The Finnish real estate market, generally characterized as a low liquidity market, has changed considerably in the 21st century. The volume of transactions has grown in recent years, due to an increase in foreign investment, vigorous restructuring of the portfolios of traditionally dominant players in the Finnish market (that is, pension insurance companies, pension funds and life insurance companies) and corporations' considerable property outsourcing. Pension and life funds are now increasingly exploring international investment prospects, and investments made by various foreign investors in the Finnish real estate market have grown since 2001.
According to market studies by The Finnish Institute for Real Estate Economics, the property transactions volume for 2004 totalled 3.2 billion and, by the end of September, the transactions volume for 2005 amounted to 2.1 billion. Up to 40% of transactions made in 2005 were made by foreign investors.
Corresponding development can be expected within property financing. Property financing has traditionally been organized in Finland through Finnish banks. Yet recently Finnish property financing institutions have been challenged by international banks that specialize in global property financing. This entry by new players into the market has resulted in a welcome change to property financing and an increasing number of options are now available for investors.
Property investors often acquire properties in Finland through a mutual real estate company (MREC) or through a non-mutual real estate company (REC). Both are limited liability companies, with somewhat similar administrative procedures. They are the legal owners of the underlying property, and owning the property is their sole purpose. The difference between an MREC and an REC is that an MREC's shareholders, in that capacity, are entitled to possess certain premises in the real estate on the basis of their shareholdings. The premises possessed with certain shares are defined in the MREC's articles of association. When the premises of an MREC are leased, the lease agreement is entered into between the lessee and the shareholder that owns the premises to be leased. Also, lease payments are made directly to the shareholder and not to the MREC. In an REC, the lease agreement is entered into by the REC and the lessee pays the rents to the REC. An REC can distribute profits to its shareholders through dividend distributions.
The MREC/REC is responsible for covering the property costs, that is, costs payable by the owner according to the lease agreement. With an REC, the property costs are covered with the REC's rental income. In the case of an MREC, the costs are covered with maintenance fees paid by the shareholders these fees are typically matched with property costs, aiming to produce a zero net result for the MREC.
Real estate investors often use a separate Finnish special purpose vehicle (SPV) to acquire the shares in an REC/MREC and to administrate the Finnish activities and the acquisition. These SPVs are standard Finnish limited liability companies, capitalized by equity and loans. In the case of an MREC, an SPV receives lease incomes and pays interests on the loans and/or distributes dividends to the investors. In the case of an REC, the lease income needs to be distributed to the SPV in the form of dividend payments to enable it to amortize the acquisition loans. Group contributions cannot be used because MRECs and RECs, as holding companies, are not taxed on the basis of the Finnish Business Income Tax Act.
By using an MREC structure, the acquisition loans and rental income are placed in the same entity because the SPV receives the lease income directly from the premises in the real estate that the MREC owns. The maintenance fees invoiced by an MREC and the interest payable on the loans are deductible in the taxation of an SPV. The targeted situation for an MREC is that the property-related costs are matched with the maintenance fees so that the MREC does not incur taxable profits. With an REC, where the company receives the lease income, the most efficient structure can be achieved by placing part of the financing in the REC. As tax treaties generally allow Finland to widely levy tax on income derived from real estates in Finland as well as on Finnish RECs and MRECs, an SPV model is often necessary to create an efficient tax structure for exit situations. However, tax treatment varies depending on the tax treaty in question, and an efficient exit structure should be examined on a case-by-case basis.
An alternative to organizing the real estate ownership through a limited liability company is the basic form of direct property ownership, including ownership of land and the buildings on it. However, in a transfer of shares in a limited liability company (such as an MREC or an REC), the applicable transfer tax rate in Finland is 1.6%, whereas the applicable transfer tax rate for property disposals is 4.0%. An efficient ownership structure from a tax perspective can also be obtained if an investor or a holding company purchases the underlying real estate directly instead of acquiring the shares in an REC or an MREC. This enables the purchaser to receive a step-up in the value of the real estate instead of maintaining the historical bookkeeping value, which would be the case if they acquired shares of an REC or an MREC. Moreover, the acquisition value of shares acquired in an MREC or a REC is not deductible during the period of ownership, which is the case with direct ownership of a real estate.
