Application of the financial arrangements rules to a public-private partnership

This determination may be cited as Special Determination S22: Application of the financial arrangements rules to 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 design, construction and ongoing provision of operation and maintenance services in respect of a prison by a certain company (the Company) under a public-private partnership agreement (the Project Agreement) with the Crown. The Company is a wholly-owned subsidiary of Holdings. The Company and Holdings are members of a consolidated group.
2. The Project Agreement comprises three basic components:
   • a construction phase under which the Company agrees to design and construct the prison for the Crown in consideration for a fixed lump-sum payment (the Construction Phase)
   • the lease of the completed prison by the Crown to the Company in consideration for rental payment (the Lease), and
   • a services phase under which the Company will provide operation and maintenance services to the Crown over a 25-year term in consideration for monthly payments (the Services Phase).
3. The Company will enter into:
   • a Construction Agreement with a contractor (the Contractor), under which the Contractor will design and construct the prison in consideration for capped monthly payments
   • an Operation and Maintenance Contract with a service provider (the Service Provider), under which the Service Provider will provide the ongoing operation and maintenance (and other) services in consideration for monthly payments, and
   • an Asset Management Agreement with the Service Provider, under which the Service Provider will provide management and administrative services to the Company and Holdings in consideration for periodic payments.
4. The Company will borrow funds (the Senior Debt) from a consortium of banks (the Banks). The Company will enter into interest rate swaps in respect of the Senior Debt (the Swaps). Holdings will also borrow money from a single shareholder during the Construction Phase (the Shareholder Pre-subscription Loan), and each of the other shareholders shall provide an investment support in the form of a stand-by letter of credit (LC) and/or cash collateral to be held in equity collateral accounts of Holdings (ECA) (for each Deferred Investor). Holdings will also borrow from each of its shareholders during the last part of the Construction Phase and during the Services Phase in the form of optional convertible notes (the Notes).
5. The Services Phase of the Project Agreement, Construction Agreement, Operation and Maintenance Contract, Asset Management Agreement and Lease are all excepted financial arrangements. The Construction Phase of the Project Agreement, Senior Debt, Swaps, Shareholder Pre-subscription Loan, Notes, and investment support represented by LCs and/or cash collateral in the ECAs are financial arrangements to which Holdings and/or the Company is a party. The Project, including all of these agreements, is a wider financial arrangement.
6. This determination prescribes:
   • the amount of consideration that is solely attributable to the Lease
   • how the financial arrangements rules apply to the Construction Phase of the Project Agreement, Services Phase of the Project Agreement, Construction Agreement, Operation and Maintenance Contract, and Asset Management Agreement, and
   • the method for spreading the payments made under the Senior Debt, Shareholder Pre-subscription Loan, Swaps and Notes.

2. Reference

This determination is made under ss 90AC(1)(bb) and 91AC(1)(h) of the Tax Administration Act 1994.

