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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

transactions had nothing to do with each other as far as ONEOK and CMS were concerned, Southern Union was able to use the low basis but higher fair market value local distribution company (LDC) properties to acquire an asset that had equivalent value, and not pay taxes on the disposition. Of course, its tax basis in the new assets were a carryover from the previously owned ones, but the effective cost was much lower than would have been incurred through the issuance either of debt or equity.

A number of times in the recent past, utility companies divested portions of their generation portfolios and created structures to permit LKEs, but they were unable to find satisfactory replacement property. We believe there are two reasons for this. First, any "tax leakage" was provided for in stranded cost recovery programs, so that the regulators essentially traded compliance with their policy initiatives for inefficient tax structures, which dramatically lowered the motivation of utility tax planners to seek the most efficient methods. This is no surprise considering the general lack of sophistication on finance and tax (outside of depreciation, contributions in aid of construction and other immediately pertinent areas) that is prevalent among regulators. Second, it is likely that utilities themselves might have been unaware of both the broad range of available swap opportunities in the real property area and of the methodologies involved in a three party swap through a qualified intermediary and/or exchange accommodation titleholder, described below.

Moreover, as indicated above, the ways in which these transactions can be structured provide a great deal of flexibility to all the participants, so long as certain basic elements required by the tax laws are observed. For these reasons, it is important to identify the potential of an LKE early on in a transaction. For instance, any acquisition or sale agreement should contain language that provides for cooperation of the other party to help facilitate such a transaction. In general, the other party will experience no cost but will reap no further benefit, so the cooperation should be secured upfront.

If the cooperation is sought at a later date, the counterparty will inevitably try to obtain a portion of the benefits as the price of cooperation. In exchange for cooperation, indemnification is usually requested, which is an appropriate tradeoff, especially since ordinarily the counterparty is not taking on any additional risk.

Key Requirements Under The Tax Law

Three key requirements arise under the tax law: First, the property sold and the property purchased must be of like kind. For personal property, the categories of property permitted by IRS pronouncements to be treated as like kind are rather narrow. For instance, computers cannot be exchanged for automobiles, airplanes cannot be exchanged for draglines, etc. But in the area of real property, the categories are much broader and potentially more flexible.

What constitutes real property will normally be a question of state law, although the boundaries will frequently be fuzzy so that planning and creative lawyering can help the characterization of a particular piece or type of property. For