Much has been written about December's Autumn Statement announcement by George Osborne, UK Chancellor of the Exchequer, of a new targeted exemption from UK withholding tax for interest on qualifying privately placed debt. The exemption was enacted in primary legislation at the end of March 2015 when Finance Act 2015 received royal assent, although the detail and date of entry into force of the exemption remain to be seen courtesy of regulations which are still to be drafted and enacted and which will, no doubt, be the subject of considerable scrutiny.
Why the private placement focus?
Rewind three years to March 2012 and the publication of the Breedon Report which was commissioned by the Conservative and Liberal Democrat coalition government to examine a range of alternative and sustainable finance sources, particularly for small and medium-sized enterprises (SMEs). The government recognised that bank lending (both traditional loans and overdrafts) was the largest source of external finance used by businesses, but even that was in decline (it continues to be so, the Financial Times reports). Commission of the Breedon Report was therefore a tacit acceptance of the need for non-bank debt finance to develop greater resilience in the financial system (while appreciating the role and benefits of equity financing).
The Breedon Report made 11 recommendations in total, ranging from increasing awareness of financing alternatives and greater access to information to facilitating access to public corporate bond markets and exploring peer-to-peer lending platforms. All were geared towards unlocking significant additional finance for UK businesses, generating new funds from institutional and individual investors. One of these recommendations (Recommendation 4) was increasing the number of UK-based private placement investors through an industry initiative led by the Association of Corporate Treasurers (ACT), in order to unlock a new source of financing for mid-sized borrowers.
"Despite the sophistication of the UK's capital markets and the concentration of international banking activities in London, the UK's domestic capital markets remain under-developed relative to those of other advanced economies. We believe that decisive action is required to bring the benefits of capital markets financing to a much broader set of UK small and mid-sized businesses"
Department for Business, Innovation and Skills (March 2012), Boosting Finance Options for Business
The taskforce (chaired by Tim Breedon, CEO of Legal & General) believed there was significant potential to develop both the demand and supply of non-bank lending to match the financial landscape of countries like the US, in which the private placement market has been popular for some time and where insurers, pension funds, asset managers and other investors avoid public markets to buy private placements (some $50 billion worth in 2013). Within Europe, France's 'Euro PP' – underpinned by the Charter for Euro Private Placements – and Germany's 'Schuldschein' markets are the most developed private placement markets. The Breedon Report considered that "if UK institutional investors invested in private placements in the same proportion as US-based private placement investors, an additional £15 billion of non-bank lending could be available for mid-sized business in the UK". The taskforce believed that industry working together to address and find solutions to overcome market and regulatory barriers could lead to an increase in investor competition and lead to a decrease in prices, allowing smaller companies (with EBITDA of circa £15 million) to issue private placement debt.
The ACT subsequently recommended introducing a new exemption for private placements from the requirement to deduct income tax at source from interest, thereby removing what has been perceived as an obstacle to the development of a market for UK-based private placements.
If the exemption is to achieve the intended aim of opening up non-bank debt finance to SMEs, it necessarily cannot have a sector bias. It is therefore expected that industries ranging from consumer products and telecommunications to the automotive industry and power generation will avail themselves of the new benefit. It is logical, of course, that the more capital intensive industries will seek to benefit from the exemption and it is therefore no secret that the energy and infrastructure sectors are expected to be key users in practice. While they may not in some cases seek private placement funding at the riskier construction phase of a project (private placement investors such as life assurance companies and pension funds tend to be risk–averse, generally speaking), such investment would be welcome (and perhaps most appropriate) at a later stage of their life cycle when the relevant asset offers a stable income stream (toll road receipts, for example, in the transport infrastructure sector). At this time, the relevant issuer is likely to have sufficient comfort to be confident that it can meet its long-term liabilities under a private placement.
