In this podcast, Brenda Coleman and Andy Howard discuss strategies for credit fund managers to address interest withholding tax issues on European investments in light of a complex and changing landscape. With new rules being introduced in line with the OECD’s BEPS (Base Erosion and Profit Shifting) Project and with treaty shopping being re-examined under BEPS, credit fund managers may be uncertain of how they should deal with withholding taxes on European investments. This podcast provides an overview of the current tax rules, the changing landscape and the actions credit fund managers may consider taking.
Andy Douglas: Hello, and thank for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts aimed at credit funds. I’m Andy Douglas, an associate in the tax and benefits group. Joining me are Brenda Coleman and Andy Howard, partners in the tax group in London. We’re going to be talking about how to deal with withholding tax on European investments. Withholding tax has long been the most significant local tax issue on European lending transactions. Withholding issues are often more difficult to navigate for credit funds than for financial institutions. Recent changes have cast some shadows on some of the strategies adopted by many credit funds by introducing an element of uncertainty. However, there are also some helpful developments in jurisdictions such as the UK. Brenda, let’s start with you. Why do you think withholding tax is such a big issue?
Brenda Coleman: For credit funds to be competitive, it is vital so far as possible, their returns incur only a single level of taxation in the hands of investors. The underlying borrowers don’t want to be concerned with withholding tax source and the ultimate investors don’t want to be in a worse position than if they had lent the money directly. It is therefore important that credit funds are able to lend money without incurring withholding tax on the interest they receive. Withholding tax is particularly problematic in the context of many credit fund structures as it will be difficult for investors to obtain credit for tax withheld within the structure.
Andy Douglas: And turning to you, Andy, is withholding tax an issue on all European investments?
Andy Howard: Major European jurisdictions are split between those that impose withholding tax on interest, such as the UK, Spain, Ireland and Italy, and those that either do not impose withholding tax on interest, or impose it only in very limited circumstances, such as France, Germany, the Netherlands and Luxembourg. Those jurisdiction that do impose withholding tax tend to have a range of available exemptions, meaning that it is typically possible to ensure that transactions are structured to be free from withholding. However, a number of exemptions are specific to financial institutions or capital markets transactions, and so arguably haven’t caught up with the realities of the current diversified lending market. This can make operating on a level playing field more challenging for credit funds as they need to rely on alternative exemptions. The relevant tax rules and their interpretation are currently undergoing a significant period of change, so it is crucial to be up to date with the latest jurisdiction-specific advice.
Andy Douglas: How have credit funds traditionally addressed this issue?
Brenda Coleman: I’ll take this one. It’s common for credit funds to establish an investment vehicle in Luxembourg or Ireland. Many European jurisdictions grant exemption from withholding tax for debt held by residents of other European jurisdictions, either through a domestic exemption or under the terms of a double tax treaty agreed with the relevant jurisdiction. Such vehicles are typically subject to tax in Luxembourg or Ireland, but are financed by the fund in such a way that the taxable profit in the relevant jurisdiction is acceptably low. It’s worth remembering, of course, that the local tax and regulatory analysis can be quite complicated and it’s usually a good idea to involve local counsel in transactions.
Andy Douglas: Andy, you mentioned the changing rules. What’s changing?
Andy Howard: Irish and Luxembourg investment vehicles are potentially affected by rules which are beginning to be introduced in line with the OECD’s BEPS (Base Erosion and Profit Shifting) Project.
There are already longstanding rules aimed at preventing treaty shopping. However, as a general rule, credit funds have become comfortable that the way in which the investment vehicles described above are established means that they should not fall foul of these rules. This is particularly the case for vehicles which are making multiple loans, often to multiple jurisdictions, including jurisdictions which do not impose withholding tax. However, the BEPS Project has re-examined the question of treaty shopping, and what ultimately became clear was that there was no consensus among the jurisdictions involved. Effectively a fudge position was found, which for most European jurisdictions involves the amendment of existing treaties to include a “principal purpose test”, or PPT as it has affectionately become known, which prevents treaty benefits applying where one of the principal purposes of the transaction or arrangement is to obtain such treaty benefits. Treaty amendments including this change are beginning to take effect.
The updated commentary to the OECD model convention now includes three examples, which are relevant to the application of the PPT, to what are known as “non-CIV” funds, and this will include most private equity-style credit funds. Unfortunately, these examples leave considerable scope for interpretation. On some readings they are very helpful, but on the more extreme interpretations they could be used to deny withholding tax exemption for some Luxembourg and Irish vehicles.
