In the developed world, the drivers are somewhat different, but no less pressing. Government finances are under pressure following the financial crisis; budget deficits and borrowing need to be reduced, economic recovery is weak and faltering in most advanced economies. Infrastructure investment can serve two purposes: as an engine of growth and economic recovery; and to satisfy the very real needs of updating and modernizing ageing infrastructure to underpin future performance.
In 2007, the OECD estimated that over USD70 trillion would be required for investment in infrastructure by 20301. The analysis is currently being updated, and will almost certainly result in a higher estimate when it is published in 2012. Most of this infrastructure must be built, financed, owned and operated by the private sector.
From an investor’s perspective, participating in the financing of government-sponsored infrastructure projects is attractive to the extent that it can provide a reliable, inflation resistant cash flow over the long term, underpinned by government contracts. However, the economic returns are critically dependent on two different factors: the extent to which individual projects receive government encouragement via favorable tax treatment; and the attractiveness of the overall fiscal environment to infrastructure investors, especially inward investors. Investors and funders value tax certainty and the ability to receive returns without tax leakage and other restrictions. However, in many cases the inefficiencies and complexities of domestic taxation regimes mean that incentives may not be perfectly aligned with objectives. When these factors are considered in light of, for example, short term political objectives and suboptimal tax administration, the global investment parameters for infrastructure investment can quickly change. Tax policies can be set with both of these objectives in mind, whereas infrastructure needs a long term view to be adopted and a stability of tax regime. A review of the current position in a number of developed and developing markets – Australia, Brazil, India, South Africa and the UK – reveals a number of common problem areas.
Inconsistent or contradictory tax provisions
Very often, governments seem to say one thing and do another. The disconnect between strategy and implementation is perhaps more pronounced when funding availability is limited. Governments may be left only with the power of exhortation and encouragement. Unfortunately, these have limited power. In the UK, for example, the government in 2007 abolished tax relief on the depreciation of industrial buildings and the structural components of, for example, waste treatment plants, power stations, dams, railways and airport terminals. Much of the expenditure on assets for the provision of energy, transport, water, waste and low-carbon technologies, which the National Infrastructure Plan aims to achieve, now do not qualify for tax relief. This makes infrastructure more expensive for the users. However, in contrast to other countries, increasingly the UK has a friendly in-bound investment regime; for example, no dividend withholding tax or foreign investor capital gains tax. India in contrast, gives many infrastructure projects tax holidays but has a tax regime which does little to encourage inward investment.
Within the Australian context, the position taken by the Australian Taxation Office (ATO) on various infrastructure initiatives at times appears in conflict with the intention of policy makers. Two recent examples2 dealing with infrastructure staples3 (an Australian equivalent
to a US REIT) have seemingly led to unfavorable tax consequences for the taxpayers. The first example relates to the position of a loan between the trust side and the company side of the staple. The ATO has held that the interest is assessable on one side but not deductible on the other side. In the second example the ATO has also concluded that the Australian participation exemption does not apply to a hybrid trust (a trust which is taxed identically to a company) which can place outbound infrastructure investment at a disadvantage.
Complexity of incentives
Governments have to balance a number of competing imperatives. In encouraging certain kinds of private sector investment behavior, they have to guard against introducing unsustainable distortions into the tax system and at the same time safeguard the overall tax take. The result is often a complex structure of incentives and penalties which, at the very least, requires expert local knowledge to navigate successfully.
In Brazil, for example, there are a number of fiscal incentives for the chain of companies involved in infrastructure investments. Also, inward investment can be made through a kind of private equity fund (Fundo de Investimento em Participações – FIP) that is increasingly being utilized by foreign investors in many infrastructure projects. Key incentives for overseas investors in FIPs include:
- income and capital gains received by the funds are usually not subject to taxation in Brazil
- there is no withholding tax on disposal of FIP quotas for nonresidents.
