FEATURE: Collateral damage

Backed by the world’s most powerful governments, think-tank the Organisation for Economic Co-operation and Development (OECD), is proposing legislation to clamp down on tax avoidance.

The rules are not being designed to touch the real estate industry; moreover, the OECD’s aim was to combat what is perceived as tax avoidance by large multinational companies and other financial institutions with cross-border activity. But, the policy response known as Base Erosion and Profit Shifting (BEPS), may inadvertently bring the property sector into the fold.

“It’s almost precisely because they are not contemplating the funds industry that it is a bit dangerous because they are not really focused on how it affects those people,” says Laura Charkin, tax partner at law firm King & Wood Mallesons.

The most contentious part of the BEPS rules for property is their restriction on the tax deductibility of debt. The OECD argues that through clever tax planning organizations are able to dramatically lower their tax bills by shifting profits from high tax jurisdictions to low tax jurisdictions through inter-group loans. This works when a parent company, in a low tax jurisdiction, makes a loan to a subsidiary in a high tax jurisdiction with an artificially high rate of interest, and as debt is tax deductible a loan such as this would significantly reduce the amount of profit that arises in the high tax jurisdiction.

To tackle this the OECD has proposed two solutions. The first is what is called a fixed ratio rule. Under this rule a set percentage of the EBITDA is allowed to be tax deductible by way of interest expense. If a company had earnings of €1 million and under a 30 percent fixed ratio rule it would be able to deduct €300,000 from that €1 million, regardless of if the company is actually paying more, say €500,000 in interest.

“We’re collateral damage in an effort to curb what is perceived as excessive gearing in pursuit of tax minimization,” says Marc Mogull, managing partner and co-founder at Benson Elliot Capital Management. “By limiting interest deductibility on arms-length financings, you’ll see equity substituting for otherwise prudent debt in capital structures, driving up the weighted average cost of capital.”

The other approach the OECD advocates is slightly more nuanced but still problematic. It is called the ‘group allocation method’ and it takes into account the total external interest cost that a group or a company incurs, which is then shared among the different group companies by reference to the proportion of the group’s earnings or assets each company makes up. So, if a company constitutes 30 percent of the group’s earnings then that company is entitled to 30 percent of the group’s interest as an interest deduction.

“One of the concerns is that if you look at this on a group basis and you have part of the group carrying out development, and also another part which has long standing investment projects collecting rent, you’ll get an odd effect,” says Heather Corben, co-head of tax, Europe and the Middle East, for corporate law firm King & Wood Mallesons. “This may lead to businesses having to re-structure their commercial operations.”

Another worry is the speed at which the incredibly comprehensive review of taxation avoidance has taken place. Tax lawyers tell PERE that usually these initiatives move at a glacial pace, but due to a high political drive BEPS is being pushed through. The UK Treasury for instance will publish a paper setting out the next steps and possibly some draft legislation this month. China too is nearing implementation on BEPS-based rules. 

Added to the speed of implementation is the diversity in each country’s interpretation of the OECD’s rules. Some nations, such as Germany and Australia, already have similar legislation in place and are unlikely to adopt the OECD template wholesale.

This could lead to a patchwork regime whereby real estate investing becomes more difficult in some countries than others, adding yet another layer of complexity to an already increasingly complex marketplace.