14/12/2016

Closing the tax loop: BEPS and aviation

Closing the tax loop: BEPS and aviation

In the years following the financial crisis, cash-strapped governments have become increasingly concerned that their tax bases have been undermined by out of date tax laws that are easily exploited by international companies.

In 2013, the governments of the G20 and the Organisation of Economic Co-operation and Development (OECD) launched the Base Erosion and Profit Shifting (BEPS) project to improve the international tax rules, currently existing under the OECD’s Model Tax Convention, and to drive out aggressive tax planning. Most aviation firms are multinational operations and airlines, leasing companies and airframe manufacturers will all be affected.

Two years later, the OECD has delivered reports on each element of the 15-point BEPS Action Plan, which is now in its implementation phase, four of which concern aviation directly.

“If you can summarise all the action points in to one sentence, it is about trying to tax companies in accordance with where the people who generate value actually are,” says Matthew Hodkin, a partner at Norton Rose Fulbright.  “It’s mainly a question of substance.”

The Ishka View is that the most consequential points for international lessors are actions six and seven, which aim to prevent treaty abuse and changes the rules regarding Permanent Establishment (PE) tax status.  Airlines on the other hand will be concerned with actions four and 13 which cap interest deductions from taxable profits and requires greater transparency on tax reporting. The overall effect is likely to increase the tax burden on airline and lessors by removing the most egregious types of corporate tax planning.

 

Action 4: Interest deduction changes harm the highly leveraged

 

Rule changes to interest deductibility will discriminate against highly leveraged industries such as aviation and is possibly the most important action for airlines and lessors.  Many OECD countries allow companies to deduct the interest expense on their debts when calculating their taxable business profit. However, some multinationals have used excessive interest deductions to lower their tax burden. For instance, groups can relocate debt in high-tax jurisdictions, via intergroup loans and third-party debt.   This is one of the oldest methods of efficient tax planning available.

“Lessors arbitrage the jurisdictions that give the best regime for deducting interest expense and some jurisdictions work very hard to aggressively attract aircraft leasing businesses,” says Andrew Charlton, managing director of Aviation Advocacy.  “Zug in Switzerland is a case in point.”

The action aims to tackle this by restricting deductions that exceed a certain ratio. Based on the recommendations, this is likely to be between 10% and 30% of EBITDA (earnings before interest, tax, depreciation and amortization). “This could be a big factor for airlines because they are very capital intensive businesses, and it will have a knock-on effect for their overall tax rate,” says Hodkin. Some airlines may issue profit warnings.

It will also be a major concern for lessors.  As the chart below indicates, five of the largest public lessors have tax deductible interest expenses that fall within the ratios proposed by the OECD.  “It will absolutely affect the tax profile of leasing companies,” says Tom Woods a partner at KPMG and head of aviation finance and leasing.  If you look at even the conservatively leveraged public lessors, they would probably breach 30% of EDITA. It will bite.”

The rules are not just restricted to capital costs, but also include the finance costs of finance leases, derivatives and hedging instruments, and foreign exchange losses and gains on borrowings. Many of which are used by airlines and lessors.

Though the results will be uneven because implementation is not mandatory. Despite this the UK government has accepted the OECD’s recommendations and is planning to incorporate it in a 2017 finance bill. And the EU has introduced its anti-tax evasion directive that incorporates action four.

 

Action 7: Closes loophole on Permanent Establishment status

 

Action seven lowers the threshold for the creation of a taxable presence in another country. Article 5 of the OECD Model Tax Convention includes the definition of permanent establishment, which is primarily used for the allocation of taxing rights when a business of one state derives business profits from another country.  But action seven of the BEPS proposals aims to close loopholes that allow companies to avoid PE, and therefore taxable, status by using intermediaries to negotiate contracts abroad. 

“Travel is a very common feature of the way the leasing business is done, and regardless of where you are based you are going to run into this issue.  It’s going to reduce the operational freedom of leasing companies. I am not sure there are any winners from this,” says Woods.

