Tax Issues Are Now in FERC's Court
The upheaval caused by FERC's multiple announcements in March concerning the tax allowance for all oil and natural gas pipelines continues unabated, as both Enbridge and Williams have announced plans to eliminate Master Limited Partnerships (MLP) from their corporate structure. Earlier this week, FERC received comments on the treatment of accumulated deferred income taxes (ADIT), which is the last set of comments FERC requested following its announcements in March.
While some view ADIT as the backwater of the tax changes wrought by the FERC's March announcements, commenters such as TransCanada made it clear that all of the issues are closely interrelated and that the "treatment of the ADIT offset, much less the disposition of alleged amortization obligations, will impact coverage ratios, capital structure, credit ratings and ultimately the risk which a pipeline experiences." So what are the contentious issues with ADIT, where will FERC land and what does that all mean?
ADIT, Explained
ADIT results from the timing differences between tax and "book," or regulatory, accounting. The most common difference that creates ADIT is methods for depreciating assets such as pipelines. In the early years of an asset's life, the ADIT balance grows as the accelerated depreciation allowed for tax purposes exceeds the straight-line book depreciation, but then the ADIT balance starts declining, once book depreciation exceeds tax depreciation. When an asset is fully depreciated for both book and tax purposes, the ADIT balance is zero. Many pipeline commenters made it clear that ADIT is not a cash balance, nor is it a "loan" from ratepayers. Instead, they reminded FERC of its prior, and in their mind, correct, characterization that ADIT represents a cost-free loan from the federal government in the form of accelerated depreciation.
What Should FERC Do With ADIT Balances For C Corporations?
The commenters all seem to agree that the way to address ADIT for C Corporations is more straightforward than for pass-through entities because of the uncertainty created by FERC's reversal of its policy regarding tax allowance for MLPs "like SFPP. ADIT of a C corporation should be treated as follows:
- Identify that portion of the current ADIT balance that will no longer be needed as a result of the change in tax rates from 35% to 21%;
- Move that portion of the ADIT balance to a separate account on the pipeline's books; and
- Amortize that balance over a period of time dependent on what caused the balance to be created.
Even in this simple process there is considerable room for substantive disagreements between the pipelines and their shippers. These issues are why many pipeline commenters have argued that FERC should not try to address ADIT generically, but rather should review the balances for each pipeline in the pipeline's next rate proceeding. However, as set forth below, we do expect FERC to try to address most of the issues on an industry-wide basis.
| Issue | Points of View | Likely FERC Resolution |
|---|---|---|
| Portion of ADIT Balance that Needs to Be Recharacterized or Eliminated |
Shippers - 14/35 of the current ADIT balance needs to be moved to an amortization account. Pipelines - only the portion of the ADIT that will be "returned to customers" needs to be moved to the amortization account. ADIT arising from assets supported with negotiated rate agreements would simply be removed from the account balance. |
FERC will universally define the amount to be moved to the amortization account but will require the pipelines to justify the amount recorded there in any future rate proceeding. |
| Should Interest Accrue on Portion Transferred to Separate Account? |
Shippers - interest should begin accruing on the excess ADIT. Pipelines - interest is inappropriate. |
FERC will not require interest to accrue on the amount transferred to the amortization account as the pipelines are not earning any return on that amount and any "regulatory lag" for amounts recorded in this account is similar to regulatory lag associated with all other costs of service. |
| Cash Refunds/Rate Surcharge |
Shippers - either a cash refund for the amount being amortized or a negative surcharge, both of which would be required without the need for a rate case. Pipelines - No basis for cash refunds or treatment other. |
FERC will not order cash refunds or create a surcharge for amortization of ADIT because this would be inconsistent with FERC's past practice. |
| When Should Amortization Begin? |
Shippers - amortization should not begin until the next rate filing by the pipeline. Pipelines - amortization should begin on January 1, 2018, when the tax change became effective. |
FERC will allow pipelines to begin amortizing the excess ADIT beginning on January 1, 2018. This treatment is beneficial to the pipelines since some of amortization will occur before it can be factored into a rate change through a rate proceeding. |
| How Quickly Should Amortization Occur? |
General Consensus - "plant-based" ADIT (also referred to as Protected ADIT), the excess ADIT should be returned to shippers over the remaining useful life of the assets that created it. Shippers - for non-plant based ADIT (Unprotected ADIT) a 3 to 5 year period Pipelines - Unprotected ADIT should be handled on a case by case basis. |
For Protected ADIT - LIKELY FERC will approve the use of either method for amortizing the excess ADIT, referred to as the Average Rate Assumption Method ("ARAM") or Reverse South Georgia Method, both of which return the excess ADIT to shippers over the remaining useful life of the assets, but onin a slightly different schedule. For Unprotected ADIT, which most companies claim is a minor part of the ADIT balances, FERC is likely to leave that for a case- by- case review because the reason for such balances can be varied. |
What Should FERC Do With ADIT Balances For Pass Through Entities?
The treatment of ADIT for pass-through entities, such as LLCs, LPs and MLPs, has an additional layer of complexity created by FERC's announced policy change regarding the income tax allowance for such entities.
Shippers basically take the position that these entities should be treated in the same manner as a C corporation that has a zero percent tax rate.
Pipelines argue that FERC should simply return to its previous tax allowance policy. But if FERC persists in denying a tax allowance for any entity, the pipelines argue that the ADIT balance for such an entity should be eliminated along with the tax allowance. There are a number of arguments offered in support of this elimination of ADIT without any credit to the shippers. The two most persuasive arguments are (1) that excess ADIT is only created from changes in the tax rate, and not changes in tax allowance policy, and (2) that to require a pipeline that no longer has a tax allowance to return any excess ADIT to shippers would be retroactive rate-making, which is not permitted under FERC statutes for both gas and oil pipelines.
FERC has indicated that it is considering the rehearing requests filed with respect to its revised tax allowance policy, and we expect that it will at least clarify what it means by the term "MLP like SFPP." We also expect it to clarify that a pass-through entity owned 100% by a C corporation would still be entitled to an income tax allowance in rates, which should mean the ADIT balances of those entities would be treated like a C corporation's ADIT. What remains uncertain is whether FERC will allow a partial tax allowance for pass-through entities that are partially owned by C corporations. None of the commenters offered suggestions on how to deal with the ADIT balances of such an entity.
What Happens to the ADIT Balances of MLP's Rolled Up Into A C Corporation?
As we stated at the beginning of this report, there have been a number of companies that have indicated that they intend to eliminate the MLPs that exist in their corporate structure. Kinder Morgan completed its roll-up back in 2014 and provides some precedent for what may happen to the ADIT balances of companies that undertake similar transactions.
In December 2016, Kinder Morgan filed a letter with FERC requesting that the ADIT balances on Tennessee Gas Pipeline's (TGP) books be eliminated without the need to return such balances to its customers. In an order issued in February 2017, FERC approved Kinder Morgan's request.
The FERC order noted that the purchase of KMP units by Kinder Morgan was deemed an asset purchase for tax treatment purposes. Accordingly, the difference between the tax basis and book basis of TGP assets was eliminated in the sale. Therefore, FERC approved TGP reducing its ADIT balance by almost a billion dollars and crediting that amount to paid-in capital rather than a regulatory liability account. We would expect other companies that have announced such roll-ups to seek a similar treatment which would result in a net increase in their rate base from the elimination of an ADIT balance, which currently acts as a reduction to a pipeline's rate base.