The world of international tax is undergoing a period of great turbulence. The taxation of aviation lessors has been subject to significant change over the past ten years. Previously reliable tax structures have fallen away. Airlines are demanding more robust tax structuring. New tax laws are emerging in key customer jurisdictions, and the OECD, EU and US are driving changes to which lessors have to react.

Plentiful capital raised in a tax efficient way contributed to a sustained period of booming growth in the industry in the 2010s. Asset-backed securitisation (ABS) debt and unsecured debt issued by lessors enjoyed a buoyant level of demand in the capital markets. Neat, tax efficient structures supported these transactions, even as high growth lessee jurisdictions turned their attention to lessor taxation and substance.

In 2020 and 2021, as the COVID-19 crisis devastated aviation, global leaders met to agree a fundamental reorganisation of international tax rules. The still-unfolding BEPS 2.0 process will have a defining effect on taxation and returns in the aviation finance industry over the coming years. Changes are on the horizon which may result in the greatest realignment of global taxation in living memory, and aircraft lessors will need to understand the potential impact on their businesses.

In this article, Joe O'Mara and Claire Waters of our Aviation Finance team review the impact of tax changes which have emerged in recent years on the aviation finance community, at investor, lessor and lessee levels. We also consider the future direction of travel in international tax and its possible effect on aviation finance. 

Tax structuring in Aviation Finance

An investor entering the aircraft leasing market for the first time will find that there are certain tried and tested structures which have long served investors and lessees well. Tax efficiency is at the heart of these structures (see diagram below), which typically feature an Irish leasing platform with aircraft held in asset-owning special purpose vehicles (SPVs) leased to airlines around the globe.

Capital is invested into the Irish platform from overseas, by way of debt raise or equity, and is pushed down into the SPVs in a tax efficient way. Employees are generally separated from the assets and are employed by an operating company, or services are bought into the group from an Irish based lease manager. Rentals are paid to the SPVs and are returned to the investors by way of interest or dividends.

These structures broadly operate across three levels (investor, platform and lessee), and at each level there are specific tax issues to be considered and managed. At a high level, these are as follows:

  • Investor Level: withholding taxes on returns of interest and dividends are a key concern for investors. Equity investors will also need comfort on potential future exit taxes which may arise on a disposal of their investment.
  • Platform Level: key platform-level tax concerns include the rate of tax applicable to profits earned, the deductibility of operating costs incurred, the availability of accelerated tax depreciation on aircraft costs and ability to offset accrued tax losses against profits to defer cash tax payable.
  • Airline Level: at the level of the airlines, a key concern is managing withholding tax exposures on lease rentals returned to the platform. Transfer taxes on aircraft novations, and local income tax and VAT / sales tax exposures, also require management.
Typical aircraft leasing structure - chart

As the aviation finance industry has developed and boomed, an Irish leasing structure with clean, efficient answers to the tax questions posed at each level has proven very effective. The diagram provided is greatly simplified for illustrative purposes. However, as platforms grow and expand into multiple SPVs, parallel / side-car structures, foreign presences and numerous holding companies, bond issuers, treasury companies and legal orphan offshoots, the fundamental tax questions and answers generally remain consistent.

At each level, the basic principles of certainty and predictability in tax treatment have been key to supporting growth. However, developments over recent years have tested that predictability, with lessee jurisdictional tax issues in particular putting pressure on some aspects of the traditional leasing structure. In the next section, we will review some significant tax changes over the past ten years and consider the impact they have had on lessor/lessee relationships. 

BEPS 1.0: First steps towards change

The OECD’s Base Erosion and Profit Shifting (BEPS) project in its first iteration in October 2015 set out fifteen ‘Actions’ designed to guide member jurisdictions in reforming domestic and international tax law to counter the erosion of the global corporate tax base. One of the underlying aims of the process was to bring about greater alignment of taxation and substance. The most significant of the Actions from an aircraft leasing perspective was Action 15 or the Multilateral Instrument (MLI).

The MLI

The MLI was an instrument which overlaid and amended existing double tax treaties, including those entered into by common leasing platform jurisdictions such as Ireland, Hong Kong and Singapore. The MLI sought to change the terms of existing treaties to tighten up key definitions and restrict access to benefits, bringing a greater focus on the substance of any company seeking to claim treaty benefits. The MLI has the potential to deny treaty relief from withholding tax on lease rentals. The MLI began to come into force for Ireland’s treaty network from 2019. It is now effective for many key airline jurisdictions, where double tax treaty relief is being availed of.

