UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY ...Affidavit+2017… · 2017-04-07 · 3 Id., citing, Opinion No. 511, 134 FERC ¶ 61,121 at PP 243-44 (2011). 3 partnership incurs

1

UNITED STATES OF AMERICA

BEFORE THE

FEDERAL ENERGY REGULATORY COMMISSION

Inquiry Regarding the Commission’s

Policy for Recovery of Income Tax Costs

)

) Docket No. PL17-1-000

REPLY COMMENTS OF THE NATURAL GAS INDICATED SHIPPERS

Pursuant to the procedures set forth in the Notice of Inquiry (“NOI”), which the

Federal Energy Regulatory Commission (“FERC” or “Commission”) issued on

December 15, 2016,1 and the Notice of Extension of Time, issued on January 4, 2017,

Chevron Natural Gas, a division of Chevron U.S.A. Inc., ConocoPhillips Company, XTO

Energy Inc., Fieldwood Energy LLC, and Petrohawk Energy Corporation (jointly

“Natural Gas Indicated Shippers”) hereby submit these reply comments on the NOI.

I. BACKGROUND

These reply comments of the Natural Gas Indicated Shippers focus on the

arguments raised in the initial comments of the following persons and participants,

which were submitted on March 7, 2017 in this proceeding: Master Limited Partnership

Association (“MLPA”), Interstate Natural Gas Association of America (“INGAA”),

SFPP, L.P. (“SFPP”), Association of Oil Pipe Lines (“AOPL”), Dominion Energy,

American Transmission Company LLC, Edison Electric Institute, TransCanada

Corporation, Meliora Capital, LLC, LSP Transmission Holdings, LLC, Enbridge Inc.,

1 Inquiry Regarding the Commission’s Policy for Recovery of Income Tax Costs, “Notice

of Inquiry,” 157 FERC ¶ 61,210 (2016).

2

Tom Horst, Erin Noakes, Suncor Energy Marketing Inc. (“Suncor”), and Process Gas

Consumers Group and American Forest & Paper Association (“PGC”).

The Natural Gas Indicated Shippers submitted initial comments requesting the

Commission to adjust its policy for the recovery of income tax costs to eliminate the

double recovery of income taxes that partnerships currently enjoy by eliminating the

income tax allowance in a pipeline’s cost of service when the first publicly-traded

owner of the pipeline is a partnership (or similar income pass-through entity). The

Natural Gas Indicated Shippers, through the affidavit of Ms. Elizabeth H. Crowe,

provided evidence in support of the D.C. Circuit’s conclusion that there is a double

recovery of income taxes for partnership pipelines; once through the cost of service

income tax allowance, and the second through the equity return on rate base calculated

as part of the Discounted Cash Flow (“DCF”) analysis. This double recovery of taxation

results in partnership pipelines receiving an inequitable return, compared to

shareholders in corporate pipelines.2

The D.C. Circuit’s decision United Airlines relied upon three indisputable factual

findings. First, the DCF “return on equity determines the pre-tax investor return

required to attract investment, irrespective of whether the regulated entity is a

partnership or a corporate pipeline.”3 Second, “unlike a corporate pipeline, a

2 See United Airlines, Inc. v. FERC, 827 F.3d 122, 136 (D.C. Cir. 2016). 3 Id., citing, Opinion No. 511, 134 FERC ¶ 61,121 at PP 243-44 (2011).

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partnership incurs no taxes, except those imputed from its partners at the entity level.”4

Third, “with a tax allowance, a partner in a partnership pipeline will receive a higher

after-tax return than a shareholder in a corporate pipeline, at least in the short term

before adjustments can occur in the investment market.”5

II. REPLY COMMENTS

INGAA, AOPL, and SFPP each provided witness statements along with their

comments, and raised several arguments opposing any modifications to the

Commission’s income tax policy with respect to partnerships. The Natural Gas

Indicated Shippers respond in particular to the comments and witness statements of

INGAA, AOPL, and SFPP with respect to their arguments against any modifications to

the Commission’s income tax policies. Several other participants, including Enbridge

Inc., MLPA, and Dominion Energy, also filed comments, but did not submit witness

statements with their comments. Given that these other participants raised

substantively similar arguments to INGAA, AOPL, and SFPP (and, in some cases, relied

upon the witness statements provided by INGAA, AOPL, and SFPP), the Natural Gas

Indicated Shippers reply comments do not separately address their substantively

similar arguments. Instead, the Natural Gas Indicated Shippers incorporate a rebuttal

to these arguments in referring to, and rebutting, the arguments raised in the witness

statements.

4 Id. at 136 5 Id.

4

Finally, the Natural Gas Indicated Shippers respond to the comments of Erin

Noakes, and Suncor, who advocated changes to the Commission’s DCF proxy group

methodologies.

A. Under The Commission’s Existing Income Tax Policy, Partnerships Receive A

Double Recovery Of Income Taxes, While Paying Taxes On That Income Once –

At The Investor Level.

Several witnesses attempted to argue that there is no “double recovery” of

taxation for partnerships. INGAA’s witness Sullivan argues that (1) there is no double

recovery of taxation because the DCF does not include an income tax allowance; and (2)

overall investor taxes are comparable for investors in partnerships and corporations,

contending that a tax on the sale of a partnership unit is “akin” to a second-tier income

tax. INGAA witness Erikson claims that taxes paid by corporations and partnerships

are comparable over time. Finally, SFPP’s witness Vander Weide argues there is no

double recovery because, while the DCF includes a pre-investor tax, Hope requires the

Commission to approve a post-investor-tax return. But these arguments are without

merit, as explained in more detail below.

1. No comments undermine the D.C. Circuit’s conclusion that there is a

double recovery of taxation for partnerships.

