Commonwealth Edison Company
Exhibit 99-1
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June 9, 2000
Mr. Robert E. Berdelle
Commonwealth Edison Company
10 South Dearborn, 37th Fl. CHQ.
P.O. Box 767
Chicago, IL 60603-0767
Dear Mr. Berdelle:
We have been engaged to report on the appropriate application of
United States generally accepted accounting principles ("GAAP")
to the proposed transaction described below. This report is
being issued to Commonwealth Edison Company ("ComEd" or the
"Company") for assistance in evaluating accounting principles
for the described proposed transaction between ComEd, its
affiliate, Unicom Investments Inc. ("UII") and City Public
Service of San Antonio ("CPS"), an unrelated municipal entity.
This letter is restricted to the internal use of management and
the Board of Directors of ComEd, and affiliates and their
external auditors and legal counsel advising on the transaction,
and if so requested or deemed necessary by ComEd, the Company's
utility regulator. Our engagement has been conducted in
accordance with standards established by the American Institute
of Certified Public Accountants.
DESCRIPTION OF THE PROPOSED TRANSACTION
You have advised us, and we have assumed without any
investigation, that the facts, circumstances and assumptions
relevant to the proposed transaction are as follows:
1. ComEd is a rate-regulated public utility that prepares its
financial statements in accordance with GAAP. The State of
Illinois, in which ComEd operates, has recently adopted
deregulation legislation that has resulted in the generation
portion of its business no longer being subject to rate-
regulation. The Company is a subsidiary of Unicom Corporation,
a holding company ("Unicom" or the "Parent Co."). The Company,
immediately prior to the transaction, owned and operated Collins
Station, a fossil fuel electric generating station (the
"Facility"). ComEd and Unicom are each registrants with the
U.S. Securities and Exchange Commission (the "SEC") and, as
such, each files separate financial statements with the SEC in
accordance with its periodic reporting requirements.
2. As a result of the deregulation legislation, ComEd
recognized an impairment loss related to certain of its
generating assets. This loss was determined in accordance with
the provisions of Statement of Financial Accounting Standards
No.121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed of" ("SFAS 121"). Because,
however, of the provision of the deregulation legislation, the
Company deferred this loss and created a regulatory asset in
accordance with the provisions of Statement of Financial
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Accounting Standards No.71, "Accounting for the Effects of
Certain Types of Regulation, ("SFAS 71") as interpreted by
Emerging Issues Task Force Consensus No. 97-4, "Deregulation of
the Pricing of Electricity-Issues Related to the Application of
FASB Statements No.71 and 101." These regulatory assets
together with pre-existing generation related regulatory assets
are herein referred to as the "Regulatory Assets." You have
asked us to assume that a deferred tax liability has been
recorded related to the Facility representing the difference
between the remaining tax basis and the book basis of the
Facility.
3. ComEd entered into an agreement for the sale of the Facility
and other assets (the "Sale Agreement") to a third party
purchaser (the "Buyer"). The Company also entered into an
agreement with a non rate-regulated subsidiary of Unicom (UII or
the "Affiliate") to transfer the Facility and such other assets
to UII immediately prior to the time that the Facility would
otherwise be transferred to the Buyer. The Sale Agreement
allowed ComEd to sell or assign the Facility and such other
assets to UII in this manner. Gain resulting from the sale of
the Facility and such other assets was applied to offset the
Regulatory Assets. This was recognized immediately by
amortizing a corresponding amount of the Regulatory Assets in
the same period the gain is recognized for regulatory purposes.
The gain did not exceed the Regulatory Assets. Regulatory
Assets written off will not be recovered by ComEd in its cost of
service when ComEd's rates are set in future rate proceedings.
4. UII entered into a like-kind exchange agreement (the
"Exchange Agreement") with a third party financial institution
that acts as an intermediary (the "Qualified Intermediary") to
facilitate the like-kind exchange of the Facility. The Exchange
Agreement and Qualified Intermediary meet the requirements of
the so-called deferred exchange safe harbor provisions pursuant
to IRC Section 1031 and the regulations promulgated thereunder.
5. On December 15, 1999 (the "Disposition Date") ComEd sold the
Facility to UII for fair market value. UII immediately assigned
its rights in respect of the sale of the Facility to the
Qualified Intermediary. The Qualified Intermediary then
completed the sale of the Facility for fair market value to the
Buyer. Legal title to the Facility passed directly to the Buyer
from UII. The Buyer was directed by UII to pay to the Qualified
Intermediary the sales proceeds related to the Facility in
accordance with the Exchange Agreement.
