Federal Energy Regulatory Commission, Department of Energy.
Notice of Inquiry.
Following the decision of the U.S. Court of Appeals for the District of Columbia Circuit in United Airlines, Inc., et al. v. Federal Energy Regulatory Commission, 827 F.3d 122 (D.C. Cir. 2016), the Commission seeks comment regarding how to address any double recovery resulting from the Commission's current income tax allowance and rate of return policies.
Initial Comments are due February 6, 2017, and Reply Comments are due February 27, 2017.
Comments, identified by docket number, may be filed in the following ways:
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- Electronic Filing through http://www.ferc.gov. Documents created electronically using word processing software should be filed in native applications or print-to-PDF format and not in a scanned format.
- Mail/Hand Delivery: Those unable to file electronically may mail or hand-deliver comments to: Federal Energy Regulatory Commission, Secretary of the Commission, 888 First Street NE., Washington, DC 20426.
Instructions: For detailed instructions on submitting comments, see the Comment Procedures Section of this document.
FOR FURTHER INFORMATION CONTACT:
Glenna Riley (Legal Information), Office of the General Counsel, 888 First Street NE., Washington, DC 20426, (202) 502-8620, Glenna.Riley@ferc.gov.
Andrew Knudsen (Legal Information), Office of the General Counsel, 888 First Street NE., Washington, DC 20426, (202) 502-6527, Andrew.Knudsen@ferc.gov.
James Sarikas (Technical Information), Office of Energy Markets Regulation, Federal Energy Regulatory Commission, 888 First Street NE., Washington, DC 20426, (202) 502-6831, James.Sarikas@ferc.gov.
Scott Everngam (Technical Information), Office of Energy Markets Regulation, Federal Energy Regulatory Commission, 888 First Street NE., Washington, DC 20426, (202) 502-6614, Scott.Everngam@ferc.gov.
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1. The Commission seeks comments regarding how to address any double recovery resulting from the Commission's current income tax allowance and rate of return policies. This Notice of Inquiry (NOI) follows the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) holding in United Airlines, Inc., et al. v. Federal Energy Regulatory Commission that the Commission failed to demonstrate that there is no double recovery of taxes for a partnership pipeline as a result of the income tax allowance and return on equity (ROE) determined pursuant to the discounted cash flow (DCF) methodology.
Accordingly, the Court remanded the decisions to the Commission to develop a mechanism “for which the Commission can demonstrate that there is no double recovery” of partnership income tax costs.
2. The Commission recognizes the potentially significant and widespread effect of this holding upon the oil pipelines, natural gas pipelines, and electric utilities subject to the Commission's regulation. The importance of the income tax policy for partnership entities extends well-beyond the particular interests of the parties to the United Airlines proceeding. The Commission also recognizes that additional industry comment may provide further insight into the relationship between a partnership's income tax allowance and the Commission's DCF methodology. Accordingly, this NOI seeks further information as the Commission re-evaluates its policies following the United Airlines decision. Initial Comments are due February 6, 2017, and Reply Comments are due February 27, 2017.
3. This proceeding involves the relationship between the Commission's income tax allowance and ROE policies. Both have evolved in the past two decades to address the emergence of partnership entities in FERC-regulated industries, particularly Master Limited Partnerships (MLPs) that own oil and natural gas pipeline assets.
A. The MLP Business Model
4. An MLP is a publicly traded partnership.
In order to be treated as an MLP for Federal income tax purposes, an MLP must receive at least 90 percent of its income from certain qualifying sources, including natural gas and oil pipelines.
5. MLPs consist of a general partner, that manages the partnership, and limited partners, that provide capital and receive cash distributions. MLP limited partner units are traded on public exchanges, just like corporate stock shares.
Based upon the MLP's partnership agreement, MLPs generally (a) distribute most “available cash flow” to the general and limited partners in the form of quarterly distributions, and, in a separate calculation, (b) allocate to the general and limited partners net partnership income for income tax purposes.
