Navigating the tax landscape through lessor distress Navigating the tax landscape through lessor distress Navigating the tax landscape through lessor distress

At the outset of 2020 the aviation sector was enjoying an unprecedented period of growth. In aviation finance, the capital markets were buoyant with demand for asset backed securitisation (ABS) issued debt and unsecured debt issued by lessors. And while the market remained ultracompetitive, the outlook was broadly positive as demand for aircraft across most asset classes was high, writes Joe O'Mara, Head of Aviation Finance.

Covid-19 has changed this landscape beyond recognition and its impact is more acute and sudden than the previous two cyclical downturns the sector has faced, after 9/11 and the global financial crash (GFC). Airline distress has been severe and on a global basis. This has impacted on lessors, who in the first instance dealt with wide scale rent deferrals but who are now dealing with airline failures and more complicated lease restructuring. 

Pre-Covid, there was a general expectation that after a relatively quiet period for M&A, lessor consolidation could increase in the hope that scale would bolster returns in the competitive landscape. Post-Covid, given expected liquidity pressures and likely impairments, the question is whether this new environment will lead to opportunistic acquisitions or if it could lead some lessors, like their airline customers, into formal debt restructuring processes. 

We wanted to explore the key tax issues that can arise on a formal restructuring for a leasing group, drawing on the practical recent experience of having advised on the Waypoint Leasing bankruptcy process. With over 160 aircraft on its balance sheet, Waypoint was the largest independent helicopter lessor prior to its filing for Chapter 11 in the US in 2018. 

While the commercial drivers that led to that process are different to those facing fixed wing lessors now, the same structural issues that arose as part of that unwind will have relevance for most other leasing groups in distress.

Particularly given the cross-border nature of aircraft leasing, tax is a key factor in determining the optimum structure for an aircraft leasing group. Generally, this has involved an Irish based platform leasing to airlines across the globe, with capital being invested from outside of Ireland. In considering the most efficient tax structure for this type of group, it is important to consider taxation at three levels (see diagram below):

1. At the investor and funding level, consideration needs to be given to the ability to manage withholding tax on payments of dividend and interest and (for investors) to minimise tax on an exit event.  
2. At the platform level, the employees generally sit in an operating company with the assets held separately underneath in aircraft owning special purpose vehicles (SPVs). At this level, issues will include the tax rate applicable on group profits, the tax deductibility of interest payments and the availability of tax depreciation to defer cash tax payments.
3. At the lessee level, the key tax issues are the management of international withholding taxes on lease rentals and the application of transfer taxes to the sale and purchase of aircraft. This is an area that has become more complex in recent years, as global changes to double tax treaties placed more focus on substance and structure of aircraft lessors. 

Given the importance of tax on the establishment and ongoing operation of a leasing group, tax also needs to be carefully considered when restructuring or unwinding an aircraft leasing business so as not to trigger adverse tax implications and adversely impact stakeholder returns.  

The graphic illustrating a typical aircraft leasing group is simplified for illustrative purposes. Depending on the size and scale of the group, it will likely include numerous holding companies, financing companies, foreign subsidiaries and a multitude of asset owning SPVs. It will also have a myriad of external and intragroup funding, including both unsecured and secured debt, which may or may not be placed directly with the asset owning SPVs. 

A typical lessor group will evolve and grow organically over time and the legal complexity of a medium/large group will generally be relieved to some degree by the flexibility that comes when transacting within a 100% corporate group. However, in the event of a formal restructuring, the flexibility previously available within a corporate group may disappear as lenders lock down their claim on secured assets. 

As a result, the operational complexity of a large leasing group can mean that navigating the rigid framework of a bankruptcy or debt restructuring process (such as the US Chapter 11 process or Irish/UK scheme of arrangement) can give rise to some significant tax challenges. 

Below we have set out the key tax issues arising from lessor distress and formal debt restructuring. While references below are primarily in respect of a bankruptcy process (e.g. a US Chapter 11 filing), the same issues will be relevant for other forms of debt restructuring (such as an Irish/UK scheme of arrangement). 

The process will likely involve the lessor company (or “debtor”) being granted a freeze on its obligations to creditors. From a tax perspective, the following needs to be considered:

• Internal debt and other intragroup arrangements may be frozen along with repayment obligations to third party creditors. It is not uncommon for leasing groups to have internal debt structures and the freezing of obligations (i.e. which could include the non-accrual of interest) can result in potential cash tax exposures. This can be particularly true where the group has utilised Irish Section 110 companies to hold assets. 
• Group companies may be prevented from settling payments between one another. In instances where you have a leasing intermediary entity, this can impact on the viability of that structure.  
• Intragroup expenses (e.g. servicing fees) may continue to accrue but without the ability (either now or at a later date) to settle those intragroup liabilities. The subsequent reversal of these costs at a later date can give rise to unforeseen tax exposures.  
  

