FERC Modifies Policy on Income Tax Allowances

On May 4, the Federal Energy Regulatory Commission (FERC) revised its policy regarding income tax allowances. Under the new policy, FERC will allow an income tax allowance for all entities or individuals owning public utility assets, provided that an entity or individual has an actual or potential income tax liability to be paid on income from those assets. Accordingly, this policy permits a utility organized as a “pass-through entity” (such as a partnership or limited liability corporation (LLC)) to reflect an income tax allowance in its cost-of-service rates. In addition, that allowance can reflect the tax liability of all of its owners or members, including not only corporations but also non-corporate owners who have an actual or potential tax liability.

In announcing this new policy, FERC reversed its previous Lakehead policy, which had permitted a utility organized as a limited partnership an income tax allowance equal to the proportion of its limited partnership interests owned by corporate partners, but prohibited a tax allowance for the proportion of partnership interests owned by non-corporations. FERC stated that the new policy will be applied in pending and future rate proceedings, and that pass-through entities seeking an income tax allowance on utility operating income must establish the tax status of its owners in such individual proceedings.

FERC’s Lakehead Policy

FERC adopted its Lakehead policy regarding income tax allowances in 1995 in an oil-pipeline rate proceeding. In 2004, the U.S. Court of Appeals for the District of Columbia issued a decision in BP West Coast Products, LLC v. FERC, rejecting FERC’s Lakehead policy. The BP West decision held that FERC had failed to justify limiting the amount of an income tax allowance permitted for a utility partnership to the amount of corporate tax liability incurred by its corporate partners. Moreover, the BP West court went even further and held that a utility organized as a non-taxable partnership should be permitted no income tax allowance at all. The court reasoned that because a utility organized as a partnership does not incur tax liability, an income tax allowance would be a “phantom cost,” notwithstanding the fact that the owners of the partnership interests — both corporate and individual — do incur tax liability on the income generated by the utility.

Following the court’s decision, FERC requested comments on the scope of the court’s decision, in particular, whether the decision should be limited to the facts of the oil pipeline utility at issue in the BP West case, or extended to other pass-through capital structures.

FERC’s Policy Statement

The resulting FERC policy statement returns to the Commission’s pre-Lakehead approach, in which a regulated entity that is a pass-through entity may include an income tax allowance in its rates reflecting tax allowance for owners who have an actual or potential income tax liability to be paid on the income generated from those assets. If any of the partners or members do not have an actual or potential income tax obligation, then the amount of any income tax allowance will be reduced accordingly to reflect the weighted income tax liability of the entity’s partners or members.

In allowing a tax allowance for non-corporate ownership interests, FERC explained that Lakehead had mistakenly focused on who pays taxes, rather than on the more fundamental cost allocation principle of what costs, including tax costs, are attributable to regulated service, and that therefore should be included in a regulated cost-of-service. Contrary to the assumption in Lakehead, FERC stated that both corporate owners and individuals pay taxes on the public utility assets they control.

FERC also addressed the BP West court’s holding that any income tax allowance for a pass-through entity is necessarily a “phantom cost.” First, the Commission noted that the court’s decision was limited to the facts presented in that case, and that the court did not consider the realities of partnership tax practice. FERC also explained that, although a pass-through entity does not itself pay taxes, its owners pay income taxes on the utility income generated by the assets they own via the pass-through entity, and that those taxes are a cost of acquiring and operating the assets.

FERC concluded that its policy will facilitate investment in infrastructure and avoid creating a disincentive for the use of the partnership form. The Commission explained that its policy should not increase costs to ratepayers, and may even reduce costs to the extent that a partnership or LLC has a lower weighted marginal tax rate and fewer administrative expenses than the normal corporate ownership form. For example, if a pass-through entity has a municipal government as a partner or LLC member, the tax allowance is reduced because municipalities and their operating entities have no actual or potential income tax liability on utility income. FERC also emphasized that partnerships or LLCs that are used for financial investments rather than for making infrastructure investments do not warrant different treatment. In this regard, FERC explained that partners of master limited partnerships, or MLPs, have actual tax liability for any income recognized by the partnership, although distributions may exceed partnership book income.

Finally, the Commission found that issues regarding whether a particular partner or LLC member has an actual or potential income tax liability, and the assumptions that should determine the amount of the related tax rate will be resolved in individual rate proceedings where fact-specific issues can be resolved based on data only the regulated entity possesses.

Importance of FERC’s Policy Statement

The court’s decision in BP West Coast Products created substantial uncertainty for FERC-regulated entities organized as pass-through entities and for the investment community. Pass-through entities have become a very significant source of capital for infrastructure investment in the energy industry. The most immediate and important effect of FERC’s policy statement is to substantially reduce regulatory and market uncertainty. Because the policy statement will be applied in individual rate proceedings, its case-specific impacts will take longer to sort out.