Contents

Infrastructure Investment: An overview

Infrastructure Investment: Commercial risks

Infrastructure Investment: Legal risks and constraints

CJEU Ruling means employer may be able to reclaim additional VAT on pension schemes

FCA to review the governance and management of unit linked life funds

Update: European Market Infrastructure Regulation

FATCA Update for UK Pension Schemes

AUTUMN | 2013

Welcome to our infrastructure edition of Investor Agenda

We’ve decided to focus on infrastructure investment for pension funds in this issue – to coincide with the anticipated launch of the NAPF’s Pension Infrastructure Platform, expected in the next couple of months.

Infrastructure investment has a number of special features – and risks – and we describe in this newsletter how our expertise in this area can help trustees ensure their decisions and infrastructure investments are legally robust.

We also include our usual round-up of other current issues.

We hope you will find Investor Agenda informative and useful, and we welcome your feedback on what you would like to see in it. As always, if you want to discuss further anything raised, please do give us a call.

Rosalind KnowlesPartner

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Infrastructure Investment: An overview

The need for increased investment in infrastructure is frequently in the press. It is a key component of the Government’s policies on economic growth, and the National Infrastructure Plan identifies £310 billion of planned infrastructure investment up to 2020. 64% of new infrastructure is expected to be owned and financed by the private sector. Traditionally infrastructure projects are highly leveraged, with much of the debt finance provided by commercial banks. Since the global financial crisis of 2008 and subsequent regulatory changes, however, the banks have less appetite to take and hold large project loans. Further, public borrowing and expenditure is constrained. The Government is seeking to fill the gap with new sources of finance – from sovereign wealth funds, foreign investors, and the £1,779bn of UK pension scheme assets.

Infrastructure: an appealing asset?Infrastructure is a wide asset class, covering utilities, transport, social infrastructure (ie schools, hospitals etc.) and energy assets. Much infrastructure has many characteristics that may appeal to pension schemes. Trustees frequently seek long-term investments that offer steady returns and that hedge against inflation and interest rate risks; features of many infrastructure assets. Infrastructure assets tend to provide essential services in well-regulated markets and can occupy monopolistic positions – this means that demand, and in consequence returns, tend to be stable. There is also limited correlation between infrastructure and other asset classes, which offers trustees diversification benefits.

In addition, bond yields are currently low and there is limited availability of index-linked government backed assets in the market that offer the returns that trustees want.

So infrastructure could be attractive to trustees as a realistic alternative investment to conventional bond investments, but has not historically featured heavily in the investment portfolios of UK schemes. It is estimated that under 1% of the average UK scheme’s assets are invested in infrastructure.

…so why is asset allocation to infrastructure by pension schemes so low?Infrastructure is a specialist area with a diverse range of asset types. Most UK trustee boards lack the expertise and in-house skills needed for direct infrastructure investment, and only the largest schemes have sufficient assets to enable direct investment. They are therefore obliged to invest through funds, but many of those funds are established to meet the needs of private equity investors: they charge high fees with a typical targeted holding of five to seven years. As a result they rarely meet the specific needs of pension schemes.

In addition trustees typically seek investment in brownfield assets (those assets which are already operational), so competition in that arena is high. The alternative greenfield assets can offer attractive returns and security, but most trustees do not find them appealing due to the increased risks at the early stages of establishment. Also, greenfield project debt is unlikely to achieve investment grade rating, absent credit enhancement measures.

Market developmentsThe market is, however, reacting to these issues, and there are a number of initiatives that may be of interest to trustees. The first of these is the Pensions Infrastructure Platform (the PIP). The PIP has been established by the PPF and NAPF in association with ten founding investor pension schemes that have each given a soft commitment to invest £100 million. The PIP (which has been modelled on Australia’s Industry Funds Management) will be a vehicle for investment

Infrastructure could be attractive to trustees as a realistic alternative investment… but under 1% of the average UK scheme’s assets are currently invested in infrastructure.

£310bnplanned infrastructure investment up to 2020

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in infrastructure by pension schemes, managed with the needs of pension schemes in mind. The founding investors are currently in the process of appointing an investment manager, and intend to open the PIP to investment by other schemes by the end of 2013.

