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PDF - Tax Reform and Infrastructure


  • pg 1
									April 1999

Prepared by
The Allen Consulting Group

                             Tax Reform and Infrastructure
                             Submission to the Review of Business Taxation
                             from the Australian Constructors Association
The Allen Consulting Group Pty Ltd
ACN 007 061 930

4th Floor, 128 Exhibition St
Melbourne Victoria 3000
Telephone: (61-3) 9654 3800
Facsimile: (61-3) 9654 6363
Email: allcon@allenconsult.com.au

3rd Floor, Fairfax House, 19 Pitt St
Sydney New South Wales 2000
Telephone: (61-2) 9247 2466
Facsimile: (61-2) 9247 2455
Table of Contents

                    Executive Summary                                              1

                    Chapter One
                    Private Investment in Infrastructure                           3
                      1.1    Importance of Investment                              3
                      1.2    Investment in Infrastructure                          6

                    Chapter Two
                    Impediments to Investment in Infrastructure                   11
                      2.1    Characteristics of Infrastructure                    11
                      2.2    The Tax Disadvantage Problem                         12
                      2.3    The Value Capture Problem                            14
                      2.4    Impact of Regulation                                 14
                      2.5    Implications for Private Investors                   15

                    Chapter Three
                    Problems with the Taxation System                             16
                      3.1    Tax Losses Problem                                   16
                      3.2    Accelerated Depreciation                             23
                      3.3    Section 51AD of the Income Tax Assessment Act 1936   24
                      3.4    Proposed Taxation of Limited Recourse Debt           26
                      3.5    International Competitiveness                        27
                      3.6    Uncertainty and the Need for Rulings                 28
                      3.7    The ‘Culture’ of the Australian Tax Office           28

                    Chapter Four
                    Conclusions: The Way Forward                                  29
                      4.1    Technical Issues                                     29
                      4.2    Strategic Issues                                     29

                     Executive Summary

                     Private Investment in Infrastructure

                     The most important determinant of how fast an economy can grow is its rate of
                     investment, and investment in physical infrastructure is an essential element in the
                     contribution of capital formation to economic growth.

                     Historically, the public sector has been responsible for much of Australia’s capital
                     expenditure on infrastructure. However, since the late 1980s, pressures on
                     Commonwealth and State budgets have led to a decline in public investment from
                     around 8 per cent of GDP in the 1960s to less than 4 per cent currently. Most of this
                     long–term decline in public investment has occurred in the provision of infrastructure.

                     Governments acknowledge the need for new investment, but are fiscally constrained
                     from undertaking new projects themselves. Instead, governments are turning
                     increasingly to the private sector to build, and in some cases own and operate,
                     infrastructure projects.

                     Impediments to Investment in Infrastructure

                     Infrastructure investments typically involve long planning horizons, with significant
                     construction effort and duration. They often incur substantial and irretrievable costs
                     before earning revenues — in other words, projects have early negative returns and long
                     pay-back periods.

                     There are at least three factors which can make private investment in infrastructure
                     relatively less attractive than investment in other businesses:

                     N   under the present tax system, where a consortium is formed, the ability to write-off
                         for tax purposes the early losses associated with infrastructure projects is severely
                     N   the frequent existence of a high level of social and environmental external benefits
                         means that investors are unable to appropriate many of the gains from their
                         investment; and
                     N   infrastructure is highly regulated, with implications for property rights and the rate
                         of return that are not present in other sectors.

                     Unless the Government provides some offsetting advantage to reduce or eliminate this
                     net disadvantage, private investment in infrastructure is likely to be significantly less
                     than it would be on a ‘level playing field’. The Review of Business Taxation offers one
                     vehicle by which this issue could be addressed.

                     Problems with the Taxation System

                     This submission identifies a number of problems with both the current taxation system
                     and with some of the proposed changes that have arisen in the public debate so far.
                     These include:

                     N   The IBTOS, program which is designed to address the tax losses problem, is far less
                         effective than the previous Infrastructure Bonds program. It is difficult to access,


                         capped at a relatively low cost to revenue, and subject to allocation on a
                         discretionary basis.
                     N   There is a high risk that removing accelerated depreciation tax concessions, as part
                         of a package designed to reduce the nominal rate of company tax to 30 per cent,
                         would have the highly undesirable effect of threatening future private investment in
                         longer lived assets such as those involved in most infrastructure projects.
                     N   Section 51AD of the Income Assessment Act 1936 is now a major impediment to
                         joint public/private sector infrastructure ventures. The current legislation has the
                         potential to deny tax deductions even if the private sector takes on significant risks.
                     N   The proposed taxation of limited recourse debt would effectively eliminate the use
                         of limited recourse finance in any meaningful sense, favouring equity and corporate
                         debt as the preferred sources of development capital. Since limited recourse debt is
                         the most common financial structure for infrastructure projects, this provision is
                         particularly damaging to privately financed infrastructure development.
                     N   There is a high level of uncertainty surrounding the tax arrangements in relation to
                         private provision of infrastructure. This adds to the sector’s costs and can act as a
                         significant deterrent to investment.
                     N   The negative attitude of the ATO in relation to interpreting the tax law is not
                         conducive to investment in infrastructure projects.

                     Conclusions: The Way Forward

                     The 1992 One Nation statement provided two initiatives that, to some extent at least,
                     offset some of the disadvantages faced by private sector investors in infrastructure. First,
                     the Infrastructure Bonds scheme provided worthwhile compensation for the tax losses
                     problem. However, that program has now been abolished and replaced by the less
                     attractive IBTOS. Secondly, accelerated depreciation of plant and equipment was of
                     value to many infrastructure projects and now faces abolition.

                     Both these measures were introduced because the Government believed that, without
                     them, investment in infrastructure would be inadequate. It is difficult to see why this
                     view would now have changed. The major issue for the infrastructure industries is how
                     the Review of Business Taxation can contribute to providing a more favourable
                     environment for private investment in infrastructure.

                     The ineffective IBTOS should be replaced by a new program that addresses the
                     shortcomings of the discontinued Infrastructure Bonds scheme and whose cost to
                     revenue is controllable. One option is an infrastructure voucher system, whereby the
                     Government would designate a certain total value for vouchers to be issued each year to
                     be used by eligible infrastructure to obtain a tax refund equal to their face value.

                     Some industries will benefit from the ‘trade off’ of accelerated depreciation for a lower
                     statutory tax rate, while some will be worse off. In the infrastructure sector, industries
                     using relatively little plant and equipment, such as road constructors, may be better off,
                     while others, such as electricity generators or gas pipeliners, are likely to be worse off.

                     To ensure the tax system is neutral between investment assets with long or short lives,
                     one option is to allow the owners of assets to nominate the depreciation rate themselves,
                     subject to some clear criteria for assessment. Although such self-assessment is
                     theoretically possible at present, the asset lives prescribed by the ATO mitigate against
                     this being effective. In order to provide more certainty to investors, the ATO should
                     undertake a review of asset lives based on economic rather than physical lives.


                                      Chapter One
                                      Private Investment in Infrastructure

                                      1.1          Importance of Investment

                                      Investment and Economic Growth

                                      The most important determinant of how fast an economy can grow is its rate of
                                      investment. The size of the capital stock in effect determines a speed limit on an
                                      economy’s growth. A capital stock that is too small imposes a physical limit on the
                                      number of people that can be employed and a limit on the economy’s ability to respond
                                      to increases in aggregate demand without emergent wage and price pressures.









Source: Australian National Accounts, Capital Stock (5221.0)
Note:   Figures derived from fiscal year end Net Capital Stock at average 1989/90 prices.

                                      As shown in Figure 1.1, since the late 1960s there has been a marked downward trend in
                                      the growth of Australia’s net capital stock — ie, the accumulation of gross investment
                                      less depreciation of old capital. Without much doubt, this fall has led to a decline in
                                      Australia’s sustainable rate of economic growth. In the 1960s, growth rates in excess of
                                      5 per cent were not uncommon, and were achieved without placing undue pressure on
                                      inflation or the current account. Until very recently, any growth rate much above 3 to 3.5
                                      per cent — other than for relatively brief periods — has been considered unsustainable.
                                      A sustainable growth of around 4 to 5 per cent, on the other hand, would mean
                                      significant inroads could be made into reducing the rate of unemployment.

                                          Investment in human capital is also increasingly seen as a major contributor to economic growth.

                                     The changing share of Gross Domestic Product (GDP) that is accounted for by gross
                                     fixed capital formation since the 1960s is depicted in Figure 1.2. Consistent with Figure
                                     1.1, it shows a downward trend. In the mid 1960s, gross fixed capital investment
                                     represented as much as 27 per cent of Australia’s GDP. During the following decade, a
                                     share of around 24 per cent was more typical. In the 1980s, the figure fluctuated
                                     between 23 and 26 per cent, whilst the early 1990s saw a sharp decline in the
                                     contribution made by gross fixed capital formation to GDP, sinking to 21 per cent in
                                     1991/92. Recent years have witnessed a recovery in the share, but the 1997/98 figure of
                                     23.4 per cent is still nevertheless relatively low by historical standards.











Source: Australian National Accounts, National Income and Expenditure.
Notes: Derived from data expressed in current price terms.

