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 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 instance, it may be possible to exchange gas or electric distribution properties for oil and gas exploration properties, even where one is owned in fee and the other takes the form of exploration rights. Also, not all of the property acquired needs to be of like kind-a mixed property transaction does not disqualify the eligible portion, although it will provide less than complete tax deferral.
The second requirement is that the property involved on one side of the exchange must be transferred within 180 days of the closing date with respect to the offsetting property. This can be done in either order, i.e. property A is sold and then property B is acquired within 180 days, or vice versa. Normally it is advisable to have both sides of the exchange at least identified, and either up for auction or other method of disposition, and under contract if possible, so that the safe harbor period is assured.
In regulated asset situations, the timing can be an element that needs special planning. The good news is that the 180-day period only runs from the date of closing of the first leg of the transaction. The offset to that is that it can be difficult to get buyers and sellers in unrelated portions of transactions to agree to put their business timetable at the mercy of another deal, which means nothing to them.
At the end of the day, the several transactions we are aware of that have been consummated did not experience any insuperable difficulty on this point. In addition, the dramatic improvement in the economics of a given transaction that can be obtained by using the LKE method can often provide for some level of "sweetener" to help the counterparties bide their time.
The third requirement under the Internal Revenue Code to qualify for LKE treatment is that, if the first leg is completed and the property that is to be substituted is not already known, the seller must identify the exchange property within 45 days of the first closing date. This time period is subsumed within the 180-day period to get both portions closed as mentioned above, and is unlikely to be relevant to planners working on utility timetables.
Finding the Right Transaction Conditions
Several elements are critical to achieving optimal results in connection with LKE transactions. First, non-core low basis assets are the best acquisition currency. Alternatively, a sale-leaseback transaction relating to headquarters buildings, R&D facilities, or other similar real-estate assets (including the type of oil and gas E&P assets that float around on many utility balance sheets) can be matched up with the acquisition of income-producing properties of many different varieties.
Because planning is critical, one key element is to provide adequate time for the market to be explored. A distress sale atmosphere needs to be avoided, which is the reason the two elements of the transaction should be decoupled as much as possible. As discussed above, this helps avoid being whipsawed between Buyer B and Seller A and helps obtain optimum pricing on both sides of the transaction.
Secondly, the size of the available benefits will be determined by several elements. The personal property portion of any element of property will not give rise to the same tax benefits unless there is very closely comparable personal property included in the exchange property. This means that allocation and appraisal issues are important to obtain maximum benefits.
Happily, buyers and sellers can choose different allocations-agree to disagree-if their tax postures are different. The issue is then left to when the respective tax returns are audited, but no one party can bind another in terms of tax results relating specifically to that other party. In addition, it is important to identify, with the help of the company's accounting firm, whether any portion of the acquired property is represented by good will in some form or another. Appraisal experts in the utility field can be extremely helpful in this area. An example of this relates to property that is subject to favorable contracts for output, transportation or the like. In some cases, accountants will require an allocation of a portion of the purchase price to the value represented by those contracts, which will reduce the total benefit.
Finally, to the extent the property being purchased is encumbered by debt, that debt must be deducted in determining the amount of tax deferral that is permitted, unless the property being sold is also encumbered. If this were not so, the game would be too easy, especially in the pure real estate area, where so many properties are heavily mortgaged.
For example, in the Southern Union situation the LDC properties were sold for $420 million, and the purchase price for the panhandle properties was $1.8 billion, including $1.166 billion in debt. Southern Union had 75 percent of the partnership that acquired Panhandle, with a unit of AIG taking the rest. Thus, of the $475.5 million net purchase price to Southern Union, $420 million represented a tax deferral.
This issue is relatively straightforward. But it should be remembered, if there is such debt on the property to be acquired, that the cooperation language mentioned above with respect to the acquisition agreement should include the exchange party agreeing to pay off the debt, if desired, before the transfer and thus increasing the purchase price and the tax benefits. This can occur on the same day, at the same closing, but the correct sequence is important.
Working With the Fed and States
Because some of the steps in the process may involve the use of single-member LLCs, which are disregarded entities for tax purposes but are useful in some circumstances that are too technical for the purposes of this article, regulatory issues and some state law issues may arise with respect to acquisitions or sales of jurisdictional assets. We have found that so long as the regulators are in sympathy with the basic purposes and goals (i.e., the benefits or lack of detriment to the company and its customers), those questions tend to be solvable on a case-by-case basis.
