The Effects of ATAD on the Aviation Industry

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      Podcast transcription:

      Hello, everyone. Thank you for joining us today for today’s webinar on The Impact of ATAD on The Aviation Industry. I’m now going to pass you on to my colleague, Frank Dowling of DMS Governance.

      Thank you, Allie. And I would like to welcome everyone to our webinar, which is based on the potential impact of ATAD on the aviation industry. And before we commence, just a little bit of housekeeping. There are quite a number of slides that we will be going through in our presentation today. These will be circulated to all attendees following the webinar. So, no need to take detailed notes or anything like that.

      So, without further ado, I would like to welcome our presenters. We’re very pleased to be joined by Brian Brennan, a tax partner in KPMG Dublin with a specialism in aviation. Furthermore, we are also joined by Seamus O Croinin, who is a senior finance partner in A&L Goodbody, with a long history also in aviation. And finally, David Morrissey, who is managing director in DMS and head of our client solutions team, will also be making a presentation on what a potential structure would look like. And finally, my colleague, Niall McNamara, who should be well-known to most of you, who is joint head of the structured finance division in DMS, is also on the panel.

      ATAD Interest Limitation Rules in Ireland 2022

      So, as I said, the topic of today’s webinar is the impact of ATAD on the aviation industry in Ireland, and specifically, the imminent introduction of interest limitation rules in Ireland, probably commencing January 2022. And who better to talk us through these changes than Brian Brennan from KPMG? So, Brian, would you like to kick off please?

      Thanks, Frank. Good afternoon, everyone. So, I’m just going to cover the interest limitation rule today. Essentially, the anti-tax avoidance directive, which is otherwise known as ATAD, was signed into law by the European Commission in 2016. And essentially, the purpose of it was to try and take the number of the BEPS measures which is part of the OECD and G20 project, and have some level of conformity within EU member states. So, that was the whole purpose of the EU ATAD. And one of the measures in the ATAD is the interest limitation rule.

      So, under the terms of the ATAD, what are provided for was that the interest limitation rule was to be implemented by all EU member states no later than 1 January 2019. However, they did allow for a deferral up to 2024 where any particular member state had equivalent measures. Ireland replied to the EU to seek a deferral of the interest limitation rules to 2024 on the basis that we do have equivalent measures with respect to payment of interest to non-residents. However, after a lengthy correspondence with the European Commission, it was decided that Ireland did not have equivalent measures. So, then they sought for Ireland to implement the rules as early as possible.

      Now, given that this correspondence only took place, you know, primarily during 2019, we couldn’t adhere to the directive to have the legislation in place from 1 Jan 2019. So, at the moment, we’re working through the process with government and it’s likely that the legislation will be implemented by 1 January 2022.

      ATAD Interest Limitation Rule Timeline

      So, as I said, the interest limitation rules were meant to be effective from 1 Jan 2019. However, we sought to defer till 2024, but as a result of the process with the European Union, we now are looking potentially at an effective date of 1 January 2022. What needs to happen in Ireland is that the Department of Finance are planning on having a consultation which hopefully will be launched later this year, which will run for approximately maybe 12 weeks which we’ll talk through the various legislative measures and what impact it’s going to have on various sectors, including aviation within Ireland.

      What Do the EBITDA Limitation Rules Apply To?

      So, just to run through very quickly the basics. So, what do the rules provide for? The rules provide for a limitation or a restriction on interest expense equal to 30% of your EBITDA. So, if your interest goes above 30% of EBITDA, that interest is restricted. The restriction applies to both third party and shareholder debt. The main basis of these rules is to avoid base erosion, i.e. where companies have…basically, they’re fully debt funded and they’re stripping the profits through interest expense payments.

      As I mentioned, there’s going to be a consultation, which will run for approximately 12 weeks. And that process will take place whereby the Department of Finance will engage with industry bodies, with professional firms, industry representatives, etc., to get their views on how Ireland should implement these rules.

      One of the things about this is, like, at the moment, we already have a number of provisions under Irish law to deal with interest expense deductions. And some of our rules are quite complex. The simplest way for the Department of Finance to actually implement these rules is to delete all our existing legislation dealing with interest expenses and limitations, and just bring in a simple rule that will say, all interest expense should be deductible subject to the 30% limitation.

      There’s a lot of various terms set out in the directive, which we’re going to have to enact into law. And as I said, part of the consultation will be looking to see how best to implement those provisions without having an adverse or negative impact on any sector in Ireland. And I mentioned, the interest limitation rule would have a significant impact on capital-intensive industries like aviation.

      The Impacts of ATAD Limitation Rules

      Group Effective Tax Rate

      Yeah. So, what are the impacts of this? Well, number one is the impact on the group effective tax rate, because if you have a restriction on the amount of interest that you can claim a tax reduction for, it means there’s going to be a higher level of taxable profits that will be subject to tax. The timing, you know, it has an impact on when you’re going to pay cash tax. So, it actually accelerates it for a number of different entities or groups.

      Compliance

      Compliance, the compliance for companies is going to get far more complicated because, number one, they’re going to have to conduct the calculations to determine if they have a restriction. Then if they have a restriction, they need to see, “Well, let’s carry forward,” because there’s rules that allow you to carry forward restrictive interest to future periods. There’s also rules around where you’ve got excess interest capacity. And you should be able to carry that forward. So, your tax computations are going to get far more complicated going forward with the introduction of this new rule.

