An introduction to PFI

Overview

What is PFI? What is it intended to achieve and how does it work?

Despite being introduced in the mid-1990s, it is only relatively recently that the Private Finance Initiative or PFI has grown significantly. In fiscal terms, PFI is intended to enable local and central government to fund capital projects out of future revenue. In PFI projects private sector bodies, ranging from construction companies to venture capitalists, invest in a capital project to design, build and fund the construction of a public building and, in many instances, operate facilities there ("DBFO"). DBFO arrangements have long been used in infrastructure projects and under PFI is commonly used to facilitate the construction etc of schools, hospitals and prisons. In return for their investment in the project, investors receive a proportion of an annual fee or "unitary charge" payable by the public authority commissioning the project for the 20 or 30 years duration of the project.

PFI structures

Broadly, there are two legal structures for a PFI project; a "concession based" and a "land based" structure. In both, a special purpose vehicle company is established by the investors who will also own shares in it (their interests as shareholders being regulated among themselves under a shareholders agreement). The commercial rationale for the SPV is the requirement of the public sector to have a single entity to contract with and thus a single entity to have contractual responsibility to deliver the project in accordance with the terms of the key legal document - the project agreement. Subcontractors (often the investors themselves) provide the specialist services necessary for the SPV to fulfil its direct obligations to the public authority. Under a concession based structure the SPV acquires no significant land interest in the project site; there is just the project agreement between the public authority and the SPV. In a land based structure, the SPV acquires significant land interests (usually under a lease and lease back of the project site) and retains that interest throughout the project term. A typical land based structure would, for example, involve a grant of a lease by an NHS trust of land upon which a new wing of a hospital was to be built to a project SPV and a lease back of the same land granted by the SPV to the trust. The main commercial reason for the grant of a lease rather than some other interest (for example, a licence) is that third party financiers will want the SPV to be backed by assets against which they can lend. In our experience, land based structures are more common; concession based structures can present opportunities for deducting what would otherwise be non-deductible capital expenditure for tax purposes but attract considerable Inland Revenue scrutiny.

In some projects, funding costs (interest on loans from third party banks) are reduced by "contributions" of surplus land (owned by the public authority concerned). These "contributions" involve outright legal transfers of the land to the SPV. The SPV then, separate from the main project, develops and sells the surplus land at a profit, with overage payable to the public authority.

Virtually all PFI projects involve the construction of some form of building and the supply of ancillary services - for example, facilities management. Other projects involve additional services, for example, a project under which the SPV supplies a new wing to a hospital may also involve the supply of clinical services (these will in fact be supplied by one of the SPV subcontractor/shareholders which specialises in healthcare).

The role of taxation

Tax plays an important part in PFI projects and affects initial pricing and cashflows. Additionally, for example in concession based structures, the interaction between tax and accounting is important. Use of tax reliefs available to the SPV in the early years of a project (for example, the surrender of consortium relief to its investor shareholders) can provide additional returns which can be factored into pricing when investors are putting a bid together. Withholding tax on transaction cashflows (for example, on interest payments or under the Construction Industry Scheme) can affect returns. In addition, tax deductions, for example, for capital allowances, which have been assumed to be available (in transaction cashflows) but which ultimately cannot be claimed because of some legal impediment produced by a defective structure will have significant cost implications. Finally, VAT planning can play a significant role. In future articles we will examine many of these issues and the pitfalls to be avoided.

The role of the Treasury Taskforce

No discussion of PFI would be complete without examining Treasury Taskforce Guidelines. From the point of view of the public sector, PFI has two central requirements. First, risk relating to the project must be transferred to or assumed by the private sector. Secondly, "value for money" must be obtained. These Guidelines represent a set of "standard" terms and conditions upon which PFI transactions should be undertaken by a public sector body. They provide what is or is not acceptable in terms of risk and provide for how "value for money" should be secured. From a tax perspective, some of the "standard" clauses are inadequate. Additionally, the emphasis upon risk transference means that any risk of a change of tax law with an adverse affect on the structure (for example, a reduction in the rate at which capital allowances are available) is borne by the private sector. Further reference will be made to the Guidelines in subsequent articles.

For further information please contact Simon Meredith on 020 7367 2959 or by e-mail on [email protected].