Over the last ten years the group that owns Heathrow Airport has earned £27bn in revenues and made £8.6bn in operating profit.¹ This is a successful business.

Not only have its revenues steadily increased from £2.2bn to £2.9bn, it has successfully managed to hold down costs. The effect has been to raise its operating margin (the percentage of its revenue that translates into operating profit) from an average of 20% between 2007 and 2010, to 41.5% between 2015 and 2017. The group has also managed to make a substantial return to investors, who include Spanish infrastructure giant Ferrovial and entities owned by the governments of Qatar, Singapore and China. Between 2012 and 2017, the group paid out £3bn in dividends.

Yet the group, which in the UK is headed by a company called FGP Topco, has not been profitable for most of its existence – at least not on paper. Between 2007 and 2014 it reported a total pre-tax loss of over £2bn, and paid a total of just £15m in corporation tax. The last three years have seen the company do better, declaring pre-tax profits of over £1bn, leading to larger tax payments of £122m.

How is it that a group which has been consistently making substantial profits on its operations has made such large losses overall? One part of the story is the enormous debt that FGP Topco has taken out. Interest payments are a deductible expense from business profits for tax purposes. In 2017, FGP Topco incurred finance costs of £1bn, wiping out 85% of the group’s £1.2bn operating profit. That was a good year. In 2010 the group made an operating profit of just £466m, whilst paying out interest and other finance costs of over £1bn, leading to large losses and the company paying nothing in corporation tax at all.

Debt and infrastructure

Large infrastructure projects often require large amounts of borrowing. Building runways, control towers, and passenger terminals is an expensive business, and it makes sense to borrow money to spread the cost.

But in Heathrow’s case there is another story behind the company’s large debt. Much of the cash borrowed by FGP Topco was was used to buy BAA (Heathrow’s previous owners). When the Ferrovial consortium bought BAA, it spent a total of £12bn, of which £4.6bn came from the consortium members. The rest of the money was borrowed from the banks by FGP Topco.

Once the deal was complete, BAA was merged with the FGP group of companies, which meant that the interest on FGP’s debt could be deducted from the operating profits of the BAA companies. The operation described above is what is called a leveraged buyout, and they can be highly profitable, and tax efficient.

Leveraged buyouts

Imagine you buy a house for £100,000 with a 90%, interest-only mortgage. This means you put in a deposit of £10,000 and borrow £90,000.

In five years, the house increases in value by 10%, a moderate increase of about 2% a year. The house will now be worth £110,000.

If you sold the house at this point, ignoring costs, you would receive £110,000 from the buyer, use £90,000 to pay off the capital you borrowed, and be left with £20,000 – a 100% return on your original £10,000 investment. Had you not borrowed anything and had to fund the purchase entirely from your own resources, your £10,000 profit would have represented only a 10% return on your £100,000 investment. Debt leverages returns on investment.

Heathrow is exceptionally highly leveraged. In 2017 the company had £18.3bn of assets, almost all of which were financed by debt. The total liabilities of the company amounted to £17.38bn. To put this into some context, Manchester Airports Group, which runs Manchester, East Midlands and Stansted airports, had assets of £3.84bn in its last published annual accounts, and liabilities of £1.56bn. In Heathrow’s case 95% of the asset value of the company has been funded by borrowing, whereas only 40% of Manchester Airport Group’s asset value has been.

Leveraged buyouts and tax

Another advantage to the leveraged buyout is that it can help a company to avoid paying taxes.

The large amounts of borrowing required to execute a deal result in large interest payments which are deducted from taxable profit, so less tax is due on profits from the day to day operations of the company.

This can easily be seen in the Heathrow accounts, where the impact of the introduction of leverage into what was then BAA was stark.² In 2006, when BAA was still stock market-listed, the company had a liabilities of £7.9bn. Interest payments were £153m and the company made a pre-tax profit of £757m. According to the company’s cash flow account, it paid income taxes of £93m in that year. The next year, 2007, saw liabilities explode to £16.6bn. Interest payments were £773m, which completely destroyed the profitability of the company. In 2007 FGP Topco reported a pre-tax loss of £106m and paid income taxes of £7m.

