The 2015 Ontario Budget, released on April 23, includes proposed measures that are intended to  set  the  stage  for  consolidation  within  Ontario’s  electricity  distribution  sector.  At  a  high level, the measures are a limited-duration reduction of barriers to private sector  investment in municipally  owned  electricity  utilities  (MEUs).

Background

The Ontario government launched a  major  restructuring  of  Ontario’s  electricity  sector  with  the passage of the Electricity Act, 1998 to create a more competitive market. As part of this  restructuring, Ontario Hydro was broken up and municipalities were required to house their  electricity  distribution  utilities  in  corporations.

In connection with the break-up of Ontario Hydro, Ontario Hydro’s total debt and other liabilities  stood at $38.1 billion, whereas the fair market value of its assets (distributed to new entities)  was $17.2-billion market value. The resulting shortfall of $20.9 billion  was determined to be  “stranded debt” that could not be serviced in the new competitive environment.

The government decided that the stranded debt would be paid by the electricity sector and  ratepayers. Accordingly, the Electricity Act provides for revenue streams to service and ultimately  retire the stranded debt. One of the primary revenue streams is a “payment in lieu of taxes” (PILs)  regime, which includes PILs on profits, and payments in connection  with  transfers  of assets and  in connection with an MEU  losing  its  tax  exempt  status  (and  thus  departing  from PILs   regime).

Under the PILs regime, an MEU that is exempt from ordinary income tax is required to pay an amount  that is intended to equal the income tax that it would have otherwise had to pay had it not been  exempt. The regime also imposes a 33 per cent transfer tax on the fair market value of the MEU’s  electricity assets  at  the  time  those  assets  are  transferred  to  an  entity  outside the  PILs regime (the transfer tax is reduced by PILs paid by the transferor up to the time of the  transfer) to compensate for the loss of future revenue from such assets. Where an MEU ceases to be  exempt from ordinary income tax, the regime imposes a departure tax by deeming the MEU to dispose  of all of its assets for fair market value.

It is widely accepted that the transfer tax and departure tax rules under the PILs regime  discourage private sector investment and consolidation within the industry. It is also widely  believed  that  such  investment  and  consolidation  can  improve  cost  efficiencies  and  lead   to other benefits within the industry.

Proposed Time-Limited Changes to PILs Regime

In  light  of  the  foregoing,  the  Ontario  Budget  proposed  time-limited  relief  pertaining   to  transfers  of  electricity  assets for all MEUs (or transfers of interests in the MEUs), including transfers to the private sector,  for the period beginning January 1, 2016, and ending December 31, 2018, by:

  • reducing the transfer tax rate from 33 per cent to 22 per cent;
  • exempting MEUs with fewer than 30,000 customers from the transfer tax; and
  • exempting capital gains from the departure tax.

The Budget also proposes to introduce measures to prevent the avoidance of PILs through  dispositions  of  partnership interests made directly, or indirectly as part of a series of  transactions, to a person who is not subject to the PILs regime or a partnership whose members are  not all subject to the PILs regime. Comments The changes will reduce and, in the case of small MEUs, remove a major barrier to consolidation   within  Ontario’s electricity distribution sector. However,  whether  the  desired  consolidation   will  occur  will  also  depend  on  other  factors. For example, although  the  measures  are  weighted  to consolidating  small  MEUs, will  any private sector participants  be interested in  smaller utilities or acquiring several small utilities to obtain sufficient scale? That remains to  be seen.

Further, while capital gains will be exempt from the departure tax, it is important to note that  income on recaptured depreciation is not so exempt. For example, assume at the time that an MEU is  to lose its tax exempt status (because of private sector investment) it has an asset valued at $1.2  million that it originally acquired for $1 million and in respect of which it claimed $400,000  of   depreciation.  Under  the  proposals,  the  departure  tax  would  not  apply  with  respect  to  the $200,000 capital gain, but it would still apply in respect of the full income inclusion of the  $400,000 recaptured depreciation.

Municipalities and their MEUs will face difficult questions around whether to merge (and if so,  with whom) or dispose of assets and how the assets of the MEUs should be valued. They will also  have to address the impact of the merger on the assets, liabilities, rights and obligations of the  merging entities and of the continuing entity formed by the merger. They will also face complex  questions in the negotiation and finalization of the merger transaction and related documentation  and concerning corporate governance, not just in the decisions related to the merger, but also in  the post-merger governance  arrangements.  It  will  be  essential  that  municipalities  receive   effective,  independent  advice  about  merger decisions.