Among the changes introduced into tax treaties by the MLI was the Principal Purpose Test (PPT), which effectively eliminated the availability of treaty relief from withholding tax on lease rentals where ‘treaty shopping’ was suspected.

The PPT states that relief will be denied where it is reasonable to conclude that obtaining a tax benefit was one of the principal purposes of entering into a transaction. The PPT places very significant pressure on what had historically been one of the primary methods of managing income tax and withholding tax risk on leases to jurisdictions such as Australia, Japan and Indonesia – the use of leasing intermediary companies, or lease-in, lease-out companies (LILOs).

The MLI also introduced into some treaties additional tests under the definition of permanent establishment (PE). These changes mean that where an employee ‘habitually plays the principal role leading to the conclusion of contracts’ in a given jurisdiction, a PE can be triggered and corporate income tax become payable. While Irish treaties do not contain the expanded definition of PE, this suggested change at OECD level has heightened countries’ awareness of the level of activity employees of foreign organisations (such as lessors) have in their jurisdictions, and has significantly raised the risk that negotiations and interactions with airlines on their home turf may lead to local tax exposures for aviation lessors.

Demands for Substance

Even before BEPS 1.0 formalised anti-treaty shopping and PE exposures in the MLI, airlines were beginning to respond to the direction of travel in international tax by tightening the demands they were making of lessors. In particular, aircraft lessors have seen an increased focus from airlines in certain key customer jurisdictions on the level of substance in the lessor entity or group.

Airlines in India, Korea, Russia and Poland, among others, have issued lessors with detailed questionnaires and letters of representation to be completed and signed before lease commencement. These documents have posed challenging questions of lessors, seeking onerous and detailed representations of their facts and circumstances. Airlines have insisted on SPVs being incorporated in the jurisdictions in which they are tax resident, ruling out the use of Cayman or Bermudan incorporated SPVs. In addition, airlines have requested the release of commercially sensitive information such as numbers of employees in the lessor SPV, properties owned or leased by the SPV, and copies of board minutes, tax returns, group structures and financial statements.  

In many cases, airlines’ demands are driven by developments at local tax office level. Airlines in India, Russia and China have been subject to investigation by the tax authorities in their home jurisdictions, with questions being asked in relation to leasing contracts. Tax authorities have queried the entitlement of airlines to apply treaty benefits to payments of lease rentals to lessors resident overseas. The airlines have responded by insisting on the provision of what they (mistakenly) understand to be evidence of Irish tax residence or the SPV’s beneficial ownership of rental income.

Demands for evidence of substance in the asset-owning SPV have posed a particular problem for lessors using intermediary leasing entities to manage withholding tax or income tax in the airline jurisdiction. They have also challenged structures holding assets offshore, in zero tax jurisdictions (such as the Cayman Islands or Bermuda), and leasing them via intermediaries resident in Ireland, Singapore or Hong Kong. Some lessors have responded to the challenges of recent years by seeking to own multiple assets in a single entity (as opposed to bankruptcy remote single asset-owning SPVs). The airlines’ preferred model of a lessor with employees and assets held in one entity remains rare, however.

EU Responses

While airlines have pushed lessors to amend their structuring to address substance concerns, at a macro level tax changes driven by the EU in response to the BEPS 1.0 project have imposed new reporting requirements and additional significant structure challenges. The EU’s Anti-Tax Avoidance Directive (ATAD), introduced in 2016, set out a number of measures it required Member States to implement in order to address perceived tax abuses among multinationals.

ATAD included requirements that Member States introduce Controlled Foreign Company (CFC) rules to tax profits held offshore in low tax jurisdictions, anti-hybrid rules to counter loopholes between tax systems, exit taxes, General Anti-Avoidance Rules (GAAR) and interest limitation rules. From an Irish tax perspective, some of these rules were already in place in Irish law. However some (CFC, anti-hybrids) have had a significant impact on lessors’ structures and on the tax deductibility of expenses incurred by lessors. Commencing in 2022, the introduction of interest limitation rules in Ireland will require aircraft lessors to consider their financing arrangements in detail, with the risk of tax deductions for interest on borrowings being partly denied.

