ITEM 1. BUSINESS.
Union Carbide Corporation (the “Corporation” or “UCC”) is a chemicals and polymers company. In addition to its consolidated operations, the Corporation participates in partnerships and joint ventures (together, “nonconsolidated affiliates”). Since February 6, 2001, the Corporation has been a wholly owned subsidiary of The Dow Chemical Company (“Dow”) as a consequence of the Corporation merging with a wholly owned subsidiary of Dow effective that date. Except as otherwise indicated by the context, the terms “Corporation” or “UCC” as used herein mean Union Carbide Corporation and its consolidated subsidiaries.
Dow conducts its worldwide operations through global businesses. The Corporation’s business activities comprise components of Dow’s global businesses rather than stand-alone operations. In order to simplify the customer interface process, the Corporation sells its products to Dow at market-based prices, in accordance with Dow’s long-standing intercompany pricing policy. The following is a description of the Corporation’s principal products.
Ethylene Oxide/Ethylene Glycol-ethylene oxide (EO), a chemical intermediate primarily used in the manufacture of ethylene glycol, polyethylene glycol, glycol ethers, ethanolamines, surfactants and other performance chemicals and polymers; di- and triethylene glycol, used in a variety of applications, including boat construction, shoe manufacturing, natural gas-drying and other moisture-removing applications, and plasticizers for safety glasses; and tetraethylene glycol, used predominantly in the production of plasticizers for automotive windows. Ethylene glycol (EG) is used extensively in the production of polyester fiber, resin and film, automotive antifreeze and engine coolants, and aircraft anti-icing and deicing fluids.
Industrial Chemicals and Polymers-broad range of products for specialty applications, including pharmaceutical, animal food supplements, personal care, industrial and household cleaning, coatings for beverage and food cans, industrial coatings and many other industrial uses. Product lines include acrolein and derivatives, CARBOWAX™ and CARBOWAX™ SENTRY™ polyethylene glycols and methoxypolyethylene glycols, solution vinyl resins, TERGITOL™ and TRITON™ surfactants, UCARTHERM™ heat transfer fluids, UCAR™ deicing fluids and UCON™ fluids.
Latex-water-based emulsions, including NEOCAR™ branched vinyl ester latexes, UCAR™ POLYPHOBE™ rheology modifiers, and UCAR™ all-acrylic, styrene acrylic and vinyl-acrylic latexes used as key components in decorative and industrial paints, adhesives, textile products, and construction products, such as caulks and sealants.
Polyethylene-includes TUFLIN™ linear low density and UNIVAL™ high density polyethylene resins used in high-volume applications such as housewares; milk, water, bleach and detergent bottles; grocery sacks; trash bags; packaging; water and gas pipe; and FLEXOMER™ very low density polyethylene resins used as impact modifiers in other polymers and to produce flexible hose and tubing, frozen-food bags and stretch wrap.
Polypropylene-end-use applications include: carpeting and upholstery; hygiene articles; packaging films; thin wall food containers and serviceware; industrial containers; housewares and appliances; heavy-duty tapes and ropes; and automobile interior panels and trim.
Solvents and Intermediates-includes oxo aldehydes, acids and alcohols, used as chemical intermediates and industrial solvents and in herbicides, plasticizers, paint dryers, jet-turbine lubricants, lube oil additives, and food and feed preservatives; esters, which serve as solvents in industrial coatings and printing inks and in the manufacturing processes for pharmaceuticals and polymers.
Technology Licensing and Catalysts-includes licensing and supply of related catalysts for the UNIPOL™ polypropylene process, the METEOR™ process for EO/EG, and the LP OXO™ process for oxo alcohols, as well as licensing of the UNIPOL™ polyethylene process and sale of related catalysts (including metallocene catalysts) through Univation Technologies, LLC, a 50:50 joint venture with ExxonMobil.
Vinyl Acetate Monomer-a building block for the manufacture of a variety of polymers used in water-based emulsion paints, adhesives, paper coatings, textiles, safety glass and acrylic fibers.
Water Soluble Polymers-polymers used to enhance the physical and sensory properties of end-use products in a wide range of applications including food, paints and coatings, pharmaceuticals, oil and gas, personal care, building and construction, and other specialty applications. Key product lines include CELLOSIZE™ hydroxyethyl cellulose, POLYOX™ water-soluble resins, and products for hair and skin manufactured by Amerchol Corporation, a wholly owned subsidiary.
Wire and Cable-polyolefin-based compounds for high-performance insulation, semiconductives and jacketing systems for power distribution, telecommunications, and flame-retardant wire and cable. Key product lines include: REDI-LINK™ polyethylene-based wire and cable compounds, SI-LINK™ polyethylene-based low voltage insulation compounds, UNIGARD™ high-performance flame-retardant compounds, UNIGARD™ reduced emissions flame-retardant compounds, and UNIPURGE™ purging compounds.
Competition The chemical industry has been historically competitive and this competitive environment is expected to continue. The chemical divisions of the major international oil companies also provide substantial competition both in the United States and abroad.
Research and Development
The Corporation is engaged in a continuous program of basic and applied research to develop new products and processes, to improve and refine existing products and processes and to develop new applications for existing products. Research and Development expenses were $71 million in 2006 compared with $78 million in 2005. In addition, certain of the Corporation’s nonconsolidated affiliates conduct research and development within their business fields.
Patents, Licenses and Trademarks
The Corporation owns almost 1,800 U.S. and foreign patents that relate to a wide variety of products and processes, has a substantial number of pending patent applications throughout the world and is licensed under a number of patents. These patents expire at various times over the next 20 years. The Corporation also has a large number of trademarks. Although the Corporation considers that its patents, licenses and trademarks in the aggregate constitute a valuable asset, it does not regard its business as being materially dependent upon any single patent, license or trademark.
Principal Partly Owned Companies
UCC’s principal nonconsolidated affiliates for 2006 and the Corporation’s ownership interest in each are listed below:
• EQUATE Petrochemical Company K.S.C. (“EQUATE”) - 42.5 percent - a Kuwait-based company that manufactures ethylene, polyethylene and ethylene glycol.
• Nippon Unicar Company Limited - 50 percent - a Japan-based manufacturer of polyethylene and specialty polyethylene compounds.
• The OPTIMAL Group [consisting of OPTIMAL Olefins (Malaysia) Sdn Bhd - 23.75 percent; OPTIMAL Glycols (Malaysia) Sdn Bhd - 50 percent; OPTIMAL Chemicals (Malaysia) Sdn Bhd - 50 percent] - Malaysian companies that operate an ethane/propane cracker, an ethylene glycol facility and a production facility for ethylene and propylene derivatives within a world-scale, integrated chemical complex located in Kerteh, Terengganu, Malaysia.
• Univation Technologies, LLC - 50 percent - a U.S. company that develops, markets and licenses polyethylene process technology and related catalysts.
Financial Information About Foreign and Domestic Operations and Export Sales
In 2006, the Corporation derived 30 percent of its trade sales from customers outside the United States and had 1 percent of its property investment located outside the United States. See Note O to the Consolidated Financial Statements for information on sales to external customers and long-lived assets by geographic area.
Protection of the Environment
Matters pertaining to the environment are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operation, and Notes A and I to the Consolidated Financial Statements.
ITEM 1A.
ITEM 1A. RISK FACTORS.
The factors described below represent the Corporation’s principal risks. Except as otherwise indicated, these factors may or may not occur and the Corporation is not in a position to express a view on the likelihood of any such factor occurring. Other factors may exist that the Corporation does not consider to be significant based on information that is currently available or that the Corporation is not currently able to anticipate.
Volatility in purchased feedstock and energy costs impact UCC’s operating costs and add variability to earnings.
During 2006, purchased feedstock and energy costs continued to rise. While purchased feedstock and energy costs have trended downward in early 2007, these costs are expected to remain volatile throughout the year. When these costs increase, the Corporation is not always able to immediately raise prices and, ultimately, its ability to pass on underlying cost increases is greatly dependent on market conditions. As a result, increases in these costs could negatively impact the Corporation’s results of operations.
Actual or alleged violations of environmental laws or permit requirements could result in restrictions or prohibitions on plant operations, substantial civil or criminal sanctions, as well as the assessment of strict liability and/or joint and several liability.
The Corporation is subject to extensive federal, state, local and foreign laws, regulations, rules and ordinances relating to pollution, protection of the environment and the generation, storage, handling, transportation, treatment, disposal and remediation of hazardous substances and waste materials. At December 31, 2006, the Corporation had accrued obligations of $77 million for environmental remediation and restoration costs, including $25 million for the remediation of Superfund sites. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Corporation has accrued liabilities, although the ultimate cost with respect to these particular matters could range up to twice that amount. Costs and capital expenditures relating to environmental, health or safety matters are subject to evolving regulatory requirements and will depend on the timing of the promulgation and enforcement of specific standards which impose the requirements. Moreover, changes in environmental regulations could inhibit or interrupt the Corporation’s operations, or require modifications to its facilities. Accordingly, environmental, health or safety regulatory matters may result in significant unanticipated costs or liabilities.
The Corporation is party to a number of claims and lawsuits arising out of the normal course of business with respect to commercial matters, including product liability, governmental regulation and other actions.
The Corporation and its subsidiaries are involved in a number of legal proceedings and claims with both private and governmental parties. These cover a wide range of matters, including, but not limited to: product liability; trade regulation; governmental regulatory proceedings; health, safety and environmental matters; employment; patents; contracts; taxes; and commercial disputes. With the exception of the possible effect of the asbestos-related liability described below, it is the opinion of the Corporation’s management that the possibility is remote that the aggregate of all such claims and lawsuits will have a material adverse impact on the Corporation’s consolidated financial statements.
The Corporation is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past three decades. The asbestos-related liability for pending and future claims was $1.2 billion at December 31, 2006 and the Corporation’s receivable for insurance recoveries related to its asbestos liability was $495 million at December 31, 2006. In addition, the Corporation had receivables for insurance recoveries of $300 million at December 31, 2006 for defense and resolution costs. Management believes that it is reasonably possible that the cost of disposing of the Corporation’s asbestos-related claims, including future defense costs, could have a material adverse impact on the Corporation’s results of operations and cash flows for a particular period and on the consolidated financial position of the Corporation.
Local, state and federal governments have begun a regulatory process that could lead to new regulations impacting the security of chemical plant locations and the transportation of hazardous chemicals.
Growing public and political attention has been placed on protecting critical infrastructure, including the chemical industry, from security threats. Terrorist attacks and natural disasters have increased concern regarding the security of chemical production and distribution. In addition, local, state and federal governments have begun a regulatory process that could lead to new regulations impacting the security of chemical plant locations and the transportation of hazardous chemicals, which could result in higher operating costs and interruptions in normal business operations.
Weather-related matters could impact the Corporation’s results of operations.
In 2005, two major hurricanes caused significant disruption in UCC’s operations on the U.S. Gulf Coast, logistics across the region and in the supply of certain raw materials which had an adverse impact on volume and cost for some of UCC’s products. If similar weather-related matters occur in the future, it could negatively affect UCC’s results of operations, due to the Corporation’s substantial presence on the U.S. Gulf Coast.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES.
The Corporation operates 15 manufacturing sites in six countries. The Corporation considers that its properties are in good operating condition and that its machinery and equipment have been well maintained. The following are the major production sites:
United States:
Hahnville, Louisiana; Texas City and Seadrift, Texas; South Charleston, West Virginia
All of UCC’s plants are owned or leased, subject to certain easements of other persons which, in the opinion of management, do not substantially interfere with the continued use of such properties or materially affect their value.
A summary of properties, classified by type, is contained in Note D to the Consolidated Financial Statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Asbestos-Related Matters
Introduction
The Corporation is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past three decades. These suits principally allege personal injury resulting from exposure to asbestos-containing products and frequently seek both actual and punitive damages. The alleged claims primarily relate to products that UCC sold in the past, alleged exposure to asbestos-containing products located on UCC’s premises, and UCC’s responsibility for asbestos suits filed against a former subsidiary, Amchem Products, Inc. (“Amchem”). In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or that injuries incurred in fact resulted from exposure to the Corporation’s products.
Influenced by the bankruptcy filings of numerous defendants in asbestos-related litigation and the prospects of various forms of state and national legislative reform, the rate at which plaintiffs filed asbestos-related suits against various companies, including the Corporation and Amchem, increased in 2001, 2002 and the first half of 2003. Since then, the rate of filing has significantly abated. The Corporation expects more asbestos-related suits to be filed against it and Amchem in the future, and will aggressively defend or reasonably resolve, as appropriate, both pending and future claims.
The table below provides information regarding asbestos-related claims filed against the Corporation and Amchem:
Plaintiffs’ lawyers often sue dozens or even hundreds of defendants in individual lawsuits on behalf of hundreds or even thousands of claimants. As a result, the damages alleged are not expressly identified as to UCC, Amchem or any other particular defendant, even when specific damages are alleged with respect to a specific disease or injury. In fact, there are no personal injury cases in which only the Corporation and/or Amchem are the sole named defendants. For these reasons and based upon the Corporation’s litigation and settlement experience, the Corporation does not consider the damages alleged against it and Amchem to be a meaningful factor in its determination of any potential asbestos liability.
Estimating the Liability
Based on a study completed by Analysis, Research & Planning Corporation (“ARPC”) in January 2003, the Corporation increased its December 31, 2002 asbestos-related liability for pending and future claims for the 15-year period ending in 2017 to $2.2 billion, excluding future defense and processing costs. Since then, the Corporation has compared current asbestos claim and resolution activity to the results of the most recent ARPC study at each balance sheet date to determine whether the accrual continues to be appropriate.
In November 2004, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2003 study. In January 2005, ARPC provided the Corporation with a report summarizing the results of its study. At December 31, 2004, the recorded asbestos-related liability for pending and future claims was $1.6 billion. Based on the low end of the range in the January 2005 study, the recorded asbestos-related liability for pending and future claims at December 31, 2004 would be sufficient to resolve asbestos-related claims against UCC and Amchem into 2019. As in its January 2003 study, ARPC did provide estimates for a longer period of
time in its January 2005 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
In November 2005, the Corporation requested ARPC to review the Corporation’s 2005 asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2005. In January 2006, ARPC stated that an update of its study would not provide a more likely estimate of future events than the estimate reflected in its study of the previous year and, therefore, the estimate in that study remained applicable. At December 31, 2005, the recorded asbestos-related liability for pending and future claims was $1.5 billion. Based on the Corporation’s own review of the asbestos claim and resolution activity and ARPC’s response, the Corporation determined that no change to the accrual was required at December 31, 2005.
In November 2006, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2006 and concluded that the experience from 2004 through 2006 was sufficient for the purpose of forecasting future filings and values of asbestos claims filed against UCC and Amchem, and could be used in place of previous assumptions to update its January 2005 study. The resulting study, completed by ARPC in December 2006, stated that the undiscounted cost of resolving pending and future asbestos-related claims against UCC and Amchem, excluding future defense and processing costs, through 2021 was estimated to be between approximately $1.2 billion and $1.5 billion. As in its January 2005 study, ARPC provided estimates for a longer period of time in its December 2006 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
Based on ARPC’s December 2006 study and the Corporation’s own review of the asbestos claim and resolution activity, the Corporation decreased its asbestos-related liability for pending and future claims to $1.2 billion at December 31, 2006 which will now cover the 15-year period ending in 2021 (excluding future defense and processing costs). The reduction was $177 million and is shown as “Asbestos-related credit” in the consolidated statements of income.
At December 31, 2006, approximately 25 percent of the recorded liability related to pending claims and approximately 75 percent related to future claims. At December 31, 2005, approximately 39 percent of the recorded liability related to pending claims and approximately 61 percent related to future claims.
Defense and Resolution Costs
The following table provides information regarding defense and resolution costs related to asbestos-related claims filed against the Corporation and Amchem:
Defense and Resolution Costs
The average resolution payment per asbestos claimant and the rate of new claim filings has fluctuated both up and down since the beginning of 2001. Union Carbide’s management expects such fluctuations to continue in the future based upon a number of factors, including the number and type of claims settled in a particular period, the jurisdictions in which such claims arose, and the extent to which any proposed legislative reform related to asbestos litigation is being considered.
The Corporation expenses defense costs as incurred. The pretax impact for defense and resolution costs, net of insurance, was $45 million in 2006, $75 million in 2005 and $82 million in 2004, and was reflected in “Cost of sales.”
