[Federal Register Volume 70, Number 93 (Monday, May 16, 2005)]
[Notices]
[Pages 25818-25825]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-9649]
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DEPARTMENT OF ENERGY
Federal Energy Regulatory Commission
[Docket No. PL 05-5-000]
Inquiry Regarding Income Tax Allowances; Policy Statement on
Income Tax Allowances
(Issued May 4, 2005)
Before Commissioners: Pat Wood, III, Chairman;
Nora Mead Brownell,
Joseph T. Kelliher, and
Suedeen G. Kelly
1. On December 2, 2004, the Commission issued a notice of inquiry
regarding income tax allowances. The Commission asked interested
parties to comment when, if ever, it is appropriate to provide an
income tax allowance for partnerships or similar pass-through entities
that hold interests in a regulated public utility. The Commission
concludes that such an allowance should be permitted on all partnership
interests, or similar legal interests, if the owner of that interest
has an actual or potential income tax liability on the public utility
income earned through the interest. This order serves the public
because it allows rate recovery of the income tax liability
attributable to regulated utility income, facilitates investment in
public utility assets, and assures just and reasonable rates.
I. Background
2. The instant proceeding was initiated by the Commission in
response to the U.S. Court of Appeals for the District of Columbia
remand in BP West Coast Products, LLC, v. FERC,\1\ in which the court
held that the Commission had not justified the so-called Lakehead
policy regarding the eligibility of partnerships for income tax
allowances. The Lakehead case \2\ held that a limited partnership would
be permitted to include an income tax allowance in its rates equal to
the proportion of its limited partnership interests owned by corporate
partners, but could not include a tax allowance for its partnership
interests that were not owned by corporations. Prior to Lakehead, the
Commission's policy provided a limited partnership with an income tax
allowance for all of its partnership interests, but did so in the
context that most partnerships were owned by corporations. This ruling
was not appealed until a series of orders involving SFPP, L.P. in the
proceedings underlying the remand.\3\ The Commission's rationales for
permitting a tax allowance for corporate partner interests were (1) the
double taxation of corporate earnings, (2) the equalization of returns
between different types of publicly held interests, i.e. the stock of
the corporate partner (which involves two layers of taxation of
partnership earnings) and the limited partnership interests (which
involve only one), and (3) encouraging capital formation and
investment.
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\1\ BP West Coast Products, LLC v. FERC, 374 F.3d 1263 (D.C.
Cir. 2004) (BP West Coast), reh'g denied, 2004 U.S. App. LEXIS
20976-98 (2004).
\2\ Lakehead Pipe Line Company, L.P., 71 FERC ] 61,388 (1995),
reh'g denied, 75 FERC ] 61,181 (1996) (Lakehead).
\3\ Opinion No. 435 (86 FERC ] 61,022 (1999)), Opinion No. 435-A
(91 FERC ] 61,135 (2000)), Opinion No. 435-B (96 FERC ] 61,281
(2001)), and an Order on Clarification and Rehearing (97 FERC ]
61,138 (2001)) (collectively the Opinion No. 435 orders.) These are
now pending before the Commission on remand and rehearing in Docket
Nos. OR92-8-000, et al., and OR96-2-000, et al., respectively.
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3. The court found all of these rationales unconvincing. First, the
court rejected the double taxation rationale in Lakehead, concluding
that (1) only the costs of the regulated entity may be recovered, and
(2) taxes are but one cost paid by a corporate partner as part of its
cost of doing business.\4\ The court also rejected the rationale that
the investor should be able to obtain the same returns without regard
to which instrument the investor purchases. The court rejected this
argument by noting that if any income tax allowance is provided, this
benefits all investors holding instruments proportionately because the
additional income is shared on a pro rata basis.\5\ Given this pro rata
distribution of income by the partnership, the court concluded that
non-corporate partners would receive an excess rate of return.
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\4\ BP West Coast at 1288.
\5\ Id. at 1292-93.
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4. Thus, while the double taxation function may affect the eventual
return for the investor, the court made clear that this is a function
of corporate structure and the attendant tax consequences, not the
regulated utility's risk.\6\ The court therefore concluded
[[Page 25819]]
that the investor's return and risk are no more appropriately
attributed to the regulated entity than are the investor's various
costs in determining the costs or allowances that the regulated entity
is permitted to recover.
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\6\ In making a decision whether to buy a limited partnership
interest (where only the unit holder's income is taxed), or a share
of a corporate partner (where the corporate income is taxed as
well), it should be the individual investor that makes the
adjustment for the double taxation. The individual investor can do
this by paying prices that equalize the pre-tax return to the
investor of the different instruments that have income derived from
the same public utility assets.
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5. The court also rejected the Commission's third rationale that an
income tax allowance should be permitted to encourage capital to flow
into public utility industries regulated by the Commission.\7\
Throughout its analysis the court stated that the Commission's central
assumption in its Lakehead decisions was that income taxes are an
identifiable cost for the regulated entity. Thus, if a partnership paid
no income taxes, or had no potential income tax liability, no cost was
incurred and therefore an income tax allowance would reimburse the
entity for a phantom cost. Accordingly, the court concluded that a
payment for a non-existent cost was still invalid even if designed to
encourage needed infra-structure investment.
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\7\ BP West Coast at 1292-93.