Alongside ATAD, the EU’s introduction of the Common Reporting Standard (CRS) and the Mandatory Disclosure Regime (DAC 6 reporting), also in response to BEPS 1.0, have added to the information gathering and disclosures burden being placed upon business. Separately, tax reform in the United States, now being revisited by the Biden administration, has created new costs and difficulties for the structuring of US investment into aviation finance. Collectively, these new rules have significantly upped the ante on lessors in terms of the complexity of their tax structuring and the tax reporting required by them.

Different Structures, Different Challenges

The tax developments of recent years have posed different kinds of challenges for different kinds of structures. Broadly, we have seen the following impacts:

  • Mature Leasing Platform: full-scale leasing platforms with significant substance and a history of transactions with existing customers have not been immune to the developments of recent years. In particular, lessors have found that LILO structures which served them well in the past have fallen away, in some cases necessitating significant restructuring. Irish lessors with offshore presence have also had to consider CFC rules.
  • ABS Structure: lessors’ ability to place aircraft leased to certain airlines into ABS structures has come under significant pressure. Novations of Russian, Indian and Korean leases have been slow, with airlines uncomfortable with the change from an existing substantial leasing platform to a legal orphan structure without employees or a physical presence. The payment of returns to E-note investors have given rise to complex anti-hybrids questions.
  • US Investment: US funds typically invest into leasing structures by way of partnerships and LLCs, entities which are treated as transparent for US tax purposes. Airlines in less sophisticated jurisdictions have been known to request group structures giving details of entities above the level of the leasing SPV, all the way to the ultimate investor. Aside from the commercial sensitivity of what is occasionally requested, some airlines have difficulty understanding the taxation of income streams received by entities typically used by US funds, and some lessors have encountered lessee resistance with novations and new leases as a result. The entities used by US investors into Irish structures have on occasion given rise to anti-hybrids problems.
  • ‘Offshore’ Ownership: lessors which have historically structured their leases by way of asset ownership offshore in tax friendly jurisdictions with head leases to (for example) Ireland and sub leases to the ultimate airlines have faced pressure from lessees seeking evidence of a substantial presence in Ireland.

All Irish resident structures will be required to consider the impact of the introduction of interest limitation rules from 2022 onwards, and all have been required to consider the DAC 6 reporting implications of new transactions being entered into.

Since the introduction of the MLI, the general direction of travel in international taxation for aviation finance has been clear. The more substance that can be demonstrated in the lessor SPV and its wider group, the easier the deal. The PPT in particular has crystallised what were already well-established moves towards insisting on greater substance from lessors. While lessors have minimised the representations given and documents delivered, ultimately, in order to be commercial and get leases signed, accommodations have been made – and costs incurred.

The demands imposed by BEPS 1.0 have not gone away, however minds are turning now towards the further, very significant changes in the global tax landscape proposed by BEPS 2.0. In what follows, we will introduce the expected rules and provide an overview of how they might apply to aviation lessors.

Airplane wing seen through plane window

BEPS 2.0: The new direction of travel

Notwithstanding the sweeping changes introduced in the first phase of the OECD’s BEPS project, the rapid digitisation of the global economy and the growth of the tech sector has sharpened calls for a further radical overhaul of international tax law. At the conclusion of the BEPS 1.0 process in 2015, certain countries remained unhappy with the ultimate output, however it took a further number of years before any real movement towards further change emerged.

The speed of progress has accelerated rapidly over 2020 and 2021, with the publication of detailed ‘blueprints’ in 2020, and G7 and G20 level agreement on broad principles earlier this year. Collectively, the proposed further changes are known as ‘BEPS 2.0’. Across two ‘Pillars’ of rules, BEPS 2.0 proposes in some specific circumstances (though most likely not for lessors) to reallocate taxing rights to customer jurisdictions, with tax arising where revenues, rather than profits, are generated, and to set a global minimum effective tax rate applicable to all multinationals over a certain size. 

New rules

As of September 2021, we have a broad general sense of how the rules might fall. Firstly, it is important to note that what is proposed under BEPS 2.0 is expected to apply only to multinationals with consolidated global revenues of over €750m. No account of inflation is taken in the rules, however, therefore monitoring will be needed going forward. There is also the risk of individual nations introducing domestic rules which apply to multinationals at a lower revenue threshold – this is a point to watch out for in the years ahead.