Andy Douglas: Many credit funds have been at pains to ensure that they have good “substance” in their vehicles. So how does that fit into the picture and what does it mean?
Brenda Coleman: The relevance of substance can be found in one of the OECD examples that Andy’s just mentioned. It also pre-dates that example in that this is a concept which tax authorities have tended to focus on in this area. The example given by the OECD (as example K in paragraph 182 of the commentary on Article 29) for those who want to look at it in detail, is not directly on point for credit funds as it describes an equity investment structure. The example also describes a fund which is resident for treaty purposes, so not a typical credit- or private equity-style partnership vehicle. Nonetheless, by analogy it can be used to support an argument that an investment holding company with sufficient substance and non-tax rationale will pass the principal purpose test.
There’s no real consensus as to what substance means. Anything which goes beyond the traditional minimum of ensuring that the vehicle has board decisions taken locally, including a majority of suitably experienced local directors, can be described as bolstering substance. Example K itself talks about employing “an experienced local management team to review investment recommendations from the fund and performs various other function such as treasury functions.”
Andy Howard: I completely agree with you, Brenda, that it’s pretty difficult still to work out what substance actually means. I wonder if there’s a clue though in the recent development where Jersey and some other territories have introduced a legal substance requirement into their tax law. Jersey’s consultation referenced a scoping paper by the EU, and that in turn referenced guidance by the OECD. So perhaps all together this gives some clues as to what the powers that be may be thinking of in terms of substance. Under Jersey’s rules, substance has three elements—companies are required to demonstrate:
- That the company is directed and managed in Jersey (broadly this corresponds to existing best practice)
- That “Core Income Generating Activities” are carried on in Jersey (and they’re carried on either by the company or by a third-party service provider); and
- That there are adequate employees, expenditure and premises in Jersey proportionate to the activity of the company.
For financing companies, the core income generating activities include agreeing funding terms, monitoring and revising agreements and managing risk. In my experience, it is not necessarily the case that credit fund vehicles will be able to demonstrate that they carry on these activities locally. So although this is an interesting side bar, in my view, in the treaty context, I think to apply the same test would be to set an unduly high bar for substance. It would be going too far to say that you don’t have acceptable substance for treaty purpose unless you carry on all of the relevant activities relating to the lending transaction locally.
Andy Douglas: So provided a credit fund has good local substance, it doesn’t need to worry?
Brenda Coleman: The reality is that it remains to be seen how individual tax authorities will interpret the PPT. It’s anticipated that some jurisdictions, particularly Italy and Spain, will take a very restrictive approach based on arguments already made by the tax authorities there. They may well look to another OECD example and look to see if the ultimate investors in the fund are treaty eligible. The examples are wide enough to support a variety of approaches. Disappointedly, some jurisdictions have even indicated that the OECD examples are too restrictive.
Andy Douglas: So how alarmed should credit fund managers be?
Brenda Coleman: It remains to be seen how aggressive tax authorities will seek to be beyond their current changes, but uncertainty is never welcome in tax matters.
Andy Douglas: Will the gross-up clause help if the storm does blow up?
Andy Howard: The general principle that borrowers take change of law risk on withholding tax remains the norm in the European market, so under most normal market documentation if unexpected withholding does blow up, a gross-up can be expected. However, lenders could face an argument in some cases that the imposition of withholding tax is actually the result of the proper application of the existing law and not as a result of a change of law. In addition, some borrowers have been able to negotiate a better position, for example, excluding forthcoming changes, such as the introduction of the PPT, from counting as a change in law.
Setting all of that aside, even if a gross-up is payable, it should be remembered that claiming under a gross-up will typically allow a borrower to replace or prepay the lender and so that might not be a good outcome for the lender in any case.
Andy Douglas: So what impact are these changes having on negotiations between fund managers and their investors?
Brenda Coleman: Investors are now much more concerned about the risk of underlying withholding tax. They may be asking managers to diligence the withholding tax position before making investments—they may be asking questions around substance. Investors in treaty jurisdictions may be concerned to ensure that if a withholding tax arises because other investors do not have treaty access, any withholding is allocated away from them. Large treaty investors may even ask for the right to come through a separate AIV. Indemnities given by investors are also being reviewed more closely, particularly by non-treaty investors who do not wish to be liable if they cause any underlying withholding. The impact of withholding on carry is also the subject of negotiation.
Andy Douglas: So what alternatives are there to deal with this issue of withholding tax?
