Taxing matters

Although last week’s Budget did not contain any specific announcements on tax issues directly relating to private equity, there have been serious concerns among many in the industry that significant changes are afoot.

In the last two months, some press reports and noises from government have predicted a hike in the tax on carried interest and management equity, which could make it harder to attract managers to run private equity-owned businesses and jeopardise the growth of the sector in the UK.

The concerns centre on HM Revenue and Customs (HMRC) apparently seeking to backtrack on two agreements made with industry body the BVCA in 2003 on taxation of carry and management equity. A third, and separate, issue has been uncertainty as to the amount of interest that is deductible in leveraged buyouts, following changes made to the legislation last year.

“There’s a lot of uncertainty surrounding taxation and private equity right now, and we really need to clear up all these issues,” says Stephen Quest, tax partner at Grant Thornton.

First is the deductible interest issue. This relates to a legislative change in March 2005. Before then, it was assumed that the interest payable on all debt put into a deal by a private equity house was tax-deductible. But the changes, which are being introduced in a transition period ending in March 2007, state that for private equity debt to be deductible it must be clear that someone who did not own shares in the company would also have loaned the same amount.

The changes relate to the approach adopted by HMRC to combat “thin capitalisation”, in other words the way that private equity houses could highly leverage companies and expect the acquisition “newco” to get a tax deduction for any interest paid. Before the changes, interest would often be rolled up, the “newco” would be able to deduct interest and less corporation tax would be paid. This in turn resulted in an advantageous cashflow in the investment.

A test issue, known as the Hozelock case, is going to judicial review. This will help clarify whether the changes affect deals before March 2005 or not.

Michelle Quest, a partner in the private equity group at KPMG, says: “To offset loans now they must show that a third party would have lent the same amount,” she says: “If there’s a very high equity-debt ratio, that’s unlikely, but in many deals some interest deductions can probably still be justified.”

Grant Thornton’s Stephen Quest says: “All the advisers have been looking at ways to reduce the impact of the changes and it looks like HMRC have become a bit more lenient and agreed to allow deductions of debt in certain circumstances, but it won’t be clear for a while how much you can deduct.”

On the issue of taxation of management equity and carried interest, the background goes back to 1987, when the BVCA came to an agreement with the Inland Revenue and government on tax and regulation. The private equity industry was then in its infancy and most

of the funds were offshore, so the government wanted to try and bring them onshore.

Essentially, the deal meant that carry and management equity would not be treated as income and therefore subject to income tax. Instead, they would be subject to capital gains tax (CGT), which could be as low as 10% or even lower if there was good tax planning.

The tax agreement is regarded by some as having helped the UK establish itself as the prime private equity location in Europe, although there were clearly many other factors at work.

Since 1987, there have been further clarifications to this approach as new tax rules were introduced, which have generally preserved the aims of the agreement. The most recent was in 2003, when two “memoranda of understanding” (MoUs) were reached with the government – one on carry and the other on management equity.

These MoUs were agreed following new rules on taxation in 2003 known as “Schedule 22”, which were aimed at countering the fact that many executives were receiving huge bonuses and managing to avoid income tax and national insurance.

The MoU on management equity clarified that if managers in a private equity-owned company satisfied the MoU conditions and held their shares for two years, they would pay CGT on any growth in value of those shares, rather than having that growth regarded as employment income and therefore liable to 40% income tax plus national insurance for the individual and employer, taking the total tax take to more than 50%.

The current controversy relates to the fact that HMRC, or one part of it at least, is now arguing that the way private equity deals are frequently structured means that management teams are, in effect, getting “a free ride” on the back of high-risk capital put into the deal by the PE house and therefore that the management is benefiting as employees (as opposed to investors) and should be subject to income tax.

Greg Morris, head of tax consultancy at law firm DLA Piper, says that there is currently a case going before the HMRC Commissioners that focuses on the high multiples that managers can gain through LBOs. The argument put forward by HMRC is that a large part of the growth in the value of the shares should be regarded as liable to income tax.

According to Morris, in December 2004, HMRC announced further changes in the rules on treatment of “employment related securities” to make them even wider. “It was announced that HMRC were aware that people were still trying to find loopholes in the legislation and as a consequence it would continue to monitor matters and, if it considered it necessary, change the legislation and backdate it to December 2004,” says Morris.

He adds that in that month’s Budget there was also an announcement that certain complicated option arrangements were being used to minimise tax and that there would be legislation in the Finance Act of 2006 to combat these, backdating them to December 2004 if necessary.

The approach of HMRC could have an impact on private equity deals, says Morris. “It means there’s a lot of uncertainty for private equity houses, as it’s hard for them to know whether their current proposals will be affected,” he says.

The fact that private equity directors invest their own money as carried interest alongside that of the managers, as a way to maximise returns, has also brought the taxation of carry into the controversy.

Grant Thornton tax partner Stephen Quest says: “Carry is the major focus of private equity executives and the MoU said that if they followed straightforward rules they would pay 10% tax, but recent reports have suggested HMRC want to re-visit this area.”

One of the problems is that the tax regime has been developed for companies in traditional situations, and the unusual nature of private equity has made it difficult to apply this framework.

Michelle Quest says: “The tax treatment of private equity has always been very complex, with returns being taxed at anything from zero to 40%. People would like to see a clearer system.”

She adds that it is difficult to compare UK tax on private equity with that in other countries. In France and Germany, like the UK, tax will vary significantly depending on factors such as how the fund is structured, when the carry kicks in and how the company is disposed of. In the US, the benchmark CGT tax rate on private equity is 15%.

HMRC is thought to be planning a review of these tax issues, which is expected to run from late May until the autumn. It is unclear so far whether such a review will focus specifically on private equity or cover a wider area.

A British Venture Capital Association (BVCA) spokesman said: “We look forward to engaging with the government over the period of the review, to ensure that the taxation regime is not changed in a way that undermines private equity’s contribution to the economy or the Chancellor’s ambitions in making London the financial services capital of the world.”

KPMG’s Michelle Quest believes that radical changes to the taxation of private equity are unlikely, given its importance to the UK economy. “For example, the Budget contained a paper about making London financial services centre of the world, which stressed the important role of private equity.”

Grant Thornton’s Stephen Quest agrees: “Ultimately, private equity attracts a lot of overseas money and is important in inward investment to the UK, so why would the government kill its golden goose?”

Simon Witney, a partner at SJ Berwin, says: “There will be industry discussions and, despite the speculation in the press, I think any significant change would be inconsistent with a lot of things this government has done, as it’s been quite private equity-friendly.”

He adds that it would be ironic if, just as other European governments were bending over backwards to become more attractive to PE fund managers, the UK took a backward step.

Despite all this, changes cannot be ruled out, although some advisers expect them to be more focused on clarifying and simplifying the tax treatment of PE, rather than simply increasing tax rates.

One adviser says: “The BVCA is seeking to come to some agreement with the Treasury that everyone is happy with, so that on the one hand there are not huge tax breaks but also that any changes do not risk the inflow of overseas money to UK-based funds.”

Meanwhile, Stephen Quest of Grant Thornton warns: “The combination of the uncertainties and the continuing trend to a more aggressive approach to perceived tax avoidance will lead to reduced deal flow in the UK and may eventually lead to PE businesses relocating offshore.”