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 But such an arrangement could provoke a challenge from the U.S.
government, since it would result in a multi-billion-dollar capital
gains tax bill that the bankrupt entity is unlikely to be able to
afford.
Earlier this year, in an unusual move, the company and the lenders
reached out to the Internal Revenue Service seeking its blessing on
the proposed structure, according to the sources, who refused to be
named because talks are private. The agency declined to rule because
the plan is not official, they said.
Barring any last-minute deals, which several people close to the
matter say is unlikely, the dispute over the tax issue will come to
a head in bankruptcy court. Energy Future is expected within weeks
to receive an auditor's opinion that it cannot survive as a going
concern, which would trigger a default on its loans. The people
close to the case expect the company to file for Chapter 11 as soon
as this month to avoid the default.
Energy Future, formerly TXU Corp, was created in a 2007 leveraged
buyout by a consortium including KKR & Co <KKR.N>, TPG Capital
Management <TPG.UL> and Goldman Sachs' <GS.N> private equity arm.
The deal loaded the company with more than $40 billion in debt
shortly before low natural gas prices made its coal-fired plants
noncompetitive. A breakup would split its unprofitable generating
unit from its regulated distribution business.
The lenders, which include Apollo Global Management <AINV.O>,
Oaktree Capital Management and Centerbridge Partners, have more
bargaining power than any other stakeholder. With more than $20
billion in loan debt at the company's generating unit, they are by
far the largest creditor faction.
Under the lenders' vision, Energy Future's subsidiaries would be
sold to the highest bidder, with existing creditors having the right
to bid using the face value of their debt. Since that value is
higher than the tax value of the assets on the company's books, the
so-called credit bid would let the buyer revalue the assets' tax
basis, a method known as a step-up, and save money on future taxes.
Such a transaction would also leave a massive capital gains tax
liability at the Energy Future parent, which is not expected to have
the money to pay it.
While most other stakeholders do not favor the proposal, they see it
as a possibility given the lenders' bargaining leverage, said
several people close to the matter.
The lenders are not the only ones who could benefit from a breakup.
Energy Future's regulated power delivery business could also be
sold, and its buyer could effect a similar step-up, one of the
people said. But, due to their top-priority payback status and
relative size of the unregulated business, it is the lenders who
have the most to gain from the scenario.
Tax issues arise often in restructurings, but the sheer size of the
potential liability at Energy Future — estimated by people close to
the case at between $5 billion and $8 billion — makes the issue
especially critical. And the nature of the proposed transaction, in
which private-equity funds would benefit from a deal that creates a
massive and perhaps unpayable debt to the IRS, makes the case
particularly sensitive, one of the sources added.
A spokesman for Energy Future declined to comment. A spokesman for
the IRS said federal law prohibits the agency from discussing
specific taxpayers or cases.
HEAVY HAGGLING AHEAD
The specter of an unpayable tax bill has haunted more than a year of
talks between Energy Future and its creditors to restructure debt
and head off a lengthy and expensive Chapter 11 battle. Energy
Future at one point proposed a tax-free spinoff of its subsidiaries,
but the deal would have eliminated the potential for a step-up, two
of the people said.
The capital gains tax that would result from the step-up scenario
would not affect the lenders or other secured creditors whose debt
holds top payback priority. Instead, it would become an unsecured
bankruptcy claim held by the IRS, diluting the claims of other
junior creditors.
In that sense, the lending group has become the bane of junior
bondholders, which mostly include investment funds with debt at
Energy Future's regulated and unregulated units.
More importantly from the government's perspective, there is not
expected to be enough money to fully repay holders of unsecured
claims in bankruptcy, meaning the IRS would recover only a fraction
of the multi-billion-dollar tax bill, if anything.
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Unsecured creditors have little power in bankruptcy to elevate their
claims or demand payback where value does not exist. But the IRS may
push hard to salvage some recovery, given the unique size of the
potential claim and the desire to avoid the perception of hurting
taxpayers, according to two of the people close to the matter.
The private equity firms, moreover, may be wary of upsetting the
government and inviting increased IRS scrutiny of their businesses,
one creditor source said.
That means Energy Future's eventual bankruptcy is likely to include
significant haggling — and maybe litigation — between the government
and any party that lends support to a plan that creates a large tax
bill.
Perhaps the government's best option for disrupting such a plan,
said one person close to the matter, is to argue under bankruptcy
law that the plan is invalid because it serves mainly as a
tax-avoidance scheme. To approve a bankruptcy exit plan, a judge
must conclude among other things that the plan is not designed to
dodge taxes.
The government may face an uphill climb. A tax step-up is legal, and
it is unclear that any unsecured creditor — even one with the
financial resources and political clout of the government — would
have the bargaining leverage to work out a deal that avoids a hefty
unpaid tax bill.
The IRS could change its own regulations to block the lenders'
attempt at the step-up, two of the people said. But others balked at
that proposition.
"It's too fundamental a part of the tax code to change," accountant
and tax expert Robert Willens, who is not involved in the case, told
Reuters. "I don't have any compunction that they would do that, nor
could they."
"OLYMPUS HAS FALLEN"
Energy Future last year had hoped to achieve a restructuring that
would avoid breaking up the company, dubbing the mission "Project
Olympus," according to two of the people close to the matter. The
name became a joke to some creditors after Millennium Films released
its action blockbuster "Olympus Has Fallen" in March of 2013, they
said.
Now, hope of a consensual deal prior to a bankruptcy has all but
dried up, and parties are more focused on arranging bankruptcy
financing, the sources said. A contentious bankruptcy could mean
months or years of negotiations between all stakeholders, including
the government, and the tax dispute could eventually be resolved
cooperatively.
If it is not, another potential avenue for Uncle Sam is to ask a
judge to void Energy Future's corporate structure, making certain "ringfenced"
assets — those protected from the reach of creditors — available to
creditors, Willens said.
That scenario seems unlikely. People close to the case believe the
asset in question — namely Oncor, Energy Future's regulated power
delivery business — will remain off-limits to stakeholders.
Dot Matthews, an analyst at CreditSights, wrote in November that the
Oncor ringfence was solid. "We have never believed that Oncor would
be dragged into an eventual (Energy Future) bankruptcy, and that
seems to be the current consensus, as well," Matthews said in a
report.
Energy Future could itself change its tax structure so that the tax
would fall to its energy-generation subsidiary rather than the
Energy Future parent, said one of the people, but that scenario was
unlikely because the lenders have enough bargaining leverage to
influence the terms of the company's restructuring.
(Reporting by Nick Brown and Billy
Cheung; editing by Amy Stevens and Prudence Crowther)
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