                                     Despite the downward trend described in Figure 1.2, gross fixed capital expenditure
                                     continues to make a significant contribution to Australia’s GDP. Figure 1.3 charts the
                                     relationship between annual growth rates of gross fixed capital formation and GDP since
                                     1986/87. It is clearly evident from the figure that there is a close correlation between
                                     capital formation and economic growth.

                                       The conclusion that investment was relatively low in the 1990s should be tempered by recognition of the
                                     substantial increase in productivity that has occurred over the same period. Opening up the economy and the
                                     increasing globalisation of investment may have meant that the efficiency of capital expenditure has been
                                     greater than in the past.


   25%                                                                                                   6%

   20%                                                                                                   5%
                                                                GDP (RHS)
   15%                                                                                                   4%

   10%                                                                                                   3%

     5%                                                                                                  2%

     0%                                                                                                  1%
                        Gross Fixed
    -5%                 Capital (LHS)                                                                    0%

   -10%                                                                                                  -1%

Source: Australian National Accounts, National Income and Expenditure, Australian Bureau of
Note: Fiscal year basis, using chain volume measures (reference year 1996/97).

                                      The Importance of Infrastructure Investment

                                      Investment in physical infrastructure is an essential element in the contribution of capital
                                      formation to economic growth. Efficient transport systems and supplies of energy, for
                                      example, are vital in terms of the ability to produce goods and services competitively
                                      and take them to market. In an era where nations effectively compete with one another to
                                      attract footloose global investment, the efficiency of a country’s infrastructure is a major
                                      factor governing its ability to attract scarce capital.

                                      Although gross fixed capital formation is a good proxy for infrastructure investment,
                                      Table 1.1 gives a clearer indication of the relative importance of the different sectors
                                      engaged specifically in infrastructure provision on the Australian economy as a whole.
                                      In 1996/97, the construction industry was the fifth highest contributor to Australia’s
                                      GDP, accounting for over 6 per cent of the total. Only the manufacturing industry,
                                      wholesale trade, retail trade and property & business services played a more important
                                      role in national income formation. Other infrastructure sectors also make sizeable
                                      contributions to the nation’s GDP. Transport and storage, for example, has a share of
                                      more than 5 per cent, with communication services close behind on 4 per cent.

                                      The importance of the construction industry to the Australian economy is even more
                                      striking when measured in terms of employment. The final column of Table 1.1
                                      indicates that the sector accounted for 7 per cent of total employed persons in 1996/97.



                         Industry                        Contribution to GDP            Employed
                                                          ($ million, average            Persons
                                                            1989/90 prices)            (Thousands)
 Agriculture, forestry & fishing                                        17,506                     427.0
 Mining                                                                 19,385                      86.7
 Manufacturing                                                          61,138                    1,129.8
 Electricity, gas & water supply                                        14,271                      66.7
 Construction                                                           29,071                     586.8
 Wholesale trade                                                        46,251                     492.5
 Retail trade                                                           31,635                    1,237.7
 Accommodation, cafes & restaurants                                      8,281                     399.1
 Transport & storage                                                    25,498                     396.2
 Communication services                                                 17,625                     163.6
 Finance & insurance                                                    26,052                     316.8
 Property & business services                                           37,049                     827.5
 Government administration & defence                                    15,467                     369.1
 Education                                                              19,181                     581.9
 Health & community services                                            23,465                     771.6
 Cultural & recreation                                                   9,262                     192.5
 Personal & other services                                               8,181                     317.4

 TOTAL                                                                 449,544                    8,389.1

Source: Australian Bureau of Statistics, Private Sector Construction Industry 1996/97 (Cat. No.

                                       1.2       Investment in Infrastructure

                                       Until recently, the public sector was responsible for much of the nation’s capital
                                       expenditure on infrastructure. The construction of roads, railways, airports, electricity
                                       generators and transmission lines, gas pipelines and ports was largely funded by
                                       governments which then owned and operated the facilities. Since the late 1980s this has
                                       changed markedly. Pressures on Commonwealth and State budgets have led to extensive
                                       pruning of outlays and much of this has occurred on the capital side of the budget.

                                       The downward trend in national gross fixed capital investment’s share of GDP identified
                                       in Figure 1.2 therefore disguises a divergent trend between capital formation by the
                                       private sector and public sector. These developments are depicted in Figure 1.4, which
                                       reveals a slight upward trend in the share of GDP accounted for by private sector capital
                                       investment, whilst public investment has declined from around 8 per cent of GDP in the
                                       1960s to less than 4 per cent currently.

                                       A large proportion of gross fixed capital formation by the private sector represents
                                       investment in dwellings. In an attempt to focus more closely on what is happening to
                                       investment in productive capital (rather than residential housing), Figure 1.4 also shows
                                       the trend in private sector non-dwelling capital formation as a share of GDP. This has
                                       fluctuated between around 3 and 5 per cent since the 1960s, and currently stands at
                                       approximately 4 per cent of GDP.








                      Total Private                 Total Public              Private Non-Dwellings

Source: Australian National Accounts, National Income and Expenditure.
Note:   Derived from data expressed in current price terms.

                                      Most of the long–term decline in public investment has occurred in the provision of
                                      infrastructure, as demonstrated in Figures 1.5 and 1.6, which are taken from the National
                                      Commission of Audit Report to the Commonwealth Government in 1996.

                                      In its Final Report of September 1995, the Economic Planning Advisory Commission
                                      (EPAC) Private Infrastructure Task Force found that the long term decline in the ratio of
                                      public investment to GDP is not, in itself, sufficient evidence that current levels of
                                      infrastructure are inadequate. Indeed, some of the fall in infrastructure investment was
                                      undoubtedly justified, as there was previously obvious over-investment in some areas.
                                      The large increase in public expenditure on gas and electricity that occurred in the early
                                      1980s (Figure 1.6) is one obvious example of an area in which there was obvious over-
                                      investment, and the subsequent fall in investment in this area may be interpreted as an
                                      attempt to correct this imbalance.

                                      In addition, there was a move away from large infrastructure projects built in large part
                                      for reasons other than on a purely economic justification (such as the Ord River
                                      Scheme). Finally, there was a recognition that, potentially, significant improvements
                                      could be made in the productivity of some of the existing infrastructure, which could
                                      then yield additional services, as an alternative to building new infrastructure.




Per cent of GDP




                         1961            1969            1977         1985              1993

                                Roads              Air             Rail               Other

Source: National Commission of Audit: Report to the Commonwealth Government, 1996


 Per cent of GDP



                         1961            1969            1977        1985              1993

                         Communication          Water & Sewerage            Gas & Electricity

Source: National Commission of Audit: Report to the Commonwealth Government, 1996


                     Nonetheless, for some categories of infrastructure, and in particular roads, many
                     observers considered it beyond doubt that there had been significant under-investment.
                     Figure 1.5 shows the very large fall in expenditure on roads that has occurred in recent
                     decades. There has also been a trend decline in expenditure on water and sewerage

                     This had been largely accepted by governments, especially State governments, who are
                     generally keen to see large infrastructure projects in their jurisdictions. However, they
                     have been generally unenthusiastic about building these projects themselves, largely
                     (although not entirely) for budgetary reasons. Instead, as discussed in the following
                     section, governments are now turning to the private sector to build, and in some cases
                     own and operate, the infrastructure projects.

                     The Shift from Public to Private Provision of Infrastructure

                     There are a number of reasons why, until recently, governments have believed they
                     should play the major role in the provision of infrastructure. In addition to certain non–
                     economic considerations (such as a philosophical desire to keep the provision of
                     ‘essential services’ within the public sector), there are a number of economic arguments
                     for public sector investment in infrastructure:

                     N   some infrastructure displays ‘public good’ characteristics — ie, it is accessible by
                         all consumers, so that charging users on an individual basis is not feasible — and
                         can result in inadequate provision if left in the hands of the private sector;
                     N   the likely existence of externalities — wider benefits and costs not captured in the
                         projects’ own finances;
                     N   the need for overall planning or coordination for infrastructure with network
                         characteristics — ie, the probability that efficiency in supply will not be achieved
                         without some mechanism of central coordination;
                     N   the potential for the public sector to manage more effectively some of the risks
                         involved in large–scale projects (noting that some of the risks to private developers
                         or operators are under government influence); and
                     N   fears that the private provision (or private operation) of infrastructure may result in
                         abuses of monopoly power.

                     However, over the past decade or so, the importance attached to the arguments for
                     public provision has declined. Whilst governments have continued to be planners and
                     initiators of infrastructure projects, they have increasingly sought private sector
                     involvement in the provision of finance and the management at some or all project
                     phases. This development was highlighted in the National Commission of Audit Report
                     to the Commonwealth Government in 1996, in which the Commission supported
                     increased private sector involvement and recommended that the role of the government
                     be restricted to regulatory and limited funder/purchaser functions.