3. Scope of determination

1. This determination applies to the Company in respect of the Project (more fully described in private ruling BR Prv 12/33 issued on 27 August 2012), including the following agreements:
   • Construction Phase of the Project Agreement, under which the Company agrees to design and construct the prison for the Crown and will receive a fixed lump-sum payment (which will be equal to and offset against the rental prepayment referred to below), once the prison is ready for operation.
   • Services Phase of the Project Agreement, under which the Company will provide ongoing operation and maintenance services for 25 years to the Crown in consideration for monthly payments.
   • Lease in respect of the prison, under which the Company will lease the prison from the Crown for 25 years and will prepay the rental to the Crown. This payment will be equal to and will offset the payment in relation to the Construction Phase.
   • Construction Agreement, under which the Contractor will design and build the prison and receive capped monthly payments from the Company.
   • Operation and Maintenance Contract, under which the Service Provider will provide services in respect of the prison and receive monthly payments from the Company.
   • Asset Management Agreement, under which the Service Provider will provide management and administrative services to the Company and Holdings in consideration for periodic payments.
   • Senior Debt, under which the Company will borrow an agreed sum from the Banks during the Construction Phase for a term of 7 years from financial close of the Project (Financial Close). Interest will be capitalised during the Construction Phase and payable at a market rate thereafter. It is intended that the Senior Debt will be refinanced within 7 years, and every 5 years thereafter over the term of the Project. While the Base Case has assumed 5 yearly refinancings, the Company has flexibility to refinance at any time. As at the date of this determination there is no intention to deviate from the Base Case. Under IFRS (as the standards apply at the date of this Determination), the Senior Debt (and any subsequent refinancings) will initially be recognised at fair value, and subsequently measured using the amortised cost/effective interest method (regardless of whether or not hedge accounting is applied), and will not be treated as a hedge of another financial arrangement.
   • Shareholder Pre-subscription Loan, under which Holdings will borrow an agreed sum from a shareholder during the Construction Phase for a market rate of interest. It is yet to be determined whether Holdings will treat the Shareholder Pre-subscription Loan, in part, as an equity instrument under IFRS.
   • Swaps, under which the Company will pay a fixed rate of interest to the swap counterparties, and receive a floating rate in return. It is intended that each refinancing of the Senior Debt will be matched by an interest rate swap on materially the same terms as the Swaps (the New Swaps).
   • Notes, under which Holdings will issue convertible notes to its shareholders for a term of 25 years and 5 months (assuming that the Services Phase commences on the planned date). The Notes will pay an agreed rate of interest quarterly in arrears in cash after the commencement of the Services Phase. If an interest payment is not paid because of insufficient project cash flows, the interest will be capitalised and added to the principal. Any capitalised interest must be paid in cash by the earlier of conversion or expiry (being, 25 years and 5 months, assuming that the Services Phase commences on the planned date). It is intended at the outset that all interest payments will be paid in cash on the quarterly due dates occurring after the commencement of the Services Phase. The Notes are also subject to a fixed inflation adjustment, that is added to the principal amount of the Notes each 1 July occurring after the Service Commencement Date. The Notes are redeemable in cash in accordance with an amortisation schedule that amortises the principal to zero over 25 years and 5 months. The Notes are convertible into shares in Holdings at the option of Holdings if Holdings experiences a material cash flow deficit because of events not taken into account in cash flow projections prepared before Financial Close and where conversion of the Notes would assist Holdings to manage its liabilities and solvency (subject to the consent of the Banks). There are no planned conversion dates for the Notes, and there is no fixed intention to convert the Notes before maturity. It is yet to be determined whether Holdings will treat the Notes, in part, as an equity instrument under IFRS.
   • Investment support by the Deferred Investors under the Investment Commitment Deed to provide and maintain investment support in the form of a stand-by letter of credit (LC) and/or cash collateral to be held in equity collateral accounts of Holdings (ECA) (for each Deferred Investor). Interest received by Holdings on amounts in the ECA representing a Deferred Investor's cash collateral is, in turn, payable by Holdings to that Deferred Investor (subject to certain criteria). Holdings will pay each Deferred Investor a quarterly fee in arrears (Investment Support Fee) for the period from Financial Close to the Deferred Equity Subscription Date.
2. This determination is made subject to the following conditions:
   • The agreed rate of interest payable on the Notes (including the inflation adjustment) will not exceed a rate that would be agreed between wholly unrelated parties having regard to the terms of the Notes and applying orthodox pricing methodologies.
   • The Notes will be converted only in circumstances in which the Company and/or Holdings experiences a material cash flow deficit because of events not taken into account in cash-flow projections prepared before completion, and where conversion of the Notes would assist the Company and/or Holdings to manage its liabilities and solvency.
   • The Company will recognise income derived from the Crown during the Construction Phase of the Project Agreement and the Services Phase of the Project Agreement, and will deduct expenditure incurred in relation to the Lease, Construction Agreement, Operation and Maintenance Contract, and Asset Management Agreement, in each case, under the relevant provisions of the Income Tax Act 2007 (outside of the financial arrangement rules).
   • The method applied to determine the income derived and the method applied to determine the expenditure incurred in respect of the investment support represented by cash collateral in each ECA will be the same.
   • The continued application of private ruling Br Prv 12/33 (under s 91EB of the Tax Administration Act 1994).

4. Principle

1. The Lease in respect of the prison is an excepted financial arrangement under s EW 5(9). Any amount that is solely attributable to an excepted financial arrangement described in s EW 5(2) to (16) is not an amount that is taken into account under the financial arrangement rules (s EW 6(2)). This determination specifies the amounts that are solely attributable to the Lease that are not taken into account under the financial arrangement rules.
2. The Services Phase of the Project Agreement, Construction Agreement, Operation and Maintenance Contract, and Asset Management Agreement are “short-term agreements for sale and purchase”, and are excepted financial arrangements under s EW 5(22). Any amount that is solely attributable to an excepted financial arrangement described in s EW 5(17) to (25) that is part of a financial arrangement is an amount that is taken into account under the financial arrangements rules (s EW 6(3)). This determination specifies that no amounts payable to or by the Company in respect of the Services Phase of the Project Agreement, Construction Agreement, Operation and Maintenance Contract, or Asset Management Agreement are required to be spread under the financial arrangements rules.
3. The Construction Phase of the Project Agreement, Senior Debt, Swaps, Shareholder Pre-subscription Loan, Notes, and investment support in the form of LCs and/or cash collateral in the ECAs are “financial arrangements” under s EW 3. This determination specifies that no amounts payable to or by the Company in respect of the Construction Phase of the Project Agreement are required to be spread under the financial arrangements rules, and that the payments made to or by the Company under the Senior Debt, Swaps, Shareholder Pre-subscription Loan and Notes must be spread under the financial arrangements rules in accordance with this determination.