It is undisputed and indisputable that the DCF methodology calculates a pre-

investor tax return. As noted above, the D.C. Circuit, in the United Airlines decision,

determined that the DCF “return on equity determines the pre-tax investor return

required to attract investment, irrespective of whether the regulated entity is a

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partnership or a corporate pipeline.”6 “SFPP and Dr. Vander Weide agree” with this

fact,7 and AOPL stated “the return that investors require as measured by the DCF

formula is a pre-investor tax return.”8 INGAA expressly acknowledged this fact,

without contradicting it, in its comments.9

Yet, in spite of either expressly agreeing with, or acknowledging, this fact SFPP,

AOPL, and INGAA claim that there is no double recovery of taxation because the

returns of partnerships and corporations are equivalent, based on their separate

analyses. As Ms. Crowe demonstrates in the attached affidavit, and as set forth below,

the analyses provided do not address the central question – whether there is a double

recovery of taxation for partnerships under the Commission’s current income tax

policy, which render these analyses irrelevant to this NOI.

a) Response to INGAA Witness Mr. Sullivan.

Mr. Sullivan’s analysis is fundamentally flawed because it fails to address the

single question that the Commission is charged with examining – whether there is a

double recovery of taxation for partnerships. The DCF formula calculates a pre-

investor tax return, which, by definition, would include a portion related to the

6 United Airlines, 827 F.3d at 136, citing, Opinion No. 511, 134 FERC ¶ 61,121 at PP

243-44 (2011). 7 SFPP Comments at 14. 8 AOPL Comments at 24, citing United Airlines, 827 F.3d at 136. 9 INGAA Comments at 31.

6

investor’s expectation of taxation.10 The quantity embedded in the pre-investor-tax

return is the tax “allowance” that offsets the investor’s income tax liability.

Mr. Sullivan’s attempts at showing “comparability” in DCF returns between

corporations and partnerships, is nothing but a red herring because it has nothing to do

with the question of whether investors understand the returns received from pipelines

owned by corporations and pipelines owned by partnerships are “pre-tax” to the

investor.11 Given that the return from a corporation is reduced by taxes the corporation

pays on income, there is logic in giving the corporation an income tax allowance for

income generated from the pipeline entity. In the same vein, there is no logic to giving a

partnership an income tax allowance for income generated from the pipeline entity,

when the partnership does not pay an income tax. “All income taxes paid at the

investor level are taken into account by investors in making their investments, and are,

therefore, provided for in the DCF returns the investor is willing to accept on its

investments in a regulated pipeline.” Given this, a further tax allowance at the entity

level would be a “double recovery.”

Mr. Sullivan’s blurring of the distinction between the pipeline entity and the

investor further undermines his analysis. “[W]hether the investor-level tax is the first

income tax paid on the pipeline’s assets (‘first-tier’ income tax), as it is for [partnership]

investors, or the second tax paid on the pipeline’s assets (‘second-tier’ income tax), as it

10 Exhibit A, Reply Affidavit of Elizabeth H. Crowe at 3:12-15. 11 Id. at 4:2-5.

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is for corporate shareholders, it is accounted for in the DCF returns.”12 This

indisputable fact is buttressed by the MLPA’s own commentary on its website, which

demonstrates that the [partnership] investor receives a windfall with respect to the

overall return when the underlying costs are the same.

Finally, Mr. Sullivan fails in his attempt to show that deferred taxes for

partnerships are “second-tier” income taxes, are akin to a shareholder’s dividend tax on

earnings. First, “potential income taxes paid at an undefined future point in time when

a unit is sold are not equivalent to actual income taxes paid each year on dividends

received each year.”13 Second, “the partner’s potential deferred taxes at the time of sale

represent basis recapture, which depends entirely on the difference between the sales

price of the unit and its underlying tax basis. If the sale price is equal to the investor’s

remaining tax basis, there will be no additional to the investor and no deferred income

taxes due at the time of sale.”14

For these reasons, the Commission should give Mr. Sullivan’s analysis no

weight.

b) Response to INGAA Witness Erikson

Dr. Erikson’s analysis is flawed for two reasons, and should be accorded no

weight. First, similar to Mr. Sullivan, Dr. Erikson’s analysis fails to respond to the

12 Id. at 4:20-23. 13 Id. at 5:16-18. 14 Id. at 5:20-24.

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question at issue in this NOI “whether the FERC’s cost-of-service ratemaking for

regulated pipelines owned by [partnerships] results in a double provision for investor

income taxes when an income tax allowance is included.”15 Dr. Erikson conflates the

regulated entity with its investors and only examines the combined taxes and after-tax

cash flows for the regulated entity plus its investors, using hypothetical inputs for a

five-year horizon.16 But this hypothetical analysis has no bearing on the question of

whether a cost of service for an entity owned by a partnership will provide two forms of

income tax coverage to the partnership investors if an income tax allowance is included

in the pipeline’s cost of service.17

Second, Dr. Erikson’s analysis ignores the fact that FERC’s cost of service

ratemaking requires an analysis of the pipeline’s costs and revenues at a specific point

in time.18 If Dr. Erikson’s input values for year 1 are used, it is clear that the MLP

investor will receive a higher rate of return than the investor in a corporation.19

Finally, the results from Dr. Erikson’s analysis depend too heavily on the inputs

and assumptions he used. Ms. Crowe lists the various values included in Dr. Erikson’s

analysis in her attached affidavit, and “[c]hanging any one of these assumed values

15 Id. at 6:11-13. 16 Id. at 6:3-17. 17 Id. at 7:5-7. 18 Id. at 7:11-14. 19 Id. at 7:14 – 8:1.

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would change the results of Dr. Erikson’s analysis.”20 Given that the analysis is results-

driven, and the “same analysis could be used to reach entirely different conclusions

simply by changing one or more of the assumed values for the variables,”21 the FERC

should accord the analysis no weight.

c) Response to SFPP Witness Vander Weide.

