The taxman cometh

Attempts to clamp down on multinationals avoiding taxes have inadvertently embroiled the world of real estate lending.

Borrowers of property development finance in the UK had some extra reading this week when the UK government published its 2017 Finance Bill.

One of its aspects involves reform of the way interest payments on companies’ debt are taxed. Traditionally, such payments are seen as a business expense and therefore tax deductible. The measures are ultimately aimed at tackling tax avoidance techniques by multinational corporations, but they also threatened to inadvertently sweep up the real estate lending market.

We’ve all read the reports about the household brands that do a roaring trade in the UK but somehow manage to get away without paying tax in the country.

The OECD calls such practices ‘base erosion and profit shifting’ (BEPS). One method is for a company to take on huge amounts of debt to fund business activities in the knowledge that they can make a tax saving on the interest payments. Meanwhile, rather than book profits in a comparatively high tax environment like the UK, profits can be shifted to jurisdictions in which lower, or no, tax is due.

Many will agree that the government is right to clamp down on such tax-avoiding techniques. However, some in the real estate industry fear that lenders and borrowers will become collateral damage in the government’s crusade.

More so than most industries, the capital-intensive nature of commercial real estate investing requires significant amounts of debt finance to be employed by firms. Although such borrowings are clearly not being used for BEPS purposes, the government’s move to address tax deductibility on interest payments has threatened to add huge costs and uncertainty to the debt side of the industry.

The British Property Federation has lobbied the government and concessions have been made, although questions remain.

By January, when draft legislation was announced, the government introduced a Public Benefit Infrastructure Exemption (PBIE), which meant debt secured by properties rented to third parties would not be affected.

However, it was not so lenient on loans that are recourse to a parent-company guarantee. The rationale is understandable; if major multinationals provide parent-level guarantees, they might be able to convince lenders to provide larger volumes of finance to their UK operations than a British company would usually be able to source on its own.

In the real estate world, development loans typically feature such guarantees because a raft of things can go wrong, meaning that lenders look for the comfort of recourse to a parent company.

The eventual Finance Bill addressed this, but only to a degree. The government agreed to ‘grandfather’ parent company guarantees, meaning that existing development loans will remain eligible for exemption. What is less clear is the government’s position on guarantees in future deals. Parent company guarantees will benefit from the exemption only if the guarantee is provided by a company which qualifies under the PBIE criteria. To qualify, a company needs to be subject to UK corporation tax, meaning overseas companies are unlikely to be eligible.

Real estate bankers and developers tend to adapt to such challenges, so it is unclear how much of an issue this new legislation will be. But development finance is already difficult to source in the UK market and further complications will not be welcomed by either borrowers or lenders.