6. Resolving the Outstanding Rehearing Issues
6.1. Background on Rehearing D.98-08-033
On April 4, 1997, Indicated Shippers filed C.97-04-025.8 The Commission reached a decision (D.98-08-033, 81 CPUC2d 418)) generally favoring SFPP. In D.99-06-093, (3 CPUC3d 418) the Commission granted rehearing of D.98-08-033 upon the request of Indicated Shippers.
The Commission ordered rehearing to reconsider four disputed issues: (1) the public utility status of the Sepulveda Line, (2) the proper ratemaking treatment of partnership tax expenses, (3) calculation of environmental costs, and (4) the proper ratemaking treatment for the Watson Station facilities.
The Commission dismissed a second application for rehearing filed by SFPP in D.99-09-038 (2 CPUC3d 344). The rehearing request alleged the Commission erred when D.99-06-093 granted rehearing of the first decision (D.98-08-033). We concluded that the second application for rehearing did not show error and was not the proper vehicle for raising SFPP's claims. Therefore, the remaining issues in C.97-04-025 are those identified by D.99-06-093 and are addressed in the following discussion.
6.2. Sepulveda Line Dedication
In D.98-08-033 the Commission found that SFPP had not dedicated the Sepulveda Line to public use and, therefore, the Sepulveda Line was not part of SFPP's public utility pipeline system. After reviewing the law of dedication, D.98-08-033 concluded dedication could only be found by a demonstration that SFPP had an "unequivocal intent to serve the public" that "evidence of that intent is missing in this case." (ARCO Products Company et al. v. SFPP, L.P.[D.98-08-033], mimeo at 14; see also D.99-06-093, supra.) In its rehearing decision, the Commission questioned the formulation of the "dedication test" used in D.98-08-033. The Commission stated in D.99-06-093 that:
The Decision's findings on dedication rely on the principle that dedication is determined by looking for an unequivocal intent to serve the public. However, the Decision does not explain that this intent can be inferred from a company's actions and need not be explicit. [Citation omitted.] Also, while it acknowledges that the public served must be indefinite, it does not clarify that the dedication requirement is met "not necessarily by service to all of the public, but to any limited portion of it, such portion, for example as could be served by [the utility's] own system, as counterdistinguished from [the utility's] holding [its]self out as serving or ready to serve only particular individuals, either as a matter of accommodation or for other reasons peculiar and particular to them." (Van Hoosear v. Railroad Com. (1920) 184 Cal. 553, 554). (D.99-06-093, 1 CPUC3d 418, 419, emphasis as added in D.99-06-093.)
Therefore, in today's decision we determine the public utility status of the Sepulveda Line in light of the proper standard for dedication. We find that D.98-08-033 too narrowly construed the requirement that SFPP must state its intention in writing to allow use of the Sepulveda Line as a public utility facility. We determine that by its actions, e.g., deliberately, and repeatedly allowing customers to ship product over the facility, SFPP has effectively dedicated the Sepulveda Line to public utility service.
6.3. Ratemaking Treatment of Partnership Tax Expenses
In this section we find that SFPP has not demonstrated that it will incur a corporate income tax paid by the utility before distributing its earnings to investors. The Commission allows a regulated utility to recover in base rates a forecast of its operating costs to provide customers safe and reliable service. Because there is no corporate tax expense incurred by SFPP, there is no need for a tax allowance in rates.
D.98-08-033 found a "tax allowance" expense of $5.4 million should be included among SFPP's expenses for the purpose of determining if SFPP's rates were reasonable. The Commission determined SFPP itself does not directly pay tax on the income it generates because SFPP is organized as a limited partnership. However, this does not mean that income generated by SFPP is necessarily tax-free. SFPP's income could be eventually taxable in the hands of SFPP's upstream owners, regardless of the amount of cash SFPP actually distributes to them. The amount of tax paid on income SFPP generates depends on the tax situation of each of its owners--including the possibility that the tax obligation may be passed on to a further, indirect owner of SFPP.
