Foreign Investment In Transpower
What’s Going On With Our Power
- by Sue Newberry
SueNewberry is Associate Professor of Accounting at the University of Sydney.
It seems ridiculous that a State-owned Enterprise (SOE), which states its function as including to “own and operate” assets of strategic importance to New Zealand, the national high voltage electricity transmission grid, should be so focused on improving its reported profits that it effectively sells those strategic assets to foreign (United States) investors. Transpower’s cross-border lease over the South Island grid involves the effective sale of that grid to the Wachovia Bank of North Carolina.
When the nature of this deal was explained to the public, Transpower claimed the details of its cross-border lease were commercially sensitive and, therefore, confidential. However, according to Transpower’s former General Manager of Public Affairs, Kevin Eagleson, this grid sale, “made good commercial sense for Transpower…and directly benefited… the country as a whole” (Press, 5/7/05, Perspectives, “Power plays: Who has it right?”) . But how does the sale of such strategic assets to US interests benefit New Zealand? And if the deal is so commercially sensitive it seems odd that the journal Asset Finance Internationalcan obtain and publish information about it that was denied to the New Zealand public who are, after all, Transpower’s owners. Documents released in 2005 under the Official Information Act, which comment on Transpower’s need to manage “communication risks” provide a more believable explanation for Transpower’s refusal to provide information to the public. Claims of commercial sensitivity can provide a smokescreen to avoid proper scrutiny.
The Asset Finance International article published in February 2004 was titled, “Transpower signs NZ’s largest US lease”, and reported that this cross-border lease deal was for $701 million; Transpower’s US counter-party was the Wachovia Bank of North Carolina; the US insurance giant AIG Financial Products financed the deal which was named the outstanding utilities deal in the Asia Pacific region for 2003; the Macquarie Bank of Australia won an award for the innovative nature of the deal which includes land; and the deal was referred to as a lease-to-service contract. As further background, it is worth noting that the Wachovia Bank is notorious for its involvement in tax-driven deals and the massive tax deductions it claims, and has been under investigation in the United States because of this. The AIG group is also currently under investigation for its activities, including its involvement in the HIH insurance group collapse in Australia. And at the time of the deal, lease-to-service contracts were under investigation in the US and have since been banned there as tax abusive.
Much of the public debate about this deal has focused on the fact that it is tax-driven and that it passes through the Cayman Islands, a well-known international tax haven. In this article, although I will provide some background information on the cross-border lease and its tax-driven nature, I want to focus attention back onto the question of ownership of the South Island high voltage electricity transmission grid and the potential for other public assets to be disposed of in similar ways.
Transpower’s Half Year Financial Report To December 31 2004
In late March 2005, Transpower published its financial reports for the half year ended December 31, 2004. Its half year profits had improved over the same period the previous year by $71.3 million. Approximately half of that profit ($34.7 million) came from Transpower’s electricity transmission activities, while the other half ($34.6 million) came from a one-off gain that Transpower reported on a cross-border lease.
Both of these figures caused me some concern. It seems ironic that a State-owned Enterprise owned on behalf of all New Zealanders should be proud to have improved profits by $34.7 million at our expense. In his report to Parliament’s Finance and Expenditure Committee, in February 2005, the Auditor-General noted that recently adopted electricity pricing policies have the effect of over-charging electricity consumers, and that Transpower was comfortable with this. Surprisingly, the Auditor-General, whose role it is to defend our interests seemed unperturbed as well. The outcome of the Commerce Commission’s investigation into Transpower’s pricing, announced in November 2005, will be interesting.
Even more worrying was the reported gain on the cross-border lease. Transpower disclosed few details about this deal, other than that it related to the South Island electricity grid; that Transpower’s one-off gain was $34.6 million; and that Transpower faces a potential liability of an unstated amount arising from a guarantee associated with the deal, although it considers that the likelihood of any actual liability occurring is “remote”. In addition, Transpower reported that this cross-border lease had occurred in December 2003 but, because of unspecified concerns that the transaction might “unwind”, Transpower did not report its gain on this deal until December 2004.
