Introduction
The restructuring of the California utility industry has been accomplished through a $6 billion securitized financing pursuant to legislation that authorized securitization of electric utility stranded costs. Since the federal tax treatment of the securitization transaction was a critical element to their success, the utilities requested and obtained private letter rulings from the Internal Revenue Service. While several utilities are contemplating securitization transactions based on the California model, others are considering the possibility of tax exempt financing.
The California Rulings
In February 1997, three California utilities filed requests for private letter rulings from the Internal Revenue Service regarding certain federal tax consequences associated with the proposed securitization transaction. On September 8, 1997, the Internal Revenue Service issued favorable federal tax rulings to Southern California Edison Company, Pacific Gas & Electric Company and San Diego Gas & Electric Company. The private letter rulings were published as PLRs 9750017, 9750018 and 9750019.
The rulings succinctly summarize the structure of the California securitization transaction, which allowed a portion of the utilities' stranded costs to be recovered by collecting a separate, non-bypassable, usage-based charge called fixed transition amounts ("FTAs") and by issuing securities secured by the companies' right to collect the FTAs from consumers pursuant to a financing order from the California Public Utility Commission.
The securitized financing was structured as follows. The public utility organized a single- member limited liability company as a bankruptcy-remote special purpose entity (the"SPE") for the purpose of effectuating the securitization. The SPE did not elect to be treated as an association taxable as a corporation, so that for federal income tax purposes the SPE and the public utility are treated as a single entity.
The public utility transferred title to its right to collect the FTAs (the "Transition Property") to the SPE through a sale designated to qualify as a "true sale" for federal bankruptcy purposes in consideration of the proceeds realized by the SPE from its issuance of notes secured by the Transition Property (the "SPE Securities"). Under California law the Transition Property is a separate property right. The SPE Securities were issued to a trust established by the California Infrastructure and Economic Development Bank (the "Trust"). The Trust holds the SPE Securities and issued securities that will be sold through underwriters to public investors in the form of passthrough certificates that will represent ownership interests in the SPE Securities held by the Trust ("Investor Securities").
For financial accounting purposes, the SPE Securities will be treated as debt of the utility. The SPE Securities will not be subordinated to the claims of any creditors or equity owners of the SPE. The Trust will not be entitled to participate in the management of the SPE.
Rulings
The California utilities received three rulings from the Internal Revenue Service as follows:
1. The issuance of the PUC financing order authorizing collection of the FTAs does not result in gross income to the public utility;
2. The issuance of the SPE securities to the Trust and the issuance of the investor securities will not result in gross income to the company; and
3. The SPE securities will be obligations of the company.
The first ruling addresses the issue of whether the creation of the right to collect FTAs results in gross income to the public utility. The public utilities were concerned that the Internal Revenue Service could take the position that the creation of this right, which is transferable and of significant value, could be treated as an income recognition event at the time of grant. Such a position would result in an acceleration of the recognition of income by the public utility because the actual collection of the FTAs is based on actual electric usage and is thereby dependent upon the rendering of service to each affected customer. The IRS ruled favorably that the creation of the right to collect FTAs will not result in the current recognition of gross income, citing Rev. Rul. 92-16, 1992-1 C.B. 15 (allocation of air emission rights by the EPA does not cause a utility to realize gross income) and Rev. Rul. 67-135, 1967-1 C.B. 20 (fair market value of an oil and gas lease obtained from the government through a lottery is not includible in income).
The second ruling, that the issuance of the SPE Securities to the Trust and the issuance of the Investor Securities to investors by the Trust will not result in gross income to the company, reflects the treatment of the transaction as a financing and not a sale of the Transition Property for federal income tax purposes. Implicit in this ruling is recognition that the transfer of the Transition Property to the SPE will not be treated as a sale or transfer for such purposes because the utility and the wholly owned SPE are viewed as a single entity for federal income tax purposes. The issuance of the SPE Securities to the Trust is viewed as a financing and not a sale for federal income tax purposes. Similarly, the issuance of the Investor Securities by the Trust is also viewed as a financing transaction. Because of differences in the terms of the SPE Securities and the Investor Securities, the IRS recognized each step as a separate financing transaction.
