Tax torpor

With most of the UK private equity industry probably still digesting the government’s weighty Pre-Budget Report (PBR), one leading financial services firm wasted no time in proclaiming that private equity funds had good reason to feel disappointed.
The PBR, which Chancellor Gordon Brown delivered on December 6, provides an indication of proposals that are being considered for inclusion in the Budget the following March. According to Grant Thornton, an adviser to mid-corporate businesses, this year’s PBR was a missed opportunity to clear up some outstanding tax issues. Stephen Quest, head of tax transactions at Grant Thornton, said: “The taxation of private equity funds has been in a state of flux for the last two years. The market needs stability to enable deals to be completed with a degree of certainty. Clarity in this area would have provided a boost to the private equity sector, which has brought so much to the British economy over the last year.”
Arguably the darkest tax cloud hanging over the heads of UK private equity professionals is the retrospective application of transfer pricing regulations to the financing of investee companies. From April 2007, consideration paid to private equity funds in respect of finance deemed not to be available on an arm’s length basis may not qualify for deduction of corporation tax relief.
It has been estimated that the new rules can increase the cost of finance by 3 to 5 percent for portfolio companies despite the fact that, at the time the finance was put in place, no such legislation existed.
Quest said: “We had hoped to see a pre-Budget in which the Chancellor put this right. His failure to do so will result in private equity funds taking a hit in April. It also sets a dangerous precedent and undermines the basis upon which funds will make investment decisions in the future.”
Grant Thornton also drew attention to tax issues still awaiting clarification in other areas, among them: Ratchets: In August 2006, Her Majesty’s Revenue and Customs (HMRC) confirmed that a proposed British Venture Capital Association (BVCA) safe harbour would apply to the tax treatment of ratchets in which management teams acquire “sweet equity”. Here, the use of loans means that only a small proportion of the cost of a deal pays for the equity, which generates a big return for investors if things go well.
However, this only applies where the manager invests at the same time as the fund. The PBR did not address the still thorny issue of post-acquisition changes to ratchets which cause problems when private equity investments are refinanced.
Earn-outs: The number of deals being structured with an earn-out element is increasing. However, in the view of Quest: “The tax law in this area is a considerable mess with uncertainty as to whether future receipts are taxed on a current or deferred basis. There is urgent need for reform in this area.”
Carried interest: Whether capital gains tax taper relief applies in respect of carried interest has long been unclear but is a vital issue given that it can make the difference between a 10 percent and 41 percent tax charge. HMRC currently takes the view that until the carried interest hurdle is met, partners do not have any entitlement to the underlying securities and, therefore, no taper can accrue. This means that, on exit, capital gains tax is payable in full by each of the partners at 40 percent rather than the lowest effective rate of 10 percent.
Given the existence of issues such as those outlined above, Quest’s view is the UK tax regime for private equity funds leaves a lot to be desired: “Private equity…deserves a fiscal regime that is consistently applied and delivers certainty to the funds in assessing investment opportunities in the UK. It remains the case that there is significant uncertainty and this is disrupting the flow of funds into the UK market.” The BVCA, which maintains an ongoing dialogue with HMRC regarding tax and other issues, was rather more measured in its response. A statement from its chief executive Peter Linthwaite, said: “We look forward to continuing the dialogue with the Chancellor about how we keep London and the UK as the centre of the European private equity and venture capital industry.”