Download taxation of infrastructure

Taxation Of Infrastructure
Gordon Mackenzie*
Introduction
Infrastructure in Australia is under strain from two influences. First, the existing limited
infrastructure is unable to keep pace with economic growth and, secondly, the demand for
health and welfare infrastructure because of an ageing population.1
There are no special rules for the taxation of infrastructure in Australian taxation law,
except in very limited circumstances. The taxation of infrastructure assets is governed by
the general taxation rules that apply to all other similar types of assets.
However, what can be said about infrastructure taxation is the number of anti tax
avoidance rules that it has attracted.
This large number of anti avoidance rules is a function of four unique aspects of
infrastructure and the way that they interact with the taxation rules.
*
B Sc LLb ( Mon) LLM (Syd) Grad Dip Securities Analysis FTIA F Fin Senior Lecturer
Atax, Faculty of Law UNSW Previously Global Tax Director AMP Ltd and team
member on Ausaid consultancy to Chinese Government on private financing for
Government infrastructure.
1
Jeffreys et al Critical success factors of the BOOT procurement system: reflections from
the Stadium Australia case study, Engineering, Construction and Architectural
Management 2002 9 p352. See, for example, Australian Financial Review front page of
30 July 2007 reporting that State Governments have $40bn of infrastructure planned.
1
First, infrastructure is characterised by large initial capital expenditure and the use of
leasing in financing structures. That raises tax issues about which party, either the project
sponsor or the financiers, should be entitled to the tax deductions for that capital
expenditure and, also, whether the lease is in fact a sale or a loan.
Secondly, seventy per cent of public infrastructure is used by State Governments in
which case it was possible to create a tax deduction for the capital expenditure that would
not otherwise have existed. 2 State Governments could reduce their cost of funding by
income tax deductions given by the Federal Government.
Thirdly, infrastructure projects typically use limited recourse debt, which is a form of
financing that continually draws the suspicion of the ATO because of its use in
aggressive tax avoidance schemes and also its ability to transfer the economic ownership
of the asset to the lenders.
Finally, the long term nature of infrastructure projects, in some case lasting for 20 to 30
years, created opportunities for the balance of the cash flows of the lease after the loans
had been repaid, to be dealt with tax efficiently.
This paper proceeds by first discussing some financing issues for infrastructure projects,
such as leasing and non-recourse debt.
2
Senator the Hon Helen Coonan, Assistant Treasurer Speech to AFR Infrastructure
Summit 5 August 2002
2
It then discusses the general tax rules that apply to typical infrastructure project financing
such as leasing, managing early stage losses and transferring depreciation deductions to
financiers. Next is a discussion of the anti tax avoidance rules that have grown up around
some of the unique aspects of infrastructure financing. These include rules that limit the
tax benefits when the user is Government, restrictions placed on limited recourse debt
and preventing tax efficient assignment of a lease.
Finally, the paper considers two initiatives that have offered investors tax preferences for
funding infrastructure financing and asks the question whether there is a need for these to
be reintroduced.
Infrastructure Financing
Leasing
There are several types of financing that are typical to large-scale infrastructure projects
and the first of these is the use of leasing to finance the project asset.
Leasing is attractive in infrastructure financing for various reasons including:
Conservation of capital and lines of credit of the sponsor, (not so readily available
since accounting standard changes brought under IFRS)
3
Cash flow and earnings generation of equipment, where the payments and term of
the lease can be varied to match the cash flow of the asset,
Convenience in terms of simpler documentation and flexibility of terms, 100%
financing of the asset,
Amortisation of the cost of acquisition of the asset, where most costs in
connection with the acquisition can be structured into the lease,
Tax timing, in terms of full deductibility of the rentals to the lessee,
Known and fixed costs,
Budget limitations,
Loan covenants, and
Joint ventures where lease financing is a convenient way of sharing costs in a
joint venture structures.3
3
Handbook of Australian Corporate Finance 5th ed. Butterworths page 276-277
4
In the normal course of events a lease is a right to use an asset for a certain period after
which it is returned to the lessor. It is possible, however, to structure the terms of the
lease such that it is difficult to distinguish the arrangement from a sale of the asset and
loan to the lessee.4 This can be achieved where, say, the rental payments over the period
of the lease correspond to the cost of the asset or the period of the lease is equal to the
period of the assets useful life. Also, the lessee can take on responsibility for the asset,
such as repairs and maintenance. In addition, the lessee will usually acquire the asset at
the end of the lease for its residual value that may be below its then market value.
In these cases the lease will be accounted for as a finance lease but for tax purposes will
be treated no differently to any other type of lease.5
Structuring a lease in that way is also attractive from a taxation point of view as the rental
payments are fully deductible and the lessor is entitled to tax deductions for owning the
asset, which it can share with the lessee in the form of reduced rental payments, thus
reducing its cost of funds.
However, that raises questions of whether the arrangement is truly a lease or whether it is
a sale of the asset or a secured loan, which is relevant to how it is taxed and is discussed
below.
4
R Krever TOFA: the unfinished agenda p10 [2006] AT Rev 1
The accounting standards (AASB 117) would require such a lease to be accounted for as
a sale of the asset to the lessee and a loan from the lessor. The taxation issues of such a
lease is discussed in detail below.