Pillar One seeks to reallocate taxing rights to jurisdictions in which revenues are realised, looking at where sales are made rather than where profits booked. There are carveouts from Pillar One for certain classes of regulated financial services, not including leasing, however overall it is agreed that Pillar One is less likely to be of immediate relevance to aircraft lessors. The calculations in Pillar One limit its scope to multinationals with annual turnover of over €20bn only (expected to shrink to €10bn in seven years). 

Minimum global effective tax rate

From an aviation finance perspective, Pillar Two is likely to be the most impactful. The aim of Pillar Two is to establish a minimum global effective tax rate (ETR), and to put in place rules designed to ensure that ETR is realised by multinationals.

Much recent media attention has been focused on the minimum global ETR. The agreements reached earlier this year at G7 and G20 levels and subsequently signed by over 130 OECD member jurisdictions reference an ETR of ‘at least’ 15%. Earlier in discussions it was hoped that the ETR would fall at between 10% and 15%. It is known that the US under President Biden prefer a higher rate of up to 21%, and it remains to be seen what ETR will be settled on.

In order to ensure that in-scope multinationals with consolidated revenues over €750m are subjected to the agreed ETR, a framework of rules has been agreed. While much detail remains to be worked out, at a high level these are as follows:

  • The Income Inclusion Rule (IIR): a CFC-style rule will tax income held offshore in jurisdictions which do not impose the agreed global minimum ETR;
  • The Under-Taxed Payments Rule (UTPR): tax deductions on payments to jurisdictions which do not impose the agreed global minimum ETR will be denied;
  • The Subject to Tax Rule (STTR): this rule will overlay tax treaties, denying withholding tax relief on related party payments to jurisdictions which do not impose a nominal rate of tax above a (to be agreed) 7.5% to 9% rate.

A complicated system of formulae has been proposed to ensure that taxable amounts are fairly shared across jurisdictions. Given the scope of the rules and the number of countries which have agreed to implement them, it appears likely that there will be limited scope for restructuring to manage exposures. 

Application of the rules

The practical impact of the BEPS 2.0 rules on aviation finance will vary depending on the jurisdictions in which the investors, asset-owning SPVs and (if different) leasing SPVs are resident for tax. The different rules and calculations will pose different problems for different kinds of structures.

The clearest impact to model is that of a change in the applicable ETR. Many of the details around ETR calculation, including the availability of carried forward losses, allowances to be made for substance in a given jurisdiction, and the rate itself, are yet to be ironed out.

The below considers at a high level the possible impact of BEPS 2.0 on three well known leasing regimes, subject to finalisation of the detail of the rules and assuming an agreed global minimum ETR of 15%:

  • The Irish regime has a headline corporation tax rate of 12.5% and this is the rate which aircraft leasing companies are generally subject to on their trading profits. Therefore, a move to a 15% minimum ETR could result in additional tax of 2.5% (i.e. an increase in your tax charge of 20%)
  • Hong Kong has a headline corporation tax rate of 16.5% but its concessionary regime for qualifying aircraft leasing activities, introduced in 2017, offers a net headline 1.65% rate (8.25% on 20% of profits), but with no deductions available for tax depreciation. This generally results in an ETR for a leasing group in Hong Kong around the 4% to 6% range. Therefore, a move to a minimum 15% ETR could result in additional tax of 9% to 11% (i.e. an increase in your tax charge of between 250% to 375%)  
  • Singapore has a headline corporation tax rate of 17%, however under the concessionary Singapore Aircraft Leasing Scheme, leasing companies can avail of reduced ETR of 8% (generally for an initial agreed period of 5-10 years but it is possible to renew). A move to a 15% ETR could result in additional tax of 7% (i.e. an increase in your tax charge of 87.5%).

While ultimately the devil will be in the detail of what is agreed at OECD level and how it is implemented in national legislatures, some possible impacts on aviation finance structures are as follows:

