Tax practitioners have long been at least
superficially attracted to the potential tax benefits of a
"concession-based" structure for certain PFI projects (often
referred to in the market currently as the "contract debtor"
structure). Under the concession-based structure
the private sector consortium acquires no significant land interest
in the project site; there is merely a project agreement between
the commissioning public authority and the consortium's special
purpose vehicle (and some form of licence to enable the SPV to go
onto the land to provide the construction and other
services). Although accounting issues can be
significant, tax deductions for the cost of the fabric of the
building (not usually tax deductible) can be
claimed. No up-front loss is likely to be
crystallised but rather, tax deductions will, in all probability,
be spread over the life of the project agreement in accordance with
GAAP. Concession-based structures were bound to
excite the interest of the Inland Revenue. In
addition, they were considered inappropriate sometimes because of
concerns over "aggressive" tax structuring and, in some cases,
because of a misconception that a land-based structure gave lenders
a better security package. However, an edition
of the Inland Revenue Tax Bulletin published at the end of last
summer quietly highlights that, perhaps, the battle is worth
fighting from the taxpayer-borrower's
perspective. This impression is reinforced by
what we understand to be the Office of Government Commerce's
response to the Inland Revenue views (or possibly a prime example
of "joined up" Government). Broadly, the OGC
approach is that the public sector should "recapture" the Exchequer
cost of any favourable tax status afforded to a PFI SPV by securing
reductions in unitary charge payments. Given
this, the question is therefore whether the tax status of an SPV
can contribute to the competitiveness of a bid rather than whether
it can produce additional margin or benefits for consortium
members.
The Issue
Under a typical PFI arrangement a private sector
SPV owned by a consortium will contract to provide certain
facilities and services to the public sector (for example, a
hospital with non-clinical support services or a prison with
custodial services). The SPV often acquires a
significant interest in the project site, often under a lease from
the public sector body (which lasts for the duration of the PFI
contract). In these circumstances, there is
normally a leaseback to the public sector. The
relevant interest in land and buildings can be characterised as a
fixed capital asset of the SPV's business (where there is a
leaseback then for tax purposes the land and buildings are treated
as let as part of a rental business). The
commercial reasons for these "land-based" structures
vary.
A typical PFI contract will invariably oblige the
SPV to design and construct the relevant building (as well as fund
its construction and operate some form of service); significant
amounts of capital expenditure are incurred.
Much of that capital expenditure is not normally taken into account
as a deduction in computing the SPVs taxable profits; relief may be
given for a proportion of it but only if it is expended on plant or
machinery that qualifies for capital allowances (in certain PFI
road projects expenditure might qualify for industrial buildings
allowances but usually IBAs are not relevant).
Therefore, as a general rule, the cost of "bricks and mortar" is a
"tax nothing" and a significant element of the design and
construction costs will not be deductible in computing taxable
profits. Transaction cash flows will reflect
this and the unitary charge payable by the public sector body for
the facilities and services will be set at a level which takes into
account the amount of tax relief anticipated in respect of capital
expenditure.
Concession-based Structures
On the other hand, some SPV's do not acquire a
significant land interest in the project site (some form of limited
licence enables the SPV to go on to the site to fulfil its
obligations to design and construct the project building and
provide the project services). In this case the
absence of a land interest and a leaseback means that capital
allowances on plant and machinery are under
threat. However, the SPV (sometimes referred to
as a "composite trader") may argue it is in no different a
position, in tax terms, to any other building or construction
company; the design and construction costs of the relevant building
are treated as Schedule D Case I deductible expenses in computing
its taxable profits (including expenditure on materials for the
fabric of the building).
Scope of the trade
In their August 2002 Tax Bulletin the Inland
Revenue said that the question of whether or not design and
construction costs are to be treated as deductible Schedule D Case
I trading expenses (a question of determining the "scope" of a
particular SPV's trade) is a question of fact.
Except where there is clearly just a rental business being carried
on (and no other services provided over and above those supplied by
a typical landlord of a commercial building), the Revenue do not
generally dispute that a PFI SPV is carrying on a trade of
providing services for tax purposes. Rather, it
is the exact scope of an SPV's trade with which they are more
closely concerned. Significant reductions in
profits (or significant losses available for surrender by way of
consortium relief to the SPV's shareholders) can be generated if a
"composite trade" can be established under a concession-based
structure. The Revenue view is that there is no
definitive list of factors but, the intention of the SPV, what the
contract says and what the SPV actually does are all relevant in
delineating the scope of the trade. The SPVs
intention, however, will never override what it actually does in
practice in the Revenues opinion. The Revenue
have, then, clearly conceded that Schedule D Case I treatment for
design and construction costs is perfectly possible in the context
of the PFI concession-based structure.
Recapturing the Exchequer Cost
Recently the OGC have emphasised the need for the
public sector to recapture any additional Exchequer cost that might
result from an SPV either:
-
restructuring an existing project so that it
can be treated as carrying on a "composite trade" under a
concession-based structure; or
-
structuring future projects or those
currently under negotiation to achieve this.
The OGC do accept that where an SPV under existing
PFI arrangements negotiates a particular tax status with the Inland
Revenue the public sector counter-party should not expect to be
able to intervene. Otherwise, tax benefits to
the SPV should reduce unitary charge paid by the public sector.
As well as requiring recapture of any Exchequer
(tax) cost by reducing unitary charge, the OGC also apparently take
the view that the proposed tax and accounting assumptions within
bids should not be too conservative. Whether
this is encouraging public authorities to point out to bidders that
more favourable tax treatment may be available in appropriate
circumstances under concession-based structures is
uncertain! The concept of "value for money"
would still seem to be working as it should where the tax take is
low but the cost to the public sector is reduced by an equal
amount; the Treasury is subsidising a reduced unitary charge and
receiving a lower tax yield. Encouraging bidders
to structure transactions to achieve "composite trader" status
should be as fiscally neutral for the public sector as a bid which
produces a higher tax yield and increased unitary charge
payments.
However, the important point is whether a local
authority would feel happier at the prospect of paying a reduced
level of unitary charge generated by a degree of tax structuring or
seeking additional funding from the Treasury where a higher tax
yield has been reflected in increased unitary charge.
The Future of Tax Structuring?
The OGC's emphasis on recapturing the cost to the
Exchequer of the tax status of PFI counterparties leads to the
wider question of whether tax structuring generally has a role in
PFI? Clearly, essential tax house-keeping must
be done to ensure that transaction cash flows, on which unitary
charge payments are based, accurately reflect the likely tax
treatment of interest and other funding costs, capital expenditure
and other payments incurred by the SPV.
Obviously, this means clear drafting and a careful review of
transaction documentation. However, significant
tax-based structuring at the SPV level should be viewed as an
opportunity to improve the competitiveness of the bid rather than a
means of producing extra revenue or additional value for consortium
members given that the Exchequer cost of any particular tax
treatment will be "recaptured" in the form of reduced unitary
charge. The natural corollary of tax based
structuring would appear to be a reduction in SPV
income. Clearly tax certainty is a pre-requisite
if that is to be the case.
Focusing on tax based structuring as a means of
improving the competitiveness of the bid must be a positive
objective if the alternative for a particular local authority is a
battle with the Treasury for an increased contribution to cover
higher levels of unitary charge where a project has a higher tax
yield. The secondary PFI market should also not
be forgotten as an area of new opportunities for tax efficient
structuring.
For more information please contact Simon Meredith
at
[email protected].