European Union: Podcast: Credit Funds: Withholding Tax On European Investments

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.

Transcript:

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:

  1. That the company is directed and managed in Jersey (broadly this corresponds to existing best practice)
  2. 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
  3. 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions