Hong Kong - Russia: An alternative structure for operating leases opens for Russian airlines
Legal update No 629
Hong Kong is expected to become one of the world’s most attractive jurisdictions for aircraft leasing and financing thanks to new tax rules introduced this summer. To take advantage of the favourable tax regime, eligible lessors will employ Hong Kong as a hub for leasing aircraft to Russian airlines and be able to offer almost the same structures as currently used for the cross-border leasing of commercial aircraft into Russian market.
Lease structures with Russian airlines
The leasing of foreign manufactured aircraft (including Airbus and Boeing) to Russian airlines will use structures which optimise the balance between the lessor’s requirement for foreign registration with the airlines operational needs (e.g. using Bermuda or Ireland) and the fiscal treatment of the leases (e.g. using Ireland or Cyprus).
Foreign lessors have generally insisted on the off¬shore registration of aircraft on lease to a Russian entity. The view is that domestic Russian law and practice gives them insufficient certainty on repossession and de-registration. The ability to have foreign aircraft registration but operational maintenance and safety oversight and administration by the Russian aviation authorities is made possible by virtue of bilateral agreements entered into under the auspices of Article 83bis of the Chicago Convention (1944). Such bilateral Article 83bis agreements have been entered into by Russia with Bermuda and Ireland.
The optimisation of the overall fiscal treatment of the ownership and leasing is naturally a key goal for both lessor and airline. For the lessor this is achieved by it being able to enjoy a low revenue and capital gain tax regime and this has typically been provided by locating the lessor entity in Ireland or Cyprus. Both the lessor and the airline benefit from being able to take advantage of any double taxation treaties (DTTs) entered into by Russia. The Russia – Ireland and Russia – Cyprus DTTs allow a lessor leasing an aircraft to a Russian airline for operating it in international traffic to enjoy full exemption from Russian withholding tax. This then benefits the airline by avoiding gross-up obligations and benefits the lessor by allowing it to offer a competitive and viable overall cost-of-leasing to the airline.
Hong Kong’s new aircraft leasing regime
Hong Kong introduced its new aircraft financing and leasing regime by way of a significant amendment to its tax laws. The amendments were made following several years of consultations with the aircraft leasing sector professionals and as a result takes into account the vast majority of the structures which are in common use in the industry.
In brief, Inland Revenue (Amendment) (No. 2) Ordinance 2017 introduces a super-low rate of profit tax and an exemption from capital gains tax to qualifying aircraft lessors:
the standard rate of revenue tax is cut by 50% to 8.25% and applicable to assessable profits;
assessable profits comprise only 20% of gross lease income less deductible expenses (except tax depreciation);
exemption from tax on realised capital gains on aircraft which have been owned and used for not less than 3 years before realisation (and, in the case of a shorter period, a lessor may still claim that the relevant gains are capital in nature and not subject to profits tax).
As a result of these changes Hong Kong now offers qualifying aircraft lessors a theoretical base tax rate of 1.65% (8.5%*20%) on their net leasing income. Detailed calculations will be required for each leasing transaction to determine the effective tax rate but comparisons with the tax position of aircraft lessors in the traditional jurisdictions for aircraft lessors (e.g. Ireland and Singapore) suggest that the new Hong Kong regime will be very competitive and when coupled with favourable DTTs utterly compelling. There are two significant balancing constraints in the new regime – tax is not deferred – it is payable every year in which there are taxable profits – and there are no tax depreciation (and no group tax consolidations).
Two key features and BEPS
A key component of the qualification requirements for aircraft lessors wanting to benefit from the Hong Kong regime is that its central management, control and profit-generating activities shall be physically present in Hong Kong. It is not sufficient that lessor is a shell/brass plate entity. Of course an individual single asset owner/lessor may have little or no substance but the management of that owner/lessor must be in and from Hong Kong. For some leasing companies that have well established and integrated management elsewhere this requirement will be a major consideration in any decision to establish a leasing platform in Hong Kong – why duplicate? In response to concerns and questions raised on this and other points the Hong Kong Inland Revenue Department has recently issued the detailed guidance in the Departmental Interpretation and Practice Notes No. 54.
In order to allow the Hong Kong regime to fit smoothly into structures commonly used in aircraft leasing the new law has adopted a broad interpretation of the concept of ownership. While it is a requirement that the qualifying aircraft lessor has ownership of an aircraft such ownership can arise under any arrangement which may or will give the lessor legal title or which gives it effective economic ownership – so a hire purchase agreement, a conditional sale or what the Ordinance refers to as a “funding lease” will all be sufficient to establish ownership. This allows the Hong Kong structure to be used in conjunction with many classic head lease/sub-lease structures (e.g. for ECA/US EXIM-backed financing, or French or Japanese tax leases, or securitisation).
Perhaps it follows from this that the Hong Kong regime is intended for use by lessors entering into operating leases – certainly it is promoted as an “dry” operating lease regime - but it may be more accurate to say that the regime does not apply where ownership will or may pass to the lessee at the end of the lease term.
The new tax regime – with its benefits and constraints - comes into effect in a very different global fiscal environment than was in place when others devised their concessionary structures. The Hong Kong authorities have been very focused on ensuring that the new regime is in strict compliance with BEPS - the measures developed as part of the initiatives promoted by the G20/OECD for preventing “base erosion and profit shifting”. The up-side of this is that the Hong Kong regime should be much less vulnerable to attack than regimes born in a less stringent environment. The Russian tax authorities have been actively involved in the BEPS initiative and are likely to see the Hong Kong regime in a favourable light.
Plugging Hong Kong into Russian leasing structures
The Russia – Hong Kong DTT applies no withholding tax on aircraft lease revenues arising from a Russian source where the leased aircraft is operated in international traffic and beneficially owned by a Hong Kong resident entity (such as a qualifying aircraft lessor must be). So there is no difficulty in plugging in a Hong Kong qualifying aircraft lessor in place of an Irish or Cyprus entity. But as yet Hong Kong has no Article 83bis arrangements with Russia. Assuming that foreign lessors will continue to insist on foreign registration of leased aircraft it will remain necessary to use the lease-in and lease-out structure with a jurisdiction having such arrangements with Russia in place (e.g. Bermuda or Ireland; depending on the preferences of the lessor and airline).
We have mentioned compliance with BEPS and the requirement for central management and control as features of the Hong Kong regime but we should also note recent developments in Russian law generally requiring, among others, foreign lessors with a source of income in Russia to confirm to Russian lessees the lessors’ beneficial ownership rights to such income for applying the DTTs exemptions. For those leasing companies having a strong presence in Hong Kong it may be much easier to procure such confirmation with respect to lease income received by their Hong Kong “qualifying aircraft lessor” entity than it would be for them to procure it for an SPV lessor in a jurisdiction in which they have no meaningful presence.
And those who are as yet undecided about establishing a presence in Hong Kong should also be aware that it will not be too difficult or too costly to establish substance in Hong Kong.
What’s in it for lessees
It is clear that lessors may find the new Hong Kong tax regime advantageous for certain types of aircraft leasing to Russia, but what is the benefit for the Russian airlines?
familiarity with the structure – no significant change to well accepted structures/documents;
easy acceptance by the Russian tax authorities;
access to new market players – e.g. Asian leasing companies not already well established in a competing jurisdiction;
potential to attract new sources of funding;
playing the China card - using the banner “belt and road initiative” to improve financing opportunities;
potential flow through advantages from the lower tax base of the Hong Kong lessor.
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