The third ruling, that the SPE securities will "be obligations of the Company," is recognition that the SPE securities are considered debt for federal income tax purposes. While the ruling does not use the term "debt," the citation of Rev. Rul. 97-3, 1997-2 I.R.B.5, is recognition that the obligations are debt obligations. Furthermore, it is significant that the ruling states that the SPE Securities will be obligations of the Company. The SPE Securities can only be obligations of the Company if the SPE is treated as a single-member LLC that is ignored for federal income tax purposes. However, the SPE can only be a single-member LLC for such purposes if the SPE Securities are treated as debt and not as equity.(1) Since the SPE Securities will be treated as debt of the Company, the public utility will be able to deduct the interest payments made thereon.
Other Tax Issues
The ruling did not address the classification of the Trust for federal income tax purposes. It is imperative that the entity holding the SPE Securities will be treated as a flow-through entity for federal tax purposes so that the items of income and deduction will flow through to the owners of the Investor Securities and taxed to them as if earned directly by them. If the entity were not treated as a flow-through entity, it would be taxed as a corporation meaning that the entity itself would be taxed on its net income, thereby resulting in double taxation to the extent its deductions did not match its income. As part of the issuance of the Investor Securities, tax counsel opined that the Trust "will not be a business entity classified as a corporation or a publicly traded partnership treated as a corporation, but will be treated as a grantor trust."
Tax Exempt Financing
State officials in some states have proposed a tax exempt bond structure in lieu of the asset securitization structure utilized in California. Under the tax exempt bond structure, a state agency would create a state instrumentality that would issue nonrecourse rate reduction bonds to finance a fixed transition amount that would be contributed by the state to the capital of the utility as a non-shareholder capital contribution.
The nonrecourse rate reduction bonds issued by the state would be funded by a non-bypassable usage charge that would be imposed on utility customers in the state and collected by the utility as collection agent for the state. The charge would be stated separately on the monthly bill of each customer in the state. The tax exempt bond scenario raises novel tax issues for both the utility company and the issuer of the tax exempt bonds.
Utility Company Issues
Code Section 118 provides that the gross income of a corporation does not include any contribution to its capital. Section 118 applies to contributions by non-shareholders as well as shareholders. Section 362(c)(2) provides that any money received by a corporation as a nonshareholder capital contribution reduces the basis of any property acquired with such money during the twelve-month period after the date the contribution is received. The excess of the amount of the contribution over the basis reduction must be applied to reduce the basis of any other property held by the taxpayer. Taken together, these two provisions allow a corporation to receive tax-free nonshareholder capital contributions provided that the corporation reduces the basis of its property by the amount of such non-shareholder capital contribution.
In order to qualify for Section 118 treatment, the transfer of money by the state instrumentality to the utility must be treated as a "contribution to capital". The phrase "contribution to capital" is not defined in the Code, regulations or legislative history. However, a series of Supreme Court decisions has established that a payment by a nonshareholder must meet two tests in order to qualify as a contribution to the capital of a corporation; these are the Contributor Motivation Test and the Economic Effect Test.
1. Contributor Motivation Test
The Contributor Motivation Test examines the nonshareholder's intent in making the contribution and is derived from two United States Supreme court decisions, Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), and Brown Shoe Co., Inc. v. Commission, 339 U.S. 583 (1950), which were decided prior to the codification of Section 118.
In Detroit Edison, potential customers of Detroit Edison were required to pay the estimated cost of the construction necessary to connect them to the company's facilities. The Supreme Court found that these payments were not contributions to capital, because "it overtaxes imagination to regard farmers and other customers who furnish these funds as makers either of donations or contributions to the Company." Detroit Edison, 319 U.S. at 102. In Brown Shoe, the Supreme Court held that money and property contributions made by community groups to a corporation to induce the corporation to locate in their locale were nonshareholder contributions to capital. The Court reasoned that when the motivation of a contributor is to benefit the community at large, and the contributor does not anticipate any direct benefit from his or her contribution, the contribution is a nonshareholder contribution to capital. Brown Shoe, 339 U.S. at 591.
