Special Report: How Will the Tax Bills Affect Oil and Gas Pipelines?

The House and Senate have finally passed their respective tax bills. There are a host of differences between the two bills that need to be reconciled in a House-Senate conference committee, but there is one similarity: both bills will cut the corporate tax rate from 35% to 20%. However, there is a substantial difference in how the bills treat taxes owed on distributions from master limited partnerships (MLP), with the House bill reportedly dropping the rate paid by individuals to 25%, and the Senate bill leaving the rate at the current 39.6%. The ultimate impact on oil and gas pipelines can't quite be determined now, but there are certain developments to watch for during the next few weeks, as well as the next year:

• What will the final corporate rate be?
• What will the final rate be on distributions from MLPs? 
• How will the tax bills impact FERC's review of its MLP tax allowance policy for pipelines?
• Will FERC require pipelines to submit revised tariffs adjusting their rates to account for either of these changes -- or will FERC simply wait for the next rate case?

Pipeline Tariff Rates

Since 2005, FERC has allowed oil and gas pipelines to include the 35% Federal tax rate as a cost of service for purposes of calculating their tariff rates. If the tax bill reduces this tax rate, there will be a correlative reduction in a pipeline's total cost of service, which in a formal rate case, would result in a reduction in the tariff rate that the pipeline charges for its services. For example, the tariff rate filed by NEXUS in its application assumed a 35% federal corporate tax rate. If that rate is reduced to 20% in the final tax legislation, NEXUS's cost of service would be reduced by almost $40 million, which, in turn, would reduce the tariff rate on its Zone 1 service by approximately 8%.
However, for such a change in the rate to actually take effect, there would need to be formal action by FERC. Until such action occurs, a pipeline owned by a corporation could continue to collect its existing rate while paying the lower corporate tax rate.

The situation for pipelines organized as MLPs is not as straightforward, because as so-called "pass-through" entities, MLP's do not pay any tax at the entity level, but pass-through all of their income to the MLP's investors, who pay tax on that income under the tax rules applicable to the particular investor. Neither the House nor the Senate tax bill reduces the generally applicable personal tax rate to the 20% rate for corporations. However, reports are that the House bill will reduce the tax owed on MLP distributions to 25% from the current 39.6%.

FERC's Tax Allowance Policy

As discussed on our prior analysis, FERC is in the process of reviewing its current tax allowance policy, which was last revised in 2005. The current policy allows oil and gas pipelines, whether owned by a corporation or organized as an MLP, to include in their cost of service a federal income tax equivalent to the 35% corporate tax rate. Almost one year ago, FERC issued a request for comments with regard to its income tax allowance policy. The FERC request was in response to a decision by the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) in the United Airlines v. FERC case. In that case, the D.C. Circuit found that FERC did not provide adequate justification for allowing the pass-through entity to obtain a tax allowance in its cost of service when it paid no entity-level taxes.

The formal comment period in response to FERC's request ended in April of this year. FERC has not indicated when, or even if, it intends to act to revise its policy, and many of the comments urged it to leave the current policy in place. Those urging FERC to change its policy were almost unanimous in recommending that FERC prohibit pass-through entities such as MLPs from including any income taxes in their cost of service calculation.

Tariff Rate Reductions

The reduction in corporate tax rates and any change in FERC's tax allowance policy will not immediately result in reduced tariff rates. As acknowledged by some of the shippers on gas pipelines in their comments in response to FERC's tax policy request, any reduction in rates under the Natural Gas Act would only be prospective. Therefore, the American Public Gas Association urged FERC to "take action to protect consumers from continuing overcharges by immediately ordering ... each pass-through natural gas company to promptly make a compliance filing eliminating the income tax component from (and commensurately reducing) its rates.

The Natural Gas Supply Association (NGSA), which represents suppliers that produce and market natural gas, suggested a more measured approach which recommended a phased-in approach with rolling waves of section 5 cases, starting with those pipelines with the highest Return on Equity (ROE). But even the NGSA argued that it would be "unacceptable to simply wait for the individual MLP pipelines to initiate a Section 4 rate case, particularly since many pipelines have no future requirement to file a new rate case."

We would expect shippers to make similar demands of FERC once the federal tax rate is reduced. Any ordered changes in tariff rates would impact the income of those pipelines who do not have a high percentage of negotiated rate contracts, something that can be quickly determined for all pipelines in our platform. Our team recently completed ROE calculations for major natural gas pipelines, which could help you determine the companies that might be at risk if FERC were to adopt a phased-in approach, as suggested by the NGSA.

However, it is also possible that FERC could adopt the position put forth by the Interstate Natural Gas Association of America (INGAA) in its comments on FERC's MLP tax allowance policy. While INGAA vehemently argued that FERC should not make any changes to its tax allowance policy, INGAA also asked FERC to not be rash in implementing any revised policy. INGAA urged FERC to honor most recent rate settlements that are so-called "black box" settlements that do not specify the individual components of the pipelines' costs of service, including an income tax allowance, arguing that "FERC should protect the parties' expectations and interests in maintaining rate and service stability established in these settlements."

While it's possible that FERC would require immediate compliance filings by all pipelines following any change to the tax rate or the tax allowance policy, we view this as less likely than waves of section 5 cases, primarily because immediate compliance filings would overwhelm FERC rate staff. Even if FERC waits for rate cases to be filed, there are a number of pipelines that are expected to file this year. Our alerting service will notify you as soon as a rate case is filed.