In December 2020, the Irish Department of Finance (the “Department”) released a consultation document, the “Feedback Statement”, considering how to approach the implementation of one of the remaining EU Anti-Tax Avoidance Directive (“ATAD”) measures; the Interest Limitation Rule (“ILR”).
The ILR requires EU Member States to introduce a fixed ratio rule which restricts a company’s allowable net interest tax deductions to a maximum of 30% of its taxable EBITDA. This new approach to interest deductibility in Ireland will take effect on 1 January 2022.
Given the capital-intensive nature of the aviation finance industry and the high levels of relative leverage, such a limitation could have a significant impact for some in the industry, potentially increasing effective tax rates in certain platforms.
In addition to supporting the industry led submission by Aircraft Leasing Ireland, the PwC Aviation Finance team submitted a response to the Feedback Statement on the various steps and issues of interest for the aviation finance industry. In our submission, we have sought maximum flexibility and optionality in the adoption of the rules. As the rules are being layered on to our existing complex interest deductibility and withholding tax provisions, which Ireland views as providing sufficient protection to deal with base erosion concerns, such asks are necessary to keep Ireland’s tax regime competitive.
We comment below on a selection of the key steps and issues in the Feedback Statement of relevance. Our full response is attached at the end and includes our commentary on other questions raised in the Feedback Statement.
The ILR is intended to limit the deductibility of in-scope taxpayers’ net interest expense (taxable interest and other interest equivalent taxable revenues less deductible borrowings).
The greater the proportion of a company’s income which is treated as taxable interest income and other interest equivalent taxable revenues, the lesser the effect of the ILR. The question for aviation finance taxpayers is whether an element of aircraft lease rentals can be regarded as equivalent to interest?
It is clear from the definition in the Feedback Statement that finance lease income/expense would be considered interest equivalent. However, in an aircraft leasing context, a lessor involved in a trade of leasing, even where such leases are treated as operating leases from an accounting perspective, should essentially be viewed as carrying on a financing activity. Considering the activity over the life-span of an aircraft leased out by way of operating lease, it is clear that the lessor is essentially interested in earning a return on its capital akin to a financing return. Indeed, certain jurisdictions already recognise this in their tax legislation, splitting operating lease payments into a financing component and capital component for tax purposes. As such, in our view, an aircraft lessor should be entitled to treat the implicit interest component included in operating lease rentals as interest equivalent for the purposes of the ILR. In order to appropriately identify this implicit interest component, similar principles to those applying under IFRS 16, which currently recognises the inherent financing charge / return included within operating lease rental income for the lessee, could be adopted. Alternatively, a simplified approach to the calculation could be considered leveraging an existing approach carried out by aircraft leasing companies in assessing transactions from a commercial perspective.
While far from definitive, the Feedback Statement’s potential definition of interest equivalent does appear positive in the sense that it is broadly defined so may be viewed as including the interest element implicit in operating lease rentals. However, given the importance of the matter to the industry, we have requested explicit legislative clarity or, failing that, acknowledgement of the position in Irish Revenue guidance on this matter in our submission.
ATAD provides two possible modifications to the general fixed ratio rule where a taxpayer is a member of a consolidated group for financial accounting purposes:
(i) the “Equity Ratio Rule”, which would allow taxpayers to fully deduct exceeding borrowing costs without limit where the ratio of the taxpayer’s equity to total assets does not fall more than 2% below the equivalent ratio of the worldwide group as a whole; and
(ii) the “Group Ratio Rule”, which replaces the 30% EBITDA restriction with a percentage determined by reference to the consolidated group’s exceeding borrowing cost for third party loans divided by the group EBITDA.
The Feedback Statement indicates that consideration is being given to providing for both “group ratios” and allowing the choice of ratio to be at the discretion of the taxpayer which is a really positive starting point. That said, the question being framed in the consultation does ask for an understanding of impact if Ireland were to offer only one option. In our submission, we have strongly recommended that both options are provided as the applicability of either ratio will depend on the facts within particular aviation finance groups based on their funding and capital structures. Considering the impact of COVID-19 alone, we are going to see huge volatility in earnings, interest costs and asset values in the aviation finance industry which may create difficulty in forecasting the impact of the application of one ratio over another.
For standalone aviation finance groups, the adoption of the group ratios could be of significant benefit. However, the application of either of the ratios may not be as beneficial for aircraft lessors which are part of large diversified groups as the equity to asset value ratios and interest to EBITDA ratios are generally higher for aviation finance than most other industries.
ATAD allows Member States to provide optionality and we believe this flexibility should be provided to ensure that one group of taxpayers is not adversely impacted at the expense of another.
In addition, a number of fundamental questions related to the technical application of the rules have yet to be addressed in the context of group ratios and indeed the definition of what constitutes a group for these purposes. These open questions are currently being advanced in the context of the next feedback statement on this matter (expected later this year) but this means that taxpayers are still significantly unclear on the likely impact of the overall rules.