  • US Investment: US structures which feature offshore blockers or Cayman holding companies may find the IIR and UTPR render the use of these entities uneconomical, imposing top-up taxes to eliminate prior benefits. The expectation of further US tax reform alongside the continuing BEPS 2.0 process means that US investors may incur additional tax costs in aviation finance structures over the coming years (though this may be the case for sectors other than aviation finance as well).
  • Japanese Operating Lease (JOL) Structures: many JOL structures are managed by large, third party Irish leasing platforms. Japan’s corporate tax system imposes sufficiently high rates of tax such that the UTPR wouldn’t be expected to impact on lease rentals paid from Ireland to Japan. The STTR also shouldn’t apply in a third-party leasing arrangement.
  • Offshore Ownership: the UTPR is designed to catch payments to jurisdictions which operate a rate of tax below the agreed global minimum. The rule is likely to increase the costs of structures which hold assets offshore in low or nil tax jurisdictions such as Bermuda or Cayman. From the perspective of the STTR, this is most likely to impact on payments within groups to countries which tax the receipt at a nominal rate of less than 7.5%. Consequently, lessors owning assets in SPVs resident in jurisdictions such as the UAE may also find that the STTR has an impact on their tax costs.
  • Chinese Investment: Chinese-headquartered leasing groups will need to be careful when paying interest and fees from platforms to Hong Kong group entities to make sure the Hong Kong sourcing rules do not apply. Where amounts received in Hong Kong are subject to a nominal rate of tax of less than approximately 7.5%, the STTR may deny tax treaty relief. The UTPR will also need to be considered in such a scenario.
Toy airplane on orange background

What happens next?

The speed of progress in the BEPS 2.0 negotiations has picked up significantly since the inauguration of US President Biden in January 2021. Agreement on elements of the proposals was reached at G7 and G20 levels in June and July, however there remains a large amount of detail to be worked through. Once a complete and final agreement is reached at OECD level, national legislatures will have further work to do to implement the agreement in domestic law. The US are pushing for a 2023 implementation and the OECD has stated its agreement, however in reality it may take a number of further years before we start to see the real impact of the changes.

As mentioned earlier in this article, very significant aspects of the incoming rules are yet to be finalised. A final ETR needs to be settled on, with the current open-ended wording referencing a rate of ‘at least’ 15%. The specifics of the calculations of the IIR and UTPR alongside the method for allocation of taxable amounts to the various jurisdictions in which a multinational has a presence need to be worked out. Certain nations have requested carve-outs from the rules for favoured industries and sectors, and the knock-on effect of any such concessions will need to be understood. There is a long road left to travel before we can be in a position to say with confidence exactly how much of a bearing BEPS 2.0 will have on aircraft lessors two, five or ten years into the future.

One notable roadblock standing between the proposals and their implementation is the Biden administration’s razor-thin margin in the Senate and House of Representatives, and its ambitious domestic agenda. Having already won significant political victories domestically, with the 2022 mid-term elections on the horizon, the administration is likely to encounter significant resistance in attempting to pass BEPS 2.0 alongside domestic US tax reform late this year or early next year. Without the US onboard, the likelihood of the BEPS 2.0 proposals being implemented would be significantly reduced. 

BEPS 2.0 & Ireland

US Treasury Secretary Janet Yellen has been liaising with the six OECD member jurisdictions which remain outside the agreement, applying pressure in an effort to reach unanimity. Of the six, Ireland is the only significant one from an aviation finance perspective (the others are Hungary, Estonia, Nigeria, Kenya, and Sri Lanka).

Ireland’s position on the BEPS 2.0 project has been clearly stated by the current Government, in that Ireland supports the process and is committed to international tax reform but cannot sign up to the agreement given its current lack of detail.

Ireland has also defended its 12.5% rate as an appropriate and fair rate and within the ambit of healthy tax competition. The Irish Government has noted that tax policy is a legitimate lever to compensate for advantages of scale, location, resources, industrial heritage and the real, material and persistent advantages enjoyed by larger countries. That said, as the BEPS 2.0 process evolves and the detail of the plans are developed, it remains a possibility that Ireland will commit to joining the agreement and corporate tax changes could follow in the coming years. 

Conclusion

The last decade has seen material levels of change in the taxation of aviation finance, with a direct effect on the structuring of transactions and the related knock-on costs for lessors. Further great change is expected as the second round of BEPS proceeds towards a final agreement. The ultimate impact of the rules and the extent to which they will hit lessors’ bottom lines remains to be seen. As always, those systems of taxation which provide business with certainty, stability and predictability in the face of increasing complexity will be most attractive to new investment. 

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

Get in touch

The pace of change is challenging leaders like never before. To find out more about how KPMG perspectives and fresh thinking can help you focus on what’s next for your business or organisation, please get in touch with Joe O'Mara or Claire Waters of our Aviation Finance team. We’d be delighted to hear from you.