Exhibit Q-2
LEBOEUF, LAMB, XXXXXX & XXXXXX
L.L.P.
A LIMITED LIABILITY PARTNERSHIP INCLUDING PROFESSIONAL CORPORATIONS
0000 XXXXXXXXXXX XXXXXX, X.X.
XXXXX 0000
XXXXXXXXXX, XX 00000-0000
January 4, 2002
TO: File 70-9849
FROM: XxXxxxx, Lamb Xxxxxx & XxxXxx, L.L.P.
RE: Memorandum in Support of Proposed Tax Allocation Agreement
Introduction
National Grid Group plc ("National Grid") proposes to revise the tax
allocation agreement for the companies in its U.S. tax paying group to include
Niagara Mohawk Holdings, Inc. ("NiMo") and its subsidiaries. The proposed tax
allocation agreement is substantially similar to the tax allocation agreement
authorized by the Commission in its order authorizing National Grid's
acquisition of New England Electric System ("XXXX")./1 National Grid requests
that the Commission authorize the new tax allocation agreement under Sections
12(b) and 12(f) of the Public Utility Holding Company Act of 1935 (the "Act")./2
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1 Order Authorizing Acquisition of Registered Holding Company by Foreign
Holding Company and Related Financings; Approving Other Related Requests;
Discussing Individual Comments on the Acquisition; and Approving Service
Transactions, Release No. 35-27154, 200 SEC LEXIS 474 (March 15, 2000) ("the
XXXX Acquisition Order").
2 National Grid's proposed tax allocation agreement is included as Exhibit Q-1
to its Application in SEC File No. 70-9849.
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Statutory Basis for the Regulation of Tax Allocation Agreements
Section 12(b) of the Act prohibits a "registered holding company or
subsidiary company thereof . . . to lend or in any manner extend its credit to
or indemnify any company in the same holding company system in contravention of
such rules and regulations or orders as the Commission deems necessary or
appropriate in the public interest or for the protection of investors or
consumers or to prevent the circumvention of the provisions of this title or the
rules, regulations, or orders thereunder."
Section 12(f) of the Act prohibits a "registered holding company or
subsidiary company thereof . . . to negotiate, enter into or take any step in
the performance of any transaction not otherwise unlawful under this title, with
any company in the same holding company system or with any affiliate of a
company in such holding company system in contravention of such rules,
regulations or orders regarding reports, accounts, costs, maintenance of
competitive conditions, disclosure of interest, duration of contracts, and
similar matters as the Commission deems necessary or appropriate in the public
interest or for the protection of investors or consumers or to prevent the
circumvention of the provisions of this title or the rules and regulations
thereunder."
Rule 45(c) under the Act was adopted under Section 12 to regulate tax
allocation agreements because they could involve implicit loans, extensions of
credit or indemnities/3 and because they had been used by holding companies to
exploit utility companies through the misallocation of consolidated tax return
benefits./4 Rule 45(c) prescribes a method of allocating tax liability and
sharing consolidated tax return savings that is designed to prevent
misallocations that would be detrimental to utility subsidiaries and consumers.
As a safe harbor rule, Rule 45(c) does not address all possible situations or
allocation methods. It merely provides an accepted method that the Commission
has found to be consistent with the Act.
National Grid's proposed tax allocation agreement complies with Rule 45(c)
in all respects except that it provides that some of the tax benefits generated
by the holding companies in the tax filing group may be retained by the holding
companies. In particular, the agreement provides that the registered holding
company parents in the U.S. Group (i.e., National Grid General Partnership
("NGGP"), its direct subsidiary National Grid Holdings Inc. ("XXXX") and NHGI's
direct subsidiary National Grid USA) may retain the tax benefit associated with
(a) interest expenses on debt incurred by NGGP to finance the XXXX and Eastern
Utilities Associates ("EUA") mergers, (b) tax deductions accrued by XXXX arising
in connection with the financing of the NiMo merger,/5 as well as (c) other
merger and acquisition expenses that are not borne by other associate companies
in the U.S. Group (collectively, "Acquisition Debt"). For this reason, National
Grid seeks an order of the Commission authorizing the agreement.
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3 Adoption of Amendment to Rule Governing Allocation of Consolidated Income
Taxes Among Member Companies of Registered Holding Company Systems, Rule
U-45(b)(6), Holding Co. Act Release No. 12776 (January 12, 1955).
