The abrupt nature of the Federal Energy Regulatory Commission’s (FERC) recent MLP tax policy statement may have jolted markets and stunned industry observers, but the announcement was just the latest episode in a long legal struggle that is unlikely to be over.

On March 15, FERC announced that it would no longer allow pipelines owned by MLPs to recover an income tax allowance in cost-of-service rates. Citing a decision by the U.S. Court of Appeals for the DC Circuit in July 2016, FERC Chairman Kevin McIntyre said that the court had been clear that the Commission’s income tax allowance policy, when coupled with its discounted cash flow methodology to set return on equity, constituted a “double recovery” of income tax costs for MLPs. Therefore, the income tax allowance that MLPs have enjoyed had to go.

Did it? FERC’s interpretation of the court’s directive was not accepted by all.

Emily P. Mallen, partner, Sidley Austin

“The trouble that I have with the way FERC is doing all of this is that I don’t think the court explicitly said there’s a double recovery,” Emily P. Mallen, Washington, D.C.-based partner with Sidley Austin, told Hart Energy. “The court is not a fact-finding entity. The court just looks at how the agency has applied the facts and whether they’ve done it in accordance with law. It sent this issue back to FERC and said, ‘you tell us if there is double recovery, and if there is, you explain how you reconcile these different policies that you have.’”

The case in question, United Airlines vs. FERC, marked the third time that the court of appeals heard a case involving FERC’s income tax allowance policy. The policy was first challenged in 2004. At that time, the court told FERC that to justify the tax allowance, it needed to prove that parity existed between partnership-owned pipelines and corporation-owned pipelines. After that case, FERC initiated an income tax allowance policy in 2005, which it revoked on March 15.

In the revoked policy statement, FERC had allowed all partnership entities to recover an income tax allowance if the partners had actual or potential tax costs. It was a parallel to a corporation receiving an income tax allowance for its corporate income tax costs.

In its March 15 proceeding, the commission gave this explanation of its former policy from 2005: “While a partnership itself does not pay taxes, the partners pay income taxes based upon the partnership income and these partner-level taxes could be imputed to the pipeline.”

During the shale boom, MLPs gained popularity as midstream structures. That policy was, in effect, applied as a rule in rate proceedings in which there was an issue of whether a non-corporate entity could recover an income tax allowance.

A policy statement cannot be appealed, though, Mallen said.

“You can’t go to a court and say, ‘this policy is bad,’” she said. “It’s the application of policy that will get you to court because then you have a party that’s actually been aggrieved and has an injury that they’re seeking the court to redress.”

That happened with the case initiated at FERC in 2008 that ended up before the court of appeals in 2016. After the court remanded the case to FERC to reconcile its policies so that it could avoid a double recovery of income tax allowance and discounted cash flow return, the commission asked for comments.

There were 24 comments and 19 replies to comments. Trade groups such as the Interstate Natural Gas Association of America (INGAA) and the Association of Oil Pipe Lines (AOPL) offered arguments that FERC could use in its response to the court of appeals.

Among the comments received:

  • Changes to the stock price eliminate the double recovery;
  • Partners’ taxes are “first tier” taxes that should be recoverable in an income tax allowance just as corporations;
  • The return produced by the discounted cash flow analysis is not adjusted to include the partners’ tax costs;
  • An income tax allowance encourages MLP investors to demand a lower return;
  • A life-cycle hypothetical introduced by a University of Chicago professor on behalf of INGAA showed that corporate and MLP tax costs and after-tax returns were similar when an income tax allowance was in place;
  • The calculation of the growth rate in the discounted cash flow formula for MLPs addresses the double-recovery issue; and
  • Various empirical studies refute the double-recovery finding.

None of these arguments persuaded the commission to return to court and defend its own policy.

“In my mind, FERC could have done a better job of explaining itself and showing its own independent thought,” said Mallen.

Investors apparently shared some of those concerns. The Alerian MLP Index slumped 4.6% on March 15 after FERC’s announcement was made. It recovered somewhat the following day but was off 8.3% for the year as of March 16.

“INGAA is extremely disappointed with FERC’s decision to reverse its longstanding policy by disallowing a tax allowance in cost-of-service rates for pass-through entities,” the organization said in response to the announcement. “INGAA believes it provided the commission with convincing and detailed empirical evidence to support a finding that Master Limited Partnership (MLP) pipelines are not double recovering taxes in both their income tax allowance and through their return on equity.”

Mallen said she expects trade groups to press FERC for some sort of clarification. INGAA told Hart Energy that it had nothing to add beyond its statement that it was “considering its next steps.”

The composition of the five-person commission is still relatively new (a quorum was only re-established last summer) and Mallen speculates that it is still figuring out how to balance FERC’s unique stakeholder constituencies. She also thinks that uncertainty over the shape of tax reform played a part.

“I don’t believe Congress really addressed this issue,” she said. “They just maintained the status quo. Maybe FERC thought there was slightly more parity between corporate tax and MLP tax because the corporate tax rate just fell to 21%; maybe in their minds it wasn’t going to create as much of a jarring difference as if it were still a 35% tax for corporations. That could be part of their reasoning for changing their minds.”

Joseph Markman can be reached at jmarkman@hartenergy.com and @JHMarkman.