Deductibility of guaranteed amounts by fund sponsors

3
Oct 2017 at 04:00 / NEWSPAPER
SECTION: BUSINESS

Deductibility of guaranteed amounts by fund sponsors

Property
funds have long been popular with investors in Thailand, where the mutual-fund
structure is being phased out and funds are being converted to real estate
investment trusts or REITs. Raising funds from investors through such vehicles
often involves a guarantee from the originator to increase confidence in the
investment. This can be the starting point for problems on the tax front.

A mutual fund lets a project owner raise
money from the market to expand the business at a rapid rate without having to
use a more complex financing structure or seek riskier means of raising money.
Instead of accumulating cash earned from day-to-day business operations, the
owner sells the complete project or future cash flow (where the assets cannot
be sold) to the fund-raising vehicle in exchange for an outright payment. This
lump sum can be used to fund the new project, hence increasing the life cycle
of the business.

Certain incentives are offered for the
establishment of infrastructure funds and REITs, although most mutual funds are
now subject to value-added tax (VAT) and specific business tax similar to
REITs, due to the expiration of some tax privileges.

To establish an infrastructure fund,
approval must be obtained from the Securities and Exchange Commission, which
requires a prospectus to disclose significant information, such as the
valuation of the transferred assets or rights, business structure, potential risks,
prevention of risks and means to mitigate risks. To increase confidence that
risk will not occur, or the rate of return will reach a satisfactory level as
claimed, some sponsors agree to provide a guarantee to induce public investors
to subscribe to fund units.

However, it appears from a recent Supreme
Court case that a sponsor may run into trouble in deducting expenditure
incurred as a consequence of providing such a guarantee in the prospectus.

A corporate developer that owned a hotel
in the centre of Bangkok established a leasehold property fund to which it
granted a 30-year lease in exchange for upfront rents amounting to 1.7 billion
baht. The fund in turn sublet the hotel to an affiliate within the developer's
group. To mitigate the commercial risk of the public investors, the developer
additionally agreed to guarantee the rents to be derived by the mutual fund
from the sublease in cases where earnings were less than the threshold level.

Because the rents the fund received were
less than the agreed threshold, the developer compensated the fund for the
difference and deducted that amount as expenses for tax purposes. The Revenue
Department denied the claim, saying the payment was not made "exclusively
in relation to profit-seeking or business purposes" pursuant to Section 65
ter of the Revenue Code. The Supreme Court agreed and stated the following in
its ruling:

"The developer was the lessor of the
hotel to the property fund and had already received the entire amount of 1.7
billion baht in rents upfront upon registration of the main lease. Thus, the
compensation required under the guarantee was paid for the benefit of the
property fund, rather than for the benefit of the developer itself.

"The developer was involved in the
business and was able to assess the value of the assets, including economic and
market conditions before the properties would be leased. Thus, there was no
necessity for the developer to provide the guarantee for the rental income for
the benefit of the property fund."

The developer asserted that, without the
guarantee, the property fund may not be able to sell units and raise enough
cash from the investors to pay for the upfront rents. The court disagreed with
this rationale by stating that "such assertion contradicted the developer's
own witnesses, who testified that the developer received such rents from the
day the lease agreement was executed". It went on to conclude:

"The guarantee had the purpose of
supporting the property fund, and had no relevance in increasing the income of
the developer. Thus, the compensation under the guarantee was not spent for the
developer's own business, and was prohibited as a tax expense."

Something seems to be missing here,
though. The court did not take into account that there was no way the fund could
find enough money to pay for the upfront rents without issuing units for sale
to public investors. It also refused to believe that the guarantee was meant to
increase public investors' confidence in subscribing the units and to enable
the fund to lease the hotel and pay the upfront rents to the developer, which
should justify the tax deductibility of the compensation amount.

In this case, it is possible that the
outcome was based on inadequate proof of how the developer's compensation under
the guarantee was necessary for its own business. Otherwise, the entire
industry could face tax assessment trouble even if guarantees are based on fair
commercial reasons.

At any rate, this case will surely put a
number of sponsors in a difficult position and will become one of the key
factors they consider when structuring a fund-raising vehicle.

By
Rachanee Prasongprasit and Professor Piphob Veraphong. They can be reached at [email protected]