Taxes on The mezzanine

Using mezzanine financing 
for investment in real estate may raise the suspicions of tax authorities. Nevertheless, such a form of finance has more advantages than disadvantages. But one has to know how to explain these advantages to the officials properly

Obtaining suitable funding for a project is vital both for its launch and for its ultimate financial success. Ideal financing should be cheap, flexible and – best of all – possess tax advantages. But because it is usually difficult to attain anything ideal, the accepted form of funding by investors is bank loans (secured by a mortgage or a pledge on shares), which cover most of the cost of the investment. Any shortfalls in finance are made up for by investors out of their own funds. Apart from applying this classic ‘duet’, in their efforts to attain an ideal form of funding more and more investors are using another form, referred to by the collective term ‘mezzanine financing’, because it is halfway between the first two.

Greater flexibility, greater risk

There is no single, closed definition of mezzanine funding, but the simplest way is to regard it as something between bank loans secured by a mortgage and a developer’s own capital. Mezzanine instruments are more flexible than loans and involve greater risks, but they offer a greater rate of return. For the investor this means exemption from some preliminary conditions (e.g. the conclusion of pre-leases) and the possibility of obtaining funding not secured by a mortgage; but on the other hand, it also involves higher costs and the need to provide other forms of guarantee, such as participation in the management of the investment or control of the management.

Greater flexibility, greater cost

In practice there are many forms of mezzanine finance. They include subordinated loans (similar in fact to ordinary loans from shareholders), loans with interest linked to profits or other factors with which the investing company’s performance is measured, or convertible bonds or other instruments that enable the investor to convert its debt into equity. All these instruments have at least one thing in common – they cost much more than ordinary bank loans secured by a mortgage (especially if the financed project is successful). It is important that the interest the SPV pays is recognized as a tax-deductible expense. It is equally important for interest paid abroad to be linked to preferential rates of withholding tax, as in practice the costs of the withholding tax, paid by the donor are often transferred to the recipient.

From a tax point of view, one should first see whether the type of instrument being applied allows the expenditure to be regarded as interest or some other tax-deductible expenditure. Pegging 
a financial instrument to the lender’s performance, control over the lender or a right to convert the loan into shares, coupled to local tax regulations, may give rise to the risk of the lender’s remuneration becoming a quasi-dividend that is not tax deductible. It is rather difficult to form clear conclusions on this important issue, especially if the tax authorities have little experience in this subject, as is the case in Poland. Nevertheless, at least from the Polish perspective, a major portion of mezzanine instruments should be recognized as debt instruments (and the interest on them recognized as a tax-deductible expense), and not as an owner-type of instrument. The next fiscal problem is to justify the amount of the interest paid.

How to talk to a tax official

Tax authorities, at least in Poland, still have 
a tendency to investigate economic facts randomly, and – guided by the cost of interest, ranging from a dozen or so to several dozen percent on an annual scale – may demand explanations from the developer. In extreme cases, they may attempt to question the payment of interest as a tax deductible expenditure. In the case of funding obtained from unrelated parties, this risk is in practice small. A transaction with an independent entity is virtually a reflection of the market conditions, and therefore should not give rise to any tax controversies. However, one should remember that the tax definition of a ‘related party’ can be very broad, and may include an entity that provides mezzanine financing, even if from the perspective of the the developer it is a completely unrelated entity. Polish tax regulations also consider a ‘related party’ to be an entity that has at least indirect participation in management or control over the second company. A provider of mezzanine financing often requires 
a certain amount of additional control over a project that it co-funds, from which it may be recognized as a related entity from the tax perspective.

In the case of mezzanine financing between parties viewed for tax purposes as ‘related’, the most important matter is to explain that the amount of interest paid reflects the market conditions. On the one hand, this should lead to a recognition of the interest as a tax-deductible expense, and on the other it should permit preferential withholding tax rates, because in most cases they are applied only to interest that is recognized as market interest. One should expect that the tax authorities – especially those with less experience in complex forms of finance – will naturally think in terms of the interest that is applied to bank credit facilities, because this provides the easiest point of reference. Of course this is quite unjustified because credit facilities and mezzanine financing are quite different from each other, and this would also conflict with the principle of comparing prices between affiliates. Should tax officials have any doubts, explaining this fact to them, as well as the general principles governing mezzanine instruments, is the key to success. No doubt a second key to success is for the investor to prepare proper materials illustrating its financial requirements (especially the fact that they exceed the amounts available under the secured credit facilities offered by banks) on the one hand, and the market offer (e.g. independent offers from other institutions) on the other hand.

Imported financing

For legal, corporate or tax considerations, mezzanine funding is implemented at the level of 
a foreign holding, while the funds reach the target country as the investor’s own contribution. On the one hand, such a solution permits greater flexibility in laying down the terms and conditions for the lender (e.g. the Polish Commercial Companies Code contains rather stiff provisions regarding the privileged payout of dividends), while on the other hand they transfer the burden of discussion on how mezzanine financing operates to the country where the fiscal authorities are acquainted with and recognize such instruments. But at the same time, this means that the investor waives the possibility of treating at least part of the remuneration paid to the lender of the mezzanine loan (basically a third party) as a tax-deductible expenditure, due to the fact that the holding company usually pays only a limited amount of income tax. Thus the costs of mezzanine financing are not used effectively.

Worth the effort

Summing up, for the Polish tax authorities, mezzanine financing is still a novel and exotic way of financing investments. Therefore, making use of them may require additional explanations during tax audits. But if the accompanying documentation has been prepared properly and the mezzanine instrument itself applied correctly, the risk of forfeiting the right to classify interest paid as a tax-deductible cost should be considered acceptable. ν

Andrzej Puncewicz, partner and Paweł Toński, senior manager 
of Accreo Taxand