Private equity braced for global tax changes

The private equity industry has long been known for its ability to take advantage of tax rules. But international changes are set to have an impact on their businesses.

After a string of multinationals such as Apple, Google and Starbucks came under fire for paying minimal tax on their British and US sales in 2013, the Organisation for Economic Co-operation and Development set about modernising the tax system to clamp down on international tax avoidance. The Base Erosion and Profit Shifting, or BEPS, agreement is being developed to align tax policy across the globe.

The OECD’s Action Plan on BEPS was published in July 2013, and was endorsed by G20 leaders at their summit in September that year. It aims to get businesses to contribute their fair share of taxes and not artificially shift their profits around the world to minimise their tax bills.

Caroline Conder, head of tax at private equity firm EQT Partners, said: “This is probably the biggest thing that has happened in international tax rules for a long time… the biggest challenge is the uncertainty that businesses currently face.”

While most of the rules are still being finalised – most are expected to be released in the autumn or in 2016 – certain themes are emerging that will affect private equity. The first is a focus on interest relief on debt that companies receive and the second is the way that firms will have to comply with rules on tax arrangements that differ between jurisdictions.

Relief on debt interest

Private equity firms often acquire assets by using a lot of debt, which is then placed on the company’s balance sheet. But, because in most countries debt is usually considered a business expense and is not taxed, a company that has so much debt that it is forced to use its earnings to pay interest on its loans will be making less profit, so will be paying less tax.

In the past, governments reasoned they would be able to tax the interest that was paid to the bank that had lent the money. But these days debt can move around the globe. In private equity, loans or bonds for a French portfolio company can be issued in the US, for example. That means that the French government could be missing out on tax revenue that it might have received from domestic lending.

Some non-private equity-owned companies have also taken advantage of differences in international tax rates to reduce profits in high-tax jurisdictions and increase profits in low-tax jurisdictions. In December 2014, the OECD put forward a fixed ratio test to address this, limiting the interest deduction available to a company based on its earnings, assets or equity.

Under this rule, which already exists in such countries as Germany and Italy, a guideline would be set to limit the amount of relief that could be claimed on interest payments. The figure under discussion for the BEPS project stands between 10% and 30% of earnings before income, taxation, depreciation and amortisation.

However, according to Freshfields Bruckhaus Deringer tax partner Jill Gatehouse, this could hamper private equity investment in certain sectors that require high debt levels but generate a stable revenue stream.

She said: “Having a fixed ratio that applies to everybody will hit those industries that have a higher leverage level as a matter of course due to the nature of their assets. Real estate is one such sector, infrastructure project finance is another.”

Although exemptions are being discussed for assets with a public interest angle, such as financial services or infrastructure, and countries can choose to implement the most generous ratio possible, the fixed ratio test could affect private equity deals with a level of debt that exceeds the threshold.

Alexander Cox, a tax partner at Ashurst, said some private equity houses were thinking about how these changes, which would in effect make debt more expensive, could affect their business.

He said: “Some private equity houses are already starting to anticipate that in their modelling. The cashflow model on private equity deals is very important, so building some flexibility into the model to accommodate potential reductions in interest deductibility may be sensible.”

But with final recommendations not due until December, this is more of an art than a science. Cox said: “If you are too conservative now, you might miss out on a deal because you cannot be as competitive on price. By the same token, you don’t want to be too bullish in case your cashflow model is out.”

Another important issue relates to the abuse of tax treaties, which ensure that an entity in one jurisdiction investing in another jurisdiction is not subject to double taxation. For example, if a Luxembourg holding company – a common structure within the private equity industry – invests in a German business and seeks to use a tax treaty between Germany and Luxembourg, it could run into difficulties. The OECD is proposing that, to apply that treaty, the private equity fund would have to show that all of its investors are active in Germany, for example by owning businesses that are listed on German stock exchanges.

Many private equity funds will have dozens of investors around the globe, making such a process time-consuming or sometimes impossible.

A consultation paper from the European Private Equity and Venture Capital Association from January on this issue said: “Private equity investors are spread across the globe and it is simply impossible to understand each investor’s tax position.”

Private equity executives claim that the ability to invest in portfolio companies through a tax-neutral holding company is essential in attracting investors. Otherwise investors may find returns are taxed as they are received by the fund, then taxed again as they are paid out to investors.

David Nicolson, chairman of the BVCA’s taxation committee, said in a consultation response in January that these new rules “would have the effect of removing treaty benefits for holding companies owned by private equity funds. This would reduce returns to investors and potentially expose them to double taxation… In the longer term, there is a risk that investment into private equity funds and, therefore, into the real economy falls as a result.”

The OECD is discussing if it could introduce a threshold that would mean only a certain percentage of investors would need to meet the requirements for the fund to qualify for tax relief. But even this is not perfect as it could cause problems if the investor base changes when fund stakes are sold on the second-hand market.

In anticipation of any threshold, Ashurst is writing new provisions into its fund documentation, including the ability to move non-qualifying investors from one vehicle to another.

Private equity firms are also reviewing where some of their funds are based, according to Adam Frais, a partner in corporate tax services at accountancy firm BDO. Frais said: “Fund managers are definitely looking at their Luxembourg structures, and those in other jurisdictions, thinking about alternative plans and seeing whether they are likely to be affected by the treaty abuse changes. There is some review of structures going on in the larger funds.

“The proposals will certainly have an impact. We’re in unknown territory because they are not finalised yet, so there is nervousness in private equity circles.”