AustLII Home | Databases | WorldLII | Search | Feedback

Journal of Law and Financial Management

USyd
You are here:  AustLII >> Databases >> Journal of Law and Financial Management >> 2007 >> [2007] JlLawFinMgmt 8

Database Search | Name Search | Recent Articles | Noteup | LawCite | Author Info | Download | Help

Mackenzie, Gordon --- "Taxation of Infrastructure" [2007] JlLawFinMgmt 8; (2007) 6(2) Journal of Law and Financial Management 22


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.

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.

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)

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]

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.

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 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.

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]

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]

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.

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.

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 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 entitlement to those deductions changed from being solely dependant on legal ownership of the asset to being dependant on either legal or economic ownership.[20]

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.[21] 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.[22]

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.[23]

The deduction also extends to cost of construction of certain structural improvements as if they were a building.[24]Examples of structural improvements are things such as sealed roads, bridges, airport runways, pipelines and so on.[25]

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).[26]

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.

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. [27]

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.[28] 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 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.[29]

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.[30] 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.[31]

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.[32]

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?

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.[33] 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.

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.[34]

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.[35] 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.[36]

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.[37]

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.[38]

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.[39]

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.

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.[40] 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.[41]

Importantly it applied where the asset Government had control “of use” of the asset which proved problematic in its application.[42]

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?[43]

A second set of provisions was introduced shortly after the first and they applied in a slightly different way.[44]

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.[45]

The capital allowances otherwise available to the private sector participant were also denied as, of course, that was the main purpose of the rules.

New rules: risk or control?

The Ralph Review considered both these provisions and made recommendations that they be re written. [46]

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. [47]

“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.”

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.[48]

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.”[49]

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.[50]

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”.[51]

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.[52]

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

The owner of the asset does not have a ‘predominant economic interest’ in the asset.[53]

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.[54] 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,

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.[55]

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.[56]

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 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.[57]

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. [58]

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.[59]

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.[60]

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.[61]

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.

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.[62]

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.[63]

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.[64]

If any of the consideration is assessable under the normal balancing adjustment rules mentioned above, they are ignored.

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. [65] The project sponsor who had borrowed the funds was denied a tax deduction for that interest payment.[66]

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 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.[67] 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.

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.[68] (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.

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 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.

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.


[*] 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.

[2] Senator the Hon Helen Coonan, Assistant Treasurer Speech to AFR Infrastructure Summit 5 August 2002

[3] Handbook of Australian Corporate Finance 5th ed. Butterworths page 276-277

[4] R Krever TOFA: the unfinished agenda p10 [2006] AT Rev 1

[5] 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.

[6] Handbook of Australian Corporate Finance 5th Ed. Butterworths P 331

[7] See footnote 1

[8] Handbook of Australian Corporate Finance 5th Ed. Butterworths page 319-320

[9] Ibid p 318

[10] Ibid

[11] Ss 6-5 and 8-1 ITAA1997

[12] “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

[13] IT 28

[14] S8-1 ITAA 1997

[15] IT 2051 and IT 2062

[16] [2001] FCA 365; (2001) 46 ATR 497

[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

[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 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 [20]01. 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.

[20] See note above

[21] S 40-40 ITAA1997

[22] Div 43 ITAA 1997

[23] S 43-150 ITAA1997

[24] S43-20 (2) to (4) ITAA 1997

[25] S43-20 (3) ITAA1997

[26] They are called a Special Purpose Vehicle (SPV) simply because they are established for the special purpose of holding the project assets.

[27] This grouping has been made easier under tax consolidation rules. Division 701 ITAA 1997

[28] CGT Event E4 s 104-70 ITAA 1997

[29] Division 6C ITAA 1936

[30] 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

[31] S 102M para (a) ITAA 1936

[32] The Federal Opposition has announced that they would simplify these rules.

[33] 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)

[34] See R Krever, TOFA: the unfinished agenda 12 [2006] AT Rev 1

[35] A Tax System Redesigned Final Report (July1999) p392 para 10.9, Taxation Laws Amendment (Taxation of Financial Arrangements) Bill 2007

[36] Press Release No 99

[37] R Krever, TOFA: the unfinished agenda 11 [2006] AT Rev 1

[38] 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, 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.

[39] s 51AD inserted in 1984 and Div. 16D ITAA 1936 inserted in 1985.

[40] S 51AD ITAA1936

[41] In technical tax language this is called an “annihilating” provision.

[42] TR 96/22

[43] M Wiley

[44] Div 16D ITAA 1936

[45] S159K ITAA 1936

[46] A Tax System Redesigned Final Report (July 1999) HTTP://www.rbt.gov.au/publications/paper/index

[47] New Business Tax System (Tax Preferred Entities-Asset Financing) Bill 2003, Exposure Draft

[48] The Exposure Draft included rules identifying at least seven elements before it applied.

[49] Press release 008

[50] Ss 250-15 and 250-50 Tax Laws Amendment (2007 Measures No 5) Act 2007

[51] See definition of this term to be inserted into s 995 (1) ITAA That term includes non-resident 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.

[52] Divs 250-C, 250-D and 250-D of Tax Laws Amendment (2007 Measures No 5) Act 2007

[53] S 250-15 Tax Laws Amendment (2007 measures No 5) Act 2007

[54] S 250-55 and 250-85 Tax Laws Amendments (2007 No 5 Measures) Act 2007

[55] S 250-110 to 250-135 Tax Laws Amendment (2007 Measures No 5) 2007 Act

[56] Ss 250-20 to 250-45 Tax Laws Amendments (2007 Measures No 5) 2007 Act

[57] 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.

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 tax treatment that the Commissioner had sought to apply in that litigation- see Div 247 ITAA 1997

[58] See for example Fletcher v FCT [1991] HCA 42; (1992) 22 ATR 613

[59] IT 2051

[60] Div 243 ITAA 1997

[61] 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

[62] Subdiv 40-D ITAA 1997

[63] S 45-5 ITAA 1997

[64] S 45-10 and 45-15 ITAA 1997

[65] Speech by Senator Helen Coonan to AFR Infrastructure Summit, 15 August 2002

[66] Div 16 L ITAA1936

[67] 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.

In all three cases, the additional cost to the revenue need not provide any benefit to the infrastructure project itself.

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.

[68] Div 396 ITAA 1997


AustLII: Copyright Policy | Disclaimers | Privacy Policy | Feedback
URL: http://www.austlii.edu.au/au/journals/JlLawFinMgmt/2007/8.html