      Modelling Impact

      The final point worth mentioning then is just on the modeling impact. So, for any transactions, be it an ABS transaction, securitisation, etc., the offering memorandums will always have a model setting out, well, what’s the projected profits and cash tax payments for a particular structure? With this new rule now, that’s going to add more complexity to those calculations. And it’s going to take longer to actually prepare models for these type of transactions.

      Interest Limitation Rule

      So, on the interest limitation rule, what we’re seeing is it’s a limitation on the amount of interest that you can claim a deduction for. When we talk about interest, what are we talking about? Are we just talking about the mere coupon you pay on load borrowing, or what does it include? Under the terms of the directive, what it provides for is, like, you know, the things that are caught will be profit-participating loans. So, any interest on those loans. Interest on finance leases, capitalised interest, transfer priced interest, FX movements on interest. If you have imputed interest, for example, that will be caught. If you have a deemed interest under Sharia finance rules, that will be caught. Amortised interest, notional interest, and guarantee fees and arrangement fees.

      So, as you can see, the meaning of interest is going to be very, very broad. So, it’s going to catch a whole pile of, you know, items in your PNL. It’s not just going to be your interest expense, as I said. There’s a whole pile of different or other items like guarantee fees, FX movements, arrangement fees. They’re all going to fall within the meaning of interest when you’re trying to calculate your net borrowing costs.

      From that point. And I particularly noted the previous slide where you talked about the compliance cost. In an industry where it is not unusual for there to be more SPVs than actual aircraft. I think that that is particularly interesting. But particularly on this slide here where you’re talking about net borrowing cost, can you allocate some income against that, Brian? And what type of income could you apply?

      Yeah. Exactly, Frank. When we talk about net borrowing cost, ultimately, what you’re talking about is my interest income less my interest expense and the net surplus. So, if you have a surplus, it’s that surplus that will be subject to the restriction. So, like, if you’re in a scenario where you’re loss making, for example, and you ended up in a deficit. Well, in that scenario, you don’t have a restriction. But when we talk about interest income, like…at the moment, obviously, we don’t have law at the moment. So, it’s likely challenging. So, you have to look to the directive. But the directive is actually silent on interest income.

      There was a prior consultation on this back in 2018. And in our response to consultation, we highlighted to the Department of Finance that we need some level of consistency here in that if the meaning of interest expense includes all the items I just referred to here in the slide, well, then similarly, the meaning of interest income should include all of those. So, you’re comparing like with like. So, you’re not in a scenario where you’re trying to compare apples with oranges, you know.

      So, for example, particularly with relevance to the aviation industry, operating leases would not be included in the net borrowing cost. But if you have loan interest income or finance lease income, they would be included in that overall determination. Would that be correct?

      That’s absolutely correct, Frank. Yup. It’s interesting. When it comes to operating leases, one of the points we raised in our response to the prior consultation was that, you know, when you’re looking at operating lease income, a lease is essentially akin to a form of finance for airlines. And in a lot of cases, there is an implicit interest rate built into the lease. So, what we said is, well, which is in line with IFRS 16. It’s trying to bifurcate the interest component to the capital component such that if you are an operating lessor, you can actually…when you’re doing this calculation, you can strip out the interest component out of your operating lease rentals, and compare it to your interest expense when you’re doing that calculation.

      Directive Exclusions

      So, under the directive, it does provide for some certain exclusions. So, these will be items that will just completely fall outside of the interest limitation route.

      Net Interest Expense is Less than €3 million

      So, the first one is if your net interest expense is less than €3 million. Now, unfortunately, this rule would apply on a group basis. So, unfortunately, a lot of groups, particularly groups that are capital-intensive that would have high amount of debt leverage, it’s just not going to apply to them.

      Standalone Entities

      Standalone entities, the exclusion for standalone entities, again, these are entities that just are not consolidated into the account of any company globally. It doesn’t have any associated entities. It is a pure, as I would call, securitization type vehicle. If it’s a standalone, they’re included.

      Loans Before 17 June 2016

      There’s also an exclusion for pre 17 June 2016 loans. Now, one might ask, “What’s the relevance of such a date like the 17th of June 2016?” That was the date that the directive was signed into law by the European Commission. So, what I’m saying is, if you had loans in place before that, they apply for an exclusion. However, the directive says, there must not be any modification to those loans. That certainly is going to lead to a lot of questions. This is something we’ve looked at an awful lot in practice with other interest provisions under Irish law.

      If you, for example, change the interest rate on a loan or you extend the term for maturity, or you make an amendment to payment dates, is that a modification to loan that breaches this rule? So, I’m not sure a whole pile of people will actually be able to rely on that particular exclusion. But time will tell when we see what sort of guidance the Irish Department of Finance and Revenue will give on modifications to loans.