The FIP investments are subject to certain restrictions, including:
- foreign investors cannot be located in a ‘low tax jurisdiction’
- foreign investors cannot hold shares representing 40 percent or more of the total capital, or an interest in more than 40 percent of the total income of the FIP
- the FIP cannot hold in its portfolio debt securities exceeding 5 percent of total net equity.
There are also a number of special tax regimes focused on infrastructure projects, which may vary depending on the area of investment, location and other aspects. Such incentives have been becoming more and more frequent and specific due to the urgent infrastructure needs arising from the upcoming football world cup in 2014, the Olympic Games in 2016 and the large oil and gas reserves found in the ‘pre-salt’ area.
The Australian Government has recently announced modifications to the Managed Investment Trust (MIT)4. The proposed changes are intended to simplify the application of the MIT rule. The MIT rules provide a tax rate of 7.5 percent to non-resident investors. This tax is payable as a final withholding tax and does not involve the lodgment of a tax return in Australia by the non-resident investor. The Australian regime at first instance appears to favor non-resident investors over resident investors5. One needs to understand that the cash flow on infrastructure assets are denominated in Australian dollars and therefore non-residents need to either hedge or notionally hedge their investment; the government imposed tax differential is an attempt to level the playing field.
Complexity of fiscal and legal environment
Highly developed countries such as the UK and Australia also have highly developed fiscal and legal frameworks. These both provide protection for investors and impose constraints on relationships and measures for seeking redress. Developing countries are sometimes simpler to do business in but there may be a cost in terms of risk.
In South Africa, infrastructure development is a key priority for government. A number of specific tax incentives have been introduced for the Public Private Partnership sector (such as tax exemption of certain income receipts and accelerated capital allowances). Certain approvals are required before repatriation of profits or for foreign loans to resident companies.
However, the overall corporation tax rate in South Africa is high and while the tax regime is simpler, for example, than in comparison to the UK, the tax litigation environment is complex, and it can take several years and significant costs to resolve an issue if litigated. Withholding taxes on the repatriation of profits can be minimized to some extent if investment is through suitable treaty jurisdictions. However, the tax authorities are looking closely at treaty planning, which has increased the need for additional scrutiny and prudence in tax planning.
Instability of tax regimes
Infrastructure projects typically take many years to plan, implement and bring to fruition. Ultimate profitability can often depend on cash flows extending over many decades. Investors need stability and certainty. However, no government will willingly bind itself and its successors far into the future.
The Government of India is committed towards increasing foreign direct investment into India and to reflect this, the exchange management guidelines and the regulatory regime for foreign investment has been substantially liberalized. Currently there are specific tax incentives in the form of profit linked incentives (such as 100 percent tax exemption for profits earned in 10 consecutive years out of the first 20 for the majority of infrastructure projects). However, the proposed revision of the Direct Taxes Code (which is to replace the existing 50 year old tax code in India) may result in projects becoming liable for tax sooner. The Indian government has previously introduced new tax laws without any public and/or industry consultation; sometimes the changes are even retrospective. There is still little clarity around the government’s position on many contentious issues which impact the infrastructure investment. With significant investments in the country coming from Mauritius, the revenue authorities have been invariably denying capital gains tax benefit under the India-Mauritius tax treaty, primarily on the ground of “lack of substance” at the Mauritius entity level.
Also, while historically sale of shares of an Intermediate Holding Company (IHC) established in overseas jurisdiction were not taxable in India, the Vodafone ruling has lead to the emergence of a new trend in the Indian Revenue Service’s position on the taxation of cross-border M&A transactions. In fact, in light of the Vodafone controversy, the Direct Tax Code proposes to tax overseas transfers of assets/shares (with underlying economic interest in India), provided the fair market value of IHC’s (direct or indirect) share in Indian assets exceed 50 percent of fair market value of IHC’s total assets. This will bring in new complexities and uncertainty around tax treatment in the future.