Dr. Vander Weide’s analysis acknowledges that the DCF model’s return on

equity is a before-tax return to the investor.22 But Dr. Vander Weide then equates the

pre-investor-tax return included with the DCF calculation to an after-tax return, even

though investors in a partnership must pay income taxes on the return earned through

the DCF calculation in the cost of service.23 Dr. Vander Weide provides no evidentiary

support that an investor would “know” that the pre-investor tax return is actually an

expected after-tax return.24 Further, Dr. Vander Weide fails to explain how investors

would be able to “(1) calculate the fraction of the [partnerships’] total income

attributable to the regulated pipeline, (2) adjust their before-tax return by the fraction

which is allegedly equal to an after-tax return, and then (3) evaluate the actual adjusted

after-tax return from the [partnership] to determine if their overall required after-tax

20 Id. at 8:19-20. 21 Id. at 8:22-23. 22 Vander Weide Declaration at 5, P 8. 23 Exhibit A, Reply Affidavit of Elizabeth H. Crowe at 9:15-18. 24 Id. at 9:18-22.

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return has been realized.”25 The number of assumptions about investor behavior that

are baked into Dr. Vander Weide’s analysis are “prohibitive.”26

Moreover, Dr. Vander Weide’s analysis is flawed because

His calculations explicitly require the assumption that the allowed ROE in the [partnership’s] cost of service (10%) is lower than the allowed ROE in the corporate pipeline’s cost of service (15.4%) by exactly the amount of income tax allowance, grossed up (54%), coupled with the assumption that the [partnership] investor pays exactly the same income tax rate (35%) as a corporation. This is a classic example of backing into the results that are desired.27

Given these flaws, the Commission should not rely upon Dr. Vander Weide’s analysis.

d) Response to AOPL Witness Graham.

Dr. Graham’s arguments similarly have little bearing on the underlying question

of this NOI – whether there is a double recovery of taxation for partnerships. First, Dr.

Graham argues that market prices of partnership units might fall if the income tax

allowance were eliminated. But this argument ignores the fact that there are many

factors in the financial markets that could affect the price of a share, and the

Commission should not develop, or establish, ratemaking policies based on speculation

on how the market might respond to the elimination of a double recovery of taxes.28

Second, Dr. Graham argues that partnerships would be in a worse financial

position if income tax allowances are removed, because partnerships would have less

25 Id. at 10:6-10. 26 Id. at 10:13. 27 Id. at 10:17-21. 28 Id. at 12:5-7.

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money to reinvest and/or to cover interest on debt. But this argument ignores the fact

that “the cost of service contains a depreciation component to cover new investment,

and an interest on debt component (through the weighted rate of return on rate base) to

cover interest costs.”29

Finally, Dr. Graham argues that partnerships could be competitively

disadvantaged if they have lower rates. But this argument is contrary to a basic

understanding of economic theory. “The pipeline able to charge lower rates for the

same service should have a competitive advantage, not a competitive disadvantage, all

other things being equal.”30

For these reasons, the Commission should accord Dr. Graham’s analysis no

weight.

B. Elimination of the Income Tax Allowance for MLPs To Ensure “Just and

Reasonable” Rates Is Not Inconsistent With Congressional Intent Regarding

MLPs.

INGAA,31 MLPA,32 and SFPP,33 each argue that elimination of the income tax

allowance as a cost of service line item would undermine Congressional intent in

establishing an exemption for partnerships from corporate-level tax liabilities. But this

argument fails because Congress did not modify the just and reasonable standards of

29 Id. at 12:12-14. 30 Id. at 12:18-20. 31 See INGAA Comments at 12-17. 32 See MLPA Comments at 3-4. 33 See SFPP Comments at 30-32.

12

the Natural Gas Act or the Interstate Commerce Act when it modified the Internal

Revenue Code to create an exception for MLPs. As the courts have already determined,

congressional mandates to agencies to carry out “specific statutory directives define[] the relevant functions of [the agency] in a particular area.” Such a mandate does not create for the agency ‘a roving commission’ to achieve those or “any other laudable goal.”34

In fact, in dealing with a nearly identical argument, the D.C. Circuit in the BP West Coast

Products decision held “[t]he mandate of Congress in the tax amendment was exhausted

when the pipeline limited partnership was exempted from corporate taxation. It did

not empower FERC to do anything, let alone to create an allowance for fictitious

taxes.”35

The Commission cannot create a congressional mandate where none exists.

Given that no participant offered any precedent or compelling rationale for this

argument, the Commission should reject it.

C. The Commission Should Not Modify Its DCF Methodology.

Ms. Erin Noakes and Suncor each included arguments that the Commission

should modify the way it establishes proxy groups to create two separate groups – one

for partnerships and one for corporations. This approach is not a practical solution at

this point in time in the oil and gas pipeline industries. “There are still not enough

corporate-owned publicly-traded entities that own interstate pipeline companies to

34 BP West Coast Products, LLC v. FERC, 374 F.3d 1263, 1293 (D.C. Cir. 2004), citing

Michigan v. EPA 268 F.3d 1075, 1084 (D.C. Cir 2001) (internal citations omitted). 35 BP West Coast Products, 374 F.3d at 1293.

13

constitute a robust proxy group for the purposes of the DCF ROE calculations.”36 The

Commission, itself, recognized this problem of shrinking proxy groups when it first

allowed MLPs to be considered in natural gas pipeline proxy group rate proceedings.37

Thus, the Commission should not, at this time, modify its criteria for establishing proxy

groups under the DCF methodology.

