Business & Money

A spate of proposed U.S. tax rule changes soon may open a window of opportunity for certain utilities.
Fortnightly Magazine - May 2004

Business & Money

A spate of proposed U.S. tax rule changes soon may open a window of opportunity for certain utilities.

In the mid-1990s, before the rise of the Internet and the fall of Enron changed the calculus of business investing and the regulatory landscape, the historically staid U.S. utility industry began to be viewed as a "growth play." This triggered a global buying spree that led U.S. companies to invest tens of billions of dollars in electricity generation and distribution businesses all over the world.

Those heady days are gone, and so are the sky-high valuations of those once-prized overseas power-plant transmission and distribution assets. However, a spate of proposed U.S. tax rule changes, such as those outlined in the Homeland Investment Act on Repatriation (HIA) may soon open a window of opportunity for U.S. companies with unrepatriated foreign earnings. If passed, HIA potentially would allow U.S. utilities to bring money back into the country without harsh tax penalties, thereby freeing up capital to reinvest in assets here, pay down U.S. debt, or fund other liabilities, (, under-funded pension plans).

However, to benefit from HIA, U.S. companies will have to move fast and incisively, because the decisions and execution windows are likely to be open only for a brief period. To get ready, companies should take the time right now to carefully analyze, understand, reorganize, refinance, and put detailed tax and business plans into place.

Braving Extreme Market Conditions

In the period since Enron's 2001 collapse, the U.S. power industry's overseas acquisitions, many in emerging markets, have been written down on company balance sheets to values far below the record-breaking purchase prices paid only a few years earlier.

This value erosion has continued. In the last 18 months alone, U.S. utilities saw the value of their holdings drop sharply, by billions of dollars. To stem this flood of losses, dozens of companies sold much of their international holdings. Others simply walked away, handing over the keys to anyone who would take them.

Indeed, the universe of U.S. investor-owned utilities and publicly traded independent power producers that purchased, sold, shed, consolidated, or morphed their global holdings is a veritable who's who of the investor-owned utility industry.

The beneficiaries of these developments have been the early U.S. sellers, and various offshore bargain hunters, including some of the largest European and Asian utilities, who were able to make strategic acquisitions at fire-sale prices. The interest of those buyers, and that of other investor groups, has created active markets for buying and selling utilities around the world: in Europe, Central and Eastern Europe, as well in the Middle East, Latin America, Asia, and the Pacific Rim. And U.S. power companies continue to show a willingness to part with overseas utility holdings at the right price. However, some asset valuations remain so far underwater that even deeply discounted prices don't justify current sales transactions.

Thus, even as strategic buyers continue to circle the field, many utilities are holding on to their remaining overseas operations, waiting for brighter days, better prices, and better disposition opportunities. Some strategic sellers are even moving to enhance the value of their international portfolios. This makes abundant good sense, since U.S. investor-owned utilities, even those that would like to divest fully, still have billions invested in overseas power generation, transmission, and distribution.

The key to future success, however, is not in simply waiting for the market to revive. It lies in taking the time now to carefully plan an exit-or a hold-and-enhance-strategy, or something in between. In part, this means gaining a closer understanding of the true current state of affairs, improving local operating and financial controls, and gaining a better understanding of the underlying foreign and U.S. tax and business implications of every potential decision.

This course of action requires patience as much as strategic precision. In some cases, utility owners may have to demonstrate a willingness to invest, rather than divest, to improve the value of assets and the quality of the information on which future decisions will rely. In other words, companies that hope to sell more profitably at a later date-regardless of whether the various proposed energy and tax legislative initiatives passes by mid-2004-must have the right information at their fingertips and the right structures in place if they hope to make informed strategic decisions.

Understanding the Strategic Options

Most U.S. owners of overseas assets contemplating a disposition will find the decision-making process begins with a complex question: How do we sustain a U.S. tax benefit for investments with built-in losses upon disposition, and how do we tax-efficiently repatriate the sale proceeds-if any-back into the United States? With respect to the repatriation question, HIA, Congress' pending tax repatriation bill, could provide an opportunity to help ease the way, but only for sellers who have a thorough understanding of the underlying structure of their offshore holdings, including how they are financed and reported, and the pattern of any actual or constructive distributions in recent years.

