(8) LEASING ACTIVITIES

Investment in Finance Leases Held in Trust

Between 1994 and 2002, PCI entered into cross-border energy lease investments consisting of hydroelectric generation facilities, coal-fired electric generation facilities and natural gas distribution networks located outside of the United States. Each of these lease investments was structured as a sale and leaseback transaction commonly referred to as a sale-in, lease-out, or SILO, transaction. As of June 30, 2013 and December 31, 2012, the lease portfolio consisted of one investment and six investments, respectively, with a net investment value of $167 million and $1,237 million, respectively.

In March 2013, PHI began to pursue the early termination of all of its remaining cross-border energy lease investments with its lessees. During the second quarter of 2013, PHI terminated early its interest in five of the six remaining lease investments. PHI received aggregate net cash proceeds of $693 million (net of aggregate termination payments of $1.4 billion used to retire the non-recourse debt associated with the terminated leases) and recorded an aggregate pre-tax loss, including transaction costs, of approximately $14 million ($9 million after-tax) in the second quarter of 2013, representing the excess of the carrying value of the terminated leases over the net cash proceeds received.

During July 2013, PHI entered into an agreement with the lessee of the last remaining PHI lease investment which provides for the early termination of such lease investment. Upon closing, on July 26, 2013, PHI received aggregate net cash proceeds of $180 million (net of aggregate termination payments of $665 million used to retire the non-recourse debt associated with the terminated leases) and expects to record in the third quarter of 2013 a pre-tax gain, including transaction costs, of approximately $11 million ($7 million after-tax), representing the excess of the net cash proceeds received over the carrying value of the terminated leases. After consideration of this final termination, the aggregate financial impact upon completion of the early terminations of the cross-border energy leases is expected to be a pre-tax loss, including transaction costs, of approximately $3 million ($2 million after-tax) for the year ending December 31, 2013.

The components of the cross-border energy lease investments as of June 30, 2013 and December 31, 2012 are summarized below:


	June 30, 2013			December 31, 2012
	*(millions of dollars)*
Scheduled lease payments to PHI, net of non-recourse debt	$	223		$	1,852
Less: Unearned and deferred income		(56	)		(615	)

Investment in finance leases held in trust		167			1,237
Less: Deferred income tax liabilities		(83	)		(756	)

Net investment in finance leases held in trust	$	84		$	481

Income recognized from cross-border energy lease investments, excluding the losses on terminated leases discussed above, was comprised of the following for the three and six months ended June 30, 2013 and 2012:


	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013			2012
	*(millions of dollars)*
Pre-tax income from PHI’s cross-border energy lease investments (included in Other Revenue)	$	2		$	13	$	7		$	26
Non-cash charge to reduce carrying value of PHI’s cross-border energy lease investments		—			—		(373	)		—

Pre-tax income (loss) from PHI’s cross-border energy lease investments after adjustment		2			13		(366	)		26
Income tax expense (benefit) related to PHI’s cross-border energy lease investments		6			3		(43	)(a)		4


Net (loss) income from PHI’s cross-border energy lease investments	$	(4	)	$	10	$	(323	)	$	22

(a)	Includes a charge of $64 million for the tax consequences associated with PHI’s change in intent regarding foreign investment opportunities and interest expense on uncertain tax positions of $16 million, each recorded in the first quarter of 2013.

PHI is required to assess on a periodic basis the likely outcome of tax positions relating to its cross-border energy lease investments and, if there is a change or a projected change in the timing of the estimated tax benefits generated by the transactions, PHI is required to recalculate the value of its net investment.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which PHI is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI has determined that its tax position with respect to the benefits associated with its cross-border energy leases no longer meets the more-likely-than-not standard of recognition for accounting purposes, and PHI recorded an after-tax non-cash charge of $377 million in the first quarter of 2013, consisting of the following components:

•

A non-cash pre-tax charge of $373 million ($307 million after-tax) to reduce the carrying value of these cross-border energy lease investments under FASB guidance on leases (ASC 840). This pre-tax charge has been recorded in the consolidated statement of income as a reduction in Other Operating revenue.

•

A non-cash charge of $70 million after-tax to reflect the anticipated additional net interest expense under FASB guidance for income taxes (ASC 740), related to estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed. This after-tax charge has been recorded in the consolidated statement of income as an increase in income tax expense and was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in the recognition of a $12 million interest benefit for the Power Delivery segment and interest expense of $16 million and $66 million for the Other Non-Regulated and Corporate and Other segments, respectively.

PHI had also previously made certain business assumptions regarding foreign investment opportunities available at the end of the full lease terms. In view of the change in PHI’s tax position with respect to the tax benefits associated with the cross-border energy lease investments and PHI’s resulting decision to pursue the early termination of these investments, management has concluded that these business assumptions are no longer supportable and the tax effects of this conclusion are reflected in the after-tax charge of $307 million described above.

PHI has accrued no penalties associated with its re-assessment of the likely outcome of tax positions associated with the cross-border energy lease investments. While the Internal Revenue Service (IRS) could require PHI to pay a penalty of up to 20% of the amount of additional taxes due, PHI believes that it is more likely than not that no such penalty will be incurred, and therefore no amount for any potential penalty was included in the charge.

For additional information concerning these cross-border energy lease investments, see Note (15), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments.”

To ensure credit quality, PHI regularly monitors the financial performance and condition of the lessees under its cross-border energy lease investments. Changes in credit quality are also assessed to determine if they should be reflected in the carrying value of the leases. PHI compares each lessee’s performance to annual compliance requirements set by the terms and conditions of the leases. This includes a comparison of published credit ratings to minimum credit rating requirements in the leases for lessees with public credit ratings. In addition, PHI routinely meets with senior executives of the lessees to discuss their company and asset performance. If the annual compliance requirements or minimum credit ratings are not met, remedies are available under the leases. At June 30, 2013, all lessees were in compliance with the terms and conditions of their lease agreements.

The table below shows PHI’s net investment in these leases by the published credit ratings of the lessees as of June 30, 2013 and December 31, 2012:


Lessee Rating (a)	June 30, 2013		December 31, 2012
	*(millions of dollars)*
Rated Entities
AA/Aa and above	$	167	$	766
A		—		471

Total	$	167	$	1,237

(a)	Excludes the credit ratings associated with collateral posted by the lessees in these transactions.