Special Purpose Entity

What is Special Purpose Entity?

The term “special purpose entity” refers to a legally separate entity created to fulfill distinct objectives, such as appropriating a parent entity’s financial or legal risk. Typically, it has a pre-defined purpose-limited scope of activities and is used as an interim solution to a potential problem. Their structure is devised accordingly. It is also popularly known as a special-purpose vehicle.

Key Takeaways

Some of the key takeaways of the article are:

• It is created as a separate company with its financial statements and limited scope of activities.
• Although it can be used for ethical and financial reasons, there are many instances of its misuse where companies employ it to undertake risky ventures while reducing the negative financial impacts on the parent companies.
• There are two major types of special purpose entities – on-balance sheet and off-balance sheet.
• A special-purpose entity is primarily used for risk sharing, securitization, asset transfer, and property sale.

How does it work?

A special purpose entity is allocated a separate balance sheet and other financial statements as the filing is made separately from the parent entities. The underlying reason is the distinct legal status of the two entities. Therefore, the parent entity can shield itself from various risks by separately maintaining the special purpose entity’s balance sheet.

Large multinational companies and small startups deploy the arrangement of special purpose entities for various ethical and financial reasons. However, there is no denying multiple instances where companies use the arrangement for misguided and nefarious purposes. For example, the real estate bubble in 2008’s financial crisis resulted from the pools of low-creditworthy mortgages that were clubbed together as special purpose vehicles and sold to investors.

Examples of Special Purpose Entity

The massive collapse of Enron in 2001 is a prime example of a special purpose entity gone wrong. The Houston-based company was considered a growing name in the energy industry until that point.

As Enron’s stock price was soaring, the company decided to transfer much of its stock to a special purpose entity in exchange for cash or notes. It used these stocks to hedge assets held on its balance sheet. Further, Enron extended the guarantee to reduce risk to the special purpose entity’s value. However, when Enron’s stock price started to plummet, the value also followed the same suit, revoking the guarantees extended by the company.

Misusing the special purpose entity was one of the most significant contributors to the abrupt fall. Eventually, Enron could not pay the huge liabilities owed to the creditors and investors, leading to its collapse. Ultimately, the company had to disclose information about its financial statements and the special purpose entity, which unearthed its conflicts of interest.

Types of Special Purpose Entity

There are two major types:

1. On-balance sheet special purpose entity: In this case, the financial results are consolidated with that of the parent entity, which means that the income of the former is transferred to the parent company.

2. Off-balance sheet special purpose entity: In this case, the financial results are not consolidated with the parent company’s, which means their incomes and assets are reported separately.

Uses of Special Purpose Entity

The following are some of the most common uses:

• Risk sharing: A company may work on projects with significant risks, which it can isolate by creating them.
• Securitization: A bank can detach a set of loans from its obligations by creating it. The investors of these securities receive the payments for the underlying loans.
• Asset transfer: Those hard-to-transfer assets can be separated by creating them and later selling them as part of a merger and acquisition process.
• Property sale: If the property sales tax is higher than the realized capital gain, a company may create a special purpose entity and sell it instead of the property. In this way, it needs to pay tax only on the capital gain while it avoids paying the property sales tax.

Advantages

Some of the significant advantages are as follows:

• It allows the parent entity to legally isolate the financial and other risks associated with a project and share them with other investors.
• The parent entities can save taxes by creating special purpose entities in the tax haven countries.
• It offers more operating freedom to the parent entity as the special purpose entity is not bound by the same rules and regulations as the parent.

Disadvantages

Some of the major disadvantages are as follows:

• Creating it requires a substantial amount of capital.
• A special-purpose entity usually enjoys relatively lower access to capital than its parent company.

Conclusion

A special-purpose entity can be seen as a subsidiary formed to allow the parent company to engage in financial transactions, which may include speculative investments, without risking the financial position of the entire group. For instance, if it goes bankrupt, the parent company remains unaffected, which is one of the most significant advantages and reasons for the popularity of this arrangement among corporates.

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