Structuring aircraft financing in Canada requires careful thought—from the choice of financial structure to the registration of security interests, a thorough understanding of the transactional mechanisms available to the parties is crucial to a successful closing.
Borrowing vs. Leasing
A key factor to consider before proceeding with an aircraft financing transaction is how the financing will be structured. Among the many options available to any borrower or debtor (“Client”) wishing to acquire an aircraft on credit, two common methods are borrowing or leasing. Obviously, various other financing structures and methods (e.g., sale-leaseback, synthetic lease) may be considered, depending on the particular situation.
In a “typical” borrowing situation, the aircraft is financed against security interests registered both in the applicable “local” jurisdiction and in the International Registry of Mobile Assets (“International Registry”). This process is quite similar to any asset-based financing. However, in addition to registering security interests in the applicable local jurisdiction, a prudent lender or creditor (“Lender”) will also apply to register international interests in the airframe and engines in the International Registry, provided the aircraft meets certain technical specifications[1]. In this scenario, both the loan and the asset will appear in the Client’s financial statements, since the aircraft will be considered part of their assets.
A leasing arrangement, on the other hand, is considered a rental for the Client’s accounting purposes— meaning that both the financed asset and the debt incurred do not appear in their financial statements. What constitutes leasing, however, is more complicated from a tax perspective, since the Canada Income Tax Act[2] (the "ITA") does not explicitly refer to leasing. This financing structure is in itself quite similar to a loan, since the Client will pay a fixed monthly amount to the Lender, but will have an option to purchase at the end of the term, which could even be set at $1. The security interests that are registered are generally the same as in a “typical” borrowing situation, subject to the particular circumstances (such as if the aircraft is under construction). However, “rent” will appear as an expense in the income statement. One of the main advantages of this structure lies in its tax treatment, since the ITA provides for a joint election mechanism between the lessor and the lessee, subject to compliance with certain conditions, which could enable the Client to take advantage of tax deductions specific to property acquisitions and loans, such as a capital cost allowance[3]. Without making this election, according to the Canada Revenue Agency, the amounts paid by the lessee must be considered as rent[4] if the leasing agreement makes the leased property available to the lessee for their use without transferring ownership.
Other Aircraft Financing Documents
A unique aspect of the aviation industry is the possibility of financing an aircraft under construction. To do this, the parties have to enter into an interim financing agreement, which, as its name suggests, provides temporary financing for an asset during its construction.
In order to provide the Lender with a guarantee during the construction period, an assignment of purchase agreement must also be signed between the parties if financing through a synthetic lease or finance lease. The idea is that the potential owner (the Client) assigns its rights in the purchase agreement to the Lender, which in turn will acquire the aircraft upon completion. In addition, a hypothec (security interest) on all the Client’s rights in the purchase contract will also be published (registered) in favour of the Lender. Note, however, that in the context of a regular loan, only the hypothec on the Client’s rights in the purchase agreement is required and not the assignment of purchase agreement. As a result, if any action or proceeding has to be initiated against the manufacturer during the construction period, this will be undertaken by the Lender. Following the aircraft’s delivery to the Client, the Lender will “rent” the aircraft, and rent will be equal to the monthly financing payments.
Nevertheless, a potential problem with this type of financing is that the initial contract is solely between the airframe and engine manufacturers and the Client. Since the manufacturers are under no obligation to allow this assignment of rights in favour of the Lender, negotiations may be required to get the manufacturers to agree to honour their respective warranties. It is also important to assign legal and contractual warranties to the Lender, which can be done by adding a clause to the agreement to assign the purchase agreement. Where the manufacturer of a certain part of the aircraft (e.g., engines) is not itself a party to the aircraft purchase agreement, it is also possible to obtain a document directly from that manufacturer attesting to the assignment of its warranties. A Lender could nevertheless ask the various aircraft part manufacturers to acknowledge the financing agreement, thereby acknowledging that, in the event of default by the Client, the legal and contractual warranties could be available to the Lender or a third party purchaser.
