December 04 2007
The use of operating company ('opco') and property company ('propco') structures has recently become increasingly common in the Swiss lending and securitization market. Using these structures often leads to more efficient and less expensive financing. By segregating the assets (ie, the propco) from the business (ie, the opco), and by lending into the propco, the lenders will get exclusive access to the assets. A key point when setting up an opco/propco structure is the proper ring fencing of the assets from the rest of the business so that the risks related to the propco as borrower will be limited. Consequently, the refinancing of the loan by way of securitization should become easier and more cost efficient. Under Swiss law, proper ring fencing of assets is permissible.
This update outlines some of the most significant features of setting up an opco/propco structure and also addresses some of the issues related to such structures. One of the main problems is tax efficiency when segregating the assets from the business and when running the business after the segregation. With real property, the segregation should preferably not trigger transfer and real estate capital gains taxes. Also, it should not result in the tax deductibility of the interest payments being lost. Another issue is that the income generated by the assets will still depend to a large extent on the business from which the assets have been segregated. Accordingly, even where there is a legal segregation, the risk related to the business will remain to a certain extent, particularly where there is no liquid market for the assets.
When evaluating the investment into an asset-backed security, investors and rating agencies are looking at the risks related to the underlying assets. In relation to commercial mortgage-backed securities (CMBS), such an asset is a mortgage loan, secured by real property. The risks related to an underlying mortgage loan and its default risks depend to a large extent on the real property by which it is secured. However, it also depends on the insolvency risk related to the borrower under the mortgage loan, which is often a special purpose vehicle (SPV). The insolvency risk depends, among other things, on the borrower's business and its capital structure. Thus, when structuring the financing, one of the goals is to separate potential liabilities of the borrower from the assets securing the underlying mortgage loan. Such a result is achieved when the mortgage loan is lent to an SPV that has no other purpose than to hold a real estate portfolio which generates a cash flow that will be used to service the mortgage loan. The separation of the assets from the business will reduce the borrower's insolvency risk and enhance the efficiency of the financing. Also, practically speaking, it is generally perceived that there are two different bank markets for property companies and operating companies.
From the point of view of the lender originating the mortgage loans, limitation of risk with regard to the underlying asset is crucial in order to ensure an efficient and low-priced refinancing in the framework of the issuance of CMBS. The more limited the risk is with regard to the mortgage loan, the more efficiently the refinancing can be structured. With greater efficiency in the structure of the refinancing, the transaction will be more attractive for the originator. As a result, originators may offer more competitive terms and conditions to their borrowers.
Under Swiss law, setting up such structures, whereby the assets of a borrower may be segregated from the business (ie, setting up an opco/propco structure), is permissible. The legal framework also provides for most of the features that are crucial to implementing such structures, except for taking security over movable assets. However, when setting up the structure and particularly when segregating the assets from the business, tax considerations will drive the structure to a large extent.
When setting up an opco/propco structure, one entity of the borrower's group will have to become the property company which is holding all the assets intended to secure the mortgage loan (ie, the propco). The propco will then lend money from the lender and provide security to the assets it holds. The other entities running the borrower's business will become the operating companies (ie, opcos). Since the opco would still need the assets of the propco to conduct its business, the opco would lease or rent such assets from the propco. The revenue generated by the propco under such leases will be used to service the loan. A typical structure could resemble the following diagram.
Propco as newly incorporated entity or as existing entity
From a Swiss corporate law perspective, it is advisable to use a newly incorporated entity ('newco') as a propco, as it is easier to transfer the assets properly into a newco. When transferring certain isolated assets into a newco, it is ensured that ultimately the assets - and nothing but the assets - will be in the newco. On the other hand, when using an existing vehicle as a propco, the whole business - except for the assets - will have to be transferred into an opco. There remains a slim risk that certain assets or liabilities that should have been transferred to the opco will remain with propco, particularly where the transfer has not been properly set up. In addition, depending on the transfer mechanism chosen, there will be a joint liability of both the transferor and the transferee for liabilities already existing at the time of the transfer. Thus, it is advisable to use a newco as the propco.