6. The Qualified Intermediary, on or before June 12, 2000,
(i.e., within the IRC Section 1031 time constraints of 180 days
from the Disposition Date), will be directed by UII to utilize a
portion of the cash proceeds received from the Buyer to acquire
like-kind property (the "Exchange Property") from CPS. Such
acquisition shall be in the form of a long term lease (the "Head
Lease") with an initial term that extends for a period in excess
of 125% of the remaining economic useful life of the Exchange
Property, as determined by independent appraisal, with annual
renewal options for twenty years thereafter for rent of no more
than $1.00 per year. You have asked us to assume that the
remaining useful life of the Exchange Property is 52 years.
Thus, the Head Lease will extend for a period of 65 years
before consideration of the annual renewal options.
The Qualified Intermediary, at the direction of UII, will
prepay the long term Head Lease for an amount equal to the
full appraised fair market value of the Exchange Property.
Legal title to the Exchange Property does not transfer to UII
or the Qualified Intermediary at the time of the acquisition.
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Rather, legal title will transfer at the end of the initial
Head Lease period for a nominal amount in the event that CPS
does not exercise its cancellation option pursuant to the
leaseback (discussed below). You have asked us to assume that
for federal income tax purposes the requisite benefits and
burdens of ownership of the Exchange Property have passed to
UII pursuant to the Head Lease and, as a result, it will be
deemed to be the owner of the Exchange Property. UII will
immediately transfer the long-term leasehold interest in the
Exchange Property to a bankruptcy remote Delaware Business
Trust (the "Trust") established by UII, thereby completing the
like-kind exchange. The transfer of the long-term leasehold
interest will be a capital contribution for financial
reporting purposes. The sole beneficiary of the Trust will be
a limited partnership (the "LP"). There will be a 99% limited
partner and a 1% general partner of LP, each of which will be
a limited liability company (together the "LLCs") whose sole
member will be UII. You have asked us to assume that the
Trust, LP and LLCs each is treated as a transparent entity for
federal income tax purposes.
7. The Trust (hereinafter "Lessor") will immediately lease the
Exchange Property back to CPS (hereinafter the "Lessee") for a
term of approximately 31.75 years (the "Lease"). Pursuant to
the Lease, the Lessee will agree to pay rent and will have a
Cancellation Option (the "CO") at the end of the Lease. The
Lessee will be required to prepay all of its scheduled rent
obligations at the end of Month 6 of the Lease. The CO price is
an amount calculated as sufficient to recover UII's original
investment and anticipated return in the transaction and is
estimated to equal or exceed the expected fair value of the
Exchange Property at the end of the Lease term. The CO contains
no net cash settlement provisions and requires the Lessor to
surrender its rights as the lessee under the Head Lease,
including the transfer of title at the end of the Lease. At the
end of the Lease the following will occur:
a) The Lessee may, but is not required to, exercise the CO by
paying the CO price to the Lessor.
b) If the Lessee does not elect to exercise the CO, it will
return the Replacement Property to the Lessor.
c) The Lessor may then keep the Replacement Property either
(i) without further Lessee obligations, or (ii) may also compel
the Lessee to arrange for a Power Toll Processing Agreement and
an Operating Agreement, including a Service Recipient and
Operator that meet certain credit requirements established by
the Lessor (collectively, the "Service Contract") which will
extend for a period of approximately 9.58 years beyond the end
of the Lease term. If arranged the Service Recipient and
Operator will not have the ability to cancel the Service
Contract except in instances of breach of contract by the
Company that are triggered by events within the control of the
Company. In either case, the Lessor will have the option to
purchase the ownership of the Exchange Property (and hence
acquire the fee interest in the Exchange Property) for $1.
d) If the Lessor compels the Lessee to arrange the Service
Contract and Lessee cannot meet the Lessor's requirements for
the Service Contract (including the credit worthy Service
Recipient and Operator) then the Lessee must exercise the CO.
