Use of IRUs in a telecommunications capacity

Indefeasible rights of use agreements (IRUs) are commonly used in telecommunications agreements for the supply of cable system capacity services.  IRUs have specific tax treatment under section 995.1 of the Income Tax Assessment Act 1997 (Cth) and are treated as capital expenditure for suppliers and customers.  Tax considerations play a central role in structuring IRUs. Below, we set out the key areas an IRU must cover to be tax compliant.

The structure of IRUs

Typical capacity agreements are structured as service agreements, whereas an IRU must be structured in the right way to be tax and accounting treated as an IRU.

The term of an IRU is usually around 15 years, during which time the supplier grants the customer exclusive access to capacity over a fibre system.  Unlike a standard capacity service agreement, typically the customer must pay the price upfront in order for the customer to have the rights to the system for the effective life of the asset and to gain the benefit of tax capital depreciation allowances which are not usually available with service agreements.

To assist in the treatment of the agreement as an IRU, the grant of access must be indefeasible and give the customer economic ownership rights over the network assets similar to those of the supplier.

What is indefeasibility?

The term indefeasible is used in property law and requires that the network asset is:

• Identifiable: For the network asset to be identifiable, it must be within a specific fibre core, or over specific fibre strands within a certain core, or over a specific route or routes.
• Fixed: The capacity must also be fixed.
• Exclusive: The capacity or infrastructure must be for the exclusive use of the customer.

To be characterized as indefeasible, an IRU agreement usually:

• does not include a right to terminate by either party; and
• does not entitle the customer to refunds of any upfront payments.

Ownership rights over the network assets similar to those of the supplier

To capture economic ownership, an IRU usually contains the following:

• Supplier has no obligation to provide maintenance.
• No compensation for defective service without separate warranty provisions.
• Customer must pay its share of the costs of uninstalling the network asset if it reaches end of life.
• Customer is entitled to share in the proceeds of disposal of the network asset.
• Customer is entitled to proceeds which arise from claims made against third parties in relation to the network asset.
• Generally, no right to terminate the IRU, even where the supplier fails to make capacity available, though many IRUs do include termination rights.

Operations and maintenance services

Under standard capacity supply agreements, network maintenance, service levels and service credits are provided for the benefit of the customer.

Under an IRU, because the customer has the risk and benefit of ownership of the network asset, the customer technically has to maintain that system, however a work around can be created whereby the supplier provides maintenance and network upgrade services under an outsourcing arrangement which can be built into the IRU or form part of a separate agreement between the parties.

How fixed is the capacity?

Indefeasibility in an IRU means that fibre strands or routes need to be specified in the IRU. In commercial reality, though, it may not be possible to set this in stone.

Therefore, the IRU must include the capacity requirements that are not expected to change as well as make provision for scaling.

The business needs of a customer might require capacity on different routes at various times.  This can be covered by stating the fixed capacity requirements in the aggregate and the potential routes over which that capacity may be needed.  To activate a route, the operations and maintenance agreement can provide rights of the customer to trigger certain routes.

Another tricky scenario is where the network has not been built and indefeasibility is not fully present.  To cover this, specified point to point capacity can be specified with certain routes and strands being subject to a separate design process under a design and network build agreement.

Termination rights

In normal capacity service agreements, the customer has a right to terminate if the supplier fails to provide the capacity services and may include a refund of upfront payments.

To provide termination relief for the parties in these circumstances, the customer can be granted a put option that can be exercised by the customer where the supplier fails to provide the capacity which obligates the supplier to buy back the customer’s interest, resulting in a net refund.

Conversely, the supplier can be granted a call option that can be exercised by the Supplier in the event that the customer breaches the agreement, such as failure to pay, which then obligates the customer to sell its interest back for an amount that would be equal to the amounts outstanding.

Takeaways

IRUs are complicated and require a careful collaboration of legal, tax and commercial considerations, often necessitating the guidance of a legal professional who specialises in technology law.

Links and further references

Legislation

Income Tax Assessment Act 1997 (Cth)

Further information about IRUs

If you need advice on IRUs, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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