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Special Determination S42: Application of the financial arrangements rules to the D&C Phase of a public-private partnership agreement.

This Determination may be cited as Special Determination S42: "Application of the financial arrangements rules to the D&C Phase of a public-private partnership agreement".

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 asset management and facilities maintenance services in respect of a prison (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.
  2. The sole limited partner in the Holding Partnership will be Investor Limited Partner, a limited partnership with multiple limited partners, some of whom are exempt from income tax. The limited partners of Investor Limited Partner that are 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.
  1. 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;
    • Leases of part of the Existing Facility and the New Facility by the Crown to the Partnership (together, the Facility Leases), under which the Partnership pays amounts representing the rental under the Facility Leases to the Crown (the Rental Prepayments); and
    • An asset management and facilities maintenance phase (the AM/FM Phase), under which the Partnership will provide asset management and facilities maintenance services to the Crown in consideration for monthly payments (the Unitary Charge). Asset management and facilities maintenance service will be provided from the Applicable Service Commencement Date (i.e. for the Existing Facility from the Existing Facility Service Commencement Date and for the New Facility from the Full Service Commencement Date) until the Actual Termination Date (a date specified in the event that the Project Agreement is terminated) or the Expiry Date, being 25 years from the Full Service Commencement Date.
  1. The Partnership has entered into an Early Works Construction Subcontract with a contractor (the Contractor), under which the Contractor will provide earthworks and any associated works that are required to form the building platform for the Facility.
  1. The Partnership will enter into:
    • a D&C Subcontract with the Contractor, under which the Contractor will design and construct the Facility in consideration for monthly and milestone payments; and
    • an Asset Management and Facilities Maintenance Contract (the AM/FM Subcontract) with a service provider (the Service Provider), under which the Service Provider will provide the on-going asset management and facilities maintenance (and other) services in consideration for monthly payments.
  1. The Partnership will raise external debt from third party financiers (the Senior Debt). The Partnership will enter into Interest Rate Swaps in respect of the Senior Debt. The Investor Limited Partner will provide investment support during the D&C Phase in the form of a standby letter of credit (the Letters of Credit) to the external lenders.
  2. The Facility Leases, AM/FM Phase of the Project Agreement, Early Works Construction Subcontract, D&C Subcontract and AM/FM Contract are all excepted financial arrangements.  The D&C Phase of the Project Agreement, Senior Debt, Interest Rate Swaps and Letters of Credit are financial arrangements to which the Partnership is a party. The Project, including all of these agreements, is a wider financial arrangement. Special Determination S41: Application of the financial arrangements rules to a public-private partnership applies to arrangements in the wider financial arrangement, excluding the D&C Payment.
  3. 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.

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 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.
  1. 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.
    • The Taxable Limited Partners use IFRS to prepare financial statements and to report for financial arrangements.
    • 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 Early Works Construction Subcontract and D&C Subcontract under the relevant provisions of the Income Tax Act 2007 (outside of the financial arrangements rules).
    • The continued application of private ruling BR Prv 15/35 issued on 4 September 2015.
    • The executed documentation not being materially different from the final documentation provided to Inland Revenue on 25 February 2015, 21 August 2015 and 28 August 2015 to the extent that it impacts on the scope of the determination or the application of the financial arrangements 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 Facility 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 12.8(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. 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.
  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:
    • All legislative references in this determination are to the Income Tax Act 2007, unless otherwise stated.
    • Capitalised terms have the same meaning as set out in the Project Agreement.
    • “IFRS” means International Financial Reporting Standards as defined in s YA 1.
    • "Project Agreement" is a public-private partnership agreement between the Partnership and Her Majesty, the Queen in right of New Zealand acting by and through the Chief Executive of the Department of Corrections (the Crown).

6. Method

Calculation of Interest Component of D&C Payment

  1. The value of the completed Facility 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 15/35 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 Interest Component of 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 is the internal rate of return (based on annual resets) calculated using the notional cash flows in para (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 under the Base Case sheet 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.

The value of the "completed Facility and the transfer of the rights set out in Clause 11.2(c)" of the Project Agreement, as set out in Clause 12.6 of the Project Agreement, is equal to $250,000.

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

The 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
($130,000)
($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 Howard Davis the 4th day of September 2015

Howard Davis
Director (Taxpayer Rulings)