Financial Services Tax Breakfast Briefings

(1)

Nick Cronkshaw

Mark Sheiham

17 December 2014

Financial Services

Tax Breakfast

Briefings

Current Tax Issues on Debt

Funds and Shadow Banking

(2)

1 / B_LIVE_EMEA1:1842195v2

What we’re going to cover



Background - growth and role of debt funds in lending markets



Tax issues on establishing and structuring a debt fund



Tax drivers for choice of holding subsidiary for loan portfolios



Debt financing for debt funds – tax and other issues



Tax issues on management of debt portfolios

–

Direct tax

–

VAT

(3)

2 / B_LIVE_EMEA1:1842195v2

Commercial background

Growth and role of debt funds



Once upon a time….

–

Banking was done by banks



But now…..

–

Shrinking balance sheets

–

Increased regulatory capital requirements

–

Pressure to reduce risk

–

Reduced scope/increased targeting

–

Winding down non-core activities

–

Political pressures



Yet loans remain UK corporates’ main source of finance

–

Capital markets funding growing but still minority…..

–

Even more so in Europe

(4)

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Commercial background

Growth and role of debt funds



Enter the debt funds

–

Wider pools of capital

–

Scale increasing rapidly

–

Growing sophistication “mini banks”



Traditionally secondary market loan purchases

–

Still mainly secondary loan markets

(5)

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Commercial background

But not all bad news for the banks



Banks are major players in the debt fund world too

–

Financing

–

Equity investors

–

Advisors

–

Distribution

–

Hedge providers



Many banks creating own or sponsored debt funds



Handy way of getting loans off balance sheet but retaining some participation/upside



Loan financing from capital markets

–

Loan repackaging

–

Securitisation – making big recovery

(6)

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FUND LP

GP LP

GP Co.

Principals

Investors

Manager

Tax issues on establishing and structuring a debt fund

Basic Fund Structure

(7)

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Structuring: tax considerations



Need to take into account tax considerations at three levels:

–

tax position of investors

–

tax position of the Fund itself

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Tax position of investors



No additional tax liabilities that would not be suffered by investors were they to invest

directly in underlying



Cannot anticipate the tax profile of a particular investor



But consider the following general points:

–

Are investors subject to tax and is their tax liability greater than for a direct

investment?

–

Do the investors qualify for any specific tax regime, e.g. pension funds, insurance

companies or collective investment schemes?

–

Anti-avoidance rules in the investors’ home jurisdictions?

–

Level of tax reporting to allow investors to comply with their obligations?

–

Can distributions and redemption proceeds be paid to investors without WHT or other

taxes?

–

Transfer or registration taxes on dealing by investors in their interests in the Fund?

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Tax position of the Fund itself



Two basic models can be used:

–

structuring the Fund as a tax transparent entity

–

structuring the Fund as an effectively tax exempt entity

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Carry structuring?



Need to preserve capital treatment of returns



May therefore need additional vehicles and features, e.g. to avoid the UK

offshore fund rules



Need to use a tax transparent Fund entity



BUT direct lending activity may mean carry is a more difficult starting position



Autumn statement announced new proposed legislation to tax on income

Investment manager’s disguised fee income. A narrow definition of ‘carry’ and

‘consists’ is secluded from this.

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Tax Objectives (1) - BlockerCo Structure

LuxCo:



To access wide treaty network



Primarily debt funded with minimum equity

(unless a securitisation company – see below)

–

Loan notes/PPL/CPECs etc

–

Debt deductible for Luxembourg tax

purposes

–

Tax ruling

BlockerCo:



To ensure capital treatment for UK carry

holders/co-investors/investors

–

Track capital receipts and income

receipts

–

Fund in proportion to expected returns

Fund LP

(Cayman/Jersey LP)

BlockerCo

(Cayman/Jersey

company)

100%

Dividends

and/or share

buyback

Equity funding (Capital

Shares and Income

Shares)

Interest and return of

principal/dividends/share

buyback

100%

Primarily debt funding

_{(if sarl)/debt}

and equity funding (if

securitisation company)

LuxCo

(Luxembourg Sarl /

securitisation

company)

Assets

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11 / B_LIVE_EMEA1:1842195v2

Tax Objectives (2) - BlockerCo Structure



Tax treatment of returns for UK resident

individuals:

