North American Oil & Gas Pipelines

MAY 2018

North American Oil & Gas Pipelines covers the news shaping the business of oil and gas pipeline construction and maintenance in North America, including pipeline installation methods, integrity management innovations and managerial strategies.

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16 North American Oil & Gas Pipelines | MAY 2 018 "A tax loophole is something that benefits the other guy. If it benefits you, it is tax reform." — Russell B. Long As I write this column, the cherry blossoms are in full bloom, prompting some locals to skip work and join tourists in the annual pil- grimage to see the billowing, pink cherry trees encircling the Tidal Basin. Like many others, I'm also working on my taxes and trying to determine how the recent tax changes impact me. But by the time you read this, the cherry blossoms will be long gone and, with luck, my tax forms will be filed. Speaking of taxes, as the result of several related orders, the U.S. Federal Energy Regulatory Commission (FERC) will no longer permit pipelines owned by master limited partnerships (MLPs) to recover an income tax allowance in their cost-of-service rates and will examine the impact of recent corporate tax reductions on pipeline rates. These proceedings could lower the rates of oil and interstate natural gas pipelines. Let's begin by explaining what prompt- ed FERC to act. Back in 2008, an oil pipeline (SFPP, LP), which transported re- fined petroleum products, filed some rate changes with the commission. Shippers (including large airlines) argued that the rates should be lower, primarily because the pipeline was an MLP. To understand the argument, you need a little background information. To be- gin, partnerships don't pay income taxes; instead, the partners individually are re- sponsible for taxes based on their share of partnership proceeds. An MLP is a limited partnership that is publicly traded and, as such, is afforded the tax benefits of a partnership and the liquidity of publicly traded securities. In contrast to partnerships, corpora- tions pay income taxes. Accordingly, when developing a pipeline's cost-of-ser- vice rates, FERC has historically included a tax allowance in the pipeline's cost-of-ser- vice. Without the tax allowance, the pipe- line would be forced to pay taxes, but have no way to recover the tax cost; it would lose money, forcing investors to shy away. Over the years, more and more pipelines changed their ownership structure from corporations to partnerships, often MLPs. Yet FERC continued to provide partner- ship pipelines with a tax allowance, as long as the partners had a tax liability, in order to encourage capital formation and investment. So what was the shipper's beef in the oil pipeline proceeding? In wonk-speak, it involves the way FERC designs rates so that the regulated entity can attract capi- tal investment. In particular, the commis- sion uses the discounted cash flow (DCF) methodology to estimate a potential in- vestor's return (i.e., the money received from an investment), adjusted for the time value of money. Because investors must pay income tax- es on any earnings received from the part- nership, the DCF must be high enough to cover the investor's tax costs and provide a reasonable after-tax return on equity. And there's the rub: the pipeline shippers ar- gued that providing a tax allowance and using a DFC analysis essentially provided the MLP pipeline with a double recovery of income tax costs. Eventually, SFPP's rate proceeding made its way through the FERC admin- istrative litigation process and ultimately landed at the DC Circuit. In 2016, the court, in United Airlines, Inc. v. FERC, 827 F.3d 122 (D.C. Cir. 2016), agreed with the shippers and remanded the case to FERC to explain why the tax allowance did not grant partnership pipelines a windfall. In December 2017, President Don- ald Trump signed into law the Tax Cuts and Jobs Act. Significantly, the new law slashed the federal corporate income tax rate from 35 percent to 21 percent. As a result, the new federal tax rates are much lower than those in effect when FERC ap- proved pipeline rates years ago. In short, the tax reduction coupled with the Unit- ed Airlines decision led to calls for FERC action to reduce pipeline rates. In mid- March, FERC responded by issuing several companion orders. "It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the tax rates." — John F. Kennedy One, on remand from the DC Cir- cuit, FERC denied an income tax allow- ance to SFPP, the refined petroleum prod- ucts pipeline. This is a harbinger of things to come at FERC, especially because FERC contemporaneously issued a Policy State- ment (Docket No. PL17-1-000) finding that an impermissible double recovery re- sults from granting an MLP pipeline both an income tax allowance and a return on equity based on a DCF analysis. There are several implications for pipe- lines: 1.) all partnership pipelines seeking to recover an income tax allowance will need to address the double recovery con- cern, and 2.) oil pipelines organized as MLPs must reflect FERC's elimination of the MLP income tax allowance in their annual Form No. 6. Moreover, pipelines can't seek rehear- ing of the policy statement because the pipelines are not "aggrieved" under the law. The policy statement is just that, a WA S H I N G T O N WA T C H By Steve Weiler When the Tax Man Cometh, FERC Follows

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