With this installment, we turn to an article that was published in Project Finance Internation in April 1997 and written by Keith Martin, a partner in our Project Finance Group.
Tax issues and opportunities in restructuring contracts
A cartoon recently in the newspaper showed a group of football players in a huddle. One asks, Have we considered the tax consequences if we punt? Thankfully, not all actions have tax consequences, but some do and it can be very costly not to take them into account.
Unfair? That's the way the tax rules work. The management company could have avoided this result if it had been more careful about how it structured the contract buyout.
Independent power companies probably face these problems more often than other companies because long-term contracts are central to project financing. Project financing is a form of financing that requires the developer of a project try to lock in his revenue stream and costs over an extended period. Yet, this effort to have certainty almost invites problems with contracts later. Market conditions are bound to change significantly over time in ways that were unexpected. One party to the contract is bound at some point during the contract term to feel he has a great deal and the other to feel he has a raw deal. This can lead to pressure to buy out contracts or restructure their terms.
Many independent power companies are winners today under power contracts. They are receiving 6¢ or more a kilowatt hour in places where spot prices for electricity are 3¢ or less. Many utilities want to restructure or terminate these contracts.
A company expecting to receive payments in a contract buyout or restructuring should focus on three things. First, it should try to delay having to pay tax on the payments for as long as possible. There is a danger in many buyout situations of having to report the buyout amount as income before the company receives the cash. Second, it should think about whether there is a benefit to striking a deal that lets it treat the buyout as capital gain rather than ordinary income. Third, if the contract is tied to a project overseas, it should try to ensure the buyout payment is foreign source income. This will help with foreign tax credits later.
Some contracts are losers. An independent power company preparing to make payments in order to restructure a losing contract should try to deduct the full payment in the year it is made. The IRS may insist that the deductions be spread out over a period of years. If a contract for a foreign project is involved, the goal should be to treat the payment as a US source expense to help with foreign tax credits.
The rest of this article discusses how to achieve these goals, focusing first on independent power companies receiving payments.
Delay incomeIt is practically impossible to avoid reporting income once the cash is received.
A supplier might delay reporting income in certain contract buydown situations where the contract will remain in place, but the supplier receives a cash payment in exchange for reducing prices on goods to be supplied under the contract over time. IRS regulations allow some advance payments for goods to be reported over the period the goods are supplied.
The biggest danger -- and the thing that might be avoided with proper planning -- is having to report income before cash is received. This was the problem in the shopping center example at the start of this article.
The problem stems from the fact that almost all independent power companies use accrual accounting. IRS regulations say, Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. In plain English, income must be reported when two things are clear: the company has a right to an amount of income and the amount can be calculated with reasonable accuracy. For example, if an independent power company agrees today to a buyout payment of $40 million to be received over five years, it must report the entire $40 million immediately.
The key to delaying income is to make either the amount or the right to receive it uncertain. An example where the right to receive is uncertain is where each future installment is conditioned on some meaningful action to be taken by the independent power producer. The amount is uncertain where calculation is tied to variables that cannot be known until later.
Be careful when putting conditions in the buyout agreement that these are drafted as conditions precedent rather than conditions subsequent. A condition precedent is a condition that must be fulfilled before a party's promise becomes absolute. There is no accrual because the right to receive remains uncertain until the condition is satisfied. A condition subsequent excuses someone from having to make a payment once the condition arises: he was obligated until then.
An independent power company has the option in situations where there is a sale of a contract with payments to be received over time to report its profit from the sale ratably over the same period as the installments. However, this option has had less attraction since 1984 when Congress required anyone choosing it to pay interest to the IRS as if he owed the full amount of taxes upon sale but was made a loan by the government. The interest rate changes quarterly. For October through December 1996, it is 9%. Installment sale treatment is automatic unless the taxpayer opts out by making an election on his tax return for the year the sale occurred.
A taxpayer using installment sale reporting should be careful not to pledge the installments as security for a loan. The pledge will trigger immediate recognition of the deferred income up to the amount of the loan.
A gas supplier argued in a case before the US Tax Court in June this year that $1.85 million it received from a gas purchaser as settlement of a contract claim did not have to be reported as income -- ever. The gas supplier claimed the payment was a loan that had to be paid back to the gas customer. The Tax Court disagreed. It said the payment was an advance payment for gas to be delivered later. Under the terms of the settlement, the customer paid the gas supplier a lump-sum amount, but the customer was to receive credit against future gas purchases at the rate of 50¢ on the dollar until the entire amount was used up. The court said that when the recipient of money has merely been loaned the amount, there is no guarantee he will be allowed to keep the money; the expectation is that he will have to pay it back. With an advance payment, the gas supplier is allowed to keep the money as long as he performs his part of the bargain.
