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GameChange_Social1
Aviation Finance and the Cost of International Tax Reform

Tony Ryan, the Irish businessman, is best remembered as the co-founder of the low cost airline that carries his name. Ryanair launched in 1985 with a single 15-seat turboprop connecting Waterford with London Gatwick. Today, it is Europe’s largest airline. More than 106 million customers boarded Ryanair planes last year.
But before popularising no-frills flying in Europe, Ryan had already revolutionised the aviation industry in a different area: In 1975, as the founder and CEO of Guinness Peat Aviation (GPA), he invented aircraft leasing as it exists today.

Patrick Blaney, who succeeded Ryan in the CEO post, described in an interview with the Irish Independent in 2016 how the GPA founder created the new industry almost single-handedly. It began when Aer Lingus, his employer at the time, tasked Ryan to solve an overcapacity problem by ridding the company of two unneeded planes.

“Tony Ryan was dispatched by [Aer Lingus] to find a home for these two planes and he found an airline in Thailand called Air Siam, which needed not just the planes but a flight crew and cabin staff,” Blaney said.

“So he very neatly organised for two aeroplanes that Aer Lingus had bought but didn’t need, they had trained crews and all the rest to fly, and he shipped the whole lot out to Thailand.”

With the creation of GPA soon after sealing the Air Siam deal, Ryan filled a niche in the market: leasing allowed airlines to quickly increase capacity in growth times, or scale back when demand dropped. In addition, there are certain advantages to airlines in the way leased planes are accounted for on the balance sheet.

Aircraft leasing and financing became big business. Today, 40–50% of all commercial planes are leased. While Ireland still dominates the industry, other jurisdictions including Singapore, Hong Kong, Cyprus and Malta have also sought to attract the sector.

New Challenges

But the business model is facing new challenges created by changes to the international tax environment. Supranational organisations have agreed measures to curb tax avoidance and the question arises whether this will have a detrimental impact on aviation finance.

In a global survey of more than 400 industry experts, conducted by Euromoney Institutional Investor Thought Leadership in conjunction with Deloitte, 78% of aviation experts working for airlines, and 87% of those working for lessors agreed that the industry will feel the impact of anti-tax avoidance measures.

General impact chart 1One of the main drivers for changes to international taxation is the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan. This project aims at closing gaps in international tax rules that allow multinationals to minimise their tax bills by playing the tax regimes of different jurisdictions against each other.

Haroun Asghar, Head of Tax at Etihad Airways, thinks that “the political support underpinning [the] BEPS [Project] can’t be under-estimated”. He adds that “the speed and scope of these changes has been impressive. It is the most significant development to international tax architecture for over half a century.”

The anti-tax avoidance directive (ATAD) is the EU’s implementation of the BEPS Action Plan. Agreed last year, the ATAD will come into effect from January 2019 and apply to all EU members, including Ireland, the global centre of aviation finance.

What financial impact will the new measures have? While the survey results display considerable uncertainty — 30% of respondents didn’t take a view — a narrow majority of the survey panel, 53%, expects the cost for leasing aircraft to increase. Only a 13% minority does not think so.

Double tax treaty changes

More recently in focus of the BEPS Project have been double tax treaties. An OECD signing ceremony scheduled to take place in June in Paris will set in motion changes to more than 2,000 tax treaties– about two-thirds of the worldwide total. First treaty amendments could come into effect from January 2018.

In addition to the other measures, the prospect of changing double tax treaties will draw increased attention to tax gross-up clauses.

Included in most standard aircraft lease agreements — but rarely triggered — gross-up clauses could almost be considered a mere formality: added to every contract, but never expected to become relevant. Now that tax bills are set to increase, they will be subject to closer scrutiny.

Half of respondents to the survey agree that “proposed double tax treaty changes will have an impact on the negotiation of aircraft lease agreements, in particular the provisions of tax gross-up clauses”.

Gross up clauses Q18Again, a considerable number of respondents refrained from taking a view, underlining the lack of clarity around the impact of international tax reform.

If — as the survey indicates — aircraft leasing costs are set to go up, who will pay for it?

Lessors’ largest customers might have sufficient buying power to force lessors to absorb rising costs themselves. It’s an indicator for market expectations that 41% of experts believe (vs 25% who disagree) that the implementation of the BEPS Action Plan via the ATAD will result in a drop of lessor profits.

Lessor profits decline Q11

But that does not mean that the aircraft leasing business invented by Tony Ryan in the 1970s has seen its best days. Leasing aircraft offers more than just tax-related advantages, and therefore it is unlikely that its popularity with airlines will change significantly. “Ultimately, the amount of leasing will depend on wider market and business factors,” comments Etihad Airways’ Haroun Asghar.

