Many US electric utilities are in talks to buy out or restructure contracts that commit the utilities to purchase electricity from independent power projects. These contracts were signed in the 1980’s when electricity prices were higher than they are today. Deregulation has given an added push to such contract talks since the utilities often need to fix the amount of their stranded costs to ensure recovery after deregulation.

The negotiations present an interesting challenge. The utility wants an immediate tax deduction for any payment it makes to cancel the contract or revise its terms. Meanwhile, the owner of the independent power project wants to delay reporting the payment as taxable income for as long as possible. These positions are hard to reconcile — but not impossible.

A new idea for satisfying both aims appears practically every couple of months. Here are some of the approaches that companies are taking.

Utility

The utility usually cannot deduct an amount until it is actually paid. A utility used to be able to claim a deduction when the obligation to make the payment accrued, but “economic performance” rules in the tax code now rule out deductions until the payment is actually made. Moreover, if the utility is viewed as paying money to cancel one contract so that it can enter into a new one, then the buyout payment is viewed as a cost of the new contract and must be deducted ratably (in equal amounts) over the term of the new agreement.

Thus, the main strategies on the utility side are as follows:

Simple buyout

Pay an amount to buy out the contract. Do not replace it with a new agreement. The amount is deductible when paid. If the amount will be paid over time, it is deductible over time.

Buydown with assignment

Pay an amount to buy down the electricity prices to market, but let the contract remain in force. This gives the utility additional tax basis in the contract that it would ordinarily have to amortize over the remaining term. However, the utility then assigns the contract to a power marketer and claims an immediate loss for its unrecovered basis.

Scrip

Buy out the contract using shares in the utility. The Internal Revenue Service told Niagara Mohawk Power Corp. in a private letter ruling last year that the utility could deduct the fair market value of shares it issued for this purpose. It is as if the utility issued its own scrip to make the buyout. Since the shares were publicly traded, the independent power companies receiving them could convert the shares readily into cash.

Auction

Take bids from power marketers to assume the obligation to buy power under the contract without any adjustment in the contract prices but for a payment from the utility. The payment to the power marketer should be deductible when paid.

Independent Power Company

The independent power company must report the payment from the utility when the amount “accrues,” meaning when all the events have occurred that give it a legal right to the payment and enable it to estimate with reasonable accuracy the amount it will ultimately receive. Thus, there is a danger for independent power companies that they will have to report taxable income before they actually receive the cash — for example, where a utility commits to pay a fixed amount over time. The main strategies on the independent power company side are as follows:

Avoid accrual

If the utility will pay an amount over time to buy out or buy down the contract, avoid having to accrue payments before the cash is received by making either the legal right or the amount of each future payment contingent on a future event. (This may be hard to do in practice.)

Advance payment

In buydown situations (where the power contract will remain in place but with the electricity price adjusted to market), structure any lump-sum payment from the utility as an “advance payment” for electricity to be delivered in future. IRS regulations allow a manufacturer who receives an “advance payment” for widgets to wait to report the amount as income as the widgets are delivered in future years. (However, there is room for argument about whether electricity is close enough to widgets to qualify for this special treatment.) The utility adds the buydown payment to its tax basis in the power contract and would ordinarily recover it over the remaining life of the power contract. However, to get an immediate deduction, it assigns the obligation to buy power under the contract to a power marketer and claims a loss for its unrecovered basis.

Borrow

Most new restructuring ideas recently have involved borrowing. For example, the power contract is amended to reduce the contract price for electricity, but not all the way to market, in exchange — among other things — for an agreement by the utility that the electricity does not have to come from a particular power plant. The independent power company then locks in an electricity supply over the same term from a power marketer at market prices. It takes the two contracts (the amended power contract plus the agreement to buy electricity from a power marketer) to the bank and borrows against the spread. The independent power company ends up with a large amount in cash at inception. The cash is not income (because it is borrowed money). The utility makes no cash payment.

Alternatively, the power contract is amended so that the energy price increases, the capacity payments are reduced slightly, the utility is freed from any obligation to buy energy but must make the capacity payments, and the independent power company can supply the capacity from any source. The independent power company assigns the right to the capacity payments to a special-purpose company. The special-purpose company “securitizes,” or borrows against, the capacity payment stream in the public debt market. A parent company with suitable credit guarantees the capacity payments.

Involuntary conversion

The IRS ruled recently that power contracts were “involuntarily converted” where the utility made a credible threat to seize power plants by eminent domain if the owners of the projects did not agree to buyouts of their contracts. When a power contract is “involuntarily converted,” the independent power company does not have to pay income taxes immediately on the buyout payment provided the money is reinvested within two years in other property that is “similar or related in service or use.” It is probably also an involuntary conversion where there is a credible threat of government action to strip the power contract of its value — for example, a curtailment order by a court or regulatory body or a unilateral change in contract terms.

Like-kind exchange

Taxes can be avoided on a buyout payment by entering into a three-way like-kind exchange. The utility acquires the power plant (which has the effect of cancelling the power contract), but pays the purchase price into escrow. The independent power company has 45 days to designate another power project in which to reinvest the money. The utility then uses the escrowed funds to purchase the other project and completes the “like kind” exchange of the new project for the old one. The utility then auctions off the old power plant (assuming it has no interest in owning generating assets). The independent power company can probably buy the power plant back at auction if it chooses.

Swap and “put”

In New York, some independent power companies have accepted a smaller buyout payment and entered into a “swap” and “put” with the utility. The “swap” is an agreement to pay the difference between the market price for electricity each month and a contract price on a notional amount of electricity. In months when the market price is below the contract price, the utility pays the independent power company the difference. In months when the market price is above the contract price, the independent power company makes payments to the utility. The “put” is an option to sell the notional amount of electricity to the utility each month at the market price. The two contracts together distill to a right to sell electricity at the contract price. It may be a lower contract price than what was in the original power purchase agreement.

Shelter

An independent power company usually has little tax basis in its power contract. However, if it conveys the power plant to the utility or abandons the power plant, it can use its unrecovered tax basis in the power plant as shelter for the buyout payment. Some independent power companies have looked into selling and leasing back the power plant as a way of realizing a loss.

Cancel other contracts

Another way to create shelter is to spend the buyout payment in a way that gives the independent power company a tax deduction. For example, if the money is used to cancel fuel supply and other contracts, provided the contracts are not replaced with new agreements, the payments to get out of these other contracts can be deducted. There has been a debate among independent power companies about whether the payment is a “capital loss” as opposed to an ordinary loss, but a tax bill that Congress enacted last November has helpful language on this issue.

by Keith Martin, in Washington