Capital gain?Another objective for independent power companies receiving payments may be to treat the payment as capital gain. This seemed impossible until recently.
Does it matter? It used to matter because of the difference in tax rates. There is still a difference for individuals but not for corporations. The maximum tax rate on long-term capital gains for individuals is 28% compared to 39.6% for ordinary income. Congress talked in 1995 about restoring the rate differential for corporations, but did nothing about it. However, corporations with capital losses still benefit from being able to report earnings as capital gain since their losses can only be claimed to the extent they have capital gains.
The IRS and the courts have been fairly consistent in denying capital gain treatment for payments for the relinquishment of contract rights.
However, the IRS opened the door to capital gain treatment -- at least in some situations -- in a technical advice memorandum involving the sale of power contract in February 1994. A technical advice memorandum is a ruling by the national office to settle a dispute between a taxpayer and an IRS agent in the field arising out of an audit. An oil company sold its specialty-chemical business to a third party. Electricity is a big cost of manufacturing chemicals, so the oil company had built cogeneration units at several of its manufacturing facilities, and it had a so-called PURPA contract to sell excess power from the units to an electric utility. The buyer of the business allocated part of the purchase price to the power contract. The oil company treated its profit from this part of the sale as capital gain. An IRS agent denied capital gain treatment on audit, but the national office allowed it.
The national office framed the issue in terms of whether this was a situation where the oil company was assigning an income stream or selling the right to earn future income. A payment that is merely an acceleration of future income is ordinary income. A payment that represents appreciation in value of the underlying contract is capital gain. Independent power companies would be wise to use contract language that points the IRS in the right direction when selling contracts.
A key factor was the oil company sold the entire contract. The IRS suggested that capital gains treatment would have been denied if the oil company had sold only a partial interest in the contract. This suggests that a buydown -- as opposed to a buyout -- is more likely to generate ordinary income, especially in situations where the payment is presented as an effort to reduce the cost of power over the remaining term of the contract. In that case, it looks like a prepayment for electricity to be delivered in the future -- an acceleration of income -- rather than a payment reflecting the increase in value of the underlying right to supply power.
It is unclear what the IRS would have said if this had been a buyout payment from a utility. A contract sold to a third party is pretty clearly a case where the buyer is purchasing the underlying right to supply electricity.
In April 1996, the IRS ruled privately that an electric utility could treat a buyout payment from a natural gas supplier as capital gain. The utility had two long-term contracts to buy gas. Gas prices had increased since the contracts were signed, and the suppliers wanted to cancel the contracts. They made cash payments to terminate.
The IRS said the contracts were capital assets to the electric utility. They would probably not have been to a gas utility since, in that case, they would have been for the purchase of stock in trade that the utility is in the business of selling to customers.
Foreign contractsIf the contract is for a foreign project or the other party to the contract is a foreign company -- for example, where an independent power producer has a contract to buy orimulsion for fuel from a supplier in Venezuela -- there are additional goals. The US independent power company should aim to treat any payment it receives in the contract restructuring as foreign source income. It may also want to receive the payment in a form that does not qualify as subpart F income.
The reason for preferring that payments be foreign source income is this helps with foreign tax credits. The more foreign source income a US independent power company has, the more foreign taxes the IRS will allow the company to credit against its income tax liability in the United States.
The reason for trying to avoid having the IRS label a contract restructuring payment as subpart F income is that subpart F income is subject to income taxes in the United States. Otherwise, it may be possible to defer US taxes on the payment by holding the payment offshore.
Whether a payment can be classified as foreign source income depends on what the payment is for. If it is for sale of the contract, then the source of the payment will turn on the residence of the seller. Example: a US independent power company sells a contract it holds in the name of a Delaware subsidiary to supply electricity to the national utility in Indonesia. The sales proceeds are US source income because the seller is a US company. The sales proceeds could have been foreign source income if the contract had been held, instead, in the name of an offshore corporation.
If the payment is really a payment for services, then the source of the payment will turn on where the services are performed. If it for sale of a product that is both manufactured and consumed abroad, then the source will turn on where title passes. In the example earlier, a payment by the Indonesian utility to buy down the electricity price would be foreign source income. Electricity should be considered a product for this purpose.
In some cases, an US independent power company receiving payment will want to try to keep the money offshore for reinvestment in other foreign projects without having to pay US income tax on it. The key to this strategy is the payment must not be subpart F income. In general, it should not be unless the payment is viewed as a payment for services.