Typically, regulators will accept the analogy between the exchange accommodation titleholder (EAT) and qualified intermediaries (QI) described below and the types of structures and entities used for pollution control or other industrial development authority types of financing. Similarly, for registered holding companies under PUHCA, our analysis indicates that these companies typically have broad generic financing orders that contain recitals about special purpose subsidiaries and tax-oriented financings, which are adequate without seeking further approvals from the Securities and Exchange Commission. Additionally, since the structures relate to a special section of the tax laws that create a set of protocols relevant only to taxes, the strictures and provisions of PUHCA that have bedeviled many creative structures and initiatives in the utility area are essentially inapplicable.
The final piece of the analysis, which is relevant to three party exchanges, is the use of financial intermediaries, essentially as escrow agents, to satisfy the requirements of the tax law. The key from the tax perspective is that the proceeds not reach the hands of the utility but remain in the intermediary's hands, which then acquires the property and transfers it to the utility, and vice versa, so that from the technical perspective, the utility and at least one counterparty has sold or bought property and received property back.
In transactions of this sort, there will ordinarily be two QIs and two EATs, special purpose entities which will serve respectively to acquire and dispose of the properties, so that there is a double layer of entities. Most financial institutions and title companies have or will create special purpose entities to serve as intermediaries or titleholders. Particularly given the 180-day window, the use of these intermediaries is crucial, but it is also well established. The fees are insignificant, both compared to the savings this method can produce and in an absolute sense as well.
Business News Bytes
Alabama Power Sold $200 Million In Senior Notes
Alabama Power Co. sold $200 million worth of senior notes, targeting the proceeds to redeem other notes and for general corporate purposes.
Alabama Power said it agreed with a group of underwriters, led by Morgan Stanley and Wachovia Securities, to issue the Series V 5.6 percent senior notes, due March 15, 2033.
With proceeds from the sale, the company said it plans to redeem its Series C 7 percent senior notes due March 31, 2048.
"The 5.60 coupon is one of the lowest for a long-term financing achieved by any company in the last 40 years. They chose to finance at a time when the benchmark 30-year treasury was at historic lows. Unlike in previous treasury market rallys, Alabama's borrowing cost improved as the treasury market rallied, reflecting the soundness of the company and investor's desire to hold high quality corporate bonds," according to Brad Hart, an executive director in Global Capital Markets at Morgan Stanley.
El Paso, California Reach $650 Million Settlement Deal
El Paso Corp. said it has reached an agreement in principle to end the investigation of allegations that it manipulated natural gas prices by as much as $3.3 billion during California's energy crisis. The Houston company said it expects the settlement, which includes no admission of wrongdoing, to result in a fourth-quarter after-tax charge of about $650 million. The settlement includes payments of $100 million in cash, $125 million in El Paso common stock and additional payments of $22 million a year over a 20-year period.
El Paso said the settlement is subject to review and approval by the courts and the Federal Energy Regulatory Commission. The final execution of the agreement and the approvals are expected by the end of this year.
Alliant's Business Plan No Longer 'Down Under'
Alliant Energy Corp. said it agreed to sell its Australian investment to New Zealand-based Meridian Energy for about $350 million.
Alliant said the sale was primarily made up of Alliant Energy's ownership of Australian electricity generator Southern Hydro. On an after-tax basis, the sale will result in net cash proceeds to Alliant Energy of about $165 million.
Northeast Utilities Sees $640 Million 2003 Construction Spending
Northeast Utilities said it expects expenditures for its gas/power transmission construction program to amount to $640 million in 2003, according to the company's annual report. Of the total, $327 million will be spent by the company's Connecticut Light & Power Co. subsidiary, $116 million by its Public Service Co. of New Hampshire unit, $73 million by Yankee Gas, $28 million by Western Massachusetts Electric Co. and up to $96 million by other company divisions, the filing said.
Duke Energy Exits the Trash-Burning Business
Duke Energy Corp. has agreed to sell its 50 percent ownership stake in the American Ref-Fuel trash-burning power plant in Niagara Falls, along with five others along the East Coast, to a group of investors for $306 million. Duke is selling its 50 percent stake in Duke/UAE Ref-Fuel, which also owns waste-to-energy facilities in Pennsylvania, New Jersey, Connecticut, Massachusetts and Hempstead, N.Y., to Highstar Renewable Fuels LLC.
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