5
5
Limited recourse debt: limiting credit risk, creating efficiencies
Another typical characteristic of infrastructure projects is the use of debt financing to
acquire the asset (leverage). For example, a lease may be a leveraged lease, where the
lessor (the owner of the asset) acquires it with borrowed funds.
Where the asset is acquired with borrowed funds the lenders primary security for
repayment will usually be the contracts giving rise to the cash flows from the project.6
For example, if the project asset is a toll road where the project sponsor has borrowed
funds to build it, the lenders security will be the tolls. This type of security can be
distinguished from the security offered in real estate project financing or equipment
leasing where the lender’s primary security is the capital value of the asset.7
Leverage in these projects is most likely to be either non-recourse or limited recourse.
Non-recourse is where the lenders can only have recourse to the project’s cash flows at
any time during the course of the project, including the pre-production period.
Limited recourse, on the other hand, is where the lenders ability to look to the projects
sponsor in the event of default is also limited, but to other than just the project cash
6
7
Handbook of Australian Corporate Finance 5th Ed. Butterworths P 331
See footnote 1
6
flows.8 In either case the lender relies on the economics of the project and not the
creditworthiness of the sponsor.9
The benefits of non-recourse and limited recourse borrowing is that the sponsor of the
project is able to isolate, either in whole or in part, the risk of the project from its other
business and, also, it can also be used to shift risks of the project to the lender who may
be better able to manage these risks, thus creating economic efficiencies.10
The relevance of this overview of financing issues in infrastructure is that they can have a
significant effect on the tax outcomes of the project. Indeed, it is the potential for
manipulation of the tax outcome from some of these financing techniques that has created
the anti avoidance rules that are discussed below.
Taxation of Infrastructure
Leasing taxation
As most infrastructure projects include a lease of the major asset in the project the general
taxation rules for leases will apply.
8
Handbook of Australian Corporate Finance 5th Ed. Butterworths page 319-320
Ibid p 318
10
Ibid
9
7
Broadly, the lessee will be entitled to a tax deduction for the lease rental payments and
the lessor will, correspondingly, be assessed on those lease rental payments.11 (The party
entitled to the capital allowance deductions is discussed below.)
Is it a sale of the asset?
Within that simplistic view of leasing taxation there are tax rulings issued by the ATO
that ensure that the lease is, in fact, a lease and is not an in substance sale of the asset by
the lessor to the lessee as discussed above.12
The matters in those rulings that are considered in determining whether the lease is a true
lease and not a sale are:
The residual value of the asset compared with its cost at commencement. The
residual value is the value of the asset, as agreed, at termination of the lease. It is,
essentially, the difference between the aggregate rental payments and the cost of
the asset. For tax purposes it must be based on a reasonable estimate of the assets
market value at termination, and
Whether the lessee has any right to acquire the asset at the termination of the
lease.13
11
Ss 6-5 and 8-1 ITAA1997
“It was necessary to decide whether the payments were lease rentals or whether they
were, in substance, consideration for the sale of the goods.” Para 7 IT 28
12
8
If the lessor has borrowed funds to acquire the asset, as in the case of a leveraged lease, it
will be entitled to a deduction for the interest expense on the borrowed funds under the
general deduction rules, subject to complying with the tax ruling referred to above and
that following.14
Leveraged lease taxation
For a leveraged lease to be accepted by the ATO as a lease;
The lessors must contribute at least twenty percent of the cost of the asset,
Any lessor partners must share partnership profits and losses in proportion to
capital contributed, and the common or majority partner accounting periods must
be used,
The cost of the asset cannot include capitalised interest, and
The pattern of rental payments should not be large at commencement and smaller
closer to termination.15
13
IT 28
S8-1 ITAA 1997
15
IT 2051 and IT 2062
14
9
Is it a secured loan?
Metal Manufacturers was a case that involved a manufacturing company that sold its
principal piece of operating machinery to a financier and immediately leased it back (a
sale and leaseback).16
The machinery was a large piece of manufacturing equipment that was immobile, had
been built in a purpose built building, had no market were it ever sold and had been
already fully depreciated by the company.
The detail of the machinery that was sold and leased back is important as it shows the
underlying economics of the transaction and, indeed, it was the point of attack by the
ATO.
The ATO challenged the sale and leaseback on two aspects. First, that part of the rentals
paid by the company represented repayment of a loan to the financier and, as such, were
capital and not deductible. In other words it argued that the arrangement was not a lease
but was a secured loan. Secondly, that the sole or dominant reason for the company
selling and leasing back the machinery was to obtain tax deductible lease rental
payments.
16
(2001) 46 ATR 497
10
The court held that the lease payments were fully deductible even though the machinery
was critical to the company’s business operations, no one else could use it and it was
inevitable that the company would repurchase it on termination of the lease. Because the
company had completed the transaction so that it could use the sale proceeds to retire
some debt, it was not a transaction that had been done for the sole or dominant purpose of
avoiding tax.
Nevertheless, this challenge by the ATO shows the concern that it has with this kind of
financing. In particular they saw this type of arrangement as a loan to the lessee,
repayable with fully deductible payments disguised as rentals.17
Hire purchase taxation
Where the lessee has a right or option to purchase the asset at expiration of the lease and
it is reasonably likely that that will occur the transaction is treated as a hire purchase
arrangement for tax.18 In that case, the lessor is treated as having sold the asset and
loaned the value of it to the lessee. The lessee, on the other hand is treated as having
purchased the asset. The rental payments are then disaggregated between payments of
principal and interest with only the interest component being deductible to the lessee and
assessable to the lessor. The lessee is treated as being entitled to the capital allowance
deductions.
