Master limited partnerships have been a popular investment vehicle among energy investors for a long time. MLPs tend to have high income yields, and they have the tax advantages of pass-through treatment rather than getting hit with a second set of taxes at the corporate level.

Ordinarily, the tax attributes of MLPs count as a point in their favor. But as investors learned earlier this month, taxes can also play a role in other elements of an MLP's business. An unexpected ruling from a regulatory body that rarely takes a close look at income tax policy has had huge implications for a certain group of master limited partnerships that hold interstate oil and natural gas pipeline assets.

Keyboard with blue tax button.

Image source: Getty Images.

Pipelines, rate setting, and FERC

The Federal Energy Regulatory Commission (FERC) isn't a tax-setting regulator, but it does play an instrumental role in the rates that pipeline companies are allowed to charge their customers. The regulator reviews pipeline company financials to seek a balance between the profit interest of the pipeline provider and the needs of its ratepayers. It's therefore critical to assess accurately the costs that MLPs and other pipeline operators bear in the course of conducting their pipeline business. Among those costs are any taxes that pipelines have to pay. Prior to the recent change, FERC generally allowed MLPs to claim an income tax allowance in calculating cost-of-service rates.

A recent court decision led FERC to change the way that it handles such taxes. In the case, users of a pipeline challenged the rates that the pipeline operator had charged, arguing that the pipeline company had been improperly permitted to include a tax allowance. This, they claimed, artificially increased costs and therefore boosted their rates. They sought to have the tax allowance disallowed as a double recovery that had already been considered elsewhere in the calculation process, with the goal of eventually reducing the amount they'd have to pay to make shipments using the pipeline.

Pipeline companies argue that a host of factors make an income tax allowance appropriate. First, even though the MLP itself doesn't necessarily pay taxes, the tax liability that its unitholders take on should be recoverable through higher rates. They also said that denying a tax allowance for MLPs would put them at a disadvantage to pipelines whose owners are taxed as corporations, because corporate pipeline owners will still get tax allowances.

Passing through tax reform benefits

In response to the decision, FERC's new "revised policy statement" said that it will no longer allow MLPs to claim income tax allowances. It rejected the arguments against the move, saying that it had concluded that its return-on-equity calculations based on discounted cash flow analysis already incorporated the appropriate impact that taxes have on MLP returns. Prices of MLP units plunged on the news, as investors anticipated that pipelines would in the future have to expect lower rates from the FERC rate-setting process.

The other thing that FERC did was to put interstate natural gas pipelines on notice that it would be looking at the potential impact of lower tax rates in the recently passed tax reform law on profits. FERC stated that in general, it thinks that since pipeline companies would pay lower taxes because of the changes in tax law, then ratepayers should get to enjoy proportionate benefits. A proposed rule will suggest a one-time filing to address this issue, with the hope that pipeline companies will simply reduce their rates accordingly to pass through an appropriate amount of their savings. Those that don't would potentially need to defend that choice before the regulatory body. FERC specifically said that it isn't taking the same action with oil or liquids pipelines at this time, although it expects to address the issues eventually.

Should pipeline investors worry?

The first thing to understand about the FERC ruling is that it won't affect every master limited partnership equally. Not all MLPs operate pipelines, and even those that have operating pipeline assets don't necessarily have all of their pipelines subject to FERC's rate-setting oversight. FERC has no power to change the actual taxes that MLPs and their unitholders pay, only the way in which any taxes are treated for purposes of setting rates on pipelines under its jurisdiction.

Pipeline operators that are organized as corporations shouldn't be affected by the MLP-specific rules. Kinder Morgan (NYSE:KMI), for example, won't be subject to the rules at the entity level. Yet even in Kinder Morgan's case, it's unclear to what extent investors have already anticipated that the energy giant might have to share the reduction in the corporate tax rate with customers in its regulated business.

Some MLPs will eventually have to charge lower rates to their customers as a result of the FERC decision. That will in some cases lead to a financial hit. MLPs with minimal margins of safety, such as Enbridge Energy Partners (NYSE:EEP), may have to cut distributions to unitholders as a result of the change.

Overall, the FERC move is unlikely to be a crushing blow to MLPs. In many cases, investors overreacted to the potential issue early on, arguably creating an opportunity for those interested in the space. We've yet to see to what extent each pipeline owner will suffer due to the regulator's actions.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has a disclosure policy.