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6. While the court's decision addressed only the Order No. 435
opinions, it became apparent that the remand has implications for other
proceedings and regulated utilities as well. As was discussed in the
more recent Trans-Elect order,\8\ denying a tax allowance would
significantly reduce the expected returns that were the basis for the
investment in that project. In light of the broader implications of BP
West Coast, the Commission sought comments here on whether the court's
ruling applies only to the specific facts of the SFPP, L.P. proceeding,
or also extends to other capital structures involving partnerships and
other forms of pass-through ownership. The Commission asked whether the
court's reasoning should apply to partnerships in which: (1) All the
partnership interests are owned by investors without intermediary
levels of ownership; (2) the only intermediary ownership is a general
partnership; (3) all the partnership interests are owned by
corporations; and (4) the corporate ownership of the partnership
interests is minimal, such as a one percent general partnership
interest of a master limited partnership. The Commission also asked if
(1) the court's decision precludes an income tax allowance for a
partnership or other ownership interests under any of these situations,
will this result in insufficient incentives for investment in energy
infrastructure; (2) or will the same amount of investment occur through
other ownership arrangements; and (3) are there other methods of
earning an adequate return that are not dependent on the tax
implications of a particular capital structure?
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\8\ Trans-Elect NTS Path 15, LLC, 109 FERC ] 61,249 (2004)
(Trans-Elect).
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II. Comments
7. After an extension of the comment period to January 21, 2005,
thirty-three comments were timely filed with an additional nine
comments filed late. As enumerated below in greater detail, the
comments advocate four general positions. While no party argues for the
continuation of the Lakehead doctrine in its current form, three appear
to argue that an approach should be used to preserve the tax allowances
now available to certain limited liability corporations (LLCs), or
possibly provide a justification for tax allowances for all
partnerships and LLCs, as long as there is no additional cost to the
rate payers beyond that which would have been incurred through a
corporate form. Three commentors argue for granting a tax allowance if
a partnership is entirely owned by a tax paying corporation filing a
consolidated return. Ten argue that the tax allowance should be granted
only to entities that actually pay taxes and that there should be no
allowance for ``phantom'' taxes. Twenty-four commentors would provide a
tax allowance to all entities to assure that tax factors do not control
the selection of the investment vehicle. Two filings were limited to
interventions or minor comments and are not discussed further in this
order.\9\
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\9\ Edison Mission Energy, which urged that the income tax
allowance issue be resolved quickly, and Piedmont Natural Gas
Company, Inc., which only intervened.
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A. Proposals Akin to Lakehead
8. Three commentors expressed concern about the possible impact of
the court's decision on existing public utility partnerships that
include for-profit private and non-profit public electric
utilities.\10\ These concerns are summarized by Wisconsin Public Power
Inc. (WPPI), which asserts that the Commission should permit LLCs and
partnerships to have an income allowance if the LLC demonstrates that
its structure would not increase the income tax component of the cost
of service to transmission rate payers. WPPI is a part owner of the
American Transmission Company, LLC (ATCLLC), which owns transmission
lines conveyed to it by various utilities, private and public, in
Wisconsin. To maintain cash flow neutrality for its owners after the
facilities were transferred to ATCLLC, ATCLLC was provided a tax
allowance equal to the blended tax rate of its owners. Thus, to the
extent that the income stream to a private owner would be taxed at 35
percent, ATCLLC was provided an allowance for taxes on that income. A
municipality pays no taxes and therefore that portion of the income
stream did not result in a tax allowance. The ATCLLC income stream is
then allocated at the owner level in a way that prevents over or under-
recovery.
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\10\ Electric Power Supply Association (EPSA); Michigan Electric
Transmission Company, LLC (METC); Wisconsin Public Power, Inc.
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9. WPPI states that this arrangement assured that the income stream
from transmission operations would not be taxed at the operating level
of ATCLLC, thus retaining the two tier structure that existed before
the various private companies divested their transmission assets to
ATCLLC. These two historical taxation tiers were the corporate income
tax and the tax on the shareholder dividends. ATLLC states that without
the use of the LLC form, and a tax allowance attributable to the
utility income stream, the private shareholders would suffer a loss in
value because of the additional level of taxation on transmission
income. Thus, the value of a transmission interest in ATCLLC would be
diminished below the value it had for the private corporation before
the transfer of the asset. For this reason the private companies would
not have transferred their assets to ATCLLC. WPPI therefore concludes
that the tax allowance on the income stream of LCC that pays no income
taxes itself was essential to the creation of an independent
transmission system on the upper Michigan peninsula.
10. METC likewise requests a solution that would preserve the rate
attributes historically extended to LLCs, consistent with the
methodology first announced in the Lakehead cases. Most importantly,
METC asserts that the Commission should take no action that would
undermine existing investments in independent transmission companies
that are LLCs. Thus, METC's concerns do not turn on the preservation of
the Lakehead doctrine as such, but that the corporate shareholders of
that LLC are not deprived of the tax allowance that was built into the
rates of return on the transmission assets that these firms contributed
to METC's independently owned transmission system.
11. EPSA urges that the Commission affirm the Lakehead philosophy
by providing the Court of Appeals with a better rationale. EPSA
suggests that there are six basic options available to the Commission.
One is to give utilities organized as corporations a tax
[[Page 25820]]
allowance, but not partnerships. A second is to treat partnerships and
corporations the same and give both a tax allowance. A third is to deny
any partnerships with non-corporate owners a tax allowance but permit
the allowance for partnerships owned wholly by corporations. A fourth
is to readopt Lakehead. A fifth is to eliminate the allowance and base
rates on pre-tax rates of return. A sixth is to decide matters of
partnership income tax allowances on a case-by-base basis.
