Fortune’s tax boogeyman

Fortune recently caused quite a stir amongst private equity folk when it ran a piece headlined “IRS scrutinizes certain corporate buyouts involving debt”. It began: “Private equity firms, buffeted by challenges to long-held tax breaks and growing scrutiny from regulators, have an ugly new headache: a wary look by the Internal Revenue Service at one of their preferred acquisition techniques.” 

Other industry media outlets went on to pick up the story, amplifying worries amongst GPs that the taxman was out to get them.

The facts of the matter are these: the US Internal Revenue Service has signaled a crackdown on US companies that borrow money from foreign affiliates for the primary purpose of generating tax-deductible interest payments – which under certain scenarios may also allow them to bypass US withholding tax. That’s important news for any US company, of any industry or sector, that accepts loans from a sister entity based abroad (especially when that foreign affiliate is located in tax-friendly jurisdictions like the Cayman Islands or Luxembourg). It means they need to take extra care during tax planning to prove that debt is actually debt, as opposed to disguised equity, which is less tax-favorable.

But to single out private equity specifically as the target of these efforts was misleading. The article went on to cite recent cases in US tax courts that demonstrate the IRS’ increased interest in related-party debt transactions – but as it acknowledged, “no challenges involving private equity-backed deals have yet spilled into public venues”. And tax experts speaking with PE Manager, some of whom have close ties to the IRS, insist that no one industry is being targeted by the investigation. 

Instead, the piece simply mentioned a few headline-grabbing large buyouts (like the $24 billion bid for computer group Dell by Silver Lake) plus a laundry list of other private equity tax and regulatory issues (like the recent case involving Sun Capital that could leave private equity funds on the hook for pension fund liabilities) – without explaining what any of this has to do with IRS scrutiny of inter-company lending.

Presumably the focus was on private equity on the grounds that buyout firms make more systematic use of debt. But this particular probe is about how leverage is being arranged between US companies and their foreign affiliates – which is not a private equity issue per se.

According to the article, “a typical scenario under scrutiny” would involve a private equity fund injecting cash into an offshore affiliate. But while it's clearly that private equity often makes use of offshore blocker corporations, which legitimately protect US tax-exempt limited partners from having to file US tax returns, this IRS investigation is more about foreign parents lending to US subsidiaries, rather than the private equity acquisition process. So it's odd that Fortune would describe this a typical scenario under investigation, especially without naming any industry-specific cases. 

Clearly IRS audit activity on inter-company lending is set to increase. But that’s an issue for all owners, private equity or otherwise. Misleading stories like this serve only to distract tax planners from legitimate IRS concerns, as well as unduly tarnishing the reputation of an industry that is already struggling with a public perception problem.