Private equity: Loss of interest

The Government wants to stop private equity funds claiming tax breaks on the interest of shareholder debt, but kid gloves are required. By Rupert Shires and David White

In March Ed Balls, the Economic Secretary to the Treasury, announced a government review of the appropriateness of the current taxation regime for private equity funds and investees. Balls stated that the Government has no plans to disadvantage private equity in the tax system relative to other forms of ownership.

He did note, however, that concerns had been raised over private equity funds masquerading risk-bearing equity as ‘shareholder debt’ in highly leveraged funding arrangements. Consequently, tax advantages are being obtained that are inconsistent with the principle that interest is a business expense and deductible from taxable profits for companies. With this in mind the current rules will be reviewed, although the general principle will not.

As Balls noted, tax legislation already contains detailed provisions to ensure that equity is not disguised as debt to obtain a tax advantage. An investee company must convince HM Revenue & Customs (HMRC) that shareholder debt is on arm’s length terms before it can obtain tax deductions on the interest. This is not easy, particularly as the tests that HMRC applies by default are conservative and do not take proper account of key factors, such as a company’s business sector or asset base, its forecast profit growth or the keenness of third-party lenders to provide funds.

To obtain tax deductions on interest on arm’s length shareholder debt, the company needs to pay the interest. Once paid, withholding tax (WHT) may arise. Private equity houses have been structuring transactions to ensure interest can be paid during the life of the loan on a cash-free basis and to ensure that WHT is minimised or eliminated. It may be that the Treasury will focus on these areas. That said, this structuring is not endemic to private equity and amendments to the relevant tax rules would potentially affect other sectors.

Transfer pricing
The application of the ‘acting together’ rules within UK transfer pricing legislation was recently broadened to include most private equity transactions. Under these rules a company must show that its borrowings are on arm’s length terms for the interest to be tax deductible.

HMRC determines this using two tests published more than 10 years ago. The first is that the debt-to-equity ratio for an investee company should be less than 1:1. The second is that the company’s profit on an earnings before interest and tax (EBIT) basis should cover the interest payable on the loans by a factor of more than 3:1. These tests were developed in respect of third-party loans to FTSE100 companies. Besides being less applicable to private companies, the practices of third-party lenders have changed since the tests were developed. Therefore the tests are conservative and most shareholder debt in private equity transactions would fail to qualify as arm’s length on this basis.

HMRC has to date been willing to entertain arguments as to why shareholder debt that fails these tests should still be considered arm’s length. Arguments may include reference to the ability of companies to forecast profit realistically, projections in relation to the repayment of debt and the growth in profitability, and the borrowing ability of asset-rich companies or companies whose value has increased markedly.

Loan relationship rules
Once HMRC has been convinced that all or part of a shareholder debt is arm’s length, an investee company needs to negotiate the loan relationship rules to obtain tax deductions.

In the past interest on debt in the private equity context was tax deductible in the accounting period in which it accrued, irrespective of it being paid during that period. Now, as a result of recent changes to these rules, this interest is tax deductible on an accruals basis only if it is paid within 12 months from the end of the accounting period. If not the interest is tax deductible only in the period in which it is paid.

Where, as is often the case, interest on shareholder debt (which can be significant due to high rates) is accrued and paid only on an exit, these rule changes have had the effect of deferring the tax deductions with consequent negative effects on cashflow. Among other things, this may affect the ability of investee companies to satisfy banking covenants.

PIK notes
To deal with the pressures brought to bear by the changes to the loan relationship rules, private equity houses are increasingly funding investee companies through the use of loan notes with a payment in kind (PIK) facility.

Where there is insufficient cash to pay interest, the terms of the loan notes allow PIK notes to be issued in satisfaction of the obligation to pay interest. The issue of the PIK notes constitutes the payment of interest for tax purposes. Accordingly, provided the PIK notes are issued in the accounting period in which the interest accrues, this method of paying interest allows it to be tax deductible on an accruals basis without immediate cashflow implications.

Withholding tax
The use of PIK notes provides a neat solution for private equity houses. However, it has one drawback for overseas lenders – WHT becomes payable on the issue of the PIK notes. Investee companies can pay this tax in cash or by issuing PIK notes to HMRC. The former method of payment effectively reduces the cashflow benefits of using PIK notes by two-thirds, while the latter method is not ideal for either the investee company or HMRC.

There are a number of ways of reducing or eliminating WHT, the chief of which rely on double tax treaties or the ‘quoted eurobond exemption’. Double tax treaties allow for the reduction or elimination of WHT. However, even where there is a favourable double tax treaty in place, it may still prove difficult to obtain clearance from HMRC, particularly where the loan is not arm’s length. There may also be no treaty between the UK and the country of residence of the lender, or the treaty may only reduce WHT with the remaining charge still being significant. These considerations sometimes prompt lenders to provide funding through companies incorporated for the purpose in jurisdictions with which the UK has a favourable treaty. HMRC takes a strong stance against the use of such ‘conduit arrangements’.

There is no WHT on interest paid on debt securities issued by a company and listed on a ‘recognised stock exchange’. Accordingly, if loan notes with PIK facilities are listed, no WHT is payable on the issuance of the PIK notes. Private equity houses, then, are increasingly listing shareholder debt.

Potential HMRC rule changes
There is a number of ways in which the rules relating to the tax deductibility of interest could be amended or enforced differently to prevent or minimise tax deductions on interest: the ‘acting together’ rules could be tightened specifically to limit the amount of shareholder debt in respect of which a company may obtain tax deductions; HMRC could adopt a stricter approach in relation to the enforcement of its current arm’s length tests or adopt new tests making it more difficult for shareholder debt to be considered arm’s length; the tax rules could be changed so that the issuance of PIK notes would not constitute the payment of interest for tax purposes; HMRC could come down harder on what it considers to be ‘double tax treaty shopping’ and become even more reticent to grant treaty clearance; or the WHT exemption in relation to quoted eurobonds could be varied to prevent its future use in respect of shareholder debt.

The Government has made it clear that its objective is not to demonise any sector, but to promote long-term investment in jobs in the UK economy while ensuring that its tax rules work fairly. Private equity is not a form of ownership that deserves to be demonised. On the contrary, it has had a positive impact on productivity and employment. There are several ways in which the Treasury might amend or enforce the rules differently and it is likely that there will be some change. However, the chances are that the Government will not wish to chase private equity funds from the UK, and nor will the funds wish to go.

Rupert Shires is a partner and David White is an associate at McGrigors