      Financial Undertaking

      The final exclusion I’ll refer to here is financial undertaking. So, where you’ve got, for example, groups such as banks, insurance companies, pension funds, fund undertakings, AIFs, for example, there is an exclusion for those type entities. They’re regulated entities. So, they’re required under regulation rules to have a certain amount of regulatory capital. So, the European Union is kind of saying, “Well, these aren’t groups that are actually really, truly base eroding through high interest expense because under regulatory rules, they’re required to have a sufficient amount of regulatory capital on the balance sheet. So, that’s why there’s an exclusion for financial undertakings.

      Group Ratio Rule

      There’s also an exclusion for a group ratio rule. Basically, the purpose for this is to…what they’re trying to look at as well, when you compare your standalone entity to the wider group, what does your interest to your EBITDA ratio look like or compare with the group?

      The first one here, it says, it raised the cap to the same ratio as the group’s interest on third party borrowing to EBITDA. So, basically, if the ratio of our interest on third party borrowing is higher from a group perspective, basically, they’ll allow a single entity to raise its interest expense capacity to that particular exposure or that particular level.

      The other one then that they look at is basically your equity-to-assets ratio versus the group ratio. So, in this particular test, if for example the SPV has a higher equity-to-assets ratio compared to the group, then basically you’re allowed to have a complete exclusion from the interest limitation rule. So, there are two exclusions, but the challenge you’re going to have with them is, like, the complexity in trying to work out those calculations on a group basis and on an annual basis. So, you might find, you meet the test one year, but you fail at another year. And how is Irish Revenue going to implement these rules in practice? Could be quite challenging. But there’ll be more to come on that.

      Carrying Forward Unused Deductions

      The other provision that the directive provides for is, there’s options to allow you to carry forward any unused deductions. So, let’s say, in a scenario where your actual interest expense for the year is 100, but based on your calculation and the 30% limitation, you’re only allowed a deduction for 75. Well, you’ve got excess interests there of 25, and the directive allows you to carry that forward. Now, it gives you three options. We’ve pushed for the Irish Revenue to implement option C. And what that provides for is that you can carry forward any unused deductions indefinitely. It’s similar to our rules for tax losses. We can carry forward tax losses indefinitely.

      The other thing with this rule as well is it allows you to carry forward any unused interest capacity for a five-year period. And what I mean by interest capacity is this. When you run your calculations and if you determine, “Well, I’ve actually got interest capacity of 100, but I actually only have a borrowing of 50, my interest expense is only 50.” There’s excess capacity there of 50. So, you can actually carry that forward out of these rules for five years. And we will be looking for the Irish Revenue and Department of Finance to implement those rules into our domestic legislation.

      ATAD Impact on the Aviation Industry

      So, I just want to illustrate the impact that this rule is going to have on companies. And I’ve got two examples here that we go through. These are two companies that are just standard trading companies. So, if we look at our facts, right, we’ve got a company here that’s bought an aircraft for 50 million. It’s got a lease rate factor of 0.7. So, it gives it an annual lease rental income of 4.2 million. We’ve got booked appreciation of 1.7 million.

      Scenario One

      In the first example, we’ve got senior debt of basically loan to value of 75% with an interest coupon of 4%. So, the other thing we have, we’ve got operating costs of 100,000. So, if I look at the calculation under the heading Trading Company 1, we run down to…we have our rental income depreciation, our external funding costs, our operating costs, and we have a profit before tax of 900,000.

      So, the first step you have to do is, well, firstly determine my EBITDA. So, EBITDA in this example is pretty straightforward. It’s leased rentals less your operating costs, which is 4.1 million. Then you’ve got to determine, “Well, what is my allowable interest expense?” So, 30% of my EBITDA, that’s all I’m allowed to take a deduction for. So, here that gives us 1.23 million. And if I compare that to my actual interest expense, which is 1.5 million, it means I’ve got a restriction or an amount of disallowed interest of 270,000. The tax effect of that at 12.5 is 33,750.

      Scenario Two

      If I look at my other example here on this page, the only change is that we’ve decided to introduce some shareholder debt. So, we continue to have our 75% external debt. We’ve got 20% shareholder debt and then 5% equity. So, with the additional shareholder debt, it increases our interest expense in the example here by 650,000. And if we look at what my EBITDA is, it’s the same as the first example. My allowable interest is the same. It’s 1.23 million. However, the amount of disallowed interest I have is far higher. It’s 920,000 here. And that’s purely because of the fact that we’ve introduced interest on shareholder debt.

      So, the anomaly here is that the higher the amount of leverage that you have, the potential higher amount of restriction that you have as well, unfortunately. Because in the first example, we had 25% equity on the balance sheet of this entity, which meant that the amount of restriction that we were suffering was lower.

      Interesting, Brian, that example, particularly in relation to how you’re going to structure a SPV scoreboard in that scenario.

      Exactly, Frank. Yeah, absolutely. Like, where you’ve got, you know, other entities within your group that may have excess borrowing capacity or excess interest deductions, etc., you would like to think that we’d have provisions that allow you to move those tax attributes between group members. But, obviously, the devil will be in the details when the legislation comes out on that, you know. But it is interesting the restriction that this can have.

      Now, for some groups with aircraft, they might say, “Well, what does that mean? Because I’ve got losses carried forward because of the tax depreciation on the assets.” But what you’ll find is your…the period in which you start paying cash tax will actually start happening a lot sooner because with the interest restriction, you’re actually eating into your tax losses. So, your pool of tax losses will actually start diminishing a lot faster than what we would have today, for example.

