It is quite common to use a special purpose entity (SPE) in the form of a company or trust for major projects, including those involving resources and infrastructure developments. The Federal Budget in May this year foreshadowed tax changes that could have adverse implications for the use of such SPEs. The Treasury has now released a Discussion Paper providing further detail of the proposed changes and inviting submissions by 10 August 2012.

Use of limited recourse debt

In financing of major projects, the lenders’ rights of repayment and security are frequently limited to the cash flows and assets of the project. In limited recourse financing lenders decide whether to finance the project by evaluating the viability of the project and its prospects of success, rather than basing the decision on the creditworthiness of the project sponsor.

Specific tax rules exist where limited recourse financing has been used to acquire assets for which capital allowances are available (Division 243 of the Income Tax Assessment Act 1997). In brief terms, if such debt is “terminated” in circumstances where the capital allowance deductions obtained exceed the amount of debt repaid, then the taxpayer will need to include in its assessable income an amount in respect of excess capital allowances previously claimed.

BHP case

The case of Commissioner of Taxation v BHP Billiton Limited [2011] HCA 17 exposed what the Government has perceived as limitations in the application of Division 243. In that case, BHP Billiton Finance Limited (Finance) lent funds on standard terms to BHP Billiton Direct Reduced Iron Pty Ltd (Iron) for use in the construction of plant and facilities for the manufacture of iron briquettes near Port Hedland in Western Australia. The project was subsequently terminated.

BHP had claimed capital allowance deductions in respect of some expenditure in the project and the Commissioner of Taxation sought to reduce the capital allowances claimed on the basis that the debt provided by Finance was limited recourse debt within the terms of Division 243. Although the debt provided by Finance did not contain the contractual limitations typically associated with limited recourse debt, the Commissioner contended that the debt had the same practical characteristics having regard to the limited assets owned by Iron and the relationship between the companies. The High Court did not agree with the Commissioner and held that the debt provided by Finance to Iron was not “limited recourse debt” for the purposes of Division 243. Accordingly, the Commissioner could not employ Division 243 to reduce the capital allowance deductions claimed by Iron.

Government response

The Government believes that the High Court’s interpretation of what constitutes “limited recourse debt” for the purposes of Division 243 is contrary to the policy objectives of that Division and may result in different tax treatment of financing arrangements that have the same economic and substantive outcome. On this basis it is proposed that Division 243 will apply to the financing of projects where the borrower is an SPE that has minimal or no assets or sources of income other than those acquired with the financing.

The Discussion Paper indicates that the definition of “limited recourse debt” in Division 243 is proposed to be amended to include:

“ … arrangements where at the beginning, the creditor’s rights against the debtor, in the event of default in payment of the debt, are limited wholly or predominantly (whether or not by contract) to certain rights in respect of the financed property or other property.”

Example of application of expanded definition

The Discussion Paper provides an example of a financing arrangement intended to be caught by the expanded ambit of Division 243. In this example a special purpose company owned by a foreign company, acquires an asset for $325 million. It has no other assets. The asset acquisition is financed using $65m equity contributed by the foreign parent and $260 million of borrowings from the bank. There is no contractual limitation on the bank’s rights to recover the debt from the SPE. The example may be depicted as follows:

Please click here to view diagram.

Under the changes proposed to be made to Division 243, the debt provided to the SPE by the bank would be treated as limited recourse debt, as the bank’s rights against the SPE “are effectively limited wholly or predominantly to the assets of [the SPE] which are financed by the debt, notwithstanding there is no contractual limit”. If the debt provided by the bank were “terminated” in circumstances where the capital allowance deductions obtained in respect of the acquired asset exceeded the amount of debt repaid, then the SPE would need to include in its assessable income an amount equal to the excess capital allowances previously claimed.

Impact of proposed changes

In view of the widespread use of SPEs as borrowing vehicles to undertake major projects, project sponsors will need to carefully consider the ramifications for the use of such entities if the changes proposed in the Discussion Paper proceed.

The changes proposed in the Discussion Paper are similar to arguments raised by the Commissioner in the BHP Billiton case as to the ambit of Division 243. Edmonds J in the Full Federal Court decision ([2010] FCAFC 25) rejected these arguments and offered comments which are pertinent also to the changes proposed by the Discussion Paper:

“While it is undoubtedly true that the construction for which the Commissioner contends does not lead to the result that the debt of every unsecured creditor, regardless of the contractual arrangements between the parties, would be treated as ‘limited recourse debt’, … even the Commissioner conceded that would be the case if the borrower were a start-up company with no or little assets at the time of borrowing to fund the expenditure, such as a special purpose project company. Moreover, whether or not Div 243 applied to reverse capital allowance deductions by including equivalent amounts in assessable income would then depend on the success of the project. If it ultimately failed and the debt could not be fully repaid, the Division would apply. The only way to avoid that consequence would be to undertake the project in an established company the unencumbered assets of which were, at the borrowing time, greater than the anticipated borrowing. That would place business in this country, particularly for those involved in resources and infrastructure projects, in a ‘tortuous straight jacket’, the likes of which could never have been part of the policy or the intention of the Parliament in enacting Div 243.” (Emphasis added)

Date of application

The proposed amendments are intended to have effect from the time of the Federal Budget announcement of 8 May 2012.