Where a government makes a grant to a corporation for the benefit of the public at large it will generally satisfy this test. See G.C.M. 36156; Rev. Rul. 93-16, 1993-1 C.B. 26. Factors indicative of the transferor's motive are whether the benefit from the contribution is "direct or indirect, specific or general, certain or speculative." CB&Q, 412 U.S. at 411. However, the Internal Revenue Service (the "Service") has sometimes considered this test satisfied even where the contribution appears to fall on the wrong side of some or all of these factors. See P.L.R. 9538037 (June 28, 1995) (finding that governmental contributions to an electric utility for the purpose of upgrading street lighting were contributions to capital even though the government expected a reduction in operating costs as a result of the grant).
It is not entirely clear how a contribution that has more than one motivation (e.g., the grant is part gift, part contribution to capital, and part compensation for services) should be treated under Section 118. Some commentators have argued that the various motivations should be valued, and that the amount allocable to each motivation should be subject to the appropriate treatment. See Jerome B. Libin, More on G.M. Trading: ISP Paper Ignores Key Factors in Section 118 Analysis, 11 Tax Notes Int'l 961, 963 (1995). In some instances, the Service has taken the position that where a "dual purpose exists, i.e. receipt of direct services as well as obtaining a benefit for the community, the result is not a contribution to capital." P.L.R. 8532005 (Apr. 17, 1985). On the other hand, the Tax Court has used a "primary motivating factor test," at least for cases where the grant was made by a government generally for the benefit of the public. Epco, Inc. v. Comm'r, 69 T.C.M. 2829, 2836 (1995) .(2) This fall, the Fifth Circuit rejected both the all-or-nothing and the dominant purpose approaches. Instead the court opted to bifurcate the transactions into a sale portion and a contribution portion. G.M. Trading Corp. v. Comm'r, 121 F.3d 977 (5th Cir. 1977). It remains to be seen whether other Circuits will also adopt this approach.
A grant from a state to an electric utility should satisfy the Contributor Motivation Test so long as the state has a reasonable expectation that the grant will be for the benefit of the general public.
2. Economic Effect Test
In United States v. Chicago Burlington & Quincy R.R. Co., 412 U.S. 40 (1973) (hereinafter, CB&Q), the Supreme Court announced that the use that the transferee makes of a payment is also relevant to the determination of its status as a contribution to the corporation's capital. Although the Court stated that it had "distilled" five characteristics of a nonshareholder contribution to capital from its earlier cases, in effect the Court articulated them as a new five-part test:
(a) The payment must become a permanent part of the transferee's working capital structure.
(b) The payment may not be compensation, such as direct payment for a specific quantifiable service provided for the transferor by the transferee.
(c) The payment must be a bargained-for transfer.
(d) The asset transferred must have a foreseeable benefit to the transferee commensurate with its value.
(e) The asset transferred must ordinarily, if not always, be employed in or contribute to the production of additional income and its value assured in that respect.
CB&Q, 412 U.S. 413. Although the court stated that these were "some" of the characteristics of a nonshareholder contribution to capital, they have generally been treated as comprising a checklist. E.g., P.L.R. 9238007 (June 10, 1992). The meaning of the individual elements of the test has received little elaboration in subsequent cases or administrative rulings. However, certain boundaries can be identified.