                     There have been several reasons for this move to private provision of infrastructure:


                     N   Market or Institutional Limits on Borrowing Capacity — The capital costs of
                         infrastructure projects are usually large, and governments have been less willing to
                         pay for them out of current taxes, particularly if it means raising taxes. Thus, such
                         projects, if undertaken by governments, tend to be financed largely by borrowing. In
                         practice, there are limits to how much governments can borrow. Even the best
                         projects involve risk, so that with each borrowing to undertake one, government
                         increases its gearing and its risk exposure. In the case of the Commonwealth
                         Government, if the financial markets perceive that the Government is borrowing
                         ‘excessively’, they will react adversely, and may reduce their holdings of Australian
                         assets (particularly government bonds) or require a higher rate of return to hold
                         them. This will lead to a rise in the interest rates on government securities. As far as
                         state governments are concerned, their borrowing can be constrained by their desire
                         to maintain (or regain) an AAA credit rating. This is partly for reasons of prestige,
                         but the primary reason is that it lowers the cost of servicing their debt, which is
                         substantial for most states.
                     N   Technological Advances — Recent technological advances have undermined the
                         ‘natural monopoly’ argument for the public provision of at least some types of
                         infrastructure. In telecommunications, for instance, the development of microwave
                         links and optic fibre cable now makes it possible to provide some long–distance
                         connections efficiently at moderate volumes, so that more than one provider of these
                         services can operate profitably. Another example can be found in the electricity
                         generation sector. Because of advances in metering, communications and computer
                         technology, it is now possible for several generators of electricity to sell into the
                         electricity distribution network. Such technological developments mean that it is
                         now feasible for the services from some types of infrastructure to be provided by a
                         competitive private market where it was not possible in the past.
                     N   The Development of Capital Markets — Advances in the development of capital
                         markets have also increased the possibility of private sector involvement in
                         infrastructure provision. Such developments include the globalisation of finance —
                         private investment becomes more likely if funds can readily be drawn from
                         investors throughout the world — and financing techniques have been developed
                         that enable the risks of infrastructure investment to be widely spread, which
                         increases its attractiveness to potential investors.
                     N   The Optimal Government Portfolio of Infrastructure Assets — For some types of
                         infrastructure, direct government provision will continue to be necessary or highly
                         desirable. For example, there will no doubt always be a great need for government–
                         funded schools — given the importance of education to life chances, equity and the
                         maintenance of an informed and cohesive society. Such social infrastructure does
                         not yield significant cash flows and is most appropriately provided and financed by
                         government itself. More commercial infrastructure, however, is clearly amenable to
                         private investment, because it can generate substantial cash flows that provide the
                         basis for a return on that investment. Airports, certain roads and other transport
                         facilities, telecommunications infrastructure and some other utility infrastructure are
                         obvious examples.


                     Chapter Two
                     Impediments to Investment in

                     2.1        Characteristics of Infrastructure

                     Infrastructure is easy to recognise but difficult to define. Infrastructure investments are
                     different from other forms of business investment for a variety of reasons, including:

                     N     they are often networks, or form parts of networks (eg, road systems, electricity
                           distribution systems, water reticulation systems, telecommunications networks and
                     N     their capital costs are typically large compared to running costs;
                     N     they typically, therefore, have substantial elements of ‘natural monopoly’ — ie, it is
                           economically inefficient to have more than one provider of the infrastructure in an
                     N     infrastructure typically involves long planning horizons, with significant
                           construction effort and duration;
                     N     investments often entail the incurrence of substantial and irretrievable costs before a
                           certain service can be offered and revenues (if any) can flow — in other words,
                           projects have early negative returns and long pay-back periods. For example, a
                           typical tollway project will be planned years ahead and involve construction costs of
                           several hundred million dollars expended over perhaps several years before any
                           revenues will be collected;
                     N     the assets associated with infrastructure investments tend to have long lives; and
                     N     certain infrastructure developments provide parallel social and environmental
                           benefits, the value of which is often not adequately captured. These are referred to
                           by economists as ‘positive externalities’. For example, in the case of land transport
                           infrastructure, such benefits might include a reduction in traffic congestion, benefits
                           to other businesses, greater safety and an improvement in the quality of urban life.

                     These characteristics of infrastructure present some particular aspects that are very
                     significant to private investors. Unless they are addressed adequately by the tax system
                     or some other policy instrument, private investment in infrastructure is likely to be well
                     below the socially optimal level. The three main issues are:

                     N     the risks of infrastructure projects are typically pronounced in the development
                           phase (eg, risks of delays in approval processes, construction delays and cost
                           changes). There may also be significant risks attaching to how fast demand (and
                           revenue) builds up, so–called 'ramp–up' risk, after which (in the full operating
                           phase) risk should be lower and revenues more steady and predictable—provided
                           there are no major changes to the operating environment (eg, a competing facility
                           introduced nearby). During the riskiest phases, therefore, there is no net revenue to
                           support a running yield to investors;
                     N     if important parts of the benefits (and to some extent the costs) cannot be fully
                           captured in the project’s finances, the characteristics of the project for private
                           investors will depend critically on the terms of government's involvement (including
                           relevant tax provisions, as well as any direct participation in the project itself) — ie,
                           on exactly how risks and returns are shared between public and private sectors; and


                                               N     these sectors are often subject to a high degree of regulation which can have a
                                                     critical impact on the rate of return, with the risk of the rules changing after the
                                                     initial investments have been made.

                                               These three issues are considered further below.

                                               2.2       The Tax Disadvantage Problem

                                               A major problem for investors is that infrastructure projects typically do not yield
                                               positive cash flows for many years after expenses begin to be incurred. Typically,
                                               infrastructure projects have the distinctive characteristic that, for a period of up to 10
                                               years (and in some cases longer) from the beginning of construction, they can yield
                                               negative cash flows. This is because there are no revenues during the construction phase,
                                               and revenues early in the operations phase are low relative to interest payments (and

                                               This is illustrated in Figure 2.1 which shows for a hypothetical road project a series of
                                               losses in early years followed by positive returns only after a good deal of elapsed time
                                               (12 years of operation). Similar patterns of returns are likely to be exhibited by investors
                                               in other infrastructural assets, such as electricity generators.





                                                         6             9             12            15             18
                   Construction (0) Operation (3)

Source: Macquarie Corporate Finance Ltd

                                               If a single company invested in these assets, the tax problem would be much reduced
                                               because losses in the early years could be offset against income earned by the company
                                               from its other investments. Investment in infrastructure, however, is typically carried out
                                               by consortia of major corporations, which form stand–alone companies mainly in order
                                               to share the substantial capital raisings that are required and, hence, the risk. These
                                               special purpose, stand–alone companies do not have other income against which to
                                               offset these losses, and Australian tax laws prohibit the flow through of these losses to
                                               company shareholders. The inability to pass through tax losses was one of the major
                                               reasons why the Very Fast Train (VFT) project did not proceed at the beginning of the


                     It is often argued, therefore, that infrastructure projects are placed at a tax disadvantage
                     relative to other projects. This argument, however, is not universally accepted and in
                     particular is disputed by the Commonwealth Treasury. In 1995, the EPAC Private
                     Infrastructure Task Force, relying on a consultant’s report , argued that in terms of
                     effective tax rates, stand–alone infrastructure projects are not in fact disadvantaged
                     relative to infrastructure projects where full use can be made of interest deductions, or
                     relative to investment in long–lived plant and equipment. For all three types of
                     investment, the effective tax rate was calculated as about 29 per cent. The same view
                     was reiterated by the Treasury in its submission to the Financial System (Wallis)

                     There a number of points which need to be made in response to this argument. First, the
                     estimates of effective tax rates for infrastructure investment are largely driven by the
                     assumption that capital gains accrue free of tax. While this is true, it is of dubious
                     relevance since, under the Australian tax system, capital gains are in fact taxed on
                     realisation, not accrual. Capital gains accrue tax free on all assets, not just infrastructure
                     projects. Moreover, infrastructure BOOT projects are eventually transferred from the
                     private owners to the public sector free of charge at the end of a specified period. Thus
                     the project owners never realise any capital gains. It is therefore highly questionable to
                     impute to them a theoretical accrued capital gain when calculating effective rates of
                     income taxation.

                     Secondly, the effective tax rates which the EPAC Task Force drew upon to make its
                     conclusions assumed away any cash flow problems in the early years of a project, when
                     revenues are low (or nil) and costs are high. In reality, cash flow problems may in fact
                     significantly constrain the ability of private investors to build infrastructure, especially
                     large projects.

                     Thirdly, effective tax rates can be highly sensitive to the assumptions made in their
                     calculations with respect to a large number of variables such as the life of the
                     investment, the rate of depreciation, the interest cost of borrowings, the rate of a
                     company’s share turnover, whether the company has sufficient taxable profits to obtain
                     benefits from depreciation allowances in the year that they occur, the rate of inflation
                     and the proportion of a project that is debt financed. It is not at all obvious that the
                     effective tax rates reported by EPAC are not sensitive to small changes in these key

                     In short, the argument that infrastructure projects (especially stand–alone projects) are
                     not tax disadvantaged is questionable. On balance, the cash flow issue has led to two
                     arguments being advanced for special taxation treatment of infrastructure:

                     N    there is a disincentive for the private sector to invest in infrastructure because of
                          these long lead times and therefore the long periods that private investors must wait
                          until deductible expenses may be claimed against income flows; and
                     N    large infrastructure investments can often only be undertaken by consortia of private
                          sector companies that cannot be grouped for tax purposes. Thus expenses on
                          infrastructure projects cannot be claimed against income from other sources within
                          the consortium.