      Scenario Three

      The final example I’m just going to walk through here is just for a section 110 company. Now, as everyone would know, the difference between a section 110 company and a trading company is that a section 110 entity is entitled to an interest deduction for profit-participating debt. So, if we look at our example here, the facts, very similar to what we had in the first example. The only difference is that we’ve got 25% of our funding is basically profit-participating debt.

      So, when we look at the calculations that I’ve done here, we’ve got our lease rental income of 4.2 million, accounting depreciation 1.7, external funding cost of 1.5. I’ve got shareholder funding cost, which is my PPN interest of 890,000. And we’ve come to that number because of what we said, we’re going to leave a profit of 10,000 in the company on an annual basis, operating costs of 100,000. So, again, work out my EBITDA at 4.1 million. My allowable interest is 1.23 million. But when I compare that to my overall interest, then my senior interest and my PPN interest, my restriction is a lot higher, which is 1.1 million. But more importantly, the actual tax effect of that is worse because a section 110 entity, as we all know, pays tax at 25%. So, the tax leakage in this particular scenario is far worse at 290,000.

      And that’s all I’m going to cover off on my presentation today. And I will hand it over to Frank. Thank you.

      Learn More About Our Aviation Services

      Thanks, Brian. We could have extended that for another 10 or 15 minutes with some questions that were coming to mind on that, but we’ll leave those for another day. Certainly, it’s going to be challenging, and it’s going to mean the management of tax losses is going to require a lot of attention to make sure they don’t get trapped in SPVs. Again, thank you, Brian, for your very detailed overview.

      In terms of the eminent introduction of ATAD and the interest limitation rules, they have yet to be legislated first. So, we are not certain as to their final impact. But one concept that has been topical in recent years has been the use of aviation fund in either Ireland or Luxembourg, but in this instance, we’re focusing on Ireland. So, we’re looking at a potential regulated aviation fund. And who better to ask about how he would see that working than my colleague, David Morrissey? So, David, would you like to take us through your experiences and how you would see this operating?

      Regulated Aviation Funds

      Yeah. Thank you very much, Frank. And good day to everyone. I suppose, to Frank’s point, obviously, today we have a number of aviation funds already in existence. They’re either established as Irish qualified alternative investment funds or indeed as Luxembourg reserved alternative investment fund. And we can touch on both of them momentarily. But, really, we want to try and demonstrate our experience today, and try to make this process as transparent and as easy for those listening in to learn from the experience and what we’ve seen today.

      So, as I’ve mentioned, most of the funds we’ve seen historically have either been Irish regulated funds established as qualified alternative investment funds. In Luxembourg, it’s a reserved alternative investment fund. It’s small technicality just to point out that the Luxembourg fund. Although not regulated officially itself by the CSSF, it is seen as a regulated structure from the European perspective because all the service providers are actually regulated.

      So, both vehicles can actually avail of the AIFMD passporting mechanism. And this is the key issue for particularly clients that may be looking to raise capital from a European institutional market, and certainly one we’ve seen many of our clients to date experience from. Both of these vehicles are well-established and well-recognized from an investor’s perspective with QIAIFs — that’s the acronym used on the Irish side — being in existence since 2012, and the Luxembourg RAIF structure is being used since 2017.

      Learn More About Regulated Aviation Funds

      Just as you’re moving on to that slide, David, why…is there particular reasons why you would choose one jurisdiction over another in terms of Ireland versus Luxembourg?

      Yeah. Thank you, Frank. That’s a good question. The reality is that, you know, jurisdictions are relatively equal when you look at it from a, I suppose, regulatory perspective. But the reality is, investors would always have their own preference or certainly a perceived preference on one jurisdiction over another. As it stands today, one of the big benefits that Luxembourg has over Ireland is the ability to establish their fund structures as a limited partnership. With the evolution and the development of the RAIF vehicle in 2017, I would say, frankly, nearly 90% of the funds that we establish today in Luxembourg are being established as Luxembourg reserved alternative investment funds and being established as limited partnership structures.

      Unfortunately, in Ireland, we do not, as it stands today, have a limited partnership vehicle. It’s typically established as an ICAV structure, which is a equivalent of a corporate vehicle that has been specifically designed for investment funds by the Irish Regulatory Authorities, and one that is used widely across the world.

      So, from an investor’s perspective, if they have a preference to be utilizing a…as well as a limited partner in a GP model, then they have a tendency to go towards Luxembourg. However, if you have what I would say an investor who’s quite comfortable with being a shareholder in the corporate structure, then they would typically default to the Irish structure.

      Moving on to the key features, I mean, the reality here is, when we’re looking at the funds, the fund structures themselves help satisfy from a substance perspective. Again, the idea that when you look at an unregulated vehicle, that is something that they have, I suppose, fallen foul of. Particularly, we find there’s an issue or a challenge. As a QIAIF structure, when we look at it from an Irish perspective and their regulated status, they’re exempt from taxable income and capital gains arising from the activities within Ireland and Luxembourg. Again, we anticipate that they can make distributions to non-residents, and investors are free of any Irish withholding taxes.