Andy Howard: Although Luxembourg or Irish vehicles will be effective in many jurisdictions, it’s already the case that it’s unlikely to work everywhere. For example, in Italy it may be necessary for the loan to be advanced by a regulated entity to qualify for exemption. In jurisdictions where it has been typical to rely on the vehicle’s treaty status, it may be worth considering alternatives. For example, in the UK an interesting recent development is the introduction of what’s called the “qualifying private placement exemption.” This is a new UK domestic exemption which doesn’t rely on the interest article of the relevant double tax treaty, which is therefore subject to the PPT, but, where the other conditions are satisfied, it only requires the lender to be resident in a jurisdiction having a double tax treaty with the UK, even if that treaty doesn’t otherwise give a withholding tax exemption. In many situations, this expands the universe of lenders that can lend free of UK withholding tax.
Rather surprisingly, following the recent entry into force of a new treaty between the UK and Jersey, this should now include Jersey tax resident companies, even where they’re not subject to Jersey tax on their income, or rather they are subject to Jersey tax at zero percent. So far, we haven’t seen Jersey lending vehicles in practice and there will be local tax and regulatory considerations to take into account, but this is a pretty interesting new alternative to see actually a relaxation of the circumstances in which holding tax will apply.
Brenda Coleman: Yes, very interesting. There is currently no indication of the UK hardening its stance on Luxembourg and Irish vehicles, but it’s very reassuring that this alternative exists should the UK choose to harden its approach, or be forced by international consensus to do so. It will, however, be necessary for any Jersey company to comply with the new local substance requirements, which Andy mentioned earlier. As an aside, similar rules on substance have quietly been introduced in a number of zero tax jurisdictions and we may start to see them having an impact on offshore companies shortly. Other jurisdictions which take a hard line on treaty shopping may ultimately consider a targeted new exemption rather than risk damaging the lending market in their jurisdiction by failing to offer a way for credit funds to access the market without withholding.
Andy Howard: It should also be noted that some funds, for example U.S. RICs, may qualify for withholding tax exemption in their own rights and so may be able to lend directly or via transparent vehicles deriving their good treaty status from the fund.
Andy Douglas: Are there any other concerns coming out of the OECD’s BEPS Project?
Andy Howard: Yes, I’m afraid so. The ability to reduce tax leakage in the vehicle to a commercially acceptable amount could be curtailed by other BEPS initiatives, particularly where the vehicle elects to be disregarded for U.S. tax purposes or is funded by hybrid securities such as CPECs, which may cause deductions to be denied under new anti-hybrid legislation. Restrictions under corporate interest restriction rules may also apply if the loans are acquired at a discount or have equity-like features. EU member states are required to adopt these and certain other BEPS rules under the ATAD and ATAD 2 Directives. Investors are starting to ask about the impact of these developments on investment vehicles and how much tax is likely to be payable locally.
Andy Douglas: That sounds like a fairly uncertain picture. What are you seeing credit funds do in practice?
Brenda Coleman: For established fund managers, keep calm and carry on is the message. Many funds continue to use their Luxembourg and Irish platforms, although in many cases are taking steps to bolster the activity taking place locally. It will continue to be crucial to get up to date local advice for new deals as ultimately the application of withholding tax is a matter for the borrower jurisdiction and the approach of a tax authority could change fast. However, first-time funds with no presence in Luxembourg or Ireland may need to think carefully about the cost implications before setting up a Luxembourg or Irish platform.
Andy Howard: Thanks Brenda, I agree. We’re also aware of several managers who are currently reviewing their existing structures together with local counsel to see how they’re impacted by the recent introduction of the interest restriction rules I mentioned just now and the forthcoming introduction of anti-hybrid rules in both Ireland and Luxembourg.
Andy Douglas: So one final question. Do you expect Brexit to change the picture?
Brenda Coleman: No, not for UK investments. For UK investments, it’s typical to rely on relief under double tax treaties with the relevant vehicles. These are not expected to be affected by any form of Brexit. There many be an issue around accessing the Luxembourg-U.S. double tax treaty if there are significant UK investors in the fund which will no longer be an EU resident and that which should be investigated.
Andy Douglas: Well, this is very interesting, but unfortunately that’s all the time we have for today. Brenda and Andy, I want to thank you for sharing these insights. For more information, please visit our website at www.ropesgray.com. Stay tuned throughout the coming months for more podcasts on topics of interest related to credit funds. And of course, if we can help you navigate any of these challenges, please do not hesitate to get in touch. Thanks for listening.
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