Trailblazer Pipeline Company LLC Docket No. RP- -000
UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION Trailblazer Pipeline Company LLC ) ) ) Docket No. RP- -000 SUMMARY OF PREPARED DIRECT TESTIMONY OF ALAN R LOVINGER ON BEHALF OF TRAILBLAZER PIPELINE COMPANY LLC Alan R. Lovinger, Vice President with Brown, Williams, Moorehead & Quinn, Inc. provides Prepared Direct Testimony in this proceeding on behalf of Trailblazer Pipeline Company LLC ( Trailblazer ). In his testimony, Mr. Lovinger presents and supports certain income tax-related cost-of-service items used by Trailblazer to develop transportation rates for services rendered on its natural gas pipeline system namely. In particular, Mr. Lovinger addresses Trailblazer s Accumulated Deferred Income Taxes ( ADIT ) balance and Trailblazer s proposed income tax allowance. Various issues covered by Mr. Lovinger relating to his ADIT and income tax allowance discussion include: normalization rules, the effect of tax rate reductions stemming from the Tax Cuts and Job Act as well as any resulting excess ADIT, the Reverse South Georgia Method, the reorganization of the Tallgrass family of companies, and the Federal Energy Regulatory Commission s Revised Policy Statement.
UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION Docket No. RP- -000 Page of 0 Trailblazer Pipeline Company LLC ) ) ) Docket No. RP- -000 PREPARED DIRECT TESTIMONY OF ALAN R. LOVINGER ON BEHALF OF TRAILBLAZER PIPELINE COMPANY LLC June, 0
Page of 0 TABLE OF CONTENTS GLOSSARY OF TERMS... I. INTRODUCTION... II. ADIT OVERVIEW... III. EXCESS ADIT RESULTING FROM THE 0 TAX CUTS AND JOB ACT 0 IV. REDUCTION OF TRAILBLAZER S ADIT BALANCE DUE TO THE 0 REORGANIZATION... V. TRAILBLAZER S INCOME TAX ALLOWANCE...
Page of 0 GLOSSARY OF TERMS ADIT ARAM BWMQ Commission D.C. Circuit DCF FERC IRC IRS KMI KPC MACRS Midcoast MLP Revised Policy Statement SEC Sponsoring Entities Tallgrass Equity Accumulated Deferred Income Taxes Average Rate Assumption Method Brown, Williams, Moorhead and Quinn Federal Energy Regulatory Commission U.S. Court of Appeals for the District of Columbia Circuit Discounted Cash Flow Federal Energy Regulatory Commission Internal Revenue Code Internal Revenue Service Kinder Morgan, Inc. Kansas Pipeline Company Modified Accelerated Cost Recovery System Midcoast Energy Resources, Inc. Master Limited Partnership Inquiry Regarding the Commission s Policy for Recovery of Income Tax Costs, FERC, (0). Securities and Exchange Commission Tallgrass Equity owners that consist of individual investors that primarily acquired their ownership in Trailblazer through being partners in various private equity funds that were original investors in Tallgrass. Tallgrass Equity, LLC TCJA TGE Trailblazer TransCanada USoA Tax Cut and Jobs Act, Pub. L. No. -, Stat. 0 (0). Tallgrass Energy, LP Trailblazer Pipeline Company LLC TransCanada Pipeline Partners Uniform System of Accounts
Page of 0 0 I. INTRODUCTION Q. Please state your name, occupation and business address. A. My name is Alan R. Lovinger and my business address is th Street, Suite 00, Washington, DC 00. I am a Vice President of Brown, Williams, Moorhead and Quinn ( BWMQ ), a regulatory consulting firm located in Washington, D.C. Q. What are the services offered by BWMQ? A. BWMQ is a leading energy-consulting firm that has been providing advice and assistance to clients for over thirty-two years. BWMQ provides comprehensive energy-related services on business and regulatory matters to over one hundred clients, including independent power producers, natural gas and oil pipelines, electric transmission providers, local distribution companies, energy producers, energy trade associations, pipeline shippers, and federal and state agencies. Q. Please briefly state your professional experience and qualifications. A. I graduated from Bryant University in with a Bachelor of Science Degree in Business Management. In, I enrolled in a Master of Business 0 Administration program at Texas Tech University majoring in Accounting. Prior to joining BWMQ, I was employed by the Federal Energy Regulatory Commission ( FERC or Commission ) as a Senior Accountant. I was employed by FERC for twenty-five years, from to the end of and from to. My work at FERC was primarily related to cost-of-service issues with an emphasis on income tax matters, gas storage accounting, allocation of shared services, and rate base matters. I provided accounting and tax advice on
Page of 0 0 0 the rate treatment of storage gas in rate proceedings and participated in proceedings involving the determination of purchased gas costs in purchased gas adjustment matters. I also represented the Commission in dealings with the Internal Revenue Service ( IRS ) on income tax issues that arose in various rate proceedings and assisted the Commission on rulemakings on various cost-ofservice matters such as tax normalization, cash working capital, and Post- Retirement Benefits Other Than Pensions. Between 0 and, I was employed by the IRS as an Internal Revenue Agent. As an agent, I was involved in the auditing of individuals, partnerships, and publicly held corporations. Q. Have you previously testified before the Commission? A. Yes. While employed at FERC, I presented expert testimony on cost-of-service matters and on accounting and accounting-related policy matters on behalf of FERC Trial Staff. Since beginning my employment with BWMQ, I also have testified extensively before FERC and several state regulatory commissions on behalf of clients whose utility assets included electric generation, natural gas, and electric and oil transmission and much of my testimony has focused on income tax and related issues. My previous testimony is listed in Attachment to this testimony. Q. On whose behalf are you submitting your prepared testimony in this proceeding? A. I am submitting testimony on behalf of Trailblazer Pipeline Company LLC ( Trailblazer ).