We are also increasingly seeing initiatives led by financial institutions that are actively seeking co-investment opportunities with institutional investors such as pension schemes. Examples range from the creation of infrastructure dedicated vehicles, through which investors can participate, to direct investment into greenfield PPP projects (evidenced by M&G’s senior debt position on Alder Hey Hospital and L&G’s equivalent on the University of Hertfordshire student accommodation deal). Banks are also looking to harness their traditional infrastructure structuring skills with long term investor participation, an example of which is the recent agreement between French bank Natixis and CNP Assurances (a French insurance and pension provider) to co-invest in infrastructure debt. Relationships like this can be attractive to trustees if the partner entity is prepared to take on the construction risk of the project, allowing the scheme’s exposure to commence only once the asset is operational.

The market has also been exploring public sector initiatives to encourage investment in infrastructure by institutional investors.

Infrastructure Investment: Commercial risks

As with any investment, there are risks associated with investment in infrastructure. Infrastructure is a wide asset class, and the associated risks vary significantly. The risk characteristics of any infrastructure investment depend upon many factors, including the sector, regulatory regime and geographical region within which the asset operates.

Potential risks include the risk that the asset is not constructed properly (construction risk); not operated adequately resulting in a failure to achieve projected returns (performance risk); or that a change in regulation significantly reduces the cash-flow from that asset (regulatory risk). Similarly, if the relevant political regime removes support previously given to that sector (eg following investment in the rail network the Government decides to discourage train travel), or if social attitudes towards the asset change, market demand for that asset may decrease resulting in lower than expected returns.

In our experience, construction risk is at the forefront of trustees’ minds. During construction an asset is not normally expected to generate income for investors, and is exposed to many different risks that could increase the cost of construction or delay the date on which income generation can begin ( eg labour cost hikes, contractual disputes, and building problems).

For this reason schemes have traditionally invested in brownfield infrastructure (ie already operational) assets, rather than new greenfield assets. However, the returns achievable from greenfield assets are usually higher than from brownfield investments and the opportunities for investing in greenfield assets greater.

Public sector initiatives to mitigate risk

> The UK Guarantees SchemeThe UK Guarantees Scheme is a Government measure designed to accelerate investment in nationally significant projects which have been delayed due to adverse market conditions.

The PIP has been established by the PPF and NAPF in association with ten founding investor pension schemes that have each given a soft commitment to invest £100 million.

Potential infrastructure risks include construction, performance and regulatory risk.

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The Scheme is available to projects that meet specified criteria, including being financially credible and needing a guarantee to proceed. The guarantee could cover key project risks such as construction, performance or revenue risk, although the exact form of each guarantee will be determined by the Government on a case-by-case basis.

The Scheme has the potential to increase investment by institutional investors by giving comfort on certain key risks that could otherwise inhibit investment. Indeed, the first guarantee granted under the Scheme was to support a loan by Friends Life to Drax for the conversion of its coal fired power plant to biomass.

> EU 2020 Project Bond InitiativeThis joint initiative by the European Commission and the European Investment Bank (EIB), which is currently at a pilot stage, envisages that the EIB will provide loans and guarantees to credit enhance bonds issued to finance long-term European infrastructure projects and reduce the risk of infrastructure investment.

When raising financing through a project bond under the Initiative, the project company will issue senior and subordinated tranches of debt. The subordinated tranche will be taken by the EIB, who will take first losses. This enhances the credit standing of the senior debt as it carries less risk. The aim is that a single ‘A’ or equivalent rating will be achieved for senior debt.

By enhancing the senior debt’s credit rating, this should reduce the long-term financing costs of the project and make it easier to place the bonds with institutional investors, such as pension schemes. The first bond issued under the Initiative, for the Castor underground gas storage project, attracted significant interest from institutional investors (in particular pension funds and insurers).

As well as public initiatives, there are also privately led ones. These are discussed further in our introductory article above.

There are of course other means of mitigating the risk of an investment that are not specific to infrastructure investment – for example, by engaging an experienced investment manager and ensuring that you take adequate investment and legal advice. Likewise, by making sure that your infrastructure portfolio is diversified, the impact of the various risks should, if they come to bear, be reduced.

Vitally, before deciding to make an investment in infrastructure, trustees should understand the risks specific to the asset that they are considering and ensure that they are comfortable that the legal solutions offered deal with those risks adequately.

