Qualifying Private Placements - UK Witholding Tax Exemption in Practice

The UK's new interest withholding tax exemption for qualifying private placements (QPP Exemption) came into force on 1 January 2016.

One major impact of the QPP Exemption is that lenders in China, Indonesia, Italy, Japan, Korea, Malaysia, Mexico and New Zealand, among others, will now generally be able to lend to UK borrowers without suffering any UK withholding tax. Previously, they incurred UK withholding tax if the debt was not lent out of a UK branch or structured as a quoted Eurobond.

This article examines the QPP Exemption and its application in practice, and considers the Loan Market Association’s (LMA) recently released drafting in respect of the QPP Exemption.

Key Points

• The QPP Exemption reduces UK interest withholding tax from 20 per cent to 0 per cent where the conditions are met.
• This is particularly helpful for lenders in China, Japan and Korea, among others, who previously would generally have suffered some withholding tax.
• Investors based in tax havens will generally not benefit from the QPP Exemption.

Background to Private Placements 

Private placements are much more common in the US than is currently the case in Europe.

There is a widely held view that the depth and resilience of the US private placement market helped speed up economic recovery, as lenders other than traditional banks stepped in to fill the funding gap as banks shrank their balance sheets. This has led to a well-publicised effort to develop a pan-European private placement market.

A typical private placement involves direct lending by non-bank investors, such as pension funds, insurers and fund managers.

UK Witholding Tax Position  

 Generally the UK imposes a 20 per cent withholding tax (WHT) on payments of interest by UK incorporated companies (and some foreign companies with a UK connection) on loans or debt securities where the loan or debt is intended to last at least a year.

Historically, the UK has had a number of domestic exemptions from this WHT. Most UK lenders that are either incorporated as a company or registered as a pension fund with HMRC can therefore receive payments of interest gross. However, the position for non-bank lenders – the category of lenders the QPP Exemption is designed to stimulate – has been more difficult where they are incorporated outside the UK. Even the quoted Eurobond exemption, which disapplies WHT from most listed bonds, does not generally apply to private placements of debt securities issued by UK-incorporated companies, since such issuances are usually unlisted.

Where lenders could not use the above UK domestic exemptions, it did not necessarily prove fatal, as lenders resident in jurisdictions that have a double tax treaty with the UK, which reduces WHT to nil, could generally still apply to HMRC for exemption from WHT pursuant to such double tax treaties. Historically, this was a somewhat painful and time-consuming process, involving a formal tax treaty clearance application to HMRC for each loan. However, since 2010, HMRC has offered an alternative streamlined process, known as the double tax treaty passport scheme (DTTP), where eligible lenders can apply for a treaty passport to extend the nil WHT position to all loans with UK interest entered into by such lender across a five-year period. This process generally works well, provided that the necessary procedural formalities in relation to both borrower and lender are complied with, which can take a little time and paperwork. The new QPP Exemption is an addition to these exemptions.

QPP exemption

The QPP Exemption is designed to simplify matters for lenders in treaty jurisdictions. However, it will not assist lenders incorporated in tax havens.

What are the conditions for the QPP exemption?

Two sets of conditions need to be met. The first of these,

effectively the "gateway" to the QPP Exemption, is in section 888A Income Tax Act 2007 and provides that the QPP Exemption is, subject to the further conditions discussed below, available for:

• interest paid on a security;
• which represents a loan to which a company is a party as debtor; and
• which is not listed on a recognised stock exchange.

It is worth noting that:

1.  despite the reference to a "security", HMRC’s stated view is that the exemption will be available for debt taking the form of loans, facility agreements, etc., as well as debt structured as notes or bonds;
2. the exemption applies whether the debt is in bearer or registered form; and
3. in theory, the exemption applies whether the debt is held through a clearing system or not and, if it is held though a clearing system, irrespective of the location of the clearing system (so long as it is not also listed on a recognised stock exchange). However, the certification required from each lender in order to qualify for the QPP Exemption (set out below) means that the exemption is currently less useful for instruments held through a clearing system.

Additional Conditions in the Regulations

The Qualifying Private Placement Regulations 2015 (SI 2002/2015) specify that the following three further sets of conditions must be met:

1.   Securities

• The securities must not have a term exceeding 50 years.

There is no minimum term specified. As noted above though, where the term is less than a year (e.g. commercial paper), there is generally no UK WHT in any    event.

• The security, or the placement as a whole, must have a minimum value of £10m at the time it is entered into and it is worth noting that it is the "value" which is to be a minimum of £10m, meaning that non-sterling securities qualify for the QPP Exemption. HMRC has indicated that this £10m threshold will remain under review as the market develops.
• There is no upper limit for the availability of the exemption.

 2. Debtor

The relevant conditions as follows:

• The debtor generally has to be a corporate entity. This means that issues by unit trusts and partnerships will not qualify, although we understand that HMRC is considering the position of LLPs.
• The debtor must reasonably believe that it is not connected to the creditor.