Page of 0 0 Q. What is the purpose of your direct testimony? A. The purpose of my testimony is to present and support income tax-related cost-ofservice items used by Trailblazer to develop transportation rates for services rendered on its natural gas pipeline system namely: Trailblazer s Accumulated Deferred Income Taxes ( ADIT ) balance, discussed in Sections II, III, and IV; and Trailblazer s income tax allowance, discussed in Section V. Q. Are you sponsoring any exhibits to support your testimony? A. Yes. I am sponsoring Exhibit No. TPC-00 where I compute the weighted composite federal and state income tax rate to be used by Trailblazer to compute ADIT and an income tax allowance in its cost of service. II. ADIT OVERVIEW 0 Q. What are Accumulated Deferred Income Taxes? A. ADIT represents the income tax effect of the book/tax timing difference between the recognition of tax depreciation on the entity s tax return and book depreciation recognized for financial statement purposes. ADIT is simply a loan from the government in the form of a deferred tax obligation. It is primarily driven by differences in the accelerated depreciation rates applicable under the IRS Modified Accelerated Cost Recovery System ( MACRS ) and the Commission s straight-line or booked depreciation rates. For ratemaking purposes, utilities use a straight-line method for determining depreciation expense, which results in the ratable collection of depreciation dollars from customers over the life of the property. The utility will generate additional cash flow for investment in the early years due to the use of accelerated depreciation but will collect less from
Page of 0 ratepayers for the later years and the ADIT will be used to pay the higher income tax costs incurred by the utility in later years. Consequently, the different methods of calculating annual depreciation expense for tax and rate purposes on utility depreciable assets produce what is commonly termed book/tax timing differences. These tax timing differences result in the utility collecting tax dollars in rates that are not yet due to the government. The Commission has recognized that since these funds are available due to an income tax deferral, they are a loan from the government. These sums are accounted for as ADIT and are recorded 0 0 in FERC Account No., Deferred Income Taxes, Other Property. Q. How do depreciation and ADIT relate in the ratemaking context? A. The Commission allows regulated entities to recover depreciation, the cost of their investment, in rates on a straight-line basis. In simplest terms, if an asset has a 00-year life, the utility will have a percent depreciation rate reflected in its cost of service. Internal Revenue Code ( IRC ) Section provides a tax deduction for a reasonable allowance for the exhaustion, wear and tear of using property in a trade or business. Section cross references Section for determining depreciation deductions for most property placed in service after 0. Section was added in to provide for accelerated methods of depreciation. Section was amended in and provides for the MACRS. Trailblazer uses MACRS in the computation of depreciation expense in its Tax Normalization for Certain Items Reflecting Timing Differences in the Recognition of Expenses or Revenues for Ratemaking and Income Tax Purposes, Order No., FERC Stats. & Regs., Regs. Preambles 0,, at p., (), reh g denied, Order No. -A, FERC Stats. & Regs., Regs. Preambles 0,0 (), aff d, Pub. Sys. v. FERC, 0 F.d (D.C. Cir. ).
Page of 0 0 0 respective income tax returns, which reduced taxable income in the earlier years of the pipeline s life. The ratemaking method used by Trailblazer to recognize book/tax timing differences prescribed by Section is in compliance with the tax normalization policy required by Section. Q. What is income tax normalization? A. As discussed above, the Commission uses straight-line book deprecation in the computation of income tax allowance in cost of service, in lieu of MACRS. This results in a utility, on an annual basis, collecting an allowance for income taxes in the initial years of a project that is greater than that paid to the government and collecting less income taxes than are due in the latter years of a project s life. Normalization requires a utility to create ADIT balances to reflect the temporary timing differences for the income tax effect of book/tax timing difference. Normalization, governed by IRS regulations and statutes, requires that the recorded balance of ADIT be used in the computation of a utility s rate base. The goal of tax normalization is to prevent regulators from discouraging investment by passing the benefits of accelerated depreciation to ratepayers by immediately reducing the income tax allowance while insuring that, at the end of the life of a project, the utility has collected all of the taxes that are includible in the cost of service. Effectively, normalization allows the utility to use the cash flow generated by the book/tax timing differences but provides a benefit to ratepayers by a reduction to their rates through the recognition of ADIT in the computation of rate base.
Page of 0 0 0 Q. What happens if there is a violation of the tax normalization rules? A. The IRS would no longer permit the utility to use accelerated depreciation, to the detriment of both the pipeline and its shippers. Congress originally enacted the normalization rules to ensure that the capital formation benefits of accelerated depreciation can be retained by the utility. In turn, ratepayers receive an adjustment to rate base on which the utility earns a return, as ADIT is an interestfree loan from the federal government. The utility does not earn a return on investment funded by that loan. The normalization rules dictate that accelerated depreciation deductions determined under Section do not apply to any utility property if the taxpayer does not use normalization method of accounting. Q. Please identify the specific IRC reference that prescribes the method used to determine tax depreciation if the IRS determines that a violation of tax normalization has occurred. A. IRC Section (i)()(c) provides: Public utility property which does not meet normalization rules. In the case of any public utility property to which this section does not apply by reason of subsection (f)(), the allowance for depreciation under section (a) shall be the amount computed using the method and period referred to in subparagraph (A)(i). Subparagraph (A)(i) of Section (i)() provides: the taxpayer must, in computing its tax expense for purposes of establishing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account, use a method of depreciation with respect to such property... that is no shorter than, the method and period used to compute its depreciation expense for such purposes....