There is a legal distinction between corporations and partnerships. Corporations are separate legal entities that receive income in their own right, and, subject to applicable law and regulations, pay tax on it. Section 11(a) of the Internal Revenue Code (IRC) provides: "A tax is hereby imposed for each taxable year on the taxable income of every corporation." (26 USC § 11.)
For federal income tax purposes, the predominant forms of business are "C" Corporations and "S" Corporations. "C" Corporation earnings are taxed first as net earnings at the corporate entity level, and secondly, after the earnings are distributed to shareholders as dividends. Each shareholder is liable for taxes on the dividends.
"S" Corporations are taxed as partnerships. There is no federal income tax on partnerships because partnerships do not pay an income tax on their earnings at the entity-level. IRC § 701 provides: "A Partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities." (26 USC § 701.) In other words, the government taxes the individual partners on their share of the partnership's earnings.
The tax law does not explicitly define a partnership. The definition or characteristics of this operating structure draw from principles of business law where a partnership is a union of two or more individuals or entities, as co-owners for the purpose of carrying on a business, venture, or other activity for profit. However, a definition by exclusion is provided in IRC § 761(a) which states: "For purposes of this subtitle, the term `partnership' includes a syndicate, group, pool, joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title (subtitle), a corporation or a trust or estate." (26 USC § 761.)
At the practical level the Internal Revenue Service states:
Generally, a partnership does not pay tax on its income but "passes through" any profits or losses to its partners. Partners must include partnership items on their tax returns. (Internal Revenue Service, Publication 541 Contents (Rev. February 2006).)9
And:
Although the partnership generally is not subject to income tax, you are liable for tax on your share of the partnership income, whether or not distributed. (2006 Internal Revenue Service, Partner's Instructions for Schedule K-1 (Form 1065).)10
An often-cited Commission decision, D.84-05-036, holds that for a regulated utility, other corporate relationships including subsidiaries, holding companies, or affiliates, should not affect the ratemaking treatment for income tax expenses. The regulated corporate entity receives a rate allowance calculated on a stand-alone basis. The objective is to provide an allowance in rates caused by the expected eventual payment of corporate income taxes on the utility's taxable income:
It is the practice of the Commission, in calculating the test-year income tax expense, to assume a separate return basis considering solely utility operations. By making this assumption the Commission presumes that the utility will pay the income taxes generated by the adopted rates. However, because of a utility's affiliated or nonutility operations, its actual income tax liability will be determined as one member of a consolidated tax return. Thus, income taxes collected through authorized rates may not actually be paid, but may be used to offset tax losses of other nonutility and affiliated members of the consolidated return. (Income Tax Expenses for Rulemaking Purposes (1984) 15 CPUC2d 42, at 49.) (Emphasis added.)
This policy grew of necessity due to the complexity of individual regulated utilities, such as Pacific Gas and Electric Company (PG&E) and others,11 expanding over time to conduct non-utility activities through subsidiaries, not just inside the utility company. This led several California utilities to seek a reorganization of their corporate structure so that a new parent company emerged owning the common stock of the regulated company and the stock of various other non-utility companies within the whole group. On a consolidated basis, only the parent pays income taxes on the total of all the affiliated companies' activities. Losers offset winners: i.e., a loss by one affiliate offset the parent's tax liability on the otherwise profitable and taxable results of another more successful venture.
Without the stand-alone treatment of the regulated entity, the non-utility activities could result in a tax expense or savings unrelated to the costs of providing utility service. By excluding the effects of affiliates, the only expense included in rates is the expense for liability attributable to the utility's income, based on an assumption that the utility's income will be taxable. An obvious result is that the income of these utilities is subject to federal income taxes while still within the overall control of the parent that is actively managing the company and making decisions on reinvestment or distribution of earnings. On a before-tax basis, the integrated management may make operational and strategic decisions that might legally avoid, or defer income tax obligations prior to disbursing earnings to investors in the form of dividends. The first time the corporate income is taxable to the individual investors is when after-tax dividends are declared and a portion of the earnings leave the control of the company.