Restrictions on financial structuring
According to the Finnish Companies Act, a Finnish limited liability company may not grant security of any kind (including guarantees, pledges, charges), or a monetary loan or other assets of the company, to facilitate the acquisition of shares in the company or in a company belonging to the same group. This financial assistance prohibition applies whether the funds are to be used for this purpose before or after an acquisition closes. So the decisive factor under scrutiny is the actual use of the funds. Deviation from this prohibition is not possible even if the board of directors or all shareholders of the company make a unanimous decision to do so, or if all creditors approve a deviation. So neither the target company nor a subsidiary within the target group may grant security to secure the repayment of financing relating to the acquisition of the shares in the target company. Based upon the opinion of certain scholars, it would, however, be possible to interpret the current company legislation in such a way that a Finnish limited company would be able to grant a loan or a security in connection with the acquisition of shares in a foreign sister company (that is, associated or affiliated companies). There are no legal precedents on this issue, so this interpretation is somewhat uncertain. The Finnish Companies Act is subject to revision and will be replaced by new legislation in September 2006. Changes regarding the rules on financial assistance are not expected to come into force, but a minor amendment in respect of intra-group acquisitions is expected.
Violating the provision on financial assistance will lead to an obligation to repay the loan or return the collateral without delay. The arrangement could also constitute a criminal act under the Finnish Companies Act.
Another legislative limitation that it is vital to acknowledge when carrying out real estate transactions in the Finnish market relates to implementation of sale and leaseback arrangements.
Frequently depending on case-specific evaluation of circumstances sale and lease-back transactions implemented by selling a property together with its buildings are, under Finnish law, considered assignments by way of security, not mere transfers of title. As such, they are encompassed by a specific provision of the Finnish Code of Real Estate, according to which a clause stating the seller has the right to redeem the real estate at will, or that the seller has the right of first refusal before the real estate is conveyed to a new titleholder, will not be binding in a sale of real estate. Equally, any separate option right agreement could be regarded as non-binding when executed in connection with a sale and purchase of real estate. Moreover, the use of a clause under which the seller has the right to rescind the sale contract might be declared non-binding if regarded as a bare attempt to evade the law.
If a sale and lease-back arrangement is, subject to all-inclusive evaluation, considered void, by law it would be void not only between the contractual parties but also against any third parties, such as creditors. If the seller later becomes bankrupt, the sale and leaseback arrangement with the financing provider would not be binding in relation to the seller's other creditors.
At the same time, a sale and leaseback arrangement implemented by simply selling the buildings and leasing the related property to the financier is permitted under the Finnish Code of Real Estate. Accordingly, sale and leaseback transactions are, as such, valid between the contractual parties. However, unless the lease right and the sale and purchase of the buildings are registered with the Finnish Land Register pursuant to the Finnish Code of Real Estate, the corresponding invalidity remains in relation to third parties. If execution proceedings of the seller begin, the arrangement with the financer would not be valid towards the seller's other creditors, and in particular, towards the seller's mortgagees. This lack of efficiency relates to the fact that the buildings and any equipment attached or appurtenant to it and located on the real estate are considered to be a part of the real estate, and, consequently, fall under the scope of the mortgage unless otherwise agreed by the other creditors, which is also a prerequisite for the above registrations.
The security position of a debt-financing provider depends on how the acquisition is structured. Due to the financial assistance restrictions of the Finnish Companies Act, as discussed above, only a pledge over the shares of an MREC/REC, as well as a pledge over the shares in an SPV, are available when acquiring shares in an MREC or an REC. However, in the case of purchasing an MREC, where the lease agreements are entered into between an SPV and respective lessees, the rental payments and other rights relating to the lease agreements can also be validly pledged by the SPV. Furthermore, a business mortgage (that is, a floating charge) governed by the Finnish Enterprise Mortgage Act consisting of business assets of an SPV can be created.
