Rate Recovery Appropriate for Actual and Potential Taxes of Investors in Energy Tax Pass-Through Entities, FERC Rules

March 11, 2008

In a late December gift to investors in energy companies organized as tax pass-through entities (PTEs), the Federal Energy Regulatory Commission (FERC) affirmed in a December 26 Order (121 FERC ¶ 61,240) that oil and gas pipelines organized as master limited partnerships (MLPs) are entitled to earn in their regulated rates an income tax allowance (ITA) on the actual or potential tax liability of their investors.  The order grew out of a May 2005 Policy Statement followed by protracted litigation at FERC and in the courts (including the 2007 decision of the U.S. Court of Appeals in ExxonMobil Oil Corp. v. FERC, 487 F.3d 945 (D.C. Cir. 2007)) in which customers challenged whether FERC should award energy PTEs any ITA, at what rate and, if allowed, when should a deferred tax liability be recognized for ratemaking purposes.

Specifically, FERC ruled that:

• the oil pipeline SFPP, LP, organized as an MLP, was eligible for an income tax allowance in its rates equal to its partners’ actual or potential income tax liability on their distributive share of income from regulated pipeline operations;
• the ITA should reflect the weighted marginal tax rate of its partners (investors); and
• in the Tax Reform Act of 1986, Congress intended that the benefits from deferral of a potential tax liability on PTE earnings should flow to the investor (unit holder) and not the ratepaying customer.

FERC‘s December 26 Order is particularly noteworthy in its recognition that the rate-setting agency may not be able to determine the marginal tax rate of individual PTE unit holders or investors and can instead base the ITA on actuarial data (from such sources as the Internal Revenue Service) to establish the classes of investors and adopt presumptions as to the marginal tax rate of each.   This will facilitate the proof of actual or potential tax liability that regulated PTEs — and possibly other energy investment vehicles, such as real estate investment trusts (REITs) — will need to produce in support of an ITA in their regulated rates.  Interestingly, because of a June, 2007 private letter ruling issued by the IRS, REITs have been receiving a significant amount of attention with respect to their potential to facilitate capital raising for the acquisition and development of energy infrastructure assets that are oriented towards real property, like a pipeline or electrical transmission and distribution system.  While not true PTEs, REITs are similar to PTEs with respect to avoiding double taxation of REIT operating income.

Income Tax Allowances

In a May 2005 Policy Statement on ITA FERC concluded that it would permit SFPP an ITA in its rates to the extent its partners had an actual or potential tax on their distributive jurisdictional income generated by the partnership.  The order also directed SFPP to separate its partners into six categories, determine the amount of partnership income allocated to each, and calculate the ITA based on an actual or presumed marginal tax rate of each category.

On May 29, 2007, in its decision in the ExxonMobil case, the US Appeals Court for the District of Columbia Circuit upheld the Policy Statement.  The court specifically held that a regulated energy PTE could include an ITA in rates to the extent that it can demonstrate — in a rate proceeding — that its partners incur an ‘actual or potential’ income tax liability on their respective shares of partnership income.

In light of the court’s decision, the Commission rejected a series of criticisms of its approach to income tax allowances — including its stance on the use of marginal tax rates, the stand-alone methodology for determining an allowance, the role and definition of income, and the discounted cash flow model used to determine the equity cost of capital — and upheld its earlier Policy Statement.

MLPs and the Proxy Group

In the December 26 order, the Commission was equally firm in determining that the SFPP proceeding in question was not appropriate for developing a new methodology for addressing rate of return issues involving MLPs or similar pass-through entities.  While acknowledging that some arguments against current FERC policy may have merit, it also reiterated that “in this proceeding there is no practical alternative to treating distributions as the equivalent of dividends and using distributions in the conventional discounted cash flow (DCF) formula.”