17
The case resulted in the ATO releasing a Tax Ruling that now accepts sale and
leasebacks done in these terms. IT 2006/13
18
Div 240 ITAA 1997
11
The following is an example that illustrates the relevance of using a hire purchase
arrangement in an infrastructure project that involved the sale of public assets by the
Victorian Government in the late 1980’s. Briefly, the Victorian government was selling a
power station in Yallourn in Gippsland to the private sector. The financing structure
chosen was a sale of the power station to a partnership of financiers. That partnership
then leased the power station under a lease that had an option to purchase, to a second
partnership of companies related to the financiers. That second partnership then leased
the power station back to the Government.
In short form the transaction was a sale and leaseback.
The point of the hire purchase arrangement (the first lease) was to pass the depreciation
deductions to the second partnership of companies, (hopefully) relying on the ATO to
follow its usual practice of allowing the lessee to claim the depreciation deductions in a
hire purchase arrangement.19 The losses generated by the capital allowance deductions
19
The ATO had historically treated a lease with an option to purchase (the first lease) as a
hire purchase transaction in other similar transactions in accordance with its long
standing administrative practice of treating the lessee as the owner for depreciation
purposes. IT 196 That in fact was contrary to what the law said. The ATO took exception
to the transaction and refused to issue a tax ruling supporting the second partnership’s
right to the capital allowance deductions under the hire purchase arrangement.
In the result the court declined to grant an order forcing the ATO to stand by its previous
practice. While the technical result of the case is of interest, what is more important is the
fact that in the whole of the litigation the ATO declined to articulate what exactly it found
offensive about the transaction. In other words, the ATO at no stage, either during the
litigation or afterwards, said why it would not issue a favourable tax ruling as it had done
12
would then be grouped with other tax paying companies in the financier’s corporate
groups.
Capital allowance (depreciation) deductions
Perhaps the most significant tax issue for infrastructure financing comes from the large
up front capital expenditure in these types of projects. The question is, then, which of the
two parties, the lessor or the lessee (assuming that lease financing is used), is entitled to
the tax deductions for that capital expenditure.20
The rules about deductions for capital expenditure recently changed from being
“depreciation” deductions to “capital allowance” deductions and, at the same time, the
so in many identical transactions. Perhaps the cost to the Revenue was an issue as the
value of this transaction was $743M, of a total value of $4.8 bn for the full privatisation.
Clearly the transaction was for a large amount and the net effect of the financing structure
was the advancement of the use of the capital allowances by the financiers. However, it
was not otherwise an unusual transaction in that the financing structure and tax effect had
been approved by the ATO in other transactions.
What is even more upsetting for the parties to the transaction was that the Government
formally changed the taxation laws to allow the lessee in a hire purchase transaction to
claim the capital allowance deductions.
Major amendments, after the Ralph Review, aligned the economic ownership of assets to
entitlement to this tax deduction - Div 40 ITAA 1997 from 1 July 2001. Previously, the
entitlement to the deduction had been based on legal concepts of ownership of the
relevant asset, which did not necessarily correctly reflect the economic relationship- s 54
ITAA 1936.
13
entitlement to those deductions changed from being solely dependant on legal ownership
of the asset to being dependant on either legal or economic ownership.21
The party now entitled to these deductions is the “holder” of the asset, which is defined in
terms of both the legal owner and the economic owner of the asset.22 In the case of a
lease, including a leveraged lease, the lessor will typically be treated as the “holder” of
the asset and thereby entitled to the tax deductions for the capital allowances.
Capital works deductions: building and structural improvements
Deductions are available for the cost of construction of a building used to produce
assessable income.23
Different rates of deduction (either 2.5% or 4%)apply depending on when the
construction commenced and the purpose to which the building is put. Relevant buildings
include industrial buildings and income producing structural improvements and industrial
activities includes producing electricity, steam or hydroelectric power.24
21
See note above
S 40-40 ITAA1997
23
Div 43 ITAA 1997
24
S 43-150 ITAA1997
22
14
The deduction also extends to cost of construction of certain structural improvements as
if they were a building.25Examples of structural improvements are things such as sealed
roads, bridges, airport runways, pipelines and so on.26
Managing early stage tax losses
Project sponsors will typically want to limit their credit exposure to the project as
discussed above in the context of limited recourse debt. That means almost invariably
each project asset will be owned by a new company or trust established by the project
sponsor for that purpose (called a Special Purpose Vehicle or SPV).27
As the SPV will not have any other income generating business or assets than the project
asset, large up front tax losses will be generated from the tax deductible capital
allowances and interest charges being incurred. These tax losses may be carried forward
and used in future years when the project begins to produce income. However, income
from the project may not start to produce income until well into the future, say three to
four years after the project is commenced.
25
S43-20 (2) to (4) ITAA 1997
S43-20 (3) ITAA1997
27
They are called a Special Purpose Vehicle (SPV) simply because they are established
for the special purpose of holding the project assets.