–

Capital profits chargeable to CGT at

28%

–

Income profits chargeable to income

tax at up to 45%

–

Remittance basis applies

–

Return of original base cost for

equity not taxable

–

Utilise base cost for carry holders to

the extent possible under the 'base

cost shift' principle

Fund LP

(Cayman/Jersey LP)

BlockerCo

(Cayman/Jersey

company)

100%

Dividends

and/or share

buyback

Equity funding (Capital

Shares and Income

Shares)

Interest and return of

principal/dividends/share

buyback

100%

Primarily debt funding

_{(if sarl)/debt}

and equity funding (if

securitisation company)

LuxCo

(Luxembourg Sarl /

securitisation

company)

Assets

(13)

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Tax Objectives (3) - Single LuxCo Structure



LuxCo funded with mixture of loan, convertible

loan and equity

–

Convertible used to avoid deeply

discounted security rules which would

tax capital profits as income

–

LuxCo applies for reporting fund status

under the offshore fund rules -

additional reporting/compliance

obligations

–

Capital receipts returned as return of

loan principal and redemption of

convertible loan at premium

–

Income receipts returned as interest on

the loan / dividends on equity

Fund LP

(Cayman/Jersey LP)

Loan principal

and interest/

redemption of

convertible

100%

Convertible debt

instrument/interest

bearing loan/equity

LuxCo

(Luxembourg Sarl /

securitisation

company)

Assets

(14)

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Tax Objectives (4) - Single LuxCo Structure



Tax treatment of returns for UK resident

individuals:

–

Return on loan principal tax free

–

Return on convertible in excess of original

base cost chargeable to CGT at 28%

–

Interest on loan and dividends chargeable

to income tax at up to 45%

–

Return of original base cost of equity tax

free

–

Annual reportable income chargeable to

income tax at up to 45%

–

Remittance basis applies

Fund LP

(Cayman/Jersey LP)

Loan principal

and interest/

redemption of

convertible

100%

Convertible debt

instrument/interest

bearing loan/equity

LuxCo

(Luxembourg Sarl /

securitisation

company)

Assets

(15)

14 / B_LIVE_EMEA1:1842195v2

Choice of holding subsidiary for debt portfolio



Structures facing borrowers very different to structures facing investors



Needs to be tailored for specific loan portfolio



Where are the Borrowers?



Performing or distressed?

(16)

15 / B_LIVE_EMEA1:1842195v2

Choice of holding subsidiary for debt portfolios

Withholding tax



Withholding tax is usually key issue (assuming loans carry interest)



For UK borrowers, treaty jurisdictions often used (eg Luxembourg)



Treaty clearance issues

–

UK WHT until treaty clearance available

–

Timing issues

–

Large numbers of borrowers

(17)

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Choice of holding subsidiary for debt portfolios

Direct tax position of debt holding vehicle



Treaty vehicles generally taxpaying – see fund structuring above

–

So need to extract income up to non-taxpaying entity

–

Often through back to back finance

–

Lux is popular as no outgoing WHT



Beneficial ownership / Indofoods issues



Beware “UK source” interest paid by treaty vehicle



Lux regulatory issues on loan origination

–

Material debt origination = Lux regulated “shadow banking”

–

Consider less regulated holding sub jurisdiction (eg Ireland, Malta or even

UK)

(18)

17 / B_LIVE_EMEA1:1842195v2

Choice of holding subsidiary for debt portfolio

UK securitisation companies



Receive interest free of UK WHT without need for treaty clearance



But must meet very detailed requirements = higher cost



Note issuing companies

–

Need to issue notes mainly to independent persons

–

Orphan the SPV?

–

£10m threshold

–

In practice notes usually need to be listed for UK WHT reasons



Warehouse company

–

Limited requirements while in warehouse

–

But must be for purpose of transfer to (or becoming) note issuing company



Normal holding structure for a UK loan securitisation

(19)

18 / B_LIVE_EMEA1:1842195v2

Choice of holding subsidiary for debt portfolio

Non-interest bearing (distressed) portfolios



Much easier – generally no WHT issues



Often use tax haven holding vehicle

(20)

19 / B_LIVE_EMEA1:1842195v2

Choice of holding subsidiary for debt portfolios

Non-UK loan portfolios



Need to consider on country by country basis based on borrower jurisdictions



Withholding tax issues in Borrower jurisdiction?



Stamp duty / transfer taxes in Borrower jurisdiction on purchase of loan portfolio?



VAT issues in Borrower jurisdiction?



Can owning loan portfolio create taxable presence in Borrower jurisdictions?

