Bank deleveraging in Ireland and Europe
This article was published in the July edition of the International Financial Law Review.
The difficult economic situation in Europe has increased the focus on bank deleveraging. In Ireland, this is just the latest phase in a process which has seen Irish banks dispose of significant non-core assets located outside Ireland throughout 2011 and 2012. In 2013, the focus will shift to Irish assets and, in particular, loan portfolios connected with Irish real estate. Frequently, these portfolios involve multiple privately-owned companies and investment structures with individuals participating as borrowers and guarantors.
The Irish tax system and the real estate focus of the loans means that Irish loan acquisition vehicles offer some distinct advantages over non-Irish vehicles. The vehicles of choice for loan portfolio acquisitions are either an Irish Qualifying Investor Fund (QIF) or a special purpose company qualifying under section 110 of the Irish Taxes Consolidation Act 1997 (referred to here as a section 110 company) or sometimes a combination of both.
Unless an exemption applies, Irish source interest is subject to 20% withholding tax. Typically, a bank will have included strong gross-up protection in the loan documentation. If it arises, however, such tax could represent a real cash flow cost to the borrower and ultimately damage the lender’s ability to maximise recovery.
All Irish borrowers can pay interest gross to section 110 companies and QIFs. A narrower exemption exists for payments to other EU member states and countries with which Ireland has a double tax treaty. Noncorporates (individuals and partnerships) must withhold tax from interest and certain guarantee payments unless a successful claim for double tax treaty relief can be made in advance. The administrative burden of such applications in situations involving multiple borrowers and guarantors is not attractive.
A non-Irish acquisition vehicle may need to ensure that it is not carrying on a trade in Ireland through a permanent establishment (the loan servicer/loan managers, for example) to avoid being subject to Irish tax on trading profits. This may limit the ability of the loan vehicle to have employees and staff in Ireland. As Irish resident entities, this is not a material concern for section 110 Companies or QIFs and can allow any loan servicer or agent greater latitude and flexibility in its operations.
Taking possession of Irish property is likely to involve significant engagement with Irish corporate entities. The emergent view is that this is best managed through an Irish loan acquisition vehicle which may act as a parent or sister company to the property vehicle.
Enforcement involving an acquisition or disposal of the Irish property will require careful implementation. Where enforcement occurs, the owner of the loan and/or the agent appointed to enforce (a receiver or manager) may be liable to account for Irish tax in respect of any rental income or capital gains realised in respect of the enforcement.
Post enforcement, the property may be held for a period of time. Ireland imposes tax on gains from the disposal of Irish land (or securities deriving their value from land). Typically Irish property is held by Irish resident companies including subsidiaries of section 110 companies and QIFs. Unlike other jurisdictions, such as the UK, there is unlikely to be a material capital gains tax advantage in holding Irish property through non-Irish resident entities.
Payments of rent to a non-resident are subject to withholding tax at 20% of the gross amount. These payments may be reclaimed from the Irish tax authorities following submission of a return relating to all Irish source income and deductions. No withholding tax arises on a payment of rent to an Irish resident, providing an immediate cash flow advantage.
One of the principal tax benefits that accrue to a section 110 company are that as interest can be deducted as a tax expense, the company can be structured in such a way that income and expenditure are equal and that only a nominal tax liability arises. This is achieved through the issue of a profit participating loan by the section 110 company. The interest on this loan can be tax deductible for the section 110 company provided a number of limited conditions are satisfied.
Ireland is one of the leading European jurisdictions for regulated investment funds (Ucits and non-Ucits). In a property context, unit trusts and companies represent the most usual form of QIF although each type of entity offers different features to suit managers and investors.
Structured properly, both vehicles allow the acquisition and holding of the loans with no Irish withholding tax on the interest payments, tax neutrality for the Irish vehicle and no withholding tax on payments out to the investors.