The March 4 announcement on transfer pricing was a body blow to the UK private equity industry. In one fell swoop the UK Government tarred the industry with the brush of tax avoidance by stating it intended to stop interest on shareholder debt being tax deductible on all deals made after March 4, 2005. For those deals done before that date, the legislation will become effective from April 1, 2007, unless any amendments are made to the terms of the shareholder debt, such as changes to the parties, interest rate or repayment terms, other terms or conditions, in which case the rules will apply from when the changes were made.
The reaction from the market was swift. Within hours of the Inland Revenue revealing its decision, the British Venture Capital Association (BVCA) made its position clear. In a statement John Mackie, chief executive of the BVCA, said: “We are disappointed that the new legislation this morning was announced as being to counter tax avoidance when the structuring of these transactions and the use of limited partnerships was explicitly agreed with the Inland Revenue as far back as 1987. Indeed we estimate that during the last tax year private equity backed businesses contributed a total of £23bn to the exchequer.”
The whole issue of transfer pricing had never been especially clear. Back in 1998 the Inland Revenue updated the legislation relating to shareholder loans, but it was not until the BVCA got an assurance from the Inland Revenue that a partnership would not be regarded as a person that anxieties eased. The BVCA interpretation of the transfer pricing rules, as they currently stand, is that the newco and the portfolio company are not considered to be owned by a single shareholder because private equity funds are generally structured as limited partnerships behind which are multiple investors.
There is disagreement over whether the Inland Revenue ever agreed with this interpretation and now it has stated that in its view a person includes a partnership for transfer pricing purposes. The Revenue has said it never intended the changes negotiated by the BVCA in 1998 to be interpreted in this way, but private equity advisers have argued against this and a judicial review is due in the autumn.
SJ Berwin states: “We now understand the Revenue to say that because they have always taken the view that a person includes a partnership for these purposes they would insist that any investee company paying interest to a partnership whose assessment is still open should re-submit its corporation tax returns taking into account the Revenue view. It would also follow that corporation tax assessments yet to be submitted should take the Revenue’s view into account if an investee company has borrowed funds from a partnership.”
Related to this confusion over when is a person a partnership is the definition of arms-length. It boils down to whether a loan from a private equity firm to one of its companies is on the same terms as it would be if the company went to an unrelated party. If the answer is yes, then the transfer pricing rules don’t apply. If the answer is no, then the Inland Revenue would treat the loan as a dividend, which is not tax deductible.
Simon Witney, a partner in the private equity team at SJ Berwin, says: “If the new rules are enacted in their current form, the question will be whether shareholder loans pass the transfer pricing test. It is clearly possible that many will fail that test and this will add significant costs.” Many private equity financing arrangements will now have to undergo arms-length tests, creating a significant amount of uncertainty, not helped by the Inland Revenue’s lack of clarification on the subject.
The ruling will also mark out the UK as having a rather odd and ambiguous system compared to its European neighbours. Many countries on the Continent have an agreed debt to equity ratio as to what constitutes an arm’s length arrangement. In Germany the ratio is 1.5 debt to one equity, and in the Netherlands it’s three to one.
The Inland Revenue’s motivations, publicly, are to close up what they see as a tax avoidance measure and this view has particularly annoyed the private equity industry, especially the way in which the announcement was made. It is the policy of the Inland Revenue not to make any pre-announcements or consultations on issues where it seeks to close tax loops because this would give individuals or companies time to find ways around it. “But this wasn’t a tax avoidance scheme,” says Witney. “It’s the way deals have been structured for many years and the Inland Revenue has always been aware of it.” That the BVCA was already in discussion with the Inland Revenue over the issue of transfer pricing before the March 4 statement makes the move all the more galling.
How much it will cost the UK private equity industry is unclear. Numerous figures have been bandied about, with the new ruling potentially costing, per year, the industry anything from £1bn at the top end to maybe only as little as £60m. An accepted figure seems to be between £400m to £500m a year, but the Treasury disputes this, and puts the amount nearer to £5m in 2005 rising to £20m in 2007.
