Funding Construction Projects
Relevant Government Initiatives
The Indian construction industry is undergoing a makeover. The Indian government has revised foreign investment guidelines to allow for the automatic approval of infrastructure projects with up to 100% foreign equity participation (not exceeding Rs15 billion). Prior to the revisions, the foreign equity investment in projects subject to automatic approval was limited to 74% (and even then, the Foreign Investment Promotion Board gave approval on a case-to-case basis).
The government hopes its new policy will encourage projects for the construction and maintenance of roads, highways, vehicular tunnels, ports and harbours. For example, with regard to highways, the government is hoping to encourage the investment of Rs1,250 billion to meet the cost of constructing expressways that will link all the major ports in the country.
The following are the most common types of construction projects undertaken in India:
- build-own-transfer (BOT);
- build-own-operate-transfer (BOOT);
- build-own-share-transfer (BOST);
- build-own-lease-transfer (BOLT); and
- build-own-operate (BOO).
A BOT project is a contractual arrangement whereby the contractor undertakes the construction, financing, operation and maintenance of an infrastructure facility for a prescribed period (ie, the concession period).
During the concession period, the contractor is allowed to charge the users of the facility a toll (ie, fee) that is sufficient to recover project costs and provide the contractor with a risk-adjusted return on its investment. Upon the termination of the contract, the contractor transfers the facility to the central or state government (as appropriate) in a condition and within a timeframe established in the original agreement.
The financing of BOT projects is on a non-recourse basis. The recourse is limited to the project company and its assets including real estate, plant, equipment, and any contractual rights, performance bonds, insurance and government guarantees the project company has obtained.
Lenders have no financial recourse against project sponsors or the host government for repayment of loans.
Most Indian states that are unable to provide financial guarantees to lenders are offering construction contracts on a BOOT basis. For example, the state of Karnataka has offered road, port and water projects on this basis, Bangalore has offered the Mysore expressway, and the state of Gujrat has used this mechanism for the Adhani port.
The BOOT method allows states to provide leasehold rights to project operators. During a 30-year construction period, the ownership of assets is vested with the project operator. (Projects offered on a BOT basis do not vest ownership with project operators.)
States are increasingly using the BOOT method as a way of making projects financially viable. However, financial institutions are not prepared to fund projects purely on a project recourse basis without an assured cash flow. States such as Gujrat have frozen guarantees given to construction contracts and are not in a position to provide escrow cover for road projects. Financial institutions typically demand physical asset cover and are not prepared to take risks entirely on a project recourse basis in the case of port projects.
Under the existing guidelines, the value of the underlying asset in a BOOT project should be 1.5 times greater than the loan amount.
A BOOST project allows a state government to negotiate revenue sharing options with the project operator during the concession period. This method is being used by the state of Orissa for the construction of the Dhamara port. (The project was awarded to International Seaports, a joint venture between Larson and Tubro of India, Precious Shipping of Thailand, and SSA International of the United States.)
In a BOLT project the private investor builds and runs the facility as the owner, and then at the end of an agreed term, transfers the right to operate the facility to the government. The private party then receives a steady income by way of a lease arrangement with the government.
In a BOO project the private investor constructs, owns and operates the facility for the entire life of the facility. Praxair India, a subsidiary of Praxair USA, entered into a BOO agreement with Haldia Petrochemicals Ltd for the supply of industrial gases to Haldia Petrochemical.
The following section highlights some of the important agreements that the various players in a construction project may enter into.
The project contract is an agreement entered into between the investor (ie, project company) and the host country or state. This agreement forms the basis on which other contracts are developed. The project agreement entitles the investor to build, own and operate the project facility. It also outlines the technical specifications of the project, as well as the toll rates, and the periods of time relating to lease, operation and transfer of the project facility.
A shareholders agreement is entered into between the shareholders of the project company and the company itself. This agreement sets out such matters as:
- the rights and liabilities of the shareholders;
- the subscription of share capital among the shareholders;
- the appointment of the directors; and
- details regarding board meetings, shareholder general meetings and special meetings.
The construction agreement is usually a fixed-price, turnkey contract that covers all aspects of the construction work. It is entered into between the project company and the construction company.
If the central or state government is the only user of the infrastructure facility, the project company enters into a purchase agreement with the government, which sets out an established minimum purchase price to be paid by the government.
A credit agreement is entered into between the project company and each of the lenders to the project. This agreement includes the loan security structure, provisions regarding risk allocation, and the consequences of defaulting on repayment of the loan.
A concession agreement is entered into between a private party and the government whereby the government gives the private party the right to provide a particular service. Therefore, concession agreements shift the risks and responsibilities of providing a particular service from the public sector to the private sector.
Construction projects such as power, telecommunications, ports, airports and expressways often involve the outlay of a substantial amount of funds. These funds are required over a long period of time (typically 10 to 20 years or more) as construction must first be completed and then the investor must operate the facility long enough to earn a return on its investment.
Over the last six or seven years, financial institutions in India have undertaken the task of fully understanding the dynamics of construction financing. They have identified the risks at each stage of these projects and have looked at establishing adequate safeguards to alleviate these risks. Several of the concepts that lenders have looked at and developed include the following:
- cashflow financing;
- the use of government guarantees to induce private financing;
- the use of escrows to ensure that lenders get first charge on income generated by the project; and
- take-out financing, subordinate debt financing and other new methods of finance.
The following section looks at some of the more important legislative acts that affect the construction industry (and construction contracts) in India.