Insurance Receivables
At December 31, 2002, the Corporation increased the receivable for insurance recoveries related to its asbestos liability to $1.35 billion, substantially exhausting its asbestos product liability coverage. The insurance receivable related to the asbestos liability was determined after a thorough review of applicable insurance policies and the 1985 Wellington Agreement, to which the Corporation and many of its liability insurers are signatory parties, as well as other insurance settlements, with due consideration given to applicable deductibles, retentions and policy limits, and taking into account the solvency and historical payment experience of various insurance carriers. The Wellington Agreement and other agreements with insurers are designed to facilitate an orderly resolution and collection of the Corporation’s insurance policies and to resolve issues that the insurance carriers may raise.
In September 2003, the Corporation filed a comprehensive insurance coverage case, now proceeding in the Supreme Court of the State of New York, County of New York, seeking to confirm its rights to insurance for various asbestos claims and to facilitate an orderly and timely collection of insurance proceeds. This lawsuit was filed against insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place with the Corporation regarding their asbestos-related insurance coverage, in order to facilitate an orderly resolution and collection of such insurance policies and to resolve issues that the insurance carriers may raise. Although the lawsuit is continuing, through the end of 2006, the Corporation reached settlements with several of the carriers involved in this litigation.
The Corporation’s receivable for insurance recoveries related to its asbestos liability was $495 million at December 31, 2006 and $535 million at December 31, 2005. At December 31, 2006, all of the receivable for insurance recoveries ($398 million at December 31, 2005) was related to insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place regarding their asbestos-related insurance coverage.
In addition to the receivable for insurance recoveries related to its asbestos liability, the Corporation had receivables for defense and resolution costs submitted to insurance carriers for reimbursement as follows:
Receivables for Costs Submitted to Insurance Carriers at December 31
After a review of its insurance policies, with due consideration given to applicable deductibles, retentions and policy limits, after taking into account the solvency and historical payment experience of various insurance carriers; existing insurance settlements; and the advice of outside counsel with respect to the applicable insurance coverage law relating to the terms and conditions of its insurance policies, the Corporation continues to believe that its recorded receivable for insurance recoveries from all insurance carriers is probable of collection.
Summary
The amounts recorded for the asbestos-related liability and related insurance receivable described above were based upon current, known facts. However, future events, such as the number of new claims to be filed and/or received each year, the average cost of disposing of each such claim, coverage issues among insurers, and the continuing solvency of various insurance companies, as well as the numerous uncertainties surrounding asbestos litigation in the United States, could cause the actual costs and insurance recoveries to be higher or lower than those projected or those recorded.
Because of the uncertainties described above, management cannot estimate the full range of the cost of resolving pending and future asbestos-related claims facing the Corporation and Amchem. Management believes that it is reasonably possible that the cost of disposing of the Corporation’s asbestos-related claims, including future defense costs, could have a material adverse impact on the results of operations and cash flows for a particular period and on the consolidated financial position of the Corporation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Omitted pursuant to General Instruction I of Form 10-K.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
The Corporation is a wholly owned subsidiary of Dow; consequently there is no public trading market for the Corporation’s common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Omitted pursuant to General Instruction I of Form 10-K.
Union Carbide Corporation and Subsidiaries
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition
and Results of Operation
Pursuant to General Instruction I of Form 10-K “Omission of Information by Certain Wholly-Owned Subsidiaries,” this section includes only management’s narrative analysis of the results of operation for the year ended December 31, 2006, the most recent fiscal year, compared with the year ended December 31, 2005, the fiscal year immediately preceding it.
References below to “Dow” refer to The Dow Chemical Company and its consolidated subsidiaries, except as the context otherwise requires.
The Corporation’s business activities comprise components of Dow’s global operations rather than stand-alone operations. Dow conducts its worldwide operations through global businesses. Because there are no separable reportable business segments for UCC under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and no detailed business information is provided to a chief operating decision maker regarding the Corporation’s stand-alone operations, the Corporation’s results are reported as a single operating segment.
Forward-Looking Information The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements made by or on behalf of Union Carbide Corporation (the “Corporation” or “UCC”). This section covers the current performance and outlook of the Corporation. The forward-looking statements contained in this section and in other parts of this document involve risks and uncertainties that may affect the Corporation’s operations, markets, products, services, prices and other factors as more fully discussed elsewhere and in filings with the U.S. Securities and Exchange Commission (SEC). These risks and uncertainties include, but are not limited to, economic, competitive, legal, governmental and technological factors. Accordingly, there is no assurance that the Corporation’s expectations will be realized. The Corporation assumes no obligation to provide revisions to any forward-looking statements should circumstances change, except as otherwise required by securities and other applicable laws.
Results of Operation
Total net sales for 2006 were $7.5 billion up 18 percent from $6.4 billion in 2005. Sales to Dow in 2006 were $7.0 billion compared with $6.1 billion in 2005. Selling prices to Dow are based on market prices for the related products. Increases in average selling prices occurred for most products in 2006 compared with 2005, including polyethylene, polypropylene, oxo products, and wire and cable products. Volume rebounded solidly from 2005 levels, which had been negatively affected by planned maintenance turnarounds at the Corporation’s two ethylene crackers at its St. Charles Operations in Hahnville, Louisiana, as well as disruptions in production and distribution caused by two hurricanes affecting the U. S. Gulf Coast in the second half of 2005. Total net sales for 2006 were also favorably impacted by significant lump sum technology licensing revenue earned in the first quarter of 2006. Technology licensing revenue varies from period to period due to the nature of the business.
Cost of sales for 2006 increased $873 million compared with 2005, primarily due to an increase in feedstock costs, which was partially offset by the impact of improved operating rates. Gross margin for 2006 was $965 million compared with $698 million for 2005 as increases in selling prices and the impact of higher volume more than offset the higher feedstock costs.
Restructuring charges in 2006 of $14 million included the write-off of the net book value of three manufacturing facilities totaling $10 million (the largest of which was $8 million associated with the shutdown of the peroxymeric chemicals production facility in St. Charles, Louisiana, in October 2006) and costs totaling $4 million related to the dissolution of a consolidated joint venture in China which ceased operations in October 2006 (including $3 million associated with the write-off of the net book value of fixed assets). In 2005, the Corporation recorded a restructuring charge of $11 million for an asset write-off associated with the shutdown of three R&D pilot plants in the South Charleston, West Virginia facility.
In the fourth quarter of 2006, following the completion of a new study to review its asbestos claim and resolution activity, the Corporation decreased its asbestos-related liability for pending and future claims (excluding future defense and processing costs) by $177 million. The reduction is shown as “Asbestos-related credit” in the consolidated statements of income. See Note I to the Consolidated Financial Statements for additional information regarding asbestos-related matters.
Equity in earnings of nonconsolidated affiliates declined from $476 million in 2005 to $395 million in 2006 due primarily to the absence of equity earnings from UOP LLC (“UOP”), which the Corporation exited in the fourth quarter of 2005. In addition, higher reported earnings from Univation Technologies, LLC were offset by lower reported earnings from the Corporation’s other joint ventures in 2006.
On November 30, 2005, the Corporation completed the sale of its indirect 50 percent interest in UOP to a wholly owned subsidiary of Honeywell International, Inc. for a purchase price of $867 million, which resulted in a pretax gain of $637 million.
Sundry income (expense) - net includes a variety of income and expense items such as dividend income, the gain or loss on foreign currency exchange, commissions, charges for management services provided by Dow, and gains and losses on sales of investments and assets. Sundry income (expense) - net for 2006 was net expense of $39 million, compared with net income of $145 million in 2005. Sundry expense for 2006 included dividend income of approximately $35 million from Dow International Holdings Company (“DIHC”). Sundry income for 2005 included a $70 million pretax gain on the sale of a portion of the Corporation’s ownership interest in EQUATE (See Note E to the Consolidated Financial Statements) and dividend income of approximately $118 million (including $86 million from DIHC and $29 million from Dow Chemical Canada Inc.).
Interest income for 2006 was $128 million compared with $29 million in 2005, reflecting a sizeable increase in the level of interest bearing assets in the fourth quarter of 2005, sustained throughout 2006, in addition to higher interest rates. Interest expense and amortization of debt discount for 2006 decreased $17 million compared with 2005, as reduced levels of long-term debt were achieved through the early extinguishment of approximately $436 million of debt, most of which occurred in the first half of 2005.
The provision for income taxes was $420 million in 2006 compared with $496 million in 2005. UCC’s overall effective tax rate was 28.6 percent for 2006, compared with 27.4 percent for 2005. UCC’s effective tax rate fluctuates based on, among other factors, where income is earned, the level of after-tax income from joint ventures, and the level of income relative to available tax credits. The effective tax rate for 2006 was higher than for 2005 principally due to lower earnings from the Corporation’s joint ventures. Since most of the earnings from nonconsolidated affiliates are taxed at the joint venture level, the impact of lower equity earnings increased the Corporation’s overall effective tax rate. In addition, the effective tax rate for 2005 reflected the favorable impact of $29 million of dividend income from Dow Canada in 2005, which was based on previously taxed income. The Corporation is included in Dow’s consolidated federal income tax group and consolidated income tax return. The underlying factors affecting UCC’s overall effective tax rates are summarized in Note N to the Consolidated Financial Statements.
The Corporation reported net income of $1.0 billion for 2006, compared with $1.3 billion for 2005. Although the results for 2006 included higher interest income and the asbestos-related credit discussed above, net income declined from 2005 which included the favorable impact of the gain on the UOP sale and higher dividends from related companies.
OTHER MATTERS
Accounting Changes
See Note A to the Consolidated Financial Statements for a summary of significant accounting policies and recent accounting pronouncements.
Critical Accounting Policies
The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note A to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. Following are the Corporation’s critical accounting policies impacted by judgments, assumptions and estimates:
Litigation
The Corporation is subject to legal proceedings and claims arising out of the normal course of business. The Corporation routinely assesses the likelihood of any adverse judgments or outcomes to these matters, as well as ranges of probable losses. A determination of the amount of the reserves required, if any, for these contingencies is made after thoughtful analysis of each known issue and an actuarial analysis of historical claims experience for incurred but not reported matters. The Corporation has an active risk management program consisting of numerous insurance policies secured from many carriers. These policies provide coverage that is utilized to minimize the impact, if any, of the legal proceedings. The required reserves may change in the future due to new developments in each matter. For further discussion, see Note I to the Consolidated Financial Statements.
Asbestos-Related Matters
The Corporation, and a former subsidiary, Amchem Products, Inc. (“Amchem”), are and have been involved in a large number of asbestos-related suits filed primarily in state courts during the past three decades. Based on a study completed by Analysis, Research & Planning Corporation (“ARPC”) in January 2003, the Corporation increased its December 31, 2002 asbestos-related liability for pending and future claims for the 15-year period ending in 2017 to $2.2 billion, excluding future defense and processing costs. The Corporation also increased the receivable for insurance recoveries related to its asbestos liability to $1.35 billion at December 31, 2002. Since then, the Corporation has compared current asbestos claim and resolution activity to the results of the most recent ARPC study at each balance sheet date to determine whether the accrual continues to be appropriate.
In November 2004, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2003 study. In January 2005, ARPC provided the Corporation with a report summarizing the results of its study. Based on the low end of the range in the January 2005 study, the recorded asbestos-related liability for pending and future claims at December 31, 2004 would be sufficient to resolve asbestos-related claims against UCC and Amchem into 2019.
In November 2005, the Corporation requested ARPC to review the Corporation’s 2005 asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2005. In January 2006, ARPC stated that an update of its study would not provide a more likely estimate of future events than the estimate reflected in its study of the previous year and, therefore, the estimate in that study remained applicable. Based on the Corporation’s own review of the asbestos claim and resolution activity and ARPC’s response, the Corporation determined that no change to the accrual was required. At December 31, 2005, the recorded asbestos-related liability for pending and future claims was $1.5 billion.
In November 2006, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2006 and concluded that the experience from 2004 through 2006 was sufficient for the purpose of forecasting future filings and values of asbestos claims filed against UCC and Amchem, and could be used in place of previous assumptions to update its January 2005 study. The resulting study, completed by ARPC in December 2006, stated that the undiscounted cost of resolving pending and future asbestos-related claims against UCC and Amchem, excluding future defense and processing costs, through 2021 was estimated to be between approximately $1.2 billion and $1.5 billion. As in its January 2005 study, ARPC provided estimates for a longer period of time in its December 2006 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
Based on ARPC’s December 2006 study and the Corporation’s own review of the asbestos claim and resolution activity, the Corporation decreased its asbestos-related liability for pending and future claims to $1.2 billion at December 31, 2006 which will now cover the 15-year period ending in 2021 (excluding future defense and processing costs). The reduction was $177 million and is shown as “Asbestos-related credit” in the consolidated statements of income.
The Corporation’s receivable for insurance recoveries related to its asbestos liability was $495 million at December 31, 2006 and $535 million at December 31, 2005. In addition, the Corporation had receivables of $300 million at December 31, 2006 and $400 million at December 31, 2005 for insurance recoveries for defense and resolution costs.
The amounts recorded by the Corporation for the asbestos-related liability and related insurance receivable were based upon current, known facts. However, future events, such as the number of new claims to be filed and/or received each year, the average cost of disposing of each such claim, coverage issues among insurers, and the continuing solvency of various insurance companies, as well as the numerous uncertainties surrounding asbestos litigation in the United States, could cause the actual costs and insurance recoveries for the Corporation to be higher or lower than those projected or those recorded.
For additional information, see Legal Proceedings, Asbestos-Related Matters in Management’s Discussion and Analysis of Financial Condition and Results of Operation, and Note I to the Consolidated Financial Statements.
Environmental Matters
The Corporation determines the costs of environmental remediation of its facilities and formerly owned facilities based on evaluations of current law and existing technologies. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. The recorded liabilities are adjusted periodically as remediation efforts progress or as additional technical or legal information becomes available. At December 31, 2006, the Corporation had accrued obligations of $77 million for environmental remediation and restoration costs, including $25 million for the remediation of Superfund sites. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Corporation has accrued liabilities, although the ultimate cost with respect to these particular matters could range up to twice that amount. At December 31, 2005, the Corporation had accrued obligations of $87 million for environmental remediation and restoration costs, including $34 million for the remediation of Superfund sites. For further discussion, see Environmental Matters in Management’s Discussion and Analysis of Financial Condition and Results of Operation and Notes A and I to the Consolidated Financial Statements.
Pension and Other Postretirement Benefits
The amounts recognized in the consolidated financial statements related to pension and other postretirement benefits are determined from actuarial valuations. Inherent in these valuations are assumptions including expected return on plan assets, discount rates at which the liabilities could be settled at December 31, 2006, rate of increase in future compensation levels, mortality rates and health care cost trend rates. These assumptions are updated annually and are disclosed in Note K to the Consolidated Financial Statements. In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, affect expense recognized and obligations recorded in future periods.
The Corporation determined the expected long-term rate of return on assets by performing a detailed analysis of historical and expected returns based on the strategic asset allocation and the underlying return fundamentals of each asset class. The Corporation’s historical experience with the pension fund asset performance and comparisons to expected returns of peer companies with similar fund assets were also considered. The long-term rate of return assumption used for determining net periodic pension expense for 2006 was 8.75 percent. This assumption was changed to 8.4 percent for determining 2007 net periodic pension expense. The actual rate of return in 2006 was 11.4 percent. Future actual pension income will depend on future investment performance, changes in future discount rates and various other factors related to the population of participants in the Corporation’s pension plans. A 25 basis point adjustment in the long-term return on assets assumption would change total pension expense for 2007 by approximately $10 million.
The Corporation bases the determination of pension expense or income on a market-related valuation of plan assets, which reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose represent the difference between the expected return calculated using the market-related value of plan assets and the actual return based on the market value of plan assets. Since the market-related value of plan assets recognizes gains or losses over a five-year period, the future value of plan assets will be impacted when previously deferred gains or losses are recorded. Over the life of the plan, both gains and losses have been recognized and amortized. At December 31, 2006, $86 million of net gains remain to be recognized in the calculation of the market-related value of plan assets. These net gains will result in decreases in future pension expense as they are recognized in the market-related value of assets and are a component of the total net loss of $569 million shown under “Amounts recognized in AOCI - pretax” in the table entitled “Change in Projected Benefit Obligations, Plan Assets and Funded Status of all Significant Plans” included in Note K to the Consolidated Financial Statements. The other $655 million of net losses represents cumulative changes in plan experience and actuarial assumptions. The net increase in the market-related value of assets due to the recognition of prior gains and losses is presented in the following table:
Net Increase in Market-Related Asset Value due to
Recognition of Prior Asset Gains and Losses
The discount rates utilized to measure the pension and other postretirement benefit obligations are based on the yield on high quality fixed income investments at the measurement date. Future expected actuarially determined cash flows of the plans are matched against the Citigroup Pension Discount Curve (Above Median) to arrive at a single discount rate by plan. The resulting discount rate increased from 5.65 percent at December 31, 2005, to 5.95 percent at December 31, 2006. A 25 basis point adjustment in the discount rate assumption would change total pension expense for 2007 by approximately $7 million, with an immaterial change on the other postretirement benefit expense due to defined dollar limits (caps).
