The Finance Act heralds changes in the UK structured finance market

United Kingdom
reports Simon Meredith

Following the enactment of the second Finance Act of 1997, it would seem that UK preference share financing in its "traditional" and more recent "FID" forms has been well and truly killed off by the Government as far as most banks and other financial traders are concerned. A typical UK preference share financing relied on the subscriber (inevitably a Bank) receiving dividends on preference shares tax free and getting tax deductions for their funding costs. This gave the issuer/borrower a lower cost of funds (the issuer/borrower usually not being in a position to deduct interest costs on a conventional loan facility and therefore choosing the preference share option to achieve a minimum, albeit still non-tax deductible, cost of funds).

The fact that UK banks usually held these shares on trading account (although some did hold them through investment companies) had no bearing on the taxation of the dividends - these were tax free under the pre-Finance Act rules exempting dividends received by one UK company from another from mainstream corporation tax.

The Finance No.2 Act changes all this and puts UK banking operations (both UK incorporated banks and UK branches of overseas banks) out of the market. Any UK corporate who now holds preference shares on trading account (as opposed to as an investment) will be taxable on dividends paid on those shares as well as any profits made from their sale. This will affect all UK financial traders who have subscribed for preference shares (except those who have made the subscription through investment company subsidiaries).

The London market has seen an enormous amount of financing by way of preference share deals in the recent past. They have undoubtedly become the favourite "commodity" product of many UK based structured finance houses generating both large up front fees and generous margins over cost of inter-bank funding for periods of anywhere between twelve months and five years.

It is now difficult to see where this market can safely go. Although existing preference share deals in associated investment company subsidiaries appear to have been grandfathered, the Government has signalled its intention to bring in rules to prevent the market shifting into these associates as a way of circumventing the new rules.

The "grandfathering" of associated investment companies will not, however, apply to the bulk of the market as only a relatively small number of financial institutions were thought to have used the investment company route in recent years (partly because of concerns over anti-avoidance rules relating to deductibility of the inter-bank funding costs raised to subscribe for preference shares).

The immediate future of preference share financing clearly seems to lie in the already buoyant market in "FTC" or "foreign tax credit" cross-border equity deals. These rely on foreign tax credits to provide a healthy return over the cost of funds to the subscriber. They typically take the form of an issue of shares in, for example, the US, subscribed by financial institutions in the UK. Dividends on the shares may, in certain circumstances, as in the US, be regarded for the purposes of the tax rules in the overseas jurisdiction as tax deductible "interest" on debt instead of dividends on shares. The dividends when received in the UK should, according to the theory, be sheltered from tax in the hands of the subscriber as they carry with them credits for "underlying tax" paid in the overseas jurisdiction on the profits out of which the dividends are paid.

These transactions are generally much more complex than the traditional form of UK preference share financing. They depend on having historic, taxed profits in the overseas jurisdiction and on the complex UK rules relating to the obtaining of foreign tax credits (either under UK domestic legislation or the terms of relevant double tax agreements). As well as throwing up complicated legal and accounting issues it is not clear why UK financial traders should consider this particular area of financing activity any safer than domestic UK preference shares. Like the typical UK preference share deals, the FTC deals depend equally as much on tax deductible interest costs and tax shelter on dividends to turn an economically unviable transaction into a profitable one.

Amongst the numerous legal and accounting issues raised by FTC transactions it is worth noting that UK branches of overseas banks must be particularly careful when considering such deals and will encounter problems without a UK associated company to channel any such transaction through.

The Government's willingness to put an end to what has been regarded as a fairly acceptable traditional form of financing over the last decade foreshadows an uncertain future for elements of the structured finance market. Issues of debt with partial equity defeasance are still technically as possible as they were prior to the introduction of anti-avoidance rules relating to interest paid on "loan relationships" entered into for "unallowable purposes" (Paragraph 13 to Schedule 9 FA1996). In addition, complex foreign exchange structures still enable corporates to obtain "product" generated tax benefits. However, it is anybody's guess as to the exact extent to which some of their Lordships pronouncements in the McGuckian case and some of Gordon Browns more pugnacious statements on the introduction of a general anti-avoidance rule will hamper or hobble the tax based financing industry.

Clearly, the most advantageous tax planning "products" for any corporate to consider are those which enable benefits to be obtained within a short period of time. It is certainly the case, however, as the new rules affecting preference shares show, that it is no longer safe to regard a tax based transaction as within the acceptable confines of existing law on the basis that genuine finance is required and being provided. "Raids on the Exchequer" have never been popular with any Government but this move against the UK preference share financing market is a sign of increased hostility.