                         Sieper, E (1995), Infrastructure Taxation, consultancy report to the EPAC Private Infrastructure Task
                     Force, April 1995.
                         These calculations were made assuming a company tax rate of 33 per cent; it has since been increased to
                     36 per cent.
                          See the paper by David Chessell, “The Fiscal Framework”, delivered to the Queensland Treasury’s
                     Infrastructure Development in Queensland ‘96 Conference, August 1996.

                     2.3      The Value Capture Problem

                     A second barrier to the private sector investing in infrastructure is the inability of private
                     investors to recoup the full value of the facility they provide. The widespread acceptance
                     of user charging these days — such as for the City Link project in Melbourne and
                     Sydney’s toll motorways — means that private investors can charge directly for use of
                     the facility. In terms of direct use, the free rider problem has been eliminated.

                     The difficulty is that indirect free riders cannot be charged for using the facility. The
                     private investor cannot derive, through user charges alone, any compensation for the
                     value the project adds to the local economy. For example, a major road or bridge may
                     add considerably to the productivity of a regional economy by cutting costs of
                     production for users and bringing additional custom to local businesses. Owners of local
                     businesses, as well as governments, may be the major financial beneficiaries of such
                     infrastructure which adds to economic activity in a region, pushing up land values and
                     the tax base. While private owners of infrastructure can charge for direct users of their
                     assets, they cannot capture the value enjoyed by entities which benefit indirectly.

                     In the past, governments built infrastructure partly because they realised that such
                     activities would ultimately strengthen their own revenue bases and thus repay (at least in
                     part) the cost of the infrastructure. Private investors do not have the means to recapture
                     such external benefits and thus may be forced to charge inappropriately high prices (ie,
                     in excess of marginal costs) to direct users unless government makes a contribution
                     which recognises the collateral benefits to society as a whole, or unless the infrastructure
                     franchises include some other value capture mechanisms.

                     The value capture problem is a genuine externality which, unless adequately addressed
                     by policy makers, can have a negative effect on the ability of the private sector to
                     provide certain kinds of infrastructure. Arguably, while the tax issue was probably of
                     primary importance, an inability to capture some of these benefits was a major factor in
                     the non-viability of the VFT project.

                     2.4      Impact of Regulation

                     In combination, the characteristics of infrastructure mean that the returns to private
                     provision are heavily dependent on current and future government actions. In particular,
                     private infrastructure projects can be subject to substantial regulatory (or policy) risks
                     that are not evident in other private sector operations. Regulatory risks can relate to
                     planning requirements, external caps on the pricing of services, environmental
                     requirements and the conditions governing the entry of new competitors. Where these
                     regulatory risks are not managed effectively, investment in infrastructure can be
                     relatively high risk. Moreover, the impact of regulatory risk is exacerbated by the fact
                     that infrastructure assets are typically high cost projects with few alternative uses once
                     the investment is made.

                     Where governments determine the terms of pricing of infrastructure services (as is
                     becoming common in the case of the energy sectors, for example), then the cashflows of
                     private infrastructure projects are also effectively regulated. The issue in Australia
                     currently is that regulatory systems for infrastructure facilities are still very much in their
                     infancy, which creates much uncertainty for potential investors. From this perspective, it
                     can be argued that investors in Australian infrastructure projects face higher regulatory
                     risks than their counterparts in countries such as the US and UK, where regulation
                     systems are well evolved.


                     The recent decisions on natural gas transmission access arrangements in Victoria
                     suggest that authorities acknowledge the high regulatory risks faced by investors in
                     Australian infrastructure. In October 1998, the Australian Competition and Consumer
                     Commission (ACCC) and the Victorian Office of the Regulator–General (ORG)
                     released their final decisions relating to the prices that will be set for the next five years
                     for gas transportation in the State. After initially basing the decisions on a real pre–tax
                     weighted average cost of capital (WACC) of 7 per cent, both the ACCC and ORG
                     subsequently determined that the appropriate WACC to use was 7.75 per cent. One of
                     the reasons for the change was a recognition that there is an element of regulatory risk in
                     Australia. It is an open question whether the WACC levels becoming established in the
                     regulated energy sector compensate adequately for this risk.

                     2.5       Implications for Private Investors

                     The above analysis suggests that there are at least three factors which can make private
                     investment in infrastructure relatively less attractive than investment in other businesses:

                     N     where a consortium is formed, the ability to write-off early losses for tax purposes
                           is severely constrained;
                     N     the frequent existence of a high level of external benefits means that investors are
                           unable to appropriate many of the gains from their investment; and
                     N     infrastructure is highly regulated, with implications for property rights and the rate
                           of return which are not present in other sectors.

                     Unless the Government provides some offsetting advantage to reduce or eliminate this
                     net disadvantage, private investment in infrastructure is likely to be significantly less
                     than it would be on a ‘level playing field’. Clearly, the Review of Business Taxation
                     offers one vehicle by which this issue could be addressed.


                     Chapter Three
                     Problems with the Taxation System

                     Tax Losses Problem

                     As suggested in Chapter Two, the Treasury may not accept the validity of the argument
                     that investment in infrastructure is deterred by the inability of consortia to write-off early
                     losses against other income of the component companies. Nevertheless, the Government
                     does appear to accept the validity of the argument, to the extent at least that they have
                     introduced measures to address it. The Infrastructure Bonds (IB) program and its
                     successor, IBTOS, are examined below.

                     Infrastructure Bonds

                     In response to some of the criticisms of the policy environment for private provision of
                     infrastructure, the Keating Government introduced a new incentive, ‘Develop Australia
                     Bonds’, in its 1992 One Nation Statement. Infrastructure Bonds (IB) as they became
                     known, were an indirect means by which (under certain conditions) project owners could
                     access tax deductions on their borrowing costs during the construction and early
                     operations phase of projects. The mechanism was indirect because it worked by making
                     the bonds non–assessable to the lenders (who would be largely indifferent between a
                     taxable bond paying, say, 10 per cent and a non–assessable bond paying 6 per cent) and
                     non–deductible to the borrowers (who had no income against which to deduct the
                     interest costs).

                     One of the criticisms made in the EPAC Private Infrastructure Task Force Report was
                     that it was not clear that the full benefits of the IB tax concession was being passed on to
                     the borrowers. That criticism was premature, and reflected the (then) immaturity of the
                     market. The progressive reduction in costs to infrastructure borrowers over time is
                     shown in Figure 3.1, reflecting a market better informed about tax–exempt bonds,
                     greater retail appetite for them, and consequently reduced costs of underwriting and
                     distribution. At the time of the Treasurer’s announcement ending the program, the cost
                     of borrowing via Develop Australia Bonds was about 60 per cent of the cost of
                     conventional borrowings. There can be no doubt that infrastructure bonds succeeded in
                     lowering project borrowing costs.




                                                              40. % 0
Redu ti nc o
B rrowi
Cost o g n

               NS     W        Pt
                     ower Ci yLin       Ql P d o S
                                        k      wer     A         P
                                                      ower F nal i       Maximum
                 S at n i  o                   t
                                          S at n i S at n i Tran ac ion t B ne e f
                                                    o   t      o    s          it

Source: Macquarie Corporate Finance Ltd

                                    It must be emphasised that Develop Australia Bonds, while having some unintended and
                                    unfortunate consequences as far as tax minimisation schemes were concerned, also
                                    brought about significant benefits to both the developers of infrastructure and the
                                    community as a whole.

                                    These benefits were recently summarised at the time by Mr George Brouwer, then
                                    Chairman and Chief Executive of Invest Australia.

                                    For the developer:

                                    N      borrowing costs were lower (up to 40 per cent below market rates), which reduced
                                           the cost of a project;
                                    N      there was a favourable impact on share prices, due to an improved interest coverage
                                    N      projects were better able to climb over the cash coverage hurdle in the early years;
                                    N      there was an opportunity to participate in a new range of ventures.

                                    For the community:

                                    N      the cost of infrastructure was reduced, resulting in lower user charges and/or
                                           subsidies by the taxpayer/rate payer;
                                    N      the call on State/Territory budgets was lowered;
                                    N      construction activity was increased;
                                    N      employment was increased;
                                    N      a new class of investments for superannuation funds was created, enhancing the
                                           nation’s ability to lift its saving rate; and
                                    N      the sustainable growth rate of the economy was increased.

                                       George Brouwer, “Develop Australia Bonds: The Latest Picture”, Proceedings of a Conference on
                                    Public/Private Infrastructure Financing: Still Feasible?, September 1996.