In the US (a reasonable proxy for what the UK private placement market may look like), a slice of the issuer spectrum of the private placement market is likely to identify the manufacturing, energy and power sectors (as a general collective) accounting for around 60% in aggregate of private placement issuers, consumer products and retail accounting for around 15%, with media and telecommunications, real estate, gaming, tech and finance reportedly plugging the gap. Figures vary, however, and the Private Placement Industry Forum represents sectors across the board, featuring airports, real estate investment trusts (REITs), universities, seaports, sports, logistics, energy, water, power, renewables and rail.
At the investor end, perhaps unsurprisingly, Legal & General (Britain's biggest pension fund manager) has announced its intention to invest in private placements, joining other insurers such as M&G (the investment arm of Prudential) who have long been keen. BAE Systems' company pension fund and Italy's Generali are reportedly also interested in private placements. To such investors, the promise of decent yields and diversification has significant appeal.
But can't such users avail themselves of existing reliefs?
UK withholding tax (currently at the rate of 20%) generally applies to payments of yearly interest arising in the UK, with exceptions under UK rules for certain payments to UK banks and UK corporates and in relation to interest paid on 'quoted Eurobonds' (that is, securities issued by a company, carrying a right to interest and listed on a recognised stock exchange). Relief may also be available under a relevant double tax treaty to reduce or eliminate the charge, subject to the completion of procedural formalities. Technically, withholding tax is a tax on a lender's income; however it is rare that a lender would agree to bear such cost and, in practice, both lenders and borrowers enter into financing arrangements on the contractual assumption that no UK withholding tax will apply (whether by application of domestic rules or treaty). Where UK withholding tax is imposed, as a commercial matter the cost would ordinarily be borne by the borrower, whether as a result of contractual cost allocation or a cost component of funding.
In the international arena, borrowers usually look to lenders who are well positioned to avail treaty reliefs in order to obtain UK source interest free of withholding tax. Where the borrower has to go outside of this pool of lenders to obtain financing, the borrower will look to list the loan in question and thereby rely on the quoted Eurobond exemption to ensure that no UK withholding tax arises on the payment of interest in relation to such loan.
These restrictions naturally narrow the options for UK borrowers as they either have to look to a limited lender jurisdictional pool or incur substantial expenditure to list the loan in a suitable stock exchange. The listing of bonds is costly and requires significant ongoing compliance and is therefore not a viable option for many prospective borrowers, especially SMEs for whom access to finance is arguably most crucial.
It is logical that the UK government is looking to take UK withholding tax out of the commercial equation as it is only right that UK borrowers are able to make financing choices without being dictated by UK withholding tax constraints.
The new withholding tax exemption (which is targeted broadly at long term unlisted debt) seeks to remove these barriers (subject to certain exchequer safeguards).
Total infrastructure issuances between 2000 and 2013
Top 10 countries (Figure 41 of ‘Corporate bond markets: A global perspective’, Volume 1 April 2014, Staff Working Paper of the IOSCO Research Department)
|Source: Dealogic. Note: 2013 figure based on data extracted end-September 2013|
So what exactly is a private placement?
One interpretation of 'private placement' is medium to long term fixed coupon debt instruments issued directly to institutional investors based on deal-specific documentation negotiated by the issuer and the borrower, with the participation of an arranger (although an arranger is not always required). In the European market, it is widely understood to mean the issue by a medium sized company to one or more institutional investors of a transferable, unsecured security of fixed coupon which is unsubordinated to existing debt of the issuer, in consideration of the grant by such institutional investors to such issuer of debt finance for a term of between five and 30 years.
Private placements, in theory, may be of listed or unlisted debt which may be rated or unrated; further, although in theory a private placement security is transferable, it is generally illiquid in practice and many private placements are undertaken as 'buy-and-hold' transactions, although this is not a key feature or requirement.
