On December 15, 2016, the Federal Energy Regulatory Commission (FERC) issued a Notice of Inquiry (NOI) seeking comments on how to address any potential double recovery that may result from the agency’s current income tax allowance and rate of return policies. The NOI responds to the U.S. Court of Appeals for the District of Columbia Circuit’s (D.C. Circuit) opinion in United Airlines, Inc., et al. v. FERC (United Airlines). In United Airlines, the D.C. Circuit concluded that FERC had failed to adequately demonstrate that the combination of (i) the agency’s current income tax allowance policies and (ii) a return on equity (ROE) determined pursuant to the discounted cash flow (DCF) methodology did not produce a double recovery of taxes for pipelines organized as partnerships. The court remanded the matter to FERC with a directive to consider mechanisms “for which the Commission can demonstrate that there is no double recovery” of partnership income tax costs.

Background 

FERC’s income tax allowance and ROE policies have evolved over two decades to address the emergence of partnership entities in FERC-regulated industries, particularly Master Limited Partnerships (MLPs) that own oil and natural gas pipeline assets. Under FERC’s cost-of-service ratemaking methodology, FERC utilizes a DCF model to determine a reasonable ROE that a regulated entity may recover in rates in addition to its costs. The purpose of the DCF methodology is to estimate the return required by investors in order to invest in a regulated entity. Under FERC’s 2005 Income Tax Policy Statement, FERC permits an income tax allowance for all regulated entities (including corporations and partnerships), and those income tax costs are included in the regulated entities’ rates. 

In United Airlines, the court held that FERC “failed to demonstrate that there is no double recovery of taxes for a partnership pipeline as a result of awarding that pipeline both an income tax allowance and a pre-investor-tax ROE pursuant to the DCF methodology.” The court also determined that allowing partnerships to double recover income tax costs would be inconsistent with the U.S. Supreme Court’s mandate in FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944) (Hope). In Hope, the Supreme Court stated that “the return to the equity owner should be commensurate with the return on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.” 

The court remanded the cases on appeal to FERC and directed the agency to consider mechanisms under which it could demonstrate that no double recovery of partnership income tax costs would result. Possible options identified by the court included removing any duplicative tax recovery for partnerships directly from the DCF ROE or eliminating all income tax allowances and setting rates based on pre-tax returns. The court further instructed FERC “to ensure parity between equity owners in partnership and corporate pipelines.”  

FERC’s Notice of Inquiry

The NOI requests comments in response to the court’s directive for FERC to consider recovery mechanisms that would avoid potential double recovery issues and ensure uniformity between equity owners of partnership and corporate pipelines. The NOI also requests that comments consider how recovery mechanisms will comply with the capital attraction standard in Hope.

Comments should consider the following concerns expressed by the shipper litigants in United Airlines:

• The DCF methodology estimates the rate of return that an investor requires in order to invest in the regulated entity.
• As a general matter, potential investors evaluate whether to invest in an entity based on the returns they expect to receive after paying any applicable taxes on the investment income, and thus, to attract capital, entities in the market must provide investors a return that covers investor-level taxes and leaves sufficient remaining income to earn their required after-tax return.
• Because the return estimated by the DCF methodology includes the cash flow necessary to cover investors’ income tax liabilities and earn a sufficient after-tax return, the Commission’s policy of allowing partnership entities to recover a separate income tax allowance may result in a double recovery.
• While allowing a partnership entity to recover the partner-investors’ tax costs is reasonable, allowing a partnership to double recover those tax costs is not.
• Changes in the share price do not resolve the double recovery issue. MLP investors will demand the same percentage return on the share price whether or not a pipeline receives an income tax allowance. If an MLP obtains a new revenue source that increases its distributions to investors (such as an income tax allowance that increases its rates), the share price will rise until, once again, the investor receives the cash flow necessary to cover investors’ income tax liabilities and earn a sufficient after-tax return. 
• As opposed to an MLP pipeline, the double recovery issue does not arise for a corporation’s income tax allowance. The corporation pays its corporate income taxes itself. Accordingly, although a return to investors must cover investor-level taxes and sufficient remaining income to earn their required after-tax return, the corporate income tax is not an investor-level tax. Thus, the corporate income tax cost recovered in the income tax allowance is not reflected in the return estimated by the DCF methodology.

FERC invites proposals that would revise the current ROE or income tax allowance policies to address the foregoing concerns. Submissions should (i) provide a detailed explanation of the proposal, (ii) include data, theoretical analyses, empirical studies or other evidentiary support, and (iii) address the practical application of the proposal. 

Initial comments in response to the NOI are due 45 days after publication in the Federal Register; reply comments are due 65 days after publication in the Federal Register.