                     Perceived problems with the IB program, however, led the Treasurer to terminate the
                     scheme in February 1997. In making his announcement, the Treasurer identified three
                     major problems with Infrastructure Bonds: the potential cost to revenue, their use in
                     aggressive tax minimisation schemes and the fact that (apart from the projects
                     themselves) the major beneficiaries were high marginal rate taxpayers and financial

                     The potential large cost to revenue arose as the financial markets and investors in
                     infrastructure became familiar with the potential of the IB program. It occurred despite
                     the apparent stated cap on revenue costs ($150 million in 1996–97 and $200 million in
                     1997–98) because of a loophole in the Development Allowance Authority Act 1992.
                     Specifically, under the Act, it appears that the Authority was obliged to consider all
                     applications received before the Treasurer directs the Authority not to accept further
                     applications for Infrastructure Borrowing Certificates, in order not to breach the revenue
                     cost cap for the year. The Treasurer gave such a direction on 10 September 1996, but all
                     applications received between 1 July and that date had to be considered on their merits.
                     Between 1 July and 20 August 1996 (Budget night) the DAA in fact received
                     applications for 71 IB projects with estimated borrowings of around $21.6 billion.

                     The second of the Treasurer’s objections — the use of infrastructure borrowings in
                     aggressive tax minimisation schemes — was apparently valid. These schemes were not
                     the ones which have received publicity in the media. (These involved quite innocuous
                     tax arbitrage which was in fact anticipated at the time infrastructure borrowings were
                     introduced.) Rather, they involved complicated structures including numerous related
                     companies (sometimes off–shore) which managed to break the symmetry of the taxation
                     arrangements. Other schemes included financing instruments such as zero coupon
                     bonds, which managed to increase the tax benefits by large multiples of the benefits
                     gained from ‘ordinary’ infrastructure bonds.

                     The last of the Treasurer’s claims, that infrastructure bonds provide tax benefits to high
                     marginal tax payers, is irrefutable. These bonds were retailed to investors in packages of
                     at least $500,000 thereby obviating the need for a prospectus which would otherwise be
                     required for an offer to the public. The amount paid to the institutions retailing these
                     schemes was 40 per cent of the deductions sought, thus only investors with a marginal
                     tax rate in excess of 40 per cent could (profitably) participate.

                     While this may have represented a problem of fairness (low marginal rate taxpayers did
                     not have the opportunity to benefit from the tax treatment of the bonds), it was inevitable
                     given the original desire to reduce borrowing costs to infrastructure projects. These costs
                     could only be reduced inasmuch as lenders were prepared to accept a lower coupon
                     return, which was free of tax. The higher was the marginal tax rate of the lender, the
                     lower the tax free rate at which they were prepared to lend, and hence the lower the
                     borrowing costs for the project.

                     The industry itself and the finance sector disputes the validity of the view that the IB
                     scheme was fatally flawed. In particular, they feel that the cost to revenue means that the
                     scheme was working as intended: if the Government wished to spend less on supporting
                     infrastructure investment, the cost to revenue cap could have been reduced. Also, the
                     industry claims strongly that most of the ‘rorts’ had already been removed when the
                     scheme was terminated.


                     Infrastructure Borrowings Tax Offset Scheme (IBTOS)

                     The IB tax concession scheme was replaced by IBTOS, a more limited tax offset scheme
                     that applies to interest derived by lenders to approved infrastructure projects. Division
                     396 of the Income Tax Assessment Act 1997 provides for a tax offset to be allowed to
                     resident lenders in the first five years of borrowings by the project borrower. The offset
                     is calculated by applying the general company tax rate to the interest that a lender
                     includes in assessable income. The offset may be subject to a maximum limit. Where the
                     lender’s interest is subject to a tax offset, the project borrower is denied a deduction in
                     respect of a comparable amount of interest.

                     Unlike the previous IB scheme, which could be used to finance the construction of a
                     wide range of infrastructure facilities (including land and air transport, gas pipelines,
                     water supply, electricity and sewerage), support under IBTOS is limited to approved
                     road and rail projects only (although non–land projects that applied under the previous
                     scheme are eligible to apply for a tax rebate). There is also a cap on the overall cost to
                     the scheme of $75 million per annum.

                     There is overwhelming criticism among industry stakeholders about the effectiveness of
                     the IBTOS scheme. For example, in its December 1998 submission to the Review of
                     Business Taxation, the Australian Council for Infrastructure Development (AusCID)
                     described the scheme as “totally inadequate to the task of catalysing private sector
                     investment in public infrastructure”. Consultations with financiers of infrastructure
                     developments have been equally damning in their criticism of IBTOS.

                     The perceived problems of IBTOS are summarised in the following paragraphs.

                     The Cap is Too Low
                     As discussed above, the tax relief available under the IBTOS is capped at $75 million,
                     which is considered to be unrealistic by industry stakeholders. It is claimed, for example,
                     that one medium–sized rail project (such as the Sydney to Canberra fast train concept)
                     could readily soak up the cap. Overhanging applications from the previous IB scheme
                     could also absorb the budget, thereby making new applications futile. Furthermore, it
                     has been argued that the transactions costs involved in applying for a share of the annual
                     $75 million of tax relief (estimated by one financier at approximately $50,000 per
                     application) are likely to be too high to make it worthwhile.

                     Lack of Transparency
                     There is concern that the IBTOS application process is not transparent, leading to great
                     uncertainty about whether a proposed project will qualify for tax relief. The previous IB
                     tax concession was enshrined in legislation and had a transparent process with clear
                     criteria, and where recommendations were made by a body at arms length from
                     Ministers. In contrast, the industry considers the IBTOS to be more of an ‘administered’
                     benefit where success or failure can be determined by political currents of which the
                     applicants are quite unaware.

                     It has been suggested that the ‘residual paranoia’ from the rorting associated with the
                     previous IB regime means that the taxation authorities adopt a very cautious approach
                     when considering IBTOS applications. The culture of the ATO, and the Treasury, is
                     directed more towards protecting the revenue than assisting business to access the


                     Another criticism of the IBTOS application procedure is that applications can only be
                     made on a twice–yearly basis. This is more restrictive than the previous IB scheme when
                     applications could be made at any time.

                     The Benefits of the Scheme are Limited for Most Financial Structuring
                     The tax benefits afforded by IBTOS (and therefore potential impact on infrastructure
                     investment) varies according to the type of institution undertaking the financing:

                     N   Investment by a Bank — IBTOS investments create a tax permanent difference and
                         therefore absorb tax credits that would otherwise be applied (by an Australian bank)
                         to frank dividends to shareholders. Australian banks, in pricing an IBTOS
                         investment, will take account of how their shareholders might value this loss of tax
                         credits. Two factors come into play:
                          –       the value that investors generally place on tax credits; and
                          –       the position of the particular organisation in relation to its generation of tax
                              credits and franking policy.
                     N   Reasonably good data are now emerging to suggest that, in the case of the former,
                         shareholders value tax credits in the range of 50 to 70 per cent of their face value. A
                         bank operating at the margin in terms of credit utilisation (ie, it distributes all tax
                         credits generated to pay a full franked dividend) will fully value the loss of credits
                         caused by an IBTOS investment. It will therefore be unable to provide any real
                         reduction in the pre tax cost of funds.
                     N   The inability of the Australian banks to efficiently price IBTOS might be overcome
                         by a wholly owned foreign bank which may not have the same requirement for tax
                         credits. However, the rebate is only available to a lender that is an Australian
                         resident for the whole of an income year. Moreover, it is argued that, in practice, the
                         lender organisation needs to have confidence that over the term of the IBTOS
                         investment (out to six years, say), it will have sufficient tax base to utilise the rebate.
                         Generally, foreign banks do not have this confidence.
                     N   Investment by a Superannuation Fund — In this case, different concerns about the
                         absorption of tax base exist. In order to take advantage of the rebate, the
                         superannuation fund investor needs to have nominal tax payable. An argument
                         commonly advanced is that super funds carefully manage their tax position such that
                         nominal tax payable is (ideally) entirely offset by tax credits received on fully
                         franked dividends such that their effective tax rate is zero. An IBTOS investment
                         would require them to take the rebate into account in managing their tax profile,
                         thereby reducing liquidity. This argument would suggest that the IBTOS is not
                         attractive to the super funds. However, it should be remembered that superannuation
                         fund income is made up not only of investment income but also undeducted
                         superannuation contributions (ie, employer contributions and personal contributions
                         from substantially self–employed persons). There is also a legislative requirement
                         that trustees must take into account diversification (including asset diversification)
                         when formulating an investment plan.
                         A more convincing argument for the lack of attraction of the IBTOS to
                         superannuation funds is that it is rare for superannuation fund investors to invest in
                         unrated senior debt obligations, reflecting the conservatism of most superannuation
                         fund trustees.
                     N   Investment by a Corporate — During the 1980s, when preference share funding
                         was highly active and tax shelter was at a premium, non financier corporates were
                         used as investors in bank enhanced preference shares. This was at a time when
                         capital management was less important than it is today and corporates would use
                         their balance sheet for anything that generated a margin. Today, the philosophy is
                         said to be different. Generally, corporates will not lend their balance sheet to any
                         activity that is not associated with their own core businesses, and thus are unlikely
                         to take advantage of IBTOS to invest in land transport infrastructure projects.


                     N   Investment by an Individual — No concerns at all exist in this class of investor
                         about absorption of tax credits. However, it is argued that it is most unlikely that
                         this investor will accept an investment of anything other than bank risk, such as
                         construction risk. Therefore, it would be necessary for a bank enhancement to be
                         arranged. Because it is a complex product, it will also be necessary to offer the
                         investment a yield pick–up in equivalent pre tax terms. However, the Australian Tax
                         Office (ATO) applies restrictions in respect of the extent to which an investor can
                         be ‘geared’ into an IBTOS investment (discussed below).

