Lack of ‘loopholes’ will hurt PE

Two of US President Barack Obama’s latest tax proposals will prove painful to private equity firms if passed – especially those which own highly leveraged portfolio companies with foreign operations.

The proposed changes, many of which were originally part of Congressman Chuck Rangel’s 2007 tax reform proposals, are part of a larger set aimed at “curbing tax havens and removing tax incentives for shifting jobs overseas” by closing “loopholes” in the existing tax code, the White House says. The two initiatives likely to be most troubling for PE firms are a change in the deductibility of interest payments on debt carried by foreign operations of US companies, and a change in the “check-the-box” regime.

The first change is described as follows in the proposal:

“Currently, businesses that invest overseas can take immediate deductions on their US tax returns for expenses supporting their overseas investments but nevertheless ‘defer’ paying US taxes on the profits they make from those investments. As a result, US taxpayer dollars are used to provide a significant tax advantage to companies who invest overseas relative to those who invest and create jobs at home. The Obama Administration would reform the rules surrounding deferral so that – with the exception of research and experimentation expenses – companies cannot receive deductions on their US tax returns supporting their offshore investments until they pay taxes on their offshore profits. This provision would take effect in 2011, raising $60.1 billion from 2011 to 2019.”

The effect of this change would be that businesses will have to chose between repatriating their foreign profits earlier than they otherwise would have, or deferring their interest deductions allocated to that foreign income, says Marc Gerson, an attorney at law firm Miller & Chevalier in Washington DC. Private equity deals, which are often structured to rely heavily on interest payment deductions, could suffer disproportionately from this change, unless they begin raising debt abroad.

This provision would affect private equity firms that own multinational portfolio companies, but depending on how it is written it could also affect US private equity firms that own foreign portfolio companies, says Rich Walton, of Counsel to law firm Buchalter Nemer in Los Angeles.

The change in the ‘check-the-box’ regime is perhaps even more sweeping:

“Traditionally, US companies have been required to report certain income shifted from one foreign subsidiary to another as passive income subject to US tax. But over the past decade, so-called ‘check-the-box’ rules have allowed companies to make their foreign subsidiaries ‘disappear’ for tax purposes – permitting them to legally shift income to tax havens and make the taxes they owe the United States disappear as well. The Obama administration proposes to reform these rules to require certain foreign subsidiaries to be considered as separate corporations for US tax purposes. This provision would take effect in 2011, raising $86.5 billion from 2011 to 2019.”

US multinationals already structure their operations, cash flows, and distribution chains around the check-the-box regime, so a sweeping change in that regime would have a huge impact on those structures. Private equity firms, who as extremely sophisticated tax planners have certainly structured their deals and holdings abroad around this regime, would have to fundamentally rethink the organisation of their global portfolio companies. It’s possible, Walton says, that some foreign portfolio company may now have to be categorised as US C-corporations, subject to double taxation – again, depending on how the code is written.

“The check-the-box regime primarily allows the foreign group of a US-headed company to move cash on a tax-efficient basis abroad in order to take advantage of different business opportunities,” Gerson says. “Essentially what [the proposal] does it increases the US tax costs of the foreign operations of a US company, which could have an impact on the competitiveness of those firms, particularly when they’re competing against foreign-based companies.”

The US already has one of the higher corporate tax rates, Gerson says, and so mechanisms like the deferral of US taxation on foreign income or the check-the-box regime that help US-based companies compete against foreign-based companies which are subject to a lower tax in their home country.

Walton also points out that one of the reasons that the check-the-box regime was created in the first place was to avoid the huge administrative burden of arguing with taxpayers, and their lawyers, about what sort of business entity they should be taxed as. A “bright line standard” that allowed them to decide for themselves saved the government a substantial amount of money in enforcement costs, even if it probably was abused by some. He questions the wisdom of taking a step backwards to the old regime.

But at the end of the day, any time Congress tampers with the tax code, they tend to create “opportunities” for every “loophole” they close, Walton says.

“Is it something that private equity firms should be aware of and concerned about, yes,” he says. “Is it the end of the world for private equity, absolutely not.”