Although obviously certain restrictions for the investors' benefit will be placed on the activities of a private placement issuer, as a general rule the limitations which feature in a typical private placement arrangement will be significantly less burdensome on an issuer than typical bank financing (pension funds, for example, are likely to lack the in-house expertise, capability or even desire to make significant demands – and would therefore typically seek less involvement – than banks). Nevertheless, the contractual covenants will remain, and arguably one reason for the success of the US private placement market is that US investors are willing to trade liquidity in exchange for the early warning provided by covenants whereas traditionally UK investors have required an illiquidity premium.
How, then, to define 'private placement' for the purposes of the new UK withholding tax exemption?
The new exemption – primary legislation
The exemption contained in the primary legislation in Finance Act 2015 applies to payments of interest on a 'qualifying private placement', which is defined in the Finance Act 2015 as a security which represents a loan relationship to which a company is a party as debtor, which is not listed on a recognised stock exchange and in relation to which such other conditions as the Treasury may specify by regulations are met. A balancing act must be struck, though, as UK withholding tax on interest is (and historically has been) a basic tenet of the UK tax system and therefore the UK government will, understandably, be mindful of the need to craft an exemption which is focused enough to achieve the desired result yet wide enough to be applicable in practice without effectively removing the withholding obligation altogether.
The primary legislation represents a relaxation of certain conditions in the draft primary legislation originally released for consultation in December 2014, a week after the announcement of the exemption and which previously required the security in question to be 'issued' by a company and, further, required the loan relationship represented by the security not to provide for its termination within three years of its coming into force (meaning that mandatory and optional redemption clauses and their equivalents should no longer prevent interest on a private placement from being eligible for the new exemption). Removal of the word 'issued' seems to suggest that loan-type arrangements would in principle fall within the purview of the exemption.
The regulations which may be made under the primary legislation and which may prescribe further conditions for the relief may now extend to conditions relating to the person by or through whom a payment of interest on the security is made. The other further conditions which may be contained in regulations relate to the security itself, the loan relationship represented by the security, the terms on which the security is entered into, the borrowing company and the investor.
In particular, as at December 10 2014 HMRC set out in its Technical Note that the detailed conditions of the private placement exemption would extend to certain matters. Some of those appear to merit the most attention:
Conditions applying to the issuer of the security
"Qualifying conditions relating to the issuer would include the primary requirement that the issuer must be a trading company. The exemption is not intended to be available for issuer companies whose business consists primarily of making or holding investments."
This condition would appear to preclude the exemption's application in relation not only to pure holding companies but also companies whose activities are cyclical and may at different times in their life cycle go through phases of 'trading' and at other times activity more typically described as 'investment'.
"Regulations would set a minimum and a maximum issuance size by an individual company. It is proposed that the minimum issuance of a qualifying private placement by an individual company would be £10 million, and the maximum issuance by an individual company would be £300 million."
The private placement exemption would appear to 'fill a gap' in the UK withholding tax landscape by introducing an exemption in relation to issuers which would not normally avail themselves of the quoted Eurobond exemption (principally for cost and ongoing administration reasons) and yet for whom treaty formalities would be unduly burdensome. Restriction by issue size is therefore logical.
Conditions applying to the holder of the security
"Qualifying conditions relating to the holder (or investor) would include the primary requirement that the holder of the security must not be connected with the issuer."
As many will be aware, the quoted Eurobond exemption has come under fire in recent years for being used in relation to intra-group financing, and it is perhaps to be expected that the UK government will be keen to ensure that the new private placement exemption not only does not serve the same function as the quoted Eurobond (which may be used in relation to intra-group financing arrangements) but that it is used by issuers genuinely looking to raise third party finance in the open private placement market.
A qualifying investor would be required to be resident in a 'qualifying territory'. This term … refers to a territory with which the UK has a double taxation treaty which includes an appropriate non-discrimination article. The HMRC International Manual has a list of such 'qualifying territories' at INTM412090. 'Resident' for these purposes is defined in section 167(5) of TIOPA, and means liable to tax there by reason of domicile, residence or place of management.
