Tax Treatment of PFI Design and Construction Costs

United Kingdom

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

simon.meredith@cms-cmck.com.