Page 0 of 0 0 Thus, the IRC restricts tax depreciation to the utility s regulatory depreciation method when there is a normalization violation. Q. Do the procedures used by Trailblazer in the computation of ADIT comply with the Commission s regulations and precedent? A. Yes. Trailblazer s treatment of ADIT is compliant with the requirements of tax normalization, the Uniform System of Accounts ( USoA ), and Commission precedent, as explained in more detail below. Q. What composite income tax rate should Trailblazer be using to compute its ADIT going forward? A. As discussed in Section V below, I calculate Trailblazer s composite income tax rate to be. percent, both for purposes of calculating Trailblazer s income tax allowance and for the purposes of normalizing Trailblazer s ADIT. III. EXCESS ADIT RESULTING FROM THE 0 TAX CUTS AND JOB ACT 0 Q. Does the Tax Cuts and Job Act of 0 ( TCJA ) have any impact on Trailblazer s ADIT balance? A. Yes. The TCJA reduced the income tax rates. The impact of this change resulted in Trailblazer s ADIT balance as of December, 0 being greater than that needed to meet Trailblazer s income tax obligations due in future years. Trailblazer has determined the difference between its remaining book and tax depreciable plant balances as of January, 0. As shown on Schedule B-, Exhibit No. TPC-000 at, sponsored by Trailblazer Witness Michael J. Rinehart, Trailblazer has $,, more ADIT in Account No. as of
Page of 0 0 0 December, 0 than will be required to pay its future federal income tax liability due to the income tax rate reduction. This $,,, the amount by which the ADIT balance is now in excess, is referred to as excess ADIT. Schedule B- also shows an adjustment related to excess deferred income taxes in Account No. 0, however the balances contained in Account No. 0 are not properly included in Trailblazer s cost of service. See C.F.R..0(c)() (0). As such, the amount of excess deferred income taxes in Account No. related to Account No. 0 are also not reflected in Trailblazer s cost of service. Q. How has Trailblazer treated the excess ADIT on its books? A. As of January, 0, Trailblazer moved the $,, out of Account No. and recorded the same amount in Account No., Other Regulatory Liabilities. Q. What is FERC s policy when the ADIT balance is deficient or in excess? A. The Commission issued Order No. in, which required FERCjurisdictional utilities to follow the tax normalization rules of the IRC. Order No. further required the liability method of accounting that required an accounting of any excess and deficiency in the deferred income tax account and use of a method to bring the deferred income tax account to a level that would equal that required using full normalization. It also required a rate applicant to compute the income tax component in its cost of service by making provision for any excess or deficiency in its deferred tax reserves resulting from tax rate changes, but established no specific method provided that, in keeping with normalization rules, any method for returning excess ADIT to ratepayers by
Page of 0 0 reducing the income tax component may be done no more rapidly than over the life of the underlying assets. On September,, in Docket No. AI--00, FERC issued Accounting for Income Taxes Under SFAS 0, FERC, (), that provided direction as to the accounting and rate treatment for occurrences when the balance in Account No. is either deficient or in excess. If deficient, a regulatory asset is established for the deficiency in FERC Account No.. (Other Regulatory Assets). If there is an excess, a regulatory liability is recorded in Account No. (Other Regulatory Liabilities). Q. Since the TCJA took effect, has the Commission altered its treatment of excess ADIT? A. No, but the Commission did recently initiate a Notice of Inquiry that seeks comment on ADIT in the context of the TCJA. pending. That proceeding remains 0 Q. What is the proper mechanism for flowing excess ADIT through in a cost of service? A. The TCJA provides that utilities should use the Average Rate Assumption Method ( ARAM ). Under ARAM, a jurisdictional pipeline calculates excess ADIT based on each of the utility s vintage-year depreciable assets by function. However, many jurisdictional pipelines do not have the necessary data to support ARAM due to the use of composite depreciation, which assigns a single depreciation rate to each of a utility s separate functions. Having one composite See Inquiry Regarding the Effect of the Tax Cuts and Jobs Act on Commission-Jurisdictional Rates, FERC, (0).
Page of 0 0 book depreciation rate for each vintage year makes the use of ARAM problematic. When the utility does not have the required records, it is required to use an alternative method approved by the Commission. FERC approves the use of the Reverse South Georgia Method (called an alternative method in the TCJA) for amortizing excess ADIT. Q. Has the IRS agreed that the use of the Reverse South Georgia Method is acceptable? A. Yes. This issue was addressed in Revenue Procedure -. In essence, Revenue Procedure - recognized that when FERC uses a composite method for depreciation, the Reverse South Georgia Method would produce a reasonable result. Accordingly, Revenue Procedure - concluded that FERC- jurisdictional pipelines would not be in violation of the tax normalization rules if they adopt FERC s Reverse South Georgia Method. Q. Please explain the South Georgia and Reverse South Georgia Methods. A. If there is a deficiency in ADIT, the South Georgia Method allows a regulated utility to amortize the deficiency over the remaining life of the pipeline. The deficiency is recorded as a regulatory asset, and as the pipeline recovers the annual amortization in rates, the balance in the regulatory asset deceases. When there is an excess of ADIT, the Reverse South Georgia Method is used, whereby See Arkla Energy Res., FERC,0, at p., n. () ( Under the reverse South Georgia method, excess deferred income taxes accumulated in a pipeline s FERC Account No. are flowed back to ratepayers in equal amounts over the remaining useful life of the pipeline s assets. ). See IRS, Examination of Returns and Claims for Refund, Credit, or Abatement, Rev. Proc. -, - I.R.B. (). See Delegated Letter Order, S. Ga. Nat. Gas Co., FERC Docket No. RP--000 (May, ).