It is therefore important to consider the impact that “turning off” internal interest or other expense payments might have on the tax profile of the group as it seeks to restructure its activities during the process. Certain costs may not always be avoidable but advanced planning may help mitigate issues before they arise. 

As part of the restructuring, the distressed group may arrange a financing facility to fund the business during the restructuring process with banks that are given preferential creditor status and that will be repaid in priority even to the debtor’s secured creditors (i.e. a debtor in possession (DIP) facility). 

The availability of a DIP facility is positive from a lessor perspective and is intended to allow the group to finance the restructuring process. However, it is important to consider how this financing is structured for tax purposes.

For example, lenders may propose that the group borrow at the top holding company level when it may give a better result from an operational and tax perspective to borrow from elsewhere in the group. This could give a better answer from a tax deductibility perspective, and/or that operationally the group will need to access the DIP facility cash in order to pay the group’s expenses during the process (noting that movement of funds intragroup or pursuant to intragroup loans may not be possible as noted above). Similarly, it is important to ensure that there are no withholding taxes or other taxes applicable to repayments to lenders as such costs are likely to be for the debtors account.

As part of a restructuring, a group re-organisation may be required in order to maximise asset values, to separate assets into “good” and “bad” silos for sale, stream performing assets into the group that will be injected with new funding, or to perfect creditor security interests. Such a re-organisation may be required either as part of an asset or business sale process or imposed by lenders themselves. The complexity of such actions from a tax perspective should not be underestimated, particularly for large corporate groups where assets are segregated into SPVs for commercial or financing reasons. 

The tax implications of such a restructuring will be unique to each group but there are some points to bear in mind. Intragroup transfers of assets are generally taxable events, but often some form of group relief may apply. However, this may not be the case in restructuring situations and clawback provisions could also be triggered where part of a group is subsequently hived off for sale to a third party. 

Group re-organisation may also involve breaking a tax losses group or a VAT group. Certain jurisdictions have rules that can have adverse tax consequences where there is a change in ultimate ownership of a group parent or its subsidiaries and this can result in cash tax being triggered.

A re-organisation may involve the movement of assets (i.e. aircraft) between group companies. Regardless of whether the circumstances of the asset transfers involve lender driven restructuring or a sale of the business to a third party, there are material transfer tax implications to be considered. 

In the Waypoint case, the limited geographical reach of helicopters (particular on-lease helicopters) meant that aircraft were located on the ground in dozens of jurisdictions at the time of the eventual sale of the Waypoint business. Furthermore, the context of the business sale pursuant to a court mandated sale process meant that the typical flexibility enjoyed by lessors in timing aircraft disposals was not available. The upshot of this was that the transfers of individual helicopters were chargeable to jurisdictional transfer taxes in more than a dozen countries. 

While the helicopter case is different to fixed wing aircraft (particularly non-regional fixed wing aircraft) and there historically has been significant flexibility when transferring aircraft to manage transfer taxes, Covid-19 brings challenges in this respect. More aircraft than ever are either grounded, in storage or flying on more limited domestic routes. A bankruptcy driven asset sale or group re-organisation in the current environment could therefore echo the challenges of the helicopter sale process, where asset location “is what it is” and transfer taxes must be borne as part of the process.

In light of the above, we have summarised some of the more material transfer tax issues that we have seen in a bankruptcy sale process:

• VAT: The primary transfer tax for any aircraft transfer is VAT, sales tax, GST or the local equivalent in the jurisdiction where the aircraft is located at the time of transfer. In some jurisdictions, it is possible to achieve a VAT exemption for aircraft transfers, most typically where the aircraft are operated internationally. In other jurisdictions, VAT cannot be exempted and market practice would be to arrange transfer in an alternative location. In a Covid-19 environment this may not always be possible. As such, VAT could be a material issue for aircraft transfers in the course of a restructuring. It is worth mentioning that there are alternative routes to achieving a VAT exemption that are becoming increasingly common in aviation transactions, particularly in the EU where assets might be transported intra-community as part of a sale transaction or where those assets are stored under customs or VAT suspension. This route to VAT exemption varies by jurisdiction and is more complex that the traditional “international airline” VAT exemption and can involve registration and compliance formalities to be completed. The primary issue with this approach in this environment is the inherent inflexibility that a lessor may face in moving its assets or in meeting any pre-transfer registration requirements. 