Under the terms of the Lease, in order to meet the Lessor's
requirements for the Service Contract, the Lessee would be
required to produce a Service Recipient who would be
responsible to pay the Service Contract fees under the Service
Contract comprised of: 1) a fixed component for an amount
sufficient to pay the return to UII of its equity investment
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plus its anticipated return and 2) a variable component set at
a level which is sufficient to pay: (i) the actual cost of
operating and maintaining the Exchange Property, including
fuel and the cost to the Lessor/Service Provider of fees
payable to an operations and maintenance contractor hired to
run the Exchange Property pursuant to an operations and
maintenance agreement and (ii) the actual cost of premiums for
casualty, business interruption and other insurance coverage.
The fixed component of the Service Contract fees will either
be paid by the Service Recipient as power is delivered under
the contract or a third-party insurer as a result of payments
under the insurance purchased under (ii) above if the Exchange
Property does not produce power, produces insufficient power
or is rendered inoperative. You have asked us to assume that
it is not reasonably assured that the Lessee will exercise the
CO. You have asked us to further assume that the Service
Contract will meet the requirements of IRC Section 7701(e) and
as such will not be treated as a lease for federal income tax
purposes and that it is reasonably expected that the Lessee
may produce the Service Recipient.
8. The sum of the present value of (i) the rental payments
during the initial 31.75 year Lease term, assuming the
prepayment at the end of Month 6 and (ii) the fixed component of
the Service Contract fees will be more than 90% of the fair
market value of the Exchange Property at the inception of the
Lease. The interest rate used to calculate the present value of
the aforementioned cash flows is the interest rate implicit in
the Lease. Such implicit interest rate would be the rate that,
when applied to the minimum lease payments (excluding executory
costs), including the Service Contract fixed payment amounts,
and the unguaranteed residual value of the Exchange Property at
the end of the Service Contract period, causes the aggregate
present value at the beginning of the Lease term to be equal to
the fair value of the Exchange Property. The Lessor would
receive only the residual value at the end of the Service
Contract period if the Service Contract were to be elected.
Further, you have asked us to assume that there are no important
uncertainties about the amount of unreimbursable costs yet to be
incurred by the Lessor.
9. The rent under the Lease will be functionally broken out
between the so-called "Equity Portion" and "Prepayment Portion"
of rent. The Prepayment Portion of rent will be all scheduled
rent amounts specified in the Lease. The entire CO price (or
the fixed component of the Service Contract fees) is referred to
as the Equity Portion of rent. As part of the Lease, the Lessee
will commit to prepay the Prepayment Portion of rent at the end
of Month 6 of the Lease.
10. The Lessee will use a portion of the Head Lease proceeds
received from the Qualified Intermediary to enter into a
Collateralized Payment Undertaking Agreement (the "CPUA") with
an affiliate of American International Group, Inc. ("AIG").
Based on the terms of the Agreement, the CPUA will be sufficient
in timing and amount to pay the Equity Portion of rent when due.
The obligations under the CPUA will be supported by a letter of
credit and further guarantee from AIG. In addition, AIG will
commit to provide separate collateral in the form of certain
Government and Federal Agency securities which will be marked to
market from time to time during the Lease so as to always exceed
accreted value of the CPUA. The CPUA and related collateral
will be pledged to the Lessor in order to support the Lessee's
obligations under the Lease. If the Lessee does not exercise
the CO, but rather arranges the Service Contract, the CPUA will
revert to the Lessee.
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11. The Lessee will use an additional portion of the Head Lease
proceeds received from the Qualified Intermediary to purchase
certain Government and/or Treasury Agency securities (the
"Prepayment Deposit"). These will, when accreted at the
underlying interest rate, be sufficient in timing and amount to
pay, when due, the Prepayment Portion of rent, which will equal
6 months of rent plus the Lessee's rent prepayment obligation at
the end of Month 6.
12. The Lessee retains the difference between the Head Lease
proceeds received from the Qualified Intermediary and the sum of
the CPUA and Prepayment Deposit described above.
13. The Lessee will pay the Prepayment Portion of rent at the
end of Month 6. You have asked us to assume that the Lessee's
prepayment of the Prepayment Portion of rent at the end of Month
6 will be treated, for federal income tax purposes, as an IRC
"Section 467 Loan".
14. The Lessee will pay the CO price, if elected, at the end of
the Lease term to the Lessor, who in turn will distribute such
amounts to UII. Such amount is paid under the Lease in an
amount required to recover UII's original investment and
anticipated return in the transaction.