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6. Quarterly cash distributions received by a partner are not equivalent to the partner's share of the MLP's taxable income. MLPs are pass-through entities and each partner is personally responsible for paying income taxes on the partnership's net taxable income.
For tax purposes, the partnership agreement allocates to each partner a share of the partnership's taxable income.
Deductions, including depreciation, losses, and credits, may substantially offset the taxable income. As a result, a partner may have no net taxable income in a given year.
7. In contrast, the partner may receive a quarterly distribution whether or not it is allocated a positive net income tax liability for that period. The quarterly distributions are considered to be a return of capital, which reduces the partner's basis in the MLP units and is only taxed at the time of distribution if the partner's adjusted basis falls to zero.
The investor's original basis (the price paid for the units) is adjusted downwards by cash distributions and allocations of deductions, and is adjusted upwards by allocations of income. When the units are sold, the taxable gain is the sales price minus the adjusted basis.
The portion of the gain attributable to basis reductions for prior depreciation deductions is “recaptured” and taxed as ordinary income rather than capital gain.
B. Return on Equity Policies
8. In Hope,
the Supreme Court stated that “the return to the equity owner should be commensurate with the return on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.” 
Since the 1980s, the Commission has used the DCF model to develop a range of returns earned on investments in companies with corresponding risks for purposes of determining the ROE for regulated entities.
9. Under the Commission's cost-of-service ratemaking methodology, the DCF model is used to determine a reasonable ROE that a regulated entity may recover in rates in addition to its costs. The purpose of the DCF methodology is to estimate the return required by investors in order to invest in the pipeline or utility whose rates are at issue.
To do this, the DCF model considers the range of returns that the market provides investors in a proxy group of publicly-traded entities with similar risk profiles.
10. The DCF model was originally developed as a method for investors to estimate the value of securities, including common stocks. It is based on the premise that “a stock's price is equal to the present value of the infinite stream of expected dividends discounted at a market rate commensurate with the stock's risk.” 
With simplifying assumptions, the DCF model results in the investor using the following formula to determine share price:
P = D/(k-g)
where P is the price of the stock at the relevant time, D is the current dividend, k is the discount rate (or investors' required rate of return), and g is the expected growth rate in dividends. For ratemaking purposes, the Commission rearranges the DCF formula to solve for “k”, the discount rate, which represents the rate of return that investors require to invest in the firm.
Under the resulting DCF formula, the required rate of return is estimated to equal current dividend yield (dividends divided by share price) plus the projected future growth rate of dividends:
k = D/P + g
11. The Commission compares the returns of proxy group entities on an after-entity-level-tax basis, rather than before-tax basis, because most comparable securities trade on the basis of an entity's after-tax return on its public utility income.
Based typically upon the median of the range of returns in the proxy group, the Commission determines the regulated entity's allowed ROE,
although the ROE may sometimes be adjusted upwards or downwards within the zone of reasonableness.
12. The Commission's proxy group criteria is based on the principle that entities included in the proxy group must be of comparable risk to the firm whose ROE is being determined in a particular rate proceeding.
As entities narrowly focused on providing oil and natural gas pipeline transportation have increasingly adopted the MLP business form, the Commission has included MLPs in the proxy group for natural gas and oil pipelines because those MLPs are likely more representative of predominantly pipeline firms than the diversified corporations otherwise available for inclusion in a proxy group.
The Commission uses the same DCF analysis for MLPs as for corporations, except that the Commission uses a lower long-term growth projection for MLPs than for corporations.
The Commission concluded that an MLP's quarterly distributions could be used to measure cash flows from the investment without any adjustment to remove return of Start Printed Page 94368capital.
The Commission explained that “since the DCF model uses the total unadjusted cash flows to determine the stock's value, it is theoretically inconsistent [with the DCF model] to use lower adjusted cash flows when using the DCF model to determine the return required by investors purchasing the stock.” 