III. CONCLUSION

For the foregoing reasons, the Natural Gas Indicated Shippers request the

Commission to revise its income tax allowance policy to eliminate the cost of service

income tax allowance for pipelines owned by partnerships or similar pass-through

entities.

Respectfully submitted,

By: /s/ John Paul Floom Katherine B. Edwards John Paul Floom Erica L. Rancilio Edwards & Floom, LLP 1409 King Street Alexandria, VA 22314 (703) 549-0888 [email protected] [email protected] [email protected]

DATED: April 7, 2017

On behalf of Natural Gas Indicated Shippers

36 Exhibit A, Reply Affidavit of Elizabeth H. Crowe at 13:21-23. 37 See Composition of Proxy Groups for Determining Gas and Oil Pipeline Return on

Equity, 123 FERC ¶ 61,048 at PP 16-19 (2008).

EXHIBIT A TO REPLY COMMENTS OF

NATURAL GAS INDICATED SHIPPERS

Docket No. PL17-1-000

Exhibit A to Reply Comments of the Natural Gas Indicated Shippers Docket No. PL17-1-000

UNITED STATES OF AMERICA BEFORE THE

FEDERAL ENERGY REGULATORY COMMISSION Inquiry Regarding the Commission’s Policy ) for Recovery of Income Tax Costs ) Docket No. PL17-1-000

REPLY AFFIDAVIT OF ELIZABETH H. CROWE

Chevron Natural Gas, a division of Chevron U.S.A. Inc., ConocoPhillips Company, Cross

Timbers Energy Services, Inc., Fieldwood Energy LLC, and Petrohawk Energy Corporation

April 7, 2017


1

UNITED STATES OF AMERICA BEFORE THE

FEDERAL ENERGY REGULATORY COMMISSION Inquiry Regarding the Commission’s Policy ) for Recovery of Income Tax Costs ) Docket No. PL17-1-000

REPLY AFFIDAVIT OF ELIZABETH H. CROWE

on behalf of

Chevron Natural Gas, a division of Chevron U.S.A. Inc., ConocoPhillips Company, Cross Timbers Energy Services, Inc., Fieldwood Energy LLC, and Petrohawk Energy Corporation

I. Introduction and Summary

1. My name is Elizabeth H. Crowe. I am the same Elizabeth H. Crowe who 1

submitted an affidavit in this proceeding on behalf of the Natural Gas Indicated Shippers. 2

This reply affidavit has been prepared at the request of the same group. 3

2. This reply affidavit primarily addresses the initial comments of the following 4

parties, with particular focus on the experts’ affidavits submitted with these parties’ 5

comments: INGAA, SFPP and AOPL. I will demonstrate that none of these parties 6

provided any substantive rebuttal to the court’s finding that a pipeline owned by an MLP 7

provides a double income tax recovery for the investors in that MLP if the pipeline’s cost 8

of service includes an income tax allowance. In many cases, the contents of the witness 9

reply affidavits do not even reach or attempt to address the main issue, which is that the 10

return provided by the Commission’s DCF analysis is a pre-tax return to the investor, and 11

thus constitutes a second, or duplicate, provision for MLP investor income taxes. I also 12

address briefly specific aspects of the initial comments filed by Erin Noakes. 13


2

1

Response to INGAA Witnesses 2

3. Mr. Barry Sullivan; summary of position and response: Mr. Sullivan undertakes 3

analysis in his affidavit that purports to show “comparability” in both ROEs produced by 4

the DCF for MLPs and corporations, and in dividend yields and growth rates (inputs to the 5

DCF formula) for MLPs and corporations.1 Mr. Sullivan appears to make a two-pronged 6

attack on the proposition that an MLP’s cost of service provides a double recovery of 7

investor income taxes when it includes a separate income tax allowance. He asserts first 8

that this is empirically not the case because the “DCF ROE methodology does not include 9

a separate allowance for income taxes.”2 Second, he states that the double-recovery or 10

over-recovery of taxes for MLPs “is baseless” because “the DCF ROE of corporations and 11

MLPs that own FERC jurisdictional natural gas pipelines are statistically the same.”3 In 12

response to the first assertion, to the best of my knowledge, no one ever claimed that the 13

DCF methodology itself includes a “separate” allowance for income taxes. The only 14

relevant fact, which Mr. Sullivan never even addresses, much less disputes, is that the DCF 15

produces returns from an investor point of view that are pre-tax returns to the investor, for 16

both corporate and MLP investors. This pre-investor-tax return represents the second, or 17

double, provision for income taxes for MLP investors when there is also an income tax 18

allowance in the cost of service. In response to the second assertion, any statistical 19

equivalence between DCF ROEs produced for corporations and those produced for MLPs 20

doesn’t prove or disprove anything with respect to the double-recovery issue, because the 21

duplicate recovery is not based on any difference in the DCF ROEs for partnerships versus 22

corporations, but on the fact that every DCF return is a pre-tax return to every investor. In 23

addition, the broader “comparability” Mr. Sullivan alleges between MLPs and corporations 24

is entirely dependent on blurring the distinction between entities and their investors, and 25

1 Sullivan affidavit, page 3, line 18 through page 4, line 4. 2 Id., page 6, lines 2-3. 3 Id., page 6, line 22 through page 7, line 2.


