No Nukes! - Using Tax-Advantaged Investments to Enhance Investment Returns in Nuclear Decommissioning Trusts

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  1. Overview

This executive summary is intended to outline the use of private placement insurance contracts as a funding vehicle for nuclear decommissioning trusts (NDT). As of the end of  28 investor-owned and 28 public owned utilities operated 104 nuclear facilities in the United States. As of this date, NDTs held $41 billion. This amount does not include nuclear facilities in the final stages of decommissioning. New NDT contributions were $445 million in 2009.

Due to large scale industry consolidation of utilities operating nuclear facilities, many of these merged operations are unregulated facilities that have a need to fund non-qualifying or tax-favored trusts.

This article focuses on the use of private placement life and annuity products in funding the decommissioning costs of utility companies that operate nuclear facilities and the mandated contributions to trusts to provide for the decommissioning of these nuclear facilities. The use of private placement insurance contracts will provide an enhanced after-tax return for nuclear decommissioning trusts.

The tax advantage of PPLI coupled with the ability to use investment asset classes such as hedge funds will allow nuclear decommissioning trust to enjoy enhanced after-tax returns with less volatility that the Market itself. This improvement in the after-tax rate of return within NDTS will reduce the amount of future contributions and diminish the need to recover costs from consumers.   The approximate cost for this structure is 125-150 basis points per annum. This cost is a small percentage of the tax cost on investment income in qualifying and non-qualifying trusts.

  1. Summary of Nuclear Decommissioning Trusts 
  1. What is a Nuclear Decommissioning Trust (“NDT”)?

Since 1990 the Nuclear Regulatory Commission (NRC) has required all nuclear power plant owners to submit a financial assurance plan that sets money aside in order to finance the considerable costs of decommissioning – or cleaning up – nuclear power plant sites after the reactors shut down. In September 1990 the NRC amended its regulations allowing regulated utilities to collect fees from customers to deposit into a trust fund.

  1. Tax Considerations for NDTs

The NDTs of public power utilities are not subject to taxation due to their tax-exempt status while private utilities are subject to taxation.  The Federal tax rules that apply to NDTs of private utility companies are contained in Internal Revenue Code (“IRC”) Sec 468A. These rules became effective in 1984 with amendments in 1993 and 2006. Prior to January 2006, IRC Sec 468A provided that a utility was permitted to make a deductible contribution to a “Qualified fund” or trust that was the lesser of the amount approved by its regulatory commission through a “cost of service” rate set by a state public service commission or the ruling amount approved by the IRS.  The ruling amount was based on a formula that related to the operating license life of the plant, the in-service date of the plant.

NDTs of private utilities are treated as corporations. Qualified trusts have a special federal tax rate of 20 percent as well as taxation at the state level.  Non-Qualified trusts are taxed at the federal corporate level based upon the level of taxable income.  Non-Qualified funds also benefit from the Federal dividends received deduction (“DRD”), which is currently 70%.

The passage of the Energy Policy Act of 2005 modified IRC Sec 468A effective   for   tax   years   beginning   in 2006.   These modifications  eliminated  the  “cost  of  service”  and  “qualifying percentage”  elements  previously  included  in  Section  468A  for  the  purpose  of determining the annual contributions to Qualified NDT funds.

At the end of 2007, the IRS issued regulations relating to deductions for contributions to Qualified funds under IRC Sec 468A. As a result of these regulations, a utility may submit a private letter ruling request to the IRS containing the assumptions utilized in determining the rationale for current and future contributions to the Qualified fund.

These regulations permit a “special transfer” of cash or property (i.e., stocks and bonds) from an existing non-qualified fund to the qualified fund. No gain or loss is recognized on the “special transfer.” ”The amount of the “special transfer” is the “non-qualifying” percentage times the present value of the decommissioning expenditures. The “special transfer” amounts are to be deductible ratably over the remaining “estimated useful life” of the generating facility.

Annual qualified fund contributions (as opposed to “special transfers”) are a deductible expense for corporate tax purposes in the year of the contribution. Contributions made by March 15 of each year may be included as a deductible expense for the prior calendar year. Distributions withdrawn from the qualified fund are treated as income to the corporation.   Nevertheless, the corporation is able to take an offsetting deduction for any related nuclear decommissioning expenditures.

Contributions to non-qualified funds are not deductible at the time of their contributions. The trusts are treated as grantor trusts and therefore any trust income is taxed to the corporation. Trust distributions from the trust spent on decommissioning expense are deductible expense in the year of the expense. Utilities with non-qualified funds have generally sought to expend non-qualified funds first to liquidate in order to take advantage of the deductible.