26
15
Tax losses: passing benefit to equity holders
In some cases the tax losses in the SPV can be immediately grouped for taxation purposes
with other tax paying entities in the corporate group of the sponsor. 28
In other cases the choice of SPV will be designed to facilitate the investors obtaining
immediate value for these losses. For example, the project asset may be owned by a unit
trust, the units in which are sold to retail and institutional investors who ultimately fund
the asset’s acquisition.
The choice of a unit trust as the SPV means that the investors can obtain immediate
access to the initial tax losses from the early stage capital allowance and interest expense
deductions. A unit trust is, in effect, able to pass the value of those tax losses to investors
through distribution of income that is not assessable income to the unit holders because it
is sheltered by those tax losses.29 Those distributions reduce the cost base of the units to
the investor for tax purposes. However, when those units are disposed of, or the cash
returned exceeds the initial cost of the investment, the investors will be assessed on a
capital gain based on the cost of the unit reduced by those distributions. In that regard,
they are a deferral of tax, but a benefit to investors nevertheless.
By way of comparison, had the SPV holding the asset been a company with retail and
institutional shareholders, the tax losses from the capital allowances and interest
28
This grouping has been made easier under tax consolidation rules. Division 701 ITAA
1997
29
CGT Event E4 s 104-70 ITAA 1997
16
deductions would be trapped in the company until the project commences to produce
income. The delay in use of those tax losses is value lost by the investors.
Care needs to be taken if the SPV holding the asset is a unit trust because of tax rules that
could cause the unit trust to be taxed as a company, rather than as a trust.30
This risk of the unit trust being taxed as if it was a company can be avoided if the unit
trust comes within one of the exemptions from application of these rules.31 Any part of
the project that is not within that exemption must be then carried on in a separate vehicle,
usually a company, to protect the unit trust’s tax status as a trust.32
Investors can then take an interest in both vehicles (units in the unit trust and shares in the
company) and those interests can be stapled if the project’ securities are listed on a stock
exchange.33
Tax losses: passing benefit to the lenders
Managing the early stage tax losses in infrastructure projects has been discussed above in
the context of passing the benefit of those loses to investors in a unit trust. But what if the
asset was financed by borrowed funds rather than by retail and institutional investors?
30
Division 6C ITAA 1936
That exemption is available provided that the unit trust is invested in wholly ‘eligible
investment business”. That term is further defined as, amongst other things, “investing in
land for the purposes, or primarily for the purpose, of deriving rent;” S102M ITAA1936
32
S 102M para (a) ITAA 1936
33
The Federal Opposition has announced that they would simplify these rules.
31
17
In that case, the tax deductions for the initial capital allowances and interest expenses can
be transferred to the lender who will have, in all likelihood, other assessable income that
it can immediately offset. The lender can then share the value of those deductions with
the project sponsor by reducing the rental payments and, thereby, reducing their cost of
funds.
In taxation terms this is called a “tax benefit transfer” or “tax preference transfer”
transaction and is disliked by the ATO because it advances the use of the capital
allowance deductions.34 Those tax losses would otherwise be trapped in the SPV holding
the asset and only used once the project commences to produce income, which could be
well into the future.
The capital allowance deductions are transferred to the lender through use of a finance
lease, as already discussed. In effect, the project sponsor will sell the asset or,
alternatively, arrange for the asset to be directly acquired by the lender, who will then
lease the asset back to the project sponsor’s SPV by way of a finance lease.
Provided that the lender satisfies all the other criteria, it will be entitled to claim the
capital allowance deductions from holding the asset, which can then be used to reduce its
other assessable income.
34
Main Objectives of Tax-based Financing: Current Issues, Wiley M, in Krever R,
Grbich Y, Gallagher P (eds) Taxation of Corporate Debt Finance (Melbourne: Longman
Professional 1990)
18
Except in the very limited circumstances that are discussed below, Australian taxation
law taxes a finance lease in exactly the same way as any other type of lease. That is the
case even though the economic nature of a finance lease is virtually identical to a sale of
the asset or a secured loan.35
Following recommendations from the Ralph Review of business taxation the re write of
the tax laws for financial arrangements (TOFA) recently included proposals that would
have treated finance leases as a sale of the asset by the lessor to the lessee and a loan of
the cost of the asset to the lessee.36 However, the Government announced in the 2007
Federal budget that it had decided to not proceed with this to avoid difficulties for small
and medium sized taxpayers.37
Notwithstanding the ATO’s dislike of finance leases it can be argued that they are not
disadvantageous to the revenue. The revenue’s usual argument is that the rental payments
are just disguised payments of the purchase price or repayments of a loan as in the Metal
Manufacturers case discussed above. On that analysis they should not be fully deductible
to the lessee. However the counter argument is that even if they are considered to be
repayment of the purchase price or of a loan those payments are fully assessable to the
lessor and, because of that symmetry, the revenue is not disadvantaged.38
35
See R Krever, TOFA: the unfinished agenda 12 [2006] AT Rev 1
A Tax System Redesigned Final Report (July1999) p392 para 10.9, Taxation Laws
Amendment (Taxation of Financial Arrangements) Bill 2007
37
Press Release No 99
38
R Krever, TOFA: the unfinished agenda 11 [2006] AT Rev 1
36
19
Another argument put forward in support of changing the way that finance leases are
taxed is that they are just transferring the capital allowance deductions from the true
economic owner of the asset (the lessee) to the lessor. The lessor may have other income
that it can shelter with those tax deductions whereas the lessee may not (see tax benefit
transfer discussion above). The loss to the ATO is the cost to it of the advancement of the
use of the capital allowance deductions.