Where an aircraft is subject to a “management agreement” and to a “consent to aircraft management and subordination,” two other documents are almost consistently part of any financing for aircraft leasing, namely leases (in the case of debt financing) and subleases (in the case of finance leases or synthetic leases). One advantage of leases and subleases is that they can be submitted to Transport Canada in lieu of the management agreement since, despite their abridged form, these documents contain the key terms and conditions of the lease arising from the management agreement. Doing so also has the advantage of not disclosing to Transport Canada all of the terms and conditions governing the relationship between the Client and the manager.
Why a management agreement? Many Clients prefer entering into a management agreement with a firm specializing in aircraft chartering, rather than leaving their aircraft in a hangar when not in use. This enables the Client to earn passive income when the aircraft is not in use. Another advantage of this option is that the manager will generally also be responsible for the maintenance and upkeep of the aircraft. To enter into a management agreement for an aircraft with credit-based financing, the aircraft must be leased or subleased in order to legally formalize the identity of the operator. Most aircraft management leases or subleases are referred to as “dry leases,” meaning that the lessor (i.e., the Client) provides only the aircraft to the manager, who in turn provides the crew and, therefore, has operational control of the aircraft. This type of lease is to be distinguished from a “wet lease,” in which the Client retains operational control of the aircraft because they provide the manager with both the aircraft and the crew. Nevertheless, regardless of whether the lease or sublease is wet or dry, security interests in favour of the Client are also published to secure their rights as lessor against the manager.
The “consent to aircraft management and subordination” enables Lenders to offset the fact that most aircraft financed in Canada will likely be controlled by managers against whom they would have no actual recourse. In this document between the Client, Lender and aircraft manager, the manager essentially allows the Lender to have a say in its operations under its aircraft management agreement with the Client. Accordingly, in the event of default by the Client, the manager will subordinate its rights in favour of the Lender. When the Client’s aircraft is operated by a manager, this document also provides for a security interest in favour of the Lender with regard to all of the Client’s rights.
When financing the acquisition of an existing aircraft, it is also prudent to send confirmation requests to NAV Canada (the company responsible for airport traffic control in Canada) and to all airports where the aircraft regularly takes off and lands, in order to verify whether there are any overdue take-off or landing charges owed to NAV Canada or any airport. Doing so is important because these entities could have a priority right to the proceeds from the seizure and sale of the financed aircraft over the Lender, which could be exercised in the event of unpaid fees pursuant to section 9 of the Airport Transfer (Miscellaneous Matters) Act[5].
Irrevocable Deregistration and Export Request Authorizations
An Irrevocable Deregistration and Export Request Authorization (“IDERA”) is another very common type of aircraft financing document. Although it is not, strictly speaking, a security interest, it is commonly requested by Lenders. It is a short document regarding an aircraft and its equipment that is voluntarily signed and sent to Transport Canada by the Client in favour of the designated Lender. In the event of default by the Client, an IDERA allows the Lender to take possession of the aircraft, deregister it from the Canadian Civil Aircraft Register (the “Register”) and export it for resale. Only a creditor to whom an IDERA has been granted has the power to request cancellation of the registration. As a result, termination of the Client’s initial obligation (e.g., repayment of a loan) does not automatically cancel the IDERA. Since the majority of aircraft financed in Canada are operated by managers, an IDERA on the financed aircraft will be requested from both the Client and the manager. Although only one IDERA may be registered with Transport Canada, the reason for signing two IDERAs is that should the aircraft be repossessed by the Client, despite the management agreement, the Lender will have a tool at its disposal to deregister and export the aircraft, regardless of whether the aircraft is under the care and control of the manager or the Client. An IDERA can only be used against the owner of the aircraft listed on the Register (the person with custody and control of the aircraft), because the owner is the one who holds the aircraft’s certificates of registration and airworthiness required for its use[6].
Conclusion
When it comes to aircraft financing in Canada, the choice of transaction structure is as fundamental as the execution of the transaction itself. To ensure a smooth closing process, it is crucial for Clients and Lenders in the aviation industry to address these issues well in advance. Lastly, the location of an aircraft sale, rental or leasing transaction’s closing may also have tax implications for the transaction. We will try to cover these topics in upcoming bulletins.
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