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Financial Services Aircraft Leasing Forum How to structure an aircraft leasing fund?

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How to structure an Aircraft Leasing Fund?

From left to right, Keith Chau, Puay Khoon Lee, Catherine Tsang, Monica Ng, Johnny Lau, William Ho, Priscilla Law, Guo Sun Lee, David Yu, Clarence Leung

Priscilla Law, Head of Financial Services at InvestHK, mentions that global demand for new aircraft is increasing and driving opportunities for aircraft leasing. The rapid development of Mainland China’s aviation industry is soaring and has triggered exponential growth in aircraft demand.

Over the next two decades, China will need 6,000-7,000 new aircraft worth more than US$1 trillion in aggregate. The global investment in aviation assets will soon exceed US$5 trillion with the main investors being pension funds & insurance companies.

Policies and actions taken by Beijing and Hong Kong have been instrumental in supporting Hong Kong’s development of a premier aircraft leasing hub. There has been the introduction of the “Opinions on Accelerating the Development of the Aircraft Leasing Industry” circular, the revision to the Arrangement for the Avoidance of Double Taxation (“DTA”) signed between Hong Kong and Mainland China in 2015, the July 2017 Ordinance relating to the profit tax concession on aircraft leasing which provided a dedicated tax regime for aircraft leasing business in Hong Kong, and the Hong Kong government has increased the number of DTA’s being entered into.

As an international financial centre, Hong Kong has many economic and legal advantages, including a common law system, strong business and property laws, a good reputation as a city for international business, political stability, free market principles, and free flow of information. There is a strong legal and banking presence in the territory with deep pools of liquidity along with large numbers of private equity and institutional investors.

Priscilla Law, InvestHK

On 22 November 2017, PwC hosted its second Financial Services Aircraft Leasing Forum at our PwC office in Central. This forum, How to Structure an Aircraft Leasing Fund, discussed how to invest into aircraft leasing business under an aircraft leasing fund.

Financial Services Aircraft Leasing Forum 2

Aircraft Finance – A New Opportunity for Private Equity and Capital Markets

From left to right, Johnny Lau of Astro Aircraft Leasing, William Ho of Berwin Leighton Paisner, Guo Sun Lee of King & Wood, David Yu of Fontainburg Capital, and Clarence Leung of PwC

Clarence Leung, PwC Hong Kong Asset Finance & Leasing Services Tax Partner, invited David Yu from Fontainburg, Johnny Lau from Astro Aircraft Leasing, William Ho from Berwin Leighton Paisner, and Guo Sun Lee from King & Wood Mallesons, to join a panel discussion on the wealth of opportunities in aircraft leasing and financing presented to the capital markets and private equity industries.

It is an exciting time for the aviation leasing and financing industry. It is predicted that in the next 15 years, aircraft manufacturers’ anticipated world air traffic will double. In the next 20 years, over 38,000 new aircraft valued at over US$6 trillion will be delivered. Asia is experiencing a stronger-than-average growth in air traffic. Asian (especially Chinese) investors are looking to diversify their investments and there is increasing willingness to accept aircraft as an asset class for investment purposes. To develop and support the growing market, the Hong Kong Special Administrative Region (“HKSAR”) Government introduced a concessionary tax regime for aircraft leasing to attract global aircraft lessors to set up leasing platforms in Hong Kong on 29 June 2017. It is fair to say that there are indeed many new and encouraging developments in this niche industry.

Financing is considered as one of the most important factors for the aircraft leasing and financing industry, and there is a huge demand in the aviation industry for cheap financing. Panellists began the session by sharing their industry experience, and commented that “aircraft leasing funds” are commonly seen in the US and Europe. Generally, the objective of an aircraft leasing fund is to provide predictable and stable returns for investors through aircraft lease rental income from top tier or reputable airlines globally. Cash invested by investors would be used to acquire aircraft owned by fund’s special purpose vehicles, acting as the owner and borrower of an aircraft. Aircraft are welcome and acceptable collateral in the capital markets, and the loan notes issued by an aircraft leasing fund are actively traded, which bodes well for the aviation finance industry.

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Panellists agreed that it is crucial for fund managers to have an in-depth understanding of the aviation industry so that investors can draw from their experiences and make the right decisions for their investments. They also agreed that the experience of the fund managers, their background, their relationship with other stakeholders in the aviation industry, their ability to raise finance and to source aircraft, their strategies on choosing the type of aircraft to invest in, and focus and foresight on the exit strategy are some of the key factors which would impact the fund performance.