“I don’t know why they have changed the rule if the estimates they have given for the increased tax receipts are right because it wouldn’t seem worth it,” says Witney. If the aim of the Inland Revenue is to increase the amount of money in the Treasury’s coffers to help fund public spending, £5m is not going to get them much, and could well disappear on administration costs if the government insists on applying the rules retrospectively to 1999. The Inland Revenue would have to undertake what has been described as a logistical nightmare if it were to go back through hundreds of tax returns from the last six years.
Preparing for the worst
At the moment no one is quite sure what is going to happen because the new ruling was not included in the new Finance Act as had been planned, so it’s possible that some major changes will take place between now and when the rules are enacted after the election (apparently the Conservative Party agrees with the Revenue’s position.) The BVCA is in consultation with the Inland Revenue, but the private equity industry is preparing for a worst-case scenario; namely that highly leveraged companies could breach banking covenants and that future deal flow will decrease.
Tom Lamb, managing director UK at Barclays Private Equity, says: “It appears that the Inland Revenue’s decision could reduce private equity returns by circa 10% and this will definitely have an impact on the prices private equity houses are prepared to pay for businesses. In terms of how this is likely to affect deals which are currently work in progress, there is likely to be hiatus with private equity teams downing tools. At the very least, there will be a major impact on the buy-out market in the second quarter.”
Will it make deals less do-able? “Without a doubt,” says Michael McCormack at DLA Piper, a partner specialising in tax. “There will have to be a fundamental restructuring of how private equity deals are done. There are various models out there, and I think there will be a move away from debt financing towards more of a preferred share type structure.” (See box on preference shares.)
Lovells argues club deals with three or more houses could benefit from the new rules, and if so then there may be an increase of private equity syndicates.
If deals are structured so that no fund owns a controlling share it will escape the transfer pricing rules, but even under these circumstances the effects will be felt. In a note, Lovells said: “The abolition of the accruals basis for granting tax deductions will have an impact on deal structuring, although there are some methods of getting around this, such as the use of funding bonds.”
Banks could also find themselves affected by the move, as the ambiguous wording of the proposed legislation as drafted in the Finance bill before it was removed referred to “persons acting together in relation to financing arrangements.” This could mean that the banks’ loans are to be treated just the same as shareholder loans.
Undoubtedly it will make some deals less attractive to do. James Stewart of ECI says: “The cost of debt will be higher for buyout vehicles and this will have to be factored into the cash flow projections of the borrower.” But more serious anxieties surround existing deals. Stewart continues: “If you have a highly leveraged transaction and you have modelled the future cash flows on the assumption that you are going to get a tax deduction then it may have implications if you are relying on the reduced tax bill to service your bank debt. What we need therefore is to understand the weighting in transactions of an arms-length definition and the impact this will have on existing portfolio companies.”
Bank debt refinancings could become rare over the next two years. Shareholder loan notes, being subordinate to the bank debt, often refer to specific bank facilities in them and so will have to be amended to show the new terms of the bank debt and this could be interpreted by the Inland Revenue as a change to the shareholder debt and so trigger the new transfer pricing ruling.
Without further clarification from the UK Government, the industry is subjected to speculation, and this means uncertainty, and when conducting multi-million pound deals, uncertainty is not something anyone wants. For its part the private equity industry is assuming the worst, and preparing to lose significant amounts of money, but until the rules are enacted (they will have to go through parliament before becoming law), the Government has left the British private equity market in limbo.
Preference shares pay a pre-agreed dividend rate ahead of any dividend paid to ordinary shareholders, likewise in the case of a liquidation the preference shareholders receive their part of any monies left before ordinary shareholders get paid. However, preference shareholders do not enjoy the voting rights that ordinary shareholders do and do not receive a dividend if the company can’t afford to pay one.
Preference shares come in four forms: cumulative, non-cumulative, participating and convertible. Cumulative refers to the fact that the pre-determined dividend may be left to accumulate rather than being paid out. Participating allows preference shareholders to share in the upside if dividends are paid to ordinary shareholders above a pre-agreed level, then the pre-agreed rate of the participating preference shareholders’ dividend is also raised. Convertible allows preference shares to be exchanged for ordinary shares.