3.23 Contracts that pass the balance of risk and reward to the private sector may coincidently be VFM. But there are many risks which are best managed and held by the public sector and the optimal allocation of risk is a fine judgement. Incentives to use off- balance sheet private finance may present a temptation to public authorities to structure contracts so as to achieve off-balance sheet treatment rather than the best possible value for money. In particular, it provides incentives to:
a Restrict public ownership of joint ventures to less than 50 per cent. Joint ventures are often structured 49:51, to avoid full incorporation in the public sector's financial accounts.51
b Manage or downplay demand risk (that the asset will not have the expected level of use). This can distort the planning for services.
c Pass residual risk to contractors (they hold the market value of the building at the end of the contract). This can cost more or mean permanently transferring ownership to the private sector.
d Increase the length of the project to reduce the residual value of the building. Small discounted residual values reduce the risk for the public sector authority of a fluctuating residual value at the end of the contract.
e Keep debt funding below 90 per cent. Higher debt funding is considered more likely to resemble a financing arrangement, so more expensive risk capital is used.
f Not include provisions for partial termination of individual services. The ability to cancel part of the contract would indicate that the relevant service was not integral to the property and the service risk did not rest with the contractor.
g Not include provisions to benchmark or market test maintenance and lifecycle refurbishment costs. The costs of maintaining the building is at the private sector's risk. This has the advantage of promoting whole-life costs, but means there is limited incentive for improvement of maintenance services.
h Ensure payments do not relate to the level of debt or interest paid by the contractors. This was one reason why, before the National Audit Office revealed the problem, contractors were able to profit from changed lending market conditions by refinancing.
i Ensure contractors accept some inflation risk that Government would be better at managing. Maintenance charges are not indexed directly to a relevant inflation index, as this would imply the public sector held the risk of inflation. Indexation is often applied to the whole of the availability portion or not at all. This creates a difference between the price contractors charge and the costs they incur, and they are likely to charge extra for holding the risk that this will not be in their favour. Government is normally considered able to handle the risk of inflation, because tax revenues increase in proportion to inflation.
3.24 The private sector has also sought to keep projects off their balance sheets, to seek tax advantages such as composite trader status. The chief advantage of composite trader status is that it allows all of the expenditure incurred in design and construction to be relieved against trading income. This encourages "off-off" accounting, where the asset is not recorded in either the public or private sectors' balance sheets. Department of Health guidance, now withdrawn, told Trusts that "In order to take advantage of this tax treatment bidders need to structure their bids so that they qualify as composite traders. … It is expected that the full benefit of the tax saving should be passed through to Trusts in the form of reduced unitary charges. … Bidders and Trusts must clear any decision not to pursue composite trade with [the Department of Health's Private Finance Unit] … It is unlikely that an SPV accounting for a fixed asset may benefit from composite trader tax treatment."52
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51 The Thames Gateway: laying the foundations, National Audit Office (HC 526, 2006-07).
52 Public Private Partnerships in the National Health Service: the Private Finance Initiative, Tax treatment for construction costs of NHS PFI schemes (composite trader), NHs executive (4 february 2003).