4 Allocation of Consolidated Federal Income Tax Liability By Registered Holding
Companies and their Subsidiaries, Holding Co. Act Release No. 21767 (October 29,
1980) ("Rule 45(c) Proposing Release").
5 Under the subscription agreement XXXX enters into an obligation to pay up
calls on share capital of its special purpose subsidiary, NG11. The obligation
to pay up the calls survives the sale of NG11 to National Grid (US) Investments
4. Under U.S. tax rules, the receipt of the funds by XXXX and the obligation to
pay up the calls is treated as a loan from National Grid (US) Investments 4 to
XXXX. The debt has original issue discount ("OID") equal to the excess of the
sum of the calls over the proceeds of the sale. The OID on a debt is generally
deducted for tax purposes over the life of the debt and generally the amount of
OID attributable to any tax year is determined under the "constant yield method"
as provided in Treasury Reg. Section 1.1272-1(b)(1). Consequently, XXXX is
treated as having debt for U.S. tax purposes.
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The Allocation Methodology of National Grid's Proposed Tax Allocation Agreement
The proposed tax allocation agreement specifies the methodology to be
followed in allocating tax liability payments and payments for the use of tax
benefits among the National Grid Group companies that participate in
consolidated U.S. federal income tax filings and select state income tax
filings. Under the agreement, each company signatory to the agreement is
referred to as a "Member" and the collection of members is referred to as the
"Group." For purposes of simplicity, the registered holding companies in the
Group are referred to collectively as the "Parent."
The agreement first apportions the federal consolidated tax liability of
the Group among the Members in accordance with the ratio that each Member's
separate taxable income bears to the sum of the separate taxable incomes of all
Members having taxable income. Each Member having taxable income is then
allocated an additional liability amount (the "Excess Separate Tax") equal to
the amount that the Member's separate return tax exceeded the portion of the
consolidated Group tax liability allocated to the Member under the first step.
The amount allocated to the Members under the first step funds the Group's
payment to the Internal Revenue Service (or state tax collector, as applicable).
The amount of Excess Separate Tax collected from the Members having taxable
income funds payments to Members that had no separate taxable incomes, but
instead contributed net operating losses, tax credits or other tax benefits
(collectively, "Tax Benefits") that reduced the overall consolidated tax
liability of the Group.
The amount of Excess Separate Tax allocated to a Member other than the
Parent is reduced by the Member's proportional share of the Tax Benefits of the
Parent, other than Tax Benefits related to Acquisition Debt. Costs incurred by
the Parent for merger and acquisition expenses that are not charged to or
otherwise passed on to Parent's direct or indirect subsidiaries are also
included in the term Acquisition Debt./6 A registered holding company will
generally have significant expenses from managing the businesses that it holds
(even disregarding acquisition debt interest expenses) and little offsetting
income since it is not directly engaged in businesses./7 Certain subsidiaries in
the Group may also have Tax Benefits, for example, in the start-up phase of
business when expenses typically exceed revenues, resulting in a net loss. These
expenses create Tax Benefits that reduce the Excess Separate Tax paid by the
Members. For this reason, for all Members with separate taxable incomes the
Excess Separate Tax plus the Member's portion of the consolidated Group tax
liability will generally be less than the Member's separate tax liability. To
make sure that a Member never pays more than its separate tax liability as a
result of participating in the filing of a consolidated tax return, the
agreement explicitly provides that "Under no circumstances shall the amount of
tax or other liability allocated to a Group Member under this Article 1 exceed
such Group Member's separate tax liability." Appendix A to this memorandum
illustrates the application of the methodology described above to a hypothetical
consolidated group.
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6 The XXXX Acquisition Order provides that "charges associated with future
mergers and acquisitions may be allocated to XXXX [now, National Grid USA]
and/or to other National Grid Group companies, but not to the XXXX
Subsidiaries." XXXX Acquisition Order Appendix C at C-2. Because these charges
are borne by Parent and not the subsidiaries they are in all relevant respects
equivalent to the acquisition-related debt interest expense.
7 In the event that Parent had net taxable income rather than the typical case
where it would be expected to have a net loss, Parent would also pay Excess
Separate Tax in the manner computed for all other Members.