Indian Contract Act
The Indian Contract Act 1872 deals with the legal principles that govern the formation of valid contracts. It also deals with quasi-contracts, contracts of indemnity, guarantees, bailments, pledges and agency. Of particular relevance to construction contracts, Section 55 of this act deals with the following:
- the effect of a failure to perform within a specified period where time for performance is essential;
- the effect of a failure to perform within a specified period where time for performance is not essential; and
- the effect of accepting performance that was completed during a period other than that which was agreed upon.
The Indian courts have held that time is of the essence for performance in the following three cases:
- where the parties have expressly stipulated in their contract that the time fixed for performance must be complied with;
- where the circumstances of the contract or the nature of the subject matter indicates that the fixed date must be complied with; and
- where time was originally not of the essence, but because of one party's undue delay in performance, the other party gives notice requiring performance within a reasonable time.
Specific Relief Act
This Specific Relief Act 1963 provides for remedies that are not available, or are inadequate, under other Indian legislation. For example, normally the remedy for a breach of contract is actual damages incurred as a result of the breach. However, where actual damages cannot be determined, specific performance can be required under the Specific Relief Act. Furthermore, if a person has been wrongfully dispossessed of his property, the normal procedure for enforcing his rights under the Civil Procedure Code may be unduly lengthy. The act allows for the summary remedy of restoring possession of the property to such person.
The Specific Relief Act also provides the remedy of recession of voidable contracts, rectification or cancellation of contracts, and court injunctions requiring a party to do, or not to do, a particular act.
Arbitration and Conciliation Act
Experience has shown that when parties to a contract belong to different jurisdictions, they are reluctant to have an action determined by the courts of the other party's home country. Litigation is also time-consuming. Because of these factors, most parties to construction contracts agree to have disputes settled by arbitration, and therefore the contract will contain an arbitration clause. The government enacted a new Arbitration and Conciliation Act in 1996.
Environment Protection Act
The Environment Protection Act of 1986 (EPA) was enacted in the wake of the Bhopal tragedy. The EPA is 'umbrella' legislation designed to provide the central government with a framework for coordinating the activities of various central and state authorities established under other relevant legislation (eg, the Water Act and Air Act).
Income Tax Act
Because India is a federation of states, there is an elaborate division of power to levy taxes between the union and the states. Corporate and personal taxation is governed by the Income Tax Act 1961. However, the actual rates of taxes are announced annually in the parliament's Finance Act for the year.
Section 80-1A of the Income Tax Act grants a five-year tax holiday for certain construction projects (eg, roads, bridges, highways, airports, ports, rail systems and any other public facility of a similar nature). Oil exploration, industrial parks and telecommunications facilities also qualify for tax concessions as construction projects.
The 46th Amendment to the Constitution of India provides for the imposition of sales tax in relation to building contracts. States may now levy sales tax on the value of goods that are supplied and used in accordance with building contracts, in the same way that sales tax is applied to goods that are actually sold.
A service tax of 5% is levied on certain taxable services such as the services of a consulting engineer. The Central Excise Department is responsible for applying and collecting service taxes.
Relevant Government Initiatives
The government of India has taken certain initiatives recently to encourage construction projects in the country. The following are some of the most important initiatives.
The central government has cleared proposals from companies (eg, Konkan Railway Corporation and Essar Power) to raise funds for their construction projects by issuing bonds and other instruments, which thereby enable the institutional investors to obtain income tax exemptions under Section 10 (23G) of the Income Tax Act.
In the case of ports, the government has identified the following areas for foreign direct investment:
- leasing existing assets of ports;
- construction of additional assets such as container terminals, cargo berths, warehouses, tank farms, captive power plants, and dry dock and ship repair facilities;
- leasing of equipment for port handling and leasing of floating crafts; and
- captive facilities for port-based industries.
The government has persuaded the Asian Development Bank to provide the country with long-term loans totaling $300 million to support private sector construction projects.
Various tax concessions have been made available to long-term construction projects and to the institutions providing the financing for those projects. For example, in 1998 a five-year tax holiday was provided for BOOT projects in certain specified areas (eg, power, roads, highways and ports).
Foreign institutional investors are now permitted to invest in unlisted companies in the same manner as they may invest in listed companies. The Securities and Exchange Board of India has amended its guidelines to provide that with regard to issues where the promoter's contribution exceeds Rs1 billion, the promoters may make contributions in phases. Half of the contribution must be made before the issue opens and the rest must be made after the issue is completed.
Finally, it has been suggested that institutional sources of capital (eg, pension, insurance and provident funds) should be made available for financing urban construction.
The Investment Information and Credit Rating Agency and the Construction Industry Development Council are developing a grading system to rate agencies involved in construction projects. The grading system will be comprehensive, covering four agencies involved in a project - the project owner, the contractor, the consultant and the project entity.
The project owner will be assessed on its capacity to generate cash through the operation of the project. Factors such as industry characteristics, market position, operational efficiency, management quality and funding policies, which impact the project's cash flows, will be taken into account in this assessment. Secondary cash flows available to supplement the primary source will also be analyzed.
The contractor will be assessed in a similar manner, although risks (business, financial and group) will also be considered.
The consultant will be rated on the basis of its market reputation, niche area of operation, project quality track record, human resources, and financial and group risks.
The project will be assessed on a stand-alone basis. Analysis of the risks associated with the project (eg, completion, price, operating, political and environmental risk) will be carried out, as well as the methods that may be incorporated to mitigate these risks.
For further information on this topic please contact Hiroo Advani or Shubhada Bhave at Advani & Co by telephone (+91 22 281 8380) or by fax (+91 22 286 5040) or by e-mail ([email protected]).
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