Tracking accountsSome power contracts, particularly for projects in New York, have tracking accounts, raising a concern in restructuring these contracts that the independent power company will have cancellation of indebtedness income.
In these contracts, the utility pays more than avoided cost for electricity in early years in exchange for paying less than avoided cost later. This is done in an effort to levelize anticipated revenue for the independent power producer so that it is in a position to pay debt service on loans to build the project during the first 12 or 15 years after commercial operation when the debt must be repaid.
There was a debate within the industry several years ago about how to report the payments above avoided cost. Some advisers took the position that these amounts were essentially a loan from the utility since the money had to be repaid with interest. At the end of the contract, if the tracking account shows a positive balance, this usually must be repaid to the utility. The balance in the tracking account is secured by a second lien on the project assets.
However, most independent power companies have reported the excess payments in early years as income. The IRS issued three private rulings in 1993 holding that these arrangements under a New York form of contract are not loans. (The independent power companies involved wanted rulings that they had to report all payments from the utility as income when received -- rather than treating the amounts above avoided cost as a loan -- in order to assure lessors to whom they were selling their projects and leasing them back that the lessors would not have to report the loan amounts as part of consideration for a sale were lessors later to sell the power plants.)
The point is to be careful if a contract has a tracking account and the parties took the position that this involved a loan. If there is any discharge in the amount of the loan that must be repaid as part of a restructuring, the discharged amount must be reported to the IRS as income.
Immediate deductionThe chief aim for anyone making payments as part of a contract restructuring is to deduct them immediately. A dollar deducted today saves 35¢ in federal taxes. A dollar deducted ratably over 15 years saves only 17.7¢ in present value terms.
Any payment that is a cost of doing business can be deducted: the question is whether it can be deducted when paid or must be spread out and amortized over a period of years. This turns on whether the payment confers a future benefit. For example, a payment to buy another five years extension on a contract that is about to expire must be amortized over the 5-year extension period. On the other hand, a payment to cancel a contract entirely can usually be deducted in full immediately.
In 1993, the IRS ruled that an electric utility had to amortize a lump-sum amount it paid to a coal supplier to cancel a coal supply contract and enter into a new agreement on revised terms. The utility signed a contract with the coal company in 1974 to buy coal through December 1999. Coal prices fell. The contract had a clause that let either party seek arbitration for an economic hardship claim beginning in January 1988. The utility sought arbitration and also filed a lawsuit to get out of the contract in January 1988. The parties reached a settlement in December 1989 under which the utility paid a lump-sum amount to the coal company to cancel the old contract and enter into a new one. The new contract gave the utility the right, but not the obligation, to buy up to 750,000 tons of coal a year for 10 years at the current spot price adjusted periodically for inflation. The utility bought 42% of its coal under this contract in 1990, but nothing after that.
The utility made two key mistakes. First, it told the state public utility commission that the payment to get out of the old contract would produce substantial future benefits. Second, it should have been more careful to separate the two acts -- terminating the old contract and entering into a new one. In this case, the IRS said, the facts demonstrate the termination of the old contract and execution of a new contract are not separate events. Rather, they are part of a single overall plan.
In contrast, the IRS let another utility deduct a lump-sum payment to terminate a coal contract in a private ruling in 1992. The utility was in the same position: it signed a long-term contract to buy coal at prices that were now significantly above market. The utility tried unsuccessfully to negotiate a buyout. Agreement was never reached. The coal company then sued alleging breach of contract. The parties settled. The utility made a lump-sum payment to cancel the contract.
The IRS said the payment could be deducted immediately, since it was a payment to reduce expenses rather than to secure better terms. The utility planned to buy coal on the spot market or enter into another long-term contract, but the IRS said any future benefit from buying coal elsewhere at lower prices was speculative.
Foreign considerationsFinally, anyone making payments should try to treat the payments as a US source rather than foreign source expense. This is relevant in cases involving a foreign project or where one of the parties to the contract is overseas.
The problem if payments are classified as foreign source is they will reduce the foreign source income of the independent power company. The less foreign source income it has, the less able it will be to claim income taxes paid abroad as a credit against its income tax liability in the United States. Payments to get out of contracts or revise their terms have the same source as the income that would have been earned had the contract been performed. Two examples will make clear how this works in practice. Example 1: a US company has a contract to supply electricity to the national utility in Indonesia. The income from performing the contract would have been foreign source, because the activity that earned it would have occurred overseas. A payment to get out of the contract or revise its terms is foreign source. Example 2: a US power company has a contract to buy coal from a Canadian supplier. The US company would use the coal to generate electricity for sale in the US market. The payment to restructure the contract is US source, since the contract relates to US source income.