Some panellists also commented that an understanding of the aviation leasing and financing industry by potential investors is equally important given the specialised nature of the industry and the assets involved. Investors must be able to appreciate the risk of aircraft leasing and financing business, and understand the value proposition by an aircraft leasing fund, both the leasing and financing structures, the security provided and the governing regulatory and legal framework in order to that their investments are properly managed.

Panellists also agreed that it is important for fund managers to manage investors’ expectations on the returns. For example, if an aircraft is leased to a reputable airline with a good credit rating, the return provided may be in the single digits, say 5-6%, over the lease term, which is very favourable compared to investments in other asset class. However, it is unlikely to ever provide a double digit return – for that, an investor would have to invest in other airlines. Investors should also remember that investing in aircraft leasing funds is different from investing in the aviation industry. For aircraft leasing fund investments, the investors are investing in a portfolio of aircraft leased to a plethora of airlines globally. As such, the risk is far more diversified. The fixed income stream payable is generally stable, and the residual value of an aircraft is relatively predictable - so much so that the overall return can be “estimated” reasonably at the outset. In comparison, the aviation

industry is heavily regulated. Fuel prices, wages and the global economy would have a direct and significant impact to the profitability of airlines, making the returns less predictable.

In light of this, first time fund managers in the aircraft leasing fund industry were advised to start small, keep relevant track records in mind, manage expectations, focus on small deals initially and have a clear exit strategy for the fund in mind. The relationship between an “investor” and a “fund manager” for an aircraft leasing fund is actually very close given the highly specialised nature of the industry and asset class. This may mean that the club format may receive significant attention due to the ability of investors to assert a greater degree of control over the club’s strategy and investments, or be more involved with fund managers to understand the strategy of the fund, investment choices, management of the residual value risk, etc.

To conclude, the panellists discussed the advantages of using a fund structure as compared to using a corporate structure e.g. joint venture, which is another alternative for aircraft leasing. It was noted that a Cayman Islands exempted limited partnership is the most common type of private equity fund used in Asia and provide more flexibility as compared to a corporate company structure. A partnership structure may be more flexible in the provision of how capital is raised, distributed, allocated and that it will be useful when a general partner would like to get a return in the form of management fee. The “deadlock” situation may also be more manageable in a limited partnership structure for the various investors. Panellists were interested to see whether or not there may be an appetite for a Hong Kong aircraft leasing fund in the future given the concessionary tax regime in Hong Kong, noting that any such regimes should be aligned with the post-Base Erosion and Profit Shifting (“BEPS”) landscape. Nevertheless, the panellists are excited to see Hong Kong position itself as an attractive location for investing in aviation leasing and financing business.

Asian investors are familiar with “fund” structures and concepts. Accordingly, “aircraft leasing funds” are seen as a viable platform for potential investors interested in aviation finance, to invest into this new industry. However, as an aircraft leasing fund is still a relatively new concept in Asia, panellists acknowledged the difficulty for investors to assess which “first-time” fund to invest in and whether or not the fund itself would become successful.

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Why tax is so important in aircraft leasing? Clarence Leung, Asset Finance & Leasing Services Tax Partner at PwC Hong Kong, discussed the key considerations in aircraft leasing. He indicated some specific aircraft leasing activities may give rise to a permanent establishment (“PE”) of the lessor in a foreign jurisdiction. For instance, signing a non-binding letter of intent in certain countries could increase the PE risk for the lessor. Given taxes are filed on a self-assessment basis in many jurisdictions, the onus of reporting rests with the lessors in the event that a taxable presence is constituted in those jurisdictions. Failure to do so could result in substantial financial penalties. Hence, it is essential for aircraft lessors to mitigate their PE risk by managing the whole process of aircraft leasing. Generally, aircraft lessors are suggested to originate, negotiate, and conclude contracts outside lessee jurisdictions.

Clarence Leung, PwC Hong Kong

Another issue noted is withholding tax (“WHT”) on the lease rentals as aircraft leasing is normally a cross-border transaction. The lease rentals are treated as a royalty in many jurisdictions and lessees need to withhold taxes when paying lease rentals to the aircraft lessors. Market practice is for a lessor to pass on the overseas taxes including WHT liability to a lessee in an aircraft leasing transaction. Hence, the lessees will usually be more willing to enter into an aircraft leasing transaction with lessors based in jurisdictions with lower withholding tax rates, a key reason why Ireland has been such an attractive aircraft leasing platform. Apart from lease rentals, other associated payments made by a lessee under the lease (e.g. maintenance reserves, security deposits, etc.) would also need to be considered to determine whether WHT is an issue.

Additionally, the lease characterisation in the lessee jurisdictions will have different WHT implications. Under a finance lease, rental payments may be classified as principal and interest and the interest component may be subject to WHT. In contrast, applicable WHT rate on operating lease payments should be determined by reference to the article of royalties under the relevant tax treaty.