                     The conclusion arising from this analysis is that the IBTOS scheme is only valuable to
                     the individual investor. However, as discussed above, an individual investor will not
                     want to bear the construction risk associated with an infrastructure project, and the ATO
                     has introduced obstacles to prevent individuals from avoiding this risk. It has issued
                     draft taxation determinations that:

                     N   it will not countenance the use of cash collateralised structures; and
                     N   there is a limitation on gearing individuals into investments such that the interest
                         expense on borrowings is not greater than the interest received on the IBTOS.

                     The potential impact of these issues are addressed in the following section.

                     The Impact of Draft Taxation Determinations Relating to IBTOS
                     In late November 1998, the Australian Tax Office (ATO) issued three draft taxation
                     determinations relating to the operation of the IBTOS: TD98/D17, D18 and D19. These
                     determinations impose restrictions on IBTOS that have no basis in existing legislation
                     and will lead to outcomes that are manifestly contrary to the intended policy of the
                     incentive scheme.

                     TD98/D17 and D19 threaten to limit tax deductions for interest paid on funds that have
                     been on-lent to Land Transport Facilities (LTF) at rates lower than the investor’s
                     funding costs. Such an outcome would go totally against the policy intent of the IBTOS
                     — especially given that the primary intent of the IBTOS is to secure lower borrowing
                     costs for transport infrastructure projects (ie, financiers lending at a lower rate than
                     would otherwise apply).

                     The implication of TD98/D19 is that where investors borrow at a particular interest rate
                     (10 per cent, say) and, due to the availability of the tax rebate, lend at a lower rate (say 7
                     per cent), it is likely that these investors will have their interest deduction for the 10 per
                     cent interest paid limited to 7 per cent. The effect of this is to ‘penalise’ the lender and
                     ensure that it increases the rate at which it is willing to lend. In fact, the only level at
                     which the lender does not suffer this ‘penalty’ is if they lend at 10 per cent. Therefore, it
                     appears that the ATO is suggesting that lenders should not provide any reduction in
                     interest rate and keep all the tax credit to themselves.

                     The ultimate impact of TD98/D19 will be to discriminate against any LTF investors
                     sourcing funds by way of debt, in favour of LTF investors capable of sourcing funds
                     from equity. In other words, TD98/D19 will effectively limit the market for LTF bonds
                     to superannuation funds, large banks and high net wealth individuals — with any benefit
                     generated by the scheme likely to be eliminated by the additional ‘risk premium’ applied
                     by these investors.


                     The perversity of the outcome that appears to be suggested by the draft determinations
                     was overcome in the case of the previous Infrastructure Bond Scheme by releasing
                     TD94/80. Although TD94/80 was drafted with specific reference to the Infrastructure
                     Bond Scheme, it did contain the following general principle relating to interest
                     deductibility in the context of a tax incentive scheme involving borrowed funds:
                          “In order for the interest to be deductible, the investor must have entered into the loan
                          solely for the purpose of funding the investment in or acquisition of the infrastructure
                          borrowings. One indicator that the investor had a purpose other than, or in addition to,
                          funding the infrastructure borrowings would be where the deductions in relation to the
                          infrastructure borrowings are greater than the exempt return on the infrastructure
                          borrowings grossed up by the investor’s marginal tax rate as it would be but for the
                          infrastructure borrowing investment and any related income and deductions.”

                     It would sensible and important that a similar principle also be applied to investments
                     made under the Tax Offset Scheme. However, TD98/D17 appears expressly directed to
                     denying the operation of such a principle.

                     On a conceptual level, the determinations fail to recognise that on–lending to
                     infrastructure borrowers at a lower interest rate is the primary and critical objective of
                     the Tax Offset Scheme, and as such is not only desirable but necessary. On a policy
                     level, the impact of the determinations could be to limit the range of potential investors
                     in IBTOS borrowing and to increase the benefits generated for the investors, not the
                     projects. Each of these significantly reduces the Scheme’s competitiveness and

                     Another concern of the infrastructure industry is draft determination TD98/D18, which
                     states that so–called ‘dual funding structures’ are likely to attract the operation of Part
                     IVA of the Income Tax Assessment Act 1936.

                     According to TD98/D18, such structures are said to facilitate:

                     N   circular flows of funds;
                     N   captive loan arrangements coupled to above–market interest rates; and
                     N   significant cost to Revenue.

                     There is little argument that contrived structures involving significant cost to Revenue
                     over and above that anticipated are contrary to intended outcomes and should be
                     disallowed. However, there are objections to the characterisation of all ‘dual funding
                     structures’ in this manner. ‘Dual funding structures’ should not be viewed prima facie as
                     a tax avoidance structure. Instead, they should be considered as market–driven
                     structures motivated by the commercial imperatives of delivering lowest cost finance to
                     infrastructure borrowers. Moreover, given the high degree of discretion available to the
                     Minister under the tax offset legislation, there is little danger that ‘tax aggressive’
                     structures involving individual investors will be adopted by project sponsors.

                     It seems sensible therefore for the ATO to amend TD98/D19 to recognise more fully the
                     commercial merits and intent of ‘dual funding structures’ and to clarify that Part IVA
                     will not be applied indiscriminately to challenge bona fide dual funding arrangements.


                     3.2      Accelerated Depreciation

                     One of the major issues for the Review of Business Taxation is whether the statutory tax
                     rate should be reduced from 36 to 30 per cent. Achieving this within the constraint of
                     revenue neutrality, imposed by the government, would mean that many ‘tax concessions’
                     would have to be eliminated. The most important of these is the accelerated depreciation
                     schedule introduced as part of the One Nation economic statement in 1992. Two main
                     points need to be made here.

                     First, given that one of the main objectives of the present review is to improve the
                     international competitiveness of the corporate tax system, it seems somewhat
                     contradictory to impose the condition of revenue neutrality. If the aggregate tax burden
                     on business remains the same, it is difficult to see how international competitiveness can
                     be significantly improved.

                     Secondly, the elimination of accelerated depreciation would re-create the situation that
                     existed before 1992 whereby the tax system effectively discriminated against investment
                     in assets with longer lives. This is discussed below.

                     Risks in Investing in Longer–Lived Assets

                     There has been a long–standing dialogue between business and governments about the
                     tax treatment of long–lived assets compared to short and medium lived assets. Before
                     1992, depreciation allowances were based on ‘effective lives’ of assets. These were
                     often very similar to physical lives, and herein lay the problem. Many investors argued
                     that the risks in investing in longer term assets are greater than in assets with shorter
                     lives. For the infrastructure sector, the risks of investing in longer–lived assets are
                     additional to the other barriers to infrastructure investment identified above.

                     One substantial risk is that of early obsolescence as new technologies, unforseen when
                     the asset was purchased, become available. Many people would view rapid
                     technological change as affecting shorter lived assets, such as computer equipment, and
                     not being particularly relevant to infrastructure assets — such as gas pipelines or
                     electricity generators, for example — but in fact this is not the case. The cost of building
                     a gas pipeline has approximately halved in recent years with the introduction of new
                     materials and construction techniques. The efficiency of the latest coal-fired electricity
                     generators is substantially greater than those built ten years ago, while technological
                     advances have, irrespective of any change in relative fuel prices, increased the
                     competitiveness of gas-fired generators.

                     Another important area of risk for the infrastructure sector is stranded asset risk. Using
                     gas pipelines as an example again, the asset could become stranded if the gas field
                     unexpectedly ‘dried up’ or could only produce uneconomic quantities of gas. This,
                     however, is an extreme example. An asset such as the Moomba-Sydney pipeline, which
                     was deliberately built with substantial excess capacity to cater for future demand, would
                     become partially stranded if a new line is constructed, as planned, connecting the
                     Gippsland Basin gas reserves with the Sydney market. In the electricity market, assets
                     could become stranded in a number of ways, not least as a result of fiscal measures to
                     address greenhouse gas emissions.


                     The tax depreciation rates introduced on 27 February 1992 went a long way to providing
                     a level playing field between assets with different lives. One reason for introducing the
                     new schedules, as well as the IB program, was to stimulate investment in infrastructure.
                     As well as acknowledging the need to bring Australian tax treatment of long–lived assets
                     more into line with other OECD and Asian countries, the government statement
                     emphasised the need to provide an appropriate environment in which the shift of
                     infrastructure investment from the public to the private sector could go ahead efficiently
                     and effectively.

                     Since the 1992 accelerated depreciation rates were introduced, a major wave of private
                     investment has taken place in the infrastructure sector. Since 1992, the number of
                     kilometres of gas pipelines has increased by nearly 50 per cent. Significant privately
                     owned motorways have been built in Sydney, and Melbourne’s City Link Project is one
                     of the world’s largest private infrastructure projects. A substantial number of
                     government-owned infrastructural assets have also been sold to private investors.