  1.  Using Tax Advantaged Insurance Contracts to Enhance Investment Returns
  1. Private Placement Life Insurance (PPLI)

PPLI is a group variable universal life insurance policy. The contract is institutionally priced and provides for customized investment options within the contract. The contract insures the lives of employees working for the private utility. The life insurance component is issued on a guaranteed basis without any medical underwriting.  The trustee of the qualifying or non-qualifying funds is the applicant, owner and beneficiary of the policy benefits. The policy assets are held as separate account assets that are segregated from the general account assets of the insurer and not subject to the claims of corporate creditors.

  1. Tax Treatment of PPLI

PPLI receives favorable tax treatment under the Internal Revenue Code. The policy cash value receives tax-deferred treatment on any investment income.  Any income, gains, or losses of the separate account pass through to the policyholder, trustee of the qualified or non-qualified trusts on a tax-free basis. Changes in the value of the separate account assets are treated as an increase or decrease in tax reserves for the insurer.

The trustee is able to take distributions on a tax-free basis from the policy up to the amount of the policy’s basis which is the policy’s cumulative premiums. The trustee is also able to access policy loans on a tax-free basis.

Death benefit payments to the trust are taxed under IRC Sec 101(j). IRC Sec 101(j) applies to policies issued after August 6, 2006. The proceeds of corporate owned life insurance will be tax-free providing the following requirements are met:

  1. Meet the Notice and Consent Requirements
  1. Must be in writing.
  2. Must be in place before the coverage is placed in force.
  3. The Notice requirement must identify – (1) The policyholder that intends to purchase coverage on the employee (2) The maximum amount of coverage on the employee’s life (3) The applicable policyholder will be a beneficiary of any proceeds on the policy.
  1.  Private Placement Variable Single Premium Immediate Annuities

A private placement  variable immediate  annuity (PPVIA) contract issued by a U.S. life insurance company or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer. The PPVIA contract is institutionally priced and transparent allowing for complete customization of the investment to include multiple real estate investments.

The policy may be issued on either a group or individual policy form. The fact of the matter is that very few PPVIAs exist in the marketplace. Variable immediate annuities are not even well known in the retail immediate annuity marketplace.

Unlike a deferred annuity, a PPVIA provides for annuity payments within the first policy year. Annuity payments may be calculated on a fixed basis or a variable basis. The variable basis assumes initial payments based upon annuity mortality factors as well as an assumed interest rate (AIR). If the annuity’s actual investment performance exceeds the AIR, payments increase. The annuity provides for payments based upon a term of years or a life contingency basis.

Under state insurance law, separate account investments are expressly authorized on a non-guaranteed or variable basis. The separate account assets belong to and are titled in the name of the insurance company.

Separate account contract holders have no right to receive in kind distributions, or direct the purchase or sale of separate account assets. Ownership and control of separate account assets legally and contractually rest with the insurer.  PPVIA contracts are taxed as a variable annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72).

(4).Tax Treatment of PPVIAs

IRC Sec 72 governs the taxation of annuities for federal tax purposes. Professionals familiar with annuity taxation assume that annuity contracts owned by a non-natural person such as a corporation do not enjoy the benefit of tax deferral under IRC Sec 72(u)/. This is largely true.

IRC Sec 72(u)(3)(E) and IRC Sec 72(u)(4) provide an exception for immediate annuities. The Code defines an immediate annuity as an annuity that  that provides for its first annuity payment as being no later than one year from the policy issue date. The annuity must provide for an annuity payment that meets the substantially equal periodic payment requirements of IRC Sec 72(t).

IRC Sec 72(t) is the set of tax rules that provide for pension or IRA distributions before age 59 ½. The tax provision provides for a ten percent early withdrawal penalty in addition to regular taxation unless it meets certain exceptions found in IRC Sec 72(t). The applicable exception for our discussion is the exception for substantially equal periodic payments. If a distribution meets the exception requirements, the ten percent penalty does not apply.

The rules for substantially equal periodic payments allow for three different methods of calculation as outlined in Rev. Rul. 2002-62 – the required minimum distribution method, amortization method and annuitization method. The latter two methods use the IRC Sec 7520 rate (currently 1.06 percent) as part of the calculation.

The exclusion ratio for variable annuities determines the amount that may be “excluded” from taxation from each annuity payment. The exclusion ratio for a variable annuity is determined by dividing the expected benefits into the investment in the contract. Payments beyond the annuitant’s actuarial life expectancy are fully taxable to the policyholder.

The substantially equal periodic payment rules specify that the payment may not be changed before the later of five years of payments or the annuitant turning 59 ½,. The rules allow for determination of a payout using the life expectancy of an employee and a designated beneficiary.

Policies must satisfy the federal tax requirements for investment diversification and investor control. The separate account is not treated as a separate entity from the insurance company for tax purposes. Since the assets and liabilities of the separate account belong to the insurance company, any income, gains, or losses of the separate account belong to the insurance company. The insurance company is able to take a reserve deduction for its investment income in the separate account.