The development of global anti-tax avoidance and Base Erosion and Profit Shifting means a lessor needs to ensure there is sufficient substance in the jurisdiction it resides and that it qualifies as the beneficial owner of the lease payments.

Clarence also discussed the sale of aircraft. When it comes to a sale and purchase transaction, multiple jurisdictions and taxes are normally considered. The key is to sell an aircraft in a “clean” transfer location to ensure transfer taxes, including value-added tax (“VAT”) do not arise. It is important for the seller to select an appropriate location for the transfer of the aircraft in order to avoid any potential transfer tax exposure.

Last but not least, Clarence touched on the tax regime introduced by the Hong Kong Government in June 2017. Under the new regime, no depreciation allowances are available, however, there should be no recapture of depreciation allowances on the disposal of the aircraft after 3 years. The concessionary tax treatment would reduce the effective tax rate, which should have positive P&L effect on the aircraft leasing companies or investors seeking for going public. Along with the introduction of the new tax regime, it is observed that an increasing number of international aviation leasing companies have started up or planned to start up their aircraft financing and leasing businesses in Hong Kong.

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Fund structures – Tax considerations

Joint venture, open-ended fund, and closed-ended fund comparisons

Puay Khoon Lee, Tax Partner at PwC Hong Kong, discussed major tax considerations for the setting up the holding and financing structures of an aircraft leasing fund. These include: where to establish the holding company taking into consideration the number of leasing platform the fund has and where the investment managers are based; whether the structure should be financed through a separate financing company or through the holding company of the leasing platforms, and the domiciling of the financing company if used. Each case is unique and should be assessed individually.

Puay Khoon Lee, PwC Hong Kong

Keith Chau, PwC Hong Kong

Keith Chau, Financial Services Assurance Partner at PwC Hong Kong, presented on the three most common aircraft leasing platforms: joint ventures, closed-ended funds, and open-ended funds.

Three key considerations for aircraft leasing funds are:

Where to domicile the fund? Aircraft leasing funds are typically domiciled in the Cayman Islands due to the low start-up costs and its tax status.

How to do proper planning tax? There are a number of tax planning opportunities in a fund.

How to structure the fund and whether or not to use an asset manager? It is common for the fund and asset manager to be the same person / entity, however it may be beneficial to set up two different entities.

The major difference between joint ventures and funds is that the funds outsource investment decision making to the fund manager or general partner in exchange for management fees and performance fees or carried interest.

A joint venture, open-ended fund, and close-ended fund are usually different in the following areas:

1. Basic structure

2. Life span

3. Number of investors

4. Decision-making process

5. Distribution policy

Do investors want to beinvolved?

What is the target life span and size?

How will conflicts be resolved?

What is the exit strategy?

How will liquidity be managed?

What fund structure will you use?

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A special thank you to all our speakers for sharing their insights

Polling results

Are you interested in setting up / investing in an aircraft leasing platform?

Given the new Hong Kong aircraft leasing regime, will you consider to set up / invest in an leasing platform in Hong Kong?

David YuFontainburg Capital

Guo Sun LeeKing & Wood

Johnny LauAstro Aircraft Leasing

Priscilla Law InvestHK

William HoBerwin Leighton Paisner

30%Yes, within 12 months

10%Yes, in 1 to 3 years

30%No interest currently

30%I am already setting up / investing in an aircraft leasing platform

Which of the below structure would you use when setting up an aircraft leasing platform?

89%Yes

11%No

13%Joint venture

13%Open-ended fund

40%Close-ended fund

34%Not decided

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This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

© 2017 PricewaterhouseCoopers Limited. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. HK-20171124-4-C1

Who can help?

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Charles ChowSouth China and Hong Kong Assurance Leader+86 (755) 8261 8988 charles.s.chow@cn.pwc.com

Rex HoFinancial Services Tax Leader+852 2289 3026 rex.ho@hk.pwc.com

Peter LiHong Kong Financial Services Assurance Leader+852 2289 2982peter.pt.li@hk.pwc.com

Monica NgPartner+852 2289 1218 monica.wy.ng@hk.pwc.com

Keith ChauPartner+852 2289 1215keith.ck.chau@hk.pwc.com

Yi Liu PartnerRui Bai Law Firm+86 (10) 8540 4650yi.liu@ruibailaw.com

Catherine TsangPartner – Tax & China Business Advisory Services +852 2289 5638catherine.tsang@cn.pwc.com

Clarence LeungAsset Finance and Leasing Services Tax Partner +852 2289 3599clarence.kf.leung@hk.pwc.com

Puay Khoon LeePartner +852 2289 3828 puay.khoon.lee@hk.pwc.com