15. Credit enhancement in the form of a Financial Guarantee
Insurance Policy ("FGIP") will be secured at the outset of the
term of the Lease from Financial Security Assurance, Inc.
("FSA"). FSA will be responsible for the portion of termination
value in excess of the accreted value of the CPUA in the event
of default or early termination by the Lessee. The termination
value shall be an amount sufficient to protect UII's principal,
pay taxes due and any yield earned to the date of early
termination.
QUESTIONS ON THE APPROPRIATE APPLICATION OF GENERALLY ACCEPTED
ACCOUNTING PRINCIPLES
You have asked us to address accounting questions on the
following specific issues:
The Exchange of the Facility
How should ComEd and UII account for the sale/exchange of
the Facility?
Will gain be recognized for accounting purposes?
The Head Lease and Lease
How will the Head Lease be classified, that is, will it be
treated as a capital lease or an operating lease?
How will the Lease be classified?
The Cancellation Option and the Service Contract Option
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Will the Cancellation Option (CO) and the Service Contract
option be considered a derivative under SFAS 133 and if so,
will it have to be marked to market on a quarterly basis?
Deferred Tax Accounting
What will be the deferred tax accounting with respect to:
- Gain on the sale of the Facility
- "Section 467 Loan"
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
The Exchange of the Facility
Transfer between UII and Qualified Intermediary: Accounting
Principles Board (APB) opinion 29, "Accounting for Nonmonetary
Transactions," (APB 29) sets forth the accounting treatment to
be accorded to both exchanges and nonreciprocal transfers that
involve little or no monetary assets. Plant and equipment are
nonmonetary assets (APB 29, paragraph 3b).
Further, we believe the plant received by UII pursuant to the
Head Lease is a non-monetary asset because that lease is
classified as a capital lease (see analysis below) and the
sublease is not pre-existing. APB 29 states that, in
general,"... accounting for nonmonetary transactions should be
based on the fair values of the assets involved which is the
same basis as that used in monetary transactions" (APB 29,
paragraph 18).
An exception to the fair value accounting approach occurs when
an exchange is not the culmination of an earnings process. An
exchange transaction is a reciprocal transfer between an
enterprise and another entity that results in the enterprise
acquiring assets by surrendering other assets (APB 29, paragraph
3(c)). Accounting for exchanges of productive assets not held
for sale in the ordinary course of business for similar
productive assets should be based on the recorded amounts of the
nonmonetary assets exchanged rather than at fair value (APB 29,
paragraph 21). For this purpose, similar productive assets are
defined in APB 29 as "productive assets that are of the same
general type, that perform the same function or that are
employed in the same line of business."
We believe, however, that this proposed transaction, which has
been arranged in form as an APB 29, paragraph 21 exchange (for
the purpose, for example, of deferring the payment of income
taxes of one of the parties to the transaction), is in substance
a sale or disposition. In the transaction described in the
facts above, all aspects of the transaction have been
prearranged by the Qualified Intermediary. The Qualified
Intermediary has little or no risk and earns a normal broker's
fee. Therefore, we believe that fair value treatment is
appropriate.
Transfer from ComEd to UII: Generally, the transfer of assets
between entities under common control would be recorded at
historical costs in accordance with AICPA Accounting
Interpretation 39 to APB 16, "Business Combinations" (AIN-APB16,
#39). Because, however, in the proposed transaction, there is a
prearranged sale with an unrelated third party and UII has never
received the benefit or incurred the costs of the Facility, we
believe it is appropriate for the ComEd to record the sale on
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the basis of fair value once the actual sale to the third party
has been completed.
Gain Recognition: Because ComEd is a rate-regulated entity that
qualifies for reporting under the provisions of Statement of
Financial Accounting Standards No. 71, "Accounting for the
Effects of Certain Types of Regulation" (SFAS 71) consideration
should be given to the actions of the regulator before the
appropriate book treatment of the gain can be determined.
Paragraph 11c of SFAS 71 indicates that a "regulator can require
that a gain or other reduction of net allowable costs be given
to customers over future periods...If a gain or other reduction
of net allowable costs is to be amortized over future periods
for rate-making purposes, the regulated enterprise should not
recognize the gain or other reduction of net allowable costs in
income of the current period. Instead, it shall record it as a
liability for future reductions of charges to customers that are
expected to result." You have asked us to assume that the
regulator will capture any gain resulting from the sale of the
Facility and other assets to offset the Regulatory Assets and
that the gain will not exceed the Regulatory Assets. You have
further asked us to assume that the regulator will require
immediate amortization of a corresponding amount of the
Regulatory Assets in the period the gain is recognized for
regulatory purposes. As a result, the net gain on the sale of
the Facility will not increase ComEd's net income.