                     Of course, Treasury may argue that this investment in infrastructure has been incentive-
                     driven and therefore represents a ‘misallocation of resources’ at the expense of ‘more
                     efficient’ investment in shorter-lived assets. Any detailed examination of the nature of
                     the investment in infrastructure which has taken place since 1992 makes this argument
                     very difficult to sustain.

                     In these circumstances, there is a high risk that removing accelerated depreciation tax
                     concessions, as part of a package designed to reduce the nominal rate of company tax to
                     30 per cent, would have the highly undesirable effect of threatening future private
                     investment in infrastructure. On its own, such an action would add one more substantial
                     barrier to infrastructure investment to add to the other disincentives identified above.

                     3.3       Section 51AD of the Income Tax Assessment Act 1936

                     It is no understatement to say that Section 51AD of the Income Tax Assessment Act
                     1936 (s51AD) has been the bane of private sector infrastructure providers in recent
                     years, and represents a major impediment to private sector infrastructure investment in
                     Australia. As the private sector’s role in infrastructure provision has grown in
                     importance, so have the problems associated with this legislation. It is reassuring to note
                     that this has already been recognised by the Review of Business Taxation:
                            “While always criticised for its severe impact, section 51AD has become more
                           problematic because of privatisation and outsourcing of government functions that were
                           not contemplated when it was first conceived.”

                                   Review of Business Taxation, A Platform for Consultation, Discussion Paper 2,
                                                                                Volume I, February 1999, p.226.
                     Specifically, s51AD applies to property predominantly financed by non recourse debt
                     which is leased to, or ‘effectively controlled’ by, an end user that:

                     N     is a tax exempt entity;
                     N     is a non–resident and uses the property outside Australia; or
                     N     previously owned the asset (eg, sale and lease back).

                        While roads themselves are not subject to accelerated depreciation, they benefited from Infrastructure
                     Bonds. The City Link consortium has advised that the project would not have gone ahead under the present
                     IBTOS program.
                       In applying s51AD, non recourse debt is broadly defined as debt where the creditor’s rights against the
                     debtor in the event of default are legally or effectively limited to the financed property.

                     This provision was introduced to counter a form of leveraged leasing used by (tax–
                     exempt) State governments in the early 1980s to access the benefits of tax deductions in
                     constructing power generators. The application of s51AD is severe, however, because it
                     disallows all tax deductions relating to the investment, whilst all income remains
                     assessable for tax purposes. Where s51AD is deemed to apply, it effectively destroys the
                     economics of the private sector undertaking infrastructure investment.

                     A related provision, Division 16D, applies in respect of a ‘qualifying arrangement’
                     where s51AD does not apply and where there is ‘use or effective control’ by an end user
                     who is:

                     N    a tax exempt public body; or
                     N    a person who uses the property outside Australia to produce income not subject to
                          Australian tax.

                     Where Division 16D applies, it denies capital allowances to the owner of the property,
                     and treats lease payments as repayments of principal and payments of interest.

                     s51AD and Division 16D were introduced in the early 1980s as anti–avoidance
                     measures aimed at preventing ‘inappropriate’ use of tax incentives designed to
                     encourage investment in plant and machinery. The legislation was devised in an era
                     where there was no private ownership of infrastructure in Australia and virtually no
                     private management of this infrastructure. Government was assumed to be the ‘natural
                     owner’ of infrastructure assets and any other arrangements involving the private sector
                     could automatically be assumed to be ‘shams’ — tax–driven transactions in which the
                     private sector merely pretended to ownership. Furthermore, anti-avoidance laws at the
                     time were generally found to be ineffective.

                     In the context of private provision of public infrastructure, s51AD and Division 16D are
                     aimed at preventing sale and lease back arrangements whereby the tax–exempt
                     government entity sells an infrastructure asset to a private company, so that the company
                     can access tax deductions for depreciation and interest payments, but which leases the
                     facility back so as to effectively maintain public control over the use of the asset.

                     There is no question that provisions need to be in place to prevent tax abuse. The main
                     concern of infrastructure providers is that, in the light of recent developments, s51D and
                     Division 16D have become inappropriate as measures to prevent tax avoidance.
                     Specifically, s51AD and Division 16D were legislated at a time when the sort of
                     continuum of risk sharing that is becoming increasingly common in the infrastructure
                     sector through BOOT–type arrangements was not envisaged. As a consequence, the
                     current legislation has the potential to deny tax deductions even if the private sector
                     takes on significant risks, thereby jeopardising joint public/private sector infrastructure

                        A Build-Own-Operate-Transfer (BOOT) arrangement is one in which the private sector builds a facility at
                     its own expense in return for the right to operate the facility and charge users a (typically government
                     regulated) fee. The private sector owns the facility for a predetermined period, after which ownership reverts
                     to the public sector.

                     Stated simply, the main problem with s51AD is that its potential scope is extremely
                     broad. Its application is essentially dependent on whether the Commissioner of Taxation
                     considers that a government retains ‘control of the use’ of the infrastructure asset. Since
                     ‘control’ need only be potential, more than one party can be deemed to control the use
                     of an asset. Given that governments often retain regulatory, coordination and safety
                     functions in respect of major infrastructure assets, the ATO frequently forms a prima
                     facie view that government control exists.

                     Virtually no private sector project will proceed without a favourable ruling on s51AD.
                     As discussed above, where s51AD is deemed to apply, all income is taxable yet all
                     deductions are disallowed (even if the private sector takes on considerable risks).
                     Consequently, private sector parties will not proceed with an investment until they have
                     obtained clearance from the ATO. A considerable amount of time and money can be
                     spent ‘structuring’ arrangements so that a project does not fall foul of s51AD (and so
                     that it is likely to receive a favourable dispensation from the Tax Commissioner in
                     relation to Division 16D deductions). An additional problem is that the operation of
                     these provisions effectively rules out any joint public/private sector infrastructure

                     The excessive time taken to process rulings on the application of s51AD and Division
                     16D to private infrastructure projects, or on related administrative problems, can also
                     jeopardise investment. ATO rulings can take several months to obtain, by which time
                     finance commitments may be withdrawn and the proposed investment may not proceed.
                     On other occasions, private consortia may decide not to bid at all for proposed
                     infrastructure projects because uncertainty surrounding the applicability of s51AD
                     makes fundraising untenable.

                     3.4        Proposed Taxation of Limited Recourse Debt

                     It is common for privately financed infrastructure and major resource projects to use
                     limited recourse debt during and just after construction until refinancing can be based on
                     better business conditions post ‘ramp–up’. Where an asset is financed by limited
                     recourse debt, a taxpayer obtains ‘capital allowance deductions’ which have previously
                     been permitted if the debt was not fully repaid. However, Division 243 of the proposed
                     Taxation Laws Amendment Bill (No.4) 1998 intended to change these arrangements —
                     by clawing back all depreciation deductions in excess of equity contributions plus debt
                     principal repayments whenever limited recourse debt is refinanced or the underlying
                     asset is disposed.

                     The proposed Taxation Laws Amendment Bill (No.4) 1998 lapsed due to the Federal
                     election. However, Division 243 has been subsequently reintroduced as part of the
                     Taxation Laws Amendment Bill (No.5) 1999. It has been slightly amended with the
                     intention of resolving some of the main concerns raised about the earlier draft. However,
                     it does not seem to have done this.

                        This is well illustrated by the experience of the Eastern Distributor toll road project linking Sydney CBD
                     with Kingsford Smith airport. The private sector accepted full commercial risk on the deal, including
                     construction, operation, maintenance and patronage. Nevertheless, it was argued by the ATO that s51AD was
                     applicable because the NSW Roads and Traffic Authority retained control of traffic lights, median strips,
                     maximum speeding limits and interconnecting roads — all of which dictate the extent and the flow of traffic
                     on the motorway. It was argued that this constituted de facto “control of the use” of the private toll road.
                     However, the ATO eventually abandoned this line of reasoning and the deal proceeded, but not without
                     considerable delay and expense.

                     In addition to the clawing back of depreciation deductions, Division 243 also has the
                     effect of increasing the amount of limited recourse debt that is deemed not to be repaid

                     N     the amount of actual repayments of the debt that are themselves directly or
                           indirectly limited recourse debts (effectively any refinancing of a limited recourse
                           debt); or
                     N     by any payment from the proceeds of the sale of the financed property.

                     In drafting Division 243, it appears that the ATO is committed to the view that the
                     availability of capital allowances in project financing should henceforth be linked to the
                     risk exposure associated with the borrowing. Thus, by definition, limited recourse debt
                     is deemed to be less risky to the borrower because it is secured only against project
                     assets and cash flows, and is not linked to the balance sheet of the borrower.

                     These proposed changes would effectively eliminate the use of limited recourse finance
                     in any meaningful sense, favouring equity and corporate debt as the preferred sources of
                     development capital. Since limited recourse debt is the most common financial structure
                     for infrastructure projects (simply for commercial reasons), this provision is particularly
                     unreasonable in the context of an emerging business sector based on privately financed
                     infrastructure development. Furthermore, as it currently stands, the proposed legislation
                     does not appear to give the Tax Commissioner discretion to apply it only in appropriate

                     It has been suggested that the financing of infrastructure projects has been
                     unintentionally included with the remit of proposed Division 243, reflecting an
                     oversight by drafters of the legislation. Nevertheless, until the situation is clarified, many
                     infrastructure projects are at risk. Schemes acknowledged to be in jeopardy because of
                     the uncertainty surrounding the refinancing of existing limited recourse debt include the
                     proposed Canberra high speed train.