However, from a Swiss tax law perspective, transferring the assets into a propco may be problematic. Where real property is to be transferred, it is in most cases crucial that such a transfer may be made tax-neutral. Thus, the tension between benefits given under Swiss corporate law and Swiss tax law will have to be outweighed. This may be done only when analyzing the consequences of the structure on a case-by-case basis and in particular by calculating the tax implications of the transaction in detail. When setting up a opco/propco structure, it may well be that in reality and for tax reasons, the whole business - except for the properties - will need to be transferred into a newco. As of June 2008, all cantons will be restricted to apply real estate transfer tax and real estate capital gains tax to corporate restructuring transactions under the Swiss Merger Act.
Asset transfer by using the Swiss Merger Act
The transfer of assets under the Swiss Merger Act is a newly created legal transaction that, under certain circumstances, facilitates the transfer of assets from one entity to another. Such transfers offer the advantage that an entire portfolio of assets and liabilities may be easily transferred, since all assets and liabilities listed in a special inventory will be transferred. Thus, a part of a business may be transferred. Often there are certain cost benefits (eg, notarial fees) compared with a series of individual asset purchases. When using this transaction, the following should be kept in mind.
The act provides for the transferor's joint and several liability. In order to protect creditors, the transferor remains, for a period of three years, jointly and severally liable for all liabilities transferred to the transferee which already existed at the time of such a transfer. Thus, it is generally preferable for the opco to be the transferor and the propco the transferee of the real property. Should the propco transfer all its assets and liabilities - except for the real property - to the opco (so that as a result only the real property remains with the propco), the propco may be exposed to recourse by opco's creditors with regard to the liabilities transferred to opco. The risk related to the opco's business may remain, to some extent, also attached to the propco. Accordingly, also when transferring assets under the act, it is advisable to use a newco as the propco and to transfer the assets from the existing company to the newco. However, the issue should not be overstated either, as the parties to the transaction may normally rely on audited financial statements as to the amount of existing liability.
Again, tax consideration may lead to a different analysis. Depending on what the consequences of a certain structure are, the most robust structure - from a Swiss merger law perspective - is not in all instances the most tax-efficient structure.
Spin-off by using the Swiss Merger Act
A similar or even identical solution may be achieved by using the spin-off under the act. The transfer is essentially the same. The spin-off may occur by an existing company spinning off its assets into an existing or a newly incorporated company (ie, a newco). Also, the spin-off may occur so that the transferring entity is split into two.
The main difference is that the consideration for the transfer of assets will not be paid to the transferring entity as a purchase price. Rather, the shareholders of the transferring company will get membership rights in the entity to which the assets have been transferred. This should be taken into account from a tax perspective, since it might lead to different tax consequences.
Finally, the most important difference is that the spin-off must be publicly announced and the transferring entity's creditors must be informed of their right to be secured as creditors. This may lead to a delay since such an announcement can take some time.
Also, the entities involved in the spin-off remain liable on a subsidiary basis for the liabilities transferred to the receiving entity. This liability of the transferring entity does not end after a period of time; rather, the transferring entity remains liable, provided that the liability results from an event that occurred prior to the spin-off. This is something that can have a negative effect on the ring-fencing analysis.
Often, the transfer of the assets is made at the book value of such assets, which may be substantially lower than the fair market value of such assets at the time of transfer.
A transfer at a value below market value might, if not qualified as a tax-neutral reorganization measure such as a split-up, spin-off, hive-down or tax-neutral asset transfers, be considered to be a deemed distribution and result in capital gains and withholding taxes. In order to qualify as a tax-neutral reorganization, the transfer must, among other things, happen at book value.
Risk of avoidance of transfer under Swiss bankruptcy law
As in other jurisdictions, under Swiss bankruptcy law, it is possible to avoid certain pre-insolvency dispositions by the debtor over its assets. The bankruptcy administrator or, if the latter renounces, creditors of the opco (and of a debtor in general), may seem to avoid claims within the terms of Articles 285 to 292 of the Swiss Debt Collection and Bankruptcy Act. Under these articles, the following transactions may be avoided:
Liability of the board of directors of an opco
The board of directors of a corporation is ultimately responsible for the overall management and supervision of the corporation, a responsibility which cannot be withdrawn from or reassigned and for which each individual member of the board is ultimately liable according to Articles 754 and following of the Code of Obligations. According to Article 754(2) of the code, each board member is liable for actions taken in his or her capacity as board member, not only to the company but also to each shareholder and to the company's creditors for the damage caused by an intentional or negligent violation of duty. 'Negligence' covers all forms of negligence, including light negligence.
