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Does weak market condition favour EPC model?

Does weak market condition favour EPC model?

Going the EPC way may not be all about targeting less viable geographic sectors. It may be a Hobson’s Choice stemming out of weak investment scenarios, and may be the government’s way of prodding along with project awards, say Jayesh Kariya and Dr S Vasudevan.

Notwithstanding the recent reforms in FDI and disinvestment policy, the general outlook in the country can described as sombre. With no foreseeable solution to the European debt crisis, persistent domestic inflation, high interest rates and a volatile rupee, there is little incentive yet for investors to dig deeper into their pockets and engage actively in nation building. Fortunately, domestic financial markets have been fairly stable and investments in infrastructure continue to happen, albeit at a much slower pace than in the past. The prolonged policy paralysis has not helped matters either.

It is interesting to observe that the current slowdown has forced certain ministries such as the Ministry of Road Transport and Highways (MoRTH) to focus on engineering, procurement, construction (EPC) contracts in expediting asset creation as opposed to scaling up the pipeline of BOT (or DBFOT) concessions which have been successfully used to create high-quality assets in the last decade across the sectors namely highways and expressways, greenfield and brownfield airports, port terminals, urban transport infrastructure, water and wastewater management. The choice of EPC is more driven by the current market conditions and their impact on the financing and risk appetite of both small and large investors, rather than any significant advantage offered by EPC over BOT models of asset creation.

Is BOT better?

This is not to suggest that EPC contracts are inferior to BOT contracts. In fact, BOT contracts are just EPC and asset maintenance contracts bundled together in a broader sense, other than the financing risk (partial, when government provides grant or equity support) and demand (traffic) risks that the investor generally takes in some of these contracts. The intended benefit of such bundled BOT contracts is better value for money for all stakeholders – the government, private investors and users, which are realisable because of the following key reasons:

1. It transfers the project risks to the party best able to bear them;
2. It leverages the efficiencies of private sector in financing and asset management;
3. It provides for greater accountability for each party and a better incentive for performance, since defaults attract stiff financial penalties and payments are linked performance;
4. It limits the extent of financing exposure to government and also provides a reasonable upside to government on its investment, subject to buoyancy of project revenues (for eg high revenue share in airport or port BOT contracts).

However, since the risks of BOT contracts are spread over a longer term, which could have a significant downside, investors’ outlook of market conditions is a key factor that influences preference for these types of contracts. The limited exposure to financing and cash flow risks in an EPC contract generally makes it favourable in a weak market environment, where certainty of cash flows and limited financing risk drive investment decisions.

The National Highways Authority of India (NHAI), for instance, has announced that it will award 4,000 km of road projects on EPC basis in FY13. There is no significant interest shown by private players in road contracts since April 2012. In contrast to an average of 20 bidders per project last year (FY12), no bids were received for certain road projects this year. Generally, the EPC option is being considered only for two lane highways, which are generally not BOT friendly because of low traffic.

The cost factor: The PPP Appraisal Committee which approves award of private sector PPP contracts has also opined that "EPC delivers savings on costs and increases accountability of the contractor". BOT (annuity) projects are 10-15 per cent costlier compared with EPC, as contractors typically raise money at an interest rate between 11.5 per cent and 12.5 per cent compared with 8-9 per cent, which the government has to pay". Let’s have a close look at the two models adopted by the authorities.

The model EPC contract drafted by MoRTH is expected to provide better control over the contractor and limit cost and time over-runs. The model contract’s EPC norms are more "output-based" compared to the earlier input focused "item rate" contracts, allowing more design flexibility and cost competitiveness to contractors. These contracts also have an extended tenure for defects liability (3-5 years) unlike traditional contracts. This is expected to mitigate risks of poor quality, cost and time over-runs in EPC contracts.

Factors affecting private participation

Some of the factors that determine the choice of EPC contracts are as follows:

  • Demand/ Traffic risk: Services having high demand or traffic risk (without adequate compensatory mechanisms in the contract or in the regulator’s dispensation), unregulated competition, tolling/tariff risks such as resistance to pay, etc are generally not conducive for BOT, especially where private players do not have the capacity to mitigate such risks.
  • Tariff structure: Infrastructure projects that rely heavily on non-tariff revenues (revenues from other than core services) such as those from advertising, retail, and real estate development are generally less attractive for BOT developers, given the volatile nature of cash flows.
  • Regulatory framework: Sectors with a matured regulatory framework may see more BOT participants as it provides comfort of stable returns on investment and mechanisms to compensate for unforeseen market risks.
  • Nature of assets and local industry experience: Profile of assets and breadth of industry experience also plays a role in determining the suitability of administering a project either through EPC or
  • BOT contract. Technology intensive high capex projects with limited local industry capacity to manage demand or tariff risks may not attract BOT players. These investments become even less attractive in the absence of state financial support or regulatory maturity.