      Again, this is something that many corporate institutional investors will already be leveraging off globally, particularly when you’re looking at some of the large pension funds from a European perspective, and indeed institutional and family offices from elsewhere. So, it’s a well-trodden path and a path that’s utilized quite widely today. So, really, I suppose, from where I would sit, Frank, the aviation industry is actually benefiting from something that’s already in existence.

      Benefits of Regulated Aviation Funds

      Continuing on with the benefits. Again, when we talk about it from a fund manager perspective, there are some key issues here, which I wanted to highlight. Again, the use of these structures, you can access larger pools of investor capital as I’ve already mentioned, the fact that these vehicles are being utilized by institutional allocators from across continent. Again, that allows them to expand what they can invest in, these asset classes that historically they would not have been able to do.

      And what I mean by that is historically a lot of institutional investors would have been allocated to these asset classes through unregulated structures. There could have been securitisations or there could have been simple SPVs. By having them in a regulated fund structure and under the AIFMD regime allows those institutional investors to invest in these regulated fund structures under the safeguard from the European regulatory perspective.

      In doing so, it’s actually cheaper capital as well. And the investors are committing to a longer-term, I suppose, horizon in their view and allocating capital to these kinds of structures. This is something that we’ve seen in other asset classes, and we’ve begun to see it in the aviation industry today as well, and how it’s actually structured.

      Sorry, David. Just cutting you here. But something that I see of relevancy in this instance is often in the funds sector, there’s reference to closed-ended funds as opposed to open funds. Perhaps you could just detail the difference and why. I think it is something that would be of interest to our audience.

      Yeah. No, I agree, Frank. Closed-ended vehicles are typically where the investors committing to give capital to the fund structure for a period of time. Now, closed-ended vehicles can range from three to five years. And the longest I’ve personally seen has been 12 years with an option of extending it for a further two years. And what the investor basically is saying is that, listen, he’s handing over his capital investment to the manager, to the fund structure on the basis that they’re going to have a yield being returned to them on an annual basis, or that they have capital appreciation over that period. That’s something, again, within this asset class, I think, is very appealing to some of your clients today.

      With regards to open-ended vehicles, it really is probably more what, I suppose, aviation people would see with securitisation products, or there might be an individual note or issuance listed on a particular stock exchange. And again, an open-ended vehicle will have some sort of liquidity requirements in there, or capital could be required to be returned to the investor. Again, it might be as frequent as on a monthly or quarterly basis, but typically, again, on these asset classes we’ve seen historically has probably been on an annual basis. So, the benefits of having a closed-ended structure are something that, again, I think that would be very appealing to not just investors, but also to the managers as well.

      That’s from a manager or the lessor perspective. When you’re looking at an investor, you have to ask yourself, why are they looking at these structures and what are the perceived benefits to them? It does come back to the whole origin of AIFMD, and why that was brought about. And the reality is, that was brought in from a regulatory perspective to protect investors within mainland Europe. The bottom line is that within an AIFMD structure, the assets should be segregated and effectively ring-fenced for the benefit and the interest of the investors within the fund.

      So, as such, if something was to go wrong with the fund, if there was an issue with the fund, the service providers that are there are there to protect the interest of the investors. And again, I’m not going to get into them here momentarily, but you have things like the management company, and the administrator and depositary whose fiduciary responsibility to safeguard those assets is actually enshrined in the legislation, and basically have an uncapped level of liability associated with it.

      Again, if I’m a European Institutional Investor, a pension fund, and I decided to employ 100 million into this fund, as long as the fund adheres to its investment strategy, and delivers on what it was supposed to deliver on from a management perspective, again, I shouldn’t have an issue. But if there’s a problem with fraud or if something was to go awry with the fund structure itself, then as an investor, I have that level of protection under the AIFMD legislation to fall back upon.

      It’s something that, again, that we’ve seen significantly grow over the last eight years since AIFMD was brought in with many institutional investors now, from a European perspective, only being permitted to invest in these structures.

      Moving on from an investor… Sorry, Frank. Were you going to ask another question?

      The Role of the Custodian

      I’m just going to interject. That is a very important point, the role of the custodian. And I know it’s something that Seamus will touch on later on. But it is something that should give the investors a high degree of comfort. But it is an important point as well.

      We will touch on this point briefly. Because I know if there’s other panelists, participants, we’ll reference it as well. The key service providers with a fund structure from a European perspective, I’ve already mentioned the management company. You then need an administrator and depositary. And I suppose, to give everyone in the audience reassurance, this is something that DMS does day in, day out for many of our clients globally. So, we’re well-positioned to pull this together for you, utilizing our partners at A&L Goodbody, and indeed the KPMG, and other key service partners to ensure that we have all of the service providers in place.

      The management company has an oversight requirement, an obligation from an investor’s perspective. The administrator, obviously, is there to do the official books and records of the fund. But to Frank’s comment about the term depositary — or historically you might’ve seen this listed as custodian — is key.

      The depositary is there to, as I’ve mentioned already, ring-fence and safeguard the assets for the investors. But I know it’s often the question that comes up with lessors with regards to the title of the aircraft. So, the aircraft will be held through an SPV structure itself, typically an Irish entity. But there’s no need for the actual, I suppose, title to the aircraft itself to change or to be impacted in any way.

