There is a widespread idea among market players that infrastructure assets have defensive and resilient returns towards inflation. Considering the recent strong increase in inflation, the inclusion of different assets under the definition of infrastructure, as well as the willingness of the governments to protect consumers from inflation, have led to a rethink of the strength of the sector with regards to inflation.
Impacts of the current inflationary environment on infrastructure investments
Revenues related to traditional investments carried out under the “infrastructure” label are often CPI-linked (i.e., linked to a Consumer Price Index), which allows a revenue increase aligned with inflation. These types of investments are, for example, utilities or toll road assets which operate under concession-type contracts that are negotiated with local governments and have embedded clauses to increase toll prices from year to year. Notable examples include the increase of toll fares by 4.75%1 in France in February 2023, while the Portuguese government decided to cap the toll fares at 4.9% in the same period, with a view to protect consumers from “too high” inflation, although the concession formula allowed tariffs to rise up to 10.5%2.
Infrastructure delivery costs are expected to significantly increase (even potentially above economy-wide inflation) due to rising commodity and energy prices. In this respect, price indexation to inflation might jeopardize returns on infrastructure assets since investors might face higher development costs.
Lastly, the European Central Bank is committed to bringing the inflation rate down, close to 2%. In this respect, another increase in interest rates (by 50 basis points) was decided on 16 March following latest inflation projections, which were assessed as staying “too high for too long”3.
Opposing effects on the return on investment
Inflation has both negative and positive effects on the valuation of infrastructure investments:
- On one hand, inflation increases cash flow because infrastructure assets mostly have the ability to increase their pricing (see the French toll prices example mentioned previously)
- On the other hand, inflation also increases interest rates used to discount the cash flow, which can have a negative impact on investments
To offset the negative effects of increasing interest rates, the increase in cash flow should be equal to the increase in inflation. However, this may not always be possible due to price elasticity and government policies (as stated in the Portuguese toll price example earlier).
In light of the above, it might be hard to conclude at first glance whether the return on the infrastructure investment will be significantly impacted by inflation.
Yet, it might be interesting for asset managers to understand if there are any other measures that can be taken to improve investor return.
Transfer pricing applied to the infrastructure sector
Infrastructure investment fund structures in Luxembourg often have asset companies located in the jurisdiction where the investment is made, while the funds and the holding companies are based in Luxembourg. Both the asset companies and the holding companies are normally considered as related parties to the funds and therefore fall under transfer pricing regulations.
When setting up their funding strategies to acquire and develop an investment, asset managers often use a combination of debt and equity to fund investments in foreign jurisdictions. To minimize the weighted average cost of capital (WACC) of the companies, the intention is to achieve a balanced mix of both equity and debt funding. The cost of equity is generally higher than the cost of debt, as equity holders expect to derive a much higher return in line with the additional risk taken. By introducing debt into their capital structure – in a balanced manner and in line with the arm’s length principle – companies can lower their WACC without necessarily increasing their probability of default. It is important to emphasize that since the transactions are carried out in a related party context, they need to comply with the arm’s length principle as defined under article 56 and 56bis of the Luxembourg Income Tax Law.
In particular, there are some constraints in relation to (i) the loans which are already in place (which do not benefit from the latest increase in interest rate), (ii) the debt quantum that companies can support, as well as (iii) the interest rate that can be applied on new loans.
Putting in place arm's length structures to reduce future tax risks
For those loans which are already in place, it is recommended to review their terms and conditions to see if any indexation or re-negotiation clause is embedded and assess whether an update of the interest rate would be required. Clauses related to “force majeure” in particular could be reviewed to determine whether a significant increase in inflation could trigger a revision of the interest rate.
In addition, in cases of refinancing existing structures, the new external loan could be given to a different entity than the original borrower, which may eventually be in a different jurisdiction to repay the original debt and may therefore trigger transfer pricing issues related to the function and risk profile of the Luxembourg borrower. This should be reviewed in light of the transfer pricing framework to ensure that the borrowing company has the capacity to bear the risk related to the investment. For new acquisitions where intragroup debt and equity is envisaged, companies should undertake transfer pricing analysis in order to ensure that the arm’s length nature of the entire transaction (including pricing of the interest as well as the quantum of debt) is respected and well documented. With the introduction of Chapter X in the OECD guidelines in 2020, the commonly accepted debt to equity ratio of 85:15 to finance shareholdings, could be potentially subject to more detailed scrutiny by tax authorities when its application would lead to an abusive situation, where the Luxembourg company borrowing the funds would no longer be able to repay its liability for instance.
Therefore, TP documentation in line with the arm’s length principle should already be prepared before the closing of a financing transaction, to decrease any future complexity and provide taxpayers with appropriate support to respond to any potential inquiry from tax authorities.
