Property EU, October 2017

Innovation in operating platforms

A focus on taxation

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In the recent past we have written about many of the external forces influencing operating platform design and the importance of innovation, including the deployment of robotics, digitalization of customer experience, managing data and using analytics and predictive technologies.  This sits alongside the key consideration as to which processes should be kept in-house or outsourced to a specialist service provider. One of the key aspects shaping the design of operating platforms is the influence of ever more granular and complex tax and regulatory requirements in which much of the industry and its products operate. In this article we will focus on some of these key elements.

Global tax rules are changing rapidly. The global efforts of the G20 and the Organization for Economic Co-operation and Development (OECD) to fight against perceived base erosion and profit shifting (BEPS) have fundamentally changed the international tax landscape and have created a host of new challenges for all businesses including real estate investment structures. One of the primary drivers of this
is the explosion of new transparency and reporting measures.

For instance, Action 13 of the OECD Framework in particular affects the tax compliance process as the new three-tiered approach (master file, local file and country-by-country report) provides tax administrations with more detailed information regarding the global value chain of a company or investment structure, including the amount of profit and corresponding tax a business pays in each country in which it operates. They can further share this information with foreign tax authorities. The immediate impact is that there will be more scrutiny from tax authorities and auditors on policies, implementation and consistency.

Tax administrations are also harnessing the power of digitalization to make better use of limited resources and extract more value from the information they receive. The design of an effective operating model must consider digitalization in the tax area.  This means that businesses need to understand the particular tax authority data requirements and be able to format source data for local country requirements.  They must also have the appropriate tools to prepare digital tax submissions.

These obligations are placing an enormous amount of pressure on businesses to improve their data management and analytic capabilities and create files that are ‘audit-ready’ when they are submitted to the tax authorities. This is even more relevant when the business operates worldwide.

In addition to this overall transparency agenda, if we look more closely at a typical real estate investment fund structure we can see that, out of the 15 BEPS action points, there are three main hot spots relevant to the real estate funds industry which need to be carefully managed.  This can be illustrated in the following diagram.

Graph 1 


Action 6 aims to prevent perceived tax treaty abuse, which may have an impact on the way real estate funds hold and finance their investments. Historically, investments have often been made through a variety of holding companies; from a tax perspective aggregating investments located in countries with a broad treaty network may prevent investors from being disadvantaged tax-wise compared with a situation where they would have invested directly. Following the OECD’s release in November 2016 of a provision on multilateral instruments, countries will be able to implement tax treaties that incorporate BEPS-related measures across their network of existing treaties without the need to bilaterally renegotiate each treaty. In this respect, they will have to adopt a principal purpose test, a limitation of benefits rule or a combination thereof. In light of the above, investment managers may wish to consider the commercial rationale for fund or other investment structures and consider alternative investment vehicles.

Action 4 aims to limit interest deduction on debt financing, which may change the economics of leverage widely used to maximize the return on investments. The proposition is to limit interest deduction to between 10% and 30% of an entity’s earnings before interest, taxes, depreciation and amortization (EBITDA), although governments may allow taxpayers to deduct a larger amount based on the group average third-party debt burden. The European Union has also enacted the Anti-Avoidance Tax Directive, which provides for a 30% EBITDA limitation, applicable to both related-party and third-party debts. Considering this significant change, investment managers should review their existing investment holding structures and debt arrangements.

Finally, Action 7 changes the definition of a permanent establishment. This may impact real estate fund manager structures that operate on a cross-border basis and who may, in the future, be considered to have a permanent establishment — and therefore a taxable presence — in the said foreign jurisdiction, where this was not previously the case.  Investment managers should therefore carefully monitor changes to permanent establishment rules in each country where their business operates.

To summarise, there are many elements in the tax landscape that make it essential for real estate fund managers to have proper controls in place to continuously monitor and implement BEPS developments as well as tax law changes in the countries of operation. Careful planning is required to ensure that business models and structures are aligned with the new global tax mindset.
 In addition, managers need to consider the impact of the digitalization of tax data and the automation of the underlying business processes in the operating model design.
Indeed, one of the fundamental decisions to be made is whether they want to retain this function within an organization or outsource it to a specialist service provider.

As a final word, in the investment management business, managing reputational risk is essential to business growth.  It is inevitable that, in the future, managers should be able to demonstrate, to investors, tax authorities and regulators alike, that their investment structures pay a fair amount of tax in the appropriate countries and in a timely manner. A well-managed tax agenda may well create a positive differentiation in comparison to their peer group.