IRC Sec. 817(h) imposes investment diversification requirements for variable life insurance and annuity policies. IRC Sec. 817(h) stipulates that a single investment may not exceed more than 55% of the account value, two investments more than 70%, three investments more than 80%, and four investments more than 90%. Therefore, an investment account must hold at least five different investments.

The tax regulations, Reg. 1.817-5 specify that all of the interests in the same real property project represent a single issue for diversification purposes. The regulations allow a five-year initial period for real estate accounts in order to comply with the diversification requirements. The same regulations provide for a two-year plan of liquidation provision in which the fund may be non-conforming with the investment diversification requirements.

The other significant component for U.S. tax qualification is the Investor Control Doctrine. The Investor Control Doctrine has been developed as a series of rulings and court cases.  Under the traditional variable annuity or life contract, the insurer and not the policyholder is considered the owner of the underlying separate account assets.

The policyholder is not taxed on the increase in the contract’s account value. However, if the insurer gives the policyholder a degree of control over investments underlying the contract that is inconsistent with treatment of the insurer’s status as owner of the assets, the tax benefits of the policy will be forfeited. Investor control is determined based upon the facts of a specific situation.

  1. Strategy Example
  1. Facts

Acme Utilities is a private utility that operates two nuclear facilities. The utility would like to allocate $100 million from its NDTs to a hedge fund of fund strategy that allocates to multiple funds. All of the investment income is short term capital gain and dividend income. The trustee of the NDT would like to minimize the “tax drag” associated with the fund of funds investment. The cost “drag” associated with a PPLI investment is 100 basis points. A similar investment within a PPVIA is 25  basis points.

Solution  

The trustee of the NDT is the applicant, owner and beneficiary of a private placement immediate annuity. The measuring lives for the annuitant are the company’s youngest employee, a sixteen year old part-time employee and the designated beneficiary for joint life expectancy determination purposes, the new born baby of one of the company employees.

The initial investment into the PPVIA contract is $100 million. The investment performance assumption in all years is 8 percent. Based on the formulae for the calculation of the required payments under IRC Sec 72(t), an approximate calculation is as follows:

  1. Required Minimum Distribution Method – $1.95 million in Yr. 1 (increases each year)
  2. Amortization Method – $2.1 million in all years
  3. Annuitization Method - $2.09 in all years

Note : The IRC Sec 7520 rate is 1.07 percent. The exclusion ratio is approximately 65 percent meaning that only 35 percent of each annuity payment will be subject to taxation. Based on the numbers above, $735,100 or less than one percent will be subject to current taxation at corporate rates. The tax rate at 35% is $257,350 which is a 25 basis point cost of the original investment amount of $100 million.

The projected account balance on the initial $100 million investment based upon an 8 percent investment return can be seen below:

                        Year                           Projected PPVIA Account Balance

                        10                                                        $169.5 million

                        15                                                        $235.7 million

                        25                                                        $476 million             

                        30                                                        $686.1 million

The annuitants are strictly measuring lives for purposes of determining the substantially equal period payment requirements under IRC Sec 72(t). The policyholder, the corporation, retains all of the rights of ownership. The annuitants have no rights or benefits.

The policy will be issued by Royal Life. The policy is a private placement immediate annuity (PPVIA) than provides for fixed annuity payout. The PPVIA contract features several customized insurance dedicated funds.

As discussed above, less than one percent of each annuity payment is subject to current taxation. The actual tax cost on the annuity payment is a negligible amount of the initial investment, 25 basis points.  The balance of the investment income within the SPIA accumulates on a tax-deferred basis.

The PPVIA contract provides for partial and complete commutation of the annuity account balance. The corporation as the policyholder may exercise this option on a periodic basis to reach and distribute additional funds from within the PPVIA. The approximate frictional “drag” due to contract costs is approximately 15-20 basis points per year.

Summary

Utilities that operate nuclear facilities face substantial costs in decommissioning the nuclear facility. These decommissioning obligations are long-term obligations and long-term investment performance is an important factor in advanced funding of decommissioning costs. Investment performance could be grossed up substantially if taxation could be overcome. PPLI is a long-term asset with institutional pricing, investment flexibility and the tax advantages of life insurance. It is an ideal structure to position long-term investments for NDTs. PPLI and PPVIA will allow NDTs to incorporate investment asset classes that market volatility and remain market neutral.

Topics:  Annuities, Life Insurance, Nuclear Decommissioning Trusts, Nuclear Power, Private Placement Insurance, Tax Deferral

Published In: General Business Updates, Energy & Utilities Updates, Finance & Banking Updates, Insurance Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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