Thus, when transferring the assets to a propco at a price that is below market level and that may not be considered to be at arm's length, the propco's board of directors risks being held liable either by the propco's shareholders (such liability will materialize even prior to a bankruptcy scenario) or by the propco's creditors (within the framework of a bankruptcy scenario).
Subject to the limitations mentioned above, ring fencing a propco is possible. However, ring fencing as such should not be overestimated under Swiss law, since the lender secured by first ranking security will in any case have a priority right in the property (with the exception of a very limited number of creditors which may have a first ranking legal lien on the property, such as tax authorities).
The agreements under which the assets will generate income for a propco are significant. In order to structure a CMBS, it essential to be able to predict the cash flow generated by the assets securing the mortgage loans and accordingly to predict the cash flow under the mortgage loans. If the predictability of the cash flow is high, credit enhancements needed in the CMBS structure (eg, liquidity facilities or guarantees) will become less expensive. Thus, the lease agreements under which real property will be rented by the opco from the propco is one of the key features of such structures. The duration of the agreements, ability to terminate the agreement and indexation of rent paid under the agreements will have to be analyzed.
Also, when structuring the income stream of the propco under the lease agreements, tax considerations will be relevant. The goal of the structuring from a tax perspective is that the tax deductibility of interests paid by the propco under the financing may be set off against the income generated under the leases.
Duration of lease agreements
Under Swiss law, lease agreements may be entered into for a fixed period or for an indefinite period. Lease agreements entered into for an indefinite period may be terminated by simply giving notice. Whereas residential real property is predominantly rented for an indefinite period, commercial property is usually rented for a fixed term.
For the purpose of financing and refinancing real property, it is advisable to have lease agreements with a fixed term. Such lease agreements may be entered into for a term of up to 20 or 30 years. Thus, the term of the lease agreements may well survive the term of the mortgage loan and the CMBS. This makes it easier to calculate the cash flow generated throughout the term of the CMBS. Ground leases are limited by law to a maximum of 100 years.
Fixed-term lease agreements may be terminated only for valid reasons. Article 266 of the code states that there is valid reason if it becomes absolutely unreasonable for either party to uphold the agreement. Termination for valid reason is possible only if the circumstances giving reason for such termination did not exist and were not foreseeable when entering into the lease agreement. Thus, in a regular business relationship, it may be expected that termination for valid reason is highly unlikely.
A further limitation of the term of lease agreements is found in Article 27 of the Civil Code. This provision states that a person (including a legal entity) may not deprive itself of freedom by committing itself excessively. In practice, this provision will rarely apply, particularly in the context of lease agreements entered into by professional parties. Even where this provision would apply, the fixed term would simply be reduced to a reasonable fixed term (see Article 20(2) of the Code of Obligations).
Indexation of rent paid under lease agreements
Under Swiss law, rents may be adjusted by indexing the rents (or part of the rent) to the Swiss Consumer Price Index. Such indexing ensures that at least part of the inflation will be covered. Indexation is possible only if the term of a lease agreement is more than five years. Also, the only index to which rents may be bound is the official index of the Swiss federal authorities.
The lessor may not increase the rents other than based on such indexation. The only other exception is an adjustment of rent where there is development of the property (which has been provided for in the lease agreement).
Staggered rents are possible under Swiss law subject to certain conditions, but cannot be combined with indexed rent over the same period of time.
Costs relating to maintenance of real property
In opco/propco structures, the understanding of the parties involved is usually that the transfer of the real property to a propco will not change anything with regard to the use and the maintenance of the real property. That being said, the idea is to get as close as possible to the concept of a 'triple net lease' (as it known in the United Kingdom and the United States) so that all costs of maintenance will be borne by the opco as tenant of the property. In Switzerland, there are some limits to imposing the costs related to the maintenance of a building on the tenant. However, lease agreements may be drafted to achieve a similar result.
Swiss law distinguishes between costs related to the use of real property (eg, heating, cleaning and electricity) (as per Articles 257a and following of the Code of Obligations) and costs related to the real property as such (eg, property taxes, basic property insurance) (as per Article 256b of the code). Costs related to the use of the real property may be separately imposed on the tenant if so agreed in the lease agreement, and the tenant will have to pay the sum of these costs in addition to the rent paid. The lessor will have certain obligations to provide a detailed statement of the costs.
