Freak Out! - FERC, Pipeline MLPs, and Income Taxes, Part 2

Two months ago, the Federal Energy Regulatory Commission shook up master limited partnerships (MLPs) and their investors by deciding that income taxes would no longer be factored into the cost-based tariff rates of MLP-owned pipelines. We said then that there was no need to panic — that all this will take time to play out, and that the end results may not be as widespread or dire as some feared. Today, we provide an update, dig into FERC’s other actions on changes in income taxes, and discuss the phenomenon known as “FERC Time.”

In Part 1 of this blog series, we described the seismic shocks caused by the Federal Energy Regulatory Commission’s (FERC) March 15 ruling that interstate gas and liquids pipelines’ cost-based tariff rates can’t factor in anything for income taxes if the pipelines are owned by master limited partnerships (MLPs) — and most are. Many investors did freak out — no other phrase sums it up better — when they heard that news. The unit prices for MLPs cratered, though many subsequently rebounded once everyone drew a breath and started digging a little deeper. Still, some unit prices are still down quite a bit from where they stood before the FERC ruling.

Before we begin in earnest, let’s do a brief recap. FERC had been working for more than a year and a half to respond to a July 2016 federal appellate court ruling saying that collecting income taxes in pipeline tariff rates — on top of how the return on equity investment is calculated for an MLP’s pipeline rates — amounts to a double recovery of cost. So FERC took a lot of comments, struggled with it, and ultimately said on March 15, “Yep, it sure is.” As covered in our Masters of the Midstream blog a while back, MLPs are a type of U.S. corporate structure that has been around since the 1980s. MLPs are, as their very name suggests, partnerships. Because the partnership is not a corporation, it pays no corporate taxes on its profits. Tax liabilities are instead “passed through” to individual unit holders who pay tax on their share of MLP profits at their individual tax rate. This structure has been extremely popular in supporting the growth of U.S. pipelines and other energy infrastructure for both natural gas and liquids such as crude oil, refined products and NGLs. So MLPs have come to own a significant portion of the interstate gas and oil pipelines in the U.S., all of which are regulated by FERC (and a fair share of intrastate pipes too, which are regulated by state agencies).

As the number of pipelines owned by MLPs grew, FERC launched into what became a decades-long struggle over how to deal with income taxes and “level the playing field” between MLPs and ordinary corporate owners in setting traditional “cost-of-service” rates (see Part 1 for details of that saga.) In 2005, FERC reverted (in part) to its original policy of allowing a full income tax allowance in cost-of-service rates, but if the pipeline was owned by an MLP it had to figure out the composite tax rate of all the owners (including individual limited unit holders) instead of pretending that the MLP paid taxes at the corporate tax rate. The July 2016 federal appellate court decision overturned that longstanding FERC policy and led to the current kerfuffle (see above).

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