The Head Lease
Before addressing the accounting for the two individual leases,
the Head Lease and the Lease, it is necessary to assess,
considering the combination of the two leases, whether the
municipal entity has conveyed the right to use property, plant,
or equipment, which is required for the Head Lease to qualify as
a lease under Statement of Financial Accounting Standards No.
13, "Accounting for Leases" (SFAS 13), paragraph 1. You have
asked us to assume that it is not reasonably assured that the
Lessee will exercise the CO. Therefore, it is reasonable to
conclude that there is at least a possibility that the CO will
not be exercised and UII (through the Trust) will obtain the
right to use the Exchange Property. Accordingly, we have
addressed the questions of lease classification for both the
Head Lease and the Lease.
The long-term lease between CPS and UII, which is then
transferred to the Trust by UII to complete the exchange
transaction, will be accounted for as a capital lease. The four
basic classification criteria set forth in paragraph 7 of the
Financial Accounting Standards Board's (SFASB) SFAS 13 are:
- 7a - The lease transfers ownership of the property to
the lessee by the end of the lease term.
- 7b - The lease contains a bargain purchase option.
- 7c - The lease term is equal to 75 percent or more of
estimated economic life of the leased property.
- 7d - The present value at the beginning of the lease
term of the minimum lease payments equals or exceeds 90 percent
of the excess of the fair value of the leased property to the
lessor at the inception of the lease over any related investment
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tax credit retained by the lessor and expected to be realized by
him.
Under SFAS 13, a lease is classified as a capital lease by the
lessee if it meets any one of the four criteria; otherwise, it
is an operating lease. The Head Lease meets the 7a, 7c and 7d
criteria.
The Head Lease will provide UII with the ability to acquire
legal title to the Exchange Property for a nominal amount at the
end of the Head Lease. Accordingly, criterion 7a will have been
met.
The term of the Head Lease will be set at 125% of the appraised
economic useful life of the Exchange Property, before
consideration of the annual renewal options. Accordingly,
criterion 7c will have been met.
Under the subject Head Lease, the Qualified Intermediary on
behalf of UII and the Trust will pay at closing all of the rents
required. The present value of such rents will equal 100% of
the fair value of the Exchange Property. Therefore, criterion
7d will have been met.
The Lease
The Lease constitutes a sublease, the accounting for which is
addressed in paragraphs 35 through 39 of SFAS 13. Because the
Head Lease qualifies as a capital lease under the criterion of
paragraph 7a of SFAS 13, paragraph 39a of SFAS 13 is applicable
to the classification of the Lease. Accordingly, the Lease
would be classified as a direct financing lease by the Lessor if
it meets at least one of the four criteria of paragraph 7 of
SFAS 13 listed above and both of the two additional criteria in
SFAS 13, paragraph 8 (reasonably predictable collectibility of
minimum lease payments and absence of important uncertainties
surrounding the amount of unreimbursable costs yet to be
incurred by the lessor). If the Lease does not qualify as a
direct financing lease, it would be classified by the Lessor as
an operating lease.
The Lease does not contain an automatic transfer of title of the
property. Therefore, criterion 7a will not be met.
You have asked us to assume that the CO is not reasonably
assured of exercise and that, therefore, criterion 7b will not
be met.
The 31.75-year term of the Lease is less than 75% of the 52-year
estimated remaining useful life of the Exchange Property.
Therefore, criterion 7c will not be met.
SFAS 13, paragraph 5j states that minimum lease payments include
(1) the minimum rental payments called for by the lease over the
lease term plus (2) any guarantee of the residual value by the
lessee or an unrelated third-party, whether or not payment of
the guarantee constitutes a purchase of the leased property.
Under the provisions of the Lease, the Lessee has only two
options at the end of the Lease term:
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Exercise the Cancellation Option (CO), or
Return the Exchange Property to the Lessor.
If the Lessee does not exercise the CO, the Lessor may (but is
not required to) compel the Lessee to:
Arrange for a Service Contract (including a Service
Recipient and Operator that meet certain credit
requirements established by the Lessor).