–

Usually not

–

But beware some very “sourced based” tax jurisdictions

(21)

20 / B_LIVE_EMEA1:1842195v2

Debt financing for debt funds



Introduction of senior debt within the structure from a bank or other financial

institution likely to give rise to requirements under Capital Requirements

Directive IV.



Fund likely to be required to hold 5% junior equity piece “skin the game”.

(22)

21 / B_LIVE_EMEA1:1842195v2

Potential Structure for CRD IV purposes

Sarl 1

1% equity

99% profit participating debt

Consolidated group

Sarl 2

99% fixed rate redeemable

preference shares

1% equity

Securitisation

vehicle

Junior

notes

Senior notes

Bank

(23)

22 / B_LIVE_EMEA1:1842195v2

Tax issues on management of debt portfolios

Direct tax



A lot in common with other fund types (eg hedge funds, private equity)



Tax residence

(24)

23 / B_LIVE_EMEA1:1842195v2

Tax issues on management of debt portfolios

Avoiding a UK taxable presence



Trading vs investment

–

No issue if investing

–

Much lower turnover rates than many fund asset classes

–

But correspondingly higher trading sensitivity due to reduced liquidity ?

–

Lack of hard and fast boundary

–

Generally play it safe



“Trading in the UK”

–

Are decisions taken / contract concluded in the UK?

–

Offshore manager, onshore adviser structures

–

Permanent establishment

(25)

24 / B_LIVE_EMEA1:1842195v2

Tax issues on management of debt portfolios

Avoiding a UK taxable presence



UK investment manager exemption

–

Conditions generally straight forward to satisfy

–

Many asset managers already very familiar

–

Debt assets generally qualify – also scope for origination

–

20% test

–

Arm’s length management fees

(26)

25 / B_LIVE_EMEA1:1842195v2

Tax issues on management of debt portfolios

VAT



Management of credit by the person who is not the original lender is subject to

standard rated VAT.



VAT group fund GP with the UK manager/adviser to mitigate UK VAT leakage



Third party servicing fees will be subject to VAT



Management/advisory services which comprise management of a “collective

investment undertaking” in Luxembourg are VAT exempt in Luxembourg.



If services are not VAT exempt in Luxembourg, consider using a recharge

structure to reclaim VAT.

(27)

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Risk management tools for our financial services tax clients

Real-time access to cross-border tax information

Proposed new navigator online subscription services

For sample content / further information, contact:

Nick Cronkshaw:

+44 20 7825 4289

Martin Shah:

+44 20 7825 4638

Candice Nichol:

+44 20 7825 4562

www.elexica.com/en/navigator/Tax

navigator: product tax

navigator: investment tax

For advisory teams

For investment teams

Covering investor-level tax

on common fund investments

Covering fund-level tax

on listed equities

Specific, practical and regularly updated information

Cost-efficient service available 24/7

Smarter

decision-making

by proactively

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tax risk

(28)

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Financial Services Tax Breakfast Briefings

Nick Cronkshaw

Mark Sheiham

17 December 2014

Financial Services

Tax Breakfast

Briefings

Current Tax Issues on Debt

Funds and Shadow Banking

1 / B_LIVE_EMEA1:1842195v2

What we’re going to cover



Background - growth and role of debt funds in lending markets



Tax issues on establishing and structuring a debt fund



Tax drivers for choice of holding subsidiary for loan portfolios



Debt financing for debt funds – tax and other issues



Tax issues on management of debt portfolios

–

Direct tax

–

VAT

2 / B_LIVE_EMEA1:1842195v2

Commercial background

Growth and role of debt funds



Once upon a time….

–

Banking was done by banks



But now…..

–

Shrinking balance sheets

–

Increased regulatory capital requirements

–

Pressure to reduce risk

–

Reduced scope/increased targeting

–

Winding down non-core activities

–

Political pressures



Yet loans remain UK corporates’ main source of finance

–

Capital markets funding growing but still minority…..

–

Even more so in Europe

3 / B_LIVE_EMEA1:1842195v2

Commercial background

Growth and role of debt funds



Enter the debt funds

–

Wider pools of capital

–

Scale increasing rapidly

–

Growing sophistication “mini banks”



Traditionally secondary market loan purchases

–

Still mainly secondary loan markets

4 / B_LIVE_EMEA1:1842195v2

Commercial background

But not all bad news for the banks



Banks are major players in the debt fund world too

–

Financing

–

Equity investors

–

Sponsors

–

Advisors