Tax and data centres – powering structural change

1. Data centre landscape

With the increasing digitalisation of the global economy and the expansion of AI and digital payment services, the global data centre market is experiencing unprecedented interest from investors, developers, funders and occupiers.

Access to energy is, unsurprisingly, critical to any successful data centre development, and is a crucial factor in term sheet negotiations. We are increasingly seeing rapid growth in the establishment of joint ventures between investors and energy providers. These partnerships can bring together capital and access to power grids and combine the parties' complementary assets, market knowledge and industry skills to create data centre investment "platforms".

As the data centre market develops, investors are adopting increasingly innovative and sophisticated structures to acquire and hold data centre assets.

2. Structural optimisation as a value driver

We are frequently asked by potential investors, developers and funders "what is market?" in terms of data centre investment structures in different jurisdictions.

In truth, the answer in many circumstances is that the market is too nascent to have established many clear norms in this regard, given that data centres can be structured, and monetised, in so many different ways.

Structural optimisation and innovation, if addressed at an early stage in negotiations with counterparties, investors and funders, can drive significant value.

3. Data centre holding structures

Many data centre assets are held within limited companies, which can (i) provide familiarity for investors, funders and occupiers, (ii) ring fence liabilities and (iii) facilitate future indirect disposals of the underlying asset (e.g. by way of a sale of the shares in a property holding company) in a manner which can mitigate real estate transfer tax leakage in certain jurisdictions.

However, with an increasing focus on investments into data centre assets from global sovereign wealth funds and other large "tax exempt" institutional investors (including pension funds), structural optimisation can potentially (depending on the type of income generated from the data centre) be achieved by utilising unit trust, REIT or "REIT-like" holding structures.

The choice of investment holding structure is also a critical decision for ensuring that tax incentives (in particular depreciation allowances for capital investment, which in some jurisdictions, such as the UK, take the form of capital allowances and structural and buildings allowances) can be claimed at the right level for maximum tax efficiency.

Additional emphasis is placed on the choice of investment and holding company vehicles in the context of "sovereign AI" structures, with an increasing focus on the use of entirely "onshore" structures.

4. Type of income

The type of underlying activity which is being undertaken can fundamentally alter the tax profile of investments and the applicable tax regime.

For example, to the extent that income streams properly comprise "income from land" held, broadly, as passive investment assets, data centre structures can potentially be held within UK widely-held, or so-called "private", REIT structures or Australian Managed Investment Trust (MIT) structures.

By contrast, to the extent that income streams properly constitute income from a trading activity, REIT/MIT structures are unlikely to be viable. Further structural optimisation (and value) can be driven by considering the application of other tax regimes (such as the UK substantial shareholding exemption).

Additional care is required in circumstances where different types of income can be generated within single or multiple entities within a structure. For example, in addition to rental income from an investment property, a data centre structure may involve the receipt of income from the provision of services (e.g. the right to use racking) and income from disposing of surplus or unused power. This income "hybridity" can have significant implications for the optimum holding structure.

The importance of correctly identifying the type of income streams which are anticipated at a term sheet stage cannot be overstated because this can have a fundamental impact on the optimal choice of asset owning and holding entities used in data centre structures.

5. Importance of "future proofing" structures

To the extent possible, parties should invest time at the outset in considering an optimal holding structure that is viable in both the short and medium term.

While "future proofing" structures may not always be feasible, where this can be achieved, this can create significant time and cost savings by avoiding complex future restructurings. This may, for example, include (i) considering the inclusion from the outset of "Midco" entities in structures which may be required to provide financing security to future lenders and (ii) the creation of separate REIT "sleeves" in structures.

This is particularly important in a data centre context because future structural changes, including the future interposition of intermediary holding companies in a structure, can require mandatory regulatory or national security related filings and clearances.

6. Key practical takeaways

(a) Early planning: It would be prudent for investors, developers, funders and occupiers to consider the optimal holding structure at a term sheet stage of data centre negotiations.

(b) Long-term structural optimisation: A small investment of initial time in this regard can significantly (i) minimise time and costs in the course of commercial negotiations, (ii) mitigate execution risks, (iii) minimise future filing requirements and (iv) maximise future financing flexibility.
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