The information Transpower disclosed in its financial report about this cross-border lease might be regarded as revealing only the tiny tip of a large, hidden iceberg. It was unlikely to alert anyone unaware of the nature of cross-border leases as to just what had happened. The $34.6 million gain is only a small fraction (less than 5%) of the whole deal. The information that emerged subsequently revealed that the whole deal involved the effective sale to the Wachovia Bank of North Carolina of the whole of the South Island high voltage electricity transmission grid, including substation and transmission site land, for $701 million. This was followed by the lease-back from Wachovia to Transpower of the grid for approximately 80 years. A provision in the lease-back deal allows Transpower to terminate it after approximately 25 years by repurchasing the grid from Wachovia. None of this information was reported.
There is a standing general requirement with financial reporting that, regardless of specific financial reporting requirements, information that is material should be reported. Transpower’s publication in its financial reports of only scanty information about the cross-border lease, and especially its failure to disclose the gross amount of the deal and its nature, represents inadequate and unacceptable financial reporting practices.
Cross-Border Leases: Tax-Driven Arrangements
Cross-border leases, also known as “big ticket leases” because they generally involve leasing arrangements over major assets, seem to have originated in the United States to exploit clauses inserted in US tax law in the mid-1980s. What the US legislators had in mind at the time of this law is not clear, but there is little doubt that the results were not intended. Over the years, the federal tax base in the US has been increasingly eroded, while those packaging and selling cross-border leases, as well as those engaging in these deals, have profited enormously from exploiting the tax law provisions with circular deals designed to attack the tax base and which have little or no commercial substance. Those involved include major chartered accounting firms and legal firms, as well as financial institutions. Because cross-border leases and their variants soon became known as an abusive means of avoiding significant amounts of tax, for some years now, there has been a running battle over these deals between the Internal Revenue Service (IRS) in the United States and the big ticket leasing industry.
The basic structure of a cross-border lease is fairly simple. One party outside the US owns major assets which it wishes to continue using, while the counter-party in the US may have taxable gains there that it wants to offset by claiming tax deductions or tax refunds. The party outside the US that owns the assets agrees to lease them to the US party, with the lease structured so the US party can claim it has purchased the assets. This allows the US party to claim tax deductions on them, such as depreciation and interest. The US party doesn’t actually want the assets and neither does it want to use them, so it leases them back to the original owner but this lease is structured so that the US party can continue to claim it owns the assets and that the original owner is merely renting them.
At the time of the lease deal, neither party pays out much money or receives much money. Instead, a major bank is likely to bankroll the deal which passes through an intermediary, usually in a tax haven. The intermediary’s role is to ensure that the “lease” payments purportedly received from the US party are used to make the lease payments by the other party back to the US party. The deal is circular. The superficially pointless nature of a cross-border lease like this is the hallmark of a tax-driven deal. The US party gains by reducing its tax or claiming tax refunds and the original owner of the assets gets a cut on those gains. As cross-border leases have developed, and the arrangements have become more complicated, they have been structured so that both parties can benefit from tax deductions. Double-dipping deals (attacking two countries’ tax bases at the same time), or even triple-dipping deals (attacking three countries’ tax bases) have emerged. Consequently, the original owner may also gain through additional tax savings in its own country as a result of the deal.
The complicated nature of cross-border leases means they contain numerous risks of something going wrong. The deals tend to be long term and involve several different parties, one of which is the intermediary company located in a tax haven where the ability to take legal action in the event of problems arising can be limited. The Cayman Islands are well known for this. The more complicated the deal, the more parties involved, and the longer the lease term involved, the more possibilities for something to go wrong.
In both the US and New Zealand, the tax authorities can reject claims for tax deductions when deals are driven for tax, rather than commercial reasons. Consequently, those involved in the cross-border leasing industry can be quite secretive about their activities and deals. It helps to avoid public attention as well as attention from the tax authorities. Transpower, however, when asked by a reporter to explain its cross-border lease responded with the advice that Transpower was assisting its then-unnamed US counter-party to the deal, “to manage its tax liabilities.” In other words, Transpower, a company owned on our behalf by the New Zealand government was, at the very least, knowingly helping a company in the United States to abuse the US tax system. Papers since released under the Official Information Act suggest that Transpower may also be claiming increased tax deductions in New Zealand as a result of that deal. Because Transpower is an SOE, if Transpower is claiming increased tax deductions there will be no overall effect on governmental funds. However, if an SOE can do that, so too can any other company. The deal warrants close attention from the tax authorities in both New Zealand and the US.