SFPP has argued consistently that the Commission should regulate its operations no differently than those of any other utility subject to the Commission's jurisdiction for cost of service rate regulation. That is, in SFPP's view, it is not relevant that it happens to be a partnership with a complex
multi-layered ownership structure: it should receive an allowance in cost of service rates for income tax expense computed as a stand alone corporate entity. SFPP further argues that an income tax allowance is a standard forecast allowance and no actual proof of payment of corporate income taxes is necessary.
SFPP also argues (2007 briefs) that only taxes in the 2004 and later rate applications are at issue because neither the rehearing decision nor the scoping memo for A.03-02-027 specifically identified income tax as an issue for the our consideration.
Indicated Shippers argue that when viewed as a stand-alone entity, the SFPP partnership does not incur a corporate tax liability. Its earnings are not directly taxed by the federal or state government before the earning are distributed (for financial reporting and/or income tax reporting purposes) to the individual partners under the specific terms of the partnership agreement. Thus, since SFPP, the regulated entity, is not itself a taxpayer, there should be no "phony" tax expense in rates. The Complainants look only to the operating utility level of structure, SFPP, and argue that because it does not pay taxes itself, there should be no tax expense allowed in rates.12
The federal tax allowance is an issue for A.03-02-027 and in the earlier proceedings, because no scoping memo need identify every single issue.13 Any expense as a component of revenue requirement in a ratesetting proceeding is at issue. Further, we believe the tax treatment issue is an open issue in the pending rehearing and we therefore address it here for all pending SFPP complaints and applications.
SFPP should receive an appropriate allowance for income tax expense, if it is liable for income tax. However, D.98-08-033 erred in adopting a specific dollar allowance for income taxes in revenue requirement without a showing that income taxes are incurred by SFPP. SFPP has failed to demonstrate that there is a corporate tax liability that should be recovered in rates. Rather, SFPP suggests that taxes are simply one of several automatic forecast allowances included in rates.
We only provide an allowance where the utility expects to incur an expense. If, for example, SFPP were suddenly able to conduct business entirely without paper, solely using electronic communications, there would no longer be a need to purchase paper, ink, pens, postage, storage boxes, file cabinets, etc. No one would reasonably argue that SFPP should still have a theoretical allowance for paper and pens, and related items included in its expense forecast. If there is no likely expense, there should be no expense forecast in rates.
Applicant has not demonstrated that it pays any corporate tax under its ownership structure, nor do we know the rates of taxation applicable when the partnership distributions are first subject to taxation.14 But this too may not matter: if there is no taxation on earnings while the earnings are still within the operating control of SFPP, there is no income tax obligation to recognize as a utility operating expense in rates.
Partnership units are beneficial to investors because a publicly traded partnership allows the business's cash distributions to circumvent the "double taxation" that would normally be imposed, which generally means greater distributions for partnership unit holders. In a structure like SFPP's, the cash distributions of the company are taxed only at the unit holder level and not at an operating business level. Another benefit of this type of investment to the investor is that because the partnership units are publicly traded, there is a high degree of liquidity for investors. These units can usually be sold in a manner similar to shares in a corporation.
In granting rehearing, the Commission acknowledged that "although we believe the use of a tax allowance is likely to be permissible," D.98-08-033 improperly concluded that to avoid reducing the return to some owners a tax expense must be adopted in order to comply with an established "tax allowance policy."15 That decision mishandled the issue of tax allowances: an allowance for tax expense is only a just and reasonable charge when there is likely to be an actual tax expense by the utility. The Commission determined that in rehearing it would be necessary to consider other alternative solutions. One suggested alternative is the "FERC approach" (Lakehead Pipeline Co. (1996) 75 FERC 61 & 181, as cited in D.99-06-093). The order granting rehearing also found: "the Decision improperly concludes that Southern California Gas co. v Public Utilities Com. (1979) 23 Cal.3d 470, 477, need not be considered when determining whether or not to allow a partnership to claim a `tax allowance' for ratemaking purposes. The Decision contends that case only applies to tax benefits resulting from the `investment tax credit' provisions of federal tax law and does not have general application, especially in cases involving partnerships." (D.99-06-093, 1999 Cal. PUC LEXIS 442.)
