Edited version of your written advice

Authorisation Number: 1012735073868

Ruling

Subject: Public Private Partnership - whether an exemption from the thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 will apply to Finance Co.

Legislative references

All legislative references are to the Income Tax Assessment Act 1997.

Question

Will Finance Co be entitled to an exemption under section 820-39 from any debt deduction being disallowed under Division 820?

Answer

Yes.

This ruling applies for the following periods

Relevant income years of the Project Term.

The scheme commences on

The date of Financial Close.

Relevant facts and circumstances

Project entities

1. The entities that are involved in the Project are:

• Principal investing entities in the Project

Neither of the principal investing entities are a resident of Australia for tax purposes, nor have a permanent establishment in Australia.

• Trustee Holding Co as trustee for the Holding Trust

• Holding Trust - an Australian resident unit trust that is wholly owned by the principal investing entities. Holding Trust will hold all of the issued units of a subsidiary, Project Trust.

• Trustee Co as trustee for the Project Trust.

• Project Trust - a wholly owned subsidiary of Holding Trust and principal vehicle for the Project.

• Finance Co - a private company securitisation vehicle that is a wholly owned subsidiary of a Charitable Trust.

• Charitable Trust - owns all of the shares in Finance Co and has only one Australian charitable deductible gift recipient as its beneficiary.

• Trustee of Charitable Trust - an independent third party trustee company of the Charitable Trust.

• Senior Debt Providers

• Statutory body that will enter into various agreements to facilitate the Project.

The Project

2. The statutory body undertook a procurement process in relation to the Project. The principal investing entities were the successful tenderers in the procurement process.

3. The Project will involve the construction of new infrastructure and will also involve the provision of asset management and maintenance services for the infrastructure. The statutory body will retain ownership and control of the infrastructure.

4. The statutory body and Trustee Co as trustee for the Project Trust will enter into the Project Deed where the Project Trust will, inter alia:

• procure the payment of the purchase price to the statutory body

• finance, design and construct the infrastructure

• provide agreed asset management and maintenance services subject to an agreed performance regime

• have the right to receive the infrastructure payments and certain other payments

• have a non-exclusive licence to enter and use areas to carry out the asset management services and a construction licence to construct the infrastructure, and

• hand-over the areas to the statutory body on the expiration date in the agreed condition.

Project term

5. The term of the Project Deed will:

• commence on the date of Financial Close being the date on which the statutory body gives notice of satisfaction of all of the conditions precedent under the Project Deed, and

• end on the Expiration Date unless it is terminated under a clause of the Project Deed.

Securitisation arrangement

6. Project Trust has the right to receive the Infrastructure Payments in consideration for the payment of Concession Fees.

7. The purpose of exchanging the Infrastructure Payments and Concession Fees under the Project Deed is so that Project Trust can provide the statutory body with a fixed, certain and assignable stream of payments that enhances the commercial ability of the statutory body to effectively securitise its future cash flow by way of the Receivables Purchase Agreement.

8. Finance Co has been established solely for the purpose of securitising the future cash flows of the Concession Fee Payments and to provide funding for the Project. In consideration for receiving the Concession Fee Payments, Finance Co will pay Receivables Purchase Payments to the statutory body.

9. On or before Financial Close, Finance Co will enter into the Receivables Purchase Agreement with the statutory body where Finance Co will pay the Purchase Price on the Purchase Date in return for the Concession Fee payments from the statutory body.

10. Under the Receivables Purchase Agreement, the statutory body will assign to Finance Co all of its rights, title and interest to receive the Concession Fee Payments from Project Trust.

11. The statutory body, Finance Co and Trustee Co as trustee for the Project Trust will enter into a Payment Directions Deed where the statutory body will direct Project Trust to pay the Concession Fees to Finance Co.

12. Under the Payment Directions Deed, the statutory body will direct each Purchase Price payable by Finance Co to the statutory body (other than an amount that the statutory body is entitled to retain) to Project Trust in satisfaction of:

• the Purchase Price of the Receivables by Finance Co to the statutory body, and

• each Construction Payment payable by the statutory body to Project Trust.

13. The Concession Fee Payments that Finance Co receives will be used to repay the senior debt (and interest), and repay other loans (and interest) over the term of the Project.

