This fourth instalment of our five-part series examines some of the key tax considerations that arise in structuring and negotiating European back-leverage transactions. Referencing in particular the structural overview in Part One of this series (see here), this article summarises the tax profile of back-leverage transactions, highlights our experience of market practice including typical allocation of relevant tax risks, and considers the main tax protections.
Terminology can be confusing because the borrower (or repo seller) under the back-leverage is also the CRE lender. We have referred to the CRE lender for consistency, including in its capacity as borrower (or repo seller).
Overview
European back-leverage transactions typically involve a number of taxing jurisdictions, each of whose treatment of the transaction will need to be considered.
At the level of the back-leverage financing itself, the residence jurisdictions of the CRE lender (often Luxembourg) and of its finance counterparty (potentially, but not inevitably, a bank in a financial centre such as the UK or the US) will dictate whether the tax treatment of the arrangement follows its economic substance as a financing and how the various payment flows are characterised and taxed. The analysis may be more straightforward in a loan-on-loan structure and more involved in an arrangement structured using a repurchase agreement or a securitisation. At this level, the CRE lender will want to be clear that it can get a deduction for the finance expense on the back-leverage and that it will not be required to withhold on payments to the repo buyer.
At the asset level, the residence jurisdictions of the CRE borrowers will also be critical to the tax analysis. In a platform financing with a pool of loans across a variety of geographies this can require detailed input from local tax specialists.
The key issues at the asset level – interest (and, on occasion, fee and other) withholding taxes and relief procedures, beneficial ownership considerations, non-resident capital gains taxes and transfer taxes – have little to no harmonisation and different jurisdictions may treat the same arrangement differently. The governing documentation as negotiated for a particular deal will need to be interpreted to determine its true nature under local tax law. For example, the fact that under the New York law MRA the seller remains the legal lender of record, while under the English-law GMRA the buyer becomes the lender of record, may be significant to the tax outcome.
For the US funds that include some of the most significant players in the European back-leverage market, US tax will also be an important factor in structuring and negotiating the deal. Even where the CRE lender itself is a non-US entity, US tax rules can apply to the extent it is treated as a US person for US tax purposes (e.g., where the CRE lender is a disregarded entity for US tax purposes).
From the US perspective, care must be taken to confirm the financing arrangement does not constitute a “taxable mortgage pool” (TMP) for US tax purposes. As a TMP, US corporate tax would be imposed on the seller entity which could reduce available cash to service the back-leverage obligations.
In addition, in many cases the regarded US borrower is a real estate investment trust (REIT). While the practical effect of TMP treatment may differ for REITs and require additional assessment of negative tax consequences, such entities are required to make minimum distributions to shareholders and therefore often negotiate for added flexibility to upstream cash from the CRE lender.
Specific tax issues: Risk allocation, borrower protections, market dynamics
The New York law MRA generally incorporates a tailored version of the tax provisions from the US LSTA form of credit agreement. In contrast to the tax provisions in the English law GMRA, which focus on potential withholdings on the purchased securities, the standard MRA provisions focus quite exclusively on tax applicable to payments under the repo and are US-centric. Loan on loan documents in Europe are more likely to follow the LMA approach.
Given that any leakage at the asset level would reduce the borrower’s overcollateralisation and could result in margin being called, to the extent local withholding tax is (potentially) relevant the CRE lender may wish to include guardrails aimed at ensuring that asset-level taxes are mitigated. This may range from a basic general cooperation obligation to access reliefs and/or cooperate in obtaining refunds to, on occasion, more granular procedural and tax authority claim obligations and limits on transfers.
Risks identified at the structuring phase may also need to be allocated; under the MRA this may include negotiation of the definition of Excluded Taxes, which are carved out of the gross-up and indemnification obligations. UK withholding tax on deemed manufactured interest, Irish non-resident capital gains tax withholdings, Spanish transfer taxes and German non-resident corporate income tax on RE-secured financing income are relatively common examples.
Other risks may be relevant on a deal-by-deal basis and the risk allocation provisions will usually be hotly negotiated. Particular finance counterparties and their advisers may also have specific approaches (e.g., seeking an expanded suite of tax representations which will generally be unacceptable to the CRE lender) while past precedents may also be relevant.
Overall, although the diversity of legal forms and governing documentation mean that there is a lesser degree of standardisation of terms than is seen in some areas of the financial markets, in our experience a generally satisfactory market practice exists in terms of tax risk allocation in European back-leverage deals and can be achieved with timely input from local tax specialists where required.
Other articles in this series are set out here:
In the next and final article in this series we will explore our outlook for the CRE back-leverage market in Europe.
