Application of the financial arrangements rules to the D&C Phase in a public-private partnership

This determination may be cited as Special Determination S28: Application of the financial arrangements rules to the D&C Phase in a public-private partnership.

1. Explanation (which does not form part of the determination)

1. This determination relates to an arrangement (the Project) involving the finance, design, construction and on-going provision of operation and maintenance services in respect of the Facility by a limited partnership (the Partnership) under a public-private partnership agreement (the Project Agreement) with the Crown.  The Holding Partnership will be the sole limited partner in the Partnership, holding 100% of the Partnership.  The limited partners in the Holding Partnership are Limited Partner A, Limited Partner B and Limited Partner C.  This determination does not apply to Limited Partner C.
2. The Project Agreement comprises three basic components:
   • A design and construction phase (the D&C Phase) under which the Partnership agrees to design and construct the Facility for the Crown in consideration for a fixed lump-sum payment (the D&C Payment), payable on completion of the D&C Phase;
   • A Facility Lease in which the Partnership and the Crown enter and under which the Partnership pays an amount representing the rental under the Facility Lease to the Crown (the Rental Prepayment); and
   • An operations and maintenance phase (the O&M Phase) under which the Partnership will provide operation and maintenance services to the Crown over a 25 year term in consideration for monthly payments (the Unitary Charge).
3. The Partnership will enter into:
   • A Construction Agreement with a contractor (the Contractor), under which the Contractor will design and construct the Facility in consideration for monthly and milestone payments; and
   • an Operation and Maintenance Contract (the O&M Contract) with a service provider (the Service Provider), under which the Service Provider will provide the on-going operation and maintenance (and other) services in consideration for monthly payments.
4. The Partnership will raise external debt from a range of third party financiers (the Bank Debt).  Limited Partner C will provide a term debt facility (the Term Debt Facility) to the Partnership to supplement the Bank Debt.
5. The Holding Partnership will receive funding from Limited Partner C during the D&C Phase in the form of a convertible debt instrument (the Convertible Note).  Limited Partners A and B will provide investment support during the D&C Phase in the form of a letter of credit to the external lenders.
6. The Partnership will enter into Interest Rate Swaps in respect of the Bank Debt.
7. The Facility Lease, O&M Phase of the Project Agreement, Construction Agreement and O&M Contract are all excepted financial arrangements.  The D&C Phase of the Project Agreement, Bank Debt, Term Debt Facility and Swaps are financial arrangements to which the Partnership is a party.  The Project, including all of these agreements, is a wider financial arrangement. 
8. Special Determination S27: Convertible Note in respect of a limited partnership applies to the Convertible Notes.  Special Determination S29: Application of the financial arrangement rules to a public-private partnership applies to arrangements in the wider financial arrangement, excluding the D&C Payment.
9. This determination prescribes the portion of the D&C Payment treated as income under the financial arrangement rules (the Interest Component) and the method for spreading that income.

2. Reference

1. This determination is made under ss 90AC(1)(bb) and 90AC(1)(i) of the Tax Administration Act 1994.

3. Scope of determination

1. This determination applies to the Partnership in respect of the Project (which is set out in detail in Private Rulings BR Prv 14/31 and BR Prv 14/32 issued on 25 July 2014), including the D&C Phase of the Project Agreement, under which the Partnership agrees to design and construct the Facility for the Crown and will receive a fixed lump-sum payment (the D&C Payment) once the Facility is ready for operation.
2. This determination is made subject to the following conditions:
   • The design and construction costs of the Facility are agreed between the Partnership and the Crown on an arm's length basis and set out in the Base Case under the Project Agreement as referenced to in the definition of "Design and Construction Payment" in section 1.1 of the Project Agreement.
   • Limited Partner A and Limited Partner B use IFRSs to prepare financial statements and to report for financial arrangements.
   • The continued application of private rulings BR Prv 14/31 and BR Prv 14/32 issued on 25 July 2014.
   • The executed documentation not being materially different from the final documentation that was provided to Inland Revenue on 23 July 2014 to the extent that it impacts on the scope of the determination or the application of the financial arrangement rules to the Applicants and the scope of the determination.

