PFI and corporation tax

"Trading" or a Schedule A Business?

The project SPV in a PFI transaction invariably generates significant losses in the early years of a project. Surrendering losses to investor-shareholders can provide valuable cash flow advantages. However, if owned (directly or indirectly) by a consortium, the SPV's activities must amount to "trading" for losses to be eligible for surrender. The SPV must not just have what is termed a "Schedule A business" - broadly, the generation of income from land. Many PFI projects involve a lease granted by the commissioning public authority to the SPV with a leaseback from the SPV. Rent under the leaseback (or unitary charge income which the Inland Revenue regard, in substance, as rent payable for the use of land under the leaseback) will be income of a Schedule A business of the SPV. This does not mean, however, that the SPV is not also "trading". The Revenue accept that the SPV is "trading" for the purposes of the rules governing the surrender of losses provided it has additional activities capable of constituting a "trade". This may be so even if it receives Schedule A income in excess of 50% of total income. Most SPV's which provide additional services (which are not ancillary to the functioning of a building) will usually be regarded as "trading".

The role of capital allowances

In the early years of a project capital allowances may be available to set against taxable income. However, as income will not flow for a number of years, excess allowances (if not surrendered to investor-shareholders) can be carried forward to provide significant tax shelter for future unitary charge income. Transaction cash flows will assume the SPV pays minimal tax and capital allowances are crucial in achieving this. This low level of taxation reflects the fact that the "real" profit, for investor-shareholders, lies in the sub-contracts the SPV enters into in order to fulfil its obligations under the main project agreement with the commissioning public authority and not in the distributable profits of the SPV.

Broadly, allowances are available for capital expenditure incurred on the provision of both fixed and free standing plant and machinery - often forming part of a building which is central to the project (industrial buildings allowances may also be available). It is a key requirement, if allowances are to be claimed, that the plant acquired by the SPV "belongs" to it. This raises difficult issues in relation to fixtures and means that careful attention must be paid to what happens on termination or expiry of the project agreement. Allowances are ordinarily available at a rate of 25% (on a reducing balance basis). Importantly, however, the rate for plant and machinery with a useful economic life of 25 years or more is only 6%.

In certain circumstances the SPV can enter into a finance lease of plant and machinery with a finance lessor. In simplistic terms, this means the SPV pays lease rentals which are lower than interest payments would be on borrowings raised to acquire the plant itself.

Other costs and expenses

The deduction of other costs and expenses also contributes to the SPV's taxable profits being minimal. These include interest on borrowings and management and administrative expenses.

Interest on borrowings will generally be deductible in accordance with the SPV's accounting treatment.. Unlike interest on loans from parties "connected" with the SPV, interest on bank borrowings can "roll up" and still be deductible on an accruals basis.

Some costs and expenses will inevitably not be deductible. These include repayments of loan principal and, in land-based (as opposed to concession-based) structures, payments made to building subcontractors (any building forming part of the project will, in those circumstances, usually be a fixed, capital asset of the SPV, central to and used in it's business and not part of its "trading stock"). Tax structures are available (using "short lease premium relief" and the tax status of a property developer) to generate tax deductions for what would otherwise be non-deductible capital expenditure on "bricks and mortar". The detail of such structures are, however, beyond the scope of this article.

Surplus land

[Public sector accounting] often requires public authorities to minimise unitary charge - sometimes achieved by introducing land which is surplus to requirements into the project. Care is needed to ensure land is introduced in a tax efficient manner. Where it is introduced as "payment" on account of future unitary charge the fair value of the land will be a taxable receipt, spread over the life of the project agreement for tax purposes. Alternatively, where surplus land is introduced as a "capital contribution" to construction costs there will be no taxable receipt. However, the SPV's capital gains base cost in any related building will be reduced.

"Using Consortium Relief "

In order to achieve the advantages afforded by surrender of losses detailed legislative requirements must be satisfied. As mentioned above, an SPV owned (directly or indirectly) by a consortium must be "trading" for losses to be eligible for surrender. Additionally, the SPV's trade must have actually commenced for it to surrender losses. It can be argued, (although there is a contrary view!) that for tax purposes a trade commences when the SPV enters into the main project agreement.

Through consortium relief investor-shareholders can provide much needed capital to the SPV whilst reducing their own tax liabilities. Losses are surrendered in return for payments by investor-shareholders, calculated so that they benefit from a reduced tax charge. The SPV, for its part, receives a tax free injection of capital. Alternatively, losses can be surrendered for no immediate payment to afford investor-shareholders maximum cash-flow advantage.

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