For 2007, the Corporation maintained its assumption for the long-term rate of increase in compensation levels of 4.5 percent. Since 2002, the Corporation has used a generational mortality table to determine the duration of its pension and other postretirement obligations.
Based on the revised pension assumptions and changes in the market-related value of assets due to the recognition of prior asset gains and losses, the Corporation expects to record $7 million less in income for pension and other postretirement benefits in 2007 than it did in 2006.
The value of the qualified plan assets totaled $4.0 billion at December 31, 2006, an increase of $118 million over the prior year. The increase in the assumed discount rate along with the asset returns increased the funded status of the qualified plan, net of benefit obligations, by $287 million from December 31, 2005 to December 31, 2006. For 2007, the Corporation does not expect to make cash contributions to its pension and other postretirement benefit plans.
Income Taxes
Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. Based on the evaluation of available evidence, both positive and negative, the Corporation recognizes future tax benefits, such as net operating loss carryforwards and tax credit carryforwards, to the extent that realizing these benefits is considered more likely than not.
At December 31, 2006, the Corporation had a net deferred tax asset balance of $156 million, including deferred tax assets for tax loss and tax credit carryforwards of $215 million, of which $7 million is subject to expiration in the years 2007-2011. In order to realize these deferred tax assets for tax loss and tax credit carryforwards, the Corporation needs taxable income of approximately $1.5 billion across multiple jurisdictions. The taxable income needed to realize the deferred tax assets for tax loss and tax credit carryforwards that are subject to expiration between 2007-2011 is $87 million. In evaluating the ability to realize its deferred tax assets, the Corporation relied principally on forecasted taxable income using historical and projected future operating results, the reversal of existing temporary differences and the availability of tax planning strategies.
The Corporation accrues for tax contingencies when it is probable that a liability to a taxing authority has been incurred and the amount of the contingency can be reasonably estimated, based on past experience. The tax contingency reserve is adjusted for changes in circumstances and additional uncertainties, such as significant amendments to existing tax law. At December 31, 2006, the Corporation had a tax contingency reserve for both domestic and foreign issues of $236 million. For additional information, see Note N to the Consolidated Financial Statements.
Environmental Matters
Environmental Policies
The Corporation is committed to the Guiding Principles of Responsible Care®, to environmental, health and safety (“EH&S”) performance improvement and to public accountability. Dow’s EH&S management system (“EMS”), progress made towards the EH&S 2005 Goals, and introduction of new 2015 Sustainability Goals at all UCC sites minimizes environmental risks and impacts, both past and future.
Dow’s EMS defines the “who, what, when and how” needed for the businesses to achieve the policies, requirements, performance objectives, leadership expectations and public commitments. EMS is also designed to minimize the long-term cost of environmental protection and to comply with applicable laws and regulations. Security aspects of EMS were strengthened to require Site Vulnerability Assessments to ensure appropriate safeguards to protect employees and physical assets in a post-September 11th world. Furthermore, EMS is integrated into a company-wide Management System for EH&S, Operations, Quality and Human Resources, including implementation of the global EH&S Work Process to improve EH&S performance and to ensure ongoing compliance worldwide.
UCC first works to eliminate or minimize the generation of waste and emissions at the source through research, process design, plant operations and maintenance. Next, UCC finds ways to reuse and recycle materials. Finally, unusable or non-recyclable hazardous waste is treated before disposal to eliminate or reduce the hazardous nature and volume of the waste. Treatment may include destruction by chemical, physical, biological or thermal means. Disposal of waste materials in landfills
is considered only after all other options have been thoroughly evaluated. UCC has specific requirements for waste that is transferred to non-UCC facilities, including the periodic auditing of these facilities.
In 2005, the next generation of Dow’s 10-year goals were developed, providing continuity to the first set of goals, while also addressing a broader set of challenges. The 2015 Sustainability Goals will set the standard for sustainability in the chemical industry by focusing on improvements in local corporate citizenship and product stewardship, and actively pursuing methods to reduce the Corporation’s environmental impact.
Chemical Security
Growing public and political attention has been placed on protecting U.S. critical infrastructure, including the chemical industry, from security threats. Terrorist attacks and natural disasters have increased concern about the security of chemical production and distribution. The focus on security is not new to UCC and UCC continues to improve its security plans, placing emphasis on the safety of UCC communities and people by being prepared to meet risks at any level and to address both internal and external identifiable risks. UCC’s security plans also are developed to avert interruptions of normal business work operations which could materially and adversely affect the Corporation’s results of operations, liquidity and financial condition.
UCC is a Responsible Care® company and adheres to the Responsible Care® Security Code that requires all aspects of security - including facility, transportation, and cyberspace - be assessed and gaps addressed. Through global implementation of the Security Code, UCC has permanently heightened the level of security - not just in the United States, but worldwide. Assessment and improvement costs are not considered material to the Corporation’s consolidated financial statements. UCC uses a risk-based approach employing the U.S. Government’s Sandia National Labs methodology to repeatedly assess the risks to sites, systems, and processes. UCC has expanded its comprehensive Distribution Risk Review process that had been in place for decades to address potential threats in all modes of transportation across its supply chain. To reduce vulnerabilities, UCC maintains security measures that meet or exceed regulatory and industry security standards in all areas in which UCC operates.
UCC continually works to strengthen partnerships with local responders, law enforcement, and security agencies, and to enhance confidence in the integrity of its security and risk management program as well as strengthen its preparedness and response capabilities. UCC also works closely with its supply chain partners and strives to educate lawmakers, regulators and communities about its resolve and actions to date which are mitigating security and crisis threats.
Climate Change There is growing political and scientific consensus that emissions of greenhouse gases (“GHG”) due to human activities continue to alter the composition of the global atmosphere in ways that are affecting the climate. UCC takes global climate change very seriously and is committed to reducing its GHG intensity (pounds of GHG per pound of product), developing climate-friendly products and processes and, over the longer term, implementing technology solutions to achieve even greater climate change improvements.
Environmental Remediation
UCC accrues the costs of remediation of its facilities and formerly owned facilities based on current law and existing technologies. The nature of such remediation includes, for example, the management of soil and groundwater contamination and the closure of contaminated landfills and other waste management facilities. In the case of landfills and other active waste management facilities, UCC recognizes the costs over the useful life of the facility. The policies adopted to properly reflect the monetary impacts of environmental matters are discussed in Note A to the Consolidated Financial Statements. To assess the impact on the consolidated financial statements, environmental experts review currently available facts to evaluate the probability and scope of potential liabilities. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. These liabilities are adjusted periodically as remediation efforts progress or as additional technical or legal information becomes available. The Corporation had an accrued liability of $52 million at December 31, 2006, compared with $53 million at December 31, 2005, related to the remediation of current or former UCC-owned sites.
In addition to current and former UCC-owned sites, under the Federal Comprehensive Environmental Response, Compensation and Liability Act and equivalent state laws (hereafter referred to collectively as “Superfund Law”), UCC is liable for remediation of other hazardous waste sites where UCC allegedly disposed of, or arranged for the treatment or disposal of, hazardous substances. UCC readily cooperates in the remediation of these sites where the Corporation’s liability is clear, thereby minimizing legal and administrative costs. Because Superfund Law imposes joint and several liability upon each party at a site, UCC has evaluated its potential liability in light of the number of other companies that also have been named potentially responsible parties (“PRPs”) at each site, the estimated apportionment of costs among all PRPs, and the financial ability and commitment of each to pay its expected share. Management’s estimate of the Corporation’s remaining
liability for the remediation of Superfund sites was $25 million at December 31, 2006 and $34 million at December 31, 2005, which has been accrued, although the ultimate cost with respect to these sites could exceed that amount. The Corporation has not recorded any third-party recovery related to these sites as a receivable.
Information regarding environmental sites is provided below:
Environmental Sites
(1) UCC-owned sites are sites currently or formerly owned by UCC, where remediation obligations are imposed (in the United States) by the Resource Conservation Recovery Act or analogous state law.
(2) Superfund sites are sites, including sites not owned by UCC, where remediation obligations are imposed by Superfund Law.
In total, the Corporation’s accrued liability for probable environmental remediation and restoration costs was $77 million at December 31, 2006, compared with $87 million at the end of 2005. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Corporation has accrued liabilities, although the ultimate cost with respect to these particular matters could range up to twice that amount. It is the opinion of management that the possibility is remote that costs in excess of those disclosed will have a material adverse impact on the Corporation’s consolidated financial statements.
The amounts charged to income on a pretax basis related to environmental remediation totaled $23 million in 2006, $19 million in 2005 and $18 million in 2004. Capital expenditures for environmental protection were $25 million in 2006, $26 million in 2005 and $26 million in 2004.
Asbestos-Related Matters
Introduction
The Corporation is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past three decades. These suits principally allege personal injury resulting from exposure to asbestos-containing products and frequently seek both actual and punitive damages. The alleged claims primarily relate to products that UCC sold in the past, alleged exposure to asbestos-containing products located on UCC’s premises, and UCC’s responsibility for asbestos suits filed against a former subsidiary, Amchem Products, Inc. (“Amchem”). In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or that injuries incurred in fact resulted from exposure to the Corporation’s products.
Influenced by the bankruptcy filings of numerous defendants in asbestos-related litigation and the prospects of various forms of state and national legislative reform, the rate at which plaintiffs filed asbestos-related suits against various companies, including the Corporation and Amchem, increased in 2001, 2002 and the first half of 2003. Since then, the rate of filing has significantly abated. The Corporation expects more asbestos-related suits to be filed against it and Amchem in the future, and will aggressively defend or reasonably resolve, as appropriate, both pending and future claims.
The table below provides information regarding asbestos-related claims filed against the Corporation and Amchem:
Plaintiffs’ lawyers often sue dozens or even hundreds of defendants in individual lawsuits on behalf of hundreds or even thousands of claimants. As a result, the damages alleged are not expressly identified as to UCC, Amchem or any other
particular defendant, even when specific damages are alleged with respect to a specific disease or injury. In fact, there are no personal injury cases in which only the Corporation and/or Amchem are the sole named defendants. For these reasons and based upon the Corporation’s litigation and settlement experience, the Corporation does not consider the damages alleged against it and Amchem to be a meaningful factor in its determination of any potential asbestos liability.
Estimating the Liability
Based on a study completed by Analysis, Research & Planning Corporation (“ARPC”) in January 2003, the Corporation increased its December 31, 2002 asbestos-related liability for pending and future claims for the 15-year period ending in 2017 to $2.2 billion, excluding future defense and processing costs. Since then, the Corporation has compared current asbestos claim and resolution activity to the results of the most recent ARPC study at each balance sheet date to determine whether the accrual continues to be appropriate.
In November 2004, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2003 study. In January 2005, ARPC provided the Corporation with a report summarizing the results of its study. At December 31, 2004, the recorded asbestos-related liability for pending and future claims was $1.6 billion. Based on the low end of the range in the January 2005 study, the recorded asbestos-related liability for pending and future claims at December 31, 2004 would be sufficient to resolve asbestos-related claims against UCC and Amchem into 2019. As in its January 2003 study, ARPC did provide estimates for a longer period of time in its January 2005 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
In November 2005, the Corporation requested ARPC to review the Corporation’s 2005 asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2005. In January 2006, ARPC stated that an update of its study would not provide a more likely estimate of future events than the estimate reflected in its study of the previous year and, therefore, the estimate in that study remained applicable. Based on the Corporation’s own review of the asbestos claim and resolution activity and ARPC’s response, the Corporation determined that no change to the accrual was required. At December 31, 2005, the recorded asbestos-related liability for pending and future claims was $1.5 billion.
In November 2006, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2006 and concluded that the experience from 2004 through 2006 was sufficient for the purpose of forecasting future filings and values of asbestos claims filed against UCC and Amchem, and could be used in place of previous assumptions to update its January 2005 study. The resulting study, completed by ARPC in December 2006, stated that the undiscounted cost of resolving pending and future asbestos-related claims against UCC and Amchem, excluding future defense and processing costs, through 2021 was estimated to be between approximately $1.2 billion and $1.5 billion. As in its January 2005 study, ARPC provided estimates for a longer period of time in its December 2006 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
Based on ARPC’s December 2006 study and the Corporation’s own review of the asbestos claim and resolution activity, the Corporation decreased its asbestos-related liability for pending and future claims to $1.2 billion at December 31, 2006 which will now cover the 15-year period ending in 2021 (excluding future defense and processing costs). The reduction was $177 million and is shown as “Asbestos-related credit” in the consolidated statements of income.
At December 31, 2006, approximately 25 percent of the recorded liability related to pending claims and approximately 75 percent related to future claims. At December 31, 2005, approximately 39 percent of the recorded liability related to pending claims and approximately 61 percent related to future claims.
Defense and Resolution Costs
The following table provides information regarding defense and resolution costs related to asbestos-related claims filed against the Corporation and Amchem:
Defense and Resolution Costs
The average resolution payment per asbestos claimant and the rate of new claim filings has fluctuated both up and down since the beginning of 2001. Union Carbide’s management expects such fluctuations to continue in the future based upon a number of factors, including the number and type of claims settled in a particular period, the jurisdictions in which such claims arose, and the extent to which any proposed legislative reform related to asbestos litigation is being considered.
The Corporation expenses defense costs as incurred. The pretax impact for defense and resolution costs, net of insurance, was $45 million in 2006, $75 million in 2005 and $82 million in 2004, and was reflected in “Cost of sales.”
Insurance Receivables
At December 31, 2002, the Corporation increased the receivable for insurance recoveries related to its asbestos liability to $1.35 billion, substantially exhausting its asbestos product liability coverage. The insurance receivable related to the asbestos liability was determined after a thorough review of applicable insurance policies and the 1985 Wellington Agreement, to which the Corporation and many of its liability insurers are signatory parties, as well as other insurance settlements, with due consideration given to applicable deductibles, retentions and policy limits, and taking into account the solvency and historical payment experience of various insurance carriers. The Wellington Agreement and other agreements with insurers are designed to facilitate an orderly resolution and collection of the Corporation’s insurance policies and to resolve issues that the insurance carriers may raise.
In September 2003, the Corporation filed a comprehensive insurance coverage case, now proceeding in the Supreme Court of the State of New York, County of New York, seeking to confirm its rights to insurance for various asbestos claims and to facilitate an orderly and timely collection of insurance proceeds. This lawsuit was filed against insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place with the Corporation regarding their asbestos-related insurance coverage, in order to facilitate an orderly resolution and collection of such insurance policies and to resolve issues that the insurance carriers may raise. Although the lawsuit is continuing, through the end of 2006, the Corporation reached settlements with several of the carriers involved in this litigation.
The Corporation’s receivable for insurance recoveries related to its asbestos liability was $495 million at December 31, 2006 and $535 million at December 31, 2005. At December 31, 2006, all of the receivable for insurance recoveries ($398 million at December 31, 2005) was related to insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place regarding their asbestos-related insurance coverage.
In addition to the receivable for insurance recoveries related to its asbestos liability, the Corporation had receivables for defense and resolution costs submitted to insurance carriers for reimbursement as follows:
Receivables for Costs Submitted to Insurance Carriers
at December 31
After a review of its insurance policies, with due consideration given to applicable deductibles, retentions and policy limits, after taking into account the solvency and historical payment experience of various insurance carriers; existing insurance settlements; and the advice of outside counsel with respect to the applicable insurance coverage law relating to the terms and conditions of its insurance policies, the Corporation continues to believe that its recorded receivable for insurance recoveries from all insurance carriers is probable of collection.
Summary
The amounts recorded for the asbestos-related liability and related insurance receivable described above were based upon current, known facts. However, future events, such as the number of new claims to be filed and/or received each year, the average cost of disposing of each such claim, coverage issues among insurers, and the continuing solvency of various insurance companies, as well as the numerous uncertainties surrounding asbestos litigation in the United States, could cause the actual costs and insurance recoveries to be higher or lower than those projected or those recorded.