To move ahead successfully, potential sellers should first acquire, or reacquire, focus and in-depth knowledge of their investments, including an understanding of:

  • Each asset's structure and cash flow. How are assets held and financed?
  • Its tax basis and U.S. earnings and profits profile. How will these earnings be treated when repatriated to the United States?
  • Salability. Is the property attractive to potential buyers? What investments or reorganizations must be made to draw buyers?
  • The character of the property's gains/losses. Will these be treated as capital or ordinary gains or losses?
  • The source of any losses. Is it foreign or domestic? Has the basket of gains/losses been analyzed for U.S. foreign tax-credit purposes?
  • The earnings and profits position in each business and the foreign tax pools. Have foreign income taxes been paid, or losses realized, during the ownership period? Have actual or deemed distributions of earnings occurred?
  • The currency used for reporting for U.S. tax purposes. Also, to what extent will gains and losses be affected for U.S. tax purposes by the realization of foreign exchange gains or losses?

Reviewing a Hold-and-Enhance Strategy

Investors who elect to hold on to an existing international portfolio in the near term, in fact, have distinct opportunities to enhance overall value for themselves as well as for future buyers. In some cases, this may take the form of tax-efficient recapitalization and refinancing transactions. It also may involve strategies that, coupled with HIA, can help to alleviate the double taxation imposed on repatriated foreign earnings. Many U.S. utilities face this exposure to double taxation on their repatriated foreign earnings given the harsh application to the leveraged, capital-intensive utilities of U.S. tax rules regarding the allocation and apportionment of U.S. interest expense between U.S. and foreign sources.

For investors who have been unable to repatriate foreign earnings because of harsh U.S. tax consequences, the HIA legislation potentially would allow these earnings to be repatriated at a reduced U.S tax cost. Additionally, the proposed bill may allow U.S. utilities to make these investments with local-country third-party financing, repatriate the proceeds at a reduced U.S. tax cost, and pay down U.S. debt or fund other liabilities. In the future, this would give U.S. utilities a use for future foreign earnings (i.e., to use those earnings to repay the third-party financing). This would have the additional benefit of freeing-up U.S. earnings for domestic investment and funding of domestic liabilities.

The overall impact of the pending U.S. legislation, and the appropriate approach to select in each case regarding restructuring, refinancing, and repatriation options will vary according to each taxpayer's overall tax posture. Thus, at first glance, the proposed rule changes may have little or no impact on a given company's finances, or disposition planning choices. However, this is one area where all assumptions and decisions must be based on a thorough and close analysis of the:

  • Current foreign and U.S. tax implications of moving earnings cross-border from and into a particular jurisdiction;
  • Taxpayers' current foreign tax credit position, including analyses of each U.S and foreign entities' debt/equity structure, future capital needs, tax bases, and earnings and profits profiles;
  • Local-country tax implications of restructuring and refinancing local-country operating companies, including the implications of existing loan covenant terms and the constraints that may arise from local regulatory considerations; and
  • Projections of earnings generated/used offshore and U.S. investors' needs to access those earnings for use in the U.S.

After the International Portfolio Review

Once a utility understands the full picture of its international portfolio, it can move ahead and develop an appropriate holding or disposition strategy.

For example, it may decide that some assets or businesses can be sold outright, as stand-alone operations. Other holdings might be more profitably sold if they are offered along with other assets in a geographic region or country. Or they might be better grouped together according to business capabilities: as a group of generation plants, perhaps, or a package of energy distribution businesses. The possibilities of public offerings in certain markets also should not be overlooked.

Restructuring or refinancing in advance of any transactions also can enhance the ultimate consequences of the overall strategy, including the offset of gains or losses, or the realization of losses with the "right" character to fit the profile of the selling group.