Page of 0 0 0 the excess is recorded as a regulatory liability and the excess is amortized as a reduction to the income tax component in the cost of service over the remaining life of the pipeline. Q. Which mechanism is appropriate for Trailblazer? A. Trailblazer should use the Reverse South Georgia Method. Using ARAM would require Trailblazer to calculate an annual refund of the excess ADIT to ratepayers based on each of the utility s tax vintage-year depreciable assets. For income tax purposes, each vintage year has a specific tax depreciation. However, Trailblazer s Commission-approved depreciation rates use the composite method for book purposes, which assigns a single depreciation rate to each operating function. Thus, each vintage year has the same book depreciation rate irrespective of the year placed into service. Consequently, Trailblazer does not currently have the appropriate records to use ARAM. To accommodate utilities that do not have the appropriate records to use ARAM, the TCJA allows rateregulated entities that use composite depreciation to use the Reverse South Georgia Method. Both ARAM and the Reverse South Georgia Method ultimately achieve the same result: the excess ADIT is reduced over the remaining life of the asset determined on the date the excess occurred. Q. When do you recommend that Trailblazer begin amortizing the excess ADIT?
Page of 0 0 0 A. There is no FERC precedent on when such amortization is to begin, as FERC did not address the issue with the enactment of the Tax Reform Act of. Accordingly, the only direction that FERC-regulated gas utilities can interpret for the start date of the amortization is the mechanism provided in the ARAM. A regulated utility using ARAM would be required to commence an immediate amortization of the excess ADIT. With no guidance from FERC as to the starting date for the amortization of the regulatory liability under the Reverse South Georgia Method, I recommend that Trailblazer begin amortizing its excess ADIT on its financial books the month following the TCJA enactment, i.e., beginning on January, 0, to be consistent with how ARAM would have been applied. Q. Please explain why the use of ARAM requires an immediate amortization of the excess ADIT. A. Amortization of the excess ADIT begins for each vintage year when book depreciation exceeds tax depreciation for that vintage year. Thus, such occurrence will start the amortization of excess ADIT immediately following the date the excess ADIT is computed, which for Trailblazer is January, 0. Q. How is the remaining life of the pipeline determined generally, and for Trailblazer specifically? A. IRC s Sections and normalization rules only govern utility property. Trailblazer utility property is its transmission facilities. Thus, its remaining life should be limited to its transmission system life. General and intangible plant Pub. L. No. -, 00 Stat. 0 (codified in U.S.C., et seq.).
Page of 0 0 0 were excluded from the computation. The calculation begins with determining the annual depreciation expense for the transmission system as of December, 0, or the date the excess is computed, utilizing the approved deprecation rate in effect on that date. December, 0 is the same balance as of January, 0, or the proposed date of the start of amortization. This calculated transmission depreciation expense is then divided into the remaining (net) depreciable transmission plant as of December, 0. The product of this computation for Trailblazer is approximately. years. Q. Should the amortization period of. years remain unchanged even if FERC agrees to revise Trailblazer s depreciation rates? A. Yes, the amortization should not change. After the Tax Reform Act of, numerous pipelines maintained the same amortization period even if there was a later change in a pipeline s depreciation rates in succeeding rate case proceedings. To reconcile when a change in the amortization period occurred, many settlements at that time were written so that the amortization would continue unchanged until the excess ADIT no longer existed. Thus, there was no need to continually update the amortization period based on a change to the depreciation rate. Changing the amortization period for excess ADIT each time a pipeline files a rate case is inefficient. As plant additions occur on a yearly basis, the pipeline s remaining life accordingly will increase. Thus, the amortization period would continue to escalate, and the regulatory liability may only be fully amortized once the pipeline is retired. Further, continuous updating of the remaining life could be
Page of 0 0 0 a violation of normalization rules as the remaining life determination must be consistent with that determined using ARAM. Q. Given the above discussion, what is your proposal for flowing Trailblazer s excess ADIT through in its cost of service? A. I recommend that Trailblazer use the Reverse South Georgia Method to calculate flow through of its excess ADIT. The total excess ADIT is $,,, when divided by the remaining life of. years, results in an annual amortization of $,0 per year. Q. How do you propose that Trailblazer reflect the amortization of excess ADIT? A. I recommend that Trailblazer include the annual amortization on Statement A as a credit to the overall cost of service. This amortization, in the amount of $,0, is included in the $, shown on Statement A (Exhibit No. TPC-000), Line, as part of the Revenue Credits. Further details regarding this cost of service credit are shown on Schedule G- (Exhibit No. TPC-00). This treatment has the same cost-of-service effect as reflecting the excess ADIT in the computation of the income tax allowance, but as proposed, provides ratepayers additional transparency. Q. How do you propose to allocate the excess ADIT? A. The excess ADIT should directly follow the assigned ADIT. For instance, if an incremental project has recorded five percent of the total ADIT, that project should be allocated five percent of the unamortized regulatory liability and
