FERC disallows MLP pipelines' recovery of income tax allowance

Wednesday, March 21, 2018

U.S. energy regulators have revised their policies, and will no longer allow master limited partnership (MLP) interstate natural gas and oil pipelines to recover an income tax allowance in their cost-of-service rates. The Federal Energy Regulatory Commission issued its Revised Policy Statement on Treatment of Income Taxes following a 2016 federal court order addressing the topic.

At issue is the Commission's policy on how MLP pipelines may set their cost-based rates. As described by the Commission, an MLP is a partnership form in which units are traded on exchanges much like corporate stock. To be treated as an MLP for Federal income tax purposes, an MLP must receive at least 90 percent of its income from certain qualifying sources, including natural gas and oil transportation.

MLP pipelines are not corporations, but are pass-through entities. This means that MLPs are not taxed at the pipeline level; instead, for tax purposes, the partnership agreement allocates to each partner a share of the partnership’s taxable income, and each partner is personally responsible for paying income taxes on the partnership’s net taxable income.

From 2005 until a 2016 court ruling, the Commission's 2005 Income Tax Policy Statement allowed all partnership entities (including MLPs) to recover an income tax allowance for the partners' tax costs, much like a corporation receives an income tax allowance for its corporate income tax costs. Alongside this income tax policy, the Commission has used a discounted cash flow (DCF) methodology to determine the rate of return regulated entities need to attract capital.

In 2008, a pipeline MLP named SFPP, L.P. filed a cost-of-service rate increase to increase the rates for a line running between California and Arizona. Shippers protested the filed rates, including the interaction between (a) the Commission’s policy permitting an income tax allowance policy for partnership business forms (such as SFPP) and (b) the Commission’s DCF methodology used to determine a cost-of-service rate of return. The Commission eventually issued orders addressing issues in the case including the income tax allowance issue, which were challenged in court.

On appeal, in 2016 the United States Court of Appeals for the District of Columbia Circuit issued a decision known as United Airlines, Inc. v. FERC, 827 F.3d 122 (2016). In that case, the D.C. Circuit held that because both the partnership income tax allowance and the DCF ROE may include investors’ tax costs, permitting both may result in a double recovery, and remanded the case back to the Commission for further action.

This week, the Commission took that further action. It issued an order in the SFPP case denying that MLP an income tax allowance. More holistically, the Commission concurrently issued a Revised Policy Statement on Treatment of Income Taxes. In the revised policy statement, the Commission found that "an impermissible double recovery results from granting a Master Limited Partnership (MLP) pipeline both an income tax allowance and a return on equity pursuant to the discounted cash flow methodology."

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