Sole purpose

14. The Finance Co Constitution provides that Finance Co will not engage in any business or activity other than that, which is necessary for, or incidental to, its role in connection with the Project.

15. Under the loan agreement, Finance Co agrees to undertake the Project as its sole business and not to undertake any activities other than the Project or ancillary to the Project and not to abandon the Project.

16. Further, the loan agreement provides that Finance Co will not do, or threaten to do, anything which would result in substantial changes to its business and operations from that contemplated in the Project Documents.

Independence

17. The Finance Co Constitution states that the Finance Co must have at least one independent director.

18. Board decisions of Finance Co will be decided by a majority of votes of the Directors present and voting.

19. The Finance Co Constitution also provides that the company must remain an independent entity and must keep written financial records in accordance with the requirements of the Corporations Act.

Funding

20. On commencement, Finance Co will initially borrow senior debt with a five year term of up to $X (plus capitalised interest) on a limited recourse basis from Senior Debt Providers. Finance Co will use this initial funding for the initial Purchase Price and some of Finance Co's up-front costs.

21. Finance Co will borrow additional senior debt with five year terms up to $Y (including capitalised interest) on a limited recourse basis from the Senior Debt Providers. These borrowings will fund the additional Receivable Purchase Payments enabling the payment of a percentage of the costs of construction of the infrastructure over the period to the expected completion.

22. Finance Co will also receive additional funds from other loans that will be used for the additional payment of the Receivables Purchase Payments enabling the funding of the remaining percentage of the costs of the construction of the infrastructure over the period to the expected completion.

23. Refinancing of the senior debt facilities under the loan agreement will occur when those facilities mature. It is intended that the refinancing of the senior debt facilities will be on equivalent terms to the loan agreement.

Financing restrictions

24. The loan agreement states that Finance Co will be restricted to only debt that is permitted under the agreement.

25. The Finance Co Constitution states that Finance Co must not amalgamate, merge or consolidate with or into any other person.

26. The loan agreement also states that Finance Co will not amalgamate, merge or consolidate with or into any other person or enter into any corporate restructuring, reorganisation or plan arrangement without prior written consent except for the purposes of a solvent reconstruction or amalgamation that is approved.

27. The loan agreement provides that recourse is limited solely to the assets and undertakings of the parties.

28. The Finance Co Constitution prevents Finance Co from amending the Constitution, other than by special resolution of the Members.

Equalisation swap agreement

29. Finance Co and Trustee Co as trustee for the Project Trust will enter into an equalisation swap agreement. The purpose of entering into the equalisation swap agreement is ensure that the Concession Fee cash flows received by Finance Co together with any net receipts from the Equalisation Swap will be sufficient to pay the interest and principal on funds raised.

30. To give effect to the equalisation swap:

• a fixed amount is payable by Finance Co - that amount is equal to the modelled Financing Costs specified in the Financial Model as payable by Finance Co on a Payment Date

• a fixed amount is payable by Project Trust - that amount is equal to the actual Financing Costs payable by Finance Co on that Payment Date, and

• the amount payable by Finance Co and the amount payable by Project Trust on a Payment Date may be netted off and the excess paid to the party that is entitled to the larger amount.

Assumption

Finance Co will, at all times during the Project, hold 'debt interests' (as defined in subsection 995-1(1)), that are at least 50% of the total value of Finance Co's assets.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 820

Income Tax Assessment Act 1997 section 820-39

Income Tax Assessment Act 1997 Subdivision 974-B

Income Tax Assessment Act 1997 section 974-15

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 section 974-30

Income Tax Assessment Act 1997 paragraph 974-35(1)(a)

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 paragraph 974-160(1)(a)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Question

Will Finance Co be entitled to an exemption under section 820-39 from any debt deduction being disallowed under Division 820?

Detailed reasoning

Division 820 (thin capitalisation rules) applies to certain entities to disallow financing expenses that an entity could otherwise deduct from its assessable income where the entity's debt exceeds the prescribed level.