Page of 0 receive credit for five percent of the annual amortization of the regulatory liability. IV. REDUCTION OF TRAILBLAZER S ADIT BALANCE DUE TO THE 0 REORGANIZATION 0 0 Q. Other than the effect of the TCJA on ADIT, as discussed above, was there another significant event that affected your computation of Trailblazer ADIT? A. Yes. As explained by Trailblazer Witness David J. Haag, Exhibit No. TPC-00, in June 0, the Tallgrass family of companies, of which Trailblazer is a member, underwent a corporate reorganization ( Reorganization ) that eliminated any ownership by a Master Limited Partnership ( MLP ). Tallgrass Energy, LP ( TGE ), an entity which is taxed as a C-Corporation, now owns. percent of Trailblazer s parent company, Tallgrass Equity, LLC ( Tallgrass Equity ). The change in ownership was a taxable event, as discussed below. The taxable event resulted in the reset of Trailblazer s ADIT balance as of the date of the ownership change. The IRC Section election applicable to Trailblazer effectively treats the transaction as an asset sale and consequently results in a step-up in Trailblazer s tax-depreciable plant basis. Q. Has FERC addressed the tax implications upon the sale of a partnership interest in a regulated natural gas pipeline? A. Yes. In Enbridge Pipelines (KPC), 00 FERC,0 (00), reh g denied, 0 FERC,0 (00), Midcoast Energy Resources, Inc. ( Midcoast ) purchased 00 percent of the partnership interest in Kansas Pipeline Company ( KPC ), a
Page of 0 0 0 partnership (prior to the Commission s order, Midcoast was purchased by Enbridge Pipelines). Upon the sale, KPC made an election under IRC Section. The implications of the election were that KPC was deemed to have sold its assets, rather than its partnership interest, to the ultimate purchaser, Midcoast. The buyer, Midcoast, was permitted to step-up the tax basis of KPC s assets to an amount equivalent to the purchase price of the partnership interest. Upon the recognition of the taxable event, KPC s deferred income tax balance was extinguished on the date of the purchase and the deferred taxes were payable to the IRS. The Commission found that a taxable event occurred, taxes were due, and the existing ADIT balances were properly reduced to zero as the result of the deemed sale. In Enbridge, the Commission further stated: Thus, tax normalization consideration comes into play in determining the correct amount of ADIT. In order to continue to qualify for accelerated depreciation, a company must follow IRS normalization rules concerning ADIT. Accordingly, the Commission must keep these tax considerations in mind in the examination of ADIT. As a result, when a sale results in a company recording a taxable event, the company has recognized this event and eliminated the ADIT balance in accordance with the normalization rules. 00 FERC,0 at P. Q. How does FERC s USoA address the acquisition of assets with respect to ADIT? A. The tax effect of the book/tax timing differences for plant investment is recorded in FERC Account No.. Deferred income tax recorded in Account No. must represent the tax liability due because of the recognition of book/tax timing differences. Further, the regulations specifically restrict transferring any balance
Page 0 of 0 0 0 to retained earnings or making any other use thereof, except as provided by instructions to Account No.. The instructions state that: Upon the disposition by sale, exchange, transfer, abandonment or premature retirement of plant on which there is a related balance herein, this account shall be charged with an amount equal to the related income tax expense, if any, arising from such disposition.... C.F.R. pt. 0, Acct. No. (D). Thus, the FERC rules recognize that upon an asset sale (or a deemed asset sale for income tax purposes as is the case with Trailblazer), the seller s ADIT balance is extinguished since any deferred taxes are due and payable by the seller at the time of sale. Q. How will the above described transaction affect Trailblazer s ADIT? A. As previously discussed, ADIT represents taxes that have been deferred and will become due on a future date. For Trailblazer, the 0 transaction resulted in the recognition of taxable income by the owners and therefore Trailblazer s ADIT was adjusted to reflect the income tax due as a result of the taxable event. IRC Section (b) provides for an adjustment to the basis of partnership assets upon the sale of a partnership interest if the partnership has an IRC Section election in place, which, as stated above, was the case. A Section election provides for an increase (or reduction) in the purchasing partner s basis in partnership assets thereby reducing or eliminating the purchasing partner s share, which is intended to put the purchasing partner in approximately the same position as if it had acquired the partnership assets directly. The step-up in basis is directly attributable to the taxable transaction engaged in by the sellers at the
Page of 0 0 0 partnership level. The adjustment is specific to the purchasing partner and affects only that partner s basis in the partnership assets. Trailblazer is required to adjust its ADIT balance because the balance relating to its assets that existed immediately prior to the acquisition is now due to the IRS and other taxing authorities. This current tax was incurred by each TEP unitholder and will reported as a taxable gain on their respective 0 federal income tax returns. The resulting Section (b) adjustment to the tax basis of Trailblazer s assets deemed to have been purchased eliminates the difference between the book basis of those assets and their tax basis (the tax basis is stepped up to equal the remaining book depreciable plant on the date of the sale). The elimination of the temporary difference eliminates the associated ADIT balance. Q. Given the above, how should Trailblazer adjust its remaining ADIT balances in light of the taxable nature of the 0 acquisition? A. Pursuant to Commission precedent discussed above, and IRS normalization rules, all remaining ADIT balances should be extinguished as of the date of the transaction. Q. What happens if there is a violation of the tax normalization rules? A. As explained earlier in my testimony, the IRS would no longer allow Trailblazer to use accelerated depreciation, to the detriment of Trailblazer and its shippers. Q. Are you aware of any IRS ruling in which a regulated utility involved in a taxable transaction would have incurred a normalization violation?