Therefore, in this decision we will determine whether SFPP is entitled to an allowance for income taxes consistent with the SoCalGas decision as argued by SFPP. We will also consider the most current FERC approach, as well as any other persuasive evidence and argument in the record. We also note that we are not required to set intra-state rates in exactly the same manner that FERC employs.
The parties have made numerous filings, including motions for the Commission to consider various FERC actions over the past few years. One of the more recent was Indicated Shipper's September 7, 2005 motion, opposed by SFPP, asking us to consider an "Initial Decision" by a FERC ALJ dated August 24, 2005, in FERC Docket Nos. OR 96-2 and IS98-1, et al.16 These filings ask the Commission to consider, admit, or abide by FERC rulings or initial decisions, that are not the final opinion by FERC. We deny these motions because the matters at FERC are not final and we will not consider the interim or proposed solutions of another agency.
SFPP filed a petition on May 5, 2005 asking the Commission to set-aside submission and take official notice of a final FERC action, the May 4, 2005 issuance of FERC's Policy Statement on Income Tax Allowances (111 FERC 61,139.).17 We will take official notice of a final FERC order or an applicable decision of the federal courts and therefore grant all motions in which either party asked to lodge, or have the Commission take official notice of, a final FERC decision or a published court opinion.
Below, we consider the most recent and relevant final decisions and policies and discuss whether FERC's current practice is relevant to California-jurisdictional rates. We note, however, that we are not bound to follow any final FERC order or rule. We will take notice of relevant decisions and will factor into our decision-making the guidance that may apply to this specific proceeding.
On May 4, 2005, FERC issued a new Policy Statement on Income Tax Allowances (Policy Statement) which holds:
The Commission concludes that such an allowance should be permitted on all partnership interests, or similar legal interests, if the owner of that interest has an actual or potential income tax liability on the public utility income earned through the interest. This order serves the public because it allows rate recovery of the income tax liability attributable to regulated utility income, facilitates investment in public utility assets, and assures just and reasonable rates. (70 FR 25818, emphasis added.)
This most recent policy statement followed the rejection of prior FERC holdings by the U.S. Court of Appeals for the District of Columbia remand in BP West Coast Products, LLC, v. FERC.18 In reversing itself, FERC concluded that it should:
. . . return to its pre-Lakehead19 policy and permit an income tax allowance for all entities or individuals owning public utility assets, provided that an entity or individual has an actual or potential income tax liability to be paid on that income from those assets. Thus a tax-paying corporation, a partnership, a limited liability corporation, or other pass-through entity would be permitted an income tax allowance on the income imputed to the corporation, or to the partners or the members of pass-through entities, provided that the corporation or the partners or the members, have an actual or potential income tax liability on that public utility income. Given this important qualification, any pass-through entity seeking an income tax allowance in a specific rate proceeding must establish that its partners or members have an actual or potential income tax obligation on the entity's public utility income. To the extent that any of the partners or members do not have such an actual or potential income tax obligation, the amount of any income tax allowance will be reduced accordingly to reflect the weighted income tax liability of the entity's partners or members. (Para. 32.) (Emphasis added.)
FERC found that the actual tax allowance would have to be determined in individual rate proceedings - the same situation we face here.
SFPP has only presented testimony that supports a pro forma application of treating SFPP as a stand-alone taxable corporation. SFPP would fail the current FERC test on the record in this proceeding. SFPP has not presented us with credible evidence of the "actual or potential" tax.
