The Government is understood to be working on legislation to erase a potential $1 billion tax liability for Telecom if the company proceeds with a proposal to split in two. The issue has arisen as Telecom seeks a way to take part in the Government-subsidised plan to connect high-speed fibre optic broadband to 75 per cent of homes. The scheme's rules effectively bar Telecom from the $1.5b state subsidy unless it structurally separates into two companies, one owning the retail business and one owning the network business. While such a move has numerous complications, the tax problem would be a deal breaker. If Telecom demerges network assets likely to include those currently in its Chorus infrastructure unit the market value ascribed to them would be much higher than their value in Telecom's books after years of depreciation. This would lead to a clawback by the IRD of past depreciation charges and a giant tax bill for Telecom, with a correspondingly large windfall for the Government. A research note in July from analyst Greg Main of First NZ Capital estimated the tax liability at up to $1b. "We assume the Government would waive any potential tax liability related to a demerger of Chorus ... and that any costs of separation ... are offset by benefits from regulatory relief. "This would leave TEL shareholders with one share in Chorus and one remaining share in TEL." Without legislation to bypass the tax liability, the economics of structural separation would not stack up for Telecom shareholders. Telecom declined to comment on the matter, citing confidentiality around negotiations with the Government's Crown Fibre Holdings. However, a spokesman said "the tax implications of a demerger are subject to the specific way in which a demerger would be enacted and we have not reached that stage. "Talk of specific numbers is conjecture." Communications Minister Steven Joyce would not confirm or deny the Government was working on the legislation but said Telecom's proposal for the ultra-fast broadband initiative was being evaluated alongside other bidders through a confidential commercial process. "Any wider regulatory impacts would be assessed by the Government should they be required,'' he said. At Telecom's full-year results announcement on August 20, chief financial officer Russ Houlden emphasised proposals for structural separation required a set of issues to be resolved. "What we've put forward [to the Government] is a package deal. "You can't just look at the commercial piece or the regulatory piece or the tax piece or the legislation piece in isolation. You need a package." "If it works for New Zealanders, if it works for government and if it works for shareholders, we need that package to be captured in a heads of agreement. "Once we've got the package into a heads of agreement then we can kick off all of the necessary streams to work with debt holders, the shareholders, passing legislation and so on." eIt is understood the Government has made progress on the Leg 5principle of tax relief for Telecom but the details are yet to be worked out. Although the sum involved could be large, the Government may see tax relief as a technicality because the liability is hypothetical and no money is actually lost to the taxpayer caused mostly by circumstances outside Telecom's control - the depreciation charges from previous years are the result of tax rules. Telecom would not act to trigger a liability, so it's not money that is actually being lost to the taxpayer if another solution is found. Any solution is likely to be structured to ensure neither shareholders nor the government benefit. One market source said the Government would want to avoid a demerged Chorus revaluing the network assets and getting a second bite at the depreciation tax benefit cherry. But the Government's willingness to look at tax relief could indicate its desire for Telecom to stay in the Crown Fibre process, he said. "If the government does think 'Telecom are at least a credible bidder', which is a given, and 'we do think there is a sensible chance we choose them', which is probably also true, but there is this big hurdle around depreciation, you'd think naturally enough they would have a look at what they could possible do that's not too costly to help them out."