• VAT compliance and refunds: Should VAT arise on an aircraft transfer occurring as part of a restructuring, consideration needs to be given to how such tax will be administered, remitted and potentially reclaimed. This process varies by jurisdiction and should be considered well in advance of closing as there are some jurisdictions where non-compliance with procedural formalities (including in advance of sale) could risk the recovery of VAT once remitted. It is worth noting that EU VAT compliance is quite manageable where a seller is an Irish incorporated and tax resident company. If the seller has a more varied fact pattern, including where the seller is non-EU incorporated, additional time should be set aside to work through additional VAT compliance. For example, some EU countries may require a local fiscal representative to be appointed to act on behalf of the non-EU established seller. If aircraft are located in less common jurisdictions, compliance requirements can become more onerous. For example, we have seen some instances in African countries where complying with local requirements would have involved having a local agent handle company funds and actually make a significant tax payment on behalf of the non-resident and face unlimited liability for any errors in the return. The small silver lining to incurring a VAT charge is that VAT is often (but not always) a recoverable tax where it is remitted, and where the purchaser is willing to register and complete certain compliance obligations. Therefore, VAT may ultimately represent a cash flow cost to the restructuring process provided all procedural formalities are addressed on a timely basis. 

• Tax rulings: Unfortunately, local transfer tax rules may not always fit neatly with the facts of a sale by a non-resident of an aircraft under a bankruptcy process. In such an instance, it may be necessary to approach a tax authority for a ruling or other confirmation on the transfer tax approach that they might expect. Time needs to be allowed for taking such actions, which in ordinary times can be lengthy and in a post-Covid era could add significant delays. 
  
• Income taxes: Income tax may be a transfer tax consideration that needs to be addressed as part of a re-organisation or asset sale. Jurisdictional income tax, were it arises, will likely not be recoverable and may come as a surprise when considered in the context of the geographic location or financial position of the leasing group.
• Other jurisdictional tax considerations: While less material than VAT and income tax, jurisdictional aircraft transfers can give rise to documentary taxes such as stamp duty or registration taxes and may trigger local tax filings.

In summary, our experience on lessor restructurings is that jurisdictional transfer taxes are a complex area and require careful navigation. Many of the issues (and cash tax costs) can be managed but usually this position requires timely consideration to ensure minimum tax drag on the bankrupt estate. 

Separate to the transfer tax points above but equally important for an asset purchaser or investor in a leasing group is that a re-organisation or sale process may involve the separation of aircraft assets from a group’s core operational substance (e.g. in the event that a lender exercises their security and takes ownership of an aircraft owning company). 

Leasing groups are generally structured to ensure that the Irish group and lessor companies are considered to have adequate substance in order to access double tax treaties (and eliminate cross border withholding tax). Where the asset re-organisation results in this link between aircraft and operational substance being broken, it will be important for an investor or asset purchaser to consider what impact (if any) this might have on the aircraft leases, the jurisdictional leasing tax risk associated with the rental stream and more generally on the capacity of that asset portfolio to be re-marketed to airlines in the future. 

Ultimately a restructuring may result in the sale of the group’s assets/business and/or a material restructuring of a group of its operations. This will likely result in a cessation to trade for tax purposes which brings its own issues. 

From a practical perspective, it will bring an acceleration of tax filing obligations. This a basic but important consideration as the timely filing of tax returns will be required before any winding up can complete, late filing may give rise to tax exposures through the denial of certain group reliefs and resources will be needed both on the tax and accounting side. 

In addition, care is required with respect to the recognition of income and expenses in the pre and post-cessation periods. It is possible that income, which is recognised late, could result in cash tax charges and impact on plans for a solvent liquidation. There can also be tax issues with the holding of non-Euro denominated balances in the post-cessation period(s).

A significant part of a formal restructuring will be likely be the forgiveness or cancellation of some of the group’s debt liabilities. This is a minefield in relation to potential tax outcomes and the legal and accounting characteristics of any debt forgiveness will be extremely important to understand. There is a high possibility that debt forgiveness could give rise to taxable income for the group and this possibility is more acute where the group has Section 110 companies within it. 