3

fails as soon as you consider returns and taxes separately for the pipeline entity and for its 1

investors. This includes his effort to characterize potential deferred taxes that might be due 2

upon the sale of an MLP unit as “akin” to dividend taxes paid by stockholders every year. 3

I address each of these positions more fully below. 4

4. Income tax “allowance” embedded in DCF: While terminology has not always 5

been precisely used or defined in the history of the income tax treatment issue for MLPs, I 6

am unfamiliar with any claim that the DCF formula or calculation itself includes any sort 7

of explicit or “separate” income tax “allowance” in its methodology. Mr. Sullivan also 8

does not cite any specific claim of this nature, only characterizes unidentified parties as 9

taking this position.4 Notably, Mr. Sullivan never acknowledges or addresses the real issue 10

raised by the court in United Air Lines, which is that the income distributed to investors is 11

income on which investors themselves must pay income tax. Thus, the return (income) 12

produced by the DCF methodology is pre-investor-tax return once it reaches the investors, 13

a fact of which investors are certainly aware, and of which they take into consideration in 14

making their investment decisions. It is this provision for income taxes represented by the 15

difference between the investor’s pre-tax return and his/her after-tax return, implicitly 16

contained in the DCF pre-investor-tax return itself, which renders an income tax allowance 17

in an MLP’s cost of service itself a second, or duplicative, provision for investor income 18

taxes (because the entity incurs no income tax liability). Thus, a separate income tax 19

allowance for an MLP constitutes a double recovery, or windfall, to the MLP pipeline’s 20

investors, because income taxes are only paid once, by the investor, but are provided for 21

twice in the MLP’s cost of service. 22

5. Alleged “comparability” in DCF returns and tax treatment for corporations and 23

MLPs: With respect to comparability in DCF returns, Mr. Sullivan spends 35 pages of his 24

affidavit allegedly demonstrating that corporations and MLPs receive DCF returns that are 25

4 See, e.g., page 18, lines 10-17, where Mr. Sullivan also characterizes unidentified parties in unidentified proceedings as “failing to understand” that the income tax allowance is a separate line item in a regulated pipeline’s cost of service. I am aware of no party in any proceeding in which I have been involved that has not understood this basic ratemaking principle.


4

comparable.5 He then spends another seven pages comparing additional DCF inputs 1

(dividend and distribution yield and growth rates) for corporations and MLPs.6 The 2

problem with all this analysis is that is has nothing to do with the question of whether 3

investors understand the returns received from both corporately-owned and MLP-owned 4

pipelines to be pre-tax to them. There is no evidence anywhere that investors do not 5

understand this. In fact, it would be almost absurd to think that investors do not 6

understand, and take into consideration when making investments, the income taxes they 7

will have to pay on income received from their investments. Thus, Mr. Sullivan’s 8

extensive discussion of DCF yields, growth rates and returns does not reach or address in 9

any fashion the main question of whether the DCF return implicitly includes, from an 10

investor point of view, cash needed to cover dividend or income taxes they will pay. His 11

analysis has no relevance in any way to this question.7 12

6. Blurring of distinction between entity and investor: In attempting to establish 13

“comparability” between MLPs and corporations from a taxation perspective, Mr. Sullivan 14

uses terminology of “first-tier” and “second-tier” income and income taxes to conclude 15

that “MLP owned pipelines have the same type of tax liability as corporate owned 16

pipelines.”8 Mr. Sullivan can only draw this conclusion by completely blurring the 17

distinction between entity-level taxes and investor-level taxes. At the entity level, MLPs 18

have no income tax liability. Corporations have income tax liability. These two things are 19

not the “same type of tax liability.” At the investor level, whether the investor income tax 20

is the first income tax paid on the pipeline’s assets (“first-tier” income tax), as it is for 21

MLP investors, or the second tax paid on the pipeline’s assets (“second-tier” income tax), 22

as it is for corporate shareholders, it is accounted for in the DCF returns. That is, all 23

5 Sullivan Affidavit, page 27, line 19 through page 62, line 15. 6 Id., pp. 62-69. 7 In addition, the Commission already dismissed the argument that differences in DCF returns have any direct bearing on the question of a double provision for income taxes, showing that many other market forces and factors impact these returns (in addition to the fact that the publicly-traded entities themselves include many businesses other than regulated interstate pipelines) (see Opinion No. 511-A, e.g., PP. 302-303). 8 Sullivan Affidavit, page 27, lines 5-12.


5

income taxes paid at the investor level are taken into account by investors in making their 1

investments, and are therefore provided for in the DCF returns they are willing to accept on 2

their investments in regulated pipelines. No party has attempted to deny or even dispute 3

this, including Mr. Sullivan. Again, this means that for MLP investors, an income tax 4

allowance in the pipeline’s cost of service itself is a double or duplicate provision for 5

income taxes they pay on the pipeline’s income. This fact is substantiated, in 6

contraindication to Mr. Sullivan’s arguments about comparability, by information provided 7

by the MLP Association itself,9 a supporter of INGAA’s comments in this proceeding. 8

The MLP Association’s example, included here as Reply Comments Appendix 1, clearly 9

shows that the MLP investor receives a windfall when the underlying costs (for purposes 10

of this analysis, a cost of service for both the corporation and the MLP that includes an 11

income tax allowance and the same DCF ROE) are the same. 12

7. Inclusion of potential deferred taxes due at time of sale of MLP unit: Mr. 13

Sullivan attempts to include deferred income taxes potentially paid by a partner upon sale 14

of its partnership units as a “second-tier” income tax “akin” to a shareholder’s dividend tax 15

on earnings.10 This fails on two counts. First, potential income taxes paid at an undefined 16

future point in time when a unit is sold are not equivalent to actual income taxes paid each 17

year on dividends received each year. The partner’s potential deferred taxes at the time of 18

sale could only properly be deemed “akin” to the shareholder’s potential deferred taxes at 19

the time his/her stock is sold. Second, the partner’s potential deferred taxes at the time of 20

sale represent basis recapture, which depends entirely on the difference between the sale 21

price of the unit and its underlying tax basis. If the sale price of the unit is equal to the 22

investor’s remaining tax basis, there will be no additional income to the investor and no 23

deferred income taxes due at the time of sale. Thus, the possibility and amount of any 24

deferred income taxes an investor might incur is market-driven, and is a speculative cost to 25

the investor that has no place being considered or factored in to the determination of 26 9 MLPA Master Limited Partnerships 101: Understanding MLPs, updated June 2016. 10 Sullivan Affidavit, page 12, lines 4-15 and page 14, lines 14-15.


