Background

Leasing has been a staple of the aviation industry for more than 40 years, and has become increasingly attractive to the shipping industry over the last five years, particularly given the scarcity of traditional bank finance.

Until 2017, Chinese money was the dominant force – particularly in aviation finance. However, the Chinese government has since put pressure on domestic corporations to sell assets and deleverage. With Chinese money no longer so readily available, a product that was better known in aviation (and container box leasing) has become increasingly common in shipping over the last few years: the Japanese Operating Lease (more commonly known as the “JOL”).

The JOL has been a feature of aviation financing for nearly 20 years. Common in the wider maritime sector, there has also been a noticeable increase in the desirability of this product in the vessel-financing market over the last five years.

Traditionally, JOLs were more popular in aircraft finance because investors were comfortable with the residual value risk. Shipping, by contrast, is a much more diverse asset class, with value being a direct consequence of the country in which a ship is built and the specification of each particular vessel.

What is it?

A JOL is an operating lease with an investment of Japanese equity, typically provided by a Japanese corporate with tax capacity. This is twinned with non-recourse senior debt from a Japanese bank or a Japanese branch of an overseas bank.

There are essentially two types of JOL: the open-ended JOL and the Japanese operating lease with call option (the “JOLCO”). In summary, the distinction is that whereas the JOL is a simple operating lease (under which the equity investor expects to assume the residual value risk), the JOLCO includes a purchase option, pursuant to which the aircraft can be sold to the airline, or the ship to the ship operator, for a pre-determined price. This mitigates the likelihood of the residual value risk being left with the investors. In either structure, the equity investor takes the minority stake in return for the tax benefits associated with the asset. The necessary evil of the residual value risk is often expressed as the ‘90 per cent test’; that is, the lease rentals payable cannot, in aggregate, exceed 90 per cent of the cost of the asset.

Whilst essentially a conventional lease, the ‘magic’ of the JOL and the JOLCO is in the tax depreciation benefits. Each Japanese equity investor, via the Japanese SPV, can opt for a double declining balance sheet method of depreciation in its accounts. This will give rise to accelerated losses for the SPV (for example, the depreciation of the asset and the interest payments on the loan) and each individual investor can use its share of the losses to offset against its own taxable profits. The financial benefits of this can be passed on to the operator in the form of a lower lease rental.

In recent years, the pool of lenders willing to invest in JOL and JOLCO transactions has widened, from mainly Japanese banks (and Japanese branches of overseas banks) to now include other overseas lenders from jurisdictions such as Germany. This has been made possible by new double taxation treaties (although as discussed below, this may now be under threat).

Looked at in the context of tax leases more widely, the JOL “family” of products is not unique – there are other leveraged lease products in countries such as France and Spain, for example. However, the key distinction is that many other products provide tax breaks only where the end user is in the same jurisdiction, whereas JOLs and JOLCOs are available to foreign lessees as well. In addition, although the lease rental payments usually go directly to the lender, at the end of the lease term, the asset can be sold (whether on the open market or, in the case of a JOLCO, to the operator). If the sale (or indeed a re-lease) achieves a price equal to or greater than the anticipated residual value, the investor benefits from this upside. In addition, the equity is largely ‘back-ended’ because the rentals are used primarily for debt repayment and debt service on the senior loan. As a consequence, the operator benefits not only from 100 per cent funding, but also from blended funding costs that are lower than under typical secured lending.

Transaction structure

The diagram below illustrates the basic structure.