This has presumably been included to prevent intra-group shareholder debt availing itself of this new exemption. That is not surprising given the historic discussions around shareholder debts structured as quoted Eurobonds.

• The debtor must enter into the relevant security for genuine commercial reasons and not as part of a tax advantage scheme.

This sort of provision is now fairly standard in new UK tax legislation.

 3. Creditor

The relevant conditions (Creditor Conditions) are as follows:

• The creditor is "resident" in a "qualifying territory". This is the key condition around the scope of the QPP Exemption.

A "qualifying territory" is, broadly, the UK or a territory with which the UK has a double tax treaty with a non¬discrimination provision. Importantly, it is not relevant whether the relevant double tax treaty reduces WHT to nil. The UK has tax treaties with a number of tax havens including the Cayman Islands, the British Virgin Islands, Guernsey and Jersey, and that sometimes causes confusion as to whether those territories count as a "qualifying territory". The point to note is that even where the UK does have a double tax treaty with a tax haven, such treaties do not generally have a "non-discrimination provision" (effectively, a clause providing that the UK shall not discriminate against nationals of the tax haven as compared to UK nationals). Consequently, the QPP Exemption will not directly assist lenders incorporated in such tax havens.

There is a (slightly dated) list of the treaties that HMRC considers are with "qualifying territories" in the HMRC International Manual at INTM412090.

The creditor must be "resident" in a qualifying territory and "resident" means "liable to tax" in that territory. Note that this condition means that such a lender would (subject to the below) often already be able to avail itself of relief from WHT under the relevant double tax treaty (assuming the relevant filings were made).

Turning then to how the residence concept applies to different lender entities:

1. Foreign pension funds and charities
   The UK will generally treat these entities as "resident" even if they are tax exempt in their home jurisdiction. If so, they should therefore be eligible for the QPP Exemption.
2. Partnerships
   In order to qualify as a "resident", the lender effectively needs to be a taxpayer in the relevant jurisdiction. Consequently, those partnerships which are treated as tax transparent will generally not, themselves, qualify. However, those partnerships which are treated as a company or taxed in the same way in their home jurisdiction (e.g. a Lux SCA) will generally qualify. On the face of it, therefore, the QPP Exemption will not directly help those widely held private equity, mezzanine, infrastructure or other funds which are set up as partnerships, whether in the UK or elsewhere.

We understand that the intention of the QPP Exemption is to look to the ultimate recipient of the interest, which, in this case, would mean looking through the partnership to the partners to see if they satisfy the Creditor Conditions for the QPP Exemption. While HMRC has informally indicated that it should be possible to look through a partnership, these views are unpublished.

We have seen some partnerships use the QPP Exemption where all the partners are resident in the UK or a "qualifying territory", though this has tended to be where the number of partners is small. There are a number of issues with this approach. First, there are questions concerning how the Creditor Certificates (see below) should be provided, particularly where there are carry arrangements. Secondly, not even the new LMA qualifying private placement loan documentation wording (see below) treats such a partnership as a "Qualifying Lender". Thirdly, some of HMRC’s guidance on this point is unpublished. In short, this means that documenting deals for such partnerships is currently much more time-consuming than doing so for the more familiar sort of vehicles.

The QPP Exemption is currently more likely to assist partnerships where a fund partnership has incorporated a subsidiary entity, such as a taxable Luxembourg company. Indeed, this new exemption could be very useful if work under Action 6 of the OECD Base Erosion and Profit Shifting (BEPS) Plan restricts the ability of such subsidiaries to access treaty relief.

• The creditor is "beneficially entitled" to the interest for genuine commercial reasons and not as part of a tax advantage scheme.

"Beneficial entitlement" in this context should be given its UK domestic meaning and not the broader international fiscal meaning which it attracts in the context of double tax treaties following Indofood, whereby a beneficial owner must have full privilege to directly benefit from the interest.

Under the UK domestic meaning, and pre-Indofood, mere back-to-back contractual arrangements were not considered to deprive an entity of beneficial ownership, and we would consider the same to be the case here.

However, as beneficial entitlement is coupled with the requirement for the creditor to not be part of a tax advantage scheme, consideration should be given to any arrangement that could be seen as constituting a conduit arrangement with a tax haven entity; for example, a total return swap or sub-participation.

Procedural Formalities

A creditor is required to confirm by producing a certificate (a Creditor Certificate) that it meets the two Creditor Conditions, and once the borrower has received that Creditor Certificate it can rely on the QPP Exemption.

There is no prescribed format in the legislation for a Creditor Certificate. The LMA has produced a form of Creditor Certificate which is scheduled to the new LMA qualifying private placement document.