6

whether an MLP pipeline’s cost of service contains a double provision for investor income 1

taxes. 2

8. Dr. Merle Erikson: Dr. Erikson provides a hypothetical analysis over a five-3

year time frame of total taxes paid and total after-tax cash flows realized by a corporation 4

and its shareholders compared to an MLP and its unitholders (partners). His conclusion is 5

that the total taxes paid and after-tax cash flows realized over this time frame by the two 6

types of entities and their investors are “comparable when one appropriately considers the 7

taxes due upon sale of units.”11 There are two reasons why Dr. Erikson’s analysis should 8

be accorded no weight in this proceeding. First, the relative amount of total taxes paid and 9

after-tax cash flow received by corporations and MLPs in a single hypothetical example 10

has no bearing on the issue of whether the FERC’s cost-of-service ratemaking for 11

regulated pipelines owned by MLPs results in a double provision for investor income taxes 12

when an income tax allowance is included. Dr. Erikson himself is careful not to suggest 13

that his calculations have any direct bearing on the questions raised in the NOI. Second, 14

Dr. Erikson’s hypothetical includes numerous input assumptions and values, each of which 15

is necessary to produce the comparability he calculates. If one or more of these input 16

assumptions or values were to change, the results would change accordingly. 17

9. Relevance to NOI: The FERC limited its inquiry in this proceeding to the 18

setting of rates to be charged by regulated pipelines. It asked for comments “regarding 19

methods to allow regulated entities to earn an adequate return consistent with Hope that do 20

not result in a double recovery of investor-level taxes for partnerships or similar pass-21

through entities” (citation omitted).12 Responsive comments must therefore examine 22

returns at the entity level for an MLP separately from those at the investor level, to 23

ascertain whether the entity earns an adequate return and whether the investor receives a 24

single or double provision of its income tax liability.13 Dr. Erikson conflates the entity 25

11 Erikson Affidavit, page 3. 12 NOI at P. 17. 13 This is how I formulated the analysis presented in Appendix 2 of my initial affidavit.


7

with its investors and only examines the combined taxes and after-tax cash flows for 1

entities plus their investors. Thus, no proper conclusions can be drawn from his analysis 2

regarding how a cost of service should be determined for a regulated pipeline entity. 3

Furthermore, his calculations of hypothetical total taxes and after-tax cash flows over a 4

five-year horizon have no bearing on the question of whether a cost of service for an MLP 5

will provide two forms of income tax coverage to MLP investors if an income tax 6

allowance is included. This question can only be addressed by analyzing the regulated 7

pipeline’s cost of service itself, which is always based on a specific point in time. What 8

may or may not happen to an investor’s earned return and taxes when that investor sells 9

his/her share or unit should not impact the calculation of a pipeline’s incurred costs of 10

providing service. When the cost of service is properly analyzed at a specific point in time, 11

it can be clearly seen that both the MLP-owned pipeline and the MLP investor receive a 12

windfall when the cost of service includes an income tax allowance for both types of 13

entities. Using Dr. Erikson’s input values for year 1 of his analysis (Table 1, page 10) 14

yields the following results: 15

16

This shows that even assuming Dr. Erikson’s high (37.3%) income tax rate for 17

MLP investors, there is a significant over-recovery, or windfall, for both the MLP and its 18


8

investors if the MLP is given an income tax allowance in its cost of service. 1

10. Dependence of results on input assumptions and values: Dr. Erikson’s 2

calculations include assumed values for almost all the variables in his analysis that he does 3

not attempt to support, each of which directly impacts the results he derives. These values 4

include: 5

• An assumed five-year time frame between purchase and sale of investment. 6

• An assumed 25% increase in the sale price of the stock relative to its 7

purchase price, coupled with an assumed sale price of the MLP unit equal to 8

the purchase price (significantly in excess of the remaining tax basis in 9

partnership unit). 10

• An assumed 20% shareholder dividend tax rate, and 37.3% MLP investor 11

income tax rate. 12

• An assumed 20% shareholder capital gains tax rate. 13

• An assumed 65% payout ratio of EBITDA for the corporation, and a 100% 14

payout ratio for the MLP. 15

• An assumed start date for the investors in year 1 of the pipelines’ 16

operations, coupled with an assumed 15-year MACRS tax depreciation 17

schedule. 18

Changing any one of these assumed values would change the results of Dr. 19

Erikson’s analysis. In addition, the number of variables which could easily be changed 20

renders his outcome highly susceptible to being unduly influenced by the desired outcome. 21

This means that the same analysis could be used to reach entirely different conclusions 22

simply by changing one or more of the assumed values for the variables. Even if his 23

calculations bear any resemblance to real-life examples (which he does not claim they do), 24

he has not shown any relationship between his hypothetical example and an income tax 25

allowance policy that the FERC should adopt to ensure that entities of differing ownership 26

structures are afforded commensurate returns under the Hope standard. His calculations 27


9

simply have no bearing on the inquiry undertaken by the Commission in this proceeding. 1

2

Response to SFPP Witness 3

11. Summary of Dr. Vander Weide’s position: To his credit, Dr. Vander Weide at 4

least acknowledges that the DCF model’s return is before-tax return to the investor.14 5

However, he then goes on to claim that investors in MLPs have the same before-tax and 6

after-tax required return, just as is the case for tax-free municipal bond investors.15 This is 7

apparently the case because investors know that their income taxes are recovered through 8

the income tax allowance in the regulated pipeline’s cost of service. Dr. Vander Weide 9

then further maintains that including an income tax allowance in an MLP pipeline’s cost of 10

service does not result in higher after-tax returns to partners in the MLP.16 This second 11

claim is entirely dependent on an analysis that posits a higher DCF ROE for the corporate 12

pipeline than for the “comparable” MLP pipeline in his example. Only in this way is he 13

able to derive an equivalent after-tax investor rate of return for both types of investors. 14