(a) Permanent Part of Working Capital
This characteristic should always be satisfied when contributed funds are used to construct facilities or other hard assets. On the other hand, the Service has ruled that "payments specifically earmarked for deductible operating expenses do not become part of a recipient corporation's permanent working capital." P.L.R. 9238007. In denying capital-contribution treatment to certain payments, a number of courts have likewise noted the fact that the funds "might be used for the payment of dividends, of operating expenses, of capital charges, or for any purpose within the corporate authority, just as any other operating revenue might be applied." Texas & Pac. Ry. Co. v. U.S., 286 U.S. 285, 290 (1932); accord Springfield St. Ry. Co. v. United States, 577 F.2d 700, 702 (Cl. Ct. 1978). In fact, the Service has stated that this characteristic means "that the money and/or property cannot be and is not used for the payment of dividends, interest, or anything else chargeable to or payable out of earnings or income." G.C.M. 37354.
The Supreme Court in Edwards v. Cuba R.R. Co., 268 U.S. 628 (1925), the case in which the rule eventually codified in Section 118 was first announced, noted the fact that the contributed funds were spent on "capital expenditures." Cuba R.R., 268 U.S. at 632. Two cases involving training expenses illustrate the possibility that "working capital structure" is equivalent or at least similar to "capitalized expenditures." In Deason v. Comm'r, 35 T.C.M. 978 (1976), the Tax Court ruled that grants made to a corporation by the Department of Labor to employ and train certain hard-core unemployed individuals were not contributions to capital. The Court reasoned that the payments were not contributions to capital because they "were not earmarked for permanent capital improvement... although some part of the amounts may have been so invested." Deason, 35 T.C.M. at 984. (3) Subsequent to this decision, the Service determined that amounts granted to a corporation by a state for start-up training costs were contributions to capital. P.L.R. 9238007. The Service distinguished its fact pattern from the holding in Deason based on the fact that the start-up training expenses are capitalized under the Code. P.L.R. 9238007. Similarly, the Service has found in other circumstances that capital expenditures such as those made for "development, planning, and the purchase of navigation and other equipment" did become part of the corporation's working capital. Rev. Rul. 93-16. (4)
The Service does not believe "earmarking is crucial" to the determination of whether particular nonshareholder payments are contributions to capital. G.C.M. 36156. In support of this position, the Service has noted that the "Supreme Court in CB&Q did not speak about earmarking of funds as a characteristic of the contribution." G.C.M. 36156. Thus, while segregating funds and earmarking them for capital expenditures may not be necessary, it is desirable as a way of ensuring favorable treatment by the Service. Nevertheless, satisfying this characteristic will be dependent on the use to which the utility will put the grants it receives.
(b) Payment for a Specific Service
This characteristic basically mirrors the analysis under the Contributor Motivation Test. If the "purpose of the grant is to benefit the public as a whole and any services to the State are incidental to this purpose," this characteristic will be present. P.L.R. 9401035 (Oct. 14, 1993); accord P.L.R. 9701007 (Sept. 25, 1996); Rev. Rul. 93-16. However, where the government contracts with a corporation to provide services to citizens (such as training services), payments under the contract will generally be considered payment for services rendered. Deason v. Comm'r, 35 T.C.M. 978, 984 (1976).
(c) Bargained for Transfer
A transaction that in substance is unilateral is not "bargained for". CB&Q, 412 U.S. at 414. In early decisions, courts read this language to preclude capital-contribution treatment of grants the primary impetus for which came from the government, even where there appeared to be substantial negotiation. Louisville & Nashville R.R. Co. v. Comm'r, 66 T.C. 962, 992 (1976). Likewise, in a later case the Tax Court found that the payment was not bargained for because the taxpayer was "never called upon to bargain for the transfer of property or for the payment of construction costs." Southern Pac. Trans. Co. v. Comm'r, 75 T.C. 497, at 762 (1980).
However, more recent decisions have been more flexible. The rule has developed that where negotiations between the corporation and the transferor have led to "certain meaningful conditions" being imposed on the contribution, the bargained-for characteristic will be present. Rev. Rul. 93-16. For instance, a grant "was bargained for through a hearing process where consultants and studies focused on the exact costs and benefits of the [capital expenditure], and contain meaningful conditions." P.L.R. 9401035 (Oct. 14, 1993); accord P.L.R. 9701007 (Sept. 25, 1996).
