Service Concession Arrangement: Accounting and Tax Analysis

What is Service Concession Arrangement and why is it called so?

A service concession arrangement is an arrangement whereby
a government or other public sector body (grantor) contracts with a private operator (service provider / concessionaire) to: 

  • develop/upgrade, operate and maintain the grantor’s infrastructure assets such as roads, bridges, tunnels, airports, energy distribution networks, prisons or hospitals, 
  • the grantor controls or regulates what services the operator must provide using the assets, to whom, and at what price, and
  • the grantor also controls any significant residual interest in the assets at the end of the term of the arrangement. 

So why is it called “Service Concession Arrangement”?
The word “service” comes here to indicate that the operator under the contract is typically treated as “service provider” who “rehabilitates-operates-and-transfers” or “builds-operates-and-transfers” the asset under the arrangement. The word “concession” comes here to indicate that the grantor has provided the right to use asset for a specified purpose, which is the meaning of “concession”. Hence the word “Service Concession Arrangement”. 

What's the main aim of introduction of IFRIC 12 for Service Concession Arrangement?

The idea of IASB was to provide guidelines for booking assets in PPP. As the private equity is invested in public infrastructures (highways, hospitals, railways, water, electricity etc) the IASB decided that assets of such companies should not be considered as tangible but rather intangible, financial or mix. Among other conditions, the main reason for such an interpretation was to transfer assets at the end of the concession period to the Grantor for free or with a contractual fee. 

Application of IFRIC 12 for Service Concession Arrangement

The objective of IFRIC 12 is to clarify how the assets under the service concession arrangement is recognized. IFRIC 12 describes the accounting treatment of concession contract arrangements. It was designed to address the plurality of practices involved in the treatment of concession contract arrangements, as well as offer a means of assistance to those who have difficulty understanding how the treatment works. It is intended to service concession arrangements and focus on both the Build-Operate-Transfer type arrangements and the Rehabilitate-Operate-Transfer type arrangements of existing IFRSs.

An arrangement is within the scope of IFRIC 12 if the grantor controls services by using its infrastructure or if there is significant residual interest found within the infrastructure at the end of the concession.

Once it is established that IFRIC 12 applies on the service concession arrangement, it should then be decided about what form of asset should be recognized under the arrangement. With application of IFRIC 12 the asset(s) is no longer recognized in its typical form. It is either recognized as an intangible asset or a financial asset.  

Recognition of Financial Asset

The financial asset is recognized to the extent that the operator has an unconditional right to receive cash irrespective of the usage of the infrastructure. 

Recognition of Intantigle Asset

The intangible asset is recognized to the extent that it has a right to charge for the usage of the infrastructure. 

Recognition of both Financial Asset and Intangible Asset

IFRIC 12 allows for the possibility that both types of arrangement may exist within a single contract: to the extent that the government has given an unconditional guarantee of payment for the construction of the public sector asset, the operator has a financial asset; to the extent that the operator has to rely on the public using the service in order to obtain payment, the operator has an intangible asset.

Important Concepts

Concession Period

Concession period is the period from Building/Rehabilitating of the asset by the concessionaire to the period of Transfer of asset to the grantor. This will typically constitute two phase: 

  1. Construction Phase
    • Service: Construction Asset
    • Cash Inflow: None
    • Cash Outflow: Construction Costs
  2. Operation Phase
    • Service: Operate and Maintain the Asset
    • Cash Inflow: Revenues from Usage of Asset
    • Cash Outflow: Operating Cost 

IFRIC 12 Conditions

Two main conditions of IFRIC 12 are related to the following questions:

  • Does the Grantor, or the public authority which grants concession, control the concession services at a certain level?
  • Does the Grantor control or give back the asset which is subject to concession at the end of concession period?

If the answers are positive in each instance, then the company falls within the jurisdiction of IFRIC 12.

Does IFRIC 12 apply to your company?

Two main conditions of IFRIC 12 are related to the following questions:

  • Does the Grantor (GoN), or the public authority which grants concession, control the concession services at a certain level?
  • Does the Grantor control or give back the asset which is subject to concession at the end of concession period?

If the answers are positive in each instance, then the company falls within the jurisdiction of IFRIC 12. In the context of the project detailed above IFRIC 12 would be applicable, and the recognition of the asset would be made not as a tangible asset but either as financial asset or intangible asset based on following test. 