And Markus Ohlert, Head of Leasing at Lufthansa, adds that this might be particularly true for companies that don’t have strong balance sheets. For them, “leasing may be the only way to get access to aircraft,” he says.

The survey and report “Game Changer not Game Over: Aviation Finance and International Tax Reform” has been prepared by Euromoney Institutional Investor Thought Leadership in conjunction with Deloitte. The complete research is available for free download here.

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Aviation Finance in the Hot Seat

Aviation finance is not an industry on everyone’s radar even though it’s huge. The term refers to the business of aircraft leasing: up to 50% of planes globally are no longer owned by airlines directly. Instead, those planes are on lease from specialist companies.
International tax reform might change the way competition among global aviation finance centres from Ireland to Singapore plays out in the future.

Leasing is an attractive way for airlines to manage their aircraft fleets. Compared to owning planes leasing increases flexibility and does not require airlines to take on huge amounts of debt.

The top 50 aircraft lessors have planes worth $260 billion under management, according to Airfinance Journal, which gives an idea about the size of this growing industry.

Aircraft leasing is concentrated in a few jurisdictions globally, and about half of that business is conducted from Ireland. It’s so important to the Irish economy that The Economist recently described aircraft finance as “perhaps the city’s [Dublin’s] most successful industry”.

This makes the country, with its population of just 4.6 million, the biggest player by far in aviation finance, competing with a handful of other territories around the world including Singapore, Hong Kong and Chinese free trade zones.

But with international tax reform on the horizon there are concerns that Ireland’s leading position will come under increased pressure from other jurisdictions.

The EU Anti-Tax Avoidance Directive

Being a member of the European Union, it is the EU’s anti-tax avoidance directive (ATAD) that poses the biggest threat to Ireland as a destination for aircraft leasing. The ATAD, which comes – with a few exemptions – into effect in January 2019 introduces a variety of measures designed to make it harder for corporations to play the tax laws in different countries in and outside the EU against each other.

When Euromoney Thought Leadership and Deloitte teamed up recently to survey the aviation finance community, it turned out that the experts are worried about the impact the ATAD may have on their business.

53% of 400 experts surveyed told us that they expect airline’s aircraft leasing costs to increase in the wake of the directive coming into effect. Only 13% disagreed.

And 40% also believe that the ATAD will result in fewer planes being leased.

ATAD statements Q11

 

That sounds like bad news for Ireland, the leading aviation finance jurisdiction not only in Europe, but globally. It appears to make intuitive sense: if the ATAD puts pressure on lessors and lessees based in the EU, they’ll move elsewhere.

And indeed, our survey reveals that the industry is prepared to take action if deemed necessary. Aircraft lessors expect to relocate 28% of their business on average in the wake of anti-tax avoidance initiatives.

In addition, when asked which aviation finance location will see the fastest growth in the next five years, Chinese free trade zones and Singapore came first and second, with Ireland in third place. The data appears to confirm expectations that the ATAD might have a direct impact on Ireland as a centre for aviation finance.

Map growth expectations

But it’s not that simple. While aircraft leasing is concentrated in jurisdictions with favourable tax regimes, there are  reasons other than low taxation that make those locations attractive.

It’s not about taxation only

“Ireland’s competitive strength is its double tax treaty network, which is hard to duplicate in a hurry,” Edward Hansom, Chief Investment Officer at Seraph Aviation Management, says. Focusing on the low tax rate in Ireland would be “a bit of a red herring in the context of aircraft leasing because companies anywhere tend to have enough legitimate capital allowances to defer tax liability”.

Our survey data concurs.

reasons for picking a location (chart 2)

Yes, the effective corporate income tax rate matters (38% of all respondents say it is very important), but double tax treaty networks get an even higher score (42% of all respondents, and 54% for lessors only).

While on the one hand other factors in addition to the tax environment are at least as important to the aviation finance community, it is on the other hand also necessary to look beyond the ATAD when it comes to taxation.

EU member states set their own respective corporate tax rates, and Ireland’s 12.5% rate is the lowest within the Union. This won’t change in light of the anti-tax avoidance directive coming into effect. “The low corporate tax rate is not going to go anywhere soon regardless of what the European Commission wants to do,” Eamonn Brennan, CEO of the Irish Aviation Authority, notes.

Other aspects include the strong and supportive regulatory environment in Ireland, an effective legal system, and a strong skill set that comes from over four decades of experience in aircraft leasing in the country.

