Website of the Department of Health

Date issued: 4 February 2003

Further details from:Private Finance Unit
Room 3W54
Quarry Hill
Quarry House
Leeds LS2 7UE
Telephone - 0113 254 5533

INTRODUCTION

1.    As a result of guidance issued by the Inland Revenue, several bidders on current PFI schemes have raised the possibility of utilising a tax treatment (often termed "composite trade") which may enable Project Cos to reduce their tax burdens significantly.

2.    In order to take advantage of this tax treatment, bidders need to structure their bids so that they qualify as composite traders. Bidders cannot apply the tax treatment unilaterally, since they would need the agreement of both the Trust and the Department of Health's Private Finance Unit (PFU) to modify the Standard Form Project Agreement. In the event that Trusts consent to the use of composite trade it is expected that the full benefit of the tax saving should be passed through to Trusts in the form of reduced unitary charges. The advantage from the private sector's perspective is that such an approach should make schemes more affordable, without impacting adversely on project returns.

3.    Whilst it is presumed that composite trade will be preferable in most cases, it is a matter for Trusts, bidders and their advisers to evaluate the advantages and disadvantages of using a conventional tax treatment or composite trade on a project by project basis. Bidders and Trusts must clear any decision not to pursue composite trade with the PFU.

4.    This note is intended for briefing purposes only and cannot be relied upon as a definitive statement on the relevant tax law and guidance governing composite trader status. Bidders and their financial advisers may wish to consult with the Inland Revenue directly prior to proceeding further.

ACCOUNTING BASIS

5.    According to Application Note F of FRS 5 Reporting the Substance of Transactions the risk and reward profile of a project could result in a PFI facility being accounted for (from Project Co's perspective) as either:

It is unlikely that an SPV accounting for a fixed asset may benefit from composite trader tax treatment. The accounting treatment applied is not optional, but is determined by risk allocation, which is in turn determined by the structure of the Project Agreement, as per Application Note F of FRS5.

COMPOSITE TRADER STATUS

6.    Under a "traditional" PFI procurement, Project Co acquires an interest in the land on which the new PFI facility is to be built. On completion, the PFI facility is then leased back to the procuring NHS Trust. The design and construction costs incurred by Project Co are not allowable expenses for the purposes of computing taxable trading profit; only capital allowances can be claimed on that element of the expenditure which is eligible for capital allowances. Depending on the nature of the project asset a significant proportion of Project Co expenditure may be, therefore, unrelieved against trading income. The fact that tax relief is not available on a proportion of the design and construction expenditure is reflected in the level of the unitary charge. Prior to August 2002, all NHS PFI schemes were structured in this way.

7.    The Inland Revenue has recently issued guidance concerning the scope of PFI trades (Inland Revenue Tax Bulletin Issue 60, PFI Projects: Scope of trade). A composite trader is one who provides design and construction services, as well as ancillary support services on trading account i.e. the design and construction costs are allowable revenue expenditure for tax purposes.

8.    The chief advantage of composite trader status is that it allows all of the expenditure incurred in design and construction to be relieved against trading income, thereby reducing the Project Co's tax burden. This reduction in the tax paid by the Project Co offers scope to reduce the unitary charge paid by the procuring NHS Trust.

9.    The significant difference is that, unlike in a conventional PFI scheme, a composite trader is not exploiting an interest in or right over land as a source of rent.

QUALIFYING CRITERIA

10.    For Project Co to be classed as a composite trader it must consider the following issues:

No rental income arises in the scheme

11.    Normally PFI schemes are structured so that the NHS Trust grants an exclusive lease for the Project Co to occupy the land and the Project Co grants a lease back to the Trust to occupy the newly-constructed facility. Because a lease arrangement exists, an element of the unitary charge may be treated as rent paid to Project Co for tax purposes. This tends to indicate that Project Co is deriving income from the exploitation of an interest in land and is, therefore, in principle, inconsistent with carrying on a composite trade.

Land Arrangements

12.    Land arrangements within PFI schemes would need to be structured as licences, rather than leases as is currently the case. This change to the Standard Form Project Agreement need not alter the risk allocations that determine balance sheet treatment. However, Trusts should obtain scheme specific guidance from their advisors on this issue.

Nature of the Activities

13.    If Project Co carries out its business from the property it is deemed to have control of essentially all the activities within the building. A common example of this is PFI prisons, where the private sector not only builds and maintains the building, but also provides custodial services. This arrangement is incompatible with composite trader status. By contrast, in an NHS PFI scheme Project Co usually provides the building and associated hard and soft FM services, but not the clinical services (the principal activity for which the building is designed and used). In these circumstances Project Co is deemed to carry out its business with the property. This is consistent with composite trader status. Again, the terms of the scheme must be structured in such a way that an interest in or right over land is not giving rise to rental income (i.e. costs are trading costs, not costs of a capital assets).

14.    The overall financial merits of each option vary from scheme to scheme. It is expected that Trusts and their advisers would evaluate these within the context of each scheme.

Nature of Project Co's business

15.    The Project Co's memorandum (the document which states the principal objectives of a company) should state that it is in the business of providing building and maintenance services.

Treatment of Profits on Completion of the Construction Work

16.    Currently, on completion of a fixed asset, the comparison of fair value of the completed asset with construction cost gives rise to a paper profit which is not taxable. Under composite trade, any gain on completion is taxable whilst any loss is deductible from taxable profits.

IMPLICATIONS FOR THE STANDARD FORM CONTRACT

17.    The NHS Standard Form Contract uses a lease structure to define the respective land interests of the NHS Trust and Project Co because it is possible, by applying for a contracting out order, to prevent the tenant (Project Co) from gaining security of tenure. Thus, the combination of the lease, plus a court order, means that the NHS's future ability to occupy the PFI facility on reversion is understood unambiguously by both sides.