Because of the uncertainties described above, management cannot estimate the full range of the cost of resolving pending and future asbestos-related claims facing the Corporation and Amchem. Management believes that it is reasonably possible that the cost of disposing of the Corporation’s asbestos-related claims, including future defense costs, could have a material adverse impact on the results of operations and cash flows for a particular period and on the consolidated financial position of the Corporation.
Union Carbide Corporation and Subsidiaries
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
UCC’s business operations give rise to market risk exposure due to changes in foreign exchange rates and interest rates. To manage such risks effectively, the Corporation can enter into hedging transactions, pursuant to established guidelines and policies, which enable it to mitigate the adverse effects of financial market risk. The Corporation does not hold derivative financial instruments for trading purposes.
As a result of investments, production facilities and other operations on a global basis, the Corporation has assets, liabilities and cash flows in currencies other than the U.S. dollar. The primary objective of the Corporation’s foreign exchange risk management is to optimize the U.S. dollar value of net assets and cash flows, keeping the adverse impact of currency movements to a minimum. To achieve this objective, the Corporation will hedge, when appropriate, on a net exposure basis using foreign currency forward contracts, over-the-counter option contracts, cross-currency swaps and nonderivative instruments in foreign currencies. Main exposures are related to assets, liabilities and cash flows denominated in the currencies of Europe, Asia Pacific and Canada.
The main objective of interest rate risk management is to reduce the total funding cost to the Corporation and to alter the interest rate exposure to the desired risk profile. The Corporation’s primary exposure is to the U.S. dollar yield curve. UCC will use interest rate swaps and “swaptions,” when appropriate, to accomplish this objective.
UCC uses value at risk (“VAR”), stress testing and scenario analysis for risk measurement and control purposes. VAR estimates the potential gain or loss in fair market values, given a certain move in prices over a certain period of time, using specified confidence levels. On an ongoing basis, the Corporation estimates the maximum gain or loss that could arise in one day, given a two-standard-deviation move in the respective price levels. These amounts are relatively insignificant in comparison to the size of the equity of the Corporation. The VAR methodology used by UCC is based primarily on the variance/covariance statistical model. The year-end VAR and average daily VAR for 2006 and 2005 are shown below:
Total Daily VAR at December 31*
*Using a 95 percent confidence level
See Notes G and M to the Consolidated Financial Statements for further disclosure regarding market risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholder of Union Carbide Corporation:
We have audited the accompanying consolidated balance sheets of Union Carbide Corporation and subsidiaries (the “Corporation”) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholder’s equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15 (a) 2. These financial statements and financial statement schedule are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Union Carbide Corporation and subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Notes A and K to the consolidated financial statements, effective December 31, 2006, Union Carbide Corporation changed its method of accounting for defined benefit pension and other postretirement plans to conform to Statement of Financial Accounting Standards No. 158.
/s/ DELOITTE & TOUCHE LLP
DELOITTE & TOUCHE LLP
Midland, Michigan
February 14, 2007
Union Carbide Corporation and Subsidiaries
Consolidated Statements of Income
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Consolidated Balance Sheets
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Consolidated Balance Sheets
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Consolidated Statements of Cash Flows
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Consolidated Statements of Stockholder’s Equity
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Consolidated Statements of Comprehensive Income
See Notes to the Consolidated Financial Statements.
Union Carbide Corporation and Subsidiaries
Notes to the Consolidated Financial Statements
NOTE A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS
Principles of Consolidation and Basis of Presentation
Except as otherwise indicated by the context, the terms “Corporation” and “UCC” as used herein mean Union Carbide Corporation and its consolidated subsidiaries. The accompanying consolidated financial statements of the Corporation were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and include the assets, liabilities, revenues and expenses of all majority-owned subsidiaries over which the Corporation exercises control and, when applicable, entities for which the Corporation has a controlling financial interest. Intercompany transactions and balances are eliminated in consolidation. Investments in nonconsolidated affiliates (20-50 percent owned companies, joint ventures and partnerships) are accounted for on the equity basis.
The Corporation is a wholly owned subsidiary of The Dow Chemical Company (“Dow”). In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share,” the presentation of earnings per share is not provided, as it is not required in financial statements of wholly owned subsidiaries.
The Corporation’s business activities comprise components of Dow’s global operations rather than stand-alone operations. The Corporation sells its products to Dow at market-based prices, in accordance with Dow’s longstanding intercompany pricing policy, in order to simplify the customer interface process. Dow conducts its worldwide operations through global businesses. Because there are no separable reportable business segments for UCC under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and no detailed business information is provided to a chief operating decision maker regarding the Corporation’s stand-alone operations, the Corporation’s results are reported as a single operating segment.
Certain reclassifications of prior years’ amounts have been made to conform to the presentation adopted for 2006.
Related Companies
Transactions with the Corporation’s parent company, Dow, or other Dow subsidiaries have been reflected as related company transactions in the consolidated financial statements. See Note M for further discussion.
Use of Estimates in Financial Statement Preparation
The preparation of financial statements in accordance with U.S. GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. The Corporation’s consolidated financial statements include amounts that are based on management’s best estimates and judgments. Actual results could differ from those estimates.
Foreign Currency Translation
While the Corporation’s consolidated subsidiaries are primarily based in the United States, the Corporation has small subsidiaries in Asia Pacific. For those subsidiaries, the local currency has been primarily used as the functional currency. Translation gains and losses of those operations that use local currency as the functional currency are included in the consolidated balance sheets in “Accumulated other comprehensive income (loss)” (“AOCI”). Where the U.S. dollar is used as the functional currency, foreign currency gains and losses are reflected in income.
Environmental Matters
Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and existing technologies. These accruals are adjusted periodically as assessment and remediation efforts progress or as additional technical or legal information becomes available. Accruals for environmental liabilities are included in the consolidated balance sheets in “Other noncurrent obligations” at undiscounted amounts.
Environmental costs are capitalized if the costs extend the life of the property, increase its capacity, and/or mitigate or prevent contamination from future operations. Costs related to environmental contamination treatment and cleanup are charged to expense. Estimated future incremental operations, maintenance and management costs directly related to remediation are accrued when such costs are probable and reasonably estimable.
Cash and Cash Equivalents
Cash and cash equivalents include time deposits and readily marketable securities with original maturities of three months or less.
Financial Instruments
The Corporation calculates the fair value of financial instruments using quoted market prices whenever available. When quoted market prices are not available for various types of financial instruments (such as forwards, options and swaps), the Corporation uses standard pricing models with market-based inputs, which take into account the present value of estimated future cash flows.
The Corporation utilizes derivative instruments to manage exposures to currency exchange rates. The fair values of all derivative instruments are recognized as assets or liabilities at the balance sheet date. Changes in the fair value of these instruments are reported in income or AOCI, depending on the use of the derivative and whether it qualifies for hedge accounting treatment under the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended.
Inventories
Inventories are stated at the lower of cost or market. On January 1, 2006, the Corporation began using the normal capacity of its production facilities as defined by SFAS No. 151, “Inventory Costs - an amendment of ARB No. 43, Chapter 4,” to calculate per unit costs of inventories. Prior to 2006, the Corporation used nameplate capacity. By subsidiary, the method of determining cost varies among last-in, first-out (“LIFO”); first-in, first-out (“FIFO”); and average cost, and is used consistently from year to year.
Property
Land, buildings and equipment are carried at cost less accumulated depreciation. Depreciation is based on the estimated service lives of depreciable assets and is provided using the straight-line method. Beginning in mid-2001, the Corporation changed the estimated useful lives assigned to newly acquired assets to conform to the estimated useful lives assigned by Dow to similar assets. No change was made to the estimated lives of assets acquired prior to 2001. Fully depreciated assets are retained in property and accumulated depreciation accounts until they are removed from service. In the case of disposals, assets and related accumulated depreciation are removed from the accounts, and the net amounts, less proceeds from disposal, are included in income.
Impairment and Disposal of Long-Lived Assets
The Corporation evaluates long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When the undiscounted future cash flows are not expected to be sufficient to recover an asset’s carrying amount, the asset is written down to its fair value. Long-lived assets to be disposed of other than by sale are classified as held and used until they are disposed of. Long-lived assets to be disposed of by sale are classified as held for sale and are reported at the lower of carrying amount or fair value less cost to sell, and depreciation is ceased.
Investments in Related Companies
Investments in related companies consist of the Corporation’s ownership interests in Dow subsidiaries located in Europe and Latin America. Investments in the Dow subsidiaries have been accounted for using the cost method.
Investments
Investments in debt and marketable equity securities are classified as either trading, available-for-sale, or held-to-maturity. Investments classified as trading are reported at fair value with unrealized gains and losses included in income. Those classified as available-for-sale are reported at fair value with unrealized gains and losses recorded in AOCI. Those classified as held-to-maturity are recorded at amortized cost. The cost of investments sold is determined by specific identification.
The excess of the cost of investments in subsidiaries over the values assigned to assets and liabilities is shown as goodwill and is subject to the impairment provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Absent any impairment indicators, recorded goodwill is tested for impairment in conjunction with the annual budgeting process by comparing the fair value of each reporting unit, determined using a discounted cash flow method, with its carrying value.
Revenue
Substantially all of the Corporation’s revenues are from transactions with Dow. Sales are recognized when the revenue is realized or realizable, and has been earned, in accordance with the U.S. Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition in Financial Statements.” Approximately 93 percent of the Corporation’s sales are related to sales of product, while 7 percent is related to the licensing of patents and technology.
Revenue for product sales is recognized as risk and title to the product transfer to the customer, which for trade sales, usually occurs at the time shipment is made. Substantially all of the Corporation’s trade sales are sold F.O.B (free on board) shipping point or, with respect to countries other than the United States, an equivalent basis. Title to the product for trade sales passes when the product is delivered to the freight carrier. UCC’s standard terms of delivery are included in its contracts of sale, order confirmation documents, and invoices. Freight costs and any directly related associated costs of transporting finished product are recorded as “Cost of sales.”
Revenue for product sales to related companies is recognized as risk and title to the product transfer to the related company, which occurs either at the time production is complete or F.O.B Supplier’s (UCC’s) manufacturing facility, in accordance with the sales agreement between the Corporation and Dow. Revenue related to the initial licensing of patents and technology is recognized when earned; revenue related to running royalties is recognized according to licensee production levels.
Legal Costs
The Corporation expenses legal costs, including those legal costs expected to be incurred in connection with a loss contingency, as incurred.
Severance Costs
Management routinely reviews its operations around the world in an effort to ensure competitiveness across its businesses and geographic areas. When the reviews result in a workforce reduction related to the shutdown of facilities or other optimization activities, severance benefits are provided to employees primarily under ongoing benefit arrangements. These severance costs are accrued (under SFAS No. 112, “Employers’ Accounting for Postemployment Benefits - an amendment of FASB Statements No. 5 and 43”) once management commits to a plan of termination including the number of employees to be terminated, their job classification or functions, their location(s) and the expected completion date.
Income Taxes
The Corporation accounts for income taxes using the asset and liability method. Under this method deferred tax assets and liabilities are recognized for the future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities using enacted rates.
Annual tax provisions include amounts considered sufficient to pay assessments that may result from examinations of prior year tax returns; however, the amount ultimately paid upon resolution of issues raised may differ from the amounts accrued. The Corporation accrues for tax contingencies when it is probable that a liability to a taxing authority has been incurred and the amount of the contingency can be reasonably estimated. Provision is made for taxes on undistributed earnings of foreign subsidiaries and related companies to the extent that such earnings are not deemed to be permanently invested.
The Corporation is included in Dow’s consolidated federal income tax group and consolidated income tax return. The Corporation uses the separate return method to account for its income taxes; accordingly, there is no difference between the method used to account for income taxes at the UCC level and the formula in the Dow-UCC Tax Sharing Agreement used to compute the amount due to Dow or UCC for UCC’s share of taxable income and tax attributes on Dow’s consolidated income tax return.
RECENT ACCOUNTING PRONOUNCEMENTS
Accounting for Conditional Asset Retirement Obligations
In March 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 47, “Accounting for Conditional Asset Retirement Obligations,” which clarifies the term conditional asset retirement obligation as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the Corporation. FIN No. 47 was effective no later than the end of fiscal years ending after December 15, 2005.
The Corporation has 15 manufacturing sites in six countries. Most of these sites contain numerous individual manufacturing operations, particularly at the Corporation’s larger sites. Asset retirement obligations are recorded in the period in which they are incurred and reasonably estimable, including those obligations for which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the Corporation. Retirement of assets may involve such efforts as remediation and treatment of asbestos, contractually required demolition, and other related activities, depending on the nature and location of the assets, and are typically realized only upon demolition of those facilities. In identifying asset retirement obligations, the Corporation considers identification of legally enforceable obligations, changes in existing law, estimates of potential settlement dates and the calculation of an
appropriate discount rate to be used in calculating the fair value of the obligations. The Corporation has a well-established global process to identify, approve and track the demolition of retired or to-be-retired facilities; no assets are retired from service until this process has been followed. The Corporation typically forecasts demolition projects based on the usefulness of the assets; environmental, health and safety concerns; and other similar considerations. Under this process, as demolition projects are identified and approved, reasonable estimates may then be determined for the time frames during which any related asset retirement obligations are expected to be settled. For those assets where a range of potential settlement dates may be reasonably estimated, obligations are recorded.
Assets that have not been submitted/reviewed for potential demolition activities are considered to have continued usefulness and are generally still operating “normally.” Therefore, without a plan to demolish the assets or the expectation of a plan, such as shortening the useful life of assets for depreciation purposes under the requirements of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Corporation is unable to reasonably forecast a time frame to use for present value calculations. As such, the Corporation has not recognized obligations for individual plants/buildings at its 15 manufacturing sites where estimates of potential settlement dates cannot be reasonably made. The Corporation routinely reviews all changes to the list of items under consideration for demolition to determine if an adjustment to the value of the asset retirement obligation is required.
Adoption of FIN No. 47 on December 31, 2005 resulted in the recognition of an asset retirement obligation of $12 million and a charge of $8 million (net of tax of $4 million), which was included in “Cumulative effect of change in accounting principle” in the fourth quarter of 2005. The discount rate used to calculate the Corporation’s asset retirement obligations was 4.6 percent.
If the conditional asset retirement obligation measurement and recognition provisions of FIN No. 47 had been in effect on January 1, 2005, the aggregate carrying amount of those obligations on that date would have been $12 million. If the amortization of asset retirement cost and accretion of asset retirement obligation provisions of FIN No. 47 had been in effect during 2005, the impact on “Net Income Available to Common Stockholder” would have been immaterial.
In accordance with FIN No. 47, the Corporation has recognized conditional asset retirement obligations related to asbestos encapsulation as a result of planned demolition and remediation activities at manufacturing and administrative sites in the United States. The aggregate carrying amount of conditional asset retirement obligations was $13 million at December 31, 2006 and $12 million at December 31, 2005. The discount rate used to calculate the Corporation’s asset retirement obligations was 4.6 percent. These obligations are included in the consolidated balance sheets as “Accrued and other current liabilities.”
As described above, the Corporation has not recognized conditional asset retirement obligations for which a fair value cannot be reasonably estimated in its consolidated financial statements. It is the opinion of management that the possibility is remote that such conditional asset retirement obligations, when estimable, will have a material adverse impact on the Corporation’s consolidated financial statements based on current costs.
Other Accounting Pronouncements
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs - an amendment of ARB No. 43, Chapter 4,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and also requires that the allocation of fixed production overhead be based on the normal capacity of the production facilities. SFAS No. 151 was effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Because the Corporation previously used nameplate capacity to calculate product costs, adoption of SFAS No. 151 on January 1, 2006 had an immaterial favorable impact on the Corporation’s consolidated financial statements.
On January 1, 2006, Dow adopted revised SFAS No. 123R, “Share-Based Payment.” The Corporation will continue to be allocated the portion of expense relating to its employees who receive stock-based compensation, which was $7 million in 2006, $8 million in 2005 and $10 million in 2004.
