Taxbreak hotels

Sinéad Pentony: The report by Peter Bacon on the Irish Hotel Industry highlights the sorry state of the industry, which has been insolvent since 2008. By the end of that year, there were a total of 59,000 hotel rooms in the country – and according to the Report, a quarter (15,000) of these rooms need to be closed down urgently. The Report also estimates that €1bn of debt in the hotel industry is not covered by assets. Peter Bacon makes a large number of recommendations in the Report that, if implemented, would effectively restructure the industry. However, it is worth taking a closer look at his recommendations in relation to the accelerated capital allowances for hotels (tax breaks), because it would result in a significant bailout of developers if implemented.

The Report on the hotel industry identifies a number of factors that have contributed to the virtual collapse of the industry. In the first instance, it points the finger at hotel tax breaks and the damage they have caused by distorting the market. The tax breaks resulted in the creation of a huge over-supply of hotels whose viability was questionable from the outset. Bacon concludes that the stock of new hotels has been seriously insolvent since 2005, and the analysis shows that in every year since 2002, new hotels on average have been insolvent from the year of their construction. The economic crisis has compounded the situation and has brought the industry to the brink of collapse.

Secondly, the Report highlights the practices of financial institutions and banks in contributing to the problems in the industry. It would appear that the banks and financial institutions are supporting a large number of insolvent hotels to remain in business. Bacon identifies a number of reasons for this in the Report, including “... the need of hotels to remain open for seven years to allow investors to avail of capital allowances and to avoid the creation of a tax liability due to a clawback of allowances that have been claimed already; the reluctance of banks to realise losses and write off loans granted to hotels with no prospect of recovery because of the additional pressure this would place on the capital adequacy of their own balance sheets; and the reluctance to act in advance of the introduction of NAMA.”

The result of these factors is that the insolvency problem is being spread through the industry, and solvent hoteliers now find themselves having to compete against ‘zombie’ hotels, many of which were created specifically to take advantage of tax breaks, and this is threatening to destroy fundamentally sound businesses. At the same time, the reluctance of banks to provide sufficient working capital is leading to liquidity problems that further undermine the businesses of solvent hotels. Peter Bacon points to the possibility that the banks have less incentive to keep viable hotels with relatively low levels of debt open, than is the case for hotels with high levels of debt, for the reasons stated above – having to realise losses and write off loans.

So how do we solve this problem? The recommendations contained in the Report outline the restructuring that needs to take place within the industry, to put it back on the road to solvency and viability. One of the key recommendations relates to the issue of over-supply and removing 15,000 rooms from the market – it goes on to specify that the reduction of excess capacity should be facilitated by the adjustment of tax regulations concerning tax allowances for new hotels.

Incredibly, the Report recommends “...that a special provision be introduced in the Finance Act 2010 to allow relevant hotels to exit the industry without disadvantaging the initial investors in terms of capital allowance. It is further recommended that an accompanying provision be introduced to the effect that capital allowances that have already been claimed in respect of any hotel should not be subject to any claw back by the Revenue should that hotel exit the industry within seven years”.

Essentially, the Report is recommending that developers who took advantage of tax breaks to build hotels that were never going to be viable should not be subject to the clawback of those capital allowances - because they won’t have an incentive to close these hotels but rather, keep them open for the seven years, which will further undermine the hotel industry. There are two questions that arise here: the first is an economic question, and the second relates to how insolvent hotels continue to be financed.

We live in a market economy and the Report clearly demonstrates the detrimental consequences of market-distorting tax breaks. The economic logic would see the removal of the tax breaks and, if the hotel ceases trading within seven years, tax allowances would be clawed back. The tax breaks for hotels have been discontinued along with other property-based tax incentive schemes. However, the Commission on Taxation Report 2009 notes that many live on for existing projects and “for pipeline projects”, as in the case of hotel accelerated capital allowances (tax breaks).

The recommendation contained in the Report in relation to the treatment of the claw back can only be described as a further market distortion and raises serious questions in relation to ‘moral hazard’, whereby failed investors are in fact freed from the consequences of their actions. If implemented, this recommendation can only be described as a bailout for hotel developers, when they should, in fact, be subject to the same rules as everyone else who operates in a market economy. This leads us to the second question.

How can struggling developers and investors afford to keep insolvent hotels open? The answer is - the banks. The Report identified the actions of banks as being “particularly damaging” because they are avoiding the need to realise losses due to bad loans on hotels that are not viable by providing a “drip feed of working capital”. Meanwhile, hotels with low debt levels and viable businesses are experiencing liquidity problems because they are having difficulty in accessing sufficient working capital. The Report recommends that the banks need to fully recognise bad loans within the hotel sector and face any capital adequacy issues which might follow.

John Power, CEO of the Irish Hotels Federation, in an interview on Drivetime on the 5th January clearly articulated the problem with the banks keeping insolvent hotels open and the detrimental effect this is having on the industry as a whole. But how can the banks, which have such serious liquidity problems afford to keep these insolvent hotels open – when we hear countless stories of viable businesses going into liquidation because of credit restrictions?

We can only assume that part of the capital that has been injected into the banks from the State (€11bn to date) is being used to keep insolvent hotels open, so that they can be transferred to NAMA and/or to prevent the developers from incurring tax clawback liabilities, should the hotel be forced to close within 7 years of being built.

The Report puts the costs to the Exchequer of removing this barrier to exit the industry at zero. Hotel-related capital allowances which remain to be claimed have an estimated value of €527 million to investors. More importantly, allowances already claimed, which potentially could be clawed back by the Revenue, have a value estimated at €1bn. The total potential loss to the Exchequer adds up to over €1.5bn.
The Finance Bill is due to be published in the coming days, so we will have to wait and see if hotel developers are next in line to be bailed out by the taxpayer. Hotel developers would not be able to keep these hotels open were it not for the support of the banks, who in turn, have questions to answer - in relation to continuing to finance insolvent hotels and the extent to which capital injected by the State is being used to support this activity. It would appear that the taxpayer is being used to prop up the whole system and is keeping the banks, speculative developers and other vested interests afloat.

But who is propping up the tax payer?
Sinéad Pentony is Head of Policy at TASC