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Deductibility of guaranteed amounts by fund sponsors

October 2017 - Tax & Private Client. Legal Developments by LawAlliance Limited.

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Deductibility of guaranteed amounts by fund sponsors

Property funds have long been popular with investors in Thailand, where the mutual-fund structure is being phased out and funds are being converted to real estate investment trusts or REITs. Raising funds from investors through such vehicles often involves a guarantee from the originator to increase confidence in the investment. This can be the starting point for problems on the tax front.

A mutual fund lets a project owner raise money from the market to expand the business at a rapid rate without having to use a more complex financing structure or seek riskier means of raising money. Instead of accumulating cash earned from day-to-day business operations, the owner sells the complete project or future cash flow (where the assets cannot be sold) to the fund-raising vehicle in exchange for an outright payment. This lump sum can be used to fund the new project, hence increasing the life cycle of the business.

Certain incentives are offered for the establishment of infrastructure funds and REITs, although most mutual funds are now subject to value-added tax (VAT) and specific business tax similar to REITs, due to the expiration of some tax privileges.

To establish an infrastructure fund, approval must be obtained from the Securities and Exchange Commission, which requires a prospectus to disclose significant information, such as the valuation of the transferred assets or rights, business structure, potential risks, prevention of risks and means to mitigate risks. To increase confidence that risk will not occur, or the rate of return will reach a satisfactory level as claimed, some sponsors agree to provide a guarantee to induce public investors to subscribe to fund units.

However, it appears from a recent Supreme Court case that a sponsor may run into trouble in deducting expenditure incurred as a consequence of providing such a guarantee in the prospectus.

A corporate developer that owned a hotel in the centre of Bangkok established a leasehold property fund to which it granted a 30-year lease in exchange for upfront rents amounting to 1.7 billion baht. The fund in turn sublet the hotel to an affiliate within the developer's group. To mitigate the commercial risk of the public investors, the developer additionally agreed to guarantee the rents to be derived by the mutual fund from the sublease in cases where earnings were less than the threshold level.

Because the rents the fund received were less than the agreed threshold, the developer compensated the fund for the difference and deducted that amount as expenses for tax purposes. The Revenue Department denied the claim, saying the payment was not made "exclusively in relation to profit-seeking or business purposes" pursuant to Section 65 ter of the Revenue Code. The Supreme Court agreed and stated the following in its ruling:

"The developer was the lessor of the hotel to the property fund and had already received the entire amount of 1.7 billion baht in rents upfront upon registration of the main lease. Thus, the compensation required under the guarantee was paid for the benefit of the property fund, rather than for the benefit of the developer itself.

"The developer was involved in the business and was able to assess the value of the assets, including economic and market conditions before the properties would be leased. Thus, there was no necessity for the developer to provide the guarantee for the rental income for the benefit of the property fund."

The developer asserted that, without the guarantee, the property fund may not be able to sell units and raise enough cash from the investors to pay for the upfront rents. The court disagreed with this rationale by stating that "such assertion contradicted the developer's own witnesses, who testified that the developer received such rents from the day the lease agreement was executed". It went on to conclude:

"The guarantee had the purpose of supporting the property fund, and had no relevance in increasing the income of the developer. Thus, the compensation under the guarantee was not spent for the developer's own business, and was prohibited as a tax expense."

Something seems to be missing here, though. The court did not take into account that there was no way the fund could find enough money to pay for the upfront rents without issuing units for sale to public investors. It also refused to believe that the guarantee was meant to increase public investors' confidence in subscribing the units and to enable the fund to lease the hotel and pay the upfront rents to the developer, which should justify the tax deductibility of the compensation amount.

In this case, it is possible that the outcome was based on inadequate proof of how the developer's compensation under the guarantee was necessary for its own business. Otherwise, the entire industry could face tax assessment trouble even if guarantees are based on fair commercial reasons.

At any rate, this case will surely put a number of sponsors in a difficult position and will become one of the key factors they consider when structuring a fund-raising vehicle.

By Rachanee Prasongprasit and Professor Piphob Veraphong. They can be reached at

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