Under current rules, intermediary agents operating in another country must have a taxable PE in that country if their activities are intended to result in the regular conclusion of contracts and they have the authority to do so.

Lessors have previously relied upon making sure that relevant employees who work in other countries do not have the authority to conclude contracts. But this may no longer be enough.  Under the BEPS proposals, the conditions for PE are met when an agent: “habitually concludes contracts or habitually plays the principle role leading to the conclusion of contacts.”

This significantly lowers the bar for the creation on PE status and could result in the creation of multiple PE jurisdictions per company and therefore an increased tax burden. Woods argues that this would inevitably be reflected in a rise in effective rates.

“Action seven is a major major concern for this industry.  At the very extreme you could end up with leasing companies having a taxable presence in all the countries that they have customers. That would be a phenomenal change in the complexity of the organisation and the administration required by lessors.”

It would also result in leasing companies conducting their businesses in a very different way, perhaps using intermediaries for multiple jurisdictions, to manage that risk to avoid creating a taxable presence or keeping it to a minimal if necessary.
 

Action 6: lessors lose double taxation privileges

 

Companies often exploit treaty clauses that aim to prevent double taxation in two jurisdictions.  In the context of aircraft leasing, withholding taxes can arise at the source of the lease and can be reduced if the lessor has a tax presence in a country with a double taxation agreement (DTA). The result is the use of a jurisdiction purely for its DTA benefits.

The proposals under action six include a limitation of benefits (LOB) clause in the model tax treaty that would remove access to treaty benefits for non-owner lessors and low-substance lessors (i.e. those with little practical purpose aside from reducing tax).

Costs will depend on the jurisdiction says Hodkin. “The UK, for example, does not levy withholding taxes on lease rentals, and by and large, if you borrow from a decent jurisdiction that has a DTA with the UK, you are not going to pay. But there are a lot of Asian  countries, for example, so typical financing routes for those jurisdictions might become harder to use in future.”

Intermediate lessors and special purpose vehicles used by lessors are likely to come under fire and be denied DTA benefits. 
 

Action 13: ISTAT seeks exemption from Country-by-country (CbC) reporting

 

Of particular concern to international airlines is action 13, which recommends a three-pronged reporting regime for multinational firms to provide foreign governments a clear picture of their tax arrangements and transfer pricing i.e. the cost of intra-group lending.  Airlines must produce a master file showing their global operations, a local file for related party transactions and a CbC report. 

IATA has kicked up a fuss on action 13, and has requested an industry exemption. It argues that the cost of compliance will be too high for an industry with traditionally low margins. Historically aviation and shipping have often been treated differently for tax purposes in international treaties.  As Charlton points out: “Fuel used on international flights is tax free. And that’s just an accident under the 1944 Chicago Convention, it seemed like a good idea at the time, but perhaps airlines would prefer not to draw attention to it.”  Though it seems unlikely that IATA will be successful in this instance.

“Most airlines organise themselves so they only pay tax in their home jurisdiction, so the country-by-country requirement will be a burden that probably won’t reveal much.  People will be surprised how little is taxed in different jurisdictions, but personally I don’t think that it’s a reason for an opt-out.”

The action is to be implemented on a CbC basis through domestic legislation and will apply to companies with revenue in excess of €750 million.

 

The Ishka View

 

The BEPS proposals have been formulated and published in record time. Bilateral tax treaties alone can take years to complete.  Each company affected must respond as they see fit.  And while the changes will bring some certainty to companies operating out of multiple jurisdictions, inconsistencies in implementation will still need to be navigated. Full visibility will emerge in mid-2017 when around 80 countries sign the multilateral instrument.  However,  the increased cost burden for airlines and lessors is unambiguous. Large and highly leveraged lessors will be able to deduct less of their interest expense from their tax bill, while changes to permanent establishment rules could result in lessors having a taxable presence in multiple jurisdictions.  Airlines will have to pay for increased compliance costs on account of the country-by-country tax disclosure requirements. And lessors will have a limitation of benefits clause imposed on them with regard to double taxation agreements.

 

 

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