5. Interpretation

1. In this determination, unles the context otherwise requires - "IFRS" means International Financial Reporting Standards.

6. Method

1. The prepaid rental the Company will pay in respect of the Lease and the leasehold property interest granted to the Company under the Lease are solely attributable to the Lease, and are not taken into account under the financial arrangement rules.
2. The Company is not required to spread any amounts under the financial arrangements rules in respect of the:
   • Construction Phase of the Project Agreement
   • Services Phase of the Project Agreement
   • Construction Agreement
   • Operation and Maintenance Contract
   • Asset Management Agreement
3. The IFRS financial reporting method in s EW 15D may be used to allocate income and expenditure (other than “non-integral fees” as defined in s YA 1) over the term of the Senior Debt. None of the restrictions for application of this reporting method in s EW 15D(2B) applies.
4. The IFRS financial reporting method in s EW 15D may be used to allocate income and expenditure (other than “non-integral fees” as defined in s YA 1) in respect of any subsequent refinancings of the Senior Debt over the term of the relevant refinancing, provided that the terms of any such refinancings are materially similar to the terms of the Senior Debt. This determination paragraph does not affect the Company’s obligation to perform a base price adjustment under s EW 31 at the time of each refinancing.
5. Determination G3: Yield to maturity may be used to allocate the income and expenditure (other than “non-contingent fees” as defined in s YA 1) of the Shareholder Pre-subscription Loan (under s EW 15I if Holdings treats the Shareholder Pre-subscription Loan, in part, as an equity instrument under IFRS, or under s EW 15E if not).
6. The expected value method in s EW 15F may be used to allocate income and expenditure (other than “non-contingent fees” as defined in s YA 1) over the term of the Swaps, provided that the Swaps are not treated under IFRS by the Company as a hedge of other financial arrangements for each of which the Company uses the “fair value method” (as defined in s YA 1). None of the mandatory spreading methods in s EW 15H or s EW 15I applies to the Swaps.
7. The expected value method in s EW 15F may be used to allocate income and expenditure (other than “non-contingent fees” as described in s YA 1) in respect of any New Swaps over the term of the relevant New Swap, provided that the terms of any New Swaps are materially similar to the terms of the Swaps, and further provided that the New Swaps are not treated under IFRS by the Company as a hedge of other financial arrangements for each of which the Company uses the “fair value method” (as defined in s YA 1). None of the mandatory spreading methods in s EW 15H or s EW 15I applies to the New Swaps. This determination paragraph does not affect the Company’s obligation to perform base price adjustments under s EW 31 in respect of the Swaps and New Swaps.
8. Determination G3: Yield to maturity may be used to allocate the income and expenditure (other than “non-contingent fees” as defined in s YA 1) of the Notes (under s EW 15I if Holdings treats the Notes, in part, as an equity instrument under IFRS, or under s EW 15E if not.
9. If interest payable under the Notes is capitalised in accordance with the terms of the Notes, Holdings must apply the method set out in Determination G25: Variations in the Terms of a Financial Arrangement to calculate income or expenditure under the Notes in the year of variation and subsequent years.
10. This determination does not determine the method that is applied to determine the income derived or expenditure incurred in respect of the investment support represented by LCs and/or cash collateral in the ECAs.

7. Example

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

This example is based on the following parameters:

The Company is not required to spread any amounts under the financial arrangements rules in respect of the Lease, Construction Phase of the Project Agreement, Services Phase of the Project Agreement, Construction Agreement, Operation and Maintenance Contract, or Asset Management Agreement.

The amounts that must be spread under the financial arrangement rules are:

• interest on the Senior Debt calculated in accordance with the IFRS financial reporting method in s EW 15D
• interest on the Shareholder Pre-subscription Loan calculated in accordance with Determination G3: Yield to maturity
• interest on the Notes calculated in accordance with Determination G3: Yield to maturity, and
• payments in respect of the Swaps calculated in accordance with the expected value method in s EW 15F

This Determination is signed by me on the 27th day of August 2012.

Howard Davis
Director (Taxpayer Rulings)