Certain special purpose entities may be entitled to an exemption under section 820-39 from the thin capitalisation rules if the entity satisfies all of the following conditions contained in subsection 820-39(3):

(a) the entity is one established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself); and

(b) the total value of *debt interests in the entity is at least 50% of the total value of the entity's assets; and

(c) the entity is an insolvency-remote special purpose entity according to the criteria of an internationally recognised rating agency that are applicable to the entity's circumstances.

* denotes a term defined in subsection 995-1(1).

In considering whether the conditions are satisfied, Explanatory Memorandum to Taxation Laws Amendment Bill (No. 5) 2003 provides the following:

1.8 The first condition is a purpose test that seeks to exclude entities that are not specifically established for what might be commonly referred to as securitisation or origination activity. It also seeks to exclude entities that undertake any activities not related to the process of securitisation or origination. The first condition seeks to cover items and risks that could be securitised or originated. For example, it covers a straightforward arrangement where assets are purchased by a special purpose entity. It also covers more complex arrangements, for example, where the risk associated with the assets is acquired by a special purpose entity but the underlying assets remain on the balance sheet of the originating entity.

1.9 The second condition recognises that while the overall objective of a securitisation or origination program is to fund the assets of the special purpose entity entirely through the issue of debt interests, there is the possibility that this may take some time to achieve or that there may be some residual equity holding in the vehicle or some other form of credit enhancement.

1.10 The third condition seeks to ensure that the special purpose vehicle meets or would meet an internationally recognised rating agency's requirements for an insolvency remote special purpose entity. A rating agency would attempt to ensure that the entity is unlikely to be subject to voluntary or involuntary insolvency proceedings. A rating agency may be satisfied where the entity can demonstrate that it:

• is restricted to activities necessary to its role in the transaction;

• is restricted from incurring additional indebtedness;

• cannot be subject to reorganisation, merger or change of ownership; and

• holds itself out to the world as a separate entity.

In Taxation Determination TD 2014/18 Income tax: can the exemption in section 820-39 of the Income Tax Assessment Act 1997 apply to the special purpose finance entity established as part of the 'securitised licence structure' used in some social infrastructure Public Private Partnerships, the Commissioner accepts that the exemption from the thin capitalisation rules may apply to a special purpose finance entity established as part of the 'securitised licence structure' used in a social infrastructure Public Private Partnership, provided that the special purpose finance entity meets the conditions in subsection 820-39(3).

ATO Interpretative Decision ATO ID 2005/357 Thin capitalisation: exemption - special purpose entities further supports the Commissioner's view that an entity that is solely established for the purpose of borrowing funds for use in a debt securitisation arrangement will not be subject to the thin capitalisation rules in Division 820.

Consideration is therefore required to be given to each of the conditions in subsection 820-39.

(a) Managing economic risk

The Commissioner accepts that the first condition in subsection 820-39(3) will be met as Finance Co has been established for the purpose of:

• managing the economic risk associated with providing finance for the Project by raising senior debt and entering into the Receivables Purchase Payment Agreement with the statutory body and Trustee Co as trustee for the Project Trust.

• assuming and managing the risks associated with the receipt of the Concession Fees from the Project Trust (Finance Co's return is contingent on the recoverability of the Concession Fees receivable and the ability of the statutory body to fund the Infrastructure Payments), and

• the repayment of the senior debt loans.

(b) Value of debt interests

The applicant has stated, and it is assumed for the purposes of this ruling that Finance Co will, at all times during the Project, hold 'debt interests' (as defined in subsection 995-1(1)), that are at least 50% of the total value of Finance Co's assets. Therefore the condition in paragraph 820-39(b) will be satisfied.

However, for completeness, the senior debt that will be raised through the loan agreement in the first five years of the Project that will represent more than 50% of the total value of Finance Co's assets will be examined to confirm that the senior debt raised meets the definition of a 'debt interest'.

The term 'debt interest' is defined in subsection 995-1(1) to have the meaning given by Subdivision 974-B.

Subsection 974-15(1) states that a scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity.

Note that each draw-down made pursuant to a debt facility will be a debt interest rather than the actual facility itself being a debt interest (ATO Interpretative Decision ATO ID 2006/230 Revolving credit facility: Facility Agreement - debt interest).