Page of 0 0 0 A. Yes, I am. On August,, the IRS, in Private Letter Ruling 00, ruled that there would be a normalization violation if, subsequent to the date of the acquisition and deemed sale of assets of a natural gas transmission company, the natural gas company s rate base was reduced for the balance in the reserve for the ADIT attributable to accelerated depreciation on public utility property before the acquisition date. In that case, the parent sold the gas company to the buyer pursuant to an IRC Section (h)(0) transaction. Such transaction, although structured as a stock sale, was treated as an asset sale by the selling and buying corporations for tax purposes. The IRS ruled that because of the deemed sale of the seller s assets, the seller s ADIT balance ceased to exist and had to be removed from the seller s regulated books of account and could not be flowed through to customers and credited to rate base. Further, the IRS ruled that a normalization violation would occur if the seller s ADIT balance that existed before the acquisition were used to reduce the buyer s rate base. Q. What are Trailblazer s ADIT balances as of July, 0? A. Trailblazer has extinguished its remaining ADIT balance effective July, 0. V. TRAILBLAZER S INCOME TAX ALLOWANCE Q. What is an income tax allowance and how is it calculated? A. Under cost-of-service ratemaking principles, a pipeline is entitled to recover from ratepayers all proper costs, including income taxes. Accordingly, income taxes are recovered in cost-of-service rates through a component referred to as the I.R.S. Priv. Ltr. Rul. 00 (Aug., ).
Page of 0 0 0 income tax allowance. The income tax allowance is calculated by computing the composite tax rate applicable to the pipeline. The composite tax rate includes applicable state and federal taxes. Q. Prior to the Commission s 0 Revised Policy Statement, what was the Commission s income tax allowance policy? A. For many years, the Commission has provided pipelines an income tax allowance based on their, or their owners, actual or potential income tax liability. For pipelines taxed as C-Corporations, at the federal level, the Commission provided an income tax allowance based on the federal corporate income tax rate, which previously was percent until recently reduced to percent by the TCJA. For pipelines taxed as partnerships, the Commission s 00 Income Tax Policy Statement clarified that the Commission provides an income tax allowance for partnerships that held interests in a regulated public utility if the owner of that interest had an actual or potential income tax liability on the public utility income earned through the interest. Thus, the partnership income tax allowance, at the federal level, was based on the federal tax rate applicable to the partners. The Commission found that such a policy served the public because it allowed rate recovery of the income tax liability attributable to regulated utility income, facilitated investment in public utility assets, and assured just and reasonable rates. Inquiry Regarding the Commission s Policy for Recovery of Income Tax Costs, FERC, (0) ( Revised Policy Statement ). Policy Statement on Income Tax Allowances, FERC,, at P (00).
Page of 0 0 0 Q. What did the D.C. Circuit hold in United Airlines v. FERC regarding the Commission s income tax allowance policy? A. The U.S. Court of Appeals for the District of Columbia Circuit ( D.C. Circuit ) held that the Commission had not convinced it that its income tax allowance policy ensured parity between C-Corporation owners and MLP partnership owners. Specifically, the D.C. Circuit found that the current income tax allowance coupled with the fact that C-Corporation owners are taxed twice at the C-Corporation level and at the ownership level whereas MLP partnership owners are only taxed once at the ownership level suggested that MLP partnership owners were double-recovering the tax allowance relative to C- Corporation owners. In addition, the D.C. Circuit expressed concerns that the calculated returns for MLP pipelines using the Commission s Discounted Cash Flow ( DCF ) methodology may also contain an implicit income tax allowance for investors. Trailblazer Witness Barry E. Sullivan (Exhibit No. TPC-00) also discussed issues related to income tax allowances and the DCF methodology. Q. What did the Commission s 0 Revised Policy Statement, which addresses United Airlines v. FERC, establish? A. The Revised Policy Statement left the Commission s policy towards pipelines organized as C-Corporations unchanged they are still entitled to an income tax allowance. Regarding pipelines owned by MLPs, the Revised Policy Statement concluded that they are no longer entitled to an income tax allowance. Lastly, the Revised Policy Statement states that pipelines organized as another form of pass-
Page of 0 0 0 through entity (such as the case for Trailblazer) proposing an income tax allowance must address the United Airlines double-recovery concern. Q. Would there be parity between partnership owners and C-Corporation owners if the Commission does not permit partnership owners any income tax allowance? A. No. If the Commission does not permit any income tax allowance for partnership owners, but continues to allow C-Corporation owners an income tax allowance based on the percent federal corporate income tax rate, the Commission would be treating C-Corporation owners more favorably than partnership owners, thus failing to ensure parity. In United Airlines, the D.C. Circuit was concerned about partnership owners over-recovering relative to C-Corporation owners. Eliminating the income tax allowance entirely would turn that concern around so that partnership owners would be under-recovering relative to C-Corporation owners. The elimination of an income tax allowance for non-c-corporations creates a different form of disparity. Q. Are partnership earnings subject to income taxes? A. Yes. Partnerships are subject to taxation at the owner level and taxes are paid on the earnings and income of partnership owned pipelines just as they are on the earnings and income of pipelines owned by C-Corporations. Each tax year, C- Corporations file an income tax return (IRS Form 0) and the C-Corporation is responsible for taxes on those earnings during the tax year at the percent rate. Similarly, each year a partnership files a tax return (IRS Form 0), but the partnership itself does not pay tax on its income. Rather, the owners of the
