Expert Advisory Committee

Query No. 5

Subject:   

Treatment of toll collections during construction phase of a project of a

company engaged in developing Toll Road Project on ‘DBFOT’ basis.1
 

A.   Facts of the Case  
                                                  

1. A company (hereinafter referred to as the ‘company’) is a wholly owned subsidiary of another company, which is an infrastructure subsidiary of yet another company. The company, which is a Special Purpose Vehicle was formed to augment the existing four lane road to six lane road for a length of 148.3 kms forming part of the National Highway between ‘X’ and ‘Y’ (…State) and, then, to operate and maintain the same in a Design, Build, Finance, Operate and Transfer (‘DBFOT’) basis.  The company has entered into a Concession Agreement (the ‘CA’) with the National Highways Authority of India (‘NHAI’) in June 2010 (copy of the ‘CA’ and related documents have been furnished by the querist for the perusal of the Committee). The total concession period is 30 years including the construction period of about 2.5 years.

2.  The scope during construction includes

a) Designing, engineering and construction for augmenting the existing four lane road to a six lane road which includes re-alignment, shifting and re-laying the roads and structures (such as culverts, underpasses, bridges).

 

b) Making proper arrangements including maintaining structures/existing roadway until they are taken up for re-laying which are necessary to facilitate traffic flow.

 

c) Re-laying the existing four lane roadway in line and level as specified in the ‘CA’ to suit the new lanes.

3. The querist has stated that the project as envisaged by the ‘CA’ is not divisible. Furthermore, once construction is complete, there would be a six lane roadway and it would not be possible to identify the old roadway, which would have lost its identity. The roadway will need to be re-aligned by the company based on the availability of land.

4.  The construction contract has been awarded on a turnkey basis to an Engineering, Procurement and Construction (‘EPC’) contractor. The scope of the EPC contract includes:                         

• Removing trees, shifting of utilities and other structures (temples, graves, etc).

• Re-aligning the centre median based on the land availability.

• Providing for traffic flow, by making proper arrangements including diversion/ temporary roads.

• Laying /re-laying road to maintain the same quality and thickness of all the lanes.

• Constructing drainage /rain water management at the corners.

• Constructing service lanes on both sides of the six lane road.

5. Since the EPC contract is not being executed by the company but by a different entity, the company will not earn any income from the construction activity. Hence, there is no profit / loss related to the construction of the asset for the company. The profit or loss on this account is with the EPC contractor. 

6. The project is being financed by way of equity, debt from banks/institutions and toll collection during the construction period. As per the ‘CA’, the financial closure needs to be achieved within six months from the date of the ‘CA’, and the same was achieved in November 2010. (Financial closure of a project normally means entering into necessary agreements with banks/institutions to obtain necessary funds for the project). The project cost and its means of funding as per the project loan documents are:

7.  Initially, for package of road projects inviting six-laning of existing four lane roadway, the bid documents of NHAI restricted the grant, if any, required by the bidder from NHAI to 40% of the total project cost (‘TPC’) as estimated by NHAI. However, in order to reduce direct commitment under the Viability Gap Funding (‘VGF’) scheme, in this road project involving widening of four lane roadway, the maximum grant was brought down by NHAI to 10% of the ‘TPC’, but the successful bidder/Concessionaire was permitted to collect toll from the road users even during the construction stage as a means to fund the project cost. According to the querist, this clearly implies that toll collection during the construction phase is a substitute for NHAI grant and is a means of funding the project ab initio. Further, the querist has drawn attention to the fact that the toll fee during the construction period is at the rates specified by NHAI in the ‘CA’. The toll rates do not increase after the construction period except for escalation, mainly for inflation as specified by NHAI annually. The querist has clarified that there is no separate toll fee for the existing roadway and for the new asset.

8. The querist has drawn attention to ‘Escrow’ mechanism specified in Article 31 of the ‘CA’. As per the Tripartite Agreement with the Lenders and NHAI, the company has to maintain an Escrow account into which all funds, including equity, term loan and toll collections are required to be deposited. Withdrawals from this account are as specified by the Escrow mechanism, whereby the funds are to be utilised only in the following order:

i Statutory obligations (TDS, Local taxes and duties etc.)

ii Debt servicing ( Principal and Interest repayment)

iii Payments to NHAI under the ‘CA’ ( such as Concession  Fees)

iv Project / construction expenditure

v Operation and maintenance expenses. (During construction period, this would be 1.5 % of the project cost).

 

If, at any point of the time, the project is not able to meet the fund requirement, the short-fall has to be brought by the promoters.  This includes short-fall in toll collections during construction period, as specified in the ‘CA’. As per the “water fall arrangement” in the Escrow Agreement, toll collections during the construction period are to be used primarily for execution of the project (i.e., construction).

9.The querist has drawn attention to the provisions for Termination of Concession by NHAI as specified in Article 37 of the ‘CA’. Accordingly, in the event six lane roadway is not completed within the stipulated time as per the ‘CA’, NHAI may terminate the Agreement. Hence, as per the querist, the project cannot be construed operational until the augmentation is completed.                  

10.The querist has stated that the total costs incurred during the project construction phase is capitalised as ‘Toll Collections Rights’ by the company and is classified as an intangible asset under ‘Fixed Assets’. The intangible asset is amortised over the Concession Period.   The company is of the view that the toll collected during the construction phase is in the nature of a capital receipt primarily because:

• The Scope of the ‘CA’ is to widen the existing roadway and, hence, the project cannot be considered as operational prior to completion of augmentation.
• There are restrictive covenants on utilisation of funds in the Escrow Account whereby toll collected can be utilised only for construction of the roadway and related expenditure.
• ‘VGF’ has been reduced from 40% to 10% for this project, thereby amplifying the intent of NHAI/ Government of India to treat toll collection during construction as means of project finance.
• Toll collections are fully fungible with other means of project finance in the Escrow Account.
• Taking a holistic view, the toll collected being utilised for construction is akin to other means of funding such as equity / debt and not an application of such funds at the discretion of the company.