However, as we have explored above, although the high levels of borrowing may wipe out the operating profit of a company, leverage multiplies the profit on the sale of an asset, which is treated for tax purposes as a capital gain.

Capital gains taxes are generally in place to prevent income being converted into capital for tax purpose. They therefore tend to include many exemptions and reliefs making them often easy to avoid. In many countries, capital gains are not taxed at all. In the UK, for example, if one company sells the shares it owns in another company the seller is not charged capital gains tax as long as it has held more than 10% of the shares in the company for more than 2 years, and the company being sold carries out a substantive trade.

The effect of leverage therefore is to reduce the day-to-day profits of the company on which tax would otherwise be paid, and to reduce the risks associated with any subsequent capital gains on which tax is often not paid at all.

BEPS and anti-avoidance measures

The use of debt in the tax structures of multinational companies has been an issue which tax experts have known about for a long time.

For that reason, in the OECD Base Erosion and Profit Shifting Action Plan, Action point 4 specifically called for the OECD to put forward rules to prevent profit shifting using high interest expenses.

The solution proposed was relatively simple. Governments should place a limit on how much interest can be deducted from a firm’s taxable profit. The OECD suggested that he limit should be set anywhere between 10-30% of a company’s operating profit. However, the OECD allowed for a number of exemptions to allow companies to get out of the stricter interest deduction rules.

One such exemption is the public benefit exemption. Under the exemption the OECD said companies should be allowed to go beyond the 30% limit if loans were taken out to fund specific public benefit projects.

It is clear from the text put forward by the OECD that the intention of the exemption was not to cover the general acquisition debt of large private sector companies, but rather to allow for specific borrowing to finance specific public benefit projects – particularly those contracted by the government.

The UK debt loophole

The UK public benefit exemption was implemented as the infrastructure exemption in the 2017 Finance Act.

When implementing this exemption, the UK took a much broader approach and excluded all debt associated with “infrastructure” projects, whether in public or private hands. The term infrastructure for the purposes of the legislation implementing the exemption was extremely broad, and included all commercial office space.

The exemption will apply to many UK companies and the accounts of FGP Topco are clear that the Heathrow group is a substantial beneficiary of the exemption.

We calculate the exemption to be worth at least £120m a year to Heathrow alone. This is based on the latest accounts of FGP Topco, the largest company in the UK to consolidate the accounts of the group that owns Heathrow, which state that the company has taken advantage of the infrastructure exemption and the Group Ratio Rule (another exemption).

Had no exemptions applied, we calculate that the maximum amount in interest payments the company would have been able to deduct from its taxable profit would have been £363.3m in 2017. This is 30% of the operating profit of £1,211,000. Instead FGP Topco was able to deduct the just over £1bn it paid out in finance costs.

The difference in the allowed deduction with a 30% limit and the total deduction actually made is £669m. This would have implied an increase in Heathrow’s tax liability of £127m.

Conclusions

The UK’s infrastructure exemption goes far beyond what the UK government agreed with the OECD during the BEPS process.

Although Heathrow is just one example of a highly leveraged company which benefits from the exemption, it is likely that many other highly leveraged infrastructure companies will derive similar benefits, leading to substantial tax losses for the Treasury.

In the case of Heathrow, the benefits of the exemption appear to flow overwhelmingly to the owners of the company, which in Heathrow’s case include a number of overseas governments. This is evidenced by the large dividends paid in recent years. The effect is a transfer of wealth from the UK government to the Chinese, Qatari and Singaporean governments – and of course, Ferrovial.

Without reform, large, privately owned infrastructure companies can continue using debt in order to leverage their assets and walk away with substantial tax-free profits.

One obvious policy available to the UK government is to amend the Finance Act in order to restrict the scope of the infrastructure exemption to correspond with the OECD recommendation.