The financial asset is recognized to the extent that the operator has an unconditional right to receive cash irrespective of the usage of the infrastructure. The intangible asset is recognized to the extent that it has a right to charge for the usage of the infrastructure. In the context of the project above, the company maintains and services the infrastructure during the concession period.

The accounting guidelines for Service Concession Arrangement would be applicable for all entities except for Micro Entities as defined by NASB. Entity with all of the following attributes are micro entities:

  • Annual Turnover: Rs. 100 million or less
  • Borrowings from banks or financial institutions or public funds or from entities holding assets in fiduciary capacity: Rs. 50 million or less
  • Balance Sheet Size: NRs 100 million (without off-setting current liabilities in current assets) or less
  • Holding assets in fiduciary capacity (includes security brokers handling demat account, micro finance and cooperatives): Rs. 50 million or less

Accounting under Financial Asset Recognition Model

The financial asset is recognized to the extent that the operator has an unconditional right to receive cash irrespective of the usage of the infrastructure. In this model, the operator receives a financial asset, specifically an unconditional contractual right to receive a specified or determinable amount of cash or another financial asset from the government in return for constructing or upgrading a public sector asset, and then operating and maintaining the asset for a specified period of time. This category includes guarantees by the government to pay for any shortfall between amounts received from users of the public service and specified or determinable amounts. 

The operator recognises a financial asset to the extent that it has an unconditional contractual right to receive cash or another financial asset from or at the direction of the grantor for the construction services. The operator has an unconditional right to receive cash if the grantor contractually guarantees to pay the operator: 
(a) specified or determinable amounts or
(b) the shortfall, if any, between amounts received from users of the public service and specified or determinable amounts, even if payment is contingent on the operator ensuring that the infrastructure meets specified quality or efficiency requirements.
The operator measures the financial asset at fair value.
Revenues are measured and recognized as per the IFRS 15: Revenue from Contracts with Customers. 

Accounting under Intangible Asset Recognition Model

The intangible asset is recognized to the extent that it has a right to charge for the usage of the infrastructure. In this model, the operator receives an intangible asset – a right to charge for use of a public sector asset that it constructs or upgrades and then must operate and maintain for a specified period of time. A right to charge users is not an unconditional right to receive cash because the amounts are contingent on the extent to which the public uses the service. 

The operator recognises an intangible asset to the extent that it receives a right (a licence) to charge users of the public service. A right to charge users of the public service is not an unconditional right to receive cash because the amounts are contingent on the extent that the public uses the service.
The operator measures the intangible asset at fair value. 
Revenues are measured and recognized as per the IFRS 15: Revenue from Contracts with Customers. 

Practical Illustrations and Examples

The terms of an arrangement are: 

  • Operator to construct a road completing construction within two years (Cost of CU 500 for year 1 and CU 500 for year 2)
  • Maintain and operate the road to a specified standard for eight years (ie years 3–10)(Cost of CU 10 per year from years 3-10)
  • Road resurfacing obligation at year 8 (Cost of CU 100)
  • Grantor to pay the operator CU 200 per year in years 3–10 for making the road available to the public 
  • In year 8 the operator will be reimbursed by the grantor for resurfacing the road. 

(a) The operator estimates the relative stand-alone selling price by reference to the forecast cost plus 5 per cent.
(b) The operator estimates the relative stand-alone selling price by reference to the forecast cost plus 20 per cent.
(c) The operator estimates the relative stand-alone selling price by reference to the forecast cost plus 10 per cent.
(d) The implied interest rate is assumed to be the rate that would be reflected in a financing transaction between the operator and the grantor. 

Financial Assets Model

Tabular Summary of the Proposition

Year

Income

Cost

Standalone Income

Standalone IRR

T1

T2

T3

T4

T5

   

Adj.

