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This memo is an attempt to give you some background on the work legal has
done for Don in the last year and a half in trying to find legal ways to avoid paying the gross receipts tax on our gas contracts. The issue came up in a staff meeting a couple of weeks ago and I wanted you to be aware of where we are on this issue. When I first arrived in BA, Don and I had some discussions trying to come up with a game plan to avoid paying the gross receipts tax. The first attempt to avoid the tax resulted in a type of Broker/Agent agreement where we would act as the broker for the enduser for gas only purposes and through an agency arrangement place ourselves in-between the producer and the enduser and transact on the endusers behalf so that the producer and enduser would not know each other. This format was developed with the help of outside counsel and the tax group. The commercial team lost interest in this approach when the complexity of the arrangement made it difficult to sell to the producers and endusers. Additionally, it would only work for customers who had their own transportation. Some time later Fede and others in the commercial team came up with two other suggestions that they felt Enron could use to avoid the gross receipts tax problem. The first example proposed for our review came from the telecommunications sector. This "tax avoidance" method is based on the fact that the local telephone companies have the ability to bill for third parties and not include such amounts for purposes of calculating its own tax liabilities. For example, cellular phone fees of cellular phone companies are billed to the enduser by its local phone company as a separate line item and are not included in its gross receipts. The commercial team suggested that Enron could specify in our invoices that we are billing for the producers and therefore not include the amounts invoiced in our gross receipts. The billing mechanism used by the local phone company is based on an agency relationship where the enduser's phone company is collecting on behalf of the cell phone company for separate services than those provided by the local phone company. This is not a "tax avoidance" scheme by the telephone company. Both the cell phone company and the local phone company are required to count the amounts they receive for their services, however those amounts are collected, as gross receipts for tax purposes. It just so happens that the cell phone company uses an agent, the local phone company, to collect their funds. We determined that this approach, as a "tax avoidance" scheme, would not work for Enron since the enduser signed a contract for the purchase of the gas with Enron, not the producer, making it impossible for us to argue we are a collecting agent for the producer. Once it was clear that the first example was not going to provide the help we were looking for, the commercial team proposed a "tax avoidance" scheme used by one of the small gas marketers. The crux of this scheme consists of two provisions, one in each of the producer and enduser contracts that they feel allows them to net their proceeds for gross receipts tax purposes. The marketer enters into contracts with endusers that specify that the enduser may be billed by third parties for the gas they purchased from the marketer. The contract also provides that the enduser would be obligated to pay the marketer the difference between what the third party billed and what would have otherwise been billed by the marketer pursuant to the contract (the "Net Amount"). The marketer also signs gas purchase contracts with producers with provisions that allow the marketer to request that the producer invoice the marketer's endusers directly, although the marketer would remain the legal counterparty to the contract with the producer. The marketer's logic appears to be that since they did not receive the invoiced amount directly they do not have to pay gross receipts taxes on the amounts collected by the producer but would only have to pay on the Net Amount. This is the scheme that Gaby mentioned two weeks ago in the staff meeting. We reviewed the documentation used by the marketer and reviewed the legal and tax issues with outside counsel and our tax advisors and came to the conclusion that the methodology used by this marketer is not legally sufficient to avoid the tax liability. Further, we were advised that if Enron tried a similar strategy Enron and its management would likely incur significant tax and legal liabilities. The problem with the scheme is that what the marketer is actually doing is an operational netting of purchases and sales and not a legal netting for tax purposes. Such operational netting does not change the fact that legally the marketer is deemed to have received the full gross amount from the enduser even if they did not physically receive the invoiced amounts. There are legal methods that could result in a lower gross receipts tax but they require that the contract rights of the marketer be assigned to the producer prior to the delivery of the gas. The marketer's documentation I reviewed was, while internally inconsistent and vague, legally insufficient to actually result in an assignment of the obligation to deliver gas to the producer which would have been the only way to allow the marketer to avoid the gross receipts tax. This would normally be the end of arguments on tax schemes that don't work but much is still made of the fact that YPF agrees to transact with marketers in this fashion and therefore the scheme must have merit. The fact that YPF agrees to invoice third parties adds nothing to bolster the merits of the marketer's scheme. There is no tax or legal liability assumed by YPF or any other producer for agreeing to bill third parties so there is no risk for the producer to do so and no tax scheme endorsement can be argued. In fact if I was a big producer dealing with a small marketer with little or no tangible assets I might agree to the same thing just because it would probably speed up the process of getting paid for the gas I sold to the marketer. As a producer I would still be required to credit the amounts received from the enduser as amounts deemed to be received from the marketer. The important point here is that whether the producer gets paid by the marketer or the enduser its gross receipts tax obligation stays the same. The producer is not engaging in any tax avoidance scheme by billing third parties. The question is not whether the producer can accept payments from third parties but rather whether the marketer can legally net the amounts it is owed by the enduser with the amounts the marketer owes to the producer by allowing the producer to invoice directly. The tax law is clearly based on gross receipts not net receipts and our counsel and tax advisors tell us that this scheme does not result in the marketer being able to legally declare its net receipts as its gross receipts. Once it became clear to Don that this marketer's method of trying to avoid the turnover tax did not really work he asked me to try and develop another broker agreement format, this time for both producers and endusers that would mimic the legal and commercial risks of marketing. He wanted a set of documents that would allow Enron to be paid a fee equal to the difference between what the producer charges and what we would have charged the enduser. He also wanted to keep the producers and endusers from knowing who the other party to the transactions were and wanted Enron, as broker, to assume all the same risks of non-performance that would have existed if we remained the marketer in the middle. I worked on a document that ended up being more complex structurally than the first broker agreement and more complex legally because of the parameters requested by Don. I worked with outside counsel to review the structure but they ultimately advised us that the structure, as outlined, would not likely withstand a challenge by any tax court since the difference between what we wanted and a marketing agreement was simply a matter of form over substance. Any taxing authority would have deemed our duel broker arrangement to be in reality contracts for the purchase and sale of gas because all the risks associated with marketing were being assumed by Enron. As we could not come up with a workable alternative that would be commercially acceptable to all parties we stopped working on the document several months ago. Additionally, it became apparent that the document was so complex as to be virtually unmarketable to either the producers or the endusers. I left the issue on my "to do" list for several months to see if I could come up with another alternative which I have not been able to do. I cannot envision another structure that would allow us to retain our desired risk profile and not have to pay a gross receipts tax. We could change our business to straight brokering but that alternative has never been considered commercially acceptable to Enron. The only other obvious choice is to work on lobbying to get the tax laws changed in such a way as to put marketers on a level playing field with producers. Please let me know if you want to discuss this further or if you have other suggestions for me to look at. Brent
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