Thin capitalisation: practical guidance: measuring debt: Private Finance Initiative (PFI) companies
PFI introduces private sector expertise and finance into the design, building and maintenance of major public-sector infrastructure projects and the operation of some public services.
The idea is that the private sector will assume much of the risk in:
- building and managing property (for example, a hospital) and/or
- providing support services
PFI is an infrastructure procurement model that was introduced by the UK Government in 1992 as a means of utilising private sector capital and project management skills to develop, upgrade and operate public sector infrastructure and services.
There is extensive guidance on the way PFI works in the Business Income Manual, from BIM64005 onwards.
Procurement is the acquisition of goods and services. In relation to a PFI project it means the full range of requirements connected with the project, for example, negotiating contracts, dealing with suppliers, undertaking project management.
Public sector procurement of infrastructure services under the PFI is subject to procurement rules, many of which originated as EU directives. These require that there must be competition between potential private sector providers, and the price eventually negotiated must be affordable and represent “value for money” for the public sector. PFI projects generally require substantial financial investment for relatively long periods and the economic viability of these projects is highly sensitive to the cost of finance.
A PFI contract will typically be signed with a consortium which brings to the project the various talents required to complete the contract, such as a building contractor (who will build the facility), a facilities management provider (who will provide the services required to operate the facility) and one or more financial investors. A PFI consortium will normally set up a special purpose vehicle (SPV), and if successful in its bid, the SPV will contract with the public authority to provide the services and assets required. PFI contracts are often long: 25 or 30 year terms are common.
The SPV finances the development of the project by a combination of borrowings and equity which are repaid by project revenues. Project revenues are paid over the life of the PFI by the public sector contracting authority, for example, a government department or local authority, by way of what is known as a “unitary charge”. The unitary charge is often index-linked in some way and is always performance related.
The PFI contract structure can provide a high degree of protection against risk, in particular with the public sector source of revenue streams. Despite senior debt levels in typical projects of 85 to 95%, the senior debt may, nevertheless, be credit rated as AAA. This very high rating will often reflect credit enhancement of some form, but even without enhancement, the debt typically remains investment grade. The senior debt will nearly always be provided by third parties, demonstrating the unusually high gearing that is possible in PFI deals.
The balance of the funding requirement is predominantly junior debt generally provided by the SPV shareholders - both shareholders connected to the contractors and unconnected investors which take an equity stake, though third-party lenders that are not shareholders may also be involved. The interest paid on the junior debt will typically be higher than for senior debt, reflecting the higher marginal risk profile assumed, although junior debt would normally be expected to earn a lower return than equity. Equity funding may provide 5% or less of the funding requirement and may even be less than 1% in some cases. The degree of risk in a PFI varies according to the nature of the project and the commercial circumstances. For example, software and technology based PFIs will generally involve more risk than construction or maintenance of buildings. However, most risks are typically passed out of the PFI SPV to appropriate parties, usually the construction and facilities management subcontractors (who have the skills and financial support to handle them), through sub-contracting arrangements and insurance. PFI contracts have special characteristics because they are based on long term, public sector backed contracts, which substantially reduces risk compared to purely private sector contracts. Risk is further reduced by rights obtained by the participants to take control of a poorly performing project. These are referred to as step in rights.
The relatively low level of financial risk combined with the modest rewards achieved by competitive tendering result in high levels of gearing. This does not of itself indicate thin capitalisation, because levels of debt that would be excessive in other contexts will frequently be a normal market reaction to the credit quality of the public sector entity, the risk profile and the long term, relatively stable nature of PFI cash flows. The question is whether the amount of loan exceeds the amount that would or could have been borrowed from an arm’s length lender. Looking at the borrowing capacity of a PFI borrower, and in particular the risks that generally deter arm’s length lenders, such as bankruptcy risk and the risk of interruption of cash flows, it is likely these risks are substantially reduced compared to other situations. This makes it difficult to draw comparisons between the gearing of PFI projects and the gearing seen in more conventional contexts.
There may be instances where PFI shareholders use excessive interest payments to shield the profits of the SPV from tax. To ensure that enquiries are targeted at high risks, the following risk factors should be considered before making enquiries:
- Does the SPV look out of line compared to typical gearing for PFI projects in the sector? Even within the context of a market where very high levels of gearing are the norm, there may be cases that appear exceptional.
- Is tax avoidance a credible motive for the participants? Also if the SPV is loss making, it may be that a thin capitalisation adjustment would have no immediate tax effect for that company. In view of the long term nature of PFI contracts, the fact that the SPV is not immediately paying tax may be a low risk indicator unless this situation continues for the long term.
- Are the interest receipts taxable in the hands of the PFI participants? If so, what is the tax incentive for paying excessive interest? As with other aspects of transfer pricing, that constitutes an important risk factor if the marginal tax rate for the other party is low, or zero.
- If there are differing commercial interests in the PFI SPV, this may make thin capitalisation less likely. For instance, a building contractor will have an interest in ensuring that investors in the PFI receive no more than a typical investor’s level of reward. Where the PFI project reflects a range of commercial interests, artificial arrangements to “dress up” distributions of profit as interest payments become far less likely.
- In circumstances where one or more participants have controlling interests in the SPV, then participation in the PFI may represent an alignment of commercial interests. In this way there may be collaboration between the parties, or arrangements falling short of collaboration, that may contradict the presumption of independence as set out in the preceding paragraph for the purpose of determining the risk of thin capitalisation.
Extension of the scope of transfer pricing rules
On 4 March 2005, changes to extend the scope of transfer pricing legislation were announced. This announcement did not affect the treatment of existing or new PFI deals that fall within the scope of the pre-existing transfer pricing rules. The following extract from Hansard makes this clear.
“Let me make it clear that no changes are being made to the existing transfer pricing rules that apply to many PFI deals. We do not expect the changes to have any effect on PFI funding…. The changes close off loopholes to prevent companies restructuring to get around the existing rules. They do not alter the way in which the existing rules apply to companies involved in PFI deals or other companies.”
The Financial Secretary to the Treasury, John Healey 13th June 2005, Hansard: Column 112
If any PFI deals are brought within the scope of transfer pricing rules by the changes announced on 4 March 2005, then this guidance will apply to those deals in the same way as it applies to PFI deals within the scope of the pre-existing rules.
Government debt funding of PFI
On 3 March 2009, the Chief Secretary to the Treasury announced plans for a temporary intervention into the funding market for PFI projects. All PFI projects that have been issued an Official Journal of the European Union notice and future PFI projects as approved will be eligible for this funding.
The Government will provide debt funding alongside commercial lenders and the European Investment Bank. It will also be able, where necessary, to provide the full amount of debt required by a project. The lending will be made by a financial institution established by the Treasury, although it is intended that the loans will be sold on, prior to maturity, as market conditions ease.
Questions may arise as to whether the application of the UK transfer pricing rules could limit tax deductions for interest in respect of this type of borrowing. The transfer pricing rules can apply where a lender is directly or indirectly participating in the management, control or capital of the borrower. While it is unlikely that the Treasury’s financial institution would be a direct participant, it is possible that in certain cases it would be treated as indirectly participating through the ‘acting together’ rules (INTM519040).
This does not necessarily mean that transfer pricing adjustments on the interest deductions will be required as transactions within the scope of rules could be on arm’s length terms. The Treasury’s financial institution will be offering the funding on commercial terms determined by market conditions. HMRC therefore considers any lending between the Treasury’s financial institution and a PFI Special Purpose Vehicle is likely to represent a low risk in terms of transfer pricing.