                     3.5       International Competitiveness

                     The need in Australia to adopt an internationally competitive tax regime is generally
                     recognised. This is essential both to encourage inward investment and to deter the
                     outflow of domestic capital overseas.

                     In the context of the infrastructure industry, this issue is important in the context of the
                     ability of domestic companies to compete with foreign competitors when bidding for
                     Australian assets. Under current arrangements, overseas bidders for Australian
                     infrastructure frequently enjoy depreciation benefits in their home tax jurisdictions that
                     they can leverage into higher bids than their Australian rivals.

                     Evidence of this is provided by the recent purchase of Victoria’s Westar and Kinetik
                     Energy gas distribution/retail company by Texas Utilities. The US-based company
                     outbidded its Australian rivals by offering a purchase price of $1.617 billion. Financiers
                     are claiming that, purely on the basis of the more favourable tax regime faced by Texas
                     Utilities, it had a $60 million advantage over Australian companies when it prepared its


                     3.6       Uncertainty and the Need for Rulings

                     There is currently a high level of uncertainty surrounding the tax arrangements in
                     relation to private provision of infrastructure. This adds to the sector’s costs and can act
                     as a significant deterrent to investment. Uncertainty stems from a number of sources,

                     N     the applicability of Section 15AD and Division 16D;
                     N     the issue of limited recourse debt arrangements;
                     N     the outcome of a number of draft tax determinations (eg, in relation to the IBTOS);
                     N     the outcome of the Review of Business Taxation.

                     In theory, the system of rulings should provide greater certainty to taxpayers in
                     calculating their tax liability. Rulings are, in principle at least, designed to provide
                     taxpayers with a definitive statement from the ATO on how the law applies to particular

                     In practice, however, the system of rulings is a major aggravation for infrastructure
                     investors. The often considerable length of time taken to issue many rulings is
                     particularly frustrating and can jeopardise investments (eg, financial commitments may
                     be withdrawn). In addition to concerns over excessive delays, other criticisms of the
                     current system of rulings include their jurisdictional limitations, incomplete coverage,
                     their poor quality and incontestability.

                     3.7       The ‘Culture’ of the Australian Tax Office

                     The ‘culture’ and negative attitude of the ATO in relation to infrastructure projects is not
                     conducive to investment. In particular, the ATO is perceived by the infrastructure
                     industry of:

                     N     being risk averse as far as infrastructure ventures are concerned and cautious in
                           dealings with proponents of projects;
                     N     taking a very short–term focus;
                     N     being fixated with the cost of concessions to Revenue, rather than with the value of
                           the proposed projects; and
                     N     being very reluctant to set precedents in terms of granting taxation concessions.

                     Whilst it is understandable that the ATO should take all reasonable steps to eliminate tax
                     evasion and close tax loop–holes, its methods of doing so are currently sending out
                     negative signals to private sector investors in infrastructure.


                     Chapter Four
                     Conclusions: The Way Forward

                     There are two broad dimensions to the business tax reform agenda as it affects the
                     infrastructure sector, namely those problems which are essentially technical and the
                     major strategic issue of the competitiveness of private investment in infrastructure.

                     4.1       Technical Issues

                     First, there are the ‘nuts and bolts’ or technical issues that need to be resolved. Included
                     among these are limited recourse debt, some of the problems surrounding IBTOS and
                     (for all its strategic importance) s51 AD. These issues have been dealt with above and
                     do not need further discussion here except to say, perhaps, that the proposal to address
                     the s51 problems discussed in the Ralph Committee’s recent discussion paper appears
                     reasonable. The other issues require further evaluation.

                     4.2       Strategic Issues

                     The major issue for the infrastructure industries is how the tax review can contribute to
                     providing a more favourable environment for private investment in infrastructure.

                     Clearly, the 1990s have seen a considerable shift in favour of private provision of
                     infrastructure to the benefit of public sector balance sheets. This has happened despite
                     three major disadvantages faced by private investors namely:

                     N     the inability of consortia to write off tax losses against other corporate income;
                     N     the fact that many investors cannot appropriate through charging many of the
                           benefits of their investment; and
                     N     in many infrastructural industries, regulatory risk.

                     The One Nation statement provided two initiatives that, to some extent at least, offset
                     some of these disadvantages. First, the Infrastructure Bonds scheme was capable of
                     reducing the cost of debt by up to 40 per cent and thereby provided worthwhile
                     compensation for the tax losses problem. That program has now been abolished and
                     replaced by one (IBTOS) which is much less attractive. It is difficult to access, capped
                     at a relatively low cost to revenue and subject to allocation on a discretionary basis.
                     Secondly, accelerated depreciation of plant and equipment was of value to many
                     infrastructure projects and now faces abolition. Both these measures were introduced
                     because the Government believed that without them investment in infrastructure would
                     be inadequate. It is difficult to see why that view would now have changed.

                     Alternatives to IBTOS

                     If the IBTOS scheme is maintained it is likely to have a detrimental effect on private
                     investment in infrastructure. Alternatives include:

                     N     a return to the Infrastructure Bond scheme;
                     N     direct government subsidies to selected projects; or


                     N   a new program offering some of the advantages of infrastructure bonds without their

                     In practical terms, a return to the IB program is unlikely even if the cost to revenue
                     could be controlled and ability to ‘rort’ the scheme readily eliminated. Governments
                     rarely re-instate discredited programs, particularly those introduced by the ‘other side’.
                     On the other hand, direct subsidies while transparent and relatively simple are rarely
                     favoured these days. A new program, which addressed the shortcomings of IBs and
                     whose cost to revenue was controllable may be the best approach.

                     One option is an infrastructure voucher system that would work as follows. The
                     Government would designate a certain total value for vouchers to be issued each year
                     (say, $250 million). Eligible infrastructure projects, as determined by an arms length
                     statutory body, would be issued with vouchers which could then be used to obtain a tax
                     refund for the project equal to their face value.

                     For example, suppose a project wants to borrow $100 million at a cost of 8 per cent per
                     annum, so the annual interest cost is $8 million. If the project consortium could deduct
                     this interest cost, it would yield a tax benefit of $2.88 million (0.36* $8 million) but this
                     is not feasible because it has no income. The Government, however, issues a voucher to
                     the project for $2.88 million, which it redeems with the Australian Tax Office, which
                     would issue a refund for this amount.

                     This process would be repeated each year for a predetermined number of years i.e. until
                     the time when the project (at its commencement) is forecast to be profitable. The interest
                     payments by the project would, of course, be non–deductible in later years when the
                     project is profitable.

                     The advantages of this scheme are that:

                     N   the cost to government would be controllable, but could be varied from year to year
                         to meet the Government’s needs;
                     N   no benefits would accrue disproportionately to high–income investors;
                     N   the transactions costs would be low; and
                     N   the rules would be clear, the process transparent and it would be relatively simple to

                     Accelerated Depreciation

                     The issue of whether it is appropriate to ‘trade-off’ accelerated depreciation for a lower
                     statutory tax rate is difficult. Some industries will benefit, while some will be worse off.
                     In the infrastructure sector, those industries using relatively little plant and equipment,
                     such as road constructors, will be better off while others, such as electricity generators
                     and gas pipeliners are likely to be worse off.

                     Provided the resulting system is neutral between investment in long or short term assets,
                     it is difficult to object to the lower statutory rate option. This, however, is a substantial
                     proviso. It means that the effective lives of assets with long lives (indeed, probably all
                     assets) would need to be re-estimated by the tax office taking account of the risks
                     involved, such as the risks of early obsolescence or the asset becoming stranded.
                     Essentially, such lives would need to be based on economic rather than physical factors.


                     An alternative is to continue to allow the owners of assets to nominate the depreciation
                     rate themselves, a process similar to self-assessment in the personal income tax system.
                     While notionally this occurs currently, the criteria underpinning such self-assessment
                     appear to be based on physical life rather than economic life. Since taxpayers would
                     tend to nominate the shortest possible term for writing off the asset, this system would
                     clearly need to be monitored by the ATO, but the Tax Office should be working on the
                     basis of a realistic economic life. The present schedule of prescribed asset lives appears
                     to be based heavily on physical criteria. One option would be for the ATO to review its
                     prescribed asset lives based on consultations with industry on economic life and
                     evaluations of international best practice.

                     If this system were adopted, the Government may claim that the savings would be less
                     than would have occurred from the simple removal of accelerated depreciation and the
                     tax rate then could not fall as far as to 30 per cent. While revenue collections may fall
                     short in the early years, this is essentially one of timing. The full value of the assets will
                     always be written off in its entirety over some time period, so in the long term the effect
                     on revenue only reflects differences in discount rates due to timing. In particular, if
                     write–offs occur more quickly, there is pressure on early budgets. While the solution
                     proposed here may not meet the Treasury’s definition of revenue neutrality, it would
                     make relatively little difference to revenue collections over the longer term (and may
                     even increase them if investment was stimulated).


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