12. EPSA states that first option would have a serious negative
consequence on raising capital for the industry, particularly with
regard to large projects with multiple owners. It notes that even if
corporate-owned partnerships could reorganize to qualify for a tax
allowance, there are additional administrative costs that would be
passed on to consumers. It further asserts that a case-by-case approach
would result in uncertainty and to disqualify a partnership based on a
single non-corporate partner seems unfair and hard to justify
analytically. Determining returns on a pre-tax basis is likely to be
controversial and difficult to implement.
13. EPSA therefore concludes that the only realistic options are
(1) treating all entities the same; or (2) a continuation of the
Commission's Lakehead policy. ESPA notes that taxes are an imputed cost
based on public utility net income. As such, EPSA claims that the court
ignored the fact that taxes are imputed to a utility in situations
where the utility pays no actual taxes because the corporate income tax
allowance is based on the regulatory book income of the utility in
question. EPSA's analysis assumes that the required rate of return is
12 percent. EPSA then asserts that in the absence of a tax allowance, a
utility subject to the 35 percent corporate income tax would only pay
out dividends equivalent to 7.8 percent net income (instead of 12
percent).
14. EPSA states that in contrast, the corporate tax allowance
increases the utility's pre-tax return on equity to 18.5 percent, which
after application of the 35 percent tax rate, results in the 12 percent
equity return. EPSA concludes that if an allowance is not allowed to
partnerships owned by one or more corporations, the amount returned to
the parent corporation will not be sufficient to attract equity
investment. Since EPSA opposes an income tax allowance for pass-through
entities that are not owned by a corporation, and believes it unfair to
deny an income tax allowance if some of the partnership interests are
not owned by a corporation, it concludes that the Lakehead approach
should be affirmed.
B. If a Corporation Owns the Partnership Interests
15. Three commentors \11\ argue that an income tax allowance should
be allowed if the partnership interests are owned wholly by
corporations filing a consolidated return. In support of this position,
Kern River states that the Commission's stand alone rate-making policy
should apply, just as it does in the case of a consolidated return that
can be filed when a parent corporation owns at least 80 percent of a
subsidiary's stock.\12\ All three of these commenters assert that in
the case of a regulated partnership held within a single corporation
and whose income is included in a consolidated return, the income from
the regulated partnership generates a tax liability that is included in
the jurisdictional cost of service of the corporate group.
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\11\ Duke Energy Corporation; Kern River Gas Transmission
Company (Kern River); Texas Gas Transmission, LLC.
\12\ The stand-alone policy provides that income tax allowance
of a corporate subsidiary should be determined based on the actual
or potential income tax obligation of that subsidiary. Thus, the
amount of the allowance is not based on the tax obligation of the
parent company in the test year in which the consolidated return is
filed. See City of Charlottesville v. FERC, 774 F.2d 1205 (D.C. Cir.
1985) (City of Charlottesville).
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16. Kern River further states that there is no question that income
generated by a partnership within a corporate group creates an income
tax liability for the group. This is because, while the partnership is
not taxed directly, its income is flowed through to the corporations
that hold the partnership interests. Duke Energy further asserts that
BP West Coast was not intended to invalidate an income tax allowance
for pass-through entities owned by corporations and at a minimum that
decision should be restricted to its facts.\13\ Thus, regardless of the
corporate structure, the income a partnership generates is a part of
the consolidated group's taxable income, and therefore generates a
corporate tax liability. These commenters therefore assert that a
partnership that is wholly owned by a corporation should be granted an
income tax allowance.
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\13\ Kern River at 7-8; Duke Energy at 4-5.
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C. Opposition to Any Allowance if Taxes Are Not Actually Paid
17. Ten commentors assert that there should be no tax allowance for
any entity that does not actually pay income taxes or has a potential
liability for such taxes.\14\ Only one such commentor, the NGSA,
suggests that the court's ruling should be applied on a case-by-cases
basis. All others assert that the court's holdings should be applied
uniformly to all partnerships, LLCs, or similar pass-through entities,
thus creating a single uniform rule. Thus, there would be no income tax
allowance for any partnership or LLC, including those owned by
corporations that do not have an actual or potential income tax
liability. They assert that the court's decision is binding on the
Commission, and that there should be no income tax allowance for
partnerships that do not pay income taxes.
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\14\ Air Transport Association of America, Inc.; American Public
Gas Association; BP West Coast Products; Calpine Corporation;
Canadian Association of Petroleum Producers; Missouri Public Service
Commission; Natural Gas Supply Association (NGSA); National Rural
Electric Cooperative Association; Society for the Preservation of
Oil Pipeline Shippers; and Valero Marketing and Supply Company.
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18. They assert that any such phantom taxes will result in a
significant increase in rates to customers or consumers. This is
because the gross-up for the income tax allowance could result in as
much as a 60 percent increase in the rate of return on equity assuming
that the regulated entity is allowed a twelve percent rate of return on
equity.\15\ Any gross-up from the tax allowance represents an increase
in return for entities that may be already charging unjust and
unreasonable rates even if a tax allowance were excluded. Rather than
provide an inflated return, they assert that any needed incentives for
increased investment should be provided by special actions to increase
the pre-tax rate of return. Given this alternative, denying a tax
allowance will not act as a disincentive to investment in infra-
structure facilities.
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\15\ See BP West Coast Products at 6; NGSA at 3.
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19. In addition, BP West Coast Products asserts that the inquiry in
Docket No. PL05-5-000 was prompted by ex parte communications to the
Commission and therefore no determinations of any specific income tax
issues should be made in this proceeding. It further asserts that the
partners investing in SFPP's parent entities will rarely pay taxes on
the income generated by that partnership and that many such master
limited partnerships (MLP) are intended to act as tax shelters that
remove cash from existing pipelines. BP West Coast Products concludes
that providing MLPs an income tax allowance is not necessary to
encourage new investment and that this should be done by providing an
increased pre-tax rate of return.