Ultimately whether a bankruptcy results in the forgiveness of debt for the debtor will be driven by non-tax factors. Therefore, the timing of a debt write-off and the recognition of any associated income may be a more important area of focus, so that the group and relevant stakeholders can plan to minimise the adverse tax implications that could potentially crystallise. 

A restructuring exercise will involve substantial legal and other professional costs being incurred by the group. Whether a tax deduction is needed for costs associated with the bankruptcy process will depend on the financial position of the company in question (e.g. if the debtor will sell its assets and be wound down on an insolvent basis, a tax deduction will not be material). However, the deductibility of restructuring costs may be a point worthy of some consideration. 

This consideration from an Irish perspective should be undertaken broadly under two headings: (i) whether the costs are “capital” or “revenue” in nature; and (ii) whether the costs have been “wholly and exclusively” incurred for the purposes of the company’s trade. Depending on the nature of the arrangements entered into by the company with creditors and the nature of the trade of the company that will incur the costs (e.g. would the costs be incurred by a group servicing company, a non-trading holding company, etc.), it may be difficult to support a view that all restructuring costs are fully tax deductible. 

Finally, in terms of some house-keeping points that are useful to bear in mind:

• A bankruptcy or debt restructuring process could result in a change in group ownership (e.g. if lenders were to exercise share pledged) or a suspension of trading in listed shares. This can lead to unexpected withholding tax charges. Many groups rely on their ownership structure as a basis to pay distributions free of withholding tax, and while dividends are unlikely in the context of a bankruptcy case or debt restructuring, re-organisations or other restructuring actions could result in deemed distributions arising. 
• As an important point of consideration for the directors of the seller company, it is useful to consider what local transfer tax laws state on secondary liability. In some instances, a director of a seller company may have personal secondary liability for transfer taxes that are not remitted, or filings not made. This can create a tension between the wider bankruptcy process, where a view might be taken on certain local taxes being immaterial or there being insufficient funds in the bankruptcy estate to cover same, and the interests of the directors to ensure that all corporate obligations are satisfied so as to ensure that they do not face personal liability.
• It is likely that a debt restructuring process will impose restrictions on intragroup transactions and may ultimately require certain intragroup transactions to be unwound as assets are sold. It is therefore important (and will save significant effort in the long run) to ensure that all intercompany balances (e.g. receivables and liabilities) are clear and supported by adequate documentation. 
  

Ultimately, distress in the wider aviation and lessor market will provide an opportunity for some. For a sector that has a long track record of providing solid returns, there is a justified belief that while this shock is seismic, it will pass. As airlines hopefully return to the sky in a meaningful way in the coming months, they will be dealing with the significant baggage of millions of dollars of additional debt. As such, while demand for aircraft may be down in the near term, the leasing channel as a financing source is likely to grow in popularity. Some will take the opportunity to invest in new platforms, acquiring aircraft at depressed values. Others may seek to maximise value with opportunistic M&A.

It may be the case that the coming months will see increased M&A by established and well capitalised lessors as well as investors, as well as a potential increase in lender enforcement actions against borrowers. In both cases, there are many tax considerations that need to be worked through in order to preserve value and prevent tax drag on future income streams. 

For lenders exercising security and for lessors or investors acquired assets or shares at depressed prices, there will be a number of tax issues that will need to be understood early in the process and managed appropriately:

• Minimising transfer taxes on asset or share acquisitions
  
• Managing withholding taxes on lease rentals, including the consideration of the application of double tax treaty benefits
  
• Linked to the above, consideration of the required substance in the asset owning group, both for Irish and international tax purposes 
  
• Maintaining tax residence where required and fitting it within a desired governance framework
  
• Determining the appropriate funding strategy, to maximise tax deductions for interest, eliminate interest withholding tax and minimise tax drag at the platform level 
  
• Considered cash repatriation and the management of withholding taxes on interest and dividends
  
• Looking out to the eventual exit strategy and ensuring minimal tax exposure on an eventual sale or divestment. 
  

Any formal restructuring will test and strain existing lessor structures. Given the design of those structures was heavily influenced by tax factors, it is important to understand how those factors will be impacted in the restructuring process. The same holds true for those who are looking at opportunistic investment in a distressed environment. A failure to adequately prepare and efficiently execute will lead to additional tax drag and a loss of value for stakeholders. 

This article was originally published in the AirFinance Journal and is reproduced here with their kind permission.

For more on any of the items above, or any aviation finance queries, contact Joe O’Mara, Head of Aviation Finance.