It may be an unforgivable cliché to say the Chinese aviation market is taking off, but there seem to be few other ways to describe it. In April this year, offshore firm Maples and Calder reported a significant uptick in that area, accompanied by a shift in aviation financing to Asia in general.
Half a year later, enthusiasm remains unabated. Practitioners report that aviation is emerging as an exciting and competitive market for both the commercial and private sectors, resulting in plenty of interesting legal work.
There is little doubt over the future of the commercial aircraft market. Airbus’ published forecast for the 20-year period up to 2032 predicts China will take delivery of 4,272 passenger aircraft worth $634 billion – the highest in the world in terms of value, and second only to the United States in terms of volume. Meanwhile, Boeing has 283 current orders yet to fill for China.
It is no surprise then, that the market for legal advice on commercial jet financing remains strong. But it is the boom in the private jet market which appears to be causing the greater stir. Lawyers say the demand from both Chinese individuals and companies has defied the global economic downturn. “It’s probably getting trendy among profitable PRC companies to own a business jet – if your peers have one, it makes sense for you to have one too,” says Simon Wong, a Hong Kong-based aviation and asset finance specialist at Stephenson Harwood.
There is a huge amount of unfulfilled demand in the Chinese market. According to Wong, there are already around 2,000 business jets in fellow BRIC nation Brazil. Greater China, by comparison, has reached fewer than 200, despite increasing demand for them, indicating plenty of room for growth. Independent reports put the figure at 132 in 2011, after a steep rise from only 32 in 2008.
“Forecasts suggest strong future growth,” agrees Andrew Lockhart, co-head of Baker & McKenzie’s Asia Pacific aircraft finance practice. While admitting that this sector is not without its challenges – operating corporate jets in China is expensive, time-consuming and bureaucratic – he reports a high volume of work from corporates and individuals who have been acquiring aircraft “in very large numbers.”
Lawyers say demand is being driven by clients including fleet managers in Hong Kong, aircraft firms in mainland China, and private banks who are bundling private jet deals as part of their offering for high net worth individuals. And in many cases, the deals those lawyers are involved in are big ones.
“It’s not just one or two deliveries – at the end of the day we’re interested in innovative deals which enable 10, 20 or 30 aircraft to get delivered,” says Hong Kong-based DLA Piper partner Robert Caldwell.
The financing of private jets is also an area that is seeing increased activity. In mid 2011, specialist media reported that China Minsheng Financial Leasing (a venture between China Minsheng Banking and Tianjin Port Free Trade Zone Investment) had signed a $2.6 billion memorandum of understanding for up to 50 Gulfstream business jets.
Since that deal, described by Caldwell as “a watershed”, Minsheng has also signed a memorandum with Dassault Falcon for 20 aircraft, and another for 13 jets from Embraer. A number of these planes have already been delivered.
Getting on the right register
Lawyers working in this field will need to assist clients with making some tricky decisions, including where they choose to register their jets. If the aircraft is to be mainly used within Chinese airspace, it makes sense to register it there too: a PRC-registered jet can fly to more domestic PRC airports than a foreign-registered jet can, and will also enjoy some benefits in terms of fuel and other operating costs.
Foreign jets are subject to more onerous reporting obligations on any cross border, unscheduled flights, and cannot land in certain more sensitive locations in China. Furthermore, a foreign operator of a foreign-registered aircraft is not allowed to operate domestic flights indefinitely within China. A foreign-registered plane has to fly out of China (before entering again) after performing eight continuous domestic legs in the country, or after having stayed there for more than one month continuously.
Although these factors may point toward local registration as the best choice, they need to be balanced against certain drawbacks of registering a jet in China, as Wong points out.
“PRC value-added tax and customs tariffs add up to some 22 percent to 25 percent (depending on the aircraft type) when it comes to business jets, although it is possible to defer such tax payment by using a leasing structure.” he says. “In contrast, no importation tax is payable at all if the aircraft is registered in, for example, Hong Kong.”
And getting an aircraft on the Chinese register is usually a time-consuming process that can take several months.
“It takes a long time for the CAAC (Civil Aviation Administration of China) to deal with the registration process; it has limited resources, and is already stretched because of obligations to deal with the commercial aviation fleet,” says Lockhart. “There are also issues with the regulatory infrastructure surrounding operating the aircraft where most of the airspace is controlled by the military.”
Another factor to consider is that U.S.-registered jets are often easier to sell as potential buyers are attracted by the fact that the jets have complied with the regulatory regime of the largest business jet market in the world. In addition, foreign-registered jets can, in practice, be parked at large PRC airports, such as Beijing, subject to the requirement to fly the aircraft out of the PRC every once a while.
After weighing these considerations, specialists say it is common for owners to decide to arrange for their jets to be registered in offshore jurisdictions such as Hong Kong or the Cayman Islands, and base the aircraft in Hong Kong or the mainland.