The most recent FERC policy was reviewed by the District of Columbia Court of Appeals, which found the FERC policy "was not arbitrary or contrary to law." (ExxonMobil Oil Corp. v. FERC, No. 04-1102, slip op. at 4 (D.C. Cir. May 29, 2007) 2007 U.S. App. LEXIS 12339). The court indicated: "While we agree that the orders under review and the policy statement upon which they are based incorporate some of the troubling elements of the phantom20 tax we disallowed in BP West Coast, FERC has justified its new policy with reasoning sufficient to survive our review. We therefore deny the petitions for review with respect to this issue." (Id. at 5.) The court held:
[W]e deny the petitions for review with respect to the income tax allowance issue. Under the arbitrary and capricious test, our standard of review is "only reasonableness, not perfection." Kennecott Greens Creek Min. Co. v. MSHA, 476 F.3d. 946, 954 (D.C. Cir. 2007). We need not decide whether the Commission has adopted the best possible policy as long as the agency has acted within the scope of its discretion and reasonably. (Id. at 17 - 18, emphasis added.)
Indicated Shippers on June 6, 2007, replied to SFPP's motion and stated it had "no objection to the Presiding Judge giving official notice to the Court of Appeals decision, although . . . we do not believe that the decision is relevant to the issues before the . . . Commission."
In this instance, we do not need our ratemaking determinations to match with FERC's ratemaking, because this Commission must also act within the scope of its discretion, and act reasonably on its record. As discussed in this decision, we find that SFPP has not shown its partnership owners have a corporate tax liability in addition to the tax liability which only accrues after partners recognize their distributed partnership income. There is no demonstrated federal tax liability on SFPP's income before it distributes earnings to its partner-owners. There is only one tax: the tax on the partner's income after distribution. (And we have no evidence related to that tax.) We find that SFPP does not have "an actual or potential income tax obligation on the entity's public utility income" in addition to the personal tax obligation of the partners after the partnership distribution. Thus, a reportable and taxable distribution of $100 in partnership income is the equivalent of $100 in reportable and taxable dividend income from a corporation. In both examples, the owner has $100 in income derived from its investment. SFPP has not demonstrated that as a partnership it incurs a federal corporate tax liability, therefore, there is no "tax expense" to include in retail rates as a part of determining just and reasonable rates.
6.4. Environmental Costs
In D.98-08-033 (the original decision) the Commission concluded that environmental costs in the amount of $2.8 million should be included in SFPP's expenses. Complainants' calculation of SFPP's expenses made no provision for environmental costs. SFPP asserted that its California operations incurred $3.8 million in environmental expense in the test year 1996, and that 75% of that expense should be allocated to CPUC-jurisdictional intrastate pipeline services. SFPP proposed a 75% allocation because it had used a 75% allocation for property tax expenses. Although Complainants challenged the allocation method, Complainants did not propose a different allocation.
The decision only found it was more likely that SFPP spent $2.8 million (75% of $3.8 million) on environmental expense than that SFPP spent nothing. In ordering a rehearing, D.99-06-093 found that there was evidence already in the record that indicated the 75% allocation might be too high because SFPP allocated 90% of its environmental costs to California, and only 10% to its extensive operations in Oregon, Nevada, New Mexico and Texas. Further, evidence indicated that a large portion (Complainants allege 39%) of the environmental expense claimed by SFPP was not properly attributable to pipeline operations because it was related to terminals.21
In this decision we determine the appropriate ratemaking allocation of environmental costs to California and the further allocation between pipeline and terminal operations.
SFPP has not persuaded us that it is likely to spend 90% of all environmental costs in California jurisdictional operations. When faced with the absence of a clear, equitable and accurate allocation factor this Commission has traditionally used allocations based upon the proportional size or cost of other related factors. In this case, operating expenses, exclusive of environmental costs, is a reasonable default factor to allocate an expense proportionally among three segments of SFPP's operations. Therefore, in the absence of more accurate data, we direct SFPP to allocate the environmental costs based on the proportional share of all other operating expenses for California pipeline, terminal, and non-California operations.
