OVERVIEW OF LEGAL DEVELOPMENTS AND ISSUES FOR AVIATION FINANCE
Three years after the market collapse of 2008, some of the effects of the disruption continue to impact the U.S. aviation finance market. During the worst period of the market turmoil, airlines were either unable to raise capital or paid very high rates. More recently, investors seeking out opportunities in relatively stable markets are focusing on commercial aviation finance, and airlines have a greater ability to raise capital. The legal environment in the U.S. for commercial aviation finance remains stable and successfully accommodates significant investment; however, ancillary issues in areas such as FAA regulation and tax still arise regularly.
Lessor Transactions. The aviation finance market has proven itself more durable and resilient than many other capital-intensive markets, such as real estate. Funds have invested substantial monies into existing lessors, such as ACG and AWAS, and new start-ups from long-time industry participants, such as Jackson Square, Avolon and Air Lease Corporation (ALC). These lessors in turn have aggressively pursued investment opportunities, consisting predominantly of sale-leasebacks on new aircraft deliveries. New aircraft also are attractive to the bank market, which has resulted in attractively priced back-leveraging transactions. Much of the new investor money has fairly short investment periods and expectations of high returns, such that, even as investments are being made, the parties are focused on exiting the investments at profitable levels. One of the logical exit strategies is the initial public offering, or IPO. To date, only ALC has successfully launched an IPO, but it is likely that other lessors will look closely at IPOs in the future.
Airline Transactions. U.S. airlines also have taken direct advantage of investor enthusiasm by successfully issuing enhanced equipment trust certificates, or EETCs. As the name implies, EETCs are “enhanced” debt structures that allow the airlines to borrow at lower costs. Prior to the market disruption, EETCs were enhanced through guaranties provided by AAA-rated insurance companies, as well as through interest payment facilities provided by other highly rated entities. The AAA-rated insurance policies are no longer available, but EETCs still have interest payment facilities, as current payment of interest remains a critical element of good credit ratings, even though fewer entities can provide these facilities.
ECAs. Although the home country rules prevent most export credit agency (ECA) funding directly into the U.S., ECA financing is available for U.S.-based lessors and affects the worldwide aviation market, which in turn affects the U.S. market. The new Aircraft Sector Understanding as agreed in Paris in February 2011 will impact all aviation finance markets. For deliveries starting in 2013 (in the case of large commercial aircraft) and deliveries starting in 2014 (in the case of regional aircraft), the 2011 ASU will significantly increase ECA pricing, bringing ECA pricing to levels that are equivalent to private market financing pricing. This in turn should create a broader and more competitive market for aviation finance.
FAA Registration Changes. On July 20, 2010, the FAA published a final rule requiring renewals of aircraft registrations. Prior to this date, aircraft registrations remained effective until affirmatively terminated. Under the new rule, all currently U.S.-registered aircraft must be re-registered within a certain time period established by the rule, based on the original registration date. Registered owners of any re-registered aircraft and any newly registered aircraft must renew the registration at the end of each rolling three year period. As part of this automatic expiration, the FAA also implemented a system of notices and reminders, as well as a website intended to assist aircraft owners in maintaining their registrations.
Non-Citizen Trusts. For more than 30 years, individuals and business entities who desired to “N” register an aircraft with the FAA, but could not certify that they met the U.S. citizenship test under the Federal Transportation Code, have relied on non-citizen trusts (NCTs) to effect this registration. NCTs are discretionary trusts established by one or more beneficiaries who are not U.S. citizens for purposes of registering an aircraft with the FAA registry. NCT trust agreements must contain provisions complying with the pertinent regulations, including restrictions on any non-citizen beneficiary’s power to influence or limit the trustee’s authority.
In the spring of 2010, the FAA raised doubts about the validity of future and existing NCT-registered aircraft. A public hearing was held in June 2011. At this time, it appears unlikely that the FAA will issue regulations or opinions rendering all NCT arrangements invalid. The FAA is considering revising the standard form NCT trust agreement, including with respect to the trustee’s unfettered control of essential aircraft-related matters, as well as changing the NCT process so that trustees could better serve as an additional resource to the FAA for information about trustors/beneficiaries, operators and operations of an aircraft.
Tax Developments. The aviation finance industry is still adjusting to several changes in the U.S. tax laws which were enacted in late 2010. On the positive side, the two-year extension of the existing 50 percent bonus depreciation deduction and the newly enacted 100 percentbonus depreciation write-off for qualified property (acquired and placed in service between September 8, 2010, and December 31, 2011) have been quite stimulative to finance and leasing transactions, especially for those in the aircraft sector.
On the other hand, the newly codified economic substance doctrine has had a negative impact on some aircraft finance and leasing transactions. Such doctrine mandates that a taxpayer has a substantial purpose for a transaction and that, apart from federal tax benefits, a transaction results in a meaningful change in economic position, which generally requires that the transaction results in a substantial present-value pre-tax profit. Aspects of this new doctrine remain unclear, and no “angel list” of transactions which will not run afoul of its requirements will be issued by the IRS. Moreover, leasing is not addressed beyond a statement in the doctrine’s legislative history, which suggests that leasing may continue to be reviewed under a pre-existing “facts and circumstances” analysis. Application of that analysis for purposes of the new doctrine has proved challenging even for traditionally structured aircraft leases because the tax guidelines permit a small non-present-valued profit and, effectively, leasing is only a timing benefit.
New foreign account tax compliance rules are also presenting challenges for foreign financial institutions because those rules will require such institutions to enter into an agreement with the Treasury Secretary which contains certain factual information about their U.S. account holders and requires them to act as a withholding agent for the same, or to subject themselves to a new 30 percent withholding tax on payments of interest on credit agreements or rent on leases made by U.S. payors after 2012 (unless such payments are being made on certain outstanding obligations). Since many credit agreement and lease forms include comprehensive gross-up provisions for withholding taxes, these new compliance and withholding rules are increasingly the subject of negotiations because lessees and borrowers are insisting upon exclusions from the gross-ups for them.
New rules which are phased in over a five-year period and which require certain business taxpayers who are subject to FASB Interpretation No. 48 to disclose uncertain tax positions on their U.S. federal income tax returns have also become the subject of negotiations between U.S. taxpayers in the aviation finance and other industries and their accountants. The IRS has said that it will adopt a policy of restraint in seeking documents relevant to an uncertain tax position disclosure. Nevertheless, the full implications of the new rules remain unclear, other than the higher compliance costs that many in the aviation finance and other industries have already had to incur to address such rules.
Other Governmental Activities. In recent years, general aviation and business aviation have been subjected to increasingly greater scrutiny by the FAA, as well as by the NTSB, DOT, TSA and DEA. The impetus for certain of this scrutiny relates to NTSB concerns highlighted by statistics evidencing a disproportionately greater number of general aviation accidents when compared with commercial aviation. Given this scrutiny, industry participants anticipate regulations regarding physical improvements, as well as operational matters and pilot performance. In particular, there are federal and state legislative initiatives under way relating to the operation, piloting and required equipment for aircraft used in emergency medical operations. Financing parties and lessors are appropriately concerned about compliance by customers with all applicable legal requirements, especially if relating to safety. Generally, the risk of third-party claims against secured parties and lessors based on vicarious liability under applicable state law should be ameliorated by a federal safe harbor afforded secured lenders and lessors who are not in possession or control of an aircraft. However, there are state court decisions in which this federal statutory protection was deemed inapplicable, including by a recent case holding that the preemption is not available with respect to death or injuries suffered by passengers inside the aircraft