20. At bottom, these commentors base their argument on three
central points in
[[Page 25821]]
the BP West Coast opinion. The first is that ``where there is no tax
generated by the regulated entity, either standing alone or as part of
a consolidated group, the regulator cannot create a phantom tax in
order to create an allowance to pass-through to the rate payer.''\16\
The second is that it is not ``the business of the Commission to create
a tax liability where neither an actual nor estimated tax is ever going
to be paid or incurred on the income of the utility in the rate making
proceeding.'' \17\ The third is even if an income tax allowance is
necessary to implement a congressional mandate designed to encourage
investment in public utility facilities, the court concluded was
inadequate to create an allowance for fictitious taxes.\18\
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\16\ BP West Coast at 1290.
\17\ Id. at 1292.
\18\ Id. at 1292-93.
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D. Comments Supporting a Tax Allowance for All Entities
21. Twenty-four commentors \19\ support a tax allowance for all
entities investing in public utility enterprises. These commentors
start from the premise that the court did not have before it the
realities of partnership or LLC taxation and as such did not address
them. These commenters thus believe there is no barrier to considering
the issue of tax allowances for partnerships in light of the fuller
record presented in this proceeding. In fact, some state that this
proceeding is an opportunity to reconsider the Commission's Lakehead
decision, which they believe was incorrect, and to return to the
Commission's pre-Lakehead policies. In this regard, they conclude,
contrary to the court's statement in BP West Coast and the Commission's
Lakehead decision, income taxes are not like all other costs. Unlike
operating expenses such as office supplies, rent, or wages, they argue
that income taxes are imposed on, or imputed to, a public utility's
income, and as such income taxes are not a cash deduction from
operations. Because the income tax allowance is imputed, it is grossed-
up on the utility's allowable dollar return rather than functioning as
a charge against operating income. Thus, the income tax allowance is a
function of the equity return, and in turn generates the cash flow that
is used to pay the utility income taxes.\20\
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\19\ Alaska Gas Transmission Company, LLC; American Gas
Association (AGA); Association of Oil Pipe Lines (AOPL); American
Transmission Company, LLC; Duke Energy Corporation; Edison Electric
Institute and the Alliance of Energy Suppliers, filing jointly;
Enbridge Inc. and Enbridge Energy Partnerships; Enterprise Products
Partners, L.P.; Guardian Pipeline; Hardy Storage Company, LLC;
INGAA; Interested Gas Pipeline Partnerships; Kaneb Pipe Line
Operating Partnership, L.P.; Kayne Anderson Capital Advisors and
Kayne Anderson MLP (Kayne); Kinder Morgan Interstate Gas
Transmission, LLC, Trailblazer Pipeline Company, and Transcolorado
Gas Transmission Company, filing jointly; MidAmerica Energy Company;
Millennium Pipeline Company, L.P.; Plains Pipeline, L.P.; Publicly
Traded Limited Partnerships; Northern Border Pipeline Company; Shell
Pipeline Company, L.P.; Tortoise Energy Infrastructure Corporation;
Trans-Elect, Inc.; Trans-Elect NTD Path 15, LLC; Wisconsin Electric
Power Company and Edison Sault Electric Company, filing jointly; and
WPS Resources Corporation (WPSR).
\20\ Thus, for example, if gross revenues are $500, and
operating expenses such as rent, fuel, labor, interest, repairs, and
depreciation of $400 are charged against gross revenues, this would
leave operating income of $100. Assuming this equals the allowed
equity return, the corporate tax on this $100 would be $35. The $100
is therefore grossed up to approximately $154 to leave a $100 return
after payment at an income tax rate of 35 percent. See Northern
Border at 5-7 and 16; INGAA at 16.
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22. Proceeding from the premise that income taxes are an imputed
cost on income, these twenty-four commentors assert that whether the
entity is a corporation or a partnership, there is an actual or
potential income tax liability generated by utility income. In turn, it
is utility income that generates the cash flow used to pay the income
taxes. They claim that this is true whether the income tax is actually
paid by a corporation as the first tier investor, or the partners of a
partnership as the first-tier investors. They define a first tier
investor is one that invested funds in assets that are generating the
public utility income. These commentors stress that the critical point
is that while a partnership owns the public utility assets, it is a
flow-through entity whose income is taxed not at the partnership level,
but is taxed to and paid by the individuals or entities that own the
partnership interests.
23. Thus, they state that in the case of a partnership, the
partners include the utility income in their income tax returns and the
tax on utility income is paid at that point.\21\ The tax on this income
is paid whether or not cash distributions are made to the partners. In
contrast, a corporation that owns a public utility asset is the
taxpaying entity on the income generated by utility income. These
commentors assert that, as with a partnership, the tax on this first
tier income is paid whether or not dividends are paid to the
corporation's shareholders. The commentors therefore assert that there
is no phantom tax liability on partnership income. This is because the
tax liability on utility income is real, but it is paid by the partners
rather than by a corporation that functions as a separate taxpaying
entity.
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\21\ The individual partner files a Form1040 tax return and pays
the marginal individual tax rate on the utility income. The
corporate partner files a Form 1120 tax return and pays the marginal
corporate tax on the utility income. At the current time the maximum
marginal tax rate in both cases is 35 percent. See EEI's comments at
10-11 for a concise summary of partnership tax law and filing
procedures.