If the utility and the state engage in extensive negotiations, which should lead to numerous "meaningful conditions" being imposed on the grant, this characteristic should be easily satisfied.
(d) Benefit Commensurate with Value
This characteristic is often combined with the Production of Additional Income requirement discussed below. In general, the payment should provide a benefit to the corporation equal to its cost. Where the government is simply replacing property adversely affected by a government program (usually a construction project), this characteristic may not be met because there is no "net benefit." See, e.g. Southern Pac. R.R. Co., 75 T.C. at 763. The Service has stated that "cash payments are equivalents to their value" and, as a result, this characteristic "always exists when cash is transferred." P.L.R. 9238007 (June 10, 1992). This characteristic should be present in the cash grants from the state.
(e) Production of Additional Income
This characteristic requires that the payment enable the corporation to produce additional income. This characteristic is not satisfied if the incremental economic benefit to the recipient corporation is "marginal" or "incidental." CB&Q, 412 U.S. at 414; Louisville & Nashville R.R. Co. v. Comm'r, 66 T.C. 962, 992 (1976). Both the CB&Q and Louisville & Nashville cases involved safety features (such as crossing equipment) that were built with public funds. The corporations argued that they were benefitted by the "probability of lower accident rates and the ability to operate [their] trains at higher speeds." Louisville & Nashville, 66 T.C. at 992; accord CB&Q, 412 U.S. at 414. The Tax Court found that such benefits were both incidental and not commensurate with the cost of the assets. Louisville & Nashville, 66 T.C. at 992. Likewise, payments made to replace property adversely affected by a government program (such as a construction project) usually do not meet the requirement that the contribution enable the corporation to generate "additional" income. See, e.g. Southern Pac. R.R. Co., 75 T.C. at 763-64. Finally, the Supreme Court appears to require that the "substantial incremental benefit in terms of the production of income" be both foreseeable and taken into consideration at the time the contribution is made. CB&Q, 412 U.S. at 415.
It appears that additional income means additional net income rather than additional gross income. In Southern Pac., the Tax Court, in denying favorable treatment for certain replacement property denoted by the government, noted that the government "could not have anticipated any substantial economic benefits to the petitioner" because it did nothing "to increase petitioner's business or its assets or to decrease its ordinary maintenance costs." Southern Pac., 75 T.C. at 763 & n.312. Similarly, in a recent ruling the Service determined that payments made by governmental units to an electric utility to upgrade lamps used in an existing street lighting system were contributions to capital. P.L.R. 9538037 (June 28, 1995). The Service stated that "the street lighting system has been used, and will continue to be used, by [the c]orporation in its trade or business to produce income." P.L.R. 9538037. Since, the size of lighting system remained the same before and after the upgrade, the corporation could only have received "additional income" from the contribution if the new lamps reduced operating costs, such as if the new lamps had a longer life.
This characteristic should be met so long as the State reasonably foresees (and takes into consideration) that the grant will enable the utility to generate additional income. It may be desirable to memorialize this finding in the documentation of the grant.
Tax Exempt Bond Principles
While interest on bonds of a state or local government or a properly constituted authority thereof is generally excluded from gross income for federal income tax purposes, interest on private activity bonds ("PABs") is excluded from gross income only if the PABs are "qualified bonds." The only "qualified bonds" relating to electric utilities generally are those 95 percent of the proceeds of which are used "to provide . . . facilities for the local furnishing of electric energy." Rate reduction bonds would appear not to qualify in any event, as any facilities to which they relate would not have been "provided" by the bonds in question. It might also be noted that the electric energy facilities that can be provided with "qualified bonds" must only serve a city and one contiguous county or two contiguous counties.
