22 February 2019

Trailblazer Pipeline Company LLC Reinforces FERC Income Tax Allowance Policy But Punts Final Determinations on Other Partnership Taxation Matters

On February 21, 2019, the Federal Energy Regulatory Commission (FERC) issued Trailblazer Pipeline Company LLC (“Trailblazer”), FERC’s first order addressing how FERC applies its Revised Income Tax Allowance Policy Statement, as further revised on rehearing (collectively “Revised Policy Statement”), to a pipeline organized as a pass-through partnership that is not a master limited partnership (“MLP”) in a Natural Gas Act (“NGA”) section 4 rate case proceeding.  FERC issued the Revised Policy Statement in response to the U.S. Court of Appeals for the D.C. Circuit’s (“D.C. Circuit”) decision in United Airlines, Inc. v. FERC (“United Airlines”), which found that FERC could not permit a specific MLP pipeline to recover an income tax allowance in its rates without further explaining why this did not result in the MLP’s investors “double recovering” their income tax costs, based on a concern that the investors’ pre-tax return on equity (“ROE”) also provided such compensation when calculated using the discounted cash flow (“DCF”) methodology.  United Airlines did not consider other types of pass-through entities, such as non-publicly traded partnerships, or alternative methodologies to calculate ROE and the Revised Policy Statement did not address them directly. 

In Trailblazer, FERC preliminarily determined that permitting partners in a private partnership to earn an income tax allowance appears to lead to a double recovery of the partner’s income tax costs.  This was based on FERC’s preliminary determination that the ROE that Trailblazer would be permitted to recover already incorporates investor level taxes sufficient to compensate the partners for their income tax costs, regardless of the methodology used to calculate ROE.  Trailblazer explained that alternative ROE methodologies, such as the Risk Premium, the Capital Asset Pricing Model (“CAPM”), and Expected Earnings methodologies, were likely to result in the same type of double recovery.  FERC based this preliminary determination on the theory that a regulated entity must provide investors a pre-investor tax return in order to attract capital regardless of the methodology used to calculate ROE.

FERC clarified that it would permit a partnership pipeline to obtain a partial income tax allowance commensurate with the ownership percentage attributable to those partners that incur “an actual or potential income tax liability” from the partnership’s income, provided their income tax costs are not already reflected in the DCF ROE, such that permitting an income tax allowance would lead to a double recovery of the partners’ tax costs.  Thus, FERC preliminarily concluded that Trailblazer would be able to include a partial income tax allowance in its rates attributable to the pipeline’s 55 percent ownership by Tallgrass Energy, a publicly traded partnership which has elected to be taxed as a corporation.  This partial income tax allowance would thus exclude Trailblazer’s remaining 45 percent ownership attributable to private equity funds.[1]  FERC distinguished this form of partial income tax allowance from another pending rate case proceeding, Enable Mississippi River Transmission, LLC, in which the pipeline had corporate ownership, but those owners were MLP unitholders that allegedly recover their tax costs through the DCF ROE.  It also defended why this rationale does not run afoul of another D.C. Circuit decision, BP West Coast Products, LLC v. FERC.

FERC had set Trailblazer’s right to recover an income tax allowance aside for separate paper hearing procedures when it set the Trailblazer NGA section 4 rate case for hearing on July 31, 2018.  Rather than make a definitive finding on the income tax allowance issues, Trailblazer deems all of its findings to be “preliminary,” and directs the presiding administrative law judge (“ALJ”) in the ongoing rate case proceeding to consider these issues.  This further punts any definitive guidance from FERC on the treatment of income tax allowances for partnership pipelines given that Trailblazer is currently in settlement talks with its shippers and other interested stakeholders and no procedural schedule has been set for the hearing proceeding.  However, if a hearing does move forward, Trailblazer’s pronounced preliminary findings appear to put a very heavy thumb on the scale concerning how FERC expects the ALJ to rule.

Regardless of whether Trailblazer leads to subsequent non-preliminary findings, Trailblazer provides key takeaways for the pipeline industry:

  1. Without further direction from the courts, FERC is unlikely to reverse course on its Revised Income Tax Policy and permit MLP pipelines to recover an income tax allowance in rates; instead, FERC is willing to extend its policy to other types of pass-through entities that were not addressed in United Airlines.
  2. Going forward, it is likely that all pipelines filing NGA section 4 rate case proceedings will propose alternative ROE methodologies if they result in higher returns than the traditional two-stage DCF methodology; similarly, pipeline stakeholders will propose alternative ROE methodologies if they result in lower ROEs in responsive pleadings and testimony.
  3. There remains opportunity for pipeline advocates to argue why alternative ROE methodologies do not result in a double-recovery of income tax costs for pipeline investors.
  4. FERC remains conscious of the impact of its orders on the capital markets, which explains why it waited until after the markets closed to issue Trailblazer. FERC’s issuance of the Revised Policy Statement during market trading resulted in a major same-day sell-off of pipeline equity interests.

[1] On January 31, 2019, Tallgrass announced a change to its ownership structure.  https://www.blackstone.com/media/press-releases/article/blackstone-infrastructure-partners-enters-into-definitive-agreement-to-acquire-controlling-interest-in-tallgrass-energy

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