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24. These commentors also start from the basic regulatory premise
that a utility must earn a return comparable to that of investment
opportunities of similar risk if it is to attract investment.\22\ They
state that concept refers to the after tax, not the pre-tax, return to
the investor in the utility assets is the standard used in public
utility rate making regardless of the form of the ownership. Thus, if
the after tax return must be 12 percent to attract capital, then all
first tier investors in the utility assets must have a reasonable
opportunity to earn a 12 percent after tax return if the utility is to
attract capital. If partnerships are not permitted a tax allowance on
utility income, then cash will not be generated to pay the taxes due on
that utility income, and the partnership form of ownership would not be
competitive with the corporate form.
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\22\ F.P.C. v. Hope Natural Gas, 320 U.S. 591, 603 (1943).
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25. These commentors also provide various numerical examples of how
income tax returns would differ if partnerships are not provided a tax
allowance. Assuming that $100 is the after tax return required return
to attract capital, the court's decision would permit a tax allowance
sufficient to cover the 35 percent maximum corporate tax that would be
paid on corporate income. The gross-up to achieve the after-tax return
is about 54 percent and generates the cash flow to pay the tax. Thus,
after the corporate income tax is paid, the after-tax return is
$100.\23\
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\23\ See INGAA at 16-17; EEI at 13-14; Northern Border at 3-5,
7-8.
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26. If a partnership is permitted an income tax allowance, the
result is the same because the maximum personal income tax allowance is
also 35 percent. As with a corporation, the income tax allowance could
provide the individual partners with the cash to pay the taxes on
utility income, and therefore results in an after tax return of $100,
the allowed regulatory return. However, if an income tax allowance is
not allowed the partnership, then the partners must pay a $35 income
tax on $100 of utility income, leaving them with only an after-tax
return of $65. Therefore these commentors conclude that partnerships
must be granted an income tax allowance to make the partnership and
corporate business forms equally
[[Page 25822]]
attractive because the tax implications are the same.
27. These commentors also explore some secondary tax factors to
demonstrate the need for a partnership tax allowance if such entities
are to be a competitive vehicle for investments. While taking some
pains to avoid the double taxation issue discussed by the Court of
Appeals, they point out that without an income tax allowance
partnerships are not competitive with corporations for the individual
investor who files a Form 1040 income tax return. As noted in the
previous example, without a partnership income tax allowance, the after
tax return to a corporate investor is $100 and to the partnership
investor it is $65. Assuming that that the corporation pays out all
$100 in dividends, the income tax for the Form 1040 individual investor
is $15, with a resulting after tax return of $85.
28. Thus, they assert, for a Form 1040 individual investor who has
the option of investing either in a corporation or partnership, the
partnership is not competitive if, all other things being equal, there
is no partnership tax allowance. Moreover, if a corporation owns less
than 80 percent of a subsidiary corporation, the subsidiary's dividends
are taxed. Pursuing the previous numerical example, if the ownership is
greater than 20 percent or less than 80 percent, the 20 percent of the
subsidiary's dividends are taxed, or a 7 percent tax differential at
the 35 percent bracket. If the ownership is less than 20 percent, 30
percent of the subsidiary's dividends are taxed, or a 9.5 percent tax
differential at the 35 percent rate. This increases the cost of
participating in large projects in which risk sharing is a
consideration.
29. These commentors also assert that there are other significant
administrative and commercial advantages to partnerships beyond
facilitating risk sharing. Benefits include the ability of some
entities, such as municipalities or public transmission owners, to
participate in partnerships, but not corporations, avoiding the expense
involved in corporate charters, by-laws, shareholder meetings, and
greater flexibility in making contributions in-kind and in distributing
of earnings. They also argue that Congress clearly intended that
utility firms were to be eligible for partnership treatment in order to
encourage investment, and that the court's ruling undercuts this
important purpose.
30. Finally, these commentors assert that numerous large public
utility investments have been made in recent years relying on the tax
allowance to provide part of the required after-tax return.\24\ They
note that as was discussed in the recent Trans-Elect order,\25\ denying
a tax allowance would significantly reduce the expected returns that
were the basis for that badly needed investment. They provide lists of
numerous publicly traded partnerships that have substantial amounts of
equity, and assert that some of these partnerships have made
significant additional investments in reliance on the income tax
allowance.\26\ For these reasons these commentors conclude that all
entities investing in utility operations, and generating utility
income, should be permitted an income tax allowance. As discussed in
the WPPI and EEI comments, the size of the allowance would be
determined by the weighted maximum tax rate of the partners involved.
Any problems of over-or under recovery would be adjusted within the
partnership structure to assure that the benefits of any income tax
allowance would not flow to a partner that had no actual or potential
income tax liability.
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\24\ These commentors include Algonquin Gas Transmission, LLC;
Alliance Pipeline, L.P; ATLLC; East Tennessee Natural Gas, LLC; Egan
Hub Partners, L.P.; Enbridge Pipeline; Horizon Pipeline Company,
LLC; Great Lakes Natural Gas Pipeline; Green Banks Gas Pipeline,
LLC; Gulfstream Natural Gas Pipeline; Iroquois Gas Transmission
Company; Islander East Pipeline Co, LLC; Kinder Morgan Interstate
Gas Transmission, LLC; Maritimes & Northeast Pipeline; Market Hub
Partners, L.P.; METC; Moss Bluff Hub Partners, L.P; North Baja
Pipeline LLC; Portland Natural Gas Transmission System; Texas East
Gas Transmission, LLP; TransCanada Corporation; Trans-Elect ND-15;
Tuscarora Gas Transmission Company; Saltville Gas Storage Company,
L.L.C; and Shell Pipeline Company.