The debt test in subsection 974-20(1) states:

A scheme satisfies the debt test in this subsection in relation to an entity if:

(a)  the scheme is a financing arrangement for the entity; and

(b)  the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme; and

(c)  the entity has, or the entity and a connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

(i) the financial benefit referred to in paragraph (b) is received if there is only one; or

(ii)  the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(d)  it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(e)  the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

For a scheme to constitute a debt interest, each of the conjunctive requirements in paragraphs 974-20(1)(a) to 974-20(e) must be present.

Debt test (a): Financing arrangement

The term 'financing arrangement' is defined in subsection 974-30(1) to mean a scheme that is entered into or undertaken:

(a) to raise finance for the entity (or the connected entity of the entity)

(b) to fund another scheme, or part of another scheme, that is a financing arrangement under paragraph (a), or

(c) to fund a return, or part of a return, payable under or provided by or under another scheme, or part of another scheme, that is a financing arrangement under paragraph (a).

Accordingly, each draw-down will constitute a financing arrangement for Finance Co if it is entered into or undertaken to raise finance for Finance Co or for a connected entity of Finance Co.

Finance Co will enter into each draw-down of the senior debt loans for the purpose of obtaining sufficient funds to meet its commitments under the Receivables Purchase Payments Agreement.

If there is a refinancing, a new scheme that raises finance for Finance Co will be established and the draw-down of funds from the refinancing will be a financing arrangement.

The requirement of paragraph 974-20(1)(a) is satisfied as each draw-down of funds from the senior debt loans and refinancing will be financing arrangements for the purposes of Division 974.

Debt test (b): Receipt of financial benefits

A 'financial benefit' is defined in paragraph 974-160(1)(a) to mean '… anything of economic value … even if the transaction that confers the benefit on the entity also imposes an obligation on the entity'.

Finance Co will obtain funds by way of successive draw-downs. Each draw-down that Finance Co makes will result in Finance Co receiving a financial benefit for the purposes of paragraph 974-20(1)(b).

Debt test (c): Effectively non-contingent obligation to provide financial benefits to one or more entities

An 'effectively non-contingent obligation' is defined in section 974-135 to mean, inter alia, an obligation that is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the willingness of that entity or connected entity to meet the obligation (subsection 974-135(3)).

Further, in determining whether there is in substance or effect a non-contingent obligation to take the action, regard must be had to the artificiality, or the contrived nature, of any contingency on which the obligation to take the action depends (subsection 974-135(6)).

Finance Co will have an effectively non-contingent obligation to provide financial benefits in respect of the loan or loans made under the loan agreement to other entities, being the Senior Debt Providers, in the form of repayments of principal and payments of interest for each Interest Period, as well as other amounts such as establishment fees and commitment fees. Finance Co must repay the principal and any other outstanding amounts in respect of the loan or loans made where repayment includes by way of refinance.

The repayments that Finance Co will make will constitute the provision of financial benefits by Finance Co to other entities in circumstances where Finance Co is under an effectively non-contingent obligation to provide financial benefits in respect of the loan or loans made under the relevant facility for the purposes of paragraph 974-20(1)(c), subsection 974-135(1) and paragraph 974-135(2)(a). Finance Co's obligation to provide financial benefits to other entities, being the Senior Debt Providers, arises after the time Finance Co receives its first financial benefit upon the first draw-down (subparagraph 974-20(1)(c)(ii)).

Debt test (d): Substantially more likely the value provided will at least be equal to the value received

The paragraph 974-20(1)(d) requirement will be satisfied in nominal terms if there is an effectively non-contingent obligation to repay all principal outstanding (as well as any interest and fees) in 10 years or less (subparagraph 974-35(1)(a)(i)).

Where greater than 10 years, the paragraph 974-20(1)(d) requirement will be satisfied in present value terms pursuant to the formula set out in section 974-50 (subparagraph 974-35(1)(a)(ii)).

Each draw-down made under the loan agreement is to be repaid in full at the Maturity Date being no later than five years after the date of Financial Close. Therefore, the paragraph 974-20(1)(d) requirement is satisfied on nominal terms pursuant to subparagraph 974-35(1)(a)(i).

Debt test (e): The values provided and received are not both nil

Finance Co will receive funds by way of successive draw-downs pursuant to the loan agreement.