Infrastructure Investment: Legal risks and constraints

As with any investment, a decision to invest in infrastructure must be taken after consideration of the general investment duties that apply to all pension trustees. These duties arise from the scheme rules, legislation and general trust law.

Most investments by pension schemes in infrastructure are indirect via the purchase of a regulated investment (for example the purchase of units in an investment fund). As such, trustees need to be aware of the associated obligations imposed by FSMA 2000. The vital distinction is between strategic decisions and day-to-day decisions. Day-to-day decisions constitute the regulated activity of managing an investment, so must be delegated to an FCA authorised person.

Potential infrastructure risks include construction, performance and regulatory risk.

Trustees need to be mindful of their general investment duties when considering an investment in infrastructure.

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Strategic decisions (ie the decisions that trustees can make without needing to be authorised) include (amongst other things) decisions regarding:

> the adoption or revision of a statement of investment principles;

> the formulation of a general asset allocation policy – this could include a high level statement relating to assets being allocated to infrastructure investment as an asset class. However, a positive or negative direction regarding any specific infrastructure project and/or company would most likely be a decision that trustees should not take. So while trustees could say that they wish to invest in utilities they could not specify, say, South West Water projects;

> the method and frequency for rebalancing asset classes, and the permitted range of divergences, following the setting of the general asset allocation policy;

> the proportion of assets that should constitute assets of a particular kind. For example, a decision that 5% of the scheme’s assets should be invested in transport infrastructure and just 1% in power generation infrastructure; or

> the balance between income and growth seeking assets.

Trustees are not, however, permitted to make most day-to-day decisions unless they are FCA authorised. Day-to-day decisions include:

> decisions (including recommendations that are strong enough to constitute decisions) to buy, sell or hold particular securities or contractually based investments such as a fund manager would be expected to make in his everyday management of the scheme’s portfolio; or

> decisions made as a result of regular or frequent interventions outside scheduled review meetings in the decision making of fund managers.

Helpfully, however, in the infrastructure context trustees can make day-to-day decisions about investments in pooled investment products including collective investment schemes such as unit trusts, contractual schemes or open-ended investment schemes without the need to be authorised where the trustees have taken advice from an authorised or exempt firm.

Trustees will always need to take their duties under the Companies Act 2006 (where relevant) and at common law into consideration when making decisions relating to infrastructure investment, as they would with any form of decision. The most relevant duties in this context include the duty to act within powers, the duty to exercise independent judgment and the duty to exercise reasonable care, skill and diligence.

It is also worth considering the requirements of the Occupational Pension Schemes (Investment) Regulations 2005 (the “Investment Regs”), which apply regardless of the nature of the investment.

The Investment Regs require that trustees exercise their powers of investment “in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole”. Infrastructure assets are typically illiquid, a fact which may cause concern in light of this requirement. We do not, however, consider that the illiquidity of most infrastructure assets is a bar to investment, as the requirement to ensure liquidity should be read in the context of other investment duties, including the duty to invest in a manner that is appropriate to the nature and duration of the benefits payable under the scheme, and the duty to ensure diversification of the scheme’s assets. Providing an appropriate balance is maintained, investment in infrastructure assets can enable trustees to obtain long term, inflation-linked returns that reflect the nature of their liabilities, and as part of a diversified portfolio.

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Employers may wish to put in protective claims…

CJEU Ruling means employer may be able to reclaim additional VAT on pension schemes

In our last addition of Investor Agenda, we highlighted the European Court of Justice (“ECJ”) judgment in Wheels Common Investment Fund Trustees Ltd and Others v HMRC. In that case, the ECJ ruled that there is no VAT exemption for defined benefit occupational pension schemes, nor for the collective investment schemes in which they pool their resources. This accorded with HMRC’s position that VAT is payable and that employer companies can reclaim VAT in relation to set-up and ongoing day-to day administration costs of a pension scheme, but not in relation to investment expenses (which can only be reclaimed by the scheme).

In a somewhat surprising ruling by the Court of Justice for the European Union (“CJEU”) (in C-26/12: PPG Holdings BV) it was found that VAT incurred on services relating to the investment management of the assets of a company’s legally separate employee pension fund may be recoverable by the company where there is a direct and immediate link with the company’s taxable activities.