\25\ Trans-Elect NTS Path 15, LLC, 109 FERC ] 61,249 (2004)
(Trans-Elect).
\26\ See comments of: Duke Energy Corporation at 9-10, 30;
Enbridge Inc and Enbridge Energy Partners at 4-5; Gas Pipeline
Partnerships at 2-4; Millennium Pipeline Company, L.P. at 2;
Northern Border Pipeline Company at Appendix A; Publicly Traded
Partnerships at 13-14.
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III. Discussion
31. The issue is under what circumstances, if any, an income tax
allowance should be permitted on the public utility income earned by
various public utilities regulated by the Commission. As stated
earlier, while the court's decision in BP West Coast only addressed the
particulars of a certain oil pipeline, the numerous comments submitted
here indicate that partnerships or other pass-through entities are used
pervasively in the gas pipeline and electric industries as well. Upon
review of the comments, there appear to be four possible choices: (1)
Provide an income tax allowance only to corporations, but not
partnerships; (2) give an income tax allowance to both corporations and
partnerships; (3) permit an allowance for partnerships owned only by
corporations; and (4) eliminate all income tax allowances and set rates
based on a pre-tax rate of return.
32. Given these options, the Commission concludes that it should
return to its pre-Lakehead policy and permit 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 that income from those assets. Thus a tax-
paying corporation, a partnership, a limited liability corporation, or
other pass-through entity would be permitted an income tax allowance on
the income imputed to the corporation, or to the partners or the
members of pass-through entities, provided that the corporation or the
partners or the members, have an actual or potential income tax
liability on that public utility income. Given this important
qualification, any pass-through entity seeking an income tax allowance
in a specific rate proceeding must establish that its partners or
members have an actual or potential income tax obligation on the
entity's public utility income. To the extent that any of the partners
or members do not have such an actual or potential income tax
obligation, 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.\27\
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\27\ This is a technically complex issue that would be addressed
in individual rate proceedings as suggested by EEI and WPPI.
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33. In reaching this conclusion, the Commission expressly reverses
the income tax allowance holdings of its earlier Lakehead orders. As
stated in EEI's comments, Lakehead mistakenly focused on who pays the
taxes rather than on the more fundamental cost allocation principle of
what costs, including tax costs, are attributable to regulated service,
and therefore properly included in a regulated cost of service.\28\
Relying on BP West Coast, some commenters assert that because a pass-
through entity pays no cash taxes itself, this results in a phantom tax
on fictional public utility income. However, the comments summarized in
sections A and D of Part II of this policy statement
[[Page 25823]]
demonstrate that this assumption was incorrect. While the pass-through
entity does not itself pay income taxes, the owners of a pass-through
entity pay income taxes on the utility income generated by the assets
they own via the device of the pass-through entity.\29\ Therefore, the
taxes paid by the owners of the pass-through entity are just as much a
cost of acquiring and operating the assets of that entity as if the
utility assets were owned by a corporation. The numerical examples
discussed in sections A and D of Part II of this policy statement also
establish that the return to the owners of pass-through entities will
be reduced below that of a corporation investing in the same asset if
such entities are not afforded an income tax allowance on their public
utility income.\30\
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\28\ EEI comments at 8. In support of this point several
commenters cite to City of Charlottesville, supra, note 12, for the
proposition that a tax cost involves real taxes but not necessarily
require that cash taxes be paid by the regulated entity. See EEI at
11-13; INGAA at 12-13; Joint Comments of the Interested Gas Pipeline
Partnerships at 10-12; AOPL at 8-9.
\29\ The comments and numerical examples submitted by the EEI,
INGAA, and Northern Border demonstrate that under partnership law
the partners, or members, of pass-through entities pay taxes on the
public utility income of the operating entities that they control
through the partnership or other pass-through entity. See EEI at 13-
15; INGAA at 15-17; Northern Border at 5-8; Shell Pipeline Company
LP at 4; and WPS Resources at 14-16.
\30\ The record suggests that there is a substantial amount of
existing investment at issue in this proceeding. See Duke Energy at
2 ( 75 percent of $14.4 billion in energy infrastructure invested
for the years 2001 through 2003 is in pass-through entities);
Enbridge, Inc. at 4 ( ownership interests in over 20,000 miles of
crude oil, petroleum products, and natural gas pipelines);
Enterprise Products Partners, L.P. at 1 (enterprise value of
approximately $14 billion); Kaye Anderson at 1 (in excess of $1
billion in MLP equity); Publicly Traded Partnerships at 1-2, 13
(Figure 1 and text, market capitalization of publicly traded
partnerships of $47.3 billion in 2004), and at 14, table of publicly
traded partnerships owning and operating energy pipelines (market
capital $38.5 billion).
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34. As several commentors point out, a detailed discussion of the
realities of partnership tax practice was not before the court when it
reviewed the Opinion No. 435 orders. Because public utility income of
pass-through entities is attributed directly to the owners of such
entities and the owners have an actual or potential income tax
liability on that income, the Commission concludes that its rationale
here does not violate the court's concern that the Commission had
created a tax allowance to compensate for an income tax cost that is
not actually paid by the regulated utility. As explained in detail by
the comments summarized in sections A and D of Part II of this order,
the reality is that just as a corporation has an actual or potential
income tax liability on income from the first tier public utility
assets it controls, so do the owners of a partnership or LLC on the
first tier assets and income that they control by means of the pass-
through entity.