In response to that it is said that the capital allowance deductions can be passed through
to the ultimate owners of the asset through choice of the legal vehicle used to hold that
asset. This is the point of the discussion above about use of a unit trust to hold the asset.
On that view a finance lease just facilitates transfer of the capital allowance deductions to
the lender, rather than the investors.
Anti Avoidance Rules In Infrastructure
Government as end user: deductions where none existed before
The most important anti avoidance rule impacting on infrastructure are those that limit
the capital allowance deductions where the end user of the asset is a tax preferred entity,
such as government or government agency.39
39
These provisions have a broader scope than just assets used by Government agencies as
they also apply to tax exempt and non–resident taxpayers using the assets. However,
20
The original rules that addressed this issue were inserted into the tax act in the early
1980’s to at a time when large amounts of government infrastructure assets were being
sold to the private sector and leased back.40
At the time, the Federal Government was concerned that the private sector owner of the
asset would be entitled to deductions for the capital allowances from ownership of the
asset, yet those deductions would not have been available to the State Government user
had it continued to be the owner. That was simply because State Government is not a tax
paying entity so had no entitlement to capital allowance deductions.
Selling the asset to the private sector then, in effect, created tax deductions which would
not otherwise have been available. Of course, the private sector buyer would share the
value of those tax deductions with the Government user by reducing the rental payments
and, thereby, its cost of funds.
Where the transactions involved very large public infrastructure assets there was a very
real risk to the Federal Government in terms of forgone revenue from granting the capital
allowance deductions.
given that Government is the main user of infrastructure assets they are the only taxpayer
considered in this paper in the context of these rules.
40
s 51AD inserted in 1984 and Div. 16D ITAA 1936 inserted in 1985.
21
In addition to being a potentially very costly exercise for the Federal government through
lost revenue it also created other problems as these transactions amounted to a
subsidisation of the State Governments by the Federal Government outside the normal
Federal/State Government funding arrangements.
Solution
Two sets of rules were introduced to deny the capital allowance deductions where,
amongst other things, the end user of the asset is a government agency.
The first of the two sections, which only applied if the private sector participant had
funded the acquisition of the asset with limited recourse debt, went much further than was
reasonable in the circumstances.41 In addition to denying the private sector participant
the capital allowance deductions, it also denied maintenance expense and interest
payment deductions and continued to assess the private sector participant on the rentals
paid under the arrangement.42
Importantly it applied where the asset Government had control “of use” of the asset
which proved problematic in its application.43
41
S 51AD ITAA1936
In technical tax language this is called an “annihilating” provision.
43
TR 96/22
42
22
In particular, it created uncertainty about when the provision applied which, in turn,
caused delays in finalising projects as project sponsors sought ATO clearance about its
application.
An example is given to illustrate the difficulties with the scope of these words is the case
of the police force’s ability to control the speed of drivers on the toll road owned by the
private sector. Did that mean that the Government “controlled the use” of that toll road?44
A second set of provisions was introduced shortly after the first and they applied in a
slightly different way.45
If this second set of provisions applied they recharacterised the transaction for income tax
purpose in the same way that the accounting standards do if the lease is accounted for as a
finance lease. That is, the asset is treated as having been sold to the private sector
participant and the cash flows are divided between notional repayment of a loan deemed
to have been made to the user and repayment of financing charges (interest) on that
notional loan. The notional loan repayments are neither deductible nor assessable but the
financing charges are deductible and assessable.46
The capital allowances otherwise available to the private sector participant were also
denied as, of course, that was the main purpose of the rules.
44
M Wiley
Div 16D ITAA 1936
46
S159K ITAA 1936
45
23
New rules: risk or control?
The Ralph Review considered both these provisions and made recommendations that they
be re written. 47 Replacement rules for both these provisions was released in 2003 in the
form of an Exposure Draft, which was based on the broad design principles that had been
announced by the then Minister for Revenue and Assistant Treasurer, Senator Helen
Coonan. 48
“The way forward will be to structure a replacement to section 51AD and the
associated 16D for tax exempt entities. It would be based around the operation of
a risk test rather that the current control test.”
Further on in that speech the Senator commented:
“A central element of the proposal framework for a replacement to Division 16D
is for the tax treatment to be based around the extent of risk transferred to the
private sector.”
47
A Tax System Redesigned Final Report (July 1999)
HTTP://www.rbt.gov.au/publications/paper/index
48
New Business Tax System (Tax Preferred Entities-Asset Financing) Bill 2003,
Exposure Draft
24
However, the Exposure Draft that emerged and which was based on concepts of risk was
not well received by industry because of its scope and difficulty of application.49
By press release on 13 September 2005 the new Assistant Treasurer advised that the risk
based test that had been announced by his predecessor was to be abandoned because of
“stakeholder concerns about the scope of arrangements affected by the reforms being
broadened by the use of new risk based test.”50
Legislation reflecting this new design principle was released on 16th August 2007 and it
uses an “effective control of use” test and a “predominant economic interest” test,
amongst other criteria, to identify transactions where capital allowance deductions will be
denied when Government is the end user of the asset.51
Financing Government Assets
The new Division to be inserted into the tax law to address this problem will deny or
reduce the capital allowance deductions that would otherwise be available to a taxpayer
in relation to the asset if it is used by what is called ‘a tax preferred end user”.52
49
The Exposure Draft included rules identifying at least seven elements before it applied.
