Understanding The Complexities Of The Special Purpose Vehicle

April 3rd, 2015

Understanding The Complexities Of The Special Purpose Vehicle

Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) are finance terms that have the same meaning: it is an arrangement used to protect a “subsidiary” of a company from being affected by financial pressure such as bankruptcy. Although the SPV is a structured finance tool whose purpose is to preserve funding, assets, or operation from being affected by the rest of the company’s business, it still leaves an unpleasant taste in the mouth for those who still remember the Enron collapse in 2001.

Today, the SPV is again in international news after India announced an ambitious “Smart City” plan which requires SPVs to be established for 100 selected cities. The long-range goal is to have 500 smart cities with modern amenities, efficient transportation, continuous power and water supply, and upgraded medical facilities designed to drive the economic growth of the country. This move is encouraging for SPVs because it portrays a more positive picture for the use of SPVs.

The Powers of an SPV

Immediately, it must be said that the powers of an SPV are limited to the purpose for which it was created. Thus, when the purpose is attained, the SPV should be terminated. A simple example would be a company’s need to set up a fund for a special project. The SPV would allow the company to isolate the needed funds to assure outside investors that the company’s assets are duly protected, as are the designated funds for the SPV.

Once an SPV is created, it must be managed and owned separately from the company, because otherwise it would act like a subsidiary. As an independent entity, an SPV is now responsible for managing its funds, decisions, and risk capital. However, many SPVs run on auto-mode, which means they have a pre-punched program, which requires minimal, or no management decisions. They may even have no actual office; just documents that contain a sharee holder agreement, joint venture contract, or Deed of Trust.

Purposes of the SPV

The following are several reasons why anyone would want to set up an SPV such as:

  • To be used for synthetic a lease, which is considered an expense in the income statement rather than a liability on the balance sheet. This is also known as On-Balance versus Off-Balance SPV, which are the 2 types of SPVs.
  • To secure a project from possible financial or operational failures of the company
  • To gain independence from the company in terms of funding, ownership, and management

However, to prevent another Enron from happening, the Financial Accounting Standards Board (FASB) has established new guidelines, namely:

  1. At least 3% of the total debt, assets, and equity of a SPV must be owned by an independent third party.
  2. The third party owner of the SPV is independent of the company and has enough equity investment in the project.
  3. The third party owner must have controlling financial interest in the SPV. This means at least enough to have a vote.
  4. The third party owner is not guaranteed by another party.

The Organization of an SPV

Before the SPV agreement is finalized and notarized, the organization should be agreed upon. This includes establishing the legal structure that could be a trust, company, mutual fund, firm, or Statutory Corporation. The Special Purpose Vehicles should also follow the incorporation laws of the parent company like the Partnership Act, Trust Act, and Companies Act.

Although an SPV may be in documentary form only, it should be able to acquire, hold, and dispose of assets. It is also required to secure the assets and avoid engaging in activities not part of the special purpose goal. If the company that set up the SPV gets into financial stress, the interests of the SPV holders are protected. In addition, it cannot be dragged into court in case it is unable to abide by the SPV securitized papers which means creditors cannot run after the SPV’s shareholders, the company that set up the SPV, its promoters, or rand constituents.

Difference between Off-Balance and On-Balance SPV

There are 2 main types of SPVs: Off-Balance SPV and On-Balance SPV. Briefly, the Off-Balance SPV is a funding form that puts the Special Purpose Vehicle owner’s equity, assets, and liabilities on the balance sheet while On-Balance is placing the same as direct debt or equity.

With SPVs, the common practice is to put assets and liabilities on the balance sheet or the Off-Balance SPV so that the company sponsoring the SPV does not carry these assets and liabilities on its balance sheet. This means the SPV is off the radar with the company’s Financial Statements and completely isolated documentarily from the company.

The characteristics of an Off-Balance SPV include the following:

  • Thin capitalization
  • The presence of a service agreement where assets are managed by the SPV
  • The absence of independent employees or managers
  • Zero possibility of declaring bankruptcy

There are a few reasons why off-balance is preferred over on-balance such as:

  • Lower risks
  • Higher finance flexibility being a stand-alone
  • Secure higher credit rating and get lower funding cost
  • Improved asset-liability management
  • Can be used to reduce regulatory capital requirements and for trust preferred securities

Who Uses SPVs?

It is standard practice for financial institutions, banks, and business owners to have SPVs. Using Special Purpose Vehicles (SPVs) can improve your finance management because it could make you more tax efficient. However, there are tax implications that go with having an SPV. First of all, the SPV will have to pay corporate tax on its profits and although there are no taxes charged on special dividends of the SPV, if the dividends are received by a person, then that person will have to pay documentary tax and Capital Gains taxes of up to 25%, maybe more depending on the country. On the other hand, SPVs make it possible for creative handling manipulation of financial statements and the windows of opportunity for companies to choose a more favorable tax residence for their SPV where their assets are better secured.

Foreign Institutional Investors (FII) also use SPVs to access business opportunities in foreign countries where the normal route is closed to them. India, for example, has closed its doors to FIIs from certain countries or has a maximum cap of 24% because of its foreign policy.

Governments used SPVs agreements with the Private Sector to achieve faster growth and avoid red tape. As many know, most governments, although automated, usually have a long list of requirements before any large-scale project can be approved for funding. Through the SPV, governments can fast track their projects and complete them without interference from government officials and agencies.

Pros and Cons to SPVs

The SPVs are a safeguard against bankruptcy and creditors since assets can be transferred to the SPV and remain virtually untouchable. At the same time, any high-risk project can use the SPV to protect the mother company from great losses should the project fail. Thus, the most important advantage of the SPV is protection of funds and assets.

SPVs also make it easier to manage funds because instead of expanding a business, one can just create special projects even if only to test the market for new business opportunities. One can also sidestep certain regulatory requirements that block investment opportunities such as the case of the FIIs.

Finally, SPVs give you the added advantages of creative accounting and an effective way of cloaking any secret project that your competitors would do anything to know about.

The disadvantages of the SPVs include the cost of setting up the SPV, loss in tax benefits for the mother company, compliance with the rigid FASB rules, lack of funding options, and the legal obligations of a limited company.

 

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