'If the media hype gets too big, this will be very dangerous,' says Gert Jan Staal, director at West Merchant Bank. 'A politician might make a career out of it, because optimising one's tax position has come very much to the forefront of the German mind.'
How has this come about? Germany is confronted with a cocktail of economic problems: high unemployment, shrinking tax revenue, weakening industrial competitiveness, intractable social costs, and a stubborn budget deficit despite the need to curb spending in the run-up to the single European currency. In late March all this led Chancellor Helmut Kohl to warn of a pressing, but so far undetailed, need for fiscal belt-tightening.
At the same time the corporate profits seeking tax-efficient investments have been massively boosted by a new flood of individual private investment. After initially seeking a home in property investment (chiefly in the former east) and in shipping finance, a government clamp-down on some aggressive lease deals in these sectors means that much of this private investment is now being directed at aircraft finance.
Driven by historically high levels of personal savings among Germany's wealthy middle classes keen to avoid the high taxation levels needed to fund the reconstruction of former East Germany - the traditional doctors and dentists and upwards - and by aggressive arrangers who were hitherto not air finance specialists, much of this private investment is being targeted at aircraft investment funds. One air finance specialist estimates that up to DM12 billion ($8 billion) a year in German private funds is now seeking a tax-efficient investment home, and that aircraft asset leasing is the natural successor of the tax-oriented property funds and ship investment companies.
But, against the macro-economic background, any continued sacrifice of potential tax income will not happen without controversy. The news magazine Der Spiegel has already carried articles asking 'Should German tax-payers subsidise Korean shipyards?' and 'Do only stupid people pay taxes?' It seems only a matter of time before one or other aircraft deal involving private investors offers itself up for public excoriation.
This possibility is worrying Germany's more traditional aircraft lease arrangers, who have the most to lose if some of the perceived abuses of the property and ship investment sectors break out in aircraft finance. Paul Steinhardt, chief managing director of Deutsche Structured Finance & Leasing, publicly expressed these concerns at the recent IIR air finance conference in Geneva. 'What we are wary of, put briefly, is that aircraft leasing funds may suffer the same fate as did the closed-end property funds.' If there are any abuses, it seems they are taking place in the structures of the private investment leasing funds, not in the traditional corporate investment sector.
This leads to a key question: what exactly might constitute an 'abuse' of German lease laws in an aircraft leasing deal involving private investment funds? The problem here is that Germany has no explicitly stated leasing law, working instead through a collection of regulations and legal precedents. But the tax authorities apply two important tests.
First, and critically, any asset leasing structure must have true 'economic substance' for the investor; investors must take an entrepreneurial position, and share in both the risks and rewards of the investment. 'Basically, the legal owner and the economic owner should be the same,' says Steinhardt.
Second, but it seems of lesser importance, is that the lease should have some German context; it should finance equipment with some German content or provide equipment for a German lessee, or at least the tax benefits should be taken by German investors. If these benefits are exported, as can happen in crossborder deals, the tax authorities are likely to take a dim view of the structure.
Many German aircraft financiers are closing ranks; while they warn of the potential for abuses, no-one will point the finger at any aircraft deal done in the past two years. These include entirely acceptable transactions for carriers like United, Air France and, of course, Lufthansa. Others left financiers wishing they knew the details, like the Airbus equipment for Cathay Pacific through a combined Hong Kong/German lease, and export-credit backed German leases for China Eastern and Dragonair. Those that caused sharp intakes of breath included a Boeing 777 for Emirates and used McDonnell Douglas MD-83s for France's AOM.
The problem at the moment is that, while there have been rumblings from the tax authorities, it is thought that no recent transactions have yet been subject to a rigorous tax audit. The authorities are likely to be fairly relaxed about 'German relevance' issues. Nowhere are these set down in law and German investors currently need all the help they can get; it would not be a good idea to divert investment to Luxembourg or Switzerland by making things tougher at home. But financiers' fears are being aroused by the 'economic substance' issue, and in particular the use of defeasance - which protects investors from various elements of asset and credit risk. This may be negating investors' entrepreneurial positions in aircraft lease deals.
Steinhardt explains that it was precisely this issue of economic substance which led to the clamp-down on private investor property funds, which had turned into mere tax schemes. For aircraft leases, the list of questionable features which could reduce the economic exposure of investors includes: non-recourse debt financing (where banks bear the lessee credit risk); deposits against remaining rental portions; deposits or guarantees for residual values; buy-back guarantees; and abandonment of the required upside potential of 25 per cent of any surplus at termination which should go to investors. Any of these features will disturb the tax authorities.
'The conclusion is very simple and blatantly clear,' says Steinhardt. 'The private investor in a transaction which uses all these features has almost no risk of economic substance to carry. He is waterproof-protected.' In effect, banks are carrying the economic risk. 'Either there is no economically relevant risk because the equity is fully defeased, or the risks are completely borne by banks.' The investors' real risk in such a case is that the authorities might disqualify the deal for tax purposes. At West Merchant Bank, Staal agrees: 'Increasingly the aircraft deals are carrying an element of defeasance, and we need to take into account that the investor has to take an element of economic risk, otherwise he is disqualified as an entrepreneur.' But he adds that defeasance usually becomes an issue only if the airline credit is marginal, or if it is short of Deutsche mark income.