In the end, the situation might be less bleak for Ireland than the numbers suggest, when taking into account all the factors that matter. Tax is an important ingredient, but not the only one. In the words of Markus Ohlert, Head of Leasing at Deutsche Lufthansa: “In many countries purely tax driven aircraft investments are not attractive any more. You must have a real business case behind it.”

The survey and report “Game Changer not Game Over: Aviation Finance and International Tax Reform” has been prepared by Euromoney Institutional Investor Thought Leadership in conjunction with Deloitte. The complete research is available for free download here.

 

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UK Aviation after Brexit

Serving almost 76 million passengers in 2016, London Heathrow is Europe’s busiest airport. The decision by the UK government in October last year to support a third runway to be built by 2025 — after eight years of political squabbling — should pave the way for further growth.

But does it?

While a third runway might address the crucial capacity issue that is currently holding back the airport from serving more customers, the future of aviation in the country will also depend on, like almost all other aspects of the British economy and life, the terms of Brexit. And those are yet unknown.

International aviation is based on terms agreed between different countries in so-called air service agreements (ASAs).

In the early 2000s the European Court of Justice had ruled that any ASA between an EU member state and a third country needs to be open to airlines from all EU states. On that basis member states renegotiated around 340 bilateral ASAs in the past fifteen years to make sure they comply with the court ruling.

More and more often, the European Commission (EC) also took over as direct negotiator with countries outside the Union. Instead of leaving it to each member state to amend their respective bilateral ASAs, the EC negotiated new agreements with third countries that would cover all EU members. To date, the EC has negotiated new horizontal agreements with 41 countries, representing 670 bilateral agreements.

The implications for aviation in the UK in a Brexit-context are twofold: firstly, the country will need to come up with a plan to deal with those arrangements the EU has in place in the name of its member states. Most likely the UK will have to negotiate its own bilateral agreements with third countries currently covered under EU-wide horizontal agreements. And secondly, the UK will need to negotiate an ASA with the EU to address their future relationship in the skies.

Replacing the US-EU Open Skies agreement

One — crucial — example for an ASA negotiated by the EC in the name of EU member states is the Open Skies agreement with the United States. From the UK perspective this ASA, which came into effect in 2008, replaced the bilateral US-UK Bermuda II agreement, which had limited transatlantic competition from London Heathrow to just two US and two UK airlines.

It was the EU-US Open Skies agreement that opened up the market for competition as it exists today. Without Open Skies, disrupters like Virgin Atlantic would not challenge incumbents for routes to New York and other US destinations.

That’s why not replacing Open Skies, or doing so with an agreement inferior to the current arrangement, could have serious consequences for Heathrow as the dominating international airport in Europe.

Open skies

To find out how aviation experts expect this to play out Euromoney Institutional Investor Thought Leadership teamed up with Deloitte to survey more than 400 aviation experts globally.

Specifically, we wanted to know whether experts expect the UK to negotiate agreements that are, in essence, similar to the existing US-EU Open Skies agreement. We asked this question with regard to a future UK-US agreement, and to a UK-EU agreement.

The good news is: most of the respondents to our global survey think such agreements will come in the foreseeable future. Only 23% believe reaching agreement with the US will take longer than four years or not happen at all.

Less optimism about a deal with the EU

Interestingly, our survey panel — more than two thirds of which are C-level, VPs and senior directors — takes a somewhat more pessimistic view when it comes to a deal with the EU. 5% think the UK won’t be able to negotiate a deal with the Union at all (only 2% think so for the US), and 18% believe it will take longer than four years.

This expectation, that it will be harder to negotiate a deal with the EU than with the US, is confirmed even by those who generally think deals can be struck within the foreseeable future: Only 37% expect a deal with the EU to come within two years, versus 40% for a deal with the US. And, in line with this finding, 42% believe a deal with the EU will take between two and four years, but only 37% think so for the US. In short: Our panel thinks it will be easier and faster to get a deal with the US than with the EU.

If panellists are correct in their predictions, this could be bad news for Heathrow and the wider UK aviation industry. Europe is by far the most important destination for flights from the UK. According to the latest available data from the UK Civil Aviation Authority (for the rolling year ending Q1 2016), 61% of UK flights originate from or go to Europe. Only 9% of routes connect the island with North America.

In addition to the impact of Brexit, our report “Game Changer not Game Over” also looks at the challenges facing aviation and aviation finance in particular in light of upcoming international tax reform. The report can be downloaded for free from the Euromoney Thought Leadership website.

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