Press release 008
51
Ss 250-15 and 250-50 Tax Laws Amendment (2007 Measures No 5) Act 2007
52
See definition of this term to be inserted into s 995 (1) ITAA That term includes nonresident and tax exempt taxpayers in general. However, as the focus of this paper is on
infrastructure the rules are discussed solely in the context of the end user being
Government.
50
25
If the capital allowance deductions are denied by these provision the payments in relation
to use of the asset are treated as a loan repayment in much the same way as the second of
the provisions being replaced do and also the accounting standards do in the case of a
finance lease, as discussed above.53
In very broad terms the new rules will apply where Government controls the use of an
asset that is leased and which asset produces goods, provides services or facilities that is
paid for by government. Plus where the economic nature of the arrangement is,
essentially, a finance lease.
The operative provisions require that five things be present before that capital allowance
deduction will be denied:
Government uses the asset,
The arrangement is for at least 12 months,
Government pay for that use of the asset,
The owner of the asset would have otherwise been entitled to capital allowances,
and
53
Divs 250-C, 250-D and 250-D of Tax Laws Amendment (2007 Measures No 5) Act
2007
26
The owner of the asset does not have a ‘predominant economic interest’ in the
asset.54
Within that schematic view of how the division is to apply there are a significant number
of defined terms to ensure that the division operates effectively. For example,
“government” is defined to include entities controlled by Government and the very broad
term of “financial benefit” is used to capture effective payments.55 These are not
discussed further here.
One of the requirements for application of the provisions is that the owner of the asset not
have a “predominant economic interest” in the asset.
A taxpayer will not have a “predominant economic interest” in the asset where the
arrangement is, essentially, a disguised financing arrangement including:
Where the asset has been acquired with more than 80% of its cost by limited
recourse debt. That level can be exceeded where it is a non-leased asset if there is
no financial support or, if the asset is leased, it is real property where no ore that
fifty percent of the area is leased to non-government tenants.
The Government has a right to acquire the asset,
54
55
S 250-15 Tax Laws Amendment (2007 measures No 5) Act 2007
S 250-55 and 250-85 Tax Laws Amendments (2007 No 5 Measures) Act 2007
27
The arrangement is effectively non-cancellable, or
The present value of expected rentals exceed 70 per cent of the market value or
construction cost of the asset.56
There are five exclusions to application of the rules which are to ease compliance costs
and these are:
For small business entity providers,
Where the nominal value of payments is less than $5M,
The arrangement is for less than five years if the asset is real property or three
years for any other type of asset. That exclusion only applies if the arrangement is
not a disguised loan,
The present value of the assessable income calculated under these rules is less
than the net assessable income that would otherwise have been calculated, and
The Commissioner determines that the provisions will not apply.57
Effectively the re written rules should make it easier for taxpayers to self assess the
determination if they apply to the transaction, unlike the provisions that they are
56
57
S 250-110 to 250-135 Tax Laws Amendment (2007 Measures No 5) 2007 Act
Ss 250-20 to 250-45 Tax Laws Amendments (2007 Measures No 5) 2007 Act
28
replacing. Also, these provisions do not have the same severe effect as the first set of
provisions being replaced as discussed above, where rentals continued to be fully
assessable.
Limited Recourse Debt
Limited recourse debt is used in infrastructure projects for the reasons that have already
been described in the first part of this paper. To reiterate, it is used to isolate the credit
exposure of the project from other parts of the sponsor’s business and used to allocate
risk to a lender who may be better able to manage those risks, resulting in economic
efficiencies.
Yet the ATO has a very jaundiced view about the use of limited recourse debt and, given
the history of it use as discussed below, that may not be an unreasonable position to
take.58
ATO Taxpoint is even more blunt. “The Tax Office often associates risk protection
afforded to the borrower by the use of limited recourse debt with tax avoidance
arrangements” at para 24 130.
In more recent times the nature of limited recourse funding has changed. The most recent
and highly public example of its use is in Instalment warrants and endowment warrants.
In effect, these are loans made to investors that are limited to the value of the assets that
the investor acquires with the loan.
58
For example, an investor may acquire an equity portfolio with the loan. The lender’s
security is limited to the equities acquired with the loan funds by the investor.
TR IT 2051 which deals with limited recourse debt in the context of a leveraged lease.
A variation of this is where the payments to the lender for the Instalment warrant also
includes a fee to pay the lender for an option over the equity portfolio. Deduction of the
fee was challenged unsuccessfully by the ATO on the basis that it was of a capital nature.
See FCT v Firth (200) 50 ATR 1. Remedial legislation was then introduced to apply the
29
Limited recourse debt was first targeted by the ATO when it was used in mass marketed
highly aggressive tax avoidance schemes in the 1970s and 1980s. 59
Its role then was to limit the financial exposure of the investor in the scheme. For
example, a round robin financing would be used where the promoter of the scheme
loaned funds on a non-recourse basis to the investor and recouped those funds from the
scheme itself. In that case, the promoter was paid all their funds and the investor, because
of the non-recourse nature of the loan, had no on-going liability to repay the funds. The
purpose of such schemes was, obviously, to generate advantageous tax benefits for the
investor.