The UK government would seem, understandably, to be keen to avoid the exemption being used to avoid tax, particularly (but not limited to) situations in which the investor is resident in a 'tax haven' and which may itself result in double non-taxation.
A qualifying investor would be treated as a holder of a security if it stands indirectly in that position by reference to a series of loans. The legislation would thus look to the person who holds the instrument for their own benefit and not as intermediary for some other person.
This condition is key to the practical application of the exemption and it indicates the UK government's receptiveness for the exemption to apply in relation to ultimate beneficial owners investing in the underlying private placement by a series of indirect investments and structures which may be in place for myriad (non-tax) reasons. Of course, it will be key to determine as a matter of compliance who the 'ultimate beneficial owner' is in any particular case; perhaps this is achievable through client diligence account opening procedures of the issuer.
Conditions applying to the security
It is expected that the exemption will be targeted at market-standard, 'plain vanilla' forms of debt and this will minimise the risk of structured avoidance arrangements. It is envisaged that the relevant instrument must:
- Be unsubordinated to any existing unsecured debt of the issuer (meaning it could not play second fiddle to secured bank debt);
- Have a maturity of between three and 30 years (although it is reasonable to assume, following the requirements of the primary legislation, that this lower limit will be dropped);
- Pay interest at a normal commercial rate;
- Be issued in a minimum denomination of £100,000; and
- Have no right to conversion into shares of the issuing company.
Set to flourish
Although the private placement market has been popular and well developed in the US for some time, a sizeable market has failed to gain traction with investors in the UK. One potential obstacle to the establishment of a buoyant UK private placement market may be the imposition of withholding tax on payments of interest.
The new UK withholding tax exemption for privately placed debt is therefore a welcome addition to the raft of tax measures introduced by the UK government since the announcement in 2010 of its long-term economic plan to boost the British economy, and its immediate success can be gauged from investment pledges from UK asset managers including Allianz Global Investors, who immediately after George Osborne's Autumn Statement announced plans to invest £9 billion in UK infrastructure in the coming years on the back of this measure. It is hoped that the new relief will allow UK borrowers a freedom of choice in their financing decisions and place the UK on a similar footing to other EU countries whose domestic tax rules provide an exemption from withholding tax on interest payments altogether, and no doubt it will be a welcome milestone in the development of a pan-European market for private placements which the European Commission is promoting as a step toward a single capital market for all of Europe.
With the release in January this year of the Loan Market Association's standardised private placement documentation and in February of the Pan-European Corporate Private Placement Market Guide by the Pan-European Private Placement Working Group (a cross-industry working group lead by the International Capital Market Association), the UK's private placement market is well supported to flourish.
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Prabhu represents clients on a broad array of international tax structuring, planning and advisory matters. He also has broad transactional experience in corporate mergers and acquisitions, private equity, investment and hedge funds, structured finance and real estate.
Clients seek his knowledge and experience to establish tax-efficient cross-border structures for international corporations, financial institutions, private equity and investment funds. He structures and implements all types of funds (including private equity, investment, real estate and opportunity funds), and also advises on transactions undertaken by them.
Prabhu has particular insight into both advisory and contentious VAT matters, especially in the context of real estate transactions. Having previously practised in the VAT advisory practice of a Big 4 accountancy firm, he is able to draw upon his extensive experience handling complex VAT issues.
Together with Peita Menon, Prabhu recently co-led the White & Case team advising HM Treasury and HM Revenue & Customs of the UK Government in the crafting of a new UK withholding tax exemption for private placements. This measure was first announced by the Chancellor George Osborne in his Autumn Statement on December 4 2014.
Prabhu has written for a number of publications on tax and finance and is a frequent commentator on tax matters in the media.
White & Case
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Peita acts for high-value multinational companies, financial institutions and funds across the full spectrum of tax matters. Clients value his ability to devise clear, user-friendly solutions to complex problems by effectively coordinating detailed technical advice from multiple sources, both internal and external.
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