New initiatives in French ship finance

Alain Gautron, partner at Watson, Farley & Williams, Paris, examines the current state of specialised shipping finance structures in France, including abolition of the quirat and the implications of new legislation designed to replace it.

ALL the principal French banks have been active in the ship finance market over the last decade. Some have specialised in the domestic French market while others have diversified their portfolio or even travelled to the Far East to export their know-how. This activity has centred mostly on classic mortgage loans, but a few interesting structures whose use is enhanced by French tax laws have permitted French financiers to be even more active in recent years.

One of the very first opportunities which French financiers had to offer innovative financing structures arose in the context of the special tax scheme implemented to promote investment in French overseas departments and territories (Dom-Tom). This law gives strong tax advantages to investors in Dom-Tom-defined activities by permitting the entity investing to deduct 100 per cent of the investment amount in the project.

As transportation activities are authorised fields of investment, this law has been particularly successful with ships. However, the home port of the ship must be in the Dom-Tom and it must be operated within the Dom-Tom region. In addition, ownership of the vessel must be retained for a period of five years from its acquisition date.

Finally, although only new assets are authorised for this type of investment, a secondhand ship is acceptable if refurbishment costs prior to being used under this law exceed the ship purchase price.

These requirements, coupled with the fact that the law will expire on December 31, 2001, are limiting factors on the number of vessels which can qualify for this type of financing.

Defunct quirat law

A recent tax-based law was adopted in July 1996 which permits investors in joint ownership of a French-flag vessel to deduct 100 per cent of the purchase price of their share in the vessel in the year of investment and to depreciate the vessel in accordance with normal depreciation rules under French law. This incentive was applicable solely to non-maritime investors, who could constitute up to eighty per cent of the joint ownership, a shipowner constituting the remaining twenty per cent. The joint ownership could then lease the vessel to the manager of the joint ownership, who received the benefits of the scheme by way of low rentals or low purchase price.

The effect of this law was to yield net benefits in excess of 20-25 per cent for shipowners. But the high yield was also the downfall of the law, which was repealed a year after its adoption by the French National Assembly on the basis that it was too much of a drain on French tax resources.

Leasing

In its continuing fight against budget deficits and tax loopholes, the French government in June this year adopted new rules for equipment leasing which provided for a limitation on the deductibility of depreciation by the tax-transparent entity entering into leasing transactions. These new rules intend to limit, in any given tax year, the amount of depreciations fiscally deductible from the rental amounts, net of all charges supported by the transparent owning entity. These measures would seem to limit the benefit of such transactions.

Nevertheless, an exemption from the new rules can be granted upon application for specific approval from the French tax administration. Obtaining the consent of the tax administration leads to greater benefits on leasing transactions. With respect to ships, there is an increase in the rate of depreciation to 43.75 per cent per year of the outstanding unamortised value of the vessel over a period of eight years. This increased depreciation benefit ensures that more than fifty per cent of the asset value is written down in the first two years.

French shipowners and financiers have been presented with this approval process as a replacement for the 1996 quirat law. In order to benefit from this law, the following prerequisites must be met:-

1. The asset subject to the approval must be a movable asset which can be depreciated on a double declining balance method over eight or more years. This first prerequisite is clearly met by merchant vessels.
2. The lessee must be a company which operates the assets within the framework of its normal business activity and has the ability to acquire ownership of the asset during the course of the lease or at its expiry.
3. The purchase price must correspond to a market price. Presumably, as was the case in other French tax shelter schemes, brokers' certificates will be sufficient to establish whether any given price is indeed a market price unless a clear market exists.
4. The investment must represent a significant French economic and social interest (particularly regarding employment) submitted to the government's discretionary appreciation. This particular criteria will be the most difficult to meet. Guidelines will no doubt be issued to indicate the meaning of 'significant'. Vessels built by French yards should presumably qualify as contributing significantly to French economic and social interests. Similarly, shipowners operating from a base in France could also claim a significant contribution. The tax authority will use this criteria to ensure that transactions contain a real French connection other than a mere tax connection.
5. The operating company must demonstrate that the asset is necessary to the continuation of its activity and that the choice of financing structure has been determined by criteria other than tax and accounting.
6. Two-thirds of the benefits derived from the transaction must be released back to the operating company in the form of decreased rents or a lower option purchase price. The amount of the benefits resulting from tax savings must be determined prior to the date of the granting of the approval by the tax administration.
7. The members of the tax-transparent entity acting as owner must agree to retain their share in the owner until the termination of the lease. Furthermore, these members must remain in any tax consolidation group to which they belonged and which benefited from the tax exemption.
8. The tax -transparent owner must agree to retain the asset until the termination of the lease agreement upon the expiry of the term of lease or resulting from the transfer of the asset to the operator.

In order to further improve the yield of the transaction, the tax administration consent can also provide, at the express request of the investor, that the sale of the asset or of the shares of the tax-transparent owner be exempt from capital gains tax or recapture of depreciation under the following conditions :-

a. The sale is made to the operator of the asset, whose identity must be disclosed prior to the conclusion of the transaction.

b. Two-thirds of the asset's normal utilisation period has elapsed prior to the sale occurring. This could effectively preclude early termination possibilities on a recapture-free basis.

c. The operating company continues to operate the asset for the duration of the unexpired lease period.

With this new law, it is expected that the twenty per cent net benefit levels which had been reached under the 1996 quirat law will once more be reached. This law should once again give French financiers and shipowners a new and advantageous source of financing. French lawyers, for their part, will once again be busy assisting both parties.