12. Before-tax and after-tax investor returns: Dr. Vander Weide appears to believe 15

that even though investors in an MLP must pay income taxes on the return earned through 16

the DCF calculation in the cost of service, they still view that return as an after-tax return 17

rather than a before-tax return. The investors apparently know that the income tax 18

allowance in the pipeline’s cost of service will flow through directly to them to cover their 19

income taxes. While Dr. Vander Weide provides no supporting evidence or indication that 20

investors “know” this, his assumptions also run counter to basic facts about MLP structure 21

that a knowledgeable investor in an MLP actually should understand. First, an investor 22

would know that the MLP in which he/she invests owns and earns income from multiple 23

businesses, only a (small) subset of which might be regulated interstate pipelines. Thus, 24

the investor would know that it would be nearly or completely impossible to figure out 25

14 Vander Weide Declaration, page 5, P. 8. 15 Id., page 6, P. 12 and page 7, P. 14. 16 Id., page 11, P. 21 and Table 2 (esp. footnote [1]).


10

from the K-1 tax form they receive from the MLP how much, if any, of the income 1

allocated to them represents some portion of the return and/or income tax allowance they 2

“know” is included in that regulated pipeline’s cost of service. In order to calculate the 3

fraction of their income that already allegedly contains part of the income tax allowance 4

they “know” is there in their before-tax return to cover their income taxes, they would have 5

to be able to 1) calculate the fraction of the MLP’s total income attributable to the 6

regulated pipeline, 2) adjust their before-tax return by that fraction which is allegedly equal 7

to an after-tax return, and then 3) evaluate the actual adjusted after-tax return from the 8

MLP to determine if their overall required after-tax return on their investment has been 9

realized. Needless to say, even if the investor is highly knowledgeable about regulated 10

interstate pipeline cost-of-service ratemaking (which I believe is a stretch to start with) the 11

remaining amounts of required knowledge and number of calculations needed to achieve 12

Dr. Vander Weide’s assumptions about investor behavior are prohibitive. 13

13. After-tax returns to shareholders and partners: Dr. Vander Weide’s Table 2 14

purports to demonstrate that investors in MLP pipelines and pipelines owned by 15

corporations both receive the same after-tax return on their investments. Yet his 16

calculations explicitly require the assumption that the allowed ROE in the MLP’s cost of 17

service (10%) is lower than the allowed ROE in the corporate pipeline’s cost of service 18

(15.4%) by exactly the amount of the income tax allowance, grossed up (54%), coupled 19

with the assumption that the MLP investor pays exactly the same income tax rate (35%) as 20

a corporation. This is a classic example of backing into the results that are desired. If the 21

two pipelines are of comparable risk, they will be given the same ROE under the 22

Commission’s DCF methodology, all other things being equal. Somehow, with no support 23

or explanation, Dr. Vander Weide stipulates a hypothetical “corporate” proxy group that 24

happens to yield a median DCF ROE of 15.4%, compared to the 10% DCF ROE yielded 25

by his hypothetical “MLP” proxy group. Not only has the Commission not had a pure 26

“corporate” proxy group available in many years for purposes of calculating the DCF ROE 27


11

for either an oil or gas interstate pipeline, but the probability that the result of using a 1

corporate proxy group would be higher than the result of using a pure MLP proxy group by 2

exactly the amount of the corporation’s 35% income tax allowance is extremely low. 3

Rather, Dr. Vander Weide’s column 5 on his Table 2 illustrates the same results as shown 4

in Appendix 2 of my initial affidavit, which is that when an MLP pipeline is given an 5

income tax allowance in its cost of service, the MLP investor earns a significantly higher 6

return on his/her investment (10%) than does the corporate shareholder (6.5%). Moreover, 7

my Appendix 2 in my initial affidavit shows that comparable returns for shareholders and 8

unitholders investing in pipelines of similar risk can be achieved much more directly and 9

cleanly than Dr. Vander Weide’s approach achieves – by removing the MLP’s income tax 10

allowance from its cost of service. 11

12

Response to AOPL Witness 13

14. Summary of Dr. Graham’s position: Dr. Graham first provides an overview of 14

corporate and MLP taxation, reviewing information already well established in the record 15

leading to this proceeding. He then responds to the analysis of Dr. Horst contained in the 16

underlying SFPP proceedings. Lastly, he postulates that removing the income tax 17

allowance from the cost of service of a pipeline owned by an MLP would lower the 18

pipeline’s rates and revenues, and thus the MLP owner’s partnership unit prices in the 19

market.17 He further speculates that MLP pipelines’ financial position could become more 20

tenuous as a result, leaving fewer funds available to reinvest and/or to pay interest on debt. 21

One additional assertion he makes is that MLP pipelines would become competitively 22

disadvantaged to pipelines owned by corporations, because corporate-owned pipelines 23

could charge higher rates for the same service. 24

15. Impact on MLP pipelines of removing income tax allowance: I do not respond 25

here to Dr. Graham’s analysis of Dr. Horst’s calculations in the SFPP proceeding, as I have 26

17 Declaration of John R. Graham, pages 11 – 13.


12

already addressed the lack of relevance that has to this proceeding in my response above to 1

Mr. Sullivan’s similar analysis. Here I would just make three observations about Dr. 2