While it is a condition of the QPP Exemption that the debtor holds a Creditor Certificate, the QPP Exemption does not expressly require that the Creditor Conditions (at (3) above) are satisfied at the time payments of interest are made. What that means is that if a Creditor Certificate has been issued but, unbeknown to borrower and lender, the Creditor Conditions are not satisfied, the borrower can nevertheless generally obtain the benefit of the QPP Exemption. Accordingly, HMRC has power to demand a Creditor Certificate be cancelled if it reasonably believes it to be materially inaccurate (a Cancelled Certificate) and similarly a lender must withdraw a Creditor Certificate if it becomes aware that the creditor confirmation ceases to apply (a Withdrawn Certificate). In both cases, a Creditor Certificate is invalid once the borrower has received notification from HMRC or the lender of any cancellation/ withdrawal respectively, and a lender is obliged to inform a borrower that the Creditor Certificate is inaccurate as soon as practicable after it has become aware that the confirmation given has ceased to apply.

While the production of a Creditor Certificate places an administrative burden on investors, these requirements are much less onerous than under a full double tax treaty claim. The difference may, however, be minimal as compared to the filings required where a lender already has a DTTP number, as it is the borrower rather than the lender who is to complete DTTP filings.

The requirement for a borrower to have a Creditor Certificate in respect of every lender creates significant administrative difficulties for bonds held through clearing systems as, absent special arrangements, the borrower will not know the identity of the bondholders. We understand that Euroclear and Clearstream are discussing how to tackle this concern. Details are currently unclear but could involve a procedure similar to that for what ICSMA calls "unlisted Eurobonds" (see the International Capital Market Service Associations’ Global Tax Procedures - Tax Relief Procedure for UK Unlisted Eurobonds). That procedure is pretty unwieldy, though, in our view.

QPP Exemption in Private Placement Documentation

The LMA released tax drafting in April 2016 to cover lenders using the QPP Exemption (New LMA Drafting). As discussed above, HMRC has confirmed that the QPP Exemption can apply to debts documented both as securities and as the sort of facility agreement more commonly seen in the syndicated loan markets. Accordingly, the New LMA Drafting comes in two formats: the Subscription Agreement and the Facility Agreement. The approach is the same in both documents. Below, we refer only to the Facility Agreement.

Generally, under such facility agreements, a lender must be qualifying lender in order to be entitled to the benefit of the gross-up. Qualifying Lenders have therefore previously included lenders who are entitled to the benefit of a UK domestic exemption from WHT, or lenders which are entitled to the benefit of a nil WHT rate under an applicable double tax treaty (subject to the completion of procedural formalities).

The key benefit of being a Qualifying Lender is that, in the event of a change of law which gives rise to UK WHT, the Qualifying Lender remains entitled to the benefit of the gross-up, whereas a non-Qualifying Lender would suffer the WHT without a gross-up.

The New LMA Drafting has introduced a new category of Qualifying Lender called the QPP Lender. The QPP Lender is one who has delivered a Creditor Certificate satisfying the Creditor Conditions outlined above and such certificate has not become a Withdrawn or Cancelled Certificate.

As set out at the start of this briefing, there are certain lenders that do not benefit from a zero WHT rate under a treaty (and thus cannot qualify as a Treaty Lender under LMA drafting) but which can benefit from the QPP Exemption. Those lenders will want to utilise the QPP procedure since it reduces the WHT to zero for them. However, there is a much larger pool of lenders that, subject to any contractual restrictions in the loan documentation, have the choice of whether to use the QPP Exemption or the withholding exemption available in the relevant Treaty. The New LMA Drafting offers those lenders both options. We note that the QPP Exemption effectively allows self-certification with consequent timing, cost and administrative benefits. Accordingly, we would expect that most such lenders would opt to use the QPP Exemption (rather than a treaty exemption) for those loans which contain the New LMA Drafting.

One practical point to note is that best practice for lenders relying on the QPP Exemption would be to provide a Creditor Certificate on signing, which is an extra document to go on the completion checklist.

The New LMA Drafting has not as at the date hereof been incorporated into all the LMA senior and leveraged loan documentation. However, the New LMA Drafting can be relatively easily transposed into new loan documentation, and we understand that this drafting will be included in future.

Given that a Creditor Certificate may be cancelled or the relief may not be available for reasons outside of a lender’s control, lenders should be careful to ensure that there is an appropriate risk allocation under the documentation.

Transitional Rules and Existing Loan Documentation

Where all the applicable conditions are satisfied, the QPP Exemption is now available for all payments of interest, irrespective of when the loan was made or acquired. Existing facility agreements will not, however, provide for lenders benefiting from the QPP Exemption to be Qualifying Lenders entitled to gross-up on any change of law.

However, where all the applicable conditions are met, the documentation should not stop the borrower and a new lender from agreeing to use the QPP Exemption should they so choose. Indeed, once the markets become more used to using this exemption, that could become an increasingly common practice. The potential risk of taking that approach is that, depending on the precise drafting, that may well remove the change of law protection from someone that would have benefited from it had they applied for treaty relief. Accordingly, we think that for historical loans without the New LMA Drafting:

1. those lenders that can avail themselves of either treaty relief or QPP Exemption will choose to claim treaty relief; and
2. it will only be those lenders that would not obtain total exemptions under the relevant treaties that will choose to use the QPP Exemption.