When the EU Commission formally proposed a new tax on financial transactions last week, the headlines focused on the estimated €57 billion annual haul the tax would generate, or whether all 27 EU member states would agree to such a tax in the first place.
Less widely reported, however, was a working paper released alongside the proposals, which outlined what the Commission perceives the origins of the financial crisis to have been. One of the key factors they believe exacerbated the 2008 chaos? Tax-induced leverage.
The tax deductibility of interest payments is poisoning financing decisions, the Commission argued, leading company owners to pursue uncomfortable leverage ratios. While debt tax shields “did not create the financial crisis…it leaned in the wrong direction and may have aggravated it,” the report said. And it clearly has a point, to an extent. High leverage levels – tax-induced or otherwise – lead to liquidity restraints in a company, a problem that can be fatal during times of tightened credit supply and reduced consumer demand.
So can we now expect to see reform of the tax code, to reduce this risk?
The Commission told PE Manager that it has no short-term intention to weaken the debt tax shield at EU level; this will be the prerogative of its individual member states, it said. However, it wouldn’t rule out the possibility in the medium- or long-term. Indeed, it has already taken the first step: the working paper lists various proposals to make equity more appealing to debt. Solutions range from simply reducing corporate tax rates to decrease the value of debt tax shields, to implementation or reform of thin capitalisation rules (which limit how much interest paid on corporate debt is tax deductible). And it had already hinted at the idea earlier this year when it proposed a “Common Consolidated Corporate Tax Base”, designed to harmonise the way EU-based companies calculate their taxable income. It isn’t difficult to imagine the body revisiting tax-deductible interest payments, should a unified EU transactions tax prove successful.
Perhaps the smarter solution, at a more micro-level, would be for the LP community to keep an even closer eye on GPs' use of leverage
But would this be a sensible move? Although private equity funds have taken plenty of heat for using leverage to amplify returns and pursue bigger corporate fish, more and more managers are focused on operational improvement and value-add (as detailed in the October supplement to our sister site Private Equity International). Cynics argue another credit boom sometime in the future may encourage past mistakes to be repeated. But this analysis ignores the fact that the banks (courtesy of the Basel III rules) are currently undergoing a seismic shift in their regulatory oversight – so even if they wanted to provide GPs with the kind of leverage levels seen in 2006 and 2007, their hands may be tied by capital-holding requirements.
If the EU has a philosophical objection to the current debt tax shield, that is a debate worth having. But either way, is now the time to attack it? Global markets are entering a new period of risk management, overseen by more aggressive market watchdogs aiming to severely reduce the chance of another once-in-a-lifetime recession. (In this month’s PE Manager, we explore whether governments’ efforts will ultimately herald a fundraising dark age in Europe.)
Perhaps the smarter solution, at a more micro-level, would be for the LP community to keep an even closer eye on GPs' use of leverage. Investors can either accept the risk and potential reward of highly-leveraged companies, or they can push the GP to take a more cautious approach. This can be done through the partnership agreement. Or alternatively, GPs can more openly discuss acceptable levels of portfolio company leverage during the negotiating phase. That way the industry would be able to assuage the regulators' concerns over excess leverage without the need for complicated and controversial new legislation – with all the unintended consequences that typically brings.