The funds of an MREC/REC (such as rents) may not be transferred to an SPV to repay the acquisition loans in any other way than in the form of dividend payments, assuming also that group contributions are not available because of the tax status of the MREC/REC.
Regardless of the above, the assets and cashflow of the target company may, through a post-transaction merger of an MREC/REC into an SPV, be put into a position where they can be used as security for acquisition financing. This can be arranged by using business mortgages consisting of business assets of an SPV pledged to acquisition lenders. By merging an MREC/REC into an SPV, business mortgages extend to cover the assets of the MREC/REC as well. Simultaneously with the merger, the pledges of an MREC's/REC's shares will expire. This view, although debated in legal literature, is based on the fact that the position of creditors and (other) shareholders of a merging company is not deteriorated without them having a possibility to oppose the merger (as stipulated under the Finnish Companies Act) and, therefore, having a possibility to require their claims to be satisfied before the execution of the merger. However, before the execution of a merger of an MREC/REC into an SPV, no assets of, or cashflow generated by, an MREC/REC may be pledged to directly or indirectly secure a third-party loan taken for financing the acquisition or to satisfy any undefined future undertaking, commitment or liability of an SPV.
A Finnish limited liability company, generally speaking, may grant a loan or provide collateral to secure the repayment of a loan on behalf of a company belonging to the same group if the purpose is other than to assist the borrower in funding the acquisition of shares in the company or in another group company. Therefore, the prohibition on financial assistance does not apply to financing used for other purposes. It does not apply, for instance, for a working capital facility or for refinancing of existing debt within the group. In such cases, the assets of an MREC/REC and its possible subsidiaries and associated companies can also be validly pledged.
Because a transaction that includes prohibited financial assistance could have serious repercussions for shareholders and directors and because a Finnish company may grant a loan or provide collateral on behalf of a company belonging to the same group in certain refinancing cases (as referred to above), the obligations of the pledgors under finance and security documents must be limited accordingly. So it is customary in Finland (as in other jurisdictions) to include limitation language in the security documents and loan agreement regardless of whether or not the relevant loan agreement is governed by the laws of Finland.
Subject to the restrictions set out above, it is also possible to create a charge over the proceeds arising from the leased premises to secure repayment of the liabilities of an MREC/REC. To be effective, the pledge of lease payments in relation to third parties requires a notice of pledge to be delivered to the lessees. Yet, based on the prevailing legal praxis and legal literature, advance notice of transfer would not be deemed enough in relation to third parties if it refers to any receivable that does not exist on the date of the notice (the so-called earnings principle).
Naturally, with a direct purchase of underlying real estate instead of shares in an REC/MREC either by an investor or a holding company, the prohibition on financial assistance will not apply and the real estate and all profits it generates can, without restrictions, be pledged as a security for the acquisition financing.
Castrén & Snellman Attorneys Ltd
Samuli Palin has many years of experience in banking and finance, capital markets, and mergers and acquisitions. He has advised on complex cross-border projects such as acquisition finance deals, structured financing transactions, securities offerings and IPOs, public tender offers, and in particular structured real estate transactions. Palin is internationally acknowledged as one of the leading Finnish experts on real estate investment law.
Castrén & Snellman Attorneys Ltd
Anu Tuomola specializes in mergers and acquisitions, and capital markets. She has been involved in diverse domestic and cross-border transactions involving Finnish and international corporations and has been responsible for negotiating and preparing documentation in a number of such arrangements. In particular, she has advised in various cross-border real estate transactions. Tuomola has a background as a securities lawyer and she holds a diploma in English commercial law from the College of Law of England and Wales.