This post was originally published on Forbes March 30th, 2015
Remember Three Mile Island? That was a really long time ago. In 1979 the movie China Syndrome, starring Jane Fonda and Michael Douglas playing a television reporter and cameraman who secretly film an accident at a nuclear power plant, was released
Twelve days later there was a partial meltdown of a Pennsylvania nuclear reactor called TMI-2 (TMI, of course stands for Three Mile Island). According to Wikipeida, the partial meltdown was the worst accident in US commercial nuclear power history.
TMI-2? That would imply that there was at least one other TMI and there was. TMI-1 was off-line for refueling at the time of the TMI-2 accident and there was sentiment that is should stay that way permanently. Nonetheless, it began operating again in 1985. TMI-1 is owned by AmerGen Energy Company LLC, which is now a wholly owned indirect subsidiary of Exelon through Exelon Generaton LLC (Generation). AmerGen acquired TMI-1 along with the Clinton Power Station in Illinois and the Oyster Creek Nuclear Generating Station in New Jersey in 1999 and 2000, prior to Exelon’s acquisition of AmerGen.
AmerGen was hoping to get some dynamite tax benefits from acquiring the three plants, but its tax advisers told the company the benefits were probably not available. In a private letter ruling the IRS indicated the same thing going so far as to indicate that the acquisition of the three plants might actually be a taxable event to AmerGen. Nonetheless, AmerGen persisted in the hope that the benefits might be available. The ultimate parent company, Exelon, in its last 10-K indicated the following:
Due to the possibility of final resolution through an appellate decision, Generation continues to believe that it is reasonably possible that the $661 million of total unrecognized tax benefits will significantly decrease in the next twelve months.
In other words, there are $661 million in potential tax benefits that have not been recognized in the company’s after tax earnings, but they were still hoping.
The heart of this case illustrates the difference between financial accounting and tax accounting when it comes to the principle of conservatism. In financial accounting expenses and liabilities are bad things since they mean lower earnings or net worth. In tax accounting expenses and liabilities are good things, since they mean deductible expenses either immediately or in the form of depreciation and amortization deductions.
The thing about nuclear power plants is that one of the biggest expenses is what needs to be done when the plants are retired – decommissioning.
For financial accounting purposes i.e. GAAP (Generally Accepted Accounting Principles) those costs should be spread over the revenue generating life of the plant. And that is, in fact, how it is done. Of course it is rather complicated to come up with a reasonable number. Here is the discussion of the issue in the Exelon 10-K.
Generation has a legal obligation to decommission its nuclear power plants following the expiration of their operating licenses. To estimate its decommissioning obligation related to its nuclear generating stations for financial accounting and reporting purposes, Generation uses a probability-weighted, discounted cash flow model which, on a unit-by-unit basis, considers multiple outcome scenarios that include significant estimates and assumptions, and are based on decommissioning cost studies, cost escalation rates, probabilistic cash flow models and discount rates.
On its balance sheet Generation has a liability of over $7 billion for asset retirement obligations and a $1 billion “spent nuclear fuel obligation”.
Tax rules are different. Generally you cannot book an expense prior to “economic performance” and, of course, economic performance on the decommissioning is something that is far down the road.
The Internal Revenue Code actually gives special recognition to the back-end costs involved in the decommissioning of nuclear power plants. A utility company can deduct amounts,determined with IRS approval, that it pays to a nuclear decommissioning fund (NDF) and the earnings of the fund are taxed at 20%. Also a net operating loss generated by actual payment of decommissioning costs can be carried back to the year that the plant was placed in service. So if you happen to own a nuclear power plant, you best hang onto those old tax returns – just saying.
To further complicate matters regulators might require the company to put aside even more money for decommissioning than the IRS allows as a deduction. The IRS treats those non qualified trust funds as “grantor trusts”, which means restrictions are ignored for tax purposes regardless of how legally binding they might be.
As it happens Generation has over $10.5 billion in decommissioning trust funds on its balance sheet. I didn’t find a breakdown between qualified and non-qualified funds.