Broader tax considerations
The extent to which governments provide tax incentives to specific infrastructure projects is only half the story. For investment to be attractive, the investing entity, especially if it is a foreign direct investor, must be convinced of the attractiveness of the overall fiscal environment.
In Australia, the statutory body Infrastructure Australia (IA) advises governments, investors and infrastructure owners and reports regularly to the Council of Australian Governments. It has recently emphasized the urgent need to reform the financing of major infrastructure projects across Australia.6
An Infrastructure Financing Working Group is exploring:
- encouraging superannuation funds to invest in infrastructure by restructuring how projects are put to the market
- updating guidelines on public-private partnerships, particularly in the area of demand risk
- recycling of government assets to fund investment in new infrastructure
- finance models such as land value capture.
IA Chairman Sir Rod Eddington has emphasized the need for greater attention to be paid to the broad fiscal context: “Currently the debate around infrastructure is about individual projects rather than policy development and systemic issues such as tax rates and charging.”
Comparative analysis reveals significant variation in the extent to which proclaimed investment priorities are effectively reflected in the tax system.
The Centre for Business Taxation at Oxford University carries out an annual survey of international tax competitiveness which sheds further light on the context for infrastructure investment. The analysis compares two widely employed indicators: the effective average tax rate (EATR) and the effective marginal tax rate (EMTR), together with the statutory rate of corporation tax (CT). It is argued that the EATR is relevant for the location of discrete investment projects, while the EMTR is relevant for the level of investment, given its location. Table 1 summarizes the key figures for the five jurisdictions under consideration here. It can be seen that while governments in all these countries, developed and developing alike, proclaim their commitment to promoting infrastructure investment, the key economic determinants of post tax profitability vary widely, by up to 25 percent at the extremes.7
Both the EATR and EMTR can be misleading at least from an Australian context as they both ignore the MIT tax rate for nonresident investors. When one considers that the rate will be 7.5 percent on taxable distributions it can be seen why the MIT tax regime has proven successful in encouraging foreign investors.
Tax regimes, even when they intend to be transparent and free of distortion, are necessarily complex. When specific incentives are introduced to encourage certain categories of investment, the result is usually greater complexity and often increased uncertainty. Disentangling the rhetoric from the reality of infrastructure tax issues requires extensive analysis and knowledge.
Source: G20 Corporate Tax Ranking 2011, Oxford University Centre for Business Taxation, 2011
1OECD, Infrastructure to 2030, 2002.
2The Commissioner of Taxation has issued two sets of private rulings to stapled infrastructure funds in the past 24 months. In the first set of private rulings the Commissioner has ruled that Section 974-80 of the Income Tax Assessment Act 1997 applies to disallow a debt deduction paid on a hybrid debt where the hybrid debt is issued by the company in the stapled group and held by the trust in the stapled group. The consequence of these rulings is that if one considers a stapled entity as one economic entity then interest is not deductible on one side of the entity and fully assessable on the other side. The second set of rulings apply where the stapled group consists of a unit trust which is tax transparent and a unit trust which is taxed as a company. The Commissioner has ruled that a non tax transparent unit trust which is the head entity of a tax consolidated group cannot avail itself of the participation exemption (section 23AJ of the Income Tax Assessment Act 1936) on dividends paid by foreign controlled companies. Accordingly stapled groups that consist of two unit trusts (one being tax transparent and the other not being tax transparent) will be treated differently to stapled groups consisting of one unit trust and one company.
3A staple is two legal entities, one of which is tax transparent and the other taxed as a company. The tax transparent side normally consists of a unit trust which owns a passive asset eg real estate. The corporate entity carries on an active business, for example, a toll operator. Both entities have executed agreements so that both sides must be sold together.
4See Commonwealth Government’s 7 May 2010 response to the Board of Taxation’s report on managed investment trusts.
5Australian pension funds are taxable at a rate of 15 percent.
6Infrastructure Australia, Report to COAG and Assessments, June 2011