Page of 0 0 0 partnership receive a Form K- from the partnership that indicates their share of the partnership s income and/or loss. The partnership s owners are then responsible for taxes on those earnings in the year earned at personal income tax rates of up to percent. Thus, the earnings of a C-Corporation and a partnership are both subject to taxation. While on the one hand, for a C-Corporation, the C- Corporation itself is responsible for paying the tax, and on the other hand, for a partnership, the partners are responsible for paying the tax, in both cases, taxes are paid. Where the income tax falls is determined by the IRC and the form of ownership of the entity. Q. Given that that both sets of owners are subject to income taxes, how can the Commission ensure parity between partnership owners and C-Corporation owners? A. The Commission s income tax allowance policy needs to reflect that both partnership owners and C-Corporation owners incur income tax liabilities. Since the Commission permits C-Corporation owners an income tax allowance based on their actual or potential income tax liability, to ensure parity between partnership owners and C-Corporation owners, the Commission must provide partnership owners an income tax allowance that reflects their actual or potential income tax liability. Q. What are the tax liabilities of C-Corporations and their owners? A. C-Corporations are taxed on their taxable income at the percent corporate income tax rate. If and when C-Corporations make distributions (i.e., pay dividends) to their owners (shareholders), there is a second level of tax on the
Page of 0 0 0 dividend that is paid by the shareholder. The tax treatment of the distribution depends on the type of distribution, and the shareholder s tax rate. There is no income tax at the shareholder level until there is a distribution (i.e., a dividend) or the shareholder sells his or her shares. The federal tax rate applicable on dividend income for individual investors is currently 0 percent, percent or zero depending on the taxpayer s tax bracket. The fact that C-Corporation earnings are subject to tax at the corporate and shareholder level is, relative to partnerships, sometimes referred to as the double taxation of C-Corporations. However, rather than comparing the number of times a tax is assessed, a more accurate comparison between C-Corporations and partnerships would compare overall tax liability caused by utility income. Such a comparison illustrates that the overall tax liabilities are similar. Q. What is the tax liability of partnership owners? A. Partnership owners are taxed on their proportionate share of the partnership s taxable income in the year in which the income is earned, regardless of whether earnings are distributed. Thus, for an individual owner, the tax rate on this income is his or her applicable marginal tax rate. The current maximum ordinary income tax rate for individuals is percent. Any portion of the cash distribution that is not currently taxable, due to various tax deductions, reduces the owner s tax basis in the partnership. Ultimately, the reduction in basis defers but does not avoid taxation. When the owner sells the partnership interest, any positive difference between the tax basis and the sale price is taxed as capital gains except for tax depreciation claimed in previous years prior to the sale, which are taxed as
Page of 0 0 0 ordinary income (referred to as recaptured depreciation ). Therefore, owners of partnerships are taxed on current distributions from the partnership, and then on the recaptured depreciation amounts upon sale of their interest. Q. Accounting for the fact that C-Corporation owners are taxed twice, at the entity level and at the individual level, and partnership owners are only taxed once, at the individual level, what income tax allowance for partnership owners would ensure parity with C-Corporation owners? A. Partnership owners should be permitted an income tax allowance based on a tax rate which ensures parity with C-Corporation owners who are permitted an income tax allowance based on a percent tax rate. While C-Corporation owners are taxed twice, at the entity level and at the individual level, and partnership owners are only taxed once, at the individual level, the number of times they are taxed is irrelevant to their overall tax liability. In fact, partnership owners and C-Corporation owners have similar overall tax liabilities. C- Corporation owners are taxed at the percent corporate income tax rate at the entity level and then at the 0 percent dividend rate or less at the individual level. Partnership owners can be taxed at up to a percent rate at the individual level almost double the rate which C-Corporation owners are taxed at on the individual level. Thus, while partnership owners are only taxed once, their overall tax liability is similar to that of C-Corporation owners on an overall basis. Thus, the Commission would not be treating them similarly or ensuring parity by eliminating partnership owners income tax allowance. To ensure parity between C-Corporation owners and partnership owners, given that the
Page of 0 0 0 Commission permits C-Corporation owners an income tax allowance based on the percent federal corporate income tax rate, partnership owners should be permitted a similar income tax allowance. By doing so, the Commission can ensure parity and address the D.C. Circuit s double-recovery concern Q. Do partnership unitholders have other additional costs that shareholders do not have? A. Yes. Partnership unitholders often have additional costs that shareholders do not have. For instance, a partnership that has taxable income may choose, for whatever reason, not to make a cash distribution of all of the income. That still requires the unitholder to pay income taxes on the unitholder s share of income regardless of whether a cash distribution is made. For example, TransCanada Pipeline Partners ( TransCanada ), on May, 0, announced it will be reducing its distribution by percent as a direct result of FERC s actions. Those distributions represent over $0 million of annual distribution lost to unitholders. Yet, the reduction in cash distribution will not directly lower its unitholder s taxable income reported on their respective K- distributions. Although the cash distributions are lower by some percent, the pipelines net taxable income may remain the same, and consequently, their unitholder s distributed taxable income would remain the same and the unitholder s income tax obligation to the IRS would be the same. Further, unitholder s recognition of the partnership s apportioned tax depreciation lowers the unitholder s cost basis and upon selling their units will consequently result in the recognition of additional taxable income. The