      Ultimately, all the depositary wants to make sure is that the assets itself and the financial benefit associated with that asset, whether its disposal or ongoing income, is there for the benefit of the investors in the fund. And again, there are various mechanisms that we’d be happy to delve into at a later date, or if anyone has any questions, to come directly to us and talk people through how that solution would actually work.

      All of the other key service providers are listed out there in the schematic on screen. And again, from a DMS perspective and our different service partners that we work with, it’s a relatively straightforward model. Please do not get alarmed on how all these different entities may appear. But I suppose the assurance we want to give you and indeed our clients today is that we’re well-positioned to be able to manage this for you. I think a lot of the depositary requirements I’ve already touched on that.

      Helping Depositaries Get More Comfortable

      And I suppose this, again, is probably more for our service partners involved. Because, certainly, one of the big challenges has been how the depositaries get comfortable with this asset class. Historically, and I have to be quite candid on this, many depositaries would look at aviation assets as something that was beyond their comfort zone. And I mean, from a DMS perspective, we’ve spent a long time working with our clients, but working with the leading depositaries to make sure that we can give them that comfort around how we’d be able to support the business.

      So, as you can see there, there’s not just, you know, aviation assets, but there’s other types of assets we can include as well. Again, we look at, I suppose, evidence of the ownership is key for us from an aviation asset perspective. We look at the register extract, the share certificate or the profit participation note. We obviously have to monitor the bank account. And again, that’s just part of the ongoing approval process from the depositary and reconciliation of the cash flows across that. And then we look at the individual aircraft. Back to birth bills of sale, verify to international registry and aircraft registry, etc. And that’s all done by the DMS aviation team.

      And then the final segment on that is in relation to the aviation or aircraft engines. Again, verifying and checking the registry, just to ensure that from a depositary perspective, there’s nothing untoward, and that they can rest assured that the assets within the structure itself are actually being held as they should. Thank you. Back to Frank.

      Thank you, David. I think that should give people a good overview of how a typical regulated structure works. Clearly, the introduction of the tax legislation in 2021 may have an impact on how to structure it. But it should give you an understanding of the key parameters, and it is something that DMS has a long history in. So, as David has illustrated, it is something that is workable.

      Legal & General Structure Considerations Around the Use of a Regulated Aviation Fund

      Okay. So, we’ve had an overview now of the tax considerations and the potential structure that can be implemented. In terms of the specific structuring considerations from a tax perspective, we have, as I said earlier, Seamus O Croinin from A&L Goodbody to present his views and his considerations of items to consider as you go through this.

      Great. Thanks very much, Frank. And hello, everybody. So, just following on from Brian and David, what I’d like to discuss are some of the legal and general structure and considerations around the use of a regulated aviation fund. And I use RAF as the acronym, just for the purposes of this presentation.

      Challenges to Irish Aviation Structures

      And probably where I’d start from is, is that, you know, it’s very clear from Brian’s slides that the new ATAD limitation rules, you know, are going to present some challenges for a number of Irish aviation structures. They are very complex rules, and there will be a lot of analysis and a lot of considerations to take into account as to what structures may be implemented and how we may change structures to address those rules when we see them in their final form. And, of course, we’re considering an RAF in that context. But I think it’s probably important to look at it in a wider context as a very interesting new potential aircraft holding structure that, I think, for a number of reasons — and David has touched on some of them — I think will become increasingly popular in the coming years.

      And I think, probably first, just to mention — and I think it is something that has to be mentioned — obviously, when you are dealing with a regulated structure, the cost of establishment, the timing for approval of the Central Bank, those costs will be higher, the timing will be longer than for an unregulated structure. But as David has explained, you know, there are very material and substantial rewards in return. I’ll cover some of them later on, but I think one that certainly is worth underlining is the potential access to new pools of capital and new investors. And certainly, if there’s been one story in the aviation space over the past few years, it has been the increasing number of new investors looking to take some exposure to the aviation sector. And I think these funds are very interesting developments in terms of bringing in new groups of investors who are used to investing in regulated fund structures and marrying that with some exposure to aviation.

      I probably would add, and just kind of in terms of that trend, we certainly are seeing regulated funds becoming more and more popular in many asset classes, but specifically, they are being used in particular by private equity firms to hold investments. And we’ve certainly seen those private equity firms move from other asset classes into aviation, and are beginning to see the use of these regulated funds to hold aviation assets alongside other private equity investments. So, definitely, that trend is already well underway.

      So, perhaps then I could move on to maybe some of the sort of key structure and considerations that we would see at a very high or general level when you’re thinking about establishing a regulated aviation fund. And I think, a couple of key points to mention here.

      I think, first of all…and again, coming back to the phrase I’ve used, “exposure to aviation assets,” I think, in the modern aviation world, I think there are a lot of investors who are happy to take exposure to aviation assets in a number of different guises, whether it’s the metal, interest in a trust, interest in a company, an aircraft loan, or aviation bonds or aviation secured or unsecured paper.