In December 2004, the FASB issued FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which provides a practical exception to the SFAS No. 109, “Accounting for Income Taxes,” requirement to reflect the effect of a new tax law in the period of enactment by allowing additional time beyond the financial reporting period to evaluate the effects on plans for reinvestment or repatriation of unremitted foreign earnings. The American Jobs Creation Act of 2004 (the “AJCA”) introduced a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer, provided certain criteria are met. In May 2005, tax authorities released the clarifying language necessary to enable Dow to complete its determination regarding the repatriation and reinvestment of foreign earnings. In December 2005, Dow repatriated funds from a foreign entity that is partially owned by the Corporation. Since the Corporation is included in Dow’s consolidated federal income tax group and consolidated tax return, the Corporation recognized an immaterial impact of the repatriation provision of the AJCA, in accordance with the terms of the Dow-UCC Tax Sharing Agreement.
In September 2006, the SEC issued SAB No. 108, which expresses the views of the SEC staff regarding the process of quantifying financial statement misstatements. SAB No. 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The guidance of this SAB is effective for annual financial statements covering the first fiscal year ending after November 15, 2006, which is December 31, 2006 for the Corporation. SAB No. 108 did not have an impact on the Corporation’s consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R).” This Statement, which is effective December 31, 2006 for the Corporation, requires employers to recognize the funded status of defined benefit postretirement plans as an asset or liability on the balance sheet and to recognize changes in that funded status through comprehensive income. SFAS No. 158 also establishes the measurement date of plan assets and obligations as the date of the employer’s fiscal year end, and provides for additional annual disclosures. UCC currently uses a December 31 measurement date for all of its plans, consistent with its fiscal year end. See Note K for the impact of adopting this Statement.
SAB No. 74 Disclosures for Accounting Standards Issued But Not Yet Adopted
In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109.This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Corporation is included in Dow’s consolidated federal income tax group and consolidated tax return. Pending further guidance from the FASB, the Corporation expects to increase liabilities and reduce retained earnings $25-$75 million due to the adoption of this interpretation in the first quarter of 2007.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements and is effective for fiscal years beginning after November 15, 2007. The Corporation is currently evaluating the impact of adopting this Statement.
NOTE B RESTRUCTURING
2006 Restructuring
In 2006, the Corporation recorded restructuring charges totaling $14 million (shown as “Restructuring charges” in the consolidated statements of income) resulting from decisions made by management in the third quarter to improve the competitiveness of its global operations. The decisions resulted in the write-off of the net book value of three manufacturing facilities totaling $10 million (the largest of which was $8 million associated with the shutdown of the peroxymeric chemicals production facility in St. Charles, Louisiana, in October 2006), and costs totaling $4 million related to the dissolution of a consolidated joint venture in China which ceased operations in October 2006 (including $3 million associated with the write-off of the net book value of fixed assets).
2005 Restructuring
In the fourth quarter of 2005, the Corporation made certain decisions regarding non-strategic assets. These decisions resulted in the write-off of the net book value of three research and development pilot plants in the South Charleston, West Virginia facility totaling $11 million and included in “Restructuring charges” in the consolidated statements of income.
2004 Restructuring
In the second quarter of 2004, the Corporation recorded restructuring charges totaling $48 million resulting from decisions made by management in the second quarter relative to employment levels as Dow restructured its business organization and as the Corporation finalized plans for additional plant shutdowns and divestitures. The resulting asset impairments totaling $18 million related to the shutdown of a latex manufacturing facility ($8 million) and the pending sale of a marine terminal ($10 million), and were included in “Restructuring charges.” The sale of the marine terminal was completed in the third quarter of 2004.
The charges also included severance of $21 million for a workforce reduction of approximately 360 people, most of whom ended their employment with UCC by the end of the third quarter of 2004, and curtailment costs of $9 million associated with UCC’s defined benefit plans (see Note K).
In the second quarter of 2005, the estimated workforce reduction was revised to reflect employee redeployment and the severance accrual was reduced by $2 million (reflected in “Cost of sales”). As of December 31, 2005, the Corporation’s workforce had been reduced by 349 people due to this restructuring and severance of $19 million had been paid, bringing the 2004 employee-related restructuring program to a close.
NOTE C INVENTORIES
The following table provides a breakdown of inventories:
Inventories at December 31
The reserves reducing inventories from a FIFO basis to a LIFO basis amounted to $160 million at December 31, 2006 and $164 million at December 31, 2005. The inventories that were valued on a LIFO basis, principally U.S. chemicals and plastics product inventories, represented 44 percent of the total inventories at December 31, 2006 and 41 percent of the total inventories at December 31, 2005.
In 2005, a reduction of certain inventories resulted in the liquidation of some of the Corporation’s LIFO inventory layers, which increased pretax income $4 million.
NOTE D PROPERTY
NOTE E NONCONSOLIDATED AFFILIATES
The Corporation’s investments in related companies accounted for by the equity method (“nonconsolidated affiliates”) were $896 million at December 31, 2006 and $887 million at December 31, 2005. At December 31, 2006, the Corporation’s investment in EQUATE Petrochemical Company K.S.C. (“EQUATE”) was $17 million less than its proportionate share of the underlying net assets (and $34 million less at December 31, 2005). This amount represents the difference between EQUATE’s value of certain assets and the Corporation’s related valuation on a U.S. GAAP basis and as such is being amortized over the remaining useful life of those assets.
In November 2004, the Corporation sold a 2.5 percent interest in EQUATE to National Bank of Kuwait for $104 million. In March 2005, these shares were sold to private Kuwaiti investors thereby completing the restricted transfer and reducing
the Corporation’s ownership interest from 45 percent to 42.5 percent. A pretax gain of $70 million was recorded in the first quarter of 2005 related to the sale of these shares.
On November 30, 2005, the Corporation completed the sale of its indirect 50 percent interest in UOP LLC (“UOP”) to a wholly owned subsidiary of Honeywell International, Inc. for a purchase price of $867 million, resulting in a pretax gain of $637 million in the fourth quarter of 2005.
UCC’s principal nonconsolidated affiliates and the Corporation’s ownership interest for each at December 31, 2006, 2005 and 2004 are shown below:
Principal Nonconsolidated Affiliates at December
The Corporation’s investment in the principal nonconsolidated affiliates was $887 million at December 31, 2006 and $876 million at December 31, 2005, and its equity in their earnings was $385 million in 2006, $473 million in 2005 and $577 million in 2004. All of the nonconsolidated affiliates in which the Corporation has investments are privately held companies; therefore, quoted market prices are not available. The summarized financial information presented below represents the combined accounts (at 100 percent) of the principal nonconsolidated affiliates.
Summarized Balance Sheet Information at December
Summarized Income Statement Information
(1) The summarized income statement information for 2005 includes the results for UOP from January 1, 2005 through November 30, 2005.
Dividends received from nonconsolidated affiliates were $371 million in 2006, $366 million in 2005 and $157 million in 2004. The Corporation has received distributions of capital from certain nonconsolidated affiliates which resulted in corresponding reductions in the Corporation’s investment in those nonconsolidated affiliates, but did not affect the Corporation’s ownership percentages. In 2006, a distribution of $4 million was received from Nippon Unicar and distributions totaling $41 million were received from Nippon Unicar and the OPTIMAL Group in 2005.
Undistributed earnings of nonconsolidated affiliates included in retained earnings were $441 million at December 31, 2006 and $485 million at December 31, 2005.
NOTE F GOODWILL AND OTHER INTANGIBLE ASSETS
During the fourth quarter of 2006, impairment tests for goodwill were performed in conjunction with the annual budgeting process. As a result of this review, it was determined that no goodwill impairments existed.
The following table provides information regarding the Corporation’s other intangible assets:
Other Intangible Assets at December 31
During 2006, the Corporation acquired software for $4 million. The weighted-average amortization period for the acquired software is five years.
The following table provides information regarding amortization expense:
Amortization Expense
Total estimated amortization expense for the next five fiscal years is as follows:
Estimated Amortization Expense
for Next Five Years
NOTE G FINANCIAL INSTRUMENTS
Investments
The Corporation’s investments in marketable securities are classified as available-for-sale. The Corporation’s investments in debt securities had contractual maturities of one to five years at December 31, 2006.
Investing Results
Fair Value of Financial Instruments at December 31
Cost approximates fair value for all other financial instruments.
The Corporation enters into foreign exchange forward contracts to hedge various currency exposures, primarily related to assets and liabilities denominated in foreign currencies. The primary business objective of the activity is to optimize the U.S. dollar value of the Corporation’s assets and liabilities. Assets and liabilities denominated in the same foreign currency are netted, and only the net exposure is hedged. At December 31, 2006, the Corporation had forward contracts to buy, sell or exchange foreign currencies, with expiration dates in the first quarter of 2007, which were immaterial. The Corporation did not designate any derivatives as hedges at December 31, 2006 and 2005.
During the three-year period ended December 31, 2006, nonconsolidated affiliates of the Corporation had hedging activities that were accounted for as cash flow hedges in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted. The Corporation’s proportionate share of the hedging results recorded in accumulated other comprehensive income by the nonconsolidated affiliates was reported as net hedging results in the Corporation’s Consolidated Statements of Stockholder’s Equity in accordance with SFAS No. 130, “Reporting Comprehensive Income.”
NOTE H SUPPLEMENTARY INFORMATION
Accrued and Other Current Liabilities
“Accrued and other current liabilities” were $172 million at December 31, 2006 and $235 million at December 31, 2005. Postretirement benefit obligation, which is a component of “Accrued and other current liabilities,” was $56 million at December 31, 2006 and $63 million at December 31, 2005. No other accrued liabilities were more than 5 percent of total current liabilities.
Other Noncurrent Obligations
“Other noncurrent obligations” were $407 million at December 31, 2006 and $361 million at December 31, 2005. Tax contingency reserve, which is a component of “Other noncurrent obligations,” was $211 million at December 31, 2006 and $131 million at December 31, 2005. No other noncurrent obligations were more than 5 percent of total liabilities.
Sundry Income (Expense) - Net
Other Supplementary Information
(1) Included in “Selling, general and administrative expenses” in the consolidated statements of income.
NOTE I COMMITMENTS AND CONTINGENT LIABILITIES
Environmental Matters
Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and existing technologies. At December 31, 2006, the Corporation had accrued obligations of $77 million for environmental remediation and restoration costs, including $25 million for the remediation of Superfund sites. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Corporation has accrued liabilities, although the ultimate cost with respect to these particular matters could range up to twice that amount. Inherent uncertainties exist in these estimates primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies for handling site remediation and restoration. At December 31, 2005, the Corporation had accrued obligations of $87 million for environmental remediation and restoration costs, including $34 million for the remediation of Superfund sites. It is the opinion of the Corporation’s management that the possibility is remote that costs in excess of those disclosed will have a material adverse impact on the Corporation’s consolidated financial statements.
The following table summarizes the activity in the Corporation’s accrued obligations for environmental matters for the years ended December 31, 2006 and 2005:
Accrued Liability for Environmental Matters
The amounts charged to income on a pretax basis related to environmental remediation totaled $23 million in 2006, $19 million in 2005 and $18 million in 2004. Capital expenditures for environmental protection were $25 million in 2006 and $26 million in 2005 and 2004.
Litigation
The Corporation and its subsidiaries are involved in a number of legal proceedings and claims with both private and governmental parties. These cover a wide range of matters, including, but not limited to: product liability; trade regulation; governmental regulatory proceedings; health, safety and environmental matters; employment; patents; contracts; taxes; and commercial disputes.
Separately, the Corporation is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past three decades. These suits principally allege personal injury resulting from exposure to asbestos-containing products and frequently seek both actual and punitive damages. The alleged claims primarily relate to products that UCC sold in the past, alleged exposure to asbestos-containing products located on UCC’s premises, and UCC’s responsibility for asbestos suits filed against a former subsidiary, Amchem Products, Inc. (“Amchem”). In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or that injuries incurred in fact resulted from exposure to the Corporation’s products.
Influenced by the bankruptcy filings of numerous defendants in asbestos-related litigation and the prospects of various forms of state and national legislative reform, the rate at which plaintiffs filed asbestos-related suits against various companies, including the Corporation and Amchem, increased in 2001, 2002 and the first half of 2003. Since then, the rate of filing has significantly abated. The Corporation expects more asbestos-related suits to be filed against it and Amchem in the future, and will aggressively defend or reasonably resolve, as appropriate, both pending and future claims.
Based on a study completed by Analysis, Research & Planning Corporation (“ARPC”) in January 2003, the Corporation increased its December 31, 2002 asbestos-related liability for pending and future claims for the 15-year period ending in 2017 to $2.2 billion, excluding future defense and processing costs. Since then, the Corporation has compared current asbestos claim and resolution activity to the results of the most recent ARPC study at each balance sheet date to determine whether the accrual continues to be appropriate.
In November 2004, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2003 study. In January 2005, ARPC provided the Corporation with a report summarizing the results of its study. At December 31, 2004, the recorded asbestos-related liability for pending and future claims was $1.6 billion. Based on the low end of the range in the January 2005 study, the recorded asbestos-related liability for pending and future claims at December 31, 2004 would be sufficient to resolve asbestos-related claims against UCC and Amchem into 2019. As in its January 2003 study, ARPC did provide estimates for a longer period of
time in its January 2005 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
In November 2005, the Corporation requested ARPC to review the Corporation’s 2005 asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2005. In January 2006, ARPC stated that an update of its study would not provide a more likely estimate of future events than the estimate reflected in its study of the previous year and, therefore, the estimate in that study remained applicable. Based on the Corporation’s own review of the asbestos claim and resolution activity and ARPC’s response, the Corporation determined that no change to the accrual was required. At December 31, 2005, the recorded asbestos-related liability for pending and future claims was $1.5 billion.
In November 2006, the Corporation requested ARPC to review the Corporation’s historical asbestos claim and resolution activity and determine the appropriateness of updating its January 2005 study. In response to that request, ARPC reviewed and analyzed data through October 31, 2006 and concluded that the experience from 2004 through 2006 was sufficient for the purpose of forecasting future filings and values of asbestos claims filed against UCC and Amchem, and could be used in place of previous assumptions to update its January 2005 study. The resulting study, completed by ARPC in December 2006, stated that the undiscounted cost of resolving pending and future asbestos-related claims against UCC and Amchem, excluding future defense and processing costs, through 2021 was estimated to be between approximately $1.2 billion and $1.5 billion. As in its January 2005 study, ARPC provided estimates for a longer period of time in its December 2006 study, but also reaffirmed its prior advice that forecasts for shorter periods of time are more accurate than those for longer periods of time.
Based on ARPC’s December 2006 study and the Corporation’s own review of the asbestos claim and resolution activity, the Corporation decreased its asbestos-related liability for pending and future claims to $1.2 billion at December 31, 2006 which will now cover the 15-year period ending in 2021 (excluding future defense and processing costs). The reduction was $177 million and is shown as “Asbestos-related credit” in the consolidated statements of income.
At December 31, 2006, approximately 25 percent of the recorded liability related to pending claims and approximately 75 percent related to future claims. At December 31, 2005, approximately 39 percent of the recorded liability related to pending claims and approximately 61 percent related to future claims.
At December 31, 2002, the Corporation increased the receivable for insurance recoveries related to its asbestos liability to $1.35 billion, substantially exhausting its asbestos product liability coverage. The insurance receivable related to the asbestos liability was determined after a thorough review of applicable insurance policies and the 1985 Wellington Agreement, to which the Corporation and many of its liability insurers are signatory parties, as well as other insurance settlements, with due consideration given to applicable deductibles, retentions and policy limits, and taking into account the solvency and historical payment experience of various insurance carriers. The Wellington Agreement and other agreements with insurers are designed to facilitate an orderly resolution and collection of the Corporation’s insurance policies and to resolve issues that the insurance carriers may raise.
In September 2003, the Corporation filed a comprehensive insurance coverage case, now proceeding in the Supreme Court of the State of New York, County of New York, seeking to confirm its rights to insurance for various asbestos claims and to facilitate an orderly and timely collection of insurance proceeds. This lawsuit was filed against insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place with the Corporation regarding their asbestos-related insurance coverage, in order to facilitate an orderly resolution and collection of such insurance policies and to resolve issues that the insurance carriers may raise. Although the lawsuit is continuing, through the end of 2006, the Corporation reached settlements with several of the carriers involved in this litigation.
The Corporation’s receivable for insurance recoveries related to its asbestos liability was $495 million at December 31, 2006 and $535 million at December 31, 2005. At December 31, 2006, all of the receivable for insurance recoveries ($398 million at December 31, 2005) was related to insurers that are not signatories to the Wellington Agreement and/or do not otherwise have agreements in place regarding their asbestos-related insurance coverage.