4. Principle

1. During the D&C Phase of the Project Agreement, the Partnership will receive consideration from the Crown (in the form of the D&C Payment) and will in turn provide consideration to the Crown (in the form of the completion of the TG Project and the transfer of its rights, set out in clause 11.2(c) of the Project Agreement, in the Facility). The D&C Phase of the Project Agreement is a "financial arrangement" under s EW 3 and an "agreement for the sale and purchase of property or services" under s YA 1.
2. The Partnership and the Crown have agreed that the D&C Payment includes capitalised interest (clause 12.5(c) of the Project Agreement). The Interest Component of the D&C Payment will be income under the financial arrangements rules under subpart EW.
3. During the D&C Phase the Partnership has variable expenditure commitments which will accrue. The capitalised interest component of the D&C Payment is intended to offset the expected funding costs incurred in relation to these commitments.
4. The Interest Component is calculated with reference to expected funding costs.  No adjustment is made for variances between actual and expected costs as the D&C Payment, including capitalised interest, is agreed in advance.
5. The Interest Component needs to be spread over the term of the D&C Phase.

5. Interpretation

1. In this determination, unless the context otherwise requires-
   • "IFRS" means International Financial Reporting Standards as defined in s YA 1.
   • Capitalised terms have the same meaning as set out in the Project Agreement.
   • All legislative references in this determination are to the Income Tax Act 2007, unless otherwise stated.

6. Method

Calculation of Interest Component

1. The value of the completion of the TG Project and transfer of the Partnership's rights to the Crown, set out in clause 11.2(c) of the Project Agreement, is the agreed design and construction costs of the Facility (excluding Fitout) set out in the Base Case under the Project Agreement.
2. The D&C Payment less the agreed design and construction costs of the Facility (excluding Fitout) set out in the Base Case under the Project Agreement, is the Interest Component that is income under the financial arrangements rules.
3. BR Prv 14/31 rules on the portion to the D&C Payment that is not income under the financial arrangements rules, and is not considered in this determination. 

Spreading of Interest Component

4. The method for determining the amount of income that is to be allocated to each income year is as follows:
   1. The expected design and construction costs of the facility (excluding fitout) as set out in the Base Case are treated as having been incurred at the beginning of each of the six income years (the Annual Expenditure).  No adjustment will be made to the Annual Expenditure in any income year to reflect actual expenditure in that year.
   2. The interest allocated to each income year is then calculated in accordance with the following formula:
      
      Interest = OB x R
      
      Where:
      
      OB is the sum of the Annual Expenditure for that income year, plus the Annual Expenditure and interest attributable to any previous income year.
      
      R is the internal rate of return (based on annual rests) calculated using the notional cash flows in paragraph (a) above at the beginning of each income year as outflows, and the D&C Payment at the end of the D&C Phase as the only inflow.

7. Example

This example illustrates the application of the method set out in this determination.

The Partnership and the Crown agree to the D&C Payment under the Base Case sheet that the D&C Payment equals $1,200,000.

The Base Case sets out that the agreed design and construction costs of the TG Project (excluding Fitout) are to be $970,748.

The value of the "completion of the TG Project and the transfer of the rights set out in clause 11.2(c)" of the Project Agreement, as set out in Clause 12.3 of the Project Agreement, is equal to $970,748.

The Interest Component of the D&C Payment is $229,252 by implication of the valuation under this determination.

Limited Partner A and Limited Partner B will spread the Interest Component over the term of the D&C Phase of the Project Agreement, as follows.

The Annual Expenditure incurred and treated as having been incurred at the beginning of the relevant income year is as follows:

Based on receipt of the $1,200,000 D&C Payment in Year 6 the Project has an internal rate of return of 4.9171%. 

The Interest Component is therefore spread as follows:

This Determination is signed by me on the 25th day of July 2014.

Howard Davis
Director (Taxpayer Rulings)