18.    By contrast, it is not possible to obtain a contracting out order for a licence. On the other hand, whilst a licence may satisfy the requirements of the Inland Revenue (which are influenced by legal form) it could still (for the purposes of giving security of tenure, if not for tax purposes) be classified as a lease if a court considered that it met certain substance-based tests. In a worst case scenario, NHS Trusts could be found to have entered into an arrangement with Project Co which is in substance a lease, but without the certainty of being able to possess the PFI facilities cleanly at the end of the concession period.

19.    However, the risks that the NHS will not be able to take possession of PFI facilities at the expiry of the PFI concession will normally be low. For example, one of the tests that a lease exists is the concept of "exclusive possession" difficult to prove in the case of a facility open to the NHS and the public.

20.    Whilst it may be possible to substitute leases for licences in clinical accommodation, the situation is more complicated for residential PFI schemes. In most residential PFI schemes, Project Co grants assured shorthold tenancies to occupants. These are leases with a duration of six months that do not confer security of tenure on the occupant. However, only the freehold or leasehold owner can grant assured shorthold tenancies. If the Project Co were operating under a licence it would only be able to grant licences to tenants. These licences could subsequently be determined by a court to be, in substance, leases (there is a significant risk of this because there would, for example, normally be exclusive occupation of each unit) but by then it would be too late for Project Co to create an assured shorthold tenancy. Project Co might then have difficulty recovering possession of a unit from an occupier who is reluctant to leave at the expiry of his/her agreement. Thus, for legal and commercial reasons composite trade may not necessarily be a suitable tax structure for such a scheme. Trusts should contact the Department of Health's Private Finance Unit if bidders wish to apply composite trade in such circumstances.

21.    Where there is difficulty with legal form like this, it would be best to structure the lease/leaseback so that the Project Co is left with some rights similar to a licence and to approach the Inland Revenue about the specifics of the case, before going too far with the project agreement.

22.    The Department of Health's Private Finance Unit is currently reviewing the impact of composite trade on the Standard Form Contract. Definitive guidance will be issued shortly. In the meantime, it is expected that NHS Trusts and their advisers should review bidders' requests for changes to the Standard Form Contract. In all cases these should be discussed with the Private Finance Unit.

ACTION FOR BIDDERS AND NHS TRUSTS IN PROCUREMENT

23.    It is expected that bidders should seek to structure their bids in order to attain composite trader status if it reduces their tax burden. The resulting tax savings should be used to reduce unitary charges levied to NHS Trusts.

24.    Before the selection of preferred bidder NHS Trusts should request that bidders guarantee their commitment to apply the most beneficial tax treatment and reflect these savings, in full, in the unitary charge. It is expected that the most beneficial treatment will be reflected in the bids that are submitted to the Trust. The selected preferred bidder should seek written advice from Inland Revenue regarding the proposed PFI transaction under Inland Revenue Code of Practice 10 ("a COP 10 letter") if it has not done so already.

25.    The action required of NHS Trusts depends on the stage of procurement that the PFI scheme has reached.

26.    Where detailed ITNs have not been issued, bidders are unlikely to have presented their tax assumptions for the scheme either as broad intentions or in a detailed financial model. In such cases, Trusts should request that bidders apply the most beneficial tax treatment and reflect these cost savings in a reduced unitary charges as part of the competitive process. It is expected that Trusts' financial advisers will review these calculations closely in order to maximise Trusts' share of tax gains. The tax treatment adopted should be that which generates most benefits for the project, taking into account all relevant factors. It is presumed that in almost all cases this will be composite trade.

27.    As a matter of policy, it is expected that Trusts should receive, by way of reductions in their unitary charge, the equivalent of 100% of Project Co's projected tax saving. The reason for this is that savings, which result from the availability of a favourable tax treatment, should be passed on to the NHS and should not result in a windfall benefit to Project Co. Any requests by bidders not to pass the full share of savings back to the public sector should be brought to the attention of the Department of Health's Private Finance Unit.

28.    By using the COP10 procedure, Project Cos will be able to obtain an indication from the Inland Revenue, in advance of financial close, of whether or not their activities are likely to qualify for composite trader tax treatment. This is not an irrevocable tax clearance, since the issue of whether a company qualifies, as a composite trader will depend on how it actually carries on its business in fact. Since this is not within the control of the Trust, any suggestion by Project Co that the Trust should bear any risk that composite trade tax treatment is denied should be rejected and the matter should be brought to the attention of the Private Finance Unit.

ACTION FOR TRUSTS WITH OPERATIONAL PFI SCHEMES

29.    Project Cos may negotiate privately with the Inland Revenue for treatment as composite traders. These negotiations are protected by taxpayer confidentiality.

30.    If Project Co requests a change in its contractual relationship with the Trust which would improve its tax position by claiming composite trader status, Trusts should ensure that they capture the benefit of the tax revenue that will be forgone by the public sector or otherwise refuse to accept the change. Trusts should not accept changes to existing contracts that diminish value for money for the public sector as whole. Trusts may request that Project Co provide the following information:

31.    In all instances where Project Cos request changes to the contractual relationship, when compared with the standard form contract, Trusts must consult the Department of Health's Private Finance Unit.

32.    For an operational PFI scheme, if Project Co does not contact Trusts to seek agreement to apply composite trader tax treatment, Trusts should not request that Project Co implement this tax treatment.IMPLEMENTATION

33.    This guidance is to be implemented with immediate effect.