Financial Services Tax Breakfast Briefings Current Tax Issues on Debt Funds and Shadow Banking Nick Cronkshaw Mark Sheiham 17 December 2014
Introduction 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 1 / 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 Unlike the US where capital markets are dominant funding source 2 / 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 But now doing loan origination too.. 3 / 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 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 CDOs/CLOs still in the doldrums 4 / B_LIVE_EMEA1:1842195v2
Tax issues on establishing and structuring a debt fund Basic Fund Structure Principals GP Co. Investors GP LP Manager FUND LP 5 / B_LIVE_EMEA1:1842195v2
Structuring: tax considerations Need to take into account tax considerations at three levels: tax position of investors tax position of the Fund itself tax position of investments by the Fund 6 / B_LIVE_EMEA1:1842195v2
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? Tax filing and/or payment obligations in the jurisdiction of the Fund or its investments? 7 / B_LIVE_EMEA1:1842195v2
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 Management of the Fund s investments 8 / B_LIVE_EMEA1:1842195v2
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. 9 / B_LIVE_EMEA1:1842195v2
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 Dividends and/or share buyback Interest and return of principal/dividends/share buyback Fund LP (Cayman/Jersey LP) 100% BlockerCo (Cayman/Jersey company) 100% LuxCo (Luxembourg Sarl / securitisation company) Assets Equity funding (Capital Shares and Income Shares) Primarily debt funding (if sarl)/debt and equity funding (if securitisation company) 10 / 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 Dividends and/or share buyback Interest and return of principal/dividends/share buyback Fund LP (Cayman/Jersey LP) 100% BlockerCo (Cayman/Jersey company) 100% LuxCo (Luxembourg Sarl / securitisation company) Equity funding (Capital Shares and Income Shares) Primarily debt funding (if sarl)/debt and equity funding (if securitisation company) Assets 11 / B_LIVE_EMEA1:1842195v2
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 Loan principal and interest/ redemption of convertible Fund LP (Cayman/Jersey LP) 100% LuxCo (Luxembourg Sarl / securitisation company) Assets Convertible debt instrument/interest bearing loan/equity Income receipts returned as interest on the loan / dividends on equity 12 / B_LIVE_EMEA1:1842195v2
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 Loan principal and interest/ redemption of convertible Fund LP (Cayman/Jersey LP) 100% LuxCo (Luxembourg Sarl / securitisation company) Assets Convertible debt instrument/interest bearing loan/equity Annual reportable income chargeable to income tax at up to 45% Remittance basis applies 13 / 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? Distressed portfolios, debt may be charged off into non-interest bearing format 14 / 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 Single clearance to payment intermediary? 15 / B_LIVE_EMEA1:1842195v2
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) 16 / 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 Too complex for many debt funds 17 / 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 Can be funded with straight equity 18 / 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 Holding vehicle in treaty jurisdiction can help 19 / 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. Could give rise to additional tax leakage in the structure. 20 / B_LIVE_EMEA1:1842195v2
Potential Structure for CRD IV purposes 1% equity 99% profit participating debt 1% equity Sarl 1 Consolidated group 99% fixed rate redeemable preference shares Sarl 2 Junior notes Securitisation vehicle Bank Senior notes 21 / 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 Avoiding UK taxable presence 22 / 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 Income tax charge 23 / 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 Non-UK managers 24 / 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. 25 / B_LIVE_EMEA1:1842195v2
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