In addition to the receivable for insurance recoveries related to its asbestos liability, the Corporation had receivables for defense and resolution costs submitted to insurance carriers for reimbursement as follows:
Receivables for Costs Submitted to Insurance Carriers at December 31
The Corporation expenses defense costs as incurred. The pretax impact for defense and resolution costs, net of insurance, was $45 million in 2006, $75 million in 2005 and $82 million in 2004, and was reflected in “Cost of sales.”
After a review of its insurance policies, with due consideration given to applicable deductibles, retentions and policy limits, after taking into account the solvency and historical payment experience of various insurance carriers; existing insurance settlements; and the advice of outside counsel with respect to the applicable insurance coverage law relating to the terms and conditions of its insurance policies, the Corporation continues to believe that its recorded receivable for insurance recoveries from all insurance carriers is probable of collection.
The amounts recorded for the asbestos-related liability and related insurance receivable described above were based upon current, known facts. However, future events, such as the number of new claims to be filed and/or received each year, the average cost of disposing of each such claim, coverage issues among insurers, and the continuing solvency of various insurance companies, as well as the numerous uncertainties surrounding asbestos litigation in the United States, could cause the actual costs and insurance recoveries to be higher or lower than those projected or those recorded.
Because of the uncertainties described above, management cannot estimate the full range of the cost of resolving pending and future asbestos-related claims facing the Corporation and Amchem. Management believes that it is reasonably possible that the cost of disposing of the Corporation’s asbestos-related claims, including future defense costs, could have a material adverse impact on the results of operations and cash flows for a particular period and on the consolidated financial position of the Corporation.
While it is not possible at this time to determine with certainty the ultimate outcome of any of the legal proceedings and claims referred to in this filing, management believes that adequate provisions have been made for probable losses with respect to pending claims and proceedings, and that, except for the asbestos-related matters described above, the ultimate outcome of all known and future claims, after provisions for insurance, will not have a material adverse impact on the results of operations, cash flows and consolidated financial position of the Corporation. Should any losses be sustained in connection with any of such legal proceedings and claims in excess of provisions provided and available insurance, they will be charged to income when determinable.
Purchase Commitments
At December 31, 2006, the Corporation had various outstanding commitments for take or pay agreements, with terms extending from one to ten years. Such commitments were not in excess of current market prices. The fixed and determinable portion of obligations under purchase commitments at December 31, 2006 is presented in the following table:
Fixed and Determinable Portion of Take or Pay Obligations
at December 31, 2006
Guarantees
The Corporation has undertaken obligations to guarantee the performance of certain nonconsolidated affiliates (including the OPTIMAL Group and Nippon Unicar Company Limited) and a former subsidiary of the Corporation (via delivery of cash or other assets) if specified triggering events occur. Non-performance under a contract for commercial and/or financial obligations by the guaranteed party would trigger the obligation of the Corporation to make payments to the beneficiary of the guarantees. Financial obligations include debt and lease arrangements.
The following table provides a summary of the final expiration, maximum future payments, and recorded liability reflected in the consolidated balance sheets for these guarantees:
Guarantees
NOTE J NOTES PAYABLE AND LONG-TERM DEBT
Notes payable - related companies consists primarily of a revolving credit agreement with Dow.
Notes Payable at December 31
Long-Term Debt at December 31
Annual Installments on Long-Term Debt
for the Next Five Years
The Corporation’s outstanding public debt has been issued under indentures which contain, among other provisions, covenants that the Corporation must comply with while the underlying notes are outstanding. Such covenants are typical based on the Corporation’s size and financial position and include, subject to the exceptions and qualifications contained in the indentures, obligations not to (i) allow liens on principal U.S. manufacturing facilities, (ii) enter into sale and lease-back transactions with respect to principal U.S. manufacturing facilities, or (iii) merge into or consolidate with any other entity or sell or convey all or substantially all of its assets. Failure of the Corporation to comply with any of these covenants could, after the passage of any applicable grace period, result in a default under the applicable indenture which would allow the note holders to accelerate the due date of the outstanding principal and accrued interest on the subject notes. As of December 31, 2006, the Corporation was in compliance with all of the covenants and default provisions referred to above.
NOTE K PENSION AND OTHER POSTRETIREMENT BENEFITS
Pension Plans
The Corporation has a defined benefit pension plan that covers substantially all employees in the United States. Benefits are based on length of service and the employee’s three highest consecutive years of compensation. The Corporation also has a non-qualified supplemental pension plan.
The Corporation’s funding policy is to contribute to the plans when pension laws and/or economics either require or encourage funding. In 2006, UCC contributed $2 million to its pension plans. In 2007, UCC does not expect to contribute assets to its qualified pension plan.
The weighted-average assumptions used to determine pension plan obligations and net periodic benefit costs are provided below:
Pension Plan Assumptions
The Corporation determined the expected long-term rate of return on assets by performing a detailed analysis of historical and expected returns based on the strategic asset allocation and the underlying return fundamentals of each asset class. The Corporation’s historical experience with the pension fund asset performance is also considered. The discount rates utilized to measure the pension and other postretirement benefit obligations are based on the yield on high quality fixed income investments at the measurement date. Future expected actuarially determined cash flows of the plans are matched against the Citigroup Pension Discount Curve (Above Median) to arrive at a single discount rate by plan.
The accumulated benefit obligation for all defined benefit pension plans was $3.7 billion at December 31, 2006 and $3.8 billion at December 31, 2005.
Pension Plans with Accumulated Benefit Obligations in Excess
of Plan Assets at December 31
Other Postretirement Benefits
The Corporation provides certain health care and life insurance benefits to retired U.S. employees. The plan provides health care benefits, including hospital, physicians’ services, drug and major medical expense coverage, and life insurance benefits. The Corporation and the retiree share the cost of these benefits, with the Corporation portion increasing as the retiree has increased years of credited service, although there is a cap on the Corporation portion. The Corporation has the ability to change these benefits at any time.
The Corporation funds most of the cost of these health care and life insurance benefits as incurred. In 2007, UCC does not expect to contribute assets to its other postretirement benefit plans.
The weighted-average assumptions used to determine other postretirement benefit obligations and net periodic benefit costs for the plans are provided in the following table:
Plan Assumptions for Other Postretirement Benefits
Increasing or decreasing the assumed medical cost trend rate by 1 percentage point in each year would have an immaterial impact on the accumulated postretirement benefit obligation at December 31, 2006 and on the net periodic postretirement benefit cost for the year.
Impact of Remeasurement in the Third Quarter of 2004
In the third quarter of 2004, an expense remeasurement of the Corporation’s pension and other postretirement benefit plans was completed as of June 30, 2004, due to a curtailment as defined in SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” related to a workforce reduction (see Note B). The remeasurement resulted in a $3 million increase in net periodic postretirement benefit cost for 2004 and a $3 million decrease in net periodic pension expense for 2004.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act expanded Medicare to include, for the first time, coverage for prescription drugs. The Act also provides for a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. Based on regulations issued in the third quarter of 2004, the Corporation determined that the benefits provided by its retiree medical plans are actuarially equivalent to Medicare Part D under the Act and remeasured its net periodic cost for other postretirement benefit plans for the effect of the Act. The impact of this remeasurement was a reduction of $12.5 million in the accumulated postretirement benefit obligation as of January 1, 2004, for actuarial purposes only, and a reduction in net periodic postretirement benefit cost of $2 million for 2004.
Adoption of SFAS No. 158
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” As required, the Corporation adopted this statement effective December 31, 2006. The following table provides a breakdown of the incremental effect of applying this statement on individual line items in the consolidated balance sheet at December 31, 2006:
Incremental Effect of Applying SFAS No. 158
Net Periodic Benefit Cost (Credit) for all Significant Plans
(1) See Note B for information regarding curtailment costs recorded in the second quarter of 2004.
Change in Projected Benefit Obligation, Plan Assets and Funded Status of all Significant Plans
In 2007, an estimated net loss of $24 million and prior service cost of $2 million for the defined benefit pension plans will be amortized from AOCI to net periodic benefit cost. In 2007, an estimated net loss of $3 million and prior service credit of $2 million for other postretirement benefit plans will be amortized from AOCI to net periodic benefit cost.
The Corporation uses a December 31 measurement date for all of its plans.
Estimated Future Benefit Payments
The estimated future benefit payments, reflecting expected future service, as appropriate, are presented in the following table:
Estimated Future Benefit Payments
at December 31, 2006
Plan Assets
Plan assets consist mainly of equity and fixed income securities of U.S. and foreign issuers. At December 31, 2006, plan assets totaled $4.0 billion and included no Dow common stock. At December 31, 2005, plan assets totaled $3.9 billion and included Dow common stock with a value of $158 million (4 percent of total plan assets).
Weighted-Average Allocation of Plan Assets
at December 31
Investment Strategy and Risk Management for Plan Assets
The Corporation’s investment strategy for the plan assets is to manage the assets in order to pay retirement benefits to plan participants while minimizing cash contributions from the Corporation over the life of the plans. This is accomplished by diversifying investments in various asset classes and earning an acceptable long-term rate of return consistent with an acceptable degree of risk, while considering the liquidity needs of the plans.
The plans are permitted to use derivative instruments for investment purposes, as well as for hedging the underlying asset exposure and re-balancing the asset allocation. The plans use value at risk to monitor risk in the portfolios.
An asset/liability study using the plans’ projected total benefit obligation was conducted to determine the optimal strategic asset allocation to meet the plans’ long-term investment strategy. The study was conducted by the Corporation’s actuary and corroborated with other outside experts. The plans’ asset allocation will move toward the strategic target allocation shown below when the Corporation believes it is prudent to do so.
Strategic Target Allocation of Plan Assets
NOTE L LEASED PROPERTY
The Corporation has operating leases primarily for facilities and distribution equipment. The future minimum rental payments under operating leases with remaining non-cancelable terms in excess of one year are as follows:
Minimum Operating Lease Commitments
at December 31, 2006
The Corporation’s Danbury, Connecticut, office building lease expired December 31, 2006. Rental expenses under operating leases were $37 million in 2006, $64 million in 2005 and $65 million in 2004 (net of sublease rental income of $22 million in 2006, $20 million in 2005 and $17 million in 2004).
NOTE M RELATED PARTY TRANSACTIONS
The Corporation sells products to Dow to simplify the customer interface process. Products are sold to and purchased from Dow at market-based prices in accordance with the terms of Dow’s long-standing intercompany pricing policies. The Corporation also procures certain commodities and raw materials through a Dow subsidiary and pays a commission to that Dow subsidiary based on the volume and type of commodities and raw materials purchased. The commission expense is included in “Sundry income (expense) - net” in the consolidated statements of income. Purchases from that Dow subsidiary were approximately $3.1 billion in 2006, $2.5 billion in 2005 and $2.2 billion in 2004.
The Corporation has a master services agreement with Dow whereby Dow provides services, including, but not limited to, accounting, legal, treasury (investments, cash management, risk management, insurance), procurement, human resources, environmental, health and safety, and business management for UCC. Under the master services agreement with Dow, for general administrative and overhead type services that Dow routinely allocates to various businesses, UCC is charged the cost of those services based on the Corporation’s and Dow’s relative manufacturing conversion costs. This arrangement results in a quarterly charge of approximately $5 million (included in “Sundry income (expense) - net”).
For services that Dow routinely charges based on effort, UCC is charged the cost of such services on a fully absorbed basis, which includes direct and indirect costs. Additionally, certain Dow employees are contracted to UCC and Dow is reimbursed for all direct employment costs of such employees. Management believes the method used for determining expenses charged by Dow is reasonable. Dow provides these services by leveraging its centralized functional service centers to provide services at a cost that management believes provides an advantage to the Corporation.
The monitoring and execution of risk management policies related to interest rate and foreign currency risks, which are based on Dow’s risk management philosophy, are provided as a service to UCC.
As part of Dow’s cash management process, UCC is a party to revolving loans with Dow that have LIBOR-based interest rates with varying maturities. At December 31, 2006, the Corporation had a note receivable of $2.5 billion from Dow under a revolving loan agreement. The Corporation may draw from this note receivable in support of its daily working capital requirements and, as such, the net effect of cash inflows and outflows under this revolving loan agreement is presented in the consolidated statements of cash flows as an operating activity.
The Corporation also has a separate revolving credit agreement with Dow that allows the Corporation to borrow or obtain credit enhancements up to an aggregate of $1 billion that matures December 30, 2007 pursuant to an amendment effective as of September 30, 2006; however, Dow may demand repayment with a 30-day written notice to the Corporation, subject to certain restrictions. A related collateral agreement provides for the replacement of certain existing pledged assets, primarily equity interests in various subsidiaries and joint ventures, with cash collateral. At December 31, 2006, $823 million was available under the revolving credit agreement. The cash collateral was reported as “Noncurrent receivable from related company” in the consolidated balance sheets.
The losses and additional costs incurred by the Corporation in 2005 due to hurricane Katrina were covered by the Corporation’s insurance program. The Corporation has an insurance receivable for losses incurred of $105 million at December 31, 2006 from its insurer (an affiliate of Dow). Additionally, the Corporation has insurance coverage for lost sales and margins caused by hurricane Katrina. No amount of recovery for lost sales and margins had been recognized at
December 31, 2006, and will only be recognized when the amount of recovery is realized through agreement among the insurers.
The Corporation received cash dividends from its related company investments of approximately $37 million in 2006 (including $35 million from Dow International Holdings Company [“DIHC”]) and approximately $118 million in 2005 (including $86 million from DIHC and $29 million from Dow Chemical Canada Inc. [“Dow Canada”]) which were included in “Sundry income (expense) - net.”
In December 2005, the ownership of Dow Canada was restructured whereby the Corporation received an 11.2 percent ownership interest in Dow Canada Holding LP (“DCHLP”) and a cash distribution of approximately $296 million in exchange for the Corporation’s 11.2 percent ownership interest in Dow Canada. The cash distribution reduced the carryover basis of the investment in DCHLP to zero and the remaining $121 million was treated as a deemed capital contribution in “Additional paid-in capital” in the consolidated balance sheets. The Corporation accounted for its 11.2 percent partnership interest in DCHLP using the equity method.
The Corporation recorded equity earnings of approximately $10 million from DCHLP for the first two months of 2006, which increased the investment balance to $10 million. On March 1, 2006, the Corporation transferred its 11.2 percent partnership interest in DCHLP to a newly formed corporation, GWN Holding, Inc. (“GWN”), in exchange for 11.2 percent of GWN’s common stock. The Corporation accounts for its 11.2 percent ownership interest in GWN using the cost method.
In accordance with the Amended and Restated Tax Sharing Agreement between the Corporation and Dow, the Corporation made payments of $268 million to Dow in 2006 to cover the Corporation’s estimated federal tax liability for 2006.
In October 2004, the Corporation sold certain NOx emission allowances to Dow for approximately $13 million (included in “Sundry income (expense) - net”).
NOTE N INCOME TAXES
Operating loss carryforwards at December 31, 2006 amounted to $643 million compared with $13 million at the end of 2005. Such amounts include U.S. state and local operating loss carryforwards determined to be more likely than not to be utilized. At December 31, 2006, $87 million of the operating loss carryforwards, is subject to expiration in the years 2007 through 2011. The remaining balances expire in years beyond 2011 or have an indefinite carryforward period. Tax credit carryforwards at December 31, 2006 amounted to $53 million ($144 million at December 31, 2005), all of which expire in years beyond 2011.
Undistributed earnings of foreign subsidiaries and related companies that are deemed to be permanently invested amounted to $73 million at December 31, 2006, $74 million at December 31, 2005 and $84 million at December 31, 2004. It is not practicable to calculate the unrecognized deferred tax liability on those earnings.
The Corporation had valuation allowances, which were primarily related to the realization of recorded tax benefits on tax loss carryforwards from operations in the United States of $112 million at December 31, 2006 ($159 million at December 31, 2005).
The reserve for tax contingencies related to issues in the United States and foreign locations was $236 million at December 31, 2006 and $156 million at December 31, 2005. This balance is the Corporation’s best estimate of the potential liability for tax contingencies. Inherent uncertainties exist in estimates of tax contingencies due to changes in tax law, both legislated and concluded through the various jurisdictions’ tax court systems. It is the opinion of the Corporation’s management that the possibility is remote that costs in excess of those accrued will have a material adverse impact on the Corporation’s financial statements.