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The total of the Excess Separate Tax payments of the Members are credited
to the Members of the Group that had Tax Benefits. Parent, however, is not
entitled under the agreement to receive payment for its Tax Benefits that relate
to items other than Acquisition Debt. It is here that National Grid's current
and proposed tax allocation agreement differs from the Tax Benefit allocation
method under Rule 45(c). Under Rule 45(c)(5), all associate companies with
taxable income, and hence a positive allocation of tax liability, are required
to pay the amount allocated, but only the subsidiary companies with Tax
Benefits, and hence a negative allocation, are entitled to receive current
payment for their Tax Benefits. The term "associate company" includes a holding
company and all of its subsidiaries, whereas the term "subsidiary company" is
generally understood to exclude holding companies. Because the agreement
proposes that Parent would receive payment for the Tax Benefits associated with
Acquisition Debt, it does not comply with Rule 45(c).
National Grid USA Service Company, Inc. will administer the preparation of
consolidated tax returns and manage the payments made under the agreement.
Excess Separate Tax payments made to Members contributing Tax Benefits to the
consolidated return will be made at approximately the same time the related
payments of consolidated group tax are made to the appropriate tax authorities.
The Commission Should Authorize the Proposed Agreement Under Section 12 of the
Act
The Commission may authorize a tax allocation agreement by order under
Section 12 of the Act if it finds that the agreement is necessary or appropriate
in the public interest or for the protection of investors or consumers and does
not circumvent the provisions of the Act and the rules thereunder. The proposed
agreement complies with the fundamental principal followed by the Commission in
the regulation of such agreements. In particular, the agreement satisfies the
separate return limitation; that no Member pay more under the agreement than
such Member's separate tax liability.
The separate return limitation has been the bedrock of the Commission's
policy in this area for 60 years. In 1941, the Commission adopted an amendment
to Rule U-45 to exempt a loan, extension of credit or an agreement of indemnity
arising out of a joint tax return filed by a holding company and its
subsidiaries./8 Rule U-45(b)(6) conditioned the exemption upon the assumption by
the top company in the group of the primary responsibility for the payment of
any tax liability involved, subject to the right to contribution of the several
members of the group in an amount not exceeding as to any company that
percentage of the total tax which the individual tax of such company (if paid
under a separate return) would bear to the total amount of individual taxes for
all members of the group, for the particular tax period. At its inception
therefore, Rule U-45(b)(6) established the fundamental principle of the separate
return limitation and did not restrict holding companies from retaining the
benefit of any tax losses that they may have generated.
In 1955, in response to the Commission's directive to make further study of
the subject of tax allocation, the SEC staff proposed, and the Commission
adopted, further amendments to Rule 45(b)(6)./9 The amendments required a tax
agreement to allocate the consolidated tax liability by either of two methods
prescribed in the Internal Revenue Code. One method allocated the consolidated
tax based on the proportion of taxable income attributable to each member and
the other method allocated the consolidated tax based on the proportion of each
member's separate return tax to the aggregate separate return tax of all the
group members. The amendment also reaffirmed the principle that the allocations
could not violate the separate return limit and, if excess tax would have been
allocated to a subsidiary company but for the separate return limit, that the
excess liability would be allocated among the other members of the group,
including the holding company, in direct proportion to the tax savings of each
member.
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8 Holding Company Act Release No. 2902 (July 23, 1941).
9 Holding Company Act Release No. 12776 (Jan. 12, 1955).
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In 1981, Rule 45(b)(6) was revised for the last time and redesignated Rule
45(c)./10 This revision was meant to eliminate the numerous declarations and
Commission orders which had been necessary because Rule 45(b)(6) did not
adequately address the case in which one or more operating companies in the
system suffers a loss. The allocation methods in Rule 45(b)(6) had been
interpreted to require sharing of tax liabilities and savings exclusively among
group companies with actual separate return tax liabilities or positive income.
Consequently, loss companies had been excluded from receiving the benefit of
their losses.
The Rule 45(c) Proposing Release observed that oil and gas exploration
subsidiaries often produced substantial losses, especially in the early years of
operation, because large up-front development expenses were immediately
deductible, while the income producing oil and gas production occurs
significantly later. The Commission considered it unfair to give the benefit of
losses generated by one company to another company in the group without payment.
The Commission declined to extend this logic to losses generated by holding
companies because it considered a reimbursement of holding company expenses by a
subsidiary to be inconsistent with Section 13(a) of the Act.