Cross-Border Leases: Who Owns The Assets After These Deals?
A key issue in the running battle over cross-border leases between the tax authorities and the leasing industry is the nature of ownership. Is legal title the only determinant of ownership? Or is it possible that economic ownership can be obtained without obtaining legal title? This issue is most easily illustrated with the purchase of a car. If you have bought a car, then you have legal title and you can think of the car as yours. But if you agree to allow someone else full use of that car in return for rental payments, then even though you still have legal title to the car, you are unable to use it. In renting the car to someone else, you are selling some of your rights over it. If the rental agreement is for, say, 15 years, then even though you have legal title to the car throughout that period, the person renting it might be regarded as having bought the car because that period is as long as, or longer than, the car’s useful life. In other words, the person renting the car under these terms is regarded as having taken economic ownership.
Cross-border leases exploit the idea that legal and economic ownership of an asset can be separated. For accounting, and to some extent for tax purposes, if a lease is for most or substantially all of an asset’s useful life, then the arrangement is treated by one party (the lessor) as an effective sale to the other party (the lessee), even though the lessor still holds the legal ownership papers. This involves separating legal and economic ownership. If the lease period is for a period shorter than the asset’s useful life, the arrangement is regarded and treated as a rental agreement in which one party (the lessor) is regarded as the owner, and the other party (the lessee) merely rents the asset. This idea of separation of legal and economic ownership and multiple leases gives rise to another issue whereby more than one party can claim to “own” the asset.
In the US, the early cross-border leases were known as LILOs (lease-in, lease-out). The IRS banned LILOs for tax purposes from 1999, but the cross-border leasing industry responded with a variant on LILOs which was known as SILOs (sale-in, lease-out), which have also since been banned as tax abusive. As suggested by the names of these deals, economic ownership of the assets involved in the cross-border lease tended to remain with the original owner with LILOs, whereas, with SILOs, effective ownership of the assets has to be transferred to the US counter-party. Transpower had previously done two cross-border leases in 1996 and 1997. Those leases would have been the now-banned LILOs. When seeking ministerial approval for this latest cross-border lease, Transpower claimed this lease-to-service contract was much the same as the earlier deals. It is another variant of the tax-driven LILOs/SILOs. The reason Transpower delayed reporting the gain from this deal was because the tax authorities in the US were challenging them there and these deals too have since been banned in the US for tax purposes.
Transpower’s Cross-Border Lease:
Transpower’s cross-border lease is complicated, but the basic structure has been outlined. The deal relates to the South Island electricity transmission grid which consists of the electricity transmission system and the transmission stations’ land. Any decision about who now owns the South Island grid requires appreciation of the idea that legal and economic ownership may be separated and/or duplicated, and stepping through each of the deals. Transpower’s protestations that it has retained title to the grid is, presumably, supposed to be taken as a denial that Transpower has sold the grid but, for this cross-border lease to succeed for tax purposes in the US, a US-based party, in this case the Wachovia Bank of North Carolina, has to be regarded there as the effective owner of the transmission grid.
In Transpower’s financial reports, the useful life of the electricity transmission system is stated as up to 50 years. Typically, no useful life is ever stated for land, but there is a common practice to regard a lease over land for more than 99 years as amounting to effectively transferring ownership of the land. For effective ownership of the whole grid to pass to Wachovia, the lease had to be for longer than both of those terms. The first part of Transpower’s cross-border lease involved Transpower leasing the whole of the South Island transmission grid (electricity transmission system and land) to the Wachovia Bank for 100 years. The deal was worth $701 million. Close scrutiny of Transpower’s financial report reveals that Transpower has treated this 100 year lease to the Wachovia Bank as a sale. Even though Transpower may still hold legal title to the grid, with this part of the deal Transpower effectively sold it to the Wachovia Bank.