Taxation aspects of BOT and EPC models

The roles, responsibilities and risk of the parties involved under BOT and EPC Model are different and it is structured in varied forms to suit the specific needs of different sectors such as airports, ports, road, railways, mining and other infrastructure sectors.

Having regard to the difference in the role, risk and responsibilities of the parties involved under BOT and EPC model, the direct and indirect tax implications under BOT and EPC model vary and can be complex, necessitating appropriate planning at the inception.

BOT Model: BOT model, including BOOT, DBOFT ("the BOT Model") have been in vogue for couple of years now and have been used more widely in roads, port, airport project and other infrastructure projects. The need to promote PPP model and reduce financing burden of the government in case of infrastructure development project has led to increase in use of BOT models.

Under BOT model, the concessionaire undertakes the entire responsibility of the project including the financing part and earns revenue from operation and maintenance of the infrastructure facility for a limited period of time. The government in order to provide necessary fillip to this model, has provided specific fiscal incentives both under the corporate taxation and indirect taxation regime. Section 80-IA (4) of the Income-tax Act, 1961 ("the Act") provides for deduction to the companies engaged in the development, operation and maintenance of the infrastructure facilities like roads, highways, water supply, water treatment, port, airport and inland water¡way projects, subject to certain conditions. This has provided necessary fillip to Concessionaires to participate in the development of the nation. However, there are several daunting tax issues, which are faced by the Concessionaire, such as:

  • Whether the notional profits accounted on the construction of the project, as required under the Exposure Draft of Guidance Note "Accounting for Service Concession Agreement is eligible for tax incentive?
  • The project is eligible to depreciation as a fixed asset or an intangible asset (ie, right to collect revenue over the concession period) is a vexed issue;
  • Whether the annuity paid by Concessionaire to the government is a revenue or capital expenditure being eligible for depreciation?
  • Taxation of subsidy/viability gap funding granted by the government?
  • Association of Person exposure for the consortium, if more than two contractors jointly execute the project and its connected negative implications which significantly increases the overall effective tax cost for all the parties involved in the execution of the contract.

Further, depending upon the project requirements, the contracts involve an onshore portion and offshore. Typically, when two or more parties collaborate for executing the contracts whether on BOT or EPC basis, the overseas party executes the offshore portion while the Indian party undertakes the onshore portion. In addition, depending upon the commercial considerations, different contractual frameworks are used, such as composite contract or split contract, with or without an umbrella/wrap around contract. Income-tax implications differ for each such commercial arrangement and are primarily depended upon the terms of the arrangement/contract. Some of the key tax aspects which attract varied tax treatment are mentioned below:

  • Taxability of overseas party in India with respect to the offshore portion, more specifically the offshore supply and design;
  • Constitution of a Permanent Establishment in India for the overseas party;
  • Taxability of retention money and tax deductibility of provision for foreseeable losses;
  • Transfer Pricing Implications in relation to transactions executed between related parties;
  • Applicability of newly introduced GAAR provisions and the consequential challenges;
  • Withholding tax implications on gross basis, possible cash trap and the challenges in obtaining a lower withholding tax certificate; and
  • Association of Person exposure in case of consortium model where domestic and foreign companies come together to undertake the execution of the contract and its connected negative implications.

Further, the infrastructure companies operating in the space have implemented a dual level holding structure whereby there exist a group holding company and separate SPVs underneath the holding company for executing projects. This is mainly on account of commercial requirements, facilitating funding by financial institutions or private equity players, specific requirement from the government for execution of projects in many cases. This dual holding structure typically results in transactions between the holding company and operating SPVs as well as among the SPVs, which give rise to some of the following tax challenges:

  • Cross charge mechanism for re-charging common expenses incurred by the holding company;
  • Applicability of newly introduced domestic transfer pricing provisions and the consequential structuring/compliances;
  • Withholding tax and service tax implications and consequential cash trap situation.
  • Tax leakage for up-streaming profits due to applicability of dividend distribution tax;
  • Tax deductibility of common expenses, if no cross charge fee is recovered by the holding company;
  • Applicability of GAAR provisions to such arrangements once GAAR is implemented and many more.

EPC Model: EPC model does have similar tax issues as highlighted under BOT model. But, one of the biggest tax issue which used to be faced by the EPC contractor was eligibility to claim the income-tax incentives under section 80-IA (4) of the Act. While the judiciary is divided on this point with rulings on both the sides, the government introduced an amendment in the Act to clarify that contractors do not qualify for the subject tax incentives.