The American Jobs Creation Act of 2004 (the “AJCA”) introduced a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer, provided certain criteria are met. In May 2005, tax authorities released the clarifying language necessary to enable Dow to complete its determination regarding the repatriation and reinvestment of foreign earnings. In December 2005, Dow repatriated funds from a foreign entity that is partially owned by the Corporation. Since the Corporation is included in Dow’s consolidated federal income tax group and consolidated tax return, the Corporation recognized an immaterial impact of the repatriation provision of the Act, in accordance with the terms of the Dow-UCC Tax Sharing Agreement.
Domestic and Foreign Components of Income
Before Income Taxes and Minority Interests
Reconciliation to U.S. Statutory Rate
Provision for Income Taxes
Deferred Tax Balances at December 31
NOTE O BUSINESS AND GEOGRAPHIC SEGMENT INFORMATION
The Corporation’s business activities comprise components of Dow’s global businesses rather than stand-alone operations. The Corporation sells its products to Dow in order to simplify the customer interface process. The products are sold to Dow at market-based prices in accordance with Dow’s long-standing intercompany pricing policy. Dow conducts its worldwide operations through global businesses. Because there are no separable reportable business segments for the Corporation under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and no detailed business information is provided to a chief operating decision maker regarding the Corporation’s stand-alone operations, the Corporation’s results are reported as a single operating segment.
Sales are attributed to geographic areas based on customer location. Long-lived assets are attributed to geographic areas based on asset location. Sales to external customers and long-lived assets by geographic area were as follows:
(1) Of the total sales to external customers, China represented approximately 15 percent in 2006, 11 percent in 2005 and 15 percent in 2004, and was included in Asia Pacific.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
As of the end of the period covered by this Annual Report on Form 10-K, the Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s Disclosure Committee and the Corporation’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures pursuant to Exchange Act Rule 15d-15(b); and whether any change has occurred in the Corporation’s internal control over financial reporting pursuant to Exchange Act Rule 15d-15(d). Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures are effective and that no change in the Corporation’s internal control over financial reporting occurred during the Corporation’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
Omitted pursuant to General Instruction I of Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Omitted pursuant to General Instruction I of Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
Omitted pursuant to General Instruction I of Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
Omitted pursuant to General Instruction I of Form 10-K.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
Dow’s Audit Committee pre-approves all auditing services and permitted non-audit services (including the fees and terms thereof) to be performed for Dow and its subsidiaries (including the Corporation) by its independent auditor, subject to the de minimus exception for non-audit services described in Section 10A(i)(1)(B) of the Exchange Act which are approved by Dow’s Audit Committee prior to the completion of the audit. The Corporation’s management and its board of directors subscribe to these policies and procedures.
For the years ended December 31, 2006 and 2005, professional services were performed for the Corporation by Deloitte & Touche LLP, the member firms of Deloitte Touche Tohmatsu, and their respective affiliates (collectively, the “Deloitte Entities”).
Audit and audit-related fees for the Corporation aggregated $1,946,000 and $1,879,000 for the years ended December 31, 2006 and 2005, respectively. Total fees paid to the Deloitte Entities were:
(a) The aggregate fees billed for the audit of the Corporation’s annual financial statements, the reviews of the financial statements in Quarterly Reports on Form 10-Q, statutory audits and other regulatory filings.
(b) Primarily for agreed-upon procedures engagements and audits of employee benefit plans’ financial statements.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a) The following documents are filed as part of this report:
1. The Corporation’s 2006 Consolidated Financial Statements and the Report of Independent Registered Public Accounting Firm are included in Item 8 of Part II.
2. Financial Statement Schedules.
The following Financial Statement Schedule should be read in conjunction with the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K:
Schedule II
Valuation and Qualifying Accounts
Schedules other than the one listed above are omitted because of the absence of the conditions under which they are required or because the information called for is included in the Consolidated Financial Statements or Notes thereto.
3. The following financial statements of the Corporation’s nonconsolidated affiliate, EQUATE Petrochemical Company K.S.C., are presented pursuant to Rule 3-09 of Regulation S-X:
Independent Auditor’s report
Balance sheets at December 31, 2006 and 2005
Statements of income for the years ended December 31, 2006, 2005 and 2004
Statements of changes in equity for the years ended December 31, 2006, 2005 and 2004
Statements of cash flows for the years ended December 31, 2006, 2005 and 2004
Notes to financial statements
4. Exhibits - See the Exhibit Index on pages 69-70 of this Annual Report on Form 10-K for exhibits filed with this Annual Report on Form 10-K (see below) and for exhibits incorporated by reference.
The Corporation will provide a copy of any exhibit upon receipt of a written request for the particular exhibit or exhibits desired. All requests should be addressed to the Corporation’s principal executive offices (address provided at the end of the Exhibit Index).
The following exhibits listed on the Exhibit Index are filed with this Annual Report on Form 10-K:
Exhibit No.
Description of Exhibit
Analysis, Research & Planning Corporation’s Consent.
31.1
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
TRADEMARKS
The following trademarks of Union Carbide Corporation or its subsidiaries appear in this report:
CARBOWAX, CELLOSIZE, FLEXOMER, LP OXO, METEOR, NEOCAR, POLYOX, POLYPHOBE, REDI-LINK, SI-LINK, SENTRY, TERGITOL, TRITON, TUFLIN, UCAR, UCARTHERM, UCON, UNIGARD, UNIPOL, UNIPURGE, UNIVAL
The following registered service mark of American Chemistry Council appears in this report: Responsible Care
SCHEDULE II
Union Carbide Corporation and Subsidiaries
Valuation and Qualifying Accounts
INDEPENDENT AUDITOR’S REPORT
To the Board of Directors and Shareholders
EQUATE Petrochemical Company KSC (Closed)
We have audited the accompanying balance sheet of EQUATE Petrochemical Company KSC (Closed) (“the Company”), a venture between Union Carbide Corporation, Petrochemical Industries Company, Boubyan Petrochemical Company and Al Qurain Petrochemical Industries Company as of December 31, 2006 and 2005, and related statements of income, cash flows and changes in equity for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with International Financial Reporting Standards (“IFRS”).
The accounting principles reflected in the above mentioned financial statements prepared in conformity with IFRS vary in certain significant respects from accounting principles generally accepted in the United States of America (“US GAAP”). The application of US GAAP would have affected the determination of net income for each of the three years in the period ended December 31, 2006 and the determination of equity as of December 31, 2006 and 2005 to the extent summarized in Note 18 to financial statements.
Jassim Ahmad Al-Fahad
Al-Fahad & Co., Deloitte & Touche
License No. 53-A
12 February 2007
Kuwait
EQUATE Petrochemical Company KSC (Closed)
Balance Sheets
The accompanying notes form an integral part of these financial statements.
EQUATE Petrochemical Company KSC (Closed)
Statements of Income
The accompanying notes form an integral part of these financial statements.
EQUATE Petrochemical Company KSC (Closed)
Statements of Changes in Equity
The accompanying notes form an integral part of these financial statements.
EQUATE Petrochemical Company KSC (Closed)
Statements of Cash Flows
The accompanying notes form an integral part of these financial statements.
EQUATE Petrochemical Company KSC (Closed)
Notes to Financial Statements
Dollars in thousands, except as noted
1. INCORPORATION AND ACTIVITIES EQUATE Petrochemical Company K.S.C. (Closed) (“the Company”) is a closed shareholding company incorporated in the State of Kuwait on 20 November 1995 as a joint venture between Union Carbide Corporation (“UCC”), Petrochemical Industries Company (“PIC”) and Boubyan Petrochemical Company (“BPC”).
The Company is engaged in the manufacture and sale of ethylene glycol (“EG”) and polyethylene (“PE”). The Company also operates and maintains a polypropylene plant on behalf of PIC.
UCC is a wholly owned subsidiary of The Dow Chemical Company (“DOW”).
The address of the Company’s registered office is at National Bank of Kuwait building, Block 8, Plot 4A/5A/6A, Jleeb Al-Shuyokh, P. O. Box 4733 Safat 13048, Kuwait.
The financial statements were approved by the board of directors and authorised for issue on 12 February 2007.
2. ADOPTION OF NEW AND REVISED STANDARDS In the current year, the Company has adopted all of the new and revised Standards and Interpretations issued by the International Accounting Standards Board (the IASB) and the International Financial Reporting Interpretations Committee (the IFRIC) of the IASB that are relevant to its operations and effective for annual reporting periods beginning on 1 January 2006.
At the date of authorisation of these financial statements, the following Standards and Interpretations were in issue but not yet effective:
• IFRS 7 Financial Instruments: Disclosures
Effective for annual periods beginning on or
after 1 January 2007
• IFRIC 7 Applying the Restatement Approach
under IAS29, Financial Reporting in
Hyperinflationary Economies
Effective for annual periods beginning on or
after 1 March 2006
• IFRIC 8 Scope of IFRS 2
Effective for annual periods beginning on or
after 1 May 2006
• IFRIC 9 Reassessment of Embedded Derivatives
Effective for annual periods beginning on or
after 1 June 2006
• IFRIC 10 Interim Financial Reporting and
Impairment
Effective for annual periods beginning on or
after 1 November 2006
The impact of the adoption of IFRS 7 “Financial Instruments: Disclosures” is to expand the disclosures provided in the financial statements regarding the Company’s financial instruments.
The directors anticipate that the adoption of these Standards and Interpretations in future periods will have no material financial impact on the financial statements of the Company.
3. SIGNIFICANT ACCOUNTING POLICIES
Statement of compliance
The financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”).
Basis of preparation
The financial statements have been prepared on the historical cost basis, except for the measurement at fair value of certain financial instruments.
Cash and cash equivalents
Cash and cash equivalents include demand accounts and fixed deposits with an original maturity of three months or less.
Trade receivables
Trade receivables are stated at invoice value, less allowance for doubtful receivables. Management determines the adequacy of the allowance based upon reviews of individual customers, current economic conditions, past experience and other pertinent factors. The allowance for doubtful receivables was not significant at 31 December 2006 or 2005.
Inventories
Work in progress and finished goods are stated at the lower of weighted average cost or net realisable value. The cost of finished products includes direct materials, direct labour and fixed and variable manufacturing overhead and other costs incurred in bringing inventories to their present location and condition.
Spare parts are not intended for resale and are valued at cost after making allowance for any obsolete or slow moving items. Cost is determined on a weighted average basis.
All other inventory items are valued at the lower of purchased cost or net realisable value using the weighted average method after making provision for any slow moving and obsolete stocks. Purchase cost includes the purchase price, import duties, transportation, handling and other direct costs.
Property, plant and equipment
Property, plant and equipment are stated at cost less accumulated depreciation and any accumulated impairment losses. Properties in the course of construction for production, rental or administrative purposes, or for purposes not yet determined, are carried at cost, less any recognised impairment loss. Cost includes professional fees and, for qualifying assets, borrowing costs capitalised in accordance with the Company’s accounting policy (see below). Depreciation is calculated based on the estimated useful lives of the applicable assets on a straight-line basis commencing when the assets are ready for their intended use. The estimated useful lives, residual values and depreciation methods are reviewed at each year end, with the effect of any changes in estimate accounted for on prospective basis. Maintenance and repairs, replacements and improvements of minor importance are expensed as incurred. Significant improvements and replacements of assets are capitalised. The gain or loss arising on the disposal or retirement of an item of property, plant and equipment is determined as the difference between the sale proceeds and the carrying amount of the asset and is recognised in profit or loss.
Intangible assets
Intangible assets consist of technology and licences for the manufacture of ethylene, EG and PE. In 1996, UCC contributed the technology and licences concerned in consideration for US$ 220 million. During 2004 and 2005, the Company paid a licence fee of US$ 11.8 million to UCC for PE expansion.
Intangibles are carried at cost less accumulated amortisation and any accumulated impairment losses. The intangible assets are amortised from the date of commencement of commercial production on a straight-line basis over twenty years, except for the olefin technology, which is amortised over five years. The estimated useful life and amortisation method are reviewed at the end of each annual reporting period, with the effect of any changes in estimate being accounted for on a prospective basis.
Provision for staff indemnity
Provision is made for staff indemnity which is payable on completion of employment. The provision is calculated in accordance with Kuwait Labour Law based on employees’ salaries and accumulated periods of service or on the basis of employment contracts, where such contracts provide extra benefits. The provision, which is unfunded, is determined as the liability that would arise as a result of the involuntary termination of staff at the balance sheet date.
Revenue recognition
Sales net of applicable discounts, are recognised when the revenue is realized or realizable, has been earned, and collectibility is reasonably assured. Revenue is recognised as risk and title transfer to the customer, which usually occurs at the time shipment is made. PE production is sold with freight paid by the Company and EG production is sold FOB (“free on board”) shipping point. Title to the product passes when the product is delivered to the freight carrier. The Company’s terms of sale are included in its contracts of sale, order confirmation documents, and invoices. Freight costs are recorded as “Cost of Sales”. Interest income is accrued on a time basis with reference to the principal outstanding and at the effective interest rate applicable.
Borrowing costs
Borrowing costs on qualifying assets are added to the cost of those assets by applying a capitalisation rate on the expenditure on such assets, until such time as the assets are substantially ready for their intended use. The capitalisation rate used by the Company is the weighted average of the borrowing costs applicable to the outstanding borrowings during the period. The remaining borrowing costs are recognised in the statement of income in the period in which they are incurred.
Translation of foreign currencies
The functional currency of the Company is United States Dollars (“US$”) and accordingly, the financial statements are presented in US$, rounded to the nearest thousand. The functional currency is different from the currency of the country in which the Company is domiciled since the majority of the Company’s revenue and expenses, and all of the Company’s borrowings, are denominated in US$.
Transactions denominated in foreign currencies are translated into US$ at rates of exchange prevailing at the transaction dates. Monetary assets and liabilities denominated in foreign currencies are retranslated into US$ at rates of exchange prevailing at the balance sheet date. The resultant exchange differences are taken to the statement of income.
Term debt
Interest bearing debts are measured initially at fair value and are subsequently measured at amortised cost, using the effective interest rate method. Any difference between the proceeds (net of transaction costs) and the settlement or redemption of borrowings is recognised over the term of borrowings in accordance with the company’s accounting policy for borrowing costs (see above).
Impairment
At each balance sheet date, the Company reviews the carrying amounts of its tangible and intangible assets to determine whether there is any indication that those assets have suffered an impairment loss. If any such indication exists, the recoverable amount of the asset is estimated in order to determine the extent of the impairment loss (if any). Where it is not possible to estimate the recoverable amount of an individual asset, the Company estimates the recoverable amount of the cash-generating unit to which the asset belongs.
The recoverable amount is the higher of fair value less costs to sell and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a discount rate that reflects current market assessments of the time value of money and the risks specific to the asset.
If the recoverable amount of an asset (or cash-generating unit) is estimated to be less than its carrying amount, the carrying amount of the asset (cash-generating unit) is reduced to its recoverable amount. An impairment loss is recognised immediately in the statement of income.
Where an impairment loss subsequently reverses, the carrying amount of the asset (cash-generating unit) is increased to the revised estimate of its recoverable amount, but so that the increased carrying amount does not exceed the carrying amount that would have been determined had no impairment loss been recognised for the asset (cash-generating unit) in prior years. A reversal of an impairment loss is recognised immediately in the statement of income.
Income Taxes
The Company, a closed shareholding company incorporated in the State of Kuwait, is not subject to income taxes.
Derivatives
Derivatives are initially recognised at fair value at the date a derivative contract is entered into and are subsequently remeasured to their fair value at each balance sheet date. The resulting gain or loss is recognised in profit or loss immediately. Foreign exchange forward contracts are treated as trading instruments and are stated at fair market value with gains or losses included in the statement of income in foreign exchange gain / (loss) in the period they occur.
Contribution to Kuwait Foundation for the Advancement of Sciences
The Company is legally required to contribute to the Kuwait Foundation for the Advancement of Sciences (“KFAS”). The Company’s contributions to KFAS are recognized as an expense in the period during which the Company’s contribution is legally required.
IASB Standards issued but not adopted
At the date of authorisation of these financial statements “IFRS 7 Financial Instruments: Disclosures” was in issue but not yet effective. The application of IFRS 7, which will be effective for annual periods beginning on or after 1 January 2007 will have no material financial impact on the financial statements of future periods of the Company.
4. CRITICAL JUDGEMENTS AND KEY SOURCES OF ESTIMATION UNCERTAINTY The preparation of financial statements in accordance with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period.
The following are the most significant accounting policies impacted by judgements, assumptions and estimates due to inherent uncertainty in making those estimates, actual results to be reported in future periods could differ from those estimates.