More recently limited recourse debt is seen by the ATO as a transfer of the economic
ownership of the asset to the lender from the borrower. An example of application of this
principle is the Tax Preferred Entity tax rules discussed above. In those rules the taxpayer
is denied capital allowance deductions where, amongst the things, the taxpayer has
limited recourse debt of more than eighty percent of the value of the assets, which is a de
facto test of economic ownership of the asset.
Nevertheless, the ATO has accepted the use of limited recourse debt in large scale
infrastructure projects subject to the borrower satisfying certain requirements.60
tax treatment that the Commissioner had sought to apply in that litigation- see Div 247
ITAA 1997
59
See for example Fletcher v FCT (1992) 22 ATR 613
30
Where limited recourse debt is used to fund the acquisition of an asset there is potential
for the debt not to be fully repaid. This could happen when the financier has fully
depreciated the project asset for tax, which together with other repayments, reimburses
the financier.
Even though such non-repayment of the limited recourse debt in full is more likely to be
the case in mass-marketed aggressive tax avoidance schemes as discussed above, it is not
unknown in large scale infrastructure projects.
The problem for the ATO is that it will have allowed capital allowance deductions for the
full value of the project asset, yet the owner of the asset may not have repaid in full funds
borrowed to acquire it.
To prevent this kind of behaviour a set of provisions was inserted into the tax law that
recaptures capital allowance deductions if limited recourse debt is terminated before it is
fully repaid.61
So, where limited recourse debt is used to acquire an income-producing asset and the
limited recourse debt arrangement is subsequently terminated, any capital allowance
deductions claimed in excess of the actual debt repaid is assessable as income.62
60
61
IT 2051
Div 243 ITAA 1997
31
Lease assignments
The final anti avoidance rule considered relates to two of the financing aspects of
infrastructure projects. The first is the early stage tax losses from the capital allowance
deductions and interest expenses and the second is the long term nature of these
arrangements.
In any arrangement the ATO, before issuing a ruling confirming the tax outcome, will
want to ensure that the arrangement will be overall net tax positive. That means,
essentially, that over the entire term of the arrangement the transaction will produce
assessable income after taking into account the early stage tax losses.
However, even though it can be demonstrated at commencement that the project overall
will be tax positive, it was possible for the project sponsor to transfer the balance of the
lease to avoid tax on future rental payments, after fully utilising the tax deductions from
the capital allowances from the project asset.
The net effect of transferring the balance of the lease rentals is that, at that stage, the
project sponsor is relieved from paying tax on the remaining rentals. Instead, they will be
paid a tax effective capital sum by the purchaser of the remaining rental payments.
62
The provisions include the notional loan in a hire purchase arrangement in the
definition of limited recourse debt and have extended application to borrower
partnerships and 100% owned borrowing subsidiaries – see Subdiv 243-D and s 243-70
32
A transfer of the remaining lease payments rentals would, in the normal course of events,
create a tax liability equal to the difference between the after tax depreciated value of the
project asset and the amount for which it was transferred. However, it was possible to
avoid that if the transaction was structured correctly.63
The remaining lease rental payments would be sold to a taxpayer who was not concerned
that they were taxable payments, such as a low rate or zero rate entity.
To counter this type of activity anti avoidance rules were inserted such that where an
asset that had been leased, and for which capital allowances deductions have been
claimed, is disposed of the difference between the money consideration and any other
benefits obtained, such as the transferee assuming any debt associated with the plant, over
the written down value of the asset, is assessable income of the transferor.64
These provisions also extend to disposal of rights under the lease, as well as partnership
interests in the asset and “downstream” interest in companies that belong to the lessors
corporate group.65
If any of the consideration is assessable under the normal balancing adjustment rules
mentioned above, they are ignored.
63
Subdiv 40-D ITAA 1997
S 45-5 ITAA 1997
65
S 45-10 and 45-15 ITAA 1997
64
33
Tax incentives for infrastructure
There have been two initiatives by Government to pass the tax losses from the interest
expense deductions to investors earlier than would have otherwise have been the case.
The purpose was to make infrastructure financing more attractive and lower the cost of
funding for the project sponsors.
The first initiative, which commenced in 1995 and finished in 1997, exempted from tax
the interest, or interest equivalent payments, paid to investors on amounts that they had
lent to the project. 66 The project sponsor who had borrowed the funds was denied a tax
deduction for that interest payment.67
After submissions by interested parties that the tax exemption of the interest payment was
not attractive to zero and low rate taxpayers, such as superannuation funds, the rules were
changed so that investors could elect between the exemption from tax of the interest or,
alternatively, including the interest in assessable income and claim a tax rebate equal to
the general corporate tax rate.
Rebateability was attractive to tax paying investors whose marginal tax rate was less than
the general tax rate. For example, a superannuation fund’s nominal tax rate is 15% so
exemption from tax resulted in a net tax saving of 15%. However, a rebate at the general
company tax rate (which initially was 36%, but is now 30%) resulted in a net tax saving
66
67
Speech by Senator Helen Coonan to AFR Infrastructure Summit, 15 August 2002
Div 16 L ITAA1936
34
of 21%, being the 15% nominal tax rate on the interest payment less rebate of 36% at the
then corporate rate.
