INTM568000 - Thin capitalisation: FA2004 legislation - risk assessment: thin capitalisation - PFIs

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. Further background to PFI is provided in BIM 64000 et seq.

Public sector procurement of infrastructure services under the PFI is subject to procurement rules, many of which originated as EU directives. There must be a competition between potential private sector providers of the services 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 the relatively long and usually finite period of the PFI contract and the economic viability of projects is highly sensitive to the cost of finance.

PFI consortia bring to the project interested parties 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 joint venture company (JV) and if successful in its bid, the JV will contract with the relevant public authority to provide the services and assets required. PFI contracts are often long: 25 or 30 year terms are common.

The JV finances the development of the project by a combination of borrowings and equity which are repaid or remunerated from project revenues. Project revenues are paid by the public sector contracting authority (e.g. government department or local authority) in return for the services and assets provided, by “unitary charge” over the life of the PFI. 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 portion of most credit rated deals achieves investment grade, which can be AAA rated. 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 for commercial, non-tax reasons.

The balance of the funding requirement is predominantly junior debt generally provided by the JV shareholders (both shareholders connected to the contractors and unconnected investors which take an equity stake), but 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 JV to appropriate parties, usually the construction and facilities management subcontractors (who have the skills and financial support to handle them), through robust sub-contracting arrangements and insurance. And in all cases JV income is 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 JV (step in rights).

Following are a number of examples to illustrate the way in which the shareholdings and funding of PFI contracts may be structured. These are purely illustrative and in practice there are many other typical arrangements. The examples below are intended to show that shareholders’ sub- debt is not necessarily held in proportion to the shareholdings in the project company.

Illustrative PFI structures

The relatively low level of financial risk combined with the modest rewards achieved by competitive tendering result in higher 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 cashflows.

As in all cases, 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 the borrower, the risks that generally deter arm’s length lenders, such as bankruptcy risk and the risk of interruption of cashflows, are substantially reduced in PFIs. This makes it difficult to draw comparisons between PFI loans and those made in more conventional contexts.

Risk factors

There may be instances where a majority shareholder or a number of shareholders (and, possibly, also a third party finance provider) who, collectively, have control uses excessive interest payments to shield profits made in the JV from tax. However to ensure that enquiries are properly targeted at high risks you should consider the following risk factors before making enquiries:

• Does the JV look out of line compared to typical gearing for PFI JVs 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 JV 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 JV is not immediately paying tax may be a weak risk indicator unless this 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, if the marginal tax rate for the other party is low, or zero, that constitutes a risk factor.
• If there are differing commercial interests in the PFI JV, 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 JV reflects a range of commercial interests, artificial arrangements to “dress up” distributions of profit as interest payments become far less likely.
• However, in circumstances where one or more participants have controlling interests in the JV, it should be borne in mind that participation in the PFI may itself 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.