The final reports on the G20/OECD Base Erosion and Profit Shifting (BEPS) project were issued on 5 October (the "Reports") after a two-year consultation period during which 62 countries and many other stakeholders (such as the World Bank, the IMF, and many trade associations) participated. These Reports, split into 15 separate "Actions", represent a multilateral approach to common issues of concern in international taxation law and practice. They offer countries recommended tax measures to implement under domestic law so as to create a more uniform approach to these issues of concern; the recommendations on tax treaty abuse may be implemented by countries adhering to a "multilateral instrument" so as to avoid the wholesale modification and re-ratification of existing treaties.
Widespread implementation in domestic law of the Reports' recommendations has not yet begun, but the situation is in flux and tax developments are moving swiftly. Some countries have acted unilaterally and adopted BEPS-like proposals already, such as the UK's "diverted profits tax" (effective 1 April), while the European Union has introduced a "main purpose" test and an anti-hybrid element into its Parent/Subsidiary Directive. Since the Reports' publication, other countries have announced preferential tax regimes which they describe as compliant with them (such as Ireland's proposal for a "knowledge development box" on 13 October), while the UK on 22 October commenced public consultations on bringing its existing patent box into compliance with the Report on "harmful tax practices", and its company interest deduction regime into compliance with the Report on "limits to interest deductions." Because of differences in countries' approach to encouraging fund formation, securitisation, and capital markets and in their attitude to eroding the tax base of their neighbours, it can be expected that the Reports' recommendations of concern to the real estate fund industry will be adopted in a piecemeal fashion, and possibly not adopted at all in certain jurisdictions.
The purpose of this note is to explore the principal features of those Reports which are consequential for real estate funds and to offer sponsors recommendations for action.
Real estate investment funds take differing forms because of the variety in underlying assets (fee or leasehold in property; mortgages; development land or buildings vs. infrastructure or renewable energy; equity in a real estate business) and in the investor base (individual, pension fund, corporate, charitable endowment, insurance company, sovereign - whether resident or nonresident, taxable or tax-exempt). Most funds seek simply to avoid adding tax costs to the taxes that would be paid by fund investors if they had invested directly rather than via the fund; and indeed the stated purpose of REITs is to offer investors in a widely held vehicle similar tax results to those achieved by a limited number of investors participating in a special purpose partnership. Many countries accept this "neutrality principle" that funds should not give rise to a materially worse tax result for investors, compared with their direct investment in the underlying asset. Because much fund investment is directed at countries which are politically and legally stable, it can be expected that a positive amount of taxes will generally be paid on a cumulative basis; in short, real estate funds do not operate as tax havens for their investors.
Real estate investment funds range from unleveraged UCITS vehicles (including REITs) aimed at the retail market, to bespoke partnerships and trusts (e.g. JPUTs) often leveraged and offered to a limited number of sophisticated institutional investors. Mortgages can be held in securitisation vehicles that benefit from tax exemptions under their jurisdiction's laws and/or interest deductions on their extremely high leverage.
In view of this variety, the three Reports which are most likely to affect the real estate fund industry are: "Preventing the Granting of Treaty Benefits in Inappropriate Circumstances" (Action 6); "Neutralising the Effects of Hybrid Mismatch Arrangements" (Action 2); and "Limiting Base Erosion Involving Interest Deductions and Other Financial Payments" (Action 4).
Action 6 - Tax Treaties
Regarding double tax treaties, many funds establish the fund vehicle in a country where it can benefit from a treaty with the country of operation (source) so that the investment's profits or the return on debt is paid without source country withholding tax. The Action 6 Report demands that such a vehicle's entitlement to treaty benefits depends on its satisfying certain minimum factors, such as being publicly listed or demonstrating that a proportion of its owners reside in the vehicle's state of organisation under the "limitation on benefits" rule - or alternatively on its establishing bona fides under a "principle purpose test."
This Report, however, agrees with source countries granting treaty benefits to certain "mainstream" funds irrespective of their listing or residence of their ultimate owners. Thus, if funds are "widely held, hold a diversified portfolio of securities and are subject to investor-protection regulation in the country in which they are established" ("CIV Funds"), they are entitled to treaty benefits in their own name. This category is considered to include UCITS funds and diversified/widely held "funds of funds."
Other funds, such as most private equity, hedge funds, real estate and infrastructure funds, and mortgage CLOs/securitisations will need to satisfy the new treaty limitations described above, on the theory that these non-CIVs are often used by investors specifically to obtain treaty benefits that would not be available in a direct investment. This may cause material difficulties for many funds, particularly of smaller size. The Report does recognise that, if a non-CIV Fund is considered fiscally transparent by the source country, treaty benefits will often be granted to those investors who qualify in their own right and provide sufficient documentation. The treatment of blocker subsidiaries owned by funds is unclear.
The Report reserves for further work the entitlement of REITs to treaty benefits on their receipts.
Action 2 - Hybrid Mismatches as to Payment Made to Related Persons
Regarding hybrid mismatches, some sponsors introduce debt instruments into the capital structure of fund vehicles or SPVs which have a different tax character in the hands of the holder(s). This is often done to mitigate entity level taxation (by means of an interest deduction), combined with a deferral or exemption of income in the hands of the holder(s). An example is the issuance by a Luxembourg company of "participating equity certificates" (PECs) to related U.S. investors, which are treated as debt by the Luxembourg company (whose interest expense is deductible on accrual) and preferred equity by the investors (who are taxable generally only upon receipt of payment).