The CJEU found that VAT incurred on third party services relating to both the administration of the pension scheme and the investment management of its assets could, in principle, be deductible for the employer company in so far as they formed part of the employer company’s general overheads and as such a component of the price of goods or services it provided.

Until now HMRC have taken the view that the costs of the investment management of the assets of a pension scheme relate solely to the activities of the pension scheme and therefore do not give rise to a right of deduction for the employing company. HMRC have not yet formally responded to the judgment. However, on the basis of the judgement and HMRC’s approach, UK employers that use a pension scheme set up under trust may not be reclaiming all the input VAT to which they are entitled. In suitable cases employers may wish to put in protective claims to HMRC for a deduction.

For more information visit http://www.linklaters.com/Publications/Publication1405Newsletter/Pages/Employers-maybe-able-reclaim-additional-VAT-costs-pension-schemes.aspx

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FCA to review the governance and management of unit linked life funds

In his speech to the Association of British Insurers on 7 July 2013, Martin Wheatley, CEO of the FCA, flagged that the FCA had been undertaking the preliminary work on a large scale investigation of the governance and management of unit-linked funds. In the UK, there is around £902bn worth of funds under management in unit-linked funds with 87% of that made up by pensions business.

Mr Wheatley flagged that details of the review would be published in the early autumn and it would likely look at questions such as:

> whether firms are acting in their customers’ best interests;

> whether firms are allocating a fair proportion of revenue received from stock-lending to the unit-linked funds;

> whether firms are managing funds in accordance with the investment objectives disclosed to investors; and

> whether firms are transferring counterparty credit risk from reinsured funds to investors without asking investors or getting their consent.

We have certainly reviewed funds where the last point is the case.

Given that pension schemes make up the bulk of investors in unit-linked funds, pension scheme trustees and their advisors may wish to keep a close watch on the review and its outcomes as part of their ongoing review of their investments. It may also be a timely reminder that trustees should ensure they understand unit-linked funds’ terms before they invest, including whether counterparty credit risk is passed on to them.

87%of funds under management

in unit-linked funds are made up by pensions

business.

PensionsInvest: Investor Agenda

Update: European Market Infrastructure Regulation

In our last edition of Investor Agenda, we looked at the provisions of the new EU regulation on OTC derivatives, central counterparties and trade repositories (more commonly known as “EMIR”), which came into force on 16 August 2012 and is taking effect in phases, starting on 15 March 2013.

EMIR imposes obligations on all EU-incorporated undertakings (including corporates), which enter into derivative contracts such as interest rate, foreign currency and inflation swaps. EMIR will apply to pension schemes.

The three main obligations EMIR imposes are in relation to:

> Clearing: of certain derivatives via a central counterparty. This will generally take effect in the second half of 2014 (but pension schemes may be exempt until August 2015);

> Reporting: of all derivatives to a trade repository – expected now to take effect in January 2014; and

> Risk mitigation techniques: for derivatives not cleared via a central clearing counterparty – these took partial effect in March 2013 and further requirements took effect in September 2013.

The risk mitigation techniques that took effect from 15 September 2013 are:

> Putting dispute resolution processes in place. This means that before entering into a non-cleared OTC derivative trustees will need to have agreed procedures to identify disputes relating to the valuation of the contract or collateral, record such disputes, monitor them and resolve them in a timely manner;

> Engaging in portfolio reconciliation and portfolio compression. This means that trustees will be subject to a new portfolio reconciliation requirement. Before entering into a non-cleared OTC derivative they (or their providers) will need to agree arrangements with their counterparties to reconcile the key terms of these portfolios in order to identify any discrepancy. The frequency of such portfolio reconciliations ranges from once a year to every business day, depending on the number of contracts outstanding between the two parties.

Trustees of UK pension schemes should speak with their providers and counterparties to ensure any derivatives documentation contains provisions which comply with these new requirements. In addition, trustees should start to consider their classification under EMIR and their longer term obligations and the effects it may have on their existing contracts.

For more information visit http://www.linklaters.com/pdfs/mkt/london/NL_EMIR_Sept2013.pdf

The first phase of new EU regulation EMIR will start to take effect on

15 March

2012

Trustees of UK pension schemes should speak with their providers and counterparties to ensure any derivatives documentation contains provisions which comply with these new requirements.