Graham’s conclusions with respect to the impact of removing an MLP pipeline’s income 3

tax allowance. First, with respect to the argument that partnership unit prices might fall 4

and current unitholders might suffer a loss, I would simply observe that this happens all the 5

time in financial markets, and am not persuaded that the Commission should establish 6

ratemaking policy based on speculation about how markets might respond. Second, with 7

respect to the assertion that the financial condition of MLPs could become more tenuous if 8

income tax allowances are removed, because MLP pipelines would have less money to 9

reinvest and/or to cover interest on debt, it is my understanding that an income tax 10

allowance is provided in Commission cost-of-service ratemaking to cover income tax 11

costs, not debt costs or new capital investment costs. The cost of service contains a 12

depreciation component to cover new investment, and an interest on debt component 13

(through the weighted rate of return on rate base) to cover interest costs. No one is 14

suggesting that either of these components be removed from any pipeline’s cost of service. 15

Third, with respect to the assertion that MLP pipelines could become competitively 16

disadvantaged by having lower rates, my understanding of basic economic theory suggests 17

the opposite should be true. The pipeline able to charge lower rates for the same service 18

should have a competitive advantage, not a competitive disadvantage, all other things 19

being equal. This suggests that the financial position of MLP pipelines could actually 20

improve if the income tax allowance (which is not needed to cover the pipeline’s 21

nonexistent income taxes) were removed and MLP pipelines actually lowered their rates. 22

23

Response to Ms. Erin Noakes 24

16. Summary of comments: Ms. Noakes provides the Commission with an 25

analysis of the varying risks and underlying costs of capital represented by different types 26

of entities that may be included in a proxy group for purposes of the Commission’s DCF 27


13

analysis and yet have very different capital structures, organizational ownership and other 1

investor risk factors (Section I). She concludes from this that the proxy group, and 2

resulting DCF ROE, may over-compensate or under-compensate the target pipeline and its 3

investors for their own cost of capital. In Section II of her comments, Ms. Noakes states 4

that if the Commission is going to look beyond the entity level in designing a pipeline’s 5

cost of service, and take into consideration income taxes paid by investors, they must also 6

take into consideration multiple other types of investor costs and benefits in order to be 7

consistent. Ms. Noakes urges the Commission not to go down that “rabbit-hole” but to 8

focus solely on the costs of capital, debt and taxes to the regulated entity itself. She 9

concludes that to avoid double or even triple-recovery of income taxes for pass-through 10

entities, the Commission should remove the income tax allowance for pipelines with these 11

pass-through ownership structures. Her final recommendations include requesting the 12

FERC to develop sub-groups of entities that face similar risks (create multiple proxy 13

groups) for purposes of determining DCF returns, and then make further specific 14

adjustments to the DCF results to account for additional differences in capital structures or 15

investment risks.18 16

17. Response: Ms. Noakes’ analysis is sound and well-reasoned. My only 17

observation with respect to her specific recommendation that separate proxy groups be 18

developed to reflect different underlying capital structures and other characteristics is that 19

this is probably not practicable, at least at this point in time in the oil and gas pipeline 20

industry. There are still not enough corporately-owned publicly-traded entities that own 21

interstate pipeline companies to constitute a robust proxy group for purposes of the DCF 22

ROE calculations. It is my understanding that the Commission does examine, and take 23

into account any differences between, the capital structure of the financing entity for the 24

target pipeline compared to that of the entities used in the proxy group. While I support 25

Ms. Noakes’ contention that costs of capital must accurately reflect underlying financial 26 18 She also recommends development of a set of general rules for different types of entities in order to help identify proper costs for each type of entity.


14

and business risks, there is simply not much choice when it comes to the selection of proxy 1

companies that have overall risk and other characteristics similar enough to the target 2

pipeline to be appropriately included in the DCF proxy group. It is also difficult, as the 3

Commission has noted from time to time, to establish general rules that can be applied 4

across a broad spectrum of regulated pipelines, without needing to take into full 5

consideration the specific circumstances and situation of each pipeline in the context of 6

each proceeding in which rates are being determined. 7

COMMONWEALTH OF MASSACHUSETTS )

COUNTY OF ESSEX )

AFFIDAVIT OF ELIZABETH H. CROWE

Elizabeth H. Crowe, being first sworn, on oath deposes and says that she caused the entitled Reply Affidavit on behalf of the Natural Gas Indicated Shippers concerning the Notice oflnquiry in Docket No. PL! 7-1 to be prepared, and that the statements contained therein are true and correct to the best of her knowledge and belief, and that she is authorized to make the same to the Federal Energy Regulatory Commission.

lizabeth H. Crowe

SUBSCRIBED AND SWORN TO BEFORE ME THIS 7'11 DAY OF APRIL, 2017

My Commission Expires: 呸

呸i呸 TREVOR D. BROOKS NolaJy Public, Commonweallh ol -

My Commi,siM E,plres - 21, 2019

MASTER LIMITEDPARTNERSHIPS 101:

Understanding MLPS

Updated June 2016

Reply Comments Appendix 1Page 1 of 2

© 2016 Master Limited Partnership Association

Investing in MLPs

Amount per share / unit: Corporation MLP

Gross Income $4.00 $4.00Deductions -$3.00 -$3.00Taxable Income $1.00 $1.00Federal corporate tax -$0.35 $0.00State tax (assumes 5% rate) -$0.05 $0.00Entity's net income $0.60 $1.00Shareholder's federal tax (15% rate for dividend, 28% rate for MLP income) -$0.09 -$0.28

Shareholder's state tax (5%) -$0.03 -$0.05

Net income to shareholder $0.48 $0.67

48

Simplified Tax Example: MLP vs. Corporation

Reply Comments Appendix 1Page 2 of 2

Documents

UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY ...Affidavit+2017… · 2017-04-07 · 3 Id., citing, Opinion No. 511, 134 FERC ¶ 61,121 at PP 243-44 (2011). 3 partnership incurs