 

In summary:

1. The Japanese equity arranger establishes an SPV in Japan and sources the equity component of the acquisition cost from Japanese investors.
2. The Japanese SPV, as the borrower, enters into a limited recourse loan agreement in respect of the debt financing of the asset.
3. The Japanese SPV then uses the aggregate of this debt and equity to acquire the aircraft or ship, and leases it to an operator (an airline or shipping company).
4. In a JOLCO, the lease or charterparty contains the purchase option in favour of the operator.
5. As security for its obligations under the lease or charterparty, the operator grants security to the Japanese SPV over certain valuable rights, including its interest in the aircraft’s or vessel’s insurances.
6. The Japanese SPV provides security to the lenders – and both debt and equity investors receive security over the asset (typically by way of a mortgage).
7. Usually, the equity arranger also provides a level of support in respect of the SPV’s obligations, typically limited to an undertaking in favour of the lenders and the operator.
8. The limited recourse nature of the structures means that share security is not usually granted over the Japanese SPV.
9. The senior loan is structured so that it will not be fully amortised and a balloon payment will be due at maturity.
10. The lessee pays rent to the SPV in an amount sufficient to pay the monthly repayment and debt service, together with a minimal dividend return to the Japanese equity.
11. To ensure the residual value of the asset at the lease maturity, there is normally a remarketing agreement and, possibly, a residual value guarantee.
12. The limited recourse nature of the loan agreement means that, unlike with other leasing structures, the lenders will look to the lessee for recourse. As such, it is key that the terms of the lease or charterparty are in line with the loan agreement, particularly as to payment obligations.

Advantages and disadvantages

The JOL and JOLCO structures are attractive for a number of reasons, one of the main ones being that as the amount of available capital (and the number of willing lenders) has declined, and given that bank lenders often require loan-to-value ratios of 70 per cent, the option to finance 100 per cent of the asset price by virtue of the equity component is particularly valuable.

Further, from a financier’s perspective, the JOL and JOLCO structure offer a proven transaction for lenders, and gives them access to clients with good credit ratings that they may not otherwise be in a position to lend to directly.

There are, however, some disadvantages associated with these structures. In particular, it has a long tenor (typically about 10 years’ duration) and the structure is inflexible at inception and, indeed, during the life of the transaction. Further, operators of ships and aircraft need to keep in mind that they are not dealing with a typical bank or fund, but with a group of Japanese investors. In particular, this may complicate the consent and waiver process.

The future of JOLs and JOLCOs

Last year saw the IFRS 16 accounting principles become effective, removing some of the benefits of operating lease structures. This alone was not enough to make the JOL and JOLCO products unattractive. However, Japan regularly changes its tax rules: on 12 December 2019, Japan’s ruling coalition published its 2020 Tax Reform Proposals, which are expected to be passed into law this March.

As noted above, double taxation treaties have facilitated non-Japanese lenders providing loans for JOL and JOLCO transactions. In an effort to implement the OECD’s final report on Base Erosion and Profit Sharing (BEPS), the Japanese authorities have proposed to amend the definition of non-deductible interest, so that interest expenses on debt from non-Japanese lenders are no longer tax deductible. The updated Earnings Stripping Rules will also limit the amount of deductible interest (in transactions where interest is paid to a non-Japanese lender) for the purposes of the Japanese SPV’s tax to 20 per cent of its EBITDA (down from 50 per cent).

This aggressive stance, which actually goes beyond the requirements of BEPS, could have the effect of narrowing the pool of lenders who can participate in JOL and JOLCO deals and make them less attractive to equity investors. Since there is still significant appetite for JOLs and JOLCOs, it is likely that overseas banks without Japanese branches will be the worst affected. However, full details are yet to be made available and it is also unclear whether the authorities intend these changes to have retrospective effect, potentially necessitating the repayment or restructuring of existing transactions (although this seems unlikely).

Assuming that the tax changes do not operate to negate the benefits of these products, the market remains buoyant and it is anticipated that there will be increasingly innovative debt structures, following from those that were combined with EETCs and ECA/AFIC-supported debt. Even with some improvement in global economic data and with the US/China trade war seemingly abating a little, the search for yield continues. As German ten year bond yields still sit below zero, the recent narrowing of the US and German yield gaps really only serves to make the situation ‘less bad’. In this environment, the Japanese investors that have built up expertise in JOLs, JOLCOs and, in particular, the underlying ship and aircraft assets, are looking for new Japanese deals to do with products they can rely on.