Apart from corporate tax issues highlighted above, indirect regime offers its own bouquet of incentives to the Concessionaires/contractors, which results in significant tax efficiency, the more benefits arise under BOT model as opposed to EPC model. Given the evolving indirect tax regime and the aggressive approach of the Revenue Authorities, the Concessionaires/contractors face many challenges at the ground level to avail various benefits available under the indirect tax regime. The negative service tax regime has created separate set of challenges for the sector.

Both BOT and EPC models have their own set of vexed tax issues given the frequent changes in the laws and the conflicting judicial rulings. Commercial objectives drive the business decisions and various factors determine the decision of the government or the private parties to adopt BOT or EPC model, however, the tax aspects play a major role in either increasing or decreasing the cost of the project. The players involved in both BOT and EPC model needs to properly factor in the tax cost while budgeting the project cost. At times, the indirect tax cost could be reduced from 1 to 5 per cent by selecting the right option and proper planning (various options exist with respect to Service Tax, VAT and Works Contract Tax and selection of the right options depending upon the project and selection of right option is very crucial).

In the author’s view, what is needed is clear/proper arrangement between parties and supportive robust documentations to avoid any unintended tax consequences. Further, appropriate tax clarifications from the government could help the contractors to plan their affairs in a more informed manner rather than finding themselves in avoidable tax spat with the government and also give away the approach of introducing retrospective amendments in the taxation regime.

OMT as part of EPC: A new paradigm

NHAI is also looking at awarding Operations, Management and Transfer (OMT) contracts for projects completed through the EPC route on fairly similar contracting principles.

Inflation in prices of key inputs (bitumen, transport, cement, steel) and delays in land acquisition coupled with less than anticipated traffic growth have adversely impacted profitability of some projects companies which have already have outstanding order books and have indicated that they would like to refrain from bidding for BOT projects for some time.

The financing cost (given higher debt and working capital requirements) for four or six-laning highways may restrict small EPC contractors from participating. This makes such projects attractive to the more established high net worth companies such as Larsen & Toubro, Reliance, IL&FS, and IVRCL to increase their margins on the EPC contracts.

The same companies have the option of participating in the follow-on OMT contracts and the knowledge of their assets would help them bid competitively for such contracts. The benefit to the government in an EPC model could be the lower risk premium that bidders would generally consider given that most of the payment is received on completion of construction.

Summing up

Road BOT projects have been one of the big success stories in India’s infrastructure development. More than 30,000 km of highway projects have been awarded to private developers/contractors in the last 7-8 years. Private companies have contributed nearly 60 per cent of total investment in these projects. It is observed that bidders bid aggressively on high traffic corridors or on expectation of high growth.

Some industry analysts are of the view that all projects in the pipeline may not satisfy the commercial viability test because of low traffic and related costs of development. Investors therefore will be inclined to cherry-pick projects since all of them may not offer expected returns.

With few opportunities in other sectors in recent years, many contractors have been bidding aggressively for road contracts to keep their order books running. The EPC model has become the default option for government for unviable projects, to address the backlog in capacity creation. So the objectives seem to marry well.

Common issues that affect both EPC and BOT projects are delays in land acquisition and dispute resolution. Evidence suggests the current dispute resolution mechanism has not been effective. In about 80 per cent of the cases arbitrated by the Dispute Resolution Board (DRB) – BOT or EPC, decisions have not been acceptable to either party.

The government’s tolling policy for highways has also been amended frequently. The basis for determination of tolls for different types of projects does not fully cover short-term inflation risks or compensate bidders over sustained adverse market conditions.

In order to revive investor interest in BOT road projects, the government could consider revising the tolling policy based on cost-plus principles that are well-defined in the regulatory guidelines for other infrastructure sectors such as airports, ports and electricity distribution. This will help ensure steady cash flows, attract more foreign investment, facilitate capacity augmentation and incentivise asset maintenance.

There is no conflict between EPC and BOT contracts. One is a subset of the other. They also serve two different segments of the market depending on the risk-return profile and external market environment.

With the government also pursuing many credit enhancement mechanisms to support long-term financing of infrastructure projects, including setting up of an Infrastructure Debt Fund (IDF), widening the ambit of take-out financing arrangements to include ECBs, and allowing pension funds and insurance companies to invest in IDF and IIFCL, it may not be long before BOT projects become flavour of the industry.

Taxation and contract structuring plays a vital role in minimising the overall taxation cost as well as avoiding prolonged litigation with the Revenue Authorities. Appropriate planning, analysis and business modelling upfront at the bidding stage as well as throughout the life cycle of the project are evident given the ever changing taxation framework to achieve the desired profitable growth.

Karia is Partner-Global International Corporate Tax and Head of Real Estate & Construction Sector, and Vasudevan is Associate Director, KPMG in India.

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