Sovereign Wealth Funds (“SWFs”) and government pensions (together, “Institutional Investors”) continue to pivot toward alternative investments, particularly infrastructure, with industry predictions that infrastructure AUM will reach USD$795 billion by 2025 (from USD$322 billion in 2015) . Much of this will come from SWFs and pensions. The long asset lives, stable cashflows and lower volatility of infrastructure relative to other asset classes is ideally suited to the patient capital and long duration liabilities of Institutional Investors.
As they pivot, these investors have added resources from top investment banks and alternative asset managers to better execute on new asset classes. Many large Institutional Investors now have sophisticated in-house capabilities to source, analyze and execute deals directly. In addition, they are increasingly establishing offices in foreign locations to better access investment opportunities by being physically closer to the deals. As a result, Institutional Investors are expanding their investment reach beyond funds operated by infrastructure asset managers, directly acquiring infrastructure assets, co-investing alongside each other or building infrastructure platforms in partnership with asset managers and ‘strategic’ corporate partners. Institutional Investors need to plan for the complexities and sensitivities that will arise.
For instance, government policy, tax and regulation can require particular structures for investing into infrastructure, which may differ between sectors and degree of government involvement. Different types of Institutional Investors may also require bespoke structures, driven largely by tax and legal considerations, and the large size of infrastructure projects often require consortiums, giving rise to challenges in coordinating contrasting structuring imperatives, including deciding where to locate a joint holding company to aggregate their capital. Insight into the reasons behind these structuring considerations will go a long way in positioning Institutional Investors as successful infrastructure investors.
1. An Institutional Investor may need to balance government level initiatives with investment and tax considerations.
Political dynamics and inter-government initiatives may be factors when considering investments, including related structures. This may serve to restrict the size or nature of individual investments, requiring the formation of consortiums for large infrastructure assets. For example, some tax exemptions and benefits associated with holding company regimes may be subject to ownership/governance limitations by the granting jurisdiction. Australia limits the sovereign tax exemption to investments of less than 10 percent in an asset and where the investor does not retain a board seat or governance rights in the asset. Other jurisdictions, such as the US, have similar limitations on specific types of assets such as real estate for certain Institutional Investors to claim a tax privilege. The UK Government has recently consulted on a bespoke holding company regime for funds and institutional investors which is likely to have certain minimum ownership thresholds for such investors to qualify for the regime. These restrictions will require that the commercial opportunity be balanced against the tax efficiency.
2. Infrastructure is a publicly sensitive asset class and tax is an important factor in screening foreign investors.
The large size and public prominence of infrastructure assets means that foreign Institutional Investors are subject to review under local investment screening processes. In an era of growing national sensitivity, this has most keenly been felt by investors in nationally strategic infrastructure, such as trade or transport related assets (e.g. ports, roads, rail) and this is expanding into sectors such as energy and communication infrastructure given their increasing national strategic significance (the UK Government is currently consulting on legislation for a mandatory notification regime under its National Security and Investment Bill 2020). Australia and New Zealand explicitly include tax as an important factor in their foreign investment review frameworks and this can require extensive upfront disclosures of structures, investor relationships and tax outcomes.
3. Tax incentives accelerate growth in some infrastructure sectors but may not be critical for Institutional Investors.
Tax credits to promote investment in renewables have driven explosive growth across Europe, the US and other key jurisdictions. Institutional investors are tax-exempt or lightly taxed and are less attracted by such tax incentives. However, the boom in renewable projects backed by taxable investors is giving rise to a growing secondary market in assets that may come to market with substantial time left under existing power purchase agreements (PPA) and strong underlying fundamentals beyond PPA terms. Institutional investors have a lower cost of capital and will invest based on these long-term fundamentals, even where tax incentives are not directly beneficial.
4. Institutional Investors need to listen closely to their members.
Investor activism is increasing, with a focus on sustainability, resilience and climate impacts. For pension funds this is being keenly felt as members make their voices heard, recently seen when REST (a large Australian superannuation fund) settled a member claim in November 2020 that it wasn’t doing enough to protect the members’ assets from climate risks. While this case focused on climate impacts to member investments, the potential for future regulatory and tax changes needs to be factored in by Institutional Investors. For example, how might future carbon taxes impact portfolio values and what should Institutional Investors be doing in anticipation of such future imposts?
