Crossborder Tax Leasing as a Means of Financing Infrastructure Development This memorandum provides a brief overview of crossborder tax leasing

as a means of financing infrastructure development in emerging nations. [1] Cross-border tax leasing may have significant applications in financing infrastructure development in emerging nations -- such as rail and air transport equipment, telephone and telecommunications equipment, and assets incorporated into power generation and distribution systems and other projects that have predictable revenue streams. A major objective of cross-border tax leases is to reduce the overall cost of financing through utilization by the lessor of tax depreciation allowances to reduce its taxable income. The tax savings are passed through to the lessee as a lower cost of finance. The basic prerequisites are relatively high tax rates in the lessor's jurisdiction, liberal depreciation rules and either very flexible or very formalistic rules governing tax ownership. Both the United States and Japan meet these criteria. [2] Other important objectives include the following:

The lessor is often able to utilize nonrecourse debt to finance a substantial portion of the equipment cost. The debt is secured by, among other things, a mortgage on the equipment and by an assignment of the right to receive payments under the lease. [3] Also, depending on the structure, in some jurisdictions the lessor can utilize very favorable "leveraged lease" financial accounting treatment for the overall transaction. In some countries, it is easier for a lessor to repossess the leased equipment following a lessee default because the lessor is an owner and not a mere secured lender. Leasing provides the lessee with 100% financing.

While details may vary widely from one transaction to another, most tax leasing structures are essentially similar and follow the "sale-leaseback" format illustrated in Figure 1. [4] The principal players are (i) one or more equity investors who provide between 10% and 30% of the funding, (ii) a special purpose vehicle formed to acquire and own the equipment and act as the lessor [5], (iii) one or more lenders, and (iv) the lessee. The lease itself is a "triple-net lease" under which the lessee is responsible for all costs of operation, maintenance and insurance. In many transactions, the lessee's fixed payment obligations are prefunded or "defeased" through an up-front payment (in an amount equal to the present value of the fixed payment obligations) to a financial entity that assumes such obligations. See Figures 3 and 4. The benefits of defeasance include (i) the lessee can lock in its financial savings by making the defeasance payment, (ii) by routing the lease payments through the defeasance entity's jurisdiction, withholding taxes applicable to lease payments in the lessee's jurisdiction may possibly be avoided, (iii) defeasance

serves to some extent as a credit enhancement technique for the lessor, and (iv) defeasance may eliminate or reduce currency risk exposure. In order for the lessor to obtain the tax benefits associated with equipment leasing, most countries require that the lease be treated as a "true lease" for tax purposes, as opposed to a conditional sale or other secured financing arrangement. This objective generally can be satisfied if the lessor has "tax ownership" of the leased equipment under the laws of its jurisdiction (or, in the case of "lease- lease-out" structures, an amortizable leasehold interest). Each country applies differing rules for determining whether the party acting as lessor under a cross-border tax lease is the "owner" of the leased asset for tax purposes and is thereby entitled to claim tax allowances. In the United States and some other jurisdictions, the principal focus is on whether the lessor possesses substantially all attributes of economic ownership of the leased asset. Other jurisdictions -- such as the United Kingdom and Germany -- apply more formalistic property law concepts and focus primarily on the location of legal title, although these jurisdictions usually also require that the lessor have some attributes of economic ownership or, at least, that the lessee have only a minimal economic interest in the equipment. In Japan, ownership of legal title is essential, but the lessor is only required under current law to obtain nominal incidents of economic ownership (all that is required is that the lease will provide a return of the equity investment plus a pre-tax profit of 1% of equipment cost). While Japan does have detailed tax lease guidelines, these guidelines are designed primarily to circumscribe the tax benefits available to the lessor in a crossborder lease to prevent undue tax deferral; they do not require the lessor to have a significant economic interest in the leased equipment. [6] Cross-border leasing obviously involves a number of tax-related concerns. All transactions involve an element of "structural" tax risk, which may or may not be covered by indemnities given by the lessee to the lessor against loss or disallowance of the contemplated tax benefits on which the transaction's economics are based. In most cross-border leasing structures, however, each party takes the risk of tax problems in its jurisdiction. In some structures -- notably Japanese leases -- the lessor will nevertheless require special termination ("unwind") rights in the event the lessor is not allowed to claim the contemplated tax benefits. In such event, the lessee may be required to make a substantial payment to the lessor that may reduce the benefit it received in the transaction. Other principal tax issues are as follows:

