Holding Liquor Deal in Virgin Islands

The U.S. Virgin Islands is holding out for better market conditions on its roughly $250 million rum-tax bond deal that will help finance production of Captain Morgan brand rum in St. Croix.

The Virgin Islands Public Finance Authority plans to issue in the fall up to $250 million of tax-exempt debt for a new distillery. Officials originally planned to sell the bonds earlier this year, but will now wait for a stronger market, according to Julito Francis, the VIPFA's director of finance and administration.

In the meantime, the authority is working with Diageo PLC, which owns the Captain Morgan rum brand, on a potential short-term financing so that construction will go forward as planned.

The USVI anticipates receiving tax revenues from Captain Morgan rum starting in fiscal 2012, which begins Oct. 1, 2012. The rum maker is moving production to the Virgin Islands from Puerto Rico, as Diageo's contract with a third-party distiller, Destileria Serralles in Ponce, P.R., will expire at the end of 2012. Officials are concerned about any delays in the development, since rum must age for at least one year.

"In order for the project construction to move forward, some interim financing needs to occur," Francis said. "And then, when the markets normalize to more historical trends - code word for lower cost - then we'll issue the bonds accordingly to take out the short-term, interim financing."

JPMorgan and Citi will price the rum-tax bonds. Hawkins, Delafield & Wood LLP is bond counsel. Fiscal Strategies Group Inc. is the authority's financial adviser.

Diageo and USVI officials broke ground on the new distillery on May 6 after the project received a costal zone management permit the month before. Jim Kelly, vice president at JPMorgan, said that once the environmental permit was in place, the authority needed to focus on getting construction started before issuing the debt.

"Obviously they want to enter the market at the right time so that they can get the most cost-effective financing, but a lot of it is [that] they did not receive what's known as the CZM permit until early April," Kelly said.

In looking at the short-term financing options, Francis said Diageo may guarantee a loan that the territory would take out with a private entity, or the authority could use bond anticipation notes.

"We're looking into different types of scenarios," and Diageo is "willing to do a loan-guarantee scenario, which is where we are right now," Francis said. "The other scenario would be a bond anticipation note, which could be privately placed by one or more financial institutions."

Having Diageo move its Captain Morgan production to the territory will increase rum-tax revenues, also called cover-over revenues, for the USVI dramatically. Fiscal Strategies projects the government's coffers will receive nearly $119 million of rum-tax receipts in fiscal 2012 from sales of Captain Morgan, with that amount to increase steadily to $227.5 million in fiscal 2038. In comparison, USVI expects to collect $20.5 million of rum-tax revenue in fiscal 2009 from Pernod Ricard's Cruzan Rum, currently the territory's sole rum maker.

In response to Diageo's leaving Puerto Rico, Resident Commissioner Pedro Pierluisi last month filed a bill that would limit rum-tax subsidies to private companies at 10%, which would have the effect of undermining USVI's current agreement with Diageo. The commonwealth anticipates losing roughly $130 million in rum-tax receipts per year once Captain Morgan switches production to the USVI.

"The purpose of the cover-over program is, and has always been, to help the two territories provide for the general welfare of their residents and to promote broad-based economic development," Pierluisi said in a press release. "The program was not designed to enable a territory to provide overly-generous subsidies to rum makers."

While the measure has gained a total of 88 sponsors, Pierluisi's bill is currently not scheduled for consideration in the House Committee on Ways and Means, which oversees tax legislation, according to Matthew Beck, communications director and policy adviser to the committee.

If the bill were to pass before the authority issues the $250 million of rum-tax bonds, USVI would need to reconsider its agreement with Diageo. In fiscal 2012 the rum maker will receive $36.3 million in tax incentives, marketing campaigns and molasses subsidies, according to Fiscal Strategies. That $36.3 million is more than 10% of the anticipated $119 million the USVI expects to collect in fiscal 2012 from Captain Morgan rum alone. Subsidies to Diageo will increase each year to $89.1 million in fiscal 2027 through fiscal 2038.

Francis said the authority is not worried about the pending legislation.

"I think that a lot of other things have to come in place before that bill is passed and I'm not concerned about that," he said.

The first $18.4 million of new rum-tax revenue will go toward paying down debt service costs on the $250 million of bonds. In exchange for the financing of the distillery and the subsidies, Diageo has agreed to produce all of its U.S. distribution of Captain Morgan rum from the new distillery for 30 years. Diageo will own and operate the facility itself.

Patricia Goins, partner at Hawkins Delafield, said the transaction is a creative public-private partnership in which the financing is a type of grant to Diageo, with the new facility offering the territory economic growth.

"Under the tax laws, you can issue tax-exempt bonds for the purpose of making a grant to a private entity for a facility that's going to result in public benefits," Goins said. "And the public benefits here are going to be employment, jobs and additional revenues. So those are all valid public purposes."

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