SECURITY SPVS AND TAX NEUTRALITY
Despite the bad press that special purpose vehicles (“SPVs”) received during the Enron scandal, SPVs are still an everyday feature of many financial structures. SPVs are commonly used in project finance transactions and in respect of employee incentive schemes, and normally serve a specific business purpose: they are generally created to be independent, bankruptcy remote vehicles and allow the financiers in syndicated loan transactions to share the proceeds of the security provided by the borrower. For example, a typical greenfields renewable energy project might have several financiers and “Security SPVs” would typically be an integral part of the financing arrangements required by the financiers of such a project. Typically, a Security SPV is obliged to guarantee a debt owed to financiers.
To safeguard itself and to ensure that it can make payment under the guarantee, it will obtain an indemnity from the borrower (and sometimes other parties, e.g. the borrower’s shareholders) for the amount that it is required to pay under that guarantee, and it will hold security given by the borrower (or those other parties) for the obligations of the parties who gave the indemnity.
The rationale for using a Security SPV is that the financiers/lenders should be protected, should the borrower default and also to enable all the lenders to share in the proceeds of the security. To ensure this, Security SPVs are restricted from conducting other activities save for the activities related to their specific purpose, and often the ownership of the SPV is held by an independent trust or other remote vehicle, so that the Security SPV is not related to the other parties to the transaction. Generally the Security SPV does not receive any fee for the performance of its functions and the intention is that the Security SPV will not suffer an economic loss.
The Security SPVs ability to pay amounts in settlement of guaranteed obligations is, in practice, limited to the proceeds it obtains from the assets held as security and, in many cases, its liability under the guarantee is contractually limited to such proceeds. When an event of default occurs, the Security SPV is contractually obliged to make a demand under the indemnity (or indemnities), enforce the security (i.e. realize the encumbered assets) and use the proceeds received for these assets in reduction of its obligations to the lenders (generally these are guaranteed obligations).
The Security SPV normally receives any proceeds of the enforcement for its own account, and not as the agent of any one of the lenders. Not only are Security SPVs intended to be bankruptcy remote vehicles, they are also created to be “tax neutral” in respect of their receipts and any payments that they have to make in terms of the security arrangements (pledges, mortgages, etc.). ’
In order to determine whether a Security SPV is tax neutral, the tax treatment of its receipts and expenditure should match, and in this context the questions that have to be considered are:
- whether the receipt by the Security SPV of proceeds for the realization of security is capital or revenue in nature;
- if these proceeds are capital in nature, how the payment to the lenders, in settlement of the guaranteed obligations should be treated, in other words, what can be 2 SecuritySPV_Article included in the base cost that can be deducted from the proceeds, in order to minimise any capital gain; and
- if the tax authorities treat the proceeds as a revenue receipt, how the expenditure by the Security SPV in respect of its obligations under the guarantee should be treated (in other words, whether payments by the Security SPV in terms of its obligations can be deducted in terms of the general deduction formula, which inter alia requires the SPV to be conducting a trade).