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An initial burst of enthusiasm for TransCanada Inc. and Enbridge Inc. shares has subsided as investors have digested a recent regulatory ruling from the United States – and may have concluded that the ruling is not quite as big a deal as initially believed.

The U.S. Federal Energy Regulatory Commission, or FERC, shocked pipeline investors in March when it said it would make rules prohibiting pipeline “master limited partnerships” (MLPs) from recovering corporate taxes when they set their regulated rates. That news sent the price of publicly traded MLP units spiralling downward and impacted the two Canadian giants because each has one or more U.S.-based MLPs.

FERC published its final rule July 18, and the language was quickly deemed more favourable than initially feared. Many U.S. MLPs jumped, and TransCanada and Enbridge rose 5.4 per cent and 3.8 per cent, respectively, in July 19 trading.

Enbridge, however, has settled back nearly to its preannouncement levels, and TransCanada has fallen 2 per cent.

FERC “did soften the blow a little bit … but not nearly as much as the market seemed to believe,” says Robert Willens, a Wall Street analyst with an eponymous firm specializing on complex tax matters.

The March announcement was FERC’s response to an issue handed to it in a court case two years prior. Customers of U.S. pipeline partnerships had sued FERC, and won, alleging that the commission’s rules improperly allowed the partnerships a “double recovery” of taxes.

The partnerships are, under U.S. law, what are called “pass-through” entities: They do not pay income taxes, instead passing through their profits to their owners, who then pay income taxes. FERC had allowed these partnerships to set rates, in part, by including an allowance for their owners’ taxes on the partnership income.

However, since the partnerships’ rates were also based on an permissible return on equity figure – which took taxes into account – the pipeline customers argued in their lawsuit that there was a “double recovery” of taxes. The court accepted the argument and in 2016 told FERC to either justify or abandon the practice, Mr. Willens says.

The FERC announcement addressing the issue suggested FERC would prohibit an income tax allowance. Since the pipeline partnerships were collecting revenue based on these taxes – but not actually paying them – many U.S. pipeline companies reacted to the announcement by reducing their expectations for revenue and cash flow.

Enbridge Energy Partners, for example, said that it expected a US$100-million reduction in revenue if the FERC policy was approved. It reduced its guidance for distributable cash flow by about US$70-million, to a range of US$650-million to US$700 million.

TC Pipelines slashed its distribution by 35 per cent, reducing the cut that TransCanada, a nearly 25-per-cent owner of the vehicle, receives.

Enbridge said in May the FERC decision was one of the reasons that it proposed to acquire all four of its “sponsored vehicles,” the publicly traded partnerships that own pipelines and other assets.

The FERC decision did not affect all MLPs equally, however. Many of the entities go outside the regulated FERC structure and strike special deals with customers. Spectra Energy Partners, 73-per-cent owned by Enbridge, said 60 per cent of its gas pipeline revenue comes from “negotiated or market-based tariffs and therefore [is] not directly affected by the FERC policy revisions.” Both Spectra and DCP Midstream Partners, a structure Enbridge owns about 20 per cent of, said they did not expect any material change to their financial performance from the March FERC announcement.

With that, the July 18 clarification could be seen as a positive, eliminating some degree of uncertainty. However, some analysts said certain language was ambiguous enough to leave them unclear on what the true benefits would be.

FERC said that MLPs that are owned by corporations and that eliminating the income-tax allowance, thereby reducing their rates to customers, could also make an offsetting change in their tax accounting that helped support rates, thereby blunting the impact.

The regulators also said that, for three years, they would not initiate any rate investigations of pipeline companies that filed a rate schedule, even including the income-tax allowance, that produced a return on equity of 12 per cent or less.

The potential effects on Enbridge and TransCanada can help explain why the two have retreated, with TransCanada retaining more of its first-day bounce than Enbridge.

While investors initially boosted Enbridge’s share price on the news, a counternarrative quickly developed that the improved cash-flow outlook for the affiliated pipeline companies would force Enbridge to improve its offer. “The Final Rule is clearly positive in many respects, but also raises more questions about the ‘bump or not’ for Enbridge’s proposed roll-up transactions,” Credit Suisse analyst Andrew M. Kuske wrote.

Robert Kwan of RBC Dominion Securities bets on no bump, noting that the upswing in Enbridge’s share price since its May restructuring announcement had already improved the terms of the deal.

TransCanada, Mr. Kwan said, faces less downside now that FERC has clarified its rules, and investors may return to viewing the MLP as a legitimate “funding vehicle,” providing regular cash flows to TransCanada.

Ben Pham of BMO Nesbitt Burns, however, says that while the July 18 announcement is a net positive, it “creates more questions than answers.” Specifically, he notes that the FERC language gives benefits to pass-through entities, "all of whose income or losses are consolidated on the federal income tax return of its corporate parent.” That’s not the same as consolidation for accounting purposes, he notes, and “it is possible that FERC meant to only allow pass-through entities 100 per cent owned by C-corps a tax allowance, but not for partially owned.”

With TransCanada owning only 25 per cent of TC Pipelines, he says, it’s possible the MLP won’t get the tax benefit, after all – and he’s not changing any of his estimates on TransCanada.

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