C. Income Tax Policy
13. In May 2005, the Commission issued an Income Tax Policy Statement 
permitting an income tax allowance for all regulated entities (including corporations and partnerships), provided that the owners can show an actual or potential income tax liability to be paid on income from the regulated assets. The Commission continued its longstanding policy of permitting corporations to recover an income tax allowance because corporations themselves incur a corporate income tax liability. The Commission reasoned that while a partnership or other pass-through entity does not pay taxes, the partners incur an income tax liability on the partnership income. Accordingly, those income tax costs are appropriately included in rates.
The D.C. Circuit upheld this policy, in ExxonMobil,
explaining that the income tax liability of partners is attributable to the regulated entity and may be recovered in pipeline rates, provided that the partners have an actual or potential income tax liability.
14. In July 2016, in United Airlines,
the D.C. Circuit, reviewing a series of orders involving SFPP, L.P.,
held that the Commission failed to demonstrate that there is no double recovery of taxes for a partnership pipeline as a result of awarding that pipeline both an income tax allowance and a pre-investor-tax ROE pursuant to the DCF methodology.
The Court upheld ExxonMobil' s finding that a pipeline may recover partnership income tax costs so long as the partners have an actual or potential income tax liability,
but concluded that allowing partnerships to double recover those tax costs would be inconsistent with the Supreme Court's mandate in Hope.
15. The Court remanded the decisions to the Commission to develop a mechanism “for which the Commission can demonstrate that there is no double recovery” of partnership income tax costs.
The Court noted that the Commission may consider the options of removing any duplicative tax recovery for partnerships directly from the DCF ROE, or eliminating all income tax allowances and setting rates based on pre-tax returns.
16. The Court also directed the Commission to ensure parity between equity owners in partnership and corporate pipelines.
The Court did not find persuasive the Commission's argument that “any disparate treatment between partners in partnership pipelines and shareholders in corporate pipelines is the result of the Internal Revenue Code, not FERC's tax allowance policy.” 
II. Commission Questions
17. The Commission seeks comment regarding methods to allow regulated entities to earn an adequate return consistent with Hope 
that do not result in a double recovery of investor-level taxes for partnerships or similar pass-through entities.
18. Comments should consider the fundamental concerns presented by United Airlines and shipper litigants that permitting a partnership entity to have an income tax allowance results in a double recovery of investor-level tax costs because:
- The DCF methodology estimates the rate of return that an investor requires in order to invest in the regulated entity.
- As a general matter, potential investors evaluate whether to invest in an entity based on the returns they expect to receive after paying any applicable taxes on the investment income,
and thus, to attract capital, entities in the market must provide investors a return that covers investor-level taxes and leaves sufficient remaining income to earn their required after-tax return.
- Because the return estimated by the DCF methodology includes the cash flow necessary to cover investors' income tax liabilities and earn a sufficient after-tax return, the Commission's policy of allowing partnership entities to recover a separate income tax allowance may result in a double recovery.
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- While allowing a partnership entity to recover the partner-investors' tax costs is reasonable,
allowing a partnership to double recover those tax costs is not.
- Changes in the share price do not resolve the double recovery issue. MLP investors will demand the same percentage return on the share price whether or not a pipeline receives an income tax allowance. If an MLP obtains a new revenue source that increases its distributions to investors (such as an income tax allowance that increases its rates), the share price will rise until, once again, the investor receives the cash flow necessary to cover investors' income tax liabilities and earn a sufficient after-tax return.
- As opposed to an MLP pipeline, the double recovery issue does not arise for a corporation's income tax allowance. The corporation pays its corporate income taxes itself. Accordingly, although a return to investors must cover investor-level taxes and sufficient remaining income to earn their required after-tax return, the corporate income tax is not an investor level tax.
Thus, the corporate income tax cost recovered in the income tax allowance is not reflected in the return estimated by the DCF methodology.
