S50
Issued
31 Oct 2016

Application of the financial arrangements rules to the D&C Phase of a Public-Private Partnership

Determination S50 (31 Oct 2016) relates to the application of the financial arrangement rules to the design and construction phase of a PPP.

This Determination may be cited as Special Determination S50: Application of the Financial Arrangements Rules to the D&C Phase of 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 provision of ongoing asset management 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.
  2. Another limited partnership (Holdings) will hold a 100% interest in the Partnership. Holdings has four limited partners. Limited Partner A is exempt from income tax. Limited Partner B is a limited partnership with multiple limited partners, some of whom are exempt from income tax. Limited Partner C and Limited Partner D are both limited liability companies. Limited Partner C, Limited Partner D, and each limited partner of Limited Partner B that is not exempt from income tax are together referred to as the Taxable Limited Partners. This determination only applies to the Taxable Limited Partners and does not apply to those limited partners that are exempt from income tax.
  3. This 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 to be entered into by the Partnership and the Crown under which the Partnership prepays an amount representing the rental the Partnership will pay to the Crown (the Rental Prepayment); and
    • an asset management and maintenance phase (the AM&M Phase) under which the Partnership will provide asset management and maintenance services to the Crown over a 25-year term in consideration for monthly payments (the Unitary Payment).
  4. 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 payments; and
    • an Asset Management and Maintenance Contract with a service provider (the Service Provider), under which the Service Provider will provide the asset management and maintenance (and other) services in consideration for payments.
  5. The Partnership will raise debt (the Senior Debt) from Limited Partner A and various third-party financiers. The Partnership will enter into interest rate swaps in respect of the Senior Debt (the Swaps).
  6. Holdings will also receive funding during the D&C Phase from:
    • Limited Partner A and Limited Partner B in the form of convertible debt instruments (the Convertible Notes); and
    • Limited Partner C and Limited Partner D in the form of deferred equity contributions backed by letters of credit (the Letters of Credit).
  7. Facility Lease, AM&M Phase, Construction Agreement, and Asset Management and Maintenance Contract are all excepted financial arrangements as defined in s EW 5. The D&C Phase, Senior Debt, Swaps, and Letters of Credit are financial arrangements as defined in s EW 3. The Project, including all of these agreements, is a wider financial arrangement. Special Determination S49: Application of the Financial Arrangements Rules to a Public¬ Private PartnershipSpecial Determination S51: Subordinated Convertible Note in Respect of a Limited Partnership Interest in a Public–Private Partnership applies to the Convertible Notes.
  8. This determination prescribes:
    • the portion of the D&C Payment treated as income under the financial arrangements rules (the Interest Component); and
    • the method for spreading that income over the term of the D&C Phase.

2. Reference

This determination is made under ss 90AC(1)(bb), 90AC(1)(d) 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 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. Limited Partner B, Limited Partner C and Limited Partner D use IFRSs to prepare financial statements and to report for financial arrangements.
  3. The Taxable Limited Partners will recognise income derived from the Crown during the D&C Phase of the Project Agreement and deduct expenditure incurred in relation to the Construction Agreement under the relevant provisions of the Income Tax Act 2007 (outside of the financial arrangements rules).
  4. 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 Clause 1.1 of the Project Agreement.
    • Private rulings BR Prv 16/64 and BR Prv 16/65 issued on 31 October 2016 continue to apply (under s 91EB of the Tax Administration Act 1994).

4. Principle

  1. During the D&C Phase, 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 Facility, including the transfer of the rights set out in clause 11.2 of the Project Agreement). The D&C Phase 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 in subpart EW.
  3. During the D&C Phase the Partnership will accrue variable expenditure commitments. 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

In this determination, unless the context otherwise requires:

  • All legislative references in this determination are to the Income Tax Act 2007, unless otherwise stated.
  • IFRS means a New Zealand Equivalent International Financial Reporting Standard in effect under the Financial Reporting Act 2013, and as amended from time to time or an equivalent standard issued in its place.

6. Method

Calculation of the interest component of the D&C Payment

  1. The value of the completed Facility (including the transfer of the rights under 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. Private Ruling BR Prv 16/65 rules on the portion of the D&C Payment that is not income under the financial arrangements rules and is not considered in this determination.

Spreading of the interest component of the D&C Payment

  1. 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 income years that make up the D&C Phase (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

7. Example

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

The Partnership and the Crown agree under the Base Case that the D&C Payment equals $250,000.

The Base Case sets out that the agreed design and construction costs of the Facility (excluding Fitout) are to be $240,000. This is value of the completed facility (including the transfer of the Partnership’s rights as set out in clause 11.2 of the Project Agreement).

The Interest Component of the D&C Payment is $10,000 by implication of the valuation under this determination.

The Taxable Limited Partners 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:

Years Actual D&C costs
1 ($31,000)
2 ($77,000)
3 ($130,000)
4 ($2,000)
D&C Payment $250,000
  ($240,000)

Based on receipt of the $250,000 D&C Payment in Year 4, the Project has an internal rate of return of 1.5980%.

The Interest Component is therefore spread as follows:

Years Actual D&C costs Cumulative Interest income
1 ($31,000) ($31,000) $495
2 ($77,000) ($108,495) $1,734
3 ($130,00) ($240,229) $3,839
4 ($2,000) ($246,068) $3,932
D&C payment   $250,000  
  ($240,000)   $10,000

This Determination is signed by me on the 31st day of October 2016.

Dinesh Gupta
Manager, Taxpayer Rulings