, as well as economists’ long-term projections for the economy, as measured by gross domestic product.

For well over a decade, the FERC has allowed MLPs to include an income tax allowance when calculating their cost-of-service rates.

But over the years, certain customers of oil pipelines, such as airlines and other types of “shippers,” said they weren’t pleased with the policy. Some, including United Airlines, took their complaints to court, asserting that MLPs — which don’t pay federal income taxes — were receiving an unfair double-recovery of tax expenses once through the DCF-based ROE and once through the income tax allowance.

In 2016, the United States Court of Appeals for the District of Columbia Circuit issued a decision in United Airlines, Inc. et al. v. FERC, determining that FERC had not adequately demonstrated that its income tax allowance policy did not provide a double-recovery of taxes to partnership investors, and remanded the matter to the FERC.

Nearly two years later, on March 15, 2018, the FERC issued a Revised Policy Statement saying it would no longer allow pipelines organized as MLPs to recover an income tax allowance in their cost-of-service rates.

The announcement sent shares of MLPs with pipeline holdings tumbling: At one point in the day, the Alerian MLP index, which tracks the performance of energy MLPs, fell nearly 10%.

“Billions of dollars in market capitalization were lost,” Oelman said.

Did the MLP market recover?

While the majority of MLP equities reacted negatively to the announcement, many recovered. Those that bounced back indicated that they believed the Revised Policy Statement would not materially impact their operations given the limited number of pipelines they owned that were subject to cost-of-service based rates.

However, for a subset of MLPs that hold a significant amount of such assets, the market reaction has been pronounced and long lasting.  Many have announced or completed corporate restructurings in the wake of the Revised Policy Statement.

On July 18, the FERC issued a follow-up order on income tax allowances. What was the takeaway for MLPs?

After the FERC issued its Revised Policy Statement in March, multiple stakeholders weighed in with comments, many asserting that the FERC had failed to properly explain its decision for changing course. The MLPA called the FERC’s decision to treat all MLPs generically, but allow all non-MLPs and other business formations to seek an income tax allowance on a case-by-case basis, “arbitrary and capricious.”

“Many MLPs have large corporate ownership,” Oelman said. “Many believe that an MLP should logically receive an ITA proportionate to its corporate ownership.”

The FERC appeared to take such reasoning to heart. On July 18, the Commission issued a pair of orders that included a series of adjustments that were favorable to MLPs.  The FERC said it would allow affected parties to challenge or support the revised policy on income taxes in individual, case-by-case proceedings. In addition, MLPs, all of whose income or losses are consolidated into a corporate parent for tax purposes, were entitled to an income tax allowance.

Also positive for MLPs: The FERC clarified its policy regarding ADIT (accumulated deferred income taxes), the income taxes that pipelines gather from their customers based on straight-line depreciation of their pipeline assets (even though the pipeline may be using an accelerated form of depreciation for tax purposes) and later send to the IRS. Under the final rule, MLPs that lose their income tax allowance do not have to return ADIT to their customers in the ratemaking process.

“For some pipelines that’s a significant amount of money,” Lyster said.

All in, investors applauded the FERC’s final order, sending shares of energy MLPs higher.

“Many smart analysts read the July 18 order and said, ‘Good. Everyone gets their day in court,’” Oelman said.

Was this a happy ending for MLPs?

It hasn’t turned out that way. Two weeks after the FERC issued its final order, MLPs got a first glimpse of how the Commission would apply the final rule — and it didn’t look pretty.

The Commission refused an income tax allowance sought by Enable Mississippi Transmission, LLC (MRT). MRT is wholly owned by an MLP, Enable Midstream Partners, which in turn has corporate owners.

MRT asserted that the FERC’s policies permit an income tax allowance when a pipeline is a corporation or a pass-through entity that is a subsidiary of one or more corporations. MRT noted that its MLP-parent’s corporate owners, like corporate owners of a pass-through pipeline, incur both a corporate income tax liability and a shareholder dividend tax liability. The pipeline further noted that Enable’s corporate owners pay income taxes on the pipeline’s earnings before issuing dividends to investors. MRT’s explanation of the multiple levels of tax liability was one part of MRT’s effort to show that there is no United Airlines double recovery concern with affording an income tax allowance.

The FERC wasn’t swayed.

“These arguments lack merit,” the FERC ruled in its order. “MRT has failed to address the court’s concern in United Airlines that permitting it to recover both a DCF ROE and its proposed income tax allowance for unit-holders’ tax costs would lead to a double-recovery.”

The implication for MLPs: Even those with corporate owners will face a tough road when seeking an income tax allowance.

“Coming out of the July 18 order, everyone was happier. We weren’t crazy about the possibility of the income tax allowance going away, but at least we’ll have a chance in individual proceedings going forward,” Lyster said. “Then the MRT order came out. The FERC made it pretty clear. Pipelines owned by MLPs apparently don’t get an income tax allowance. End of story.  We’ll see how this plays out going forward.”