Critical judgements in applying the entity’s accounting policies
As described in notes 2 and 6, the Company’s management has considered it appropriate to capitalise borrowing costs directly attributable to the qualifying assets under construction.
Key sources of estimation uncertainty
During the year the Company reviewed the estimated useful life over which its tangible assets are depreciated and intangible assets are amortised. The Company’s management is satisfied that the estimates of useful life are appropriate.
5. CASH AND CASH EQUIVALENTS
All bank accounts of the Company are assigned as security for the Company’s obligations under the term debt facility agreement (see note 14). The effective interest rate on time deposits ranged from 1.875% to 5.4% (2005: 2.01% to 4.82%) per annum.
6. INVENTORIES
7. PROPERTY, PLANT AND EQUIPMENT
Assets under construction mainly consist of capital construction costs incurred on new utilities and infrastructure facilities and EQUATE expansion project under the Olefins II projects (see note 12). The related commitments are reported in note 19.
In 2006, borrowing costs amounting to US$17 million (2005: US$1.2 million) on qualifying assets was added to the cost of those assets.
The Company’s property, plant and equipment have been assigned as security for the term debt facility granted to the Company (see note 14).
The following useful lives are used in the calculation of depreciation :
8. INTANGIBLE ASSETS
9. ACCRUALS AND OTHER LIABILITIES
10. DEFERRED INCOME Deferred income represents reservation right fees accrued to the extent of construction cost incurred by the Company during 2005 and 2006. Such fees are receivable from the Olefins II project entities (see note 12).
11. SHARE CAPITAL The share capital consists of 2,160 million authorised, issued and fully paid shares of Fils 100 each.
The ownership percentages of the shareholders at December 31, 2006 are as follows:
12. PROPOSED DIVIDEND The directors propose a cash dividend of US$ 510 million for the year ended December 31, 2006 (2005: US$ 530 million) which is subject to the approval of shareholders at the annual General Assembly. This dividend has not been recorded in the accompanying financial statements, and will be recorded only once it has been approved by the shareholders.
13. RELATED PARTY TRANSACTIONS In the normal course of business the Company enters into transactions with its shareholders PIC, UCC, BPC and UCC’s parent company DOW and its affiliates.
EQUATE Marketing Company EC, Bahrain (“EMC”), which is owned by PIC and UCC, is the exclusive sales agent in certain territories for the marketing of PE produced by the Company.
On February 1, 2005 the Company signed a distribution agreement with MEGlobal Europe GMBH (“MEG Europe”) and MEGlobal Asia Ltd (“MEG Asia”) as distributors for EG produced by the Company. MEG Europe and MEG Asia are 50:50 joint ventures of PIC and DOW.
During 2004, DOW and PIC initiated a number of joint venture petrochemical projects (“Olefins II projects”) in Kuwait to manufacture polyethylene, ethylene glycol and styrene monomer. The Olefins II projects consist of the Equate expansion project, and the incorporation and development of The Kuwait Olefins Company (“TKOC”), The Kuwait Styrene Company (“TKSC”), and Kuwait Aromatics Company (“KARO”). TKOC is a joint venture of DOW Europe Holding B.V (“DEH”) (42.5%), PIC (42.5%), BPC (9%) and QPIC (6%). TKSC is joint venture of DEH (42.5%) and KARO (57.5%). KARO is a joint venture of PIC (80%) and QPIC (20%). The Olefins II projects are expected to be operational by the third quarter of 2008.
On December 2, 2004 the Company signed a Materials and Utility Supply Agreement (“MUSA”) with TKOC, TKSC, KARO and PIC. Under the terms of the MUSA the Company will receive a reservation right fee from those companies that will equal the total capital construction costs that would be incurred by the Company on the new utilities and infrastructure facilities under the Olefins II projects (see note 9).
During 2005, Services Agreements were signed between DOW, PIC and the Company with TKOC, TKSC, KARO and PIC for the provision of various services to the Olefins II projects.
An agreement to amend the MUSA and Service Agreements (“primary agreements”) was signed between the parties to the primary agreements on February 8, 2006 releasing KARO from its obligations and liabilities under the primary agreements and appointing Kuwait Paraxylene Production Company K.S.C. (“KPPC”) in place of KARO to assume and perform all obligations of KARO as if KPPC were and had been a party to the primary agreements. KPPC is a 100% owned subsidiary of KARO.
On May 31, 2006 the Company signed term loan agreements with TKOC and TKSC, under which the Company will provide a US$ 1.5 billion term loan to TKOC and US$ 497 million term loan to TKSC. The term loans are repayable over a period of 11 years in biannual instalments starting from December 15, 2009 and carry annual interest rates ranging from 0.625% to 0.825% over LIBOR.
All transactions with related parties are carried out on a negotiated contract basis.
The following is a description of significant related party agreements and transactions:
a) Supply by UCC of technology and licences relating to manufacture of polyethylene and ethylene glycol;
b) Supply by PIC to the Company of certain minimum quantities of feed gas and fuel gas on a priority basis;
c) Supply by UCC, DOW and UNIVATION of certain catalysts to the Company;
d) Secondment of certain staff to the Company by UCC;
e) Supply by the Company of certain materials and services required by PIC to operate and maintain polypropylene plant;
f) Provision of various services by the Company to TKOC, TKSC, KARO and PIC under Olefins II projects.
Details of significant related party transactions are disclosed below:
14. SHORT-TERM DEBT On February 21, 2006 the Company repaid its syndicated bank loan of US$ 100 million (December 31, 2005: US$ 100 million) and the finance lease of US$ 100 million (December 31, 2005: US$ 100 million).
At December 31, 2006 the Company repaid its outstanding revolving loan of US$ 300 million (see note 14). The effective interest rate on the revolving loan was 5.81% per annum.
15. LONG-TERM DEBT
On May 19, 2006 the Company signed a US$ 2.5 billion debt facility agreement with a consortium of banks which includes a term loan facility of US$ 2.2 billion and a revolving loan facility of US$ 300 million. The term loan is repayable over a period of 11 years in biannual instalments starting from December 15, 2009. The effective interest rate on this facility as of December 31, 2006 was 5.82% per annum. The facility is secured by a charge over the Company’s property, plant and equipment and bank balances.
At December 31, 2006 the Company repaid its outstanding revolving loan of US$ 300 million. The effective interest rate on the revolving loan was 5.81% per annum.
At December 31, 2006, the Company had available US$ 1.6 billion of undrawn committed borrowing facilities in respect of which all conditions precedent had been met.
16. STAFF COSTS, DEPRECIATION AND AMORTIZATION Staff costs, depreciation and amortisation charges are included in the statement of income under the following categories:
17. FINANCE COSTS
18. RECONCILIATION TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES IN THE UNITED STATES The financial statements of the Company are prepared in accordance with IFRS which differ in certain respects from accounting principles generally accepted in the United States of America (“US GAAP”). The significant differences and their effect on the net income and equity are set out below:
The Company’s comprehensive income in accordance with US GAAP for the years ended December 31, 2006, 2005 and 2004 was $ 577,314; $ 599,059 and $632,133 respectively.
In 1996, UCC contributed technology and licences valued at US$ 220 million to the Company in exchange for subordinated debt. In June 1999, the Company converted this subordinated debt, as well as other subordinated debt due to PIC and BPC, as well as accrued interest on such notes, to equity. Under US GAAP, the intangible assets were recognized at UCC’s historical cost, which was zero. These US GAAP adjustments eliminate the intangible assets and accumulated amortisation on the intangible assets, from the Company’s balance sheet, and eliminate amortisation expense on the intangible assets from the Company’s statement of income.
Under US GAAP, the Company’s contribution to KFAS, and directors’ fees are considered part of operating income, as follows:
19. FINANCIAL INSTRUMENTS - FAIR VALUE AND RISK MANAGEMENT Financial instruments consist of contractual claims on financial assets. Financial instruments include both primary instruments, such as trade accounts receivable, payable and financial commitments, bank borrowings, and derivative financial instruments, which are used in the normal course of business.
Information on fair value and risk management of these financial instruments is set out below:
Primary financial instruments are reflected in the balance sheet. Those on the asset side are recognised at nominal value less any provisions for impairment, except derivative financial instruments which are stated at fair market value; financial instruments constituting liabilities are carried at nominal or redemption value, whichever is higher.
Fair values of the financial assets and liabilities are determined using generally accepted methods. Because no quoted market prices are available for a significant part of the Company’s financial assets and liabilities, the fair values of such items have been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Management believes that the carrying value of all its financial instrument assets and liabilities on the balance sheet is not materially different from their fair values.
a) Interest rate risk
Interest rate risk - the possibility that the value of a financial instrument will change due to movements in market rates of interest - applies mainly to receivables and payables with maturities of over one year.
The Company is exposed to interest rate risk on all interest bearing borrowings and deposits. The interest rate and terms of repayment of loans are disclosed in notes 13 and 14. The interest rate on bank deposits is disclosed in Note 4.
The Company’s total borrowings at the balance sheet date were US$ 885 million (2005: US$ 200 million). All borrowings carry a floating rate of interest (see notes 13 and 14).
b) Credit risk
The Company is exposed to credit risk if counterparties fail to perform as contracted.
In respect of the recognised financial assets, the Company’s maximum exposure to credit risk is equal to the carrying amount of assets in the balance sheet. In the case of interest rate swaps or currency contracts, the Company’s exposure is the cost of replacing contracts at current market rates should the counter party default prior to the settlement date.
The Company’s credit risk as of December 31, 2006 is considered to be low as it does not have significant exposure to any individual customer or counterparty. Cash is placed with banks with high credit ratings. Policies
and procedures are in place to perform ongoing credit evaluations of the financial condition of counterparties and customers.
c) Foreign exchange risk
The Company is exposed to the following foreign exchange risks:
i. Transaction risk - the risk of the Company’s commercial cash flows being adversely affected by a change in exchange rates for foreign currencies against US dollars; and
Balance sheet risk - the risk of net monetary assets in foreign currencies acquiring a lower value when translated into US dollars as a result of currency movements.
ii. The Company’s exposure to transaction risk is limited since a substantial part of the Company’s sales and expenses are in US dollars. The Company uses forward exchange contracts to reduce its exposure to fluctuations in foreign exchange rates. At the balance sheet date the Company has forward exchange contracts to buy and sell foreign currencies amounting to US$ 32.9 million (2005: US$ 22.6 million). The fair value of these forward exchange contracts was insignificant at both December 31, 2006 and 2005.
The Company’s exposure to balance sheet risk is insignificant since all significant assets and liabilities are denominated in US$.
20. COMMITMENTS AND CONTINGENT LIABILITIES The Company has a fixed gas purchase commitment with KNPC of approximately US$ 300,000 per day until the agreement is cancelled in writing by both parties.
The Company had the following commitments and contingent liabilities outstanding at December 31:
21. COMPARATIVE FIGURES Certain comparative figures have been reclassified to conform to the current year’s presentation.
Union Carbide Corporation and Subsidiaries
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on the 20th day of February 2007.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed on the 20th day of February 2007 by the following persons in the capacities indicated:
Union Carbide Corporation and Subsidiaries
Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Act by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act
The Corporation, which is a wholly owned subsidiary of Dow, does not send an annual report to security holders or proxy material with respect to any annual or other meeting of security holders, to Dow or any other security holders.
Union Carbide Corporation and Subsidiaries
Exhibit Index
EXHIBIT NO.
DESCRIPTION
2.1
Agreement and Plan of Merger dated as of August 3, 1999 among Union Carbide Corporation, The Dow Chemical Company and Transition Sub Inc. (See Exhibit 2 of the Corporation’s Current Report on Form 8-K dated August 3, 1999).
3.1.1
Restated Certificate of Incorporation of Union Carbide Corporation under Section 807 of the Business Corporation Law, as filed June 25, 1998 (See Exhibit 3 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1998).
3.1.2
Certificate of Merger of Transition Sub Inc. into Union Carbide Corporation under Section 904 of the Business Corporation Law effective February 6, 2001 (See Exhibit 3.1.2 of the Corporation’s 2000 Form 10-K).
3.1.3
Certificate of Change of Union Carbide Corporation under Section 805-A of the Business Corporate Law, dated April 27, 2001 and filed on May 3, 2001 (See Exhibit 3.1 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).
3.2
Amended and Restated Bylaws of Union Carbide Corporation, amended as of April 22, 2004 (See Exhibit 3.2 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004).
4.1
Indenture dated as of June 1, 1995, between the Corporation and the Chase Manhattan Bank (formerly Chemical Bank), Trustee (See Exhibit 4.1.2 to the Corporation’s Form S-3 effective October 13, 1995, Reg. No. 33-60705).
4.2
The Corporation will furnish to the Commission upon request any other debt instrument referred to in Item 601(b)(4)(iii)(A) of Regulation S-K.
10.1
Amended and Restated Service Agreement, effective as of July 1, 2002, between the Corporation and The Dow Chemical Company (See Exhibit 10.23 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002).
10.1.1
Service Addendum No. 2 to the Service Agreement, effective as of August 1, 2001, between the Corporation and The Dow Chemical Company (See Exhibit 10.23.2 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002).
10.1.2
Restated Service Addendum No. 1 to the Service Agreement, effective as of February 6, 2001, between the Corporation and The Dow Chemical Company (See Exhibit 10.23.3 of the Corporation’s 2002 Form 10-K).
10.1.3
Service Addendum No. 3 to the Amended and Restated Service Agreement, effective as of January 1, 2005, between the Corporation and The Dow Chemical Company (See Exhibit 10.1.3 of the Corporation’s 2004 Form 10-K).
10.2
Second Amended and Restated Sales Promotion Agreement, effective January 1, 2004, between the Corporation and The Dow Chemical Company (See Exhibit 10.24 of the Corporation’s 2003 Form 10-K).
10.3
Second Amended and Restated Agreement (to Provide Materials and Services), dated as of April 1, 2005, between the Corporation and Dow Hydrocarbons and Resources Inc. (See Exhibit 10.3 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).
10.4
Amended and Restated Tax Sharing Agreement, effective as of February 7, 2001, between the Corporation and The Dow Chemical Company (See Exhibit 10.27 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).
EXHIBIT NO.
DESCRIPTION
10.5
Amended and Restated Revolving Credit Agreement dated as of May 28, 2004, among the Corporation, The Dow Chemical Company and certain Subsidiary Guarantors (See Exhibit 10.28 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).
10.5.1
First Amendment dated October 29, 2004 to the Amended and Restated Revolving Credit Agreement, dated as of May 28, 2004, among the Corporation, The Dow Chemical Company and certain Subsidiary Guarantors (See Exhibit 10.5.1 of the Corporation’s 2004 Form 10-K).
10.5.2
Second Amendment to the Amended and Restated Revolving Credit Agreement, effective as of December 30, 2004, among the Corporation, The Dow Chemical Company and certain Subsidiary Guarantors (See Exhibit 10.5.2 of the Corporation’s 2004 Form 10-K).
10.5.3
Third Amendment to the Amended and Restated Revolving Credit Agreement, dated as of September 30, 2005, among the Corporation, The Dow Chemical Company and certain Subsidiary Guarantors (See Exhibit 10.5.3 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).
10.5.4
Fourth Amendment to the Amended and Restated Revolving Credit Agreement, dated as of September 30, 2006, among the Corporation, The Dow Chemical Company and certain Subsidiary Guarantors (See Exhibit 10.5.4 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006).
10.6
Amended and Restated Pledge and Security Agreement dated as of May 28, 2004, between the Corporation and The Dow Chemical Company (See Exhibit 10.29 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).
10.7
Second Amended and Restated Revolving Loan Agreement, effective as of November 1, 2005, between the Corporation and The Dow Chemical Company (See Exhibit 10.7 of the Corporation’s 2005 Form 10-K).
10.8
Purchase and Sale Agreement dated as of September 30, 2005, between Catalysts, Adsorbents and Process Systems, Inc. and Honeywell Specialty Materials LLC (See Exhibit 10.8 of the Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).
Omitted pursuant to General Instruction I of Form 10-K.
Analysis, Research & Planning Corporation’s Consent.
31.1
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Wherever an exhibit listed above refers to another exhibit or document (e.g., “See Exhibit 6 of . . .”), that exhibit or document is incorporated herein by such reference.
A copy of any exhibit listed above may be obtained on written request to the Secretary’s Department, Union Carbide Corporation, 400 West Sam Houston Parkway South, Houston, TX 77042.