Equipment financing in emerging markets

Business America, Oct, 1997 by Jerrold B. Rosen, Donald G. Becker

Tax Issues

The tax issues presented to a U.S. lessor when entering into emerging global markets differ depending upon the method of entry: (1) leasing through an offshore affiliate of an emerging market lessee, (2) direct cross-border leasing to an emerging market lessee, and (3) "permanent establishment" for in-country leasing. Although it can be argued that the tax "tail" should not be permitted to "wag" the leasing dog, in the highly tax-motivated world of international leasing, the tax results can mortally wound the dog if not properly structured.

Depreciation Slowdown. When leased equipment is located outside die United States, the U.S. tax rules generally require a slower rate of depreciation than is normally available and may also require a longer depreciable period as well ("Pickle" rules). Although there are some exceptions to these slowdown rules, the depreciation methodology will often affect the transaction economics and must be evaluated when pricing an international transaction. For example, a commercial aircraft usually qualifies for seven-year MACRS depreciation if it is used in the United States, but the same aircraft must be depreciated over 12 years (using the straight-line method) if leased exclusively outside the United States.

Permanent Establishment Rules. The permanent establishment rules, which are dictated by local country law and are often modified by operative tax treaties,. determine the local country's ability to tax income earned on leasing transactions conducted with lessees in their home country. Typically, a U.S. lessor creates a taxable presence by opening an office in the foreign country or by locating employees in that country to conduct sales activities locally. In most cases, cross-border leasing transactions can be structured so as to minimize the potential for local country taxation. Lessors with a more long-term view may desire to develop a local presence in order to compete effectively with home-grown financing companies.

Withholding Taxes. Local country laws may create an obligation for withholding taxes on lease payments to foreign lessors. Typically, these taxes are assessed only if a permanent establishment does not exist. Many of the emerging market countries have tax treaties with the United States that eliminate or reduce the impact of withholding taxes between residents.

The classification of the lease (operating lease, true lease, or finance lease) must be based on local country laws where the lessee is located to determine if withholding taxes will be based on rental payments (operating and true leases) or on interest payments (finance leases). In addition, since the withholding taxes are technically an obligation of the payee/lessor, the prudent lessor will either price the net withholding obligation into the lease transaction (after considering available foreign tax credits) or increase the lease payments such that the lessee bears the cost directly.

VAT and Other Sales Taxes. An often overlooked and costly area in the international leasing realm is the value-added tax and other such sales taxes. VAT and other commodity taxes are especially prevalent in emerging markets in Europe, the former Soviet Union, and Latin America, with rates ranging from 5 percent to 20 percent or higher. These taxes can be applied both on the importation of equipment into a foreign jurisdiction (based on the import value of the equipment) as well as on the lease payments made to an in-country or foreign lessor. If the lease transaction is properly structured, these commodity taxes usually are recoverable he local lessee or by the lessor so that they do not represent a net transaction cost.