The Controversy
AmerGen paid $93 million for the three power plants it acquired around the turn of the millennium. Along with the power plants it received trust funds – $393 million in qualified funds and $581 million in non-qualified funds. AmerGen also wanted to book, for tax purposes, $2.19 billion in decommissioning liabilities. Now when you buy a going business, which is what these power plants are, there are rules about how you allocate the consideration you paid. The consideration is applied to different classes of assets in sequential order. Class V is where the assets that get depreciation deductions are and class VI is where assets amortizable under Code Section 197 are. I’m thinking the permits and the like would be Class VI. The mutant cockroaches would be Class III if they are being sold to mad scientists on a regular basis.
Now the $393 million qualified fund kind of just slides over, because it is not really on your tax balance sheet. Different story for the $581 million in non-qualified funds. The trust is a grantor trust ignored for income tax purposes, making assets in the trust Class I and Class II assets – cash and actively traded personal property. So that would leave AmerGen with over $1.7 billion to spread over the good stuff that could be producing deductions, if it were allowed the treatment it wanted.
In the IRS view, though, since there was no economic performance on the decommissioning in the relevant period so that $2.19 billion does not add to basis. AmerGen actually ends up with a gain on the purchase to the extent that cash assets in the non-qualified fund exceed $93 million and it has no basis in any of the rest of the stuff.
That is also the way the Federal Circuit saw it.
Here, AmerGen might not fully satisfy its nuclear decommissioning liabilities until 2106. The actual decommissioning process can take sixty years to complete after the plants cease operations, with costs incurred along that time frame. The interpretation of § 461(h) that AmerGen urges would create disparate treatment of taxpayers facing the same nuclear decommissioning liabilities. Thus, there is no support for a conclusion that the economic performance rule applies only to taxpayers who build and retain plants, but not to those who buy and sell plants. ….
AmerGen was advised before it purchased the plants that it could not accelerate the future decommissioning liabilities. It requested the sellers of the plants to increase the amount of their decommissioning funds before transferring both qualified and nonqualified decommissioning funds to AmerGen. After the purchase, AmerGen did not contribute additional money of its own to those funds, but instead sought to include the estimated decommissioning costs in the basis of its acquired assets in order to make depreciation and amortization deductions.
We therefore agree with the Claims Court and conclude that § 461(h) is applicable in determining when and whether an accrual method taxpayer, such as AmerGen, incurs nuclear decommissioning liabilities for purposes of calculating the basis of acquired nuclear power plants and associated assets. AmerGen’s future decommissioning liabilities must be deemed incurred under § 461(h) before they are includable in the basis of the purchased assets.
Does Anybody Read The Notes To The Financial Statements?
The financial accounting for income taxes is one of the most arcane areas of Generally Accepted Accounting Principles. In your larger firms it is the only area where the tax geeks are interacting with the GAAP geeks. In my declining days at a not quite Big 4 firm they moved a young kid into the geriatric wing of the office who spent a lot of his time working on tax provisions. I rarely understood what he was talking about when I overheard him. I’ve since studied the topic a bit more because the great state of Florida requires its CPAs to have half their CPE hours in audit and accounting.
A lot of time, talent and money goes into computing those provisions and drafting the required disclosures. Exelon is audited by PWC. Heck they count the votes for the Academy Awards and do Mitt Romney’s return, so they must be good. It seems that people who analyze securities don’t pay any attention to that stuff. According to its 10-K, Exelon could have picked up $661 million if it won the case, which is over 2% of its market capitalization. In the week that the decision came, Exelon’s stock price went up and I can’t find any mention of the case in news about the stock. It seems like it should have a least created a little bit of a ripple.
I noticed a similar thing earlier this year with a Tax Court decision concerning Moneygram.
How Can I Buy A Nuclear Power Plant?
I found it interesting that AmerGen when it spent its $93 million got essentially a bag of money nearly ten times as large along with the nuclear power plants. There is that nasty decommissioning exposure, but that’s in the far, far future. My inner villain sees opportunity here, but I suspect that the regulators are all over it and there is not that much you can really get away with. On the other hand I used to believe that stock analysts actually read the notes to the financial statements and I’m beginning to wonder about that.