Offshore or onshore
There is also a third option, and one which lawyers say is rising in popularity with PRC lessors and lenders. The aircraft can be registered in the PRC but held in a bonded area (also known as free trade zones, or FTZs) in China such as the Tianjin Dongjiang Free Trade Port Zone or its equivalent in Shanghai and Beijing.
FTZs offer significant incentives in the case of commercial aircraft, such as the reduction of customs duty to 1 percent and import duty to 4 percent, and the rebate or postponement of business tax. Aircraft leasing companies that set up operations in these free zones can also take advantage of some local tax incentives.
“This has already caused a change to the market,” comments Harvey Lau of Baker & McKenzie, co-chair of the firm’s regional aircraft finance practice. “Chinese companies are able to take advantage of the tax situation in these bonded zones … This gives them an advantage over their counterparts outside of China.”
Caldwell describes the two main ways in which FTZs can be used. The first is where a lease company incorporated in the FTZ imports a commercial aircraft (by way of lease) into the zone and subleases it to a Chinese airline. Under this structure, the import will be exempt from customs and import VAT, while the sublease of the aircraft by an airline could take advantage of the preferential VAT treatment mentioned earlier.
The second structure takes advantage of the fact that FTZs permit the use of a bankruptcy-remote special purpose vehicle – a key requirement for asset finance – similar to those used in the traditional offshore jurisdictions. A special purpose vehicle held by a PRC lease company and incorporated in the FTZ is able to buy an aircraft from an onshore seller and then lease it to an offshore company. In this case, the export could enjoy a tax rebate, provided certain conditions are satisfied (such as the lease term being over five years).
It is also possible, says Caldwell, for a lease company to consult individually with the FTZ and get other benefits, such as a summary procedure for the settlement of foreign exchange and security registration.
Although they are increasingly being used by Chinese companies, FTZs are not yet popular among international lessors and lenders. This could be due to concerns about the clarity of the relevant laws and regulations, as well as uncertainties over other involved parties.
“FTZs are an unknown entity for many people – the instinct is to go for something tried and tested,” says Mark Western, a Maples and Calder finance partner covering the Asian region. “Unlike using Cayman or Irish entities, the lessors and banks still have to do diligence in respect of what risks there are in using an entity setting up in an FTZ – they are new and untested.”
“FTZs are an unknown entity for many people – the instinct is to go for something tried and tested,” says Mark Western, a Maples and Calder finance partner covering the Asian region. “Unlike using Cayman or Irish entities, the lessors and banks still have to do diligence in respect of what risks there are in using an entity setting up in an FTZ – they are new and untested.”
It seems the FTZ structure is generally best suited in terms of its regulatory requirements to leasing companies incorporated under PRC law. This can, however, include foreign-invested finance leasing companies approved by the Chinese Ministry of Commerce, and some lawyers report that larger foreign leasing companies are actively considering setting up entities in one of the special zones.
Coming up with the cash
No matter how the deal is structured, most aircraft operators will need to find someone to buy and lease out the aircraft. As Reuters reported back in February, it is Asian lenders – including Chinese banks – who are increasingly providing the cash. Although U.S. banks had built up very strong financing practices, due to economic constraints, they are now limited to export credit agency-supported financings where they can get optimal credit treatment with sovereign credit coverage. This has a left a vacuum which Asian lenders are only too happy to fill.
“Every time we go to industry conferences, we see the head of the aviation division of ICBC (Industrial and Commercial Bank of China) being the most popular person at the event,” says Lau. “They are not just interested in the local market; they are very active in the international market.”
To give an idea of the scale of deals in which ICBC is involved, at the end of August 2012, it signed an agreement with Airbus for a total of 50 A320 jets. Although this was ostensibly a commercial deal, the signing took place at Beijing’s Great Hall of the People in the presence of German Chancellor Angela Merkel and Chinese Prime Minister Wen Jiabao.
China Development Bank’s leasing subsidiary and Bank of China have also been active, the latter in particular after its acquisition of Singapore Aircraft Leasing Enterprise (the largest such outfit in Asia at the time) a few years ago.
Lockhart acknowledges that Chinese banks are on a steep learning curve and still have some way to go in building up their expertise, particular when venturing outside China. But he and Lau both feel the institutions already have sufficient reputation – and money – to gain plenty of business.
A promising practice
Lawyers focusing on aviation have faced some tough challenges in the past five years. A year after the collapse of Lehman Brothers, new aircraft orders in the US and Europe dipped dramatically and corporations reconsidered their need to own or use private jets. But those working in China and Asia found themselves relatively insulated from this turmoil. As the world emerges from recession, it is becoming clear that the aviation sector in China never really slowed down. Western aircraft manufacturers are forecasting very high demand from the region over the next two decades. Although this may not come as a great surprise, it is the private jet sector which is raising some eyebrows. It could be this practice area which offers experienced firms reliable growth in the years to come.
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