Last Wednesday, the Federal Energy Regulatory Commission (FERC) issued its final rule (subject to comments) on the treatment of income taxes for natural gas or liquids cost-of-service pipelines. The final rule takes some of the sting out of the proposed rule first revealed in March.
The issue is whether a pipeline company should be allowed to recover income taxes in the cost-of-service agreements. Under the previous policy, master limited partnerships (MLPs) were allowed to receive both an income tax allowance and a return on equity based on discounted cash flow, a policy the Federal Circuit Court in Washington, D.C., ruled gave MLPs double recovery of income tax costs and that the FERC was forced to roll back. The FERC’s March ruling sent a panic through the ranks of MLPs that own and operate pipelines.
What had always been a feature of MLPs (no income tax at the company level) became a bug, and the convoluted corporate structures that characterize MLPs would no longer benefit the general partners or the limited partners to the degree that they once did. Weighed against a lower cost of capital for corporations that issue common stock, MLPs might have faded away.
The FERC modified its March ruling last week to reduce the negative effects of the rule change. In the original March proposal, pipeline operators were required to file a form with the FERC that the agency would use to determine if the change in corporate income tax rates from 35% to 21% were fairly reflected in the cost-of-service rate the MLPs charge.
Pipeline companies have been using accumulated deferred income tax (ADIT), which adjusted the operator’s tax deduction to match the accelerated depreciation rate on its pipeline. The 2017 tax law change meant that pipeline company had collected tax payments of 35% from their customers but would only have to pay tax at the 21% rate in the future. So there’s a pile of ADIT money that operators would have to give back to customers. At the same time, the operator would not be allowed to include an income tax charge of even 21% in its cost-of-service rate. A double whammy.
The outlook for MLPs was cloudy until the FERC made its final rule proposal last week. Here’s how asset management firm Tortoise Advisors’ portfolio manager and managing director Rob Thummel summarized the FERC’s actions:
(1) If an MLP files a rate case with the FERC then the FERC will allow the pipeline to only reflect the change in the corporate tax rate from 35% to 21%. So what this means is that MLPs would not have to eliminate the entire income tax allowance in its filing.
(2) The FERC guaranteed that it would not initiate a rate case on a pipeline owned by an MLP for three years as long as pipeline is earning a return on equity of 12% or less after factoring in the change in the corporate tax rate.
(3) The FERC stated that an income tax allowance can remain in the rates for pass-through entities like MLPs if income or losses from the pass through are consolidated on the tax returns of a corporate parent. We believe this will have a positive impact on some of the drop down stories for interstate and natural gas pipelines with a corporate parent.
(4) Then lastly, FERC stated that negotiated rates would not be impacted by changes to cost of service rates. Keep in mind that we believe a majority of the pipelines put into service over the past decade are operated under negotiated rates. Additionally, we expect most if not all of the future pipelines that are constructed will be operated under negotiated rates as well.
In our opinion, we believe the issuance of this final ruling revives MLPs as some declared MLPs were dead in March. We believe this ruling removes uncertainty from the MLP sector allowing investors to focus on the cash flow growth tied to the expansion of the U.S. energy infrastructure network.
The FERC’s action could be challenged in the courts, but such an action is unlikely to come soon, according to Rick Smead at RBN Energy, who has a detailed explanation of what has just happened.