If more than 10 percent of the proceeds of an issue of governmental bonds are used in a trade or business of a person other than either a governmental unit or a person using the proceeds on the same basis as other members of the general public, the bonds are PABs if the payment of the principal or interest on more than 10 percent of the proceeds of the bonds is "directly or indirectly . . . to be derived from payments in respect of property . . . used or to be used for a private business use." Code Section 141(b)(2). Temporary Treasury Regulations were published on January22, 1998, that have the effect of allowing utilities owned by governmental units to transmit power generated by others in a deregulated environment via lines or other transmission facilities without causing the interest on PABs used to finance those facilities to become taxable, but these rules are of no help to investor-owned utilities.
If proceeds of a governmental bond are contributed to an electric utility under the contemplated scenario, they would be treated as used in the utility's trade or business, whether or not they qualify as a nonshareholder contribution to capital. Thus, the contemplated non-bypassable usage charge imposed on the utility's customers and used to pay the debt service on the bonds would cause the bonds to be PABs unless the regulatory exception for "generally applicable taxes" were met.
This exception, provided by Treasury Regulations §1.141-4(e), promulgated only in January 1997, says that "generally applicable taxes" are not taken into account as payments in respect of property used for a private business use. However, this provision goes on to define that term in a manner that raises serious questions as to its possible application to the contemplated usage charge, especially if the service area of the utility is not coterminous with the geographical jurisdiction of the governmental unit that issues (or the duly constituted authority of which issues) the bonds.
These Regulations provide that a "generally applicable tax is an enforced contribution exacted pursuant to legislative authority in the exercise of the taxing power that is imposed and collected for the purpose of raising revenue to be used for governmental purposes." The contemplated usage charges might be structured in such a way that they could be held to meet that threshold requirement, but the definition goes on to say that a "generally applicable tax must have a uniform rate that is applied to all persons of the same classification in the appropriate jurisdiction, and a generally applicable manner of determination and collection." A usage-based charge imposed on electric utility customers would seem to raise questions as to the meaning of the terms "uniform rate," "same classification," and "appropriate jurisdiction" for these purposes.
The Regulations also specify that a payment for a "special privilege granted or service rendered is not a generally applicable tax," and that a tax does not have a "generally applicable manner of determination and collection to the extent that one or more taxpayers make any impermissible agreements relating to payment of those taxes." Further questions appear to be raised by these requirements.
Unfortunately, this exception for "generally applicable taxes" has only been in existence for slightly longer than one year. Virtually no guidance is currently available on the many questions inherent in its possible application to the tax exempt financing proposal.
If the proposed usage charges could qualify as "generally applicable taxes," the bonds would still be PABs, under Code Section 141(d), if the proceeds were deemed to be used for the acquisition by a governmental unit of "nongovernmental output property." That term is defined as meaning "any property (or interest therein) which before such acquisition was used (or held for use) by a person other than a governmental unit in connection with an output facility." Electrical generation facilities would certainly be output facilities for this purpose. An interesting question would be raised, therefore, as to whether the right to recover investment in utility plant through future rate charges would be deemed to be "property . . . used (or held for use) . . . in connection with an output facility."
Code Section 141(d)(4) provides a general exception from this rule in the case of "property which is to be converted to a use not in connection with an output facility." However, that exception, even if otherwise applicable, is specifically denied to "any property which is part of the output function of a nuclear power facility."
It is readily apparent that the feasibility, from a tax law standpoint, of using tax exempt bond financing as proposed raises many questions the answers to which are uncertain. Favorable private letter rulings from the Internal Revenue Service on these points would be a practical prerequisite to use of this approach.
1. Note that if the SPE Securities were treated as equity, the SPE would not be a single-member LLC, and thus would be an entity distinct from the Company for federal income tax purposes.
2. The Service and the Tax Court have taken the exactly opposite position. See G.M. Trading Corp. v. Comm'r, 121 F.3d 977, 981 (5th Cir. 1997).
3. The court also concluded that the payments were for services rendered because they were made pursuant to a contract between the government and the corporation.
4. In this Ruling, the word "permanent" was conspicuously absent from the Service's analysis (although not its restatement) of this prong of the Economic Effect Test.