As the value received by Finance Co is not nil, the paragraph 974-20(1)(e) requirement that the value provided, and the value received, by Finance Co are not both nil is satisfied.

Debt test conclusion

The draw-downs under the Loan agreement will be debt interests for the purposes of Subdivision 974-B.

Finance Co will, at all times during the Project, hold 'debt interests' as defined in subsection 995-1(1) through the loan agreement (or refinancing that is on equivalent terms to the loan agreement), that are at least 50% of the total value of Finance Co's assets. Accordingly, the condition in paragraph 820-39(b) will be satisfied.

(c) Insolvency-remote special purpose entity

Whether Finance Co will satisfy the criteria of an internationally recognised rating agency is a question of fact, which includes a consideration of criteria published by internationally recognised rating agencies.

A number of rating agencies have published criteria that set out the characteristics required to be classified as an 'insolvency remote' entity. The criteria that is sought to be applied must be appropriate to the entity's circumstances.

Paragraph 31 of TD 2014/18 refers to rating agency Standard & Poor's (S&P) which has published two criteria that sets out the characteristics of insolvency-remoteness in relation to special purpose entities in the context of project finance and securitisation transactions respectively.

Under subsection 820-39(4), the requirement of meeting such criteria can be met without a determination by a rating agency.

In the present context, the most appropriate criteria for Finance Co is S&P's Criteria for Special-Purpose Entities in Project Finance Transactions, issued 20 November 2000 and revised 4 March 2011 (Criteria).

Finance Co does not need to satisfy each criterion in order to be assessed as insolvency remote. However, the appropriate weight to be given to each criterion is a matter of judgment having regard to the facts of each arrangement and the commentary provided by the relevant rating agency in respect of each criterion.

The characteristics set out in the Criteria to assess insolvency remoteness are:

(1) restrictions on objects and powers

(2) debt limitations

(3) independent director

(4) no merger or reorganisation

(5) non-petition language in contracts to which the SPE is a party, and

(6) separateness.

(1) Restrictions on objects and powers

The Finance Co Constitution provides that Finance Co will not engage in any business or activity other than that, which is necessary for, or incidental to, its role in connection with the Project.

The loan agreement with the Senior Debt Providers restricts Finance Co to a single purpose and not to undertake any activities other than the Project and not to abandon the Project.

Further, the loan agreement provides that Finance Co will not do, or threaten to do, anything which would result in substantial changes to its business and operations from that contemplated in the Project Documents.

It is also intended that any refinancing of the senior debt facility will be on equivalent terms to that of the loan agreement.

(2) Debt limitations

The loan agreement provides that Finance Co will be restricted to only debt that is permitted under the agreement.

(3) Independent director

The Finance Co Constitution requires that there be at least one independent non-executive Director.

(4) No merger or reorganisation

The Finance Co Constitution states that Finance Co must not amalgamate, merge or consolidate with or into any other person.

Further, the loan agreement provides that Finance Co will not amalgamate, merge or consolidate with or into any other person or enter into any corporate restructuring, reorganisation or plan arrangement without prior written consent except for the purposes of a solvent reconstruction or amalgamation that is approved.

(5) Non-petition language in contracts to which the SPE is a party

The loan agreement provides that recourse is limited solely to the assets and undertakings of the parties.

Further, the Finance Co Constitution prevents Finance Co from amending the Constitution, other than by special resolution of the Members.

(6) Separateness

The Finance Co Constitution provides that the company must remain an independent entity and must keep written financial records in accordance with the requirements of the Corporations Act.

The entering into of the equalisation swap agreement by Finance Co and Trustee Co as trustee for the Project Trust further supports the insolvency-remoteness of Finance Co as it ensures that Finance Co has sufficient funds to meet its obligations.

On balance, the Commissioner accepts that the 'characteristics' of insolvency remoteness are satisfied, and therefore the requirements of paragraph 820-39(3)(c) will in turn be satisfied.

Conclusion

As each of the conditions set out in paragraphs 820-39(3)(a), 820-39(3)(b) and 820-39(3)(c) are satisfied, Finance Co will be entitled to an exemption under section 820-39 from any debt deduction being disallowed under Division 820.

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