   

11.As per the querist, if the toll collections are treated as revenue receipt, it will:

 (i) Violate the ‘Matching’ concept.

 

If the company treats the toll collection as revenue receipt, the company would disclose huge profits during the construction period, since, almost the entire expenditure during this period would be capitalised. The amortisation of the asset starts only after the completion of construction period and, hence the treatment of toll collection as income would be against the matching concept.

 

(ii) Vitiate ‘True and Fair’ view.

 

If the toll collection is treated as revenue receipt, the company will have very high profits during construction period and considerable loss during the early years of the operations. The financial statements drawn during the construction period would show profits which is a misrepresentation of the status of the financials, and, would mislead the stakeholders.

12.As per the querist, although clause 15.1.1 of the ‘CA’ states that Commercial Operation Date is the date from which the company is to start construction and is eligible to collect toll, considering substance over form and, in order to present a true and fair view, the toll collections during construction period are not to be treated as income but as a capital receipt and, hence, the project cost is to be reduced by the toll collected during the construction period.

B. Query

13. The querist has sought the opinion of the Expert Advisory Committee on treatment of toll collection during the construction phase of the project undertaken on DBFOT basis, viz., whether such toll collection is a capital receipt or a revenue receipt.

C. Points considered by the Committee

14. The Committee notes that the basic issue raised by the querist relates to the treatment of toll collection during the period when the existing four-lane toll road is being upgraded to develop a high speed six-lane toll road. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, accounting for costs and revenue relating to construction/upgradation activity, classification of the expenditure incurred during construction period as tangible or intangible asset and amortisation thereof, items of expenditure eligible for capitalisation, determination of construction period for accounting purposes, timing of recognition of toll collections, treatment of concession fee or sharing of toll collections with NHAI as additional concession fee, etc. Further, the Committee wishes to clarify that it has expressed its views purely from the point of view of general purpose financial statements and not for any other purposes including regulatory purposes (for example, grant under ‘VGF’ scheme) etc. Incidentally, the Committee notes that the querist’s use of the terms ‘toll collection’, ‘capital receipt’ and ‘revenue receipt’ is not proper in the context of adjustment against project cost/ recognition in profit and loss account. This is because as per section 209 of the Companies Act, 1956, books of account of a company should be kept on accrual basis and not on receipt basis. Hence, the Committee has hereinafter avoided the use of the above terms in the context of adjustment against project cost/ recognition in profit and loss account while expressing its views. Further, the Committee notes that the ‘EPC’ contract has been awarded to a different entity by the company and not by NHAI and expenditure towards the same is recognised by the company. The Committee also wishes to point out that although the querist has stated that in order to reduce direct commitment under the Viability Gap Funding (‘VGF’) scheme, in this road project involving widening of four lane roadway, the maximum grant was brought down by NHAI to 10% of the ‘TPC’, but as observed from the Article 25 of the Concession Agreement, no grant has been given to the company.

15. The Committee notes from the Facts of the Case that in the extant case, the company has been awarded a right to collect toll fees during concession period in lieu of the company’s obligation to undertake the upgradation / construction  of four lanes toll road into six lane toll road project while ensuring smooth flow of traffic on the existing four lanes and for which the company is incurring operation and maintenance expenditure and is also collecting toll charges from the users of the existing four-lane toll road. Insofar as the grantor is concerned, the toll collections over the concession period are intended to cover both construction activity and O & M activity. Thus, the Committee is of the view that the toll revenue is the consideration for these two services, viz., construction and operation and maintenance provided by the company over the concession period. The Committee notes that the querist has stated in the Facts of the Case (paragraph 5 above) that since the EPC contract is not being executed by the company but by a different entity, the company will not earn any income from the construction activity and hence, there is no profit / loss related to the construction of the asset for the company. The Committee is of the view that since the company has been awarded a construction contract in the capacity of a contractor although that is sub-contracted to another party, the company should account for both the contract costs and contract revenue of such contract in its financial statements even though the company may decide to pass on any profit to the sub-contractor.

16. The Committee is further of the view that merely because of the difference in the timing of receipt of an income during, pre or post construction, its nature does not change. Further, the mere fact that an income is used to finance a project cost does not determine its accounting treatment. As such, it is not relevant to consider the arguments given by the querist in paragraph 10 above for the proposition that toll revenue during the construction period is a means of funding the project. Also, merely because the right to collect toll fee during the construction period might be given to reduce the quantum of government grant, it cannot be equated with a government grant as the purpose of grant is gratuitous. Grant is non-exchange revenue. However, in the extant case, the company is being granted toll collection right in exchange of its obligation to construct / upgrade the toll road and operation and maintenance thereof. The Committee is of the view that the total toll collections during the concession period is basically consideration arising from the two types of services rendered by the company, viz., construction/upgradation and operation and maintenance and accordingly, it is revenue for the company and not of the nature of a ‘capital receipt’ and therefore, such revenue arising during the construction/upgradation period cannot be deducted from the total project cost as being argued by the querist.

D.        Opinion

17.  On the basis of the above, the Committee is of the opinion that the toll collections during the constructon/upgradation period is not a ‘capital receipt’ rather it is revenue in nature and accordingly, it cannot be reduced from the total project cost.

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¹Opinion finalised by the Committee on 26.4.2012.