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FATCA Update for UK Pension Schemes

The Foreign Account Tax Compliance Act provisions of the Hiring Incentives to Restore Employment Act (“FATCA”) seeks to encourage foreign (non-US) financial institutions (“FFIs”) to provide certain information to the IRS (regarding their clients or members) by imposing a 30% withholding tax on payments to the FFI unless the FFI enters into an agreement with the US IRS (“an FFI Agreement”) or is otherwise deemed compliant with or exempt from FATCA. In the absence of an exemption, pension schemes would be treated as an FFI. Withholding under FATCA of US source payments will generally not begin until 1 July 2014 and withholding in respect of gross proceeds from the sale of assets that generate US source interest and dividends will not apply until 1 January 2017.

On 17 January 2013, the IRS issued the long-awaited final regulations implementing FATCA (the “Final Regulations”). These clarify and provide guidance on the account identification, information reporting and withholding requirements for FFIs and UK withholding agents under FATCA.

Where a pension scheme is established as a trust under English law (or the law of another jurisdiction within the UK) and is registered for the purposes of the Finance Act 2004, the scheme should fall within the definition of an “exempt beneficial owner” for the purposes of the UK-US Intergovernmental Agreement on FATCA. This agreement was signed between the US and UK on 12 September 2012 and revised on 7 June 2013. The definition requires that the scheme is a pension scheme established in the UK and falls within Article 3 of the main UK-US double tax treaty. HMRC Guidance notes on the implementation of the UK-US Intergovernmental Agreement support the proposition that UK registered pension schemes fall within this definition.

This means that trust-based UK registered pension schemes should not be subject to withholding under FATCA as it currently stands; and should not need to enter into an FFI Agreement or undertake any due diligence or reporting in relation to US members. They would also be an exempt beneficial owner for the purposes of the Final Regulations.

The Finance Act 2013 includes a power enabling HM Treasury to make regulations to give effect to the terms of the US-UK Intergovernmental Agreement. These regulations were published in draft form on 31 May 2013, but until the final form of the regulations are available, it is not possible to say with certainty what administrative obligations may be imposed on UK pension schemes.

For more information visit http://www.linklaters.com/pdfs/mkt/london/FATCA_UK_Pension_Scheme_Update.pdf

IRS issued the long-awaited final regulations implementing FATCA

17 January

2013

30%Withholding tax imposed on

payments by FATCA to encourage FFIs to provide

certain information to the IRS

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What is PensionsInvest?

PensionsInvest is your one-stop shop for pensions investment-related legal advice. Investment for pension schemes requires more than just pensions advice. Through PensionsInvest, you will have access to experts in all the areas of law relevant to pension scheme investment.

DERIVATIVES & STRUCTURED

PRODUCTS PRACTICE

> ISDAs > GMRAs > SLA

YOUR PENSIONS CONTACT

INSURANCE PRACTICE

> Buy-ins > Buy-outs > Insurance wrappers

FUNDS PRACTICE

> Hedge/PE Fund > Real Estate Funds > Alternatives

TAX PRACTICE

> Tax structuring > Reviews > Integrated advice with your tax adviser

FINANCIAL REGULATION PRACTICE

> Regulatory Advice

CORPORATE PRACTICE

> SPVsPROJECTS PRACTICE

> Infrastructure

YOUIntegrated advice

tailored to the needs of your scheme

For trustees, this means: > Cost-effective advice leveraging off class-leading experience;

> The most rigorous legal advice to protect you and your members;

> Pragmatic advice that is solution-focused;

> Advice that meets your deadlines;

> Seamless access to the broader firm’s expertise through your usual pensions contact.

Please get in touch with your usual pensions contact to find out how PensionsInvest can work for you.

Rosalind KnowlesPartnerTel: (+44) 20 7456 3710rosalind.knowles @linklaters.com

Mark LatimourManaging AssociateTel: (+44) 20 7456 4639mark.latimour @linklaters.com

Estella BogiraAssociateTel: (+44) 20 7456 3109estella.bogira @linklaters.com

ContactsIf you would like to discuss anything further, please contact:

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Linklaters LLP One Silk Street London EC2Y 8HQ Tel: (+44) 20 7456 2000 Fax: (+44) 20 7456 2222

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