Costs related to the real property as such are somewhat more difficult to deal with. The basic idea in the legislation is that such costs must be borne by the landlord. Such costs may be imposed indirectly on the tenant by their inclusion in the rent. In such case, the amount charged will be a fixed amount since it is part of the rent and consequently may be higher or lower than the actual costs. However, it is debated among scholars whether it would be possible under Swiss law to impose such costs on the tenant separately so that the actual amount of costs incurred would be charged to the tenant.
For added assurance, such costs should be included in the fixed rent. Imposing such costs separately on the tenant is risky and a court might find such a provision of the lease agreement to be void. If the parties nevertheless want to impose such costs separately on the tenant, it is advisable to mention in the lease agreement that the rent has been fixed at an amount which reflects the fact that the other costs will be imposed separately. By drafting the lease agreement as described, the tenant may no longer use the argument that he or she paid twice for such costs and the risk that such provisions of the lease agreement would be held void is reduced. In some cases it was proposed to establish a newly formed entity to serve as maintenance company for a particular portfolio. Ultimately, it is possible under Swiss law to get close to the concept of a triple net lease. However, when drafting lease agreements, this point must be carefully addressed.
Set-up of the opco/propco structure
When segregating the assets from the business, it is vital that such segregation occurs on a tax-neutral basis to succeed, as a mere sale at market value would trigger corporate income and/or capital gains taxes on the underlying assets and, should properties be involved, real estate transfer taxes. However, if well planned and carefully structured, it should be possible to arrive at the preferred opco/propco structure by way of tax-neutral restructuring measures such as split-ups, spin-offs, hive-downs or tax-neutral asset transfers and to get binding tax rulings for the restructuring before its implementation.
However, from a lender's perspective, it is nonetheless important to calculate the deferred corporate income/capital gain taxes properly (roughly 20% on the difference between the tax book value and the fair market value of the real estate portfolio), and factor these into the terms of the loan. In particular, lenders must bear in mind that such deferred taxes, if triggered, are - at least in some of the cantons - secured by legal liens on behalf of the tax authorities, ranking ahead of the first ranking security provided to the lenders.
Typically, a propco will be a special purpose vehicle that is highly leveraged and, accordingly, thinly capitalized. As in other jurisdictions, the Swiss Federal Tax Administration has issued thin capitalization and debt/equity rules. Under the thin capitalization rules, the interest on the amount of debt exceeding the permitted level may be re-characterized as equity and the interest may be treated as a dividend for tax purposes. However, the Swiss thin capitalization rules apply only if debt financing is provided by a lender which a related party. In general, third-party debt is therefore subject to no thin capitalization restrictions if not guaranteed by a group company.
Deductibility of rental fees
In principle, intra-group rental fees to be paid from opco to propco as a consequence of the sale and lease-back transaction typically implemented in order to form to the opco/propco structure are deductible for corporate income tax purposes, to the extent they are at arm's length.
Opco/propco structures offer certain advantages, since the assets that are backing the loan and the securities are ring-fenced and the risk related to the business of the borrower's group is isolated from the propco to a large extent.
Swiss law offers most of the features to set up an opco/propco structure properly and to ring-fence the assets that are backing the loan and the CMBS. Also, the income stream on the real estate portfolio may be structured in a manner so that the mortgage loan will be securitization friendly.
However, the most difficult part of the transaction structure is to achieve a tax-efficient solution. Most importantly, the price under which the assets will be segregated from the business is essential for capital gains tax purposes. Also, ensuring the tax deductibility of the interest costs at propco level and of the rental costs at opco level is crucial. The most tax-efficient structure might not be the most robust structure as to the ring fencing of the assets. The analysis must be done on a case-by-case basis.
Finally, the cash flow generated by the assets which will service the loan and accordingly the CMBS still depends on the business of the borrower's group, even when legally ring-fenced. This risk is remote where there is a liquid market of tenants and where re-letting of the real property might be expected to occur within a relatively short period of time.
For further information on this topic please contact Lukas Wyss, Maurus Winzap or Johannes Bürgi at Walder Wyss & Partners by telephone (+41 1 265 7511) or by fax (+41 1 265 7550) or by email (firstname.lastname@example.org or email@example.com or firstname.lastname@example.org).
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