Updated July 7, 2023
What is a 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 useful as an interim solution to a potential problem. Their structure is devised accordingly. It is also popularly known as a special-purpose vehicle.
Some of the key takeaways of the article are:
- It is a separate company with its financial statements and limited scope of activities.
- Although it can be useful 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 useful for risk sharing, securitization, asset transfer, and property sale.
How Does it Work?
A special purpose entity has 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 then.
As Enron’s stock price soared, the company transferred 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 consolidate with that of the parent entity, which means that the income of the former transfers to the parent company.
2. Off-Balance Sheet Special Purpose Entity
In this case, the parent company does not consolidate the financial results, meaning they separate their incomes and assets.
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 separable by creating them and later selling them as part of a merger and acquisition process.
- Property sale: If the property sales tax exceeds 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.
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 same rules and regulations as the parent do not bind this type of entity.
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.
A special-purpose entity can be a subsidiary that allows the parent company to engage in financial transactions. It 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.
This is a guide to Special Purpose Entity. We also discussed the definition, working, examples, types, uses, and advantages and disadvantages. You may also have a look at the following articles to learn more –