FERC Issues Notice of Inquiry on Income Tax Allowance Policy Statement and ROE Methodology

By William M. Keyser, Sandra E. Safro, Michael L. O’Neill, and Benjamin L. Tejblum

On December 15, 2016, the Federal Energy Regulatory Commission (FERC) issued a Notice of Inquiry (NOI) seeking comment on how to address any double recovery resulting from income tax allowance policy set forth in its Income Tax Allowance Policy Statement and current policies regarding the derivation of return on equity (ROE).  FERC’s existing Income Tax Allowance Policy Statement has been in place since 2005 and permits an income tax allowance for partnerships, or similar pass-through entities, to the extent that partners or members have actual or potential income tax obligations on the partnership entity’s income.

The NOI stems from the July 1, 2016 decision of the U.S. Court of Appeals for the District of Columbia Circuit (DC Circuit) in United Airlines Inc. v. Federal Energy Regulatory Commission, 827 F.3d 122 (D.C. Cir. 2016) (UAL v. FERC).  In that decision, the DC Circuit held that FERC had not adequately demonstrated that the application of its Income Tax Allowance Policy Statement in combination with its use of a discounted cash flow (DCF) methodology to determine ROE does not result in double recovery of taxes for a pipeline organized as a partnership.  The DC Circuit remanded the issue to FERC to develop a mechanism “for which the Commission can demonstrate that there is no double recovery” of partnership income tax costs.  Among the potential options that the DC Circuit outlined was eliminating all income tax allowances and setting rates based on pre-tax returns.  The NOI explicitly notes “the potentially significant and widespread effect of [the decision in UAL v. FERC] upon the oil pipelines, natural gas pipelines, and electric utilities subject to the Commission’s regulation.”  NOI at P 2.

As the DC Circuit did in UAL v. FERC, the NOI references Fed. Power Comm’n v. Hope Natural Gas Co., 320 U.S. 591 (1944) (Hope), where the U.S. 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 NOI invites comments on methods to adjust the current income tax policy or ROE policy to resolve any double recovery of investor-level tax costs for partnerships or similar pass through entities.  Commenters should explain how their proposals address any double recovery of income tax costs resulting from the Commission’s current income tax allowance and rate of return policies while maintaining an adequate return consistent with Hope.  NOI at PP 8 and 17.

Comments should include a detailed explanation of any proposal made, evidentiary support, and an explanation of how the proposed change to the Income Tax Allowance Policy Statement and/or ROE policy should be implemented.  NOI at PP 19-20.  In addition, FERC advises that comments should address the following fundamental concerns raised in UAL v. FERC , which bear on the argument that application of the Income Tax Allowance Policy Statement in combination with the Commission’s current ROE policies results in double recovery at the investor level:

• The DCF methodology estimates the rate of return that an investor requires in order to invest in the regulated entity.
• 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 needed 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.  Master Limited Partnership (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, investors receive 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.

NOI at PP 17-18.  Initial comments are due within 45 days after notice of the NOI is published in the Federal Register and reply comments are due within 65 days after such publication.