Alternatively, a utility may elect to hold and enhance the value of its current portfolio by focusing on local-country tax planning, treasury-management strategies, and foreign tax-credit planning. Some companies may even consider making other strategic purchases in the near term to maximize the sale potential of the asset groups to be sold in the future. Or, they may want to use cash from a sale in one operation to reduce their leverage from indebtedness in another, thereby making that second property more salable as well.

Whatever strategy a company ultimately employs, the goal is likely to be the same: to increase after-tax cash positions to reduce economic losses, and to recognize the tax benefit of any losses, especially those that affect financial and tax reporting.

To successfully achieve these goals, and to do so within the window of opportunity the pending legislation may allow, companies must have a solid plan in place. This is especially true for companies that already have written down the value of troubled assets on their balance sheets. The tax rules that govern such assets are complex, and there are many potential traps for the unwary. Penalties also can occur from a lack of adequate controls surrounding reporting requirements. Ignoring the presence of these issues can make a bad situation worse.

Business Bytes

Pacific Gas & Electric Exits Bankruptcy

PG&E Corp. subsidiary Pacific Gas & Electric Co. said April 12 that it emerged from bankruptcy, three years after filing for Chapter 11 protection. The utility said that it resolved $8.4 billion in allowed creditor claims and deposited $1.8 billion in escrow for disputed claims.

Entergy Expects Lower First-Quarter Earnings

Entergy Corp. said first-quarter earnings will be in the range of "at least" 85 cents per share due to mild weather and decreased earnings from an energy-trading venture with Koch Industries Inc., according to an April 12 Associated Press report. The Thomson First Call mean estimate is 95 cents a share for the first quarter. Last year, the company reported earnings of $400.9 million, or $1.73 a share, with operating income of $1.05 per share for the first quarter. Entergy also experienced added expenses due to a natural gas leak at its Magnolia storage facility, but it noted that insurance would cover most of the costs related to the incident.

Two Utility Consortiums Apply To Build Nuclear Reactors

Entergy Corp. said March 31 that it, along with six other companies, will form a consortium to test a new licensing process for building advanced nuclear power reactors. The consortium will work with the U.S. Department of Energy (DOE) to obtain the combined construction and operating license. The group plans to complete the license and submit it to the NRC in 2008. The DOE asked companies to demonstrate the new licensing process in November 2003. If the NRC approves the application in late 2010, the companies could use the license to begin building a new plant, Entergy said. The company said, however, that the consortium is not making a commitment to building a nuclear plant at the present time. Companies in the consortium include Constellation Energy Group Inc., EDF International North America, Entergy Nuclear, Exelon Corp.'s Exelon Generation, Southern Co., and two nuclear reactor vendors, Westinghouse Electric Co. and GE Energy.

Moreover, a second consortium of companies has applied with the NRC to construct a new nuclear reactor, according to an April 1 New York Times report. The group, consisting of Dominion Resources Inc., Hitachi America, Bechtel, and a subsidiary of Atomic Energy of Canada Ltd., seeks to construct the facility adjacent to Dominion's existing North Anna reactors.

S&P Lowers Aquila Credit Rating To B- from B

Standard & Poor's Ratings Services said April 8 that it lowered its corporate credit rating of Aquila to B- from B and the outlook is negative. "The downgrade reflects continued uncertainty regarding Aquila's ability to restructure its gas prepay contracts and the expectation that credit measures will remain pressured despite management's efforts to stem its deteriorating credit profile," the rating agency commented in a news release.

Sempra Considering Locations for Idaho Coal-Fired Power Plant

Sempra Energy unit Sempra Energy Resources is in the early stages of siting a coal-fired power plant in Idaho, according to an April 5 report from the Idaho Statesman. "We're not providing any specific information about land and water options at this time," spokesman Art Larsen told the paper.

"We're still in the very early stages of identifying the viability of such a project." Larsen said Sempra has been studying the site, which lies along the Snake River between Glenns Ferry and Bliss, for about one year. He did not comment as to when the company would make definitive plans for the plant.


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