35. The first tier income involves the investors in the pass-
through entity holding the specific physical assets that are generating
the public utility income that results in a potential or actual income
tax liability. In the case of Trans-Elect, this would be the investment
that the partnership made in the upgrade to the Path 15 transmission
line in California. As discussed in Trans-Elect, supra, the owners of
Trans-Elect NTD Path 15, LLC, are a Subchapter C corporation (PG&E) and
one LLC, Trans-Elect, LLC.\31\ If no income tax allowance is permitted
on Trans-Elect NTD Path 15's public utility income, the return to the
investing entities would be less than if PG&E had invested directly in
the line.
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\31\ Trans-Elect, supra, note 8, at PP 2-4. Trans-Elect develops
merchant transmission lines. Trans-Elect comments at 1-2.
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36. As set forth in the previously cited examples provided in the
comments discussed in section D of Part II of this policy statement,
termination of the allowance would clearly act as a disincentive for
the use of the partnership format for two reasons. First is the
difference in the nominal return itself. The second is that the income
taxes paid by two corporations investing in this situation would
increase because one or both would not be able to benefit from the tax
advantages of a consolidated income tax return.\32\ It should be noted
that if such first tier assets are owned only by Subchapter C
corporations, their rates would include an income tax allowance
designed to recover the 35 percent maximum corporate marginal tax
rate.\33\ The same result obtains if the assets are owned by a
partnership or an LLC that is in turn owned either by Subchapter C
corporations or by individual investors.
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\32\ As discussed in the comments, if a Subchapter C corporation
owns 80 percent or more of a subsidiary, there is no income tax paid
by the subsidiary. All taxation is at the parent level through the
use of a consolidated return. See Northern Border at 6-7 and 11-12;
INGAA at 15-17.
\33\ This analysis suggests that if partnerships and limited
liability companies are not permitted to have an income tax
allowance, there are strong incentives to shift to the taxable
corporate ownership form. This could be done by converting a
partnership to an LLC and then electing to have that entity taxed as
a Subchapter C corporation. Once this was done, then the newly
taxable entity, which would be operating the very same assets as it
did as a pass-through entity, would be entitled to a 35 percent
income tax allowance. Cf. AOPL at 9.
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37. Thus, the policy the Commission is adopting should not result
in increased costs to public utility ratepayers, and may actually
reduce them if a partnership or LLC has a lower weighted marginal tax
rate and fewer administrative expenses than the normal corporate
ownership form.\34\ The Commission therefore concludes that, as is
argued by the commentors urging an income tax allowance for all public
utility entities, providing an income tax allowance to partnerships in
proportion to the interests owned by entities or individuals with an
actual or potential income tax liability does not create a phantom
income tax liability. The fact that some partnerships or LLCs may be
used for financial investments rather than for making infrastructure
investments does not warrant a different policy result here.\35\
Moreover, the Commission emphasizes that the primary rationale for
reaching the conclusion here is to recognize in the rates the actual or
potential income tax liability ultimately attributable to regulated
utility income. Having concluded that this will not result in phantom
income taxes, it is then legitimate to conclude that the result
[[Page 25824]]
here will facilitate important public utility investments such as that
made by Trans-Elect NTD Path 15, LLC in the Path 15 upgrade.
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\34\ As discussed in the WPPI and EEI comments, if a partnership
or LLC has municipal governments as some of the partners or LLC
members, the tax allowance is reduced because municipalities and
their operating entities have no actual or potential income tax
liability on utility income.
\35\ The partners of master limited partnerships have actual tax
liability for any income recognized by the partnership. However,
distributions may substantially exceed partnership book income. Such
distributions do have an ultimate income tax liability depending on
the status of the capital account of the individual partners. This
matter can present complex allocation and timing issues that would
be addressed in individual rate proceedings. However, a simple
numerical example can illustrate the basic principles. For example,
assume that an individual invests $100 in a partnership and obtains
a ten percent interest in that partnership. This establishes a
partnership account (or basis) for the individual of $100. During
year one of that investment the partnership has $100 in income
before depreciation and depreciation of $70. The partnership
therefore has net income of $30 and also makes a distribution of
$100. Since the individual partner owns ten percent of the
partnership, that partner must declare $3 in income on the
individual's 1040 tax form, but does not pay taxes on the $10
distribution made to that partner.
The capital account of the individual partner is adjusted as
follows. Ten percent of the partnership income before depreciations
(or $10) is allocated to the individual partner and is added to that
partner's account. Ten percent of the partnership depreciation, or
$7, is deducted from the account, as is the cash distribution. The
individual's partnership account therefore stands at $93 ($100+$10-
$10-$7). In year two the partnership income is zero and no
distributions are made, so the individual's partnership account is
unchanged. However, that individual partner sells the partnership
interest for $105. This difference is taxable as follows. Since $7
of the sale price is a gain above the year 2 partnership account
level of $93, it will be taxed as income. This results in a tax on
the cash that was distributed in the prior year but for which no
income tax was paid at that time. Depending on the nature of the
depreciation taken, the $7 may be taxed as ordinary income through
the operation of various recapture provisions. The additional $5 is
also income and is also taxed, most likely at the capital gains rate
since it is gain in excess of the partner's original capital
investment of $100.
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38. In retrospect, it was the Commission's failure to distinguish
between first and second tier income that lead to the double taxation
rationale that the Commission incorrectly advanced in Lakehead.
Dividends paid to the common stock investor and by the corporate
investor in a pass-through entity are second tier income to such a
common stock investor. As such, an income tax is paid by the investor
in addition to the corporate tax that is due on the first tier income.
