Special Report - ADIT: What is it and Why Should You Care

Accumulated Deferred Income Taxes (ADIT) balances, which accumulate on the books of interstate natural gas pipelines, will be impacted by the Tax Cuts and Jobs Act and FERC's recent change to its MLP Income Tax Allowance Policy. But FERC has not yet decided how it will treat these balances. Contrary to what some in the industry have said, we do not believe that ADIT balances will result in pipelines issuing cash refunds to shippers. Nonetheless, the size of the ADIT balances for a particular pipeline and FERC's ultimate disposition of these balances could have a significant impact on the rates to be charged by a pipeline, should it choose to file or be brought in for a rate case. As detailed below, the higher a pipeline's ADIT balance is as a percentage of its rate base, the higher the risk that the pipeline's rates may come under scrutiny, and the greater any change to those rates may be.

What you need to know

ADIT arises from differences between the method of computing taxable income for reporting to the IRS and the method of computing income for regulatory accounting and ratemaking purposes. Most of these differences arise from the treatment of depreciation for rate purposes as compared to tax purposes. For tax purposes, natural gas pipelines are usually able to take advantage of accelerated depreciation, but they are required to use straight-line depreciation for rate purposes. Accelerated depreciation usually lowers income taxes payable during the early years of an asset's life, followed by corresponding increases in income taxes payable during the later years. The difference between the income taxes based on straight-line depreciation and under accelerated depreciation are reflected in the pipeline's ADIT.

The change in the corporate tax rate and the change in FERC's tax allowance policy will mean that ADIT balances that were accumulated during a time period when the pipeline anticipated that it would owe future taxes at 35% will have to be adjusted to reflect the fact that the pipeline will either be paying a 21% tax, or will no longer be entitled to take any tax into consideration for rate purposes.

On March 15, FERC issued a notice of inquiry (NOI) seeking comment on the following issues with respect to these excess ADIT balances, which shows this issue is far from settled:

• Whether, and if so, how pipelines should make adjustments so that the rate base may be appropriately decreased by excess ADIT;
• How to implement the requirement in the Tax Cut and Jobs Act that excess ADIT related to a pipeline's assets be returned to customers over the remaining useful life of the assets which created the ADIT;
• How quickly and in what manner to require the return to customers of excess ADIT that is not related to a pipeline's assets; and
• For MLPs and pass-through entities that FERC determines are no longer entitled to an income tax allowance, whether to eliminate ADIT altogether from the pipeline's cost of service, and whether any previously accumulated sums should be returned to ratepayers.

Why you should care

T he NOI made clear that pipelines are required to adjust their ADIT balances to account for the effect  of the change in tax rates in the period that the change is enacted, meaning that pipelines are required to re-measure their ADIT balances at the 21% rate and record a regulatory liability associated with excess ADIT that is likely to be returned to customers. In addition, the Form 501-G that FERC issued as part of its notice of proposed rulemaking regarding rate changes relating to federal income tax rate includes a line for amortizing excess ADIT and returning such amortized amounts to customers through a reduction in the income tax allowance.

It seems likely that the end result of this process will be treating excess ADIT in a manner similar to how FERC treated such balances after the 1986 tax cut. For pipelines still entitled to a tax allowance, this likely means that the excess ADIT will be moved to an account that will continue to reduce a pipeline's rate base, as the ADIT balance currently does, and that the excess will be amortized over the remaining useful life of the asset. As reflected in the Form 501-G, the amortization will likely be passed back to customers through a reduction in the income tax allowance going forward. It is also likely that a similar process will be followed for those pipelines that are no longer entitled to an income tax allowance. In this case, the entire current ADIT balance would be reduced to zero and the entire amount would be treated as excess ADIT.

A Hypothetical Example

We have modeled this treatment using a simple pipeline financial statement as presented in the charts below. First, if we assume that a pipeline has no ADIT balance, the Return on Equity (ROE) of the pipeline is impacted only by the tax cut and the change in income tax allowance.

Even under this scenario, the pipeline's ROE grows substantially as the tax rate changes or as the the tax allowance is eliminated entirely.

Second, as part of our tax white paper analysis, we calculated the ratio between excess ADIT and rate base for all of the pipelines included in that analysis. This excess ADIT to rate base ratio ranged from a low of 0.18% to a high of 21.79%. 

Using these as the bounds of determining the impact of ADIT flowing back to customers shows that the ADIT impact is significant when the ADIT balance is high compared to the rate base.

A chart showing an ADIT balance of only .18%:

At such low levels of ADIT, there is negligible impact. However, when we jump to an ADIT balance equal to 21.79% of the pipeline's rate base, the impact becomes substantial:

Approximately half of the 62 pipelines we analyzed for our tax cut white paper had "Excess ADIT" balances that exceeded 10% of their rate base. The following chart shows the impact of such an ADIT balance on our hypothetical pipeline's ROE.

We will continue following the impact of the ADIT issue as pipelines file their Form 2s later this month, and as they file their Form 501-Gs later this year.