The corporate relationships required by the Act assure that the deductible
corporate expenses of the holding company itself will always create a
consolidated tax saving, since Section 13(a) of the Act precludes such
expenses being passed on to the subsidiaries, through service charge or
contract, so as to transform them into corporate deductions of the
subsidiaries. In light of the legislative history referred to, an expense
reimbursement of the holding company, in the guise of a tax allocation,
would seem inconsistent with Section 13(a). The exclusion in our earlier
rule of the holding company from sharing in consolidated return savings was
intentional and will continue. These considerations do not apply to other
companies in the group that incur losses./11
The Commission's statement that Section 13(a) prohibits the recovery of all
holding company expenses from subsidiaries in the context of a tax allocation is
overbroad because it is clear that with regard to intrasystem loans it is
appropriate for a holding company to recover financing expenses incurred
consistent with Sections 6, 7, 9, 10 and 12 of the Act from subsidiaries./12
These divergent positions can be reconciled by understanding the "matching"
principle of Rule 45(c).
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10 Holding Company Act Release No. 21968 (Mar. 18, 1981) ("Rule 45(c) Adopting
Release").
11 Rule 45(c) Proposing Release at 6.
12 Section 13 is concerned with fairness of allocation in charges for goods and
service contracts and the economical and efficient performance of such
contracts. Section 13 does not address financing transactions among companies in
a registered holding company system. Sections 6, 7, 9, 10 and 12 of the Act
cover intrasystem financing transactions and provide standards to assure that
such transactions are entered into on terms that are consistent with the public
interest and the interest of investors and consumers. Those provisions of the
Act do not prevent a holding company from charging reasonable and fair interest
on a loan to a subsidiary in connection with financing the subsidiary's
business.
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In addition to the separate return limitation, Rule 45(c) also embodies a
"matching" principle. "The rule specifies the amount to be allocated, that is,
the difference between the consolidated return and separate return results, and
establishes the principle of allocating to the individual members of the group
the material effects of any particular features of the tax law applicable to
them."/13 The example given above involving the oil exploration subsidiary that
does not benefit from its production expenses illustrates the unfairness that
results from violating the matching principle.
The matching principle is particularly important when utility subsidiaries
are involved. The Act "deals principally with utility companies, whose rates are
separately regulated under procedures which assign material weight to taxes as
part of the cost of service. Uncompensated use of tax benefits intended for one
utility company, to reduce the costs of another utility company, permanently
assigns those benefits to an entirely different group of consumers, based solely
on the fortuity of the common ownership of the utility companies and the
relative timing of their respective periods of prosperity or distress."/14
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13 Rule 45(c) Adopting Release at 2-3.
14 Rule 45(c) Proposing Release at 10.
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To illustrate, if a utility subsidiary earns investment tax credits from
building a plant, its tax liability should reflect the benefit of the credits
and its rates should also reflect the tax savings from the credits. Similarly,
if the holding company incurs legal expenses from a corporate reorganization
that may not properly be passed through to the subsidiary companies, the holding
company should retain the tax benefit produced by the expenses. The Rule 45(c)
Proposing Release observed: "The investment tax credit, an important addition to
the tax law subsequent to the adoption of [Rule 45(b)(6)], is similar in
significant respects to the tax loss. It is clearly identifiable to a particular
member of the group, its incidence has no necessary relationship to current
income, and its use in the consolidated return precludes a carryover by the
company entitled to it." When a holding company Tax Benefit can be identified as
clearly generated by or belonging to the holding company, it too should be
permitted to be retained by the holding company.
The Acquisition Debt that generated the Tax Benefits that Parent seeks to
receive payment for under the agreement is "clearly identifiable to" the Parent.
The Acquisition Debt is clearly an obligation of Parent. It is not backed by the
credit of the other Members. National Grid USA and its subsidiaries have not
pledged their assets as collateral to secure the Acquisition Debt, they have not
guaranteed it and they are not obligated to pay interest or principal payments
to service the Acquisition Debt./15 The Acquisition Debt was not on-loaned to
National Grid USA or its subsidiaries to fund operating or capital expenses. It
was simply used to acquire the equity securities of XXXX and EUA (and NiMo if
the pending acquisition is authorized). The interest expense incurred by Parent
continues to accrue whether or not it has net income or a net loss. Lastly, if
net operating losses incurred by Parent as a result of the Acquisition Debt are
used in the consolidated return, Parent would be precluded from carrying over
the loss to future periods.