T2-T5

1

(500)

525

(525)

2

(500)

525

(525)

3

200

(10)

12

188

4

200

(10)

12

188

5

200

(10)

12

188

6

200

(10)

12

188

7

200

(10)

12

188

8

300

(110)

122

178

9

200

(10)

12

188

10

200

(10)

12

188

Total

1,700

(1,180)

1,256

7.61%

Grantee Account and Overdraft Account

Grantee (@7.61%)

 Bank/(OD) (@6.7%, say)

Opening

Income

Int. Income

Bank

Closing

Opening

Cost

Int. Exp

Bank

Closing

B1

B2

B3

B4

B5

C1

C2

C3

C4

C5

  

B1×IRR

 

B1+B2+ B3+B4

  

C1×6.7%

 

C1+C2+ C3+C4

525

525

(500)

(500)

525

525

40

1,090

(500)

(500)

(34)

(1,034)

1,090

12

83

(200)

985

(1,034)

(10)

(69)

200

(913)

985

12

75

(200)

872

(913)

(10)

(61)

200

(784)

872

12

66

(200)

750

(784)

(10)

(53)

200

(646)

750

12

57

(200)

619

(646)

(10)

(43)

200

(500)

619

12

47

(200)

479

(500)

(10)

(33)

200

(343)

479

122

36

(300)

337

(343)

(110)

(23)

300

(176)

337

12

26

(200)

175

(176)

(10)

(12)

200

2

175

12

13

(200)

2

(10)

0

200

192

5,832

1,256

444

(1,700)

5,832

(4,894)

(1,180)

(328)

1,700

(4,702)

Intangible Assets Model

Tabular Summary of the Proposition

Year

Income

Cost

Standalone Income

A1

A2

A3

A4

    

1

(500)

525

2

(500)

525

3

200

(10)

Standalone Income is used for computation of amount of Intangible Asset until the construction phase and it is subsequently amortized. 

4

200

(10)

5

200

(10)

6

200

(10)

7

200

(10)

8

300

(110)

9

200

(10)

10

200

(10)

Total

1,700

(1,180)

1,050

Intangible Asset and Overdraft Account

Intangibles

 Bank/(OD) (@6.7%, say)

Opening

Income

Int. Cap

Amortz.

Closing

Opening

Cost

Int. Exp

Int. Cap

Bank

Closing

B1

B2

B3

B4

B5

C1

C2

C3

C4

C5

C6

  

C1×6.7%

 /policy

B1+B2+ B3+B4

 

 

C1×6.7%

C1×6.7%

 

C1+C2+ C3+C4+C5

525

525

(500)

 

(500)

525

525

34

1,084

(500)

(500)

 

(34)

(1,034)

1,084

(135)

948

(1,034)

(10)

(69)

 

200

(913)

948

(135)

813

(913)

(10)

(61)

 

200

(784)

813

(135)

677

(784)

(10)

(53)

 

200

(646)

677

(135)

542

(646)

(10)

(43)

 

200

(500)

542

(135)

406

(500)

(10)

(33)

 

200

(343)

406

(135)

271

(343)

(110)

(23)

 

300

(176)

271

(135)

135

(176)

(10)

(12)

 

200

2

135

(135)

2

(10)

0

 

200

192

5,401

1,050

34

(1,084)

5,401

(4,894)

(1,180)

(294)

(34)

1,700

(4,702)

The Tax Perspective

The main concern is: When we prepare our accounts as per the application of IFRIC 12 Service Concession Arrangement, does it have any bearing for tax purpose. 
The answer is: Huge Yes. IFRIC 12 is concerned with the form of the recognition of the asset. Under the application of IFRIC 12, the assets under concession arrangement would not be recognized as tangible asset. However, it is recognized as either financial asset or an intangible asset or both. 

This implication in form of recognition of asset has implication in how the asset is treated for tax purposes. Intangible asset is depreciable under straight line basis under Income Tax Act 2058, over the period of the useful life i.e over the concession period. However, financial assets are business assets and business assets are not depreciable and are derecognized from books only at the time of disposal. 

Under Intangible Asset model the value of the Intangible Asset recognized during the construction phase is  amortized during the operation phase. Income is recognized during the construction phase assuming as if the construction were a standalone contract. During the operation phase income is recognized in actual basis.  

Under Financial Asset model the value of the Financial Asset is recognized corresponding to the income recognized. Income is recognized assuming as if the construction were a standalone contract. 

The same expense and income recognition criteria would be applicable in the context of tax perspective of Income Tax Act 2058 as well. No deferred tax assets/liabilities would arise in the case of recognition of assets and income under Service Concession Arrangement model.