Inquiry Regarding Income Tax Allowances; Policy Statement on Income Tax Allowances, 25818-25825 [05-9649]

Agencies

• DEPARTMENT OF ENERGY
• Federal Energy Regulatory Commission

[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