Death Knell for Cross-Border Leasing Deals

German municipalities have just lost a lucrative source of income after the U.S. House of Representatives, following the path already taken by the Senate, voted in favor of closing a loophole in the country's tax law, thus putting an end to cross-border leasing.

The decision on June 17 will not only stop future cross-border leasing agreements, it could also have massive ramifications for German municipalities and other bodies that have already leased infrastructure to U.S. investors.

From 1996 to the end of 2003, more than 150 German cross-border leasing agreements were sealed. Although tax specialists warn against unnecessary panic, municipalities that signed one-size-fits-all contracts are advised to comb through the weighty legal documents, praying they find no nasty surprises in the fine print.

“Municipalities that negotiated their contracts in fine detail, ensuring that their individual needs were included in the contract, don't have anything to worry about from the developments in the United States,“ Ulrich Eder, the managing director of Due Finance, a tax advisory firm in Düsseldorf that specializes in cross-border leases, told F.A.Z. Weekly. “Others, however, are soon going to be brought back to reality,“ he added.

Cross-border leasing, a controversial financing instrument, essentially allowed German city councils and state-owned utilities to lease long-life assets such as sewage plants, waste water facilities, fresh water systems, gas and electricity networks, waste incineration plants and subway systems to U.S. investors, who then immediately rented them back at a much cheaper rate to the same German municipalities.

They were attractive for U.S. investors because the leased infrastructure, paid for in a lump sum, could be declared as a foreign investment, allowing the investor to receive a substantial tax break over the years. German towns received a portion of the tax break - the net present value - in return for leasing out the property or infrastructure.

With the tax advantages of leasing a huge fixed asset, which depreciates each year, no longer as attractive as it once was, some fear that U.S. investors will try to find an early exit from their contracts. While the infrastructure is leased out for 99 years, the re-leasing arrangement runs out after 25 to 30 years. At that point the lessee can exercise a termination option, thus canceling the main leasing agreement.

“When investors don't reap the tax advantage they had expected, they'll start looking for ways to prematurely end the contract and to be able to claim compensation,“ warns Malte Kreutzfeldt from the anti-globalization group Attac. A contract could be terminated, for instance, if the U.S. investor could show that the municipality or state-owned utility had violated the contract.

Since compensation damages are already calculated at five to 10 times the net present value, a breach of contract would cost the municipalities dearly. Arnd Bühner, a tax expert at Ernst & Young, agrees on this point with Kreutzfeldt. He expressed his concern to F.A.Z. Weekly that “the odd U.S. partner, frustrated with the lower tax advantage, may try to find a breach of contract.“ But he added that “The Germans tend to follow contracts to the letter.“

Assuming, however, that U.S. investors will immediately start scourging infrastructure facilities en masse for breach of contract is insulting, said one tax specialist from an eastern state bank heavily involved in cross-border leasing who did not want to be named.

One concern kept resurfacing among opponents to cross-border leasing: “What risks are involved for the German parties if the U.S. tax law is changed?“

Municipalities that understand their duties and factored in such a risk before signing the contract have no reason to be anxious, financial and legal experts say. “We insured ourselves against such changes to the tax law,“ Jens Schreiber, a spokesperson from Frankfurt Messe, told F.A.Z. Weekly. Germany's largest fair authority leased part of its site through a cross-border leasing agreement.

Though cross-border leasing in its current form is dead in the water, tax specialists agree that it won't take too long before similar financing instruments are found.