The Action 2 Report encourages countries to counteract this mismatch on hybrid securities held by related persons by denying the payors a deduction for interest. If that does not incur, the payee jurisdiction is encouraged to force holders to take the income into account currently.
REITs and other entities which provide for a deduction for dividend payments are not considered to generate hybrid payments for the purposes of these rules, and highly leveraged investment vehicles that are "subject to special regulation and tax treatment under the laws of the establishment jurisdiction" fall outside their scope in certain circumstances (i.e, when the investors can be expected to take the yield into account currently).
This Report also addresses "hybrid entities," which are fairly common in real estate fund structures, and "hybrid transfers" (such as repos over securities).
Action 4 - Interest Deductions
The core recommendation of the Report on Interest Deductions is to limit the deduction of net interest expense by a member of a multinational group (payable to any party) to a fixed percentage of that member's EBITDA, within a range of 10% to 30%. If the group of which the entity is a member has a higher ratio of net interest/EBITDA on its debt owed to third parties, the entity may deduct its net interest expense up to this higher ratio. To address earnings volatility, the Report offers the option of carrying forward or back disallowed interest (or interest capacity).
Depending on the eventual definitions, the ability of an entity to access a higher ratio of third party debt employed by its group may not benefit real estate funds in practice. Also, while the application of these rules to banks and insurance companies has been reserved, no exemptions are made for real estate debt issuers or debt-issuing securitisation vehicles (which is surprising in that their high leverage often depends primarily on the high quality of their assets rather than tax considerations).
While Germany and the United States already have implemented EBITDA-based limitations, other jurisdictions such as the UK, Ireland, Luxembourg and the Netherlands would undergo a significant transition damaging to their real estate investment industry were they to adopt the Action 4 Report's recommendations. If implemented, these proposals would be critical for real estate and infrastructure funds seeking to deduct interest expense on related-party debt (such as shareholder loans), and also for traditional leveraged buyout funds used to acquire real estate businesses.
Because of the frequency of payments to related (and often nonresident) parties in the fund management industry, the Report on transfer pricing documentation and reporting (Action 13) is highly relevant to sponsors.
Preferential regimes or vehicles relating to real estate were not considered in connection with the investigation into harmful tax practices (Action 5).
Recommendations for action
The real estate investment fund industry would be turned on its head if all the jurisdictions which favour it (e.g., the Netherlands, Luxembourg, Ireland, Jersey) were immediately to adopt all of the recommendations described above. We anticipate that many of these jurisdictions will seek to defer implementing, or fail to implement, the most damaging of these recommendations. Nevertheless, pending countries' decisions on implementation, sponsors need guidance on what to do.
We recommend that sponsors continue to form funds in the most tax-efficient way under the current laws and treaties. Jurisdictions that hitherto have been hospitable to fund formation are unlikely to be early adopters, and it is better to form a fund with the knowledge that it may need to be amended, that not to form one at all.
However, because the tax environment can change swiftly, the sponsor should ensure that the fund documentation gives it maximum discretion to restructure the fund in the event of changes to the laws or treaty provisions governing the material elements underlying the intended tax results. This contractual power to amend would be similar to the redemption power of a corporate issuer of bonds if a subsequent law change leads to a gross up obligation, but would also embrace changes in the relevant tax laws or treaties of any jurisdiction used by the fund vehicle or any SPV. While investors may not enjoy participating in a restructuring of an investment vehicle, or possibly even the redemption of their ownership interests, they may prefer that possibility to the risk of owning an illiquid investment in a fund suffering unanticipated taxes.
Second, a sponsor must understand thoroughly the technical underpinnings of its fund's tax planning so that it can decide quickly in response to a tax law or treaty change whether the fund needs to be restructured, and if so, whether in whole or part. Thus, we recommend that a sponsor allocate a budget to commissioning a tax report from its advisor which explains each element of the tax planning throughout the structure in light of the recommendations in the Reports.
Such a tax report will highlight those elements of a fund structure which are vulnerable under BEPS, but should also concentrate thinking about standard structural elements and any alternatives that may be available. For example, what may appear at first sight to be a financial instrument generating a hybrid mismatch may be nothing of the kind. While Luxembourg companies often issue PECs to related persons to obtain interest deductions (which may give rise to a vulnerable hybrid mismatch), sometimes they do it solely to reduce withholding tax (which does not appear to do so); and it is critical for a sponsor to understand the principal purpose which are served by any hybrid securities (or entities) in its fund structure.
Similarly, an operating company may rely on a treaty to pay dividends to a non-CIV fund vehicle without withholding tax, which treaty benefit may be eliminated by a BEPS amendment (perhaps by the multilateral instrument). It is obviously important for a sponsor to know whether alternative methods of mitigating withholding tax are available absent the treaty (such as under the EU Parent/Subsidiary Directive or a provision of the domestic law of the operating company's country).
Third, in order to react as quickly as possible, we recommend that a sponsor either commission a tax advisor to maintain a watching brief on changes to the tax laws and treaties of the relevant jurisdiction(s), or do so itself.
Sponsors and their advisors cannot ignore the influence of BEPS, which has been called the most radical reinterpretation of international tax norms for nearly one hundred years. But real estate funds must be formed while we await the reactions of countries to the BEPS recommendations. The best course is to continue to form funds under the current laws and treaties; to insist on maximum flexibility in the documentation in case the structure needs to be modified; to understand thoroughly the technical underpinnings of each element of the tax planning; and to maintain a watching brief on changes to tax laws and treaties relevant to the structure.