In contrast, first tier income flows either to the corporation, a
corporate partner, or individual partners (or LLC members) and is taxed
at that level. To the extent Lakehead either concluded or assumed that
dividend payments and income, and partnership distributions and income,
have the same ownership and income tax characteristics, this is simply
incorrect as a matter of partnership and income tax law.\36\ The court
summarized this situation succinctly when it stated that presumably
both corporate owners and individuals would pay taxes on public utility
assets they control. Similarly, like a Subchapter C corporation,
partners may have deductions or losses that offset the income from a
specific public utility asset or which may neutralize the operating
income from the asset itself. But this does not preclude such a
corporation from obtaining an income tax allowance under the
Commission's stand-alone doctrine.\37\ Just as there are no rational
grounds for granting an income tax allowance on partnership interests
owned by a corporation and denying one to those owned by individuals,
there are no rational grounds for reaching a different conclusion for
the deductions and offsets for taxpaying partners or LLC members.
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\36\ See ATCLLC at 5.
\37\ See City of Charlottesville, supra, note 12.
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39. The Commission further concludes that the alternatives listed
at the beginning of this Part III of this policy statement are not
practical or are inconsistent with the court's remand. First the
Commission agrees with the court's conclusion in BP West Coast that the
Commission in Lakehead did not articulate a rational ground for
concluding that there should be no tax allowance on partnership
interests owned by individuals, but that there should be one for
partnership interests owned by corporations. As the court stated,
presumably individual partners pay taxes on their public utility income
just as corporate partners pay income tax on theirs. The comments
summarized in sections A and D of Parts II of this order affirm that
common sense observation. The court's rejection of Lakehead likewise
establishes why the Commission cannot simply limit income tax
allowances to partnerships that are wholly owned by corporations, since
doing so in effect denies a tax allowance to the partners of a
partnership with no corporate ownership.
40. Similarly, there is no rational reason to limit the income tax
allowance to public utility income earned by a corporation. Public
utility income controlled directly by an individual may also be taxed.
The partnership entity is simply an intermediate ownership device that
leads to the same tax result. Since both partners and Subchapter C
corporations pay income taxes on their first tier income, the
inconsistency that undermined Lakehead applies here as well. Finally,
the comments rightly suggest that it would be difficult to establish
rates based on a pre-tax rate of return. If the Commission were simply
to raise the rates to equalize the pre-tax and after-tax returns, all
this would do incorporate a presumed marginal income tax rate into the
rate structure. The result is the same for the rate payer although the
nominal rate of return is much higher. Moreover, most comparable
securities trade on the basis of a corporation's after-tax return on
its public utility income.\38\ Thus, it would be hard to determine what
the appropriate pre-tax return should be based on traded equities
alone. Since it is impractical not to give an income tax allowance to
any jurisdictional entities due to the problems of determining an
appropriate pre-tax rate of return, the Commission again concludes that
an income tax allowance should be afforded all jurisdictional entities,
provided that the owners of pass-through entities have an actual or
potential income tax liability.
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\38\ As discussed, the investor then receives a dividend and
pays a second tax on that income to determine the investor's after
tax return. This is somewhat less than the return from a partnership
interest that benefits from an income tax allowance.
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41. There are three final points that should be discussed in
addressing the effect of the court's remand. First, the court concluded
that denying a partnership an allowance on the proportion of
partnership interests owned by individuals would not prevent over-
recovery by such individuals, since any tax savings would be
distributed in proportion to all the partnership interests. The
Commission recognizes that rate payers should not incur the expense of
an income tax allowance to the extent that an owning partner or LLC
member has no actual or potential income tax liability for the income
generated by the interest it owns. As WPPI and ATCLLC explain, this can
be avoided by limiting the income tax allowance to a blended rate that
reflects the income tax status of the owning interest.\39\ The use of
the weighting approach assures that the rate payers will not be charged
more than the actual tax cost the investors incur regardless of the
ownership form. The problems of over- and under-recovering alluded to
in the court's order can be addressed through the distribution
provisions of the partnership agreement.\40\
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\39\ WPPI at 5-6 and 12-13; ATCLLC at 6.
\40\ The court was concerned that the income tax allowance
granted for corporate partners would increase the cash available for
distribution to all partners, thus providing an increased return to
the individual partners that the Lakehead doctrine was intended to
prevent. Adjustments within the partnership agreement should assure
that this does not result while preserving the incentives to
establish flexible investment vehicles.
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42. Second, whether a particular partner or LCC member has an
actual or potential income tax liability, and what assumptions, if any,
should determine the amount of the related tax rate, are matters that
should be resolved in individual rate proceedings. This is a fact
specific issue for which the relative data is uniquely within the
control of the regulated entity. Thus, any pass-through entity desiring
an income tax allowance on utility operating income must be prepared to
establish the tax status of its owners, or if there is more than one
level of pass-through entities, where the ultimate tax liability lies
and the character of the tax incurred. This could be done through
determining the distribution of ownership interests at the end of the
standard test year. Finally, some parties assert that this proceeding
is tainted by ex parte communications that preceded the issuance of the
Commission's December 2, 2004 notice of inquiry. These are without
merit as the relevant communications were filed in the appropriate
dockets and the Commission's notice of inquiry provided all interested
parties an opportunity to comment. The decision here is based on the
record developed by those comments.
The Commission orders:
The income tax allowance policy adopted in the body of this policy
statement shall be applied in pending and future rate proceedings of
public utilities subject to the Commission's rate jurisdiction.
[[Page 25825]]
By the Commission.
Linda Mitry,
Deputy Secretary.
[FR Doc. 05-9649 Filed 5-13-05; 8:45 am]
BILLING CODE 6717-01-P