6.5. Watson Station & Sepulveda Market Rates
The proposed rates for both Watson Station and Sepulveda are market-based rather than cost-based rates (separate from the proposal in A.00-03-044 for market-based rates generally) and applicant argues (1) SFPP's principal customers are sophisticated oil producers; (2) SFPP faces potential competition from new pipelines; (3) SFPP's shippers have reasonable alternatives to the use of SFPP's Watson Station and Sepulveda facilities, such as shipment by truck, vessel or proprietary pipeline; and (4) SFPP's pipeline's proposed rates compare favorably to other pipeline rates. (SFPP May 17, 2007 Reply Brief, at 43.) SFPP cites to 66 CPUC2d 28, a decision where the Commission held it could use non-cost of service methods to regulate the rates of UNOCAP, also a regulated oil pipeline.
In the January 30, 2004 Opening Brief filed by BP West Coast Products, LLC and Exxonmobil Oil Corporation, the parties argue there are no new pipelines which threaten SFPP with market competition; any near-by proprietary pipelines (used solely by the owners, not openly offered as common carriers) cannot be compelled to carry products and thus are not competition to SFPP; and barges, trains and trucks are not viable competitors. (Opening Brief at 4 - 20.)
We find these theoretical arguments of competition unpersuasive: there is no evidence of actual competition. Otherwise the shippers would rationally use the alternatives, certainly if they were cheaper, and pragmatically in order to preserve the diversity and option of the other means, if the competing services' price were near the pipeline price.
8 ARCO Products Company, Mobil Oil Corporation, and Texaco Refining and Marketing Inc., v. SFPP L.P. (alleging violations of the Pub. Util. Code § 451 for charging rates that are not just and reasonable for the intrastate transportation of refined petroleum product).
9 http://www.irs.gov/pub/irs-pdf/p541.pdf.
10 http://www.irs.gov/pub/irs-pdf/i1065sk1.pdf.
11 In addition to PG&E Corp., which is the parent holding company that now owns the utility PG&E, SEMPRA is now the holding company parent of utilities Southern California Gas Company (SoCalGas) and SDG&E, and SCE Corp. is now the parent of electric utility Southern California Edison Company (Edison). All of these regulated utilities gave birth to new parent companies. The parent, or holding company, was spun off the original company, a regulated utility.
12 We should be clear that here, when Indicated Shippers speak of a "phony" tax, they mean there is never a corporate income tax imposed on a taxpayer corporate owner of SFPP. This is different from another long-resolved California ratemaking tax issue, that of "phantom" taxes, which are the result of the timing differences between accounting for financial reporting and accounting for federal income taxes. "Phantom taxes" are not at issue here. In a later section of this decision on FERC policy, the appeals court uses the term "phantom" whereas here we use Indicated Shippers' term, "phony."
13 A scoping memo may specifically exclude issues, but it is not reasonable to otherwise require a scoping memo to include every disputed issue. Many detailed specific issues are known only after parties perform discovery. Others are simply subsumed within the broader issue of deriving the just and reasonable revenue requirements for a test year. An appropriate income tax allowance would be just one of many items within the revenue requirement.
14 See the discussion on income tax issues in D.98-08-033 (81 CPUC2d 573, 587 - 590) and D.99-06-093. (1 CPUC3d 418, 420 - 422.)
15 D.99-06-093.
16 Similar motions were filed by Indicated Shippers in the other pending SFPP case and applications.
17 Similar motions were filed by SFPP in the other pending SFPP case and applications.
18 BP West Coast Products, LLC v. FERC, 374 F.3d 1263 (D.C. Cir. 2004) (BP West Coast), reh'g denied, 2004 U.S. App. LEXIS 20976-98 (2004), as cited in FERC's policy statement.
19 Lakehead Pipe Line Company, L.P., 71 FERC 61,388 (1995), reh'g denied, 75 FERC 61,181 (1996) (Lakehead) (footnote citation not in original.)
20 The Court here uses "phantom" tax to describe a different situation than the California "phantom" issue of flow-through of tax benefits in rates. The Court's reference to "phantom" tax is the same as "phony" or non-existent tax argued by Indicated Shippers. (See footnote 12.)
21 See D.99-06-093 (1 CPUC3d 418, at 422.)