      Make Sure that Your Fund Structure Is Flexible

      So, I think one very important point — and, again, our colleagues in DMS and KPMG can assist you in this regard — is very much making sure that your fund structure does build in flexibility as to the type of aviation assets that you want to invest in. And, in particular, we’ll probably highlight aviation loans as an important point here. And, you know, if you are looking to originate aviation loans, as well as acquiring interest in aviation assets, I think it’s very important to ensure that you have the necessary flexibility in your sub-funds to make sure that they have, within their constitute of documents, the ability to make those investments.

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      Level of Control Over Assets

      I think, probably, the second diligence point — and again, it’s probably coming into contact with an increasing trend in the aviation sector — is the level of control over the assets. And I think, David has explained how regulated funds work. Obviously, there is a need for a regulated fund manager. That manager can delegate certain tasks, including day-to-day administration to unregulated third parties who can be related with the sponsor. But there are certain functions and certain key functions that need to be retained by the manager or delegated to regulated entities. And in that regard, I think it’s very important in the aviation sector that investors and managers focus on the level of control over their assets and how that will work on a day-to-day basis.

      And I think, that control can be developed through the matrix of contracts around the regulated aviation fund. But it does require some focus on board representation, the management arrangements, and the delegation arrangements. And I would probably say that aviation expertise in relation to your manager and the choice of your manager is extremely important in that regard. And I would also suggest the ability of a manager and a custodian to interact and liaise in a practical manner which ensures that the assets are managed properly. That is also very, very important.

      New Product

      And I think, probably, the last point I’d make here is that this is, in the aviation space at least, a new product. And I think, if you are a manager or an investor, and looking to bring this to other counter parties, such as lessees and lenders or other third parties, I think it’s reasonable to expect that there will be some diligence required to explain the product, to share the incorporative constitute of documents, and the formative contracts. And we need to explain the key terms to these customers. I don’t see that as a particular challenge, but I think it is worth making sure that you have that diligence in mind when you’re preparing your contracts, and you have your information packaged in a manner that can be shared in a format of a type that can be easily understood by those counter parties, whether lenders lessees or other third parties.

      Operational Considerations

      So, moving from the high-level considerations then just to some of the operational considerations, always a very important consideration for any Irish aviation holding structure, how can the assets be managed? And I think the key point here is that whether you hold aviation assets through the regulated aviation fund itself or through Irish subsidiaries, as David and Brian have both mentioned, I think, in either case we are still dealing with an Irish company. And the good news is that all of the usable basic corporate rules as to structure, approval and execution of documents, entering into contractual arrangements, they will all apply to the Irish regulated aviation fund and to its subsidiaries.

      There is here, for this type of structure, the overlay of the management agreements. And I would probably suggest that the management arrangements, by delegating power to a manager, may facilitate simpler execution processes. And by that, I mean, unlike perhaps some regulated aviation structures in this regulated aviation fund structure, the manager is far more used to assuming responsibility for key decisions. And that potentially allows the fund, the company which is effectively the central fund vehicle, to delegate more authority to a manager who can make decisions without constantly having to refer back to the board as would be the case with an unregulated structure. So, that is something…it’s probably an interesting question and something that might be considered in terms of these sort of structures.

      However, I probably would flag that, you know, we are dealing with an aviation world that has a very set way of doing business. And it’s likely that board resolutions and powers of attorney will still be required by airlines, by tax authorities, by lessees, by lenders. So, we do have to prepare ourselves to deliver those documents, but that still can be done within a regulated aviation fund.

      I think, two other small points to mention. As many of you are aware, there is a Central Bank of Ireland registration requirement where an unregulated fund enters into finance, leases, or lending activities that does not apply for regulated aviation fund, it would apply to any Irish subsidiaries. But if the regulated aviation fund already has KYC processes, it should be a relatively simple matter to extend those to the subsidiary. So, probably something that’s probably an easier issue to handle in the regulated fund structure.

      And lastly then, and going back to a point David made around substance and the substance requirement that has been created through the Central Bank of Ireland regulated fund, there is an interesting question here as to whether that may, in certain circumstances, assist the double taxation treaty residence analysis with foreign tax authorities, where one can point to the fact that this is a financial institution of sorts, which is regulated by the Irish Financial Services regulator. Not something, I think, where there’s been any practice established at this stage, but probably an interesting space to watch as at the use of these funds becomes more popular.

      Financial Considerations

      Just very quickly then, to finish just on finance considerations, obviously, in relation to these structures, third party debt is a very important consideration. I think it’s important to note that you can use insolvency remote structures with these regulated aviation funds. You can set up orphans, which will then sell e-notes or other instruments back into the funds. And I think we will need to carry out probably a more detailed related company insolvency analysis if you’re using subsidiary companies to borrow money from third parties. But there are structures already in the marketplace in the unregulated space, and they are becoming more common where lenders are happy to lend into structures, which have an element of ring-fencing, but are still within an overall group. And I think, certainly, the regulatory element of this fund structure may give some comfort to lenders in that regard.

      I think the other point that’s worth mentioning, and I think David touched on it earlier, is that these fund structures are specifically designed to protect investors, and to segregate their assets from other sub-funds and from other claims unrelated to the fund itself. And those segregated cell provisions, I think, are another interesting development. We don’t have them in the unregulated fund structure, which may be of interest to both investors and to lenders.