5. Institutional Investors often have different perspectives to other investors.
Firstly, Institutional Investors may have concerns about issues that would typically be favorably received by other investors. Due to the variety of sovereign tax exemptions that exist globally, the tax-driven sensitivities that Institutional Investors need to manage can be substantial and nuanced. Some seemingly innocuous “investor-friendly” conditions or arrangements (e.g. advisory board seats or management fee rebates) can be problematic to the investor’s qualification for sovereign exemptions. These sensitivities need to be managed within infrastructure consortiums and across co-investors in large infrastructure projects.
6. A manager’s activities will need to be carefully defined.
As a threshold matter, Institutional Investors will want to manage the risk of a manager being treated as an agent of the investor under local tax law. Where an agency relationship exists, the manager’s activities can be attributed to the investor and put the investor’s tax status at risk. With a growing focus on tax transparency at a global level, some differences may also arise between a manager’s preference for international fund tax-neutral jurisdictions and an Institutional Investor’s preference for using vehicles in countries where greater substance may exist within their organization. This issue is growing as Institutional Investors seek to build global infrastructure platforms in partnership with asset managers and it must be balanced against the risk of double-taxation if fund vehicles are not based in tax-neutral jurisdictions. Institutional Investors need to be closely involved in designing platform structures and governing management agreements, which typically need to contain some very strict limitations on what manager activities are permitted or prohibited.
7. Infrastructure asset managers may need education on data needs.
As Institutional Investors build in-house capabilities to help source and manage larger, more complicated deals, increasing disclosure obligations and heightened community expectations, they require ever greater access to data in connection with investments. The emergence of Infratech is also delivering new data for enhanced management of assets. Institutional Investors may need to educate infrastructure asset managers on their particular needs for financial and performance data.
8. Active involvement in tax reform, both locally and globally is important.
Many Institutional Investors are focused on managing the risk of adverse publicity from tax structuring that may be perceived as aggressive and structures once considered uncontroversial may become outmoded as tax reform occurs and public perception shifts. Asset managers that think about these risks from an Institutional Investor’s perspective can generate long-lasting value for their stakeholders, whereas inattention by an asset manager can lead to unintended but serious reputational damage.
Investors and their asset managers also need to proactively engage with policymakers to prevent ill-considered reforms that may damage legitimate infrastructure projects. For example, the global debate on interest deductibility limitations under the BEPS project was particularly important for infrastructure given these large capital investments often require a mix of debt and equity funding, and the infrastructure investor community will similarly need to monitor closely the progress of the OECD’s Pillar Two proposals given their potential for unintended consequences for large-scale infrastructure ownership structures.
9. Responsible tax policy may need to be mandated at the fund and investee company level.
Infrastructure plays a critical part in driving the green energy transition and economic recovery from COVID-19, with the ESG agenda taking center stage. Transparency and accountability for tax structures is a key element, particularly for Institutional Investors that invest into infrastructure projects in foreign countries. Institutional Investors need a clear, well-documented, tax governance framework and must be prepared to demonstrate it both in principle and action to public stakeholders. Asset managers that partner with Institutional Investors also need to understand the ESG frameworks of investors and develop policies that pursue consistent objectives. This involves periodic re-assessment of global infrastructure investment structures, in addition to underlying investee portfolios through close engagement between asset managers and investors to coordinate responsible tax policies and practices.
10. Not all Institutional Investors, or investments, are the same and flexibility is needed to accommodate different investors in large infrastructure projects.
Availability of tax privilege will vary by jurisdiction and by investor. Certain types of Institutional Investors may enjoy broader benefits than others, even within the same jurisdiction. For instance, the US generally offers expanded benefits to Qualified Foreign Pension Funds (“QFPF”), as opposed to other types of Institutional Investors. While this can provide opportunities for simplified structuring, it can also increase the complexity for an infrastructure consortium, where investor classes limit the size of each Institutional Investor’s (e.g. CFC ownership thresholds, associated entity rules under ATAD 2 and anti-hybrid regimes outside of Europe). Co-mingling different classes of Institutional Investors in structures can result in the loss of certain preferences. Institutional Investors need to be aware of the profile of their fellow co-investors and be confident that their Asset Managers appreciate these important differences.
Understanding the reasons for special structuring and other efforts will help ensure Institutional Investors are well-placed to invest across the spectrum of infrastructure classes and in combination with different types of investors. KPMG firms have dedicated Infrastructure and Institutional Investor Group practices that work with leading Institutional Investors globally. KPMG professionals can help provide insights and advice on market leading structures to accommodate all parties in a transaction.
1 Source: Preqin Global Infrastructure Report 2021
2 See LCR 2020/3 issued by the Australian Taxation Office
3 See IRC Section 897(l)
*Unless otherwise noted, all information within this article was contributed by KPMG professionals.
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