However, both those initiatives were withdrawn in 1997 as a result of aggressive tax
planning.68 The estimated revenue cost of the abandoned concessions over the period from
1996 until 1999 (assuming that all the projects which had applied for approval had been
implemented) was $4bn, which was clearly unsustainable.
68
Page 2 Senate Economics Legislation Committee Report on Taxation Laws
Amendment (Infrastructure Borrowings) Bill 1997
“As mentioned already this concession was abandoned in 1997 because of aggressive tax
planning around it. For example there was manipulation of the interest payments. The
previous government had introduced amendments to the legislation governing IBs to stop
tax-aggressive schemes but these had not been successful in decreasing the cost to the
revenue. These schemes utilise a number of features to extend the concession beyond its
intention and to substantially increase the cost to revenue.
• Firstly, many start with artificially high interest rates that provide scope for the
conversion of part of the expected future exempt interest receipts into a premium on
the sale of the bonds. Under the IBs concession, this premium is a tax exempt
receipt.
• Secondly, the interest receipts on the bond which has an artificially inflated value
are also exempt.
• Thirdly, high-wealth individuals that purchase IBs at the retail level generally
utilise borrowings to ‘fund’ the purchase of these bonds at inflated prices and obtain
tax deductions for that interest, whilst the interest earnt on the bonds is tax free.
In all three cases, the additional cost to the revenue need not provide any benefit to
infrastructure project itself.
the
Against that background, the Treasurer (Mr Costello) announced on 14 February 1997 the
cessation of the infrastructure borrowing tax concession.”
The estimated revenue cost of the abandoned concessions over the period from 1996 until
1999 (assuming that all the projects which had applied for approval had been implemented)
was $4bn, which was clearly unsustainable.
35
On budget night of that year the Treasurer announced the introduction of a more limited tax
benefit that was far more controlled than the one that it replaced.
These replacement provisions allowed a tax offset (rebate) at the general company tax
rate for interest (and interest equivalents) payments on borrowings for “land transport”
assest only. To further protect the revenue this concession was limited to the first five
years of the lending.69 (The 2004 Federal Budget announced that no new projects would
be approved under these provisions.)
Within that context and taking into account the massive need for upgrading and new
infrastructure projects the question is whether there is any need for tax concessions
similar to those that were available until 2004?
The answer is probably not. To the extent that those tax concession were intended to
advance the tax losses from the interest expense in these projects, that is available
through the (indirect) mechanism of unit trust distributions that have been discussed, as it
is for the tax losses generated by the capital allowance deductions.
To the extent that funding for these projects is by way of debt funding from financial
institutions then mechanisms such as finance leases are available to transfer the capital
allowance deductions to the financial institutions, thus having the same effect.
69
Div 396 ITAA 1997
36
Conclusion
Except in very limited circumstances there is no separate set of rules for taxing
infrastructure projects.
When one considers some of the typical financing structures in infrastructure projects
interacting with the general tax rules can lead to tax outcomes which require specific anti
avoidance rules to address them.
First, lease financing and very large early stage losses from the very large capital
expenditure is typical for infrastructure projects. This leads to some challenging taxation
issues such as which of the two parties, the lessor or the lessee, should be entitled to the
capital allowance deductions from those tax deductions.
A finance lease, which is where the risks and rewards of ownership are transferred to the
lessee, is used as medium to transfer the tax benefits of the capital allowance deductions
to the lessor. Finance leases are separately recognised from other forms of lease for
accounting purposes and there was a recommendation that they receive a similar
treatment for income tax purpose but the Government has announced that that is no
longer going to happen. In that case fiancé lease continue to be taxed in exactly the same
way as any other form of lease, including facilitating the capital allowance deductions to
be transferred to the lessor.
Debt or leverage is another typifying characteristic of infrastructure projects and in
particular limited recourse debt. That is seen as advantageous for two reasons. First, it
37
limits the credit exposure of the project sponsor because the security for the debt is
limited, either in whole or part , to the project assets. Secondly, it can provide economic
efficiencies by transferring risk from the infrastructure project to the lender who may be
in a better position to manage that risk.
However, from a taxation point of view limited recourse debt is saddled with it having
been used in aggressive tax avoidance schemes in the 1980’s and, in addition, can in
substance transfer the economic ownership of the asset to the lender, while the borrower
is receiving tax benefits from ownership.
In that case anti avoidance rule shave been inserted into the tax law such that if the
limited recourse debt is terminated before it is completely repaid, there is a reclaim of
some of the capital allowance deductions that have been given.
Finally in this regard, infrastructure projects, in addition to having early stage tax losses
from the large capital outlay, typically last for very long periods.
Even though the ATO will ensure at commencement that the net cash flows from the
project will produce assessable income it was possible for project sponsors in certain
circumstance to dispose of the future rental payments that would otherwise have been
assessable, once the initial cost of the project had been recouped in the form of rentals
and capital allowance deductions.
38
To combat such practices anti avoidance rules were inserted into the tax laws that reclaim
capital allowance deductions to the extent that the debt has not been fully repaid.
Finally, the Government has, on two occasions, offered tax concessions for investors who
made loans for infrastructure projects. It is considered that there is no need for such
incentives as the same result that those initiatives achieved can be achieved under
existing rules.
39