These questions have left many German aircraft financiers with a sense of sitting on a time bomb. Will the tax authorities act against any deals? What might they actually do to cool the market? 'Well, they can simply be obnoxious and obstructive,' says one arranger, who is still chuckling about the authorities' request to one US bank for a full German translation of all documentation. There is little doubt that the German tax man can give a harder ride to deals coming from more aggressive, marginal deal-makers, and particularly non-German crossborder players.
More seriously, the tax authorities' chief weapon is likely to be their own subsequent individual audits of the leases. If a structure fails the 'economic interest' test - if the legal owner is not the economic owner - or if it is viewed entirely as a tax-sheltering scheme with no German relevance, the authorities can rule that the lessor cannot depreciate the aircraft, thus denying investors much of the tax benefit and reducing net present value benefits for lessees. One legal expert says: 'The basic test is that the leasing fund must not be structured outside the traditional corporate lease; the general rules as to companies apply to private investors.'
Steinhardt believes there is a possibility some aircraft deals will suffer this fate. 'It's highly unlikely that any aircraft deals have been audited so far, but it did happen in real estate. They won't change the deal; they will just say the lessor can't take any depreciation.' Another banker says this could result in a retrospective tax hit on investors, perhaps between five and seven years after a deal's closing. 'It is this defeasance element which could kill the financial function of the lease, and then there will be a problem.' Defeasance, he adds, makes it highly unlikely that an asset will be returned, further undermining the lease's economic substance for lessors and investors.
Since 1993 several aircraft deals have featured some elements of defeasance, and this is especially likely where the lessee's credit is not the best, or where Deutsche mark income may be a problem. Here, again, no obvious course of action is clear, although the authorities are likely to start making distinctions. For example, if a lessee's currency exposure is hedged through the use of a special up-front Deutsche mark deposit, that may be permissible. But if this deposit - or any Deutsche mark deposit made against future residual value payments - clearly belongs to the lessor, then the lessor is being protected from credit risk. The authorities would view this critically, and could disqualify the lessor as an entrepreneur.
The tax authorities' difficulty is that any other action will have wider effects, often extending beyond the aircraft leasing sector. Changing the accelerated depreciation allowances, which was discussed in 1994 when Lufthansa changed from 12 to 10-year depreciation, would undermine the incentive for German airlines to maintain the most modern fleets. It would also affect leasing deals for other assets. But it must be said that the tax authorities chose to end the days of the property funds by limiting accelerated special depreciation to projects to be completed by the end of 1996.
In 1994, the authorities also briefly discussed a change or abolition of the half-tax rate on any liquidation surplus in a private investment fund. But two factors suggest there will be no change here. First, the fact that this provides a balloon pay-out at the end of a full pay-out lease confirms the lessor's economic interest in the lease, and promotes investment in this type of asset. Second, and more important, is that any change here will also affect the myriad of equipment and asset leasing deals which sustain the entire German Mittelstand, that swathe of small and medium-sized companies which many describe as the engine-room of the German economy. This would be politically and productively catastrophic, at a time when Germany's overall industrial competitiveness is very much in the spotlight.
However, the German lease market has not suddenly transformed itself into an aggressive free-for-all overnight, and retains several characteristics which will have their own dampening effect. Some bankers doubt that a bottomless supply of equity can be presumed, even with the influx of private investors alongside the traditional corporate investors. No-one believes that all DM12 billion from the former property market will suddenly divert to aircraft. And good credit airlines these days are intent on funding diversification, spreading their leasing around the German, US and Japanese markets. In Germany it remains much easier to syndicate smaller-ticket, single aircraft deals for better credit airlines.
Some deals may go a little sour for unexpected reasons; for example, there are some German tax-lease funded Fokker 100s whose rental and residual assumptions now look highly questionable. Also, the number of players in Germany who can put together such complex deals remains very small and although non-German institutions and some domestic financiers new to the aircraft market may hawk around some apparently mouthwatering offers, they are highly unlikely to complete without the participation of exactly those players who are aware of the risks of over-aggression and know the legal and tax issues intimately. Nor do better credit airlines want to be seen working within an abusive structure.
The key dampener is likely to be German private investors themselves. While they are relatively unsophisticated, and may be tempted by the glossy investment brochures now coming their way, they remain essentially risk-averse. 'It comes down to psychology,' says Staal. 'A large number of investors still prefer to have property as an investment vehicle. It's all very simple, not very intellectual.' Another banker agrees that the private investors whose needs are generating the heat will help reduce the risk. 'German investors are conservative, even the private investors. If the apparent yield from an investment is too high, the German investor will not be interested.'
It is likely, too, that some of the dire warnings of a finance ministry clamp-down are simply the result of the traditional German lease sector's fear that new players may bring new products into the market and capture much of the new investment stream. This fear also underlies the pleas from some banks and arrangers for German tax lease law to be much more codified than it is now. But the finance minister and tax authorities will probably prefer to direct the market through more gentle movements of the tiller rather than through inflexible, tight regulations.
There is no doubt that the German lease sector is on warning to behave itself. If it does, private investor aircraft funds and traditional corporate investors could together yield steady annual growth of between 10 and 15 per cent in aircraft asset value funding, up from last year's estimated $1 billion and compared to just $300 million just three years ago. And the German market's present highly attractive net present value benefits of between 8 and 10 per cent for airlines, compared with 5 or 6 per cent for Japanese leases, will be preserved.
Unless, of course, one politician or another decides to make a career out of a crusade against tax-efficient financing. If that happens, the players in the German aircraft lease market will be hoping that they have done nothing to hand the politician a weapon to stop the market in its tracks.
Source: Airline Business