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15 Similarly, National Grid USA's subsidiaries are prohibited under the XXXX
Acquisition Order from bearing the burden of merger and acquisition-related
expenses. See note 6, supra.
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This view of the Acquisition Debt is consistent with the position taken by
the Commission's accounting staff under Staff Accounting Bulletin 54, Question
3. In that bulletin, the staff was asked how to present subsidiary B's financial
statements where holding company A had borrowed funds to acquire substantially
all of subsidiary B's common stock. Subsidiary B had subsequently filed a
registration statement to issue equity or debt and the question presented was
whether subsidiary B's new basis ("push down") financial statements should
include holding company A's debt related to its purchase of subsidiary B. The
staff responded:
The staff believes that Company A's debt, related interest expense,
and allocable debt issue costs should be reflected in Company B's
financial statements included in the public offering (or an initial
registration under the Exchange Act) if: (1) Company B is to assume
the debt of Company A, either presently or in a planned transaction in
the future; (2) the proceeds of a debt or equity offering of Company B
will be used to retire all or part of Company A's debt; or (3) Company
B guarantees or pledges its assets as collateral for Company A's debt.
Other relationships may exist between Company A and Company B, such as
the pledge of Company B's stock as collateral for Company A's debt.
While in this latter situation, it may be clear that Company B's cash
flows will service all or part of Company A's debt, the staff does not
insist that the debt be reflected in Company B's financial statements
providing that there is full and prominent disclosure of the
relationship between Companies A and B and the actual or potential
cash flow commitment. . . .
Under these standards, the Acquisition Debt is clearly an obligation of
Parent and not an obligation of the other Members. Consequently, the Tax Benefit
related thereto should be permitted to be retained by Parent. In the XXXX
Acquisition Order the Commission reached the same conclusion. "In addition,
because the XXXX Group has no obligation with respect to the Merger-Related Debt
and the debt does not affect the XXXX Group's financial position or credit, it
is not inappropriate to exclude these companies from the benefits of the tax
consequences arising out of the debt. Accordingly, we approve the use of the Tax
Allocation Agreement."/16
UK law also has traditionally applied a general matching principle in its
handling of tax matters. Each company is taxed as a separate entity. If a UK
company ("the surrendering company") incurs a loss it may "surrender" that loss
to another UK company in the same group which has profits (the "claimant
company"), thereby reducing the taxable profits and hence tax liability of the
claimant company. This is known as "group relief" and is available where the
companies are at least 75% owned by a common UK parent company.
A claimant company may pay the surrendering company for the losses
surrendered and such payments are ignored for UK tax purposes (i.e., they are
neither tax deductible nor taxable), provided that the payment does not exceed
the amount of the loss./17 In many cases payment for losses must be made by a
claimant company, otherwise the surrender of the losses is unlawful and is void.
This is because the losses are seen as an "asset" of the surrendering company
and in many cases a company cannot dispose of an asset for less than its value.
This principle can apply, for purposes of creditor protection, even within a
group of wholly owned companies. Furthermore, the surrender of losses without
payment could, in certain circumstances, amount to unlawful "financial
assistance" for the acquisition of a company's shares; a criminal offense.
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16 XXXX Acquisition Order at 71.
17 UK Income and Corporation Taxes Xxx 0000, section 402(6).
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For these reasons, National Grid has a group policy requiring payments by
group companies whose tax liability is reduced due to transfers of tax losses
from other group companies. National Grid's intention is that such policy be
applied to all companies within the group, including US companies.
Conclusion
National Grid's proposed tax allocation agreement is substantially the same
in all material respects as the tax allocation agreement authorized by the
Commission in the XXXX Acquisition Order. It is consistent with Rule 45(c),
except to the limited extent that it allows Parent to retain the Tax Benefit
associated with the Acquisition Debt. The proposed agreement is also consistent
with Section 12 of the Act and the general investor, consumer and public
interest standards of the Act. The Commission may authorize the proposed
agreement based upon the sound policy and equitable arguments evident in the
Commission's statements in its Rule 45(c) Proposing and Adopting Releases and
restated in this memorandum. Furthermore, the proposed agreement is sufficiently
similar to and consistent with prior decisions and the Commission's policies
under the Act that it may be authorized by delegated authority. The proposed
agreement presents no novel issues under the Act.
For all these reasons, the Commission should authorize National Grid's
proposed tax allocation agreement.