Local Income Tax Exposure. The location of the leased asset in the lessee's jurisdiction may also give rise to local income tax exposure, and the lessee may be expected to provide an indemnity against these taxes. [7] Withholding Taxes. The lessee generally is required to indemnify the lessor and the lender against withholding taxes on payments of rent under the lease and payments of interest under the loan. The parties often will agree to use mitigation efforts to avoid any such tax exposure. Also, the lessee is often

credited any tax savings achieved by the indemnified party in its jurisdiction by way of a tax credit or deduction for any taxes that were the subject of a lessee indemnity obligation. [8] The non-tax issues associated with cross-border leasing can be best be described by reference to the various structural risks that may arise in a given transaction and must be addressed in the documentation. A summary of the principal concerns and some of the techniques which have been developed for dealing with them follows: A. Lessee Credit Concerns. The lessor (and, when nonrecourse debt financing is utilized, the lender) must look primarily to the lessee for the payments due under the lease. In the event of a default by the lessee, they will have to look to the resale value or revenue generating capacity of the leased equipment to be repaid. If the leased equipment is located within a larger project (e.g., a turbine incorporated into a power generation facility), repossession may be difficult, particularly in emerging nations, and the lessor and lenders may be forced to look to project revenues for payment. These concerns can often be ameliorated through local government or central bank guarantees and, in appropriate cases, political risk insurance. B. Lessor Credit Concerns. The creditworthiness of the lessor may be an issue of concern to the lessee. A bankruptcy or insolvency event relating to the lessor may make it unable to comply with its obligations to pass title to the lessee on exercise of a purchase option contained in the lease and may also interfere with the quiet enjoyment of the leased equipment by the lessee. These concerns have been addressed in practice in a variety of ways. First, the lessor is almost always constituted as a special purpose and, hopefully, "bankruptcy-remote" vehicle. Additionally, the lessee may require a guarantee from a creditworthy institution (often the lessor's parent) of the obligations of the lessor under the lease. C. Legal Risk. It is obviously of great importance to lessors and lenders that the law applicable to the transaction is well-developed and clear as it relates to such matters as property rights, enforcement of contractual rights and remedies (including perfection and enforcement of rights in collateral), the consequences of bankruptcy or insolvency of the lessee or a credit support provider and the like. Also of concern, particularly in emerging nations where local courts may be hostile, is the ability to obtain judicial relief in default and repossession scenarios. These concerns have usually been addressed by having the transaction documents governed by the law of a country (such as the United States or the United Kingdom) having an internationally recognized body of commercial law precedents and by providing for the parties to submit to the jurisdiction of the courts in that country in the event of litigation. Also, where the lessee or a credit support provider is a governmental entity or is controlled by a governmental entity, the documents should provide for a waiver of sovereign immunity. Even with these contractual protections, however, the parties usually attempt to get comfortable (usually through legal opinions) that they are enforceable under local law. D. Project Risks. Most cross-border leasing to date has been utilized to finance investment in transportation assets (e.g., aircraft and railroad rolling stock) and other discrete assets (e.g., telecommunications equipment, printing presses etc.). In these

cases, the principal risks are lessee defaults (which are covered by exercise of remedies under the lease) and loss or expropriation of the leased equipment (which are covered by insurance). In the case of equipment that is incorporated into a larger project, the financing parties may, as a practical matter, be unable to foreclose and be forced to look to project revenue for ultimate payment in the case of a lessee default. They thus may be exposed to additional project risks:

Political Risk. Political risk may include, among other things, changes in local law that increases the cost of operating the facility and other events, such as expropriation, nationalization and direct or indirect governmental interference, as well as political unrest. Fuel Supply. Power generation projects, among others, are often dependent on a dependable source of fuel at fixed prices or on terms that enable a passthrough of fuel price increases. Supply Risk. Many projects -- such as oil refineries -- are dependent on having a stable source of supply of raw materials. Output. The project must have a committed purchaser of its output. Currency Risk. Almost all emerging nation projects will generate "soft currency" revenues. However, the financing parties usually will require repayment in "hard currencies," such as Dollars, Yen or Sterling. It may be difficult, if not impossible, to arrange long-term currency swap arrangements for this purpose.

The foregoing risks must all be dealt with through project documentation with creditworthy entities that are willing to take the risks. For example, fuel supply might be assured through long-term fuel supply contracts with a major supplier or with the state oil company in the host country. Raw materials supply often is guaranteed by the project sponsor through "through-put" contracts or similar arrangements. All power generation projects are supported by a long-term power purchase with a local utility (which may provide for pass through of increases in fuel prices and other embedded fixed costs). Currency risk can be addressed by swaps, in appropriate cases, or by foreign exchange risk insurance (which generally must be supported by a fixed rate exchange facility provided by the central bank or the government in the host country).