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Business & Money

In a "like kind exchange" transaction, the IRS permits a seller to defer taxes on its inherent gain on assets being sold.
Fortnightly Magazine - April 15 2003

In a "like kind exchange" transaction, the IRS permits a seller to defer taxes on its inherent gain on assets being sold.

The utility community is starting to experiment with a "like kind exchange" (LKE)-a type of tax-advantaged asset acquisition and disposition transaction used extensively in connection with commercial real estate and various types of personal property, but which heretofore has not achieved widespread acceptance in the utility industry.

The principal benefit of this type of transaction, specifically authorized in Section 1031 of the Internal Revenue Code and related regulations, is that it can permit a seller redeploying its asset base (e.g., a seller that is disposing of non-core assets and increasing investment in core assets) to defer taxes on the inherent gain on the assets being sold, thereby allowing the full pre-tax value of those assets to be used to finance the acquisition of the desired core assets and dramatically improving the economics of those transactions.

The LKE transaction has matured into a pure financing transaction. An actual exchange between the same two parties is not necessary. A company can buy from Seller A and sell another piece of property to Buyer B and, if the proper formalities specified in the tax law are observed, the transaction will be respected and no tax will be payable in connection with the sale to Buyer B. In fact, many of the major financial institutions have subsidiaries that do nothing but facilitate such trades by acting as intermediaries, essentially in the nature of escrow agents, and charging relatively nominal fees.

At a time when many tax oriented "structured transactions" have come into disfavor or been substantially or entirely discredited, this transaction particularly recommends itself in the right combination of circumstances, especially since the tax code specifically provides a "safe harbor" for this type of deal. In addition, this transaction may properly provide an earnings benefit-while taxes are deferred, book income is recognized at once.

In this difficult market, many assets are likely to be for sale at bargain prices in the near future. However, most utilities do not want to make dilutive acquisitions, or those that require the issuance of common stock, and they also do not want to add to their debt load. Pressure from creditors and rating agencies to reduce debt, and the continual process and threat of downgrading, combined with the increasingly difficult terms on which capital is available, means the issuance of additional debt must be justified on strategic grounds. At the same time, many utility companies have non-core assets on their books that have a low tax cost but a substantially higher fair market value. Redeploying the values embedded in these assets in a tax efficient manner into core assets obtained at bargain prices could be the proverbial grand slam home run.

The LKE: Southern Union Does the Deal

A recent transaction that illustrates the benefits and flexibility of like kind exchanges is the disposition by Southern Union of several of its gas distribution companies to ONEOK and its purchase from CMS of certain Texas pipeline properties. Although the

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