The Service Contract will provide for fixed payments thereunder
that are sufficient to pay the return to UII of its equity
investment and its anticipated return. If the Lessee cannot
arrange for the Service Contract (including the requirement to
deliver a credit worthy Service Recipient irrespective of the
value of the Exchange Property) then the Lessee must exercise
the CO. Due to the nature of the Lessee's obligations with
respect to arranging the Service Contract and the fact that
payment of the fixed component of the Service Contract fees is
guaranteed by a third party insurer if power is not produced or
not produced in sufficient amounts, we view such obligations as
constituting a residual guarantee. Accordingly, pursuant to
paragraph 5j above, minimum lease payments would include not
only the rents to be paid during the Lease term, but also the
fixed obligations payable by the Service Recipient or third-
party insurer as a result of electing the Service Contract
option.
Such amounts must be discounted at the interest rate implicit in
the Lease in order to determine whether the present value of
such amounts equals or exceeds 90% of the fair value of the
Exchange Property at the inception of the Lease. The present
value, using the implicit interest rate of the Lease, of (i) the
rental payments during the initial 31.75-year lease term and
(ii) the fixed component of the Service Contract fees will be
more than 90% of the fair market value of the Exchange Property
at the inception of the Lease, thus criterion 7d will be met.
The Lessee will fund its financial responsibilities under the
Lease by making a deposit of a sum, the future value of which
will satisfy the Lessee's financial responsibilities with
respect to the minimum rental payments under the Lease. In
addition, election of the Service Contract option is conditional
upon the Lessee's producing a creditworthy Service Recipient and
payment by the Service Recipient is guaranteed by an acceptable
insurer, the insurer agreeing to cause the Lessor to be paid
even in the event that (insufficient power or) no power is
produced by the Exchange Property during the Service Contract
period. Accordingly the collectibility of the minimum lease
rents is reasonably predictable. Furthermore, you have asked us
to assume that there are no important uncertainties about the
amount of unreimbursable costs yet to be incurred by the Lessor.
Therefore, the Lease should be classified as a direct financing
lease.
The Cancellation Option and the Service Contract Option
The FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and for Hedging
Activities" (SFAS 133), in June 1998. The statement is
effective for all fiscal years beginning after June 15, 2000 as
deferred by Statement of Financial Accounting Standards No. 137
"Accounting for Derivative Instruments and Hedging Activities -
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Deferral of the Effective Date of FASB Statement No. 133".
SFAS 133 applies to all entities and to all instruments that it
defines as derivatives. Certain financial instruments and other
types of contracts (i.e., certain hybrid instruments) that do
not, in their entirety, meet the definition of a derivative
instrument, including leases, may contain "embedded" derivative
instruments that contain implicit or explicit contract terms
that affect some or all of the cash flows or the value of other
exchanges required by the contract in a manner similar to that
of a derivative instrument.
We believe that the CO contained in the Lease is not a
derivative instrument within the understanding of that term in
SFAS 133 because the CO has no net cash settlement provisions,
either explicitly or implicitly (paragraphs 9(a) and 9(b) of
SFAS 133). Further, the property underlying the CO is a non-
financial asset that through the surrender of the lessee's
rights under the Head Lease, including the automatic transfer of
title at the end of the Head Lease, results in the asset being
effectively physically delivered. That asset is not "readily
convertible to cash" (as defined in SFAS 133 paragraph 9(c)).
Therefore, the Lease would be excluded from the scope SFAS 133.
Similarly, the Service Contract option is not a derivative
instrument because paragraph 10(e)(3) of SFAS 133 excludes
contracts that are not exchange-traded for which settlement is
based on specific volumes of sales or service revenues of one of
the parties to the contract. The Service Contract option is
based on, among other items, the cost to operate the Exchange
Property.
Deferred Tax Accounting
Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes" (SFAS 109), mandates an asset and liability
method for computing deferred income taxes. The focus is on
measuring the balance sheet accounts. Deferred income tax is a
calculable liability or asset representing the future tax
consequences of events that have been recognized in an
enterprise's financial statements or tax returns. Under SFAS
109, temporary differences are segregated into two primary
categories: those for which the reversals will generate future
taxable income and those that will generate future tax
deductions.
SFAS 109 also sets forth the requirements for allocating current
and deferred taxes among members of a controlled group. This
statement does not require a single allocation method.