      And I think, lastly, just some other points on finance just to finish, some smaller points. I think, obviously, if you are dealing with third party debt, it will be necessary to consider what the consequences of enforcement are if you are using the funds directly, but also in relation to subsidiaries, if an appointment of a receiver or a similar officer charged with enforcing and realizing security is appointed. You know, what consequences will that have for the structure? That is a point, again, which I think can be worked through, but it’s important to just take into account.

      And I think, then just lastly, some smaller finance points. Obviously, Irish regulated aviation funds can make Cape Town filings, and can benefit from the new aviation working group GATS system, which is of course this new trading system whereby aircraft will be placed into Irish law trusts or indeed Delaware or Singapore trust with the beneficial interest then being traded electronically. So, all that optionality is available to these funds and their subsidiaries. And similarly, although there is a different mechanism for filing security interests similar to USU CC and the Irish CRO form C1 mechanism, there is a separate mechanism for regulated aviation funds, but it’s not materially different in any respect. However, security filings are required in relation to the funds, and that does help in terms of giving lenders and third parties some visibility in terms of the interests that have been created, or security interests that have been created by the regulated aviation fund.

      So, I think, just to finish on that point, probably a very interesting development in the aviation space, some considerations, both general and specific and operational to take into account, but very much an interesting development and one that I think we’ll see a lot of development in the coming years.

      Thanks, Seamus. That was very informative, and probably confirms the sense for many of us that it is a natural convergence of two sectors, for those of us that have been involved in the aviation finance space for many years, and potentially, now the fund sector.

      So, one item that, I think, when you look at these structures, that comes up regularly is the role of the depositary and how they perform their tasks and their duties. We have met many of them in Dublin, discussing their role in terms of aviation. Seamus, from your side, from the legal perspective, and in terms of them getting comfortable with, I suppose, the existence of the assets, do you see a specific challenge with aviation assets as opposed to, say, real estate with similar…with leases associated? Do you anticipate that it will involve a similar process?

      Yeah, Frank. I mean, it’s a really interesting question. And perhaps for those of us in the aviation sector, you know, coming into contact with the regulated fund sector for the first time, this is a new concept that you have a depositary or custodian who is charged with maintaining some sort of oversight and control of the assets. But I think, what’s really interesting is, I think that, you know, the industry probably has quite a lot to offer to satisfy those concerns. And I think, in particular, some of the developments over the last 15 to 20 years, I think specifically, the international registry and the ability to search, I think as was mentioned in David’s presentation, for a chain of title in relation to assets and also in relation to leases and security, I think is of real value.

      I think also just the general management of these assets under existing rules and practices in the aviation sector, you know, does lend itself to quite positive engagement with custodians and depositaries in terms of, you know, displaying control of the key technical records, and also in terms of monitoring the aircraft maintenance and its movements as well. So, I think, all of that, I think, generally to my mind, I think I would be pretty confident that there’s a lot there that can be used to satisfy depositaries and custodians.

      I think there’s probably two interesting points here. And to touch on something you said, I think the most important exercise here will really be to educate depositaries and custodians as to the nature of the asset, how it operates, what the considerations are, what the control points are. And I think, in that regard, as I said in my presentation, a custodian/depositary who is comfortable with the asset class, and who has taken time to understand it in terms of engaging with the manager, I think that’s really important. And I think that should be a very important factor for anyone looking to set up a fund here to make sure that the depositary/custodian does have that necessary expertise.

      The New AWG GATS System

      I think, probably one other point that’s worth making is, there is an interesting convergence here with the new AWG GATS system, where beneficial interest in aircraft will be traded electronically through trust arrangements. And probably an open question as to whether perhaps some of the trustees who are going to be working within the GATS framework may now start looking, and perhaps fulfilling depositary or custodian roles as well.

      Where those two are separate, you know, so far as far as I’m aware, I don’t think depositaries and custodians are looking for their own form of limitation or restriction on the asset itself. Hopefully, that will continue that way. But I would say, in other asset classes where we’ve dealt with depositaries and custodians, we have managed to work out very workable solutions in terms of how depositaries and custodians exercise their control over assets, principally in the real estate sector. And those arrangements have become fairly standard and, I think, are quite easy to put in place now in relation to real estate financing.

      So, certainly, there are good precedents out there. But I think, you know, a depositary or custodian who has taken time to understand the asset class and indeed, you know, a manager has taken time to explain it to the depositary or custodian, I think that’s going to be really important, going forward.

      And that’s a really good point, Seamus. We have taken the time in DMS to go and meet with some of the depositaries. And they have shown real engagement on this process. We expect them all to apply their own specific approach in getting comfortable. But there has been a real engagement on this, which can only be beneficial for the industry.

      Conclusion

      So, I think the key message is, this is a potential structure that can work, but it will depend on the specifics of the legislation to be introduced in 2021, and also will depend on the specifics and facts of each particular structure that is envisaged to be implemented. But it’s going to be a fascinating area. And for the aviation industry, it is anticipated to be an area of much consideration in the coming 12 months.

      Thank you, gentlemen, for joining us today. That was a very informative webinar. If anyone has any questions to any of the attendees, then you’re very welcome to contact them directly. We’ll make sure that everyone is furnished with a copy of today’s presentation, including all of the panelists’ contact details. Thanks for joining.

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