19. In light of the above, the Commission invites comments regarding any proposed methods to adjust the income tax allowance policy or current ROE policies to resolve any double recovery of investor-level tax costs for partnerships or similar pass-through entities. Comments should provide a detailed explanation of any proposal, including evidentiary support and how any adjustment to the Commission's tax allowance and/or ROE policies should be specifically implemented. Comments should explain how the proposed approach would (a) resolve any double recovery of investor-level income tax costs for partnership entities, and (b) allow regulated entities to earn a sufficient return consistent with the capital attraction standard in Hope.
Comments should support any proposed methods with data, theoretical analyses, empirical studies, or any other evidence relevant to demonstrating the level of partner-investor tax costs reflected in the ROE estimated by the DCF methodology. Comments should address how these proposals apply to publically traded pass-through entities, such as MLPs and real estate investment trusts (REITS), as well other pass through entities, including closely held partnerships and joint ventures.
20. Comments should also address the practical application of their proposals. For example, to the extent a commenter advocates eliminating the income tax allowance for partnerships and relying on the ROE awarded the pipeline for the recovery of investor-level tax costs, its comments should address whether any changes to the Commission's ROE policies are necessary to ensure that the ROE reflects appropriate tax costs for the particular entity whose rates are at issue.
Alternatively, commenters could propose reducing the DCF return to remove all investor-level tax costs and rely on an income tax allowance to recover the investor-level tax costs. Commenters advocating this latter approach should explain how an adjustment to the DCF return could be made to remove investor-level tax costs for each entity in the DCF proxy group.
In addition, those commenters should describe how to determine the level of the income tax allowance for partnership entities.
As stated above, commenters should ensure that their proposals do not result in a double recovery of investor level income tax costs for partnership entities as required by United Airlines.
III. Procedure for Comments
21. The Commission invites interested persons to submit written comments on the issue identified in this Notice of Inquiry as discussed above. Comments are due February 6, 2017 and reply comments are due February 27, 2017. Comments must refer to Docket No. PL17-1-000, and must include the commenter's name, the organization it represents, if applicable, and its address. To facilitate the Commission's review of the comments, commenters are requested to provide an executive summary of their position. Additional issues the commenters wish to raise should be identified separately. The commenters should double space their comments.
22. The Commission encourages comments to be filed electronically via the eFiling link on the Commission's Web site at http://www.ferc.gov. The Commission accepts most standard word processing formats. Documents created electronically using word processing software should be filed in native applications or print-to-PDF format and not in a scanned format. Commenters filing electronically do not need to make a paper filing.
23. Commenters that are not able to file comments electronically must send an original of their comments to: Federal Energy Regulatory Commission, Secretary of the Commission, 888 First Street NE., Washington, DC 20426.
24. All comments will be placed in the Commission's public files and may be viewed, printed, or downloaded remotely as described in the Document Availability section below. Commenters on this proposal are not required to serve copies of their comments on other commenters.
IV. Document Availability
25. The Commission provides all interested persons an opportunity to view and/or print the contents of this document via the Internet through the Commission's Home Page (http://www.ferc.gov) and in the Commission's Public Reference Room during normal business hours (8:30 a.m. to 5:00 p.m. Eastern time) at 888 First Street NE., Room 2A, Washington, DC 20426.
26. From the Commission's Home Page on the Internet, this information is available in the Commission's document management system, eLibrary. The full text of this document is available on eLibrary in PDF and Microsoft Word Start Printed Page 94370format for viewing, printing, and/or downloading. To access this document in eLibrary, type the docket number (excluding the last three digits) in the docket number field.
27. User assistance is available for eLibrary and the Commission's Web site during normal business hours. For assistance, please contact the Commission's Online Support at 1-866-208-3676 (toll free) or 202-502-6652 (email at FERCOnlineSupport@ferc.gov) or the Public Reference Room at 202-502-8371, TTY 202-502-8659 (email at firstname.lastname@example.org).
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By direction of the Commission.
Issued: December 15, 2016.
Nathaniel J. Davis, Sr.,
[FR Doc. 2016-30970 Filed 12-22-16; 8:45 am]
BILLING CODE 6717-01-P