Page 0 of 0 0 0 recaptured depreciation is taxed at ordinary income tax rates. The recognition of tax depreciation by a corporation does not impact the computation of a corporate shareholder s cost basis when selling their shares on the open market. The gain recognized by the corporate shareholder is all subject to a capital gains tax which is much lower than ordinary income tax rates. The Sponsoring Entities in this proceeding, as defined below, must be provided an opportunity to sufficiently recover the incremental costs of ownership relative to the costs of owning that same regulated asset as a corporate shareholder. Q. What income tax allowance are you proposing for Trailblazer? A. As detailed in my Ex. No. TPC-00, I propose an income tax allowance for Trailblazer based on a composite income tax rate of. percent. Q. Who owns Trailblazer? A. Post the June 0 Reorganization, Trailblazer is indirectly owned. percent by TGE and. percent by the private equity owners of Tallgrass Equity, LLC ( Tallgrass Equity ). Q. Is Trailblazer a tax paying entity? A. For income tax purposes, Trailblazer is a disregarded entity. Trailblazer s income is reported in the tax return of its ultimate parent. Q. Please describe Trailblazer s majority owner, TGE. A. TGE (formerly known as Tallgrass Energy GP, LP) filed an election with the IRS to be taxed as a C-Corporation. See Ex. No. TPC-00. As of April, 0, the IRS approved that election. Accordingly, TGE is taxed as a C-Corporation at the
Page of 0 0 0 percent federal income tax rate and thus the resulting income tax obligation for its. percent ownership share of Trailblazer is the same as the income tax obligation Trailblazer would incur if it was a C-Corporation itself. Q. Please describe Tallgrass Equity s minority owners. A. Tallgrass Equity s minority owners consist of individual investors that primarily acquired their ownership in Trailblazer through being partners in various private equity funds that were original investors in Tallgrass. I refer to these individual owners as Sponsoring Entities. This ownership distinction is an important factor in the determination of Trailblazer s taxable income. Each of the Sponsoring Entities pay income taxes, at their applicable rate, on their allocated share of Trailblazer s earnings. The Sponsoring Entities also have the right to convert their ownership interests into TGE shares. To the extent any conversion takes place, Trailblazer will reflect them in test period updates and/or file supplemental or rebuttal testimony accordingly. Q. How will the taxable income be distributed to Tallgrass Equity s Sponsoring Entities? A. The Sponsoring Entities will receive K-s, as their ownership is through a passthrough partnership. Q. Is Tallgrass Equity an MLP? A. No. Tallgrass Equity is not an MLP and none of its current partnership interest was ever included in an MLP. The ownership originated through the purchase of utility assets from another utility and the ownership structure since the purchase has been a pass-through LLC.
Page of 0 0 Q. Is Trailblazer s proposed income tax allowance consistent with the Commission s Revised Policy Statement? A. Yes, under the Revised Policy Statement, Trailblazer is entitled to an income tax allowance. MLPs are the only entities denied an income tax allowance by the Revised Policy Statement. Trailblazer is not an MLP and is not owned by an MLP. Further, the Revised Policy Statement did not suggest that the Commission had any concern with double-recovery for pipelines taxed as a C-Corporation. Accordingly, the. percent of Trailblazer that is owned by TGE and taxed as a C-Corporation is entitled to the income tax allowance under the Revised Policy Statement. As for the. percent of Trailblazer owned by the private equity owners of Tallgrass Equity, the Revised Policy Statement permits a pipeline to justify an income tax allowance for such an entity by demonstrating that there is no double-recovery of income taxes as discussed in the Revised Policy Statement. Accordingly, the remainder of my testimony demonstrates that an income tax allowance for the. percent of Trailblazer owned by the private equity owners of Tallgrass Equity would not lead to a double-recovery. Q Are the Sponsoring Entities in the same investment class as MLP partners that buy their partnership units on the New York Stock Exchange? 0 A. No, the Sponsoring Entities are not in the same investment class as MLP partners. They are significantly different. The Sponsoring Entities were part of the original investment group who purchased the Tallgrass assets, including Trailblazer, from Kinder Morgan, Inc. ( KMI ). Unlike the investors the Commission focused on in the Revised Policy Statement, the Sponsoring Entities were not purchasing
Page of 0 0 0 publicly traded MLP units and did not analyze their investment in Tallgrass under a DCF / return on equity methodology. Thus, the concerns identified in the Revised Policy Statement are not applicable to the Sponsoring Entities. As discussed by Trailblazer Witness Paul R. Moul, the DCF analysis applies only to publicly traded investments and cannot be utilized to analyze an investment made through a Private Equity Fund. See Ex. No. TPC-00. The Sponsoring Entities could not have made a DCF analysis comparable to that performed by the Commission to inform their investment decision because they were not buying any publicly traded assets. Q. How does your proposal conform to the Revised Policy Statement? A. The Revised Policy Statement did not consider entities such as the equity funds that originally acquired their ownership through a purchase of the Tallgrass assets from KMI. This distinguishes the Sponsoring Entities ownership from the MLP s ownership addressed in the Revised Policy Statement. The acquisition of the units, along with the interests and motives of the Sponsoring Entities, are fundamentally different from the purchase of units and the interests and motives of an individual investor seeking a return from publicly traded MLP units for which a yield can be calculated, and a growth rate estimated. The Sponsoring Entities did not participate in the open market and could not make the same demand for a pre-tax return as the Commission asserts is made by individual unitholders purchasing publicly traded units.