The second part of the cross-border lease involves Transpower leasing the grid back from the Wachovia Bank. For the deal to succeed for tax purposes in the US, the Wachovia Bank would need to arrange this lease in a manner that allows it to continue to claim it owns the grid. This part of the deal is known to be for a period shorter than 100 years, approximately 80 years, which is longer than the useful life of the electricity transmission system, but less than the time required for the land part of the deal to be regarded as an effective purchase. At this point it seems likely that the Wachovia Bank is treating the grid as one asset which it owns and is merely renting it to Transpower (the renting probably being the service part of the contract) while Transpower treats the arrangement as the lease of two separate assets (the land and the transmission equipment). That would allow Transpower to treat the electricity transmission equipment part of the lease-back as an effective purchase because an 80 year lease is for longer than the useful life of the transmission equipment. It seems to be treating the land part of the lease-back as a rental arrangement because an 80 year lease-back over the land is less than what would be required for economic ownership.
This lease-back arrangement contains an option at about year 25 for Transpower to terminate the whole deal by repurchasing the grid. The term “repurchase” is Transpower’s word. If the cross-border lease goes to plan throughout this time, we might expect that in about 25 years time Transpower will exercise this repurchase option, the cost of which will have already been factored into and covered in the deal. Until then, although Transpower continues to say that it owns the South Island grid, the Wachovia Bank of North Carolina has to be making the same claim in the United States. In other words, they both claim to own it.
If this cross-border lease does go to plan, and Transpower exercises its option to repurchase the grid after 25 years, with the result that the whole cross-border lease terminates, Transpower’s one-off $34.6 million profit on this deal will represent about $1.34 million per year. Even if the deal does proceed without a hitch, does it really make good commercial sense for Transpower to engage in such arrangements? And does this really benefit New Zealand as a whole?
Issues Arising From Foreign Investment Of This Nature
This cross-border lease over such strategic assets raises policy matters that require consideration. In August 2003, the Treasury advised that any decision about this cross-border lease “should not be influenced by the nature of the assets subject to the lease, as long as Transpower can fulfil the conditions that Ministers have previously conveyed” (T2003/1376, 11 August 2003). Included among those conditions was the expectation that such a deal should not be overly tax-aggressive and that “ownership risks” should be remote.
Tax Aggression Or Tax Justice?
The Treasury advice seemed unaware that the type of cross-border leases Transpower had previously engaged in had since been banned in the United States for tax purposes. Neither did it seem aware that exactly this type of lease was under investigation at the time and likely to be banned given its derivation from the banned LILO/SILO deals. Clearly the deal is regarded as overly tax-aggressive in the US. But, even if Dr Cullen’s Treasury advisers were unaware of these facts, basic tax justice considerations should prompt further thought about the wisdom of proceeding with such deals. A recent publication titled “Tax us if you can”
The other question is for governments, and this one becomes especially pertinent because Transpower’s Government ownership might imply that Transpower’s behaviour is the behaviour of, or is at least condoned by, the New Zealand government: “If another government behaved as we do would we consider their actions a threat to the welfare of our state or its taxation revenues?”.
“Ownership Risks” And The Disposal Of Public Assets
The present Government has stated as policy its desire to draw back from privatisation initiatives, but lease-to-service contracts have been referred to in the US as aligned with and facilitating privatisation. Arguably, the cross-border lease Transpower engaged in is contrary to the Government’s stated policy against further privatisation, and the public unpopularity of earlier initiatives privatising crucial assets is well-known.
The Treasury’s advice that the nature of the assets subject to the cross-border lease should not influence considerations of whether such deals should proceed seemed unaware that for this tax-driven deal to succeed in the US, the US-based counter-party, in this case the Wachovia Bank, had to claim ownership of the assets concerned, in this case the South Island section of the transmission grid. Full ownership of those assets will not revert to Transpower unless and until it exercises its repurchase option in approximately 25 years time. Even if deals like this were not tax-abusive, the advice to ignore the nature of the assets is worrying. As was noted in the January 2004 issue of Asset Finance International, deals like this have become popular in New Zealand’s public sector. Is it really acceptable to ignore the nature of the assets disposed of in this way? And if it is acceptable to effectively sell the electricity grid, where should we draw the line? Hospitals? Schools? Roads? Hydro dams? Water supply facilities? These could equally be disposed of through similar arrangements without public awareness until too late. The furtive manner in which Transpower’s deal proceeded in New Zealand suggests the need for public debate about the exposure of public assets.
Foreign Control Watchdog, P O Box 2258, Christchurch, New Zealand/Aotearoa. December 2005.
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