PwC has sought maximum flexibility as to what approach can be adopted here as there is likely no one size fits all outcome - in short providing for both group ratios would represent the optimal outcome here. We have also sought clarity on a number of other elements of the proposed means of applying the ratios.
ATAD provides an option to apply the ILR on a company-by-company basis or to a local group of companies as defined under domestic law. The Feedback Statement indicates that consideration is being given to the adoption of the group approach, at the discretion of the taxpayer. Such approach would be welcomed by the aviation finance industry as the application of the measures on an entity by entity basis could represent a significant compliance burden for lessors and could result in increased restrictions on interest deductibility as excess interest capacity or restricted interest carried forward from a prior period could get trapped in individual entities. However, as with the group ratios, the detail on this element will be dealt with in the second feedback statement later in the summer. As a result, this consultation leaves much of the detail on the rules outstanding which will ultimately be crucial to the effectiveness of these provisions.
PwC welcomes the potential adoption of the group approach but we have also put forth requests for flexibility in defining the local group to take account of various commercially led structuring issues prevalent in the aviation finance industry.
Positively, an exemption to exclude loans which were concluded before 17 June 2016 from the ILR is proposed in the Feedback Statement.
However, to the extent that there is “any modification to the terms of that debt on or after 17 June 2016, including modifications to the duration of that debt, the principal drawn down or the interest rate on that legacy debt”, the ILR would subsequently be imposed.
The fact that either an interest rate change, which could occur for any number of reasons including simply an opportunity (or requirement) to switch from a fixed to variable rate or vice-versa, or a drawdown of principal post 17 June 2016 could be viewed as constituting a modification could significantly curtail the benefit of the carve out. Such an approach, particularly on the principal drawdown, seems unfair as many transactions will have been contemplated or even committed to in advance of the cut-off date. That being said, the Feedback Statement did invite comments on the approaches to defining and exempting “legacy debt”, and on the concept of “modification” in the context of these legacy loans. We and others in the industry have responded with these issues and other technical matters in mind. In addition, helpfully, both the Department of Finance and Irish Revenue have indicated that, to the extent a modification does arise, the grandfathering can still apply to the original terms so there may be some element of relief available.
ATAD also provides that Member States may exclude both the income and associated expenses of certain ‘long-term public infrastructure projects’ from the scope of the ILR restriction. The Feedback Statement indicates that the Department is contemplating the introduction of such an exemption but no detail on the possible scope and criteria for qualification has been put forward.
Ideally, we would like to see such an exemption included in Irish legislation, with the scope of application being sufficient to include the financing of aircraft operated in the EU which appear to meet the key conditions under ATAD for inclusion, being long-life, large scale assets with a general public interest purpose. As with other aspects, we encourage a wide adoption here, as a long term exemption such as this will need to be flexible as public infrastructure requirements adapt over time.
The Feedback Statement outlines the approach to calculating the exceeding borrowing costs and applying the interest deductibility restriction. The approach is considered in detail in our general ILR insight available here.
In our view, the approach proposed is overly complicated and one aspect of the calculation in particular gives some cause for concern. Under the proposed approach, if an interest deductibility restriction arises, the restricted amount will be subject to tax under Case IV with no ability to offset the charge with a loss. As an aviation finance entity will typically be in a Case I tax loss position in the early years of a transaction, the Case IV taxing mechanism could inadvertently accelerate a charge to cash tax which would not otherwise have arisen due to losses brought forward or excess capital allowances. However, we do not believe that it is the intention to create rules which trigger a tax liability where one would not exist outside of any restriction of interest deductibility. In our submission, we have raised our concerns on the current proposals in particular, the level of complexity that it brings for a Case 1 trader, and sought clarity on the matter.
With implementation of the ILR set for 1 January 2022, there will be limited time to assess the potential impact and consider options to mitigate any negative effects that could arise come the next feedback statement issuance set for mid-2022.
It will be necessary for aviation finance groups to consider the possible impact of these rules sooner rather than later. We are already working to model out the potential tax impact on aircraft leasing platforms across several scenarios and to consider next steps once a clearer picture emerges as the year progresses. PwC have developed an ILR analysis tool specifically to illustrate the potential impact on the corporation tax position of groups in a visual and interactive manner. We would be happy to discuss how we can assist you in assessing the possible impact of the proposed rules, including modelling out the effects on your group.
The open consultation process run by the Department of Finance shows their commitment to getting stakeholder engagement and we would encourage aviation finance groups, either individually, or collectively, to continue to feed into the process with the Department. PwC will continue to engage with the Department and monitor developments as the process progresses and we approach the second consultation on this issue later this summer.
Director, PwC Ireland (Republic of)
Tel: +353 1 792 6787