Accordingly, this letter deals with the deferred tax effects of
this transaction on the consolidated financial statements of
Unicom (referred to as the Consolidated Group).
You have asked us to assume that the regulator will capture any
gain resulting from the sale of the generating assets to offset
Regulatory Assets created by the deregulation legislation and
that the gain will be credited to the regulatory assets related
to such Regulatory Assets. You have also asked us to assume
that a deferred tax liability has been recorded related to the
Facility representing the difference between the remaining tax
basis and the book basis of the Facility. Thus, the treatment
of the gain as a reduction of the Regulatory Assets will result
in a reduction in the previously established deferred tax
liability.
From a tax perspective, the transaction is designed to qualify
as a "like-kind" exchange pursuant to section 1031 of the
Internal Revenue Code on which no gain or loss is recognized for
tax purposes at the asset transfer date. The Head Lease is a
capital lease for financial accounting purposes as explained
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above. The Head Lease will be treated as a finance lease for
tax purposes. As a result of the sale of the Facility and the
recording of the capital Head Lease, a deferred tax liability
will be recorded in the consolidated financial statements at the
time of the transaction equal to the difference between the
adjusted tax basis of the Exchange
Property and the amount recorded for the asset under the capital
Head Lease (the "tax-deferred gain"), multiplied by the enacted
tax rate expected to be in effect when the book/tax differences
reverse.
By entering into the direct financing Lease, the capital Head
Lease is recharacterized for financial accounting purposes from
a nonmonetary asset to an asset which is primarily a receivable.
However, because the Lease will be a "true lease" for tax
purposes, the asset recorded on the tax balance sheet will be a
leasehold depreciable property.
We believe that it is acceptable under SFAS 109 to consider
either one temporary difference or two temporary differences to
exist in such a situation. The main distinction between the two
different approaches would be in the disclosures that would need
to be provided in the consolidated financial statements. Since
gross deferred tax assets and liabilities must be disclosed, the
two-difference approach would lead to the recognition of
deferred tax assets related to the tax basis of the depreciable
property and the recognition of deferred tax liabilities related
to the investment in the direct financing lease.
If, on the other hand, the Lease is considered to generate a
single temporary difference, a single net deferred tax asset or
liability would be included in the disclosure and in the
financial statements.
In any event, if the Consolidated Group has used one or the
other method in reporting previous transactions, the method used
previously must be used for this transaction since previous use
constitutes adoption of an accounting policy.
Regardless of whether the one-difference or the two-difference
approach is elected, deferred tax effects will be recognized in
the consolidated financial statements as each of the two
elements change in the future, i.e. as the rent is collected
reducing the investment in the direct financing Lease and
depreciation is deducted reducing the tax basis of the Exchange
Property. At each period-end, the remaining temporary
differences multiplied by the enacted tax rate expected to be in
effect at the time of each reversal will constitute the deferred
tax asset or liability (or net deferred tax) balance related to
the Head Lease and the Lease.
Similarly, the amortization into taxable income of the tax-
deferred gain will change the related deferred tax liability for
that temporary difference.
The prepayment by the Lessee of the Prepayment Portion of rent
at the end of Month 6 will not result in recognition of income
in the consolidated financial statements (recovery of
principal). Under Section 467 of the Internal Revenue Code
such a prepayment of rents will be treated as a loan to the
Trust which will not result in recognition of taxable income. As
indicated above, taxable income or loss will be recognized at
the time rent is accrued by the Lessor under the terms of the
Lease. If the one temporary difference approach is used, this
transaction will result in the creation of a new second
temporary difference for the tax financing (which will result in
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a deferred tax liability) and a change in the amount of the
temporary difference related to the Head Lease/ Lease for the
decline in the book basis (which will result in a deferred tax
asset.) If the two temporary difference approach is used, this
transaction will result in a portion of the deferred tax
liability related to the investment in the direct financing
lease being recharacterized as a deferred tax liability related
to the tax financing.
Concluding Comments
The ultimate responsibility for the decision on the appropriate
application of generally accepted accounting principles for an
actual transaction rests with the preparers of financial
statements, who should consult with their continuing
accountants. Our judgment on the appropriate application of
generally accepted accounting principles for the described
proposed transaction is based solely on the facts provided to us
as described above; should these facts and circumstances differ,
our conclusions may change.
Pricewaterhouse Coopers LLP
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