On 6 September 2016 the Irish Finance Minister announced proposed changes to Ireland’s Section 110 securitisation tax regime related to the holding of assets linked to Irish real estate.  The vast majority of Section 110 companies will remain unaffected as the proposed changes do not impact upon non-Irish assets.  The changes follow considerable Irish political and media attention on the use of Section 110 SPVs to acquire loan portfolios sold by Irish banks and NAMA which were backed by Irish land and commercial and residential property.  The changes seek to restrict the level of interest deduction in the Section 110 Company and tax profits from Irish real estate linked assets at 25%.  The Section 110 changes will be included in the upcoming Finance Bill in October 2016 and will be effective from 6 September 2016 when the Bill is enacted before the year end.  The Minister also signalled further proposed tax changes targeted at Irish investment funds (QIAIFs) holding Irish real estate assets.  Consultations are ongoing in relation to these proposed funds changes and they are likely to also be included in the Finance Bill.  The use of charitable trusts to hold shares in Section 110 companies is also under review by the Department of Finance.

What are the proposed changes?

The proposed changes introduce a separate business within a Section 110 company for financial assets which derive all or the majority of their value directly or indirectly from Irish real estate. The proposed legislation defines these assets as ‘specified mortgages’. This new ‘specified property business’ will continue to be taxed under the Section 110 legislation but is effectively ring-fenced from other activities and assets with special rules applying only to that property business.

The key change will impact upon the ability of the property business to deduct interest on profit participating debt. In many cases, the property business will now only be able to take a tax deduction for an amount of interest which represents an arm’s length rate and is not dependent on the profits of the Section 110 company. This restriction on the deductibility of interest may therefore remove the effective tax neutrality of a Section 110 company and result in a level of residual profits taxable at the rate of 25%.

What structures are unaffected?

The restriction on interest deductibility will not apply in all cases and the vast majority of Section 110 companies will not be affected by these changes. Any Section 110 company which only holds Irish assets or non-Irish assets which do not derive their value from Irish real estate will not be impacted by these changes.

Where a Section 110 company does have a specified property business, interest on profit dependent loans (above the arm’s length rate) will still be deductible against profits of that property business where the interest is paid by the Section 110 company to:

  • An Irish tax resident company (or an Irish trading branch of a foreign company) where the person is within the charge to Irish corporation tax in respect of that profit dependent interest (this should not include Irish investment funds),
  • Certain Irish retirement and pension schemes, or
  • A person resident in an EU/EEA Member State where:
    • The interest is subject to a tax in that country which generally applies to foreign source profits, income or gains received by local residents and provided the recipient of the interest does not avail of a notional tax deduction or participation exemption,
    • It would not be ‘reasonable’ to consider that the profit dependent loan forms part of a scheme or arrangement of which the main, or one of the main, purposes of which is to avoid Irish tax, and
    • The recipient of the interest carries on ‘genuine economic activities’ in the EU/EEA Member State.

No guidance has yet been provided in respect of when and how the Irish Revenue Commissioners will apply the reasonableness test and what is to be understood by ‘genuine economic activities’ noted in the above exception to the new rules.

What does this mean in practice?

Where a Section 110 company has two separate businesses as a result of these changes (i.e. by holding both Irish real estate linked assets and other assets), the proposed legislation provides for the apportionment of expenses between the two businesses on a ‘just and reasonable basis’. Again there is currently no guidance on what Revenue will regard as just and reasonable in this context. However, many financial services businesses and tax practitioners will be familiar with applying allocation methodology in the context of exempt and non-exempt activities for Irish VAT and so lessons may be taken from here. It is currently unclear whether separate businesses within a Section 110 Company will be able to share any tax losses between them, however it is unlikely.

The proposed legislation also removes for specified property businesses the current default option for Section 110 companies to calculate their taxable profits under Irish GAAP as applied on 31 December 2004. The new ring-fenced property business will now have to calculate its profits based on existing Irish GAAP/IFRS.

The changes apply as of 6 September 2016, therefore Section 110 companies which are affected will need to carry out a valuation on their Irish property assets as of that date to ensure that any income and gains arising before 7 September 2016 are correctly captured in the existing Section 110 company business and not the new property business. With the rebound in the Irish property market and the economy generally there may be significant unrealised gains to be recognised in certain cases.

Further, an analysis of the appropriate arm’s length interest rate to be applied from 7 September 2016 onwards will be required. In the absence of Revenue guidance, it is currently unclear whether this arm’s length rate should be calculated as at 7 September 2016, on an ongoing basis (which seems unlikely) or at the time the loan was originally entered into. Each of these may result in very differing arm’s length interest rates. It certain cases it may be worth considering re-tranching the debt in order to differentiate this arm’s length rate of return from what could be regarded as the above-commercial / profit dependent element.

On a more fundamental level, a key question, particularly for Irish real estate assets linked to performing loans, is whether or not such loans do in fact derive the greater part of their value from Irish real estate. This may be an interesting area for the practical application of these new rules as it could perhaps be argued that the overall financial health of a borrower, rather than any underlying Irish real estate, is the true source of value in a performing loan.

What should you do next?

There will be engagement with the Department of Finance and Revenue from tax practitioners and industry alike on these proposals. As we have highlighted a number of areas will require clarification and guidance. It is likely that certain amendments, if not the overall thrust of the proposals, will change before the legislation is enacted before year end. Therefore, caution should be taken when any restructuring options are being considered before the final legislation is known.

All Section 110 companies should however clarify whether they are likely to fall within the scope of the new rules. If so, asset valuations and transfer pricing analysis is likely required; there may be merit therefore to explore these areas in advance of the release of the final legislation.