Murmurs of a new tax zeitgeist

Following every financial crisis is a period of reflection and reform. But the magnitude of the most recent recession and dwindling state coffers may have spurred tax authorities across Europe to fundamentally reform how their respective private equity industries are taxed.

Case in point is a European Commission proposal to introduce a new “Financial Transaction Tax” on all transactions where at least one party to the deal was located in the EU. If passed the tax would impact private equity fund managers when purchasing or selling shares, bonds or options in portfolio companies. The EU government estimates an annual haul of €57 billion if implemented.

The proposal appears dead in the water due to a lack of agreement among EU nations. The UK in particular has emerged as a vocal critic of any tax that could jeopardise its status as a premier financial centre. However, proposals with more life behind them include changes to tax-deductible interest payments; the ease in which GPs can establish offshore investment companies and various other regulations designed to capture more tax from private equity firms.

Dents in debt tax shield 

A working paper released alongside the FTT tax proposal outlined what the Commission perceives as the origins of the financial crisis. One of the key factors they believe exacerbated the 2008 chaos? Tax-induced leverage, a staple of the private equity model. This is because interest payments on loans in many jurisdictions can be claimed a taxdeductible business expense against a company’s profits, a policy especially beneficial in leveraged buyouts.

 The tax deductibility of interest payments is poisoning financing decisions, the Commission argues, 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.

A Commission spokesperson said the EU government has no short-term intention to  weaken the debt tax shield; instead leaving the prerogative to individual member states – many of which are indeed doing just that.

However, the Commission wouldn’t rule out the possibility of reform in the medium- or long-term. To this end the EU government has already taken the first step: the working paper lists various proposals to increase the appeal of equity over debt. Solutions range from simply reducing corporate tax rates to decreasing 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).

Germany and France are two of the most notable examples to have taken up the Commission’s cause at the member state-level. Take Germany for example: since 2008 private equity firms operating in the country could offset no more than 30 percent of a company’s earnings with tax-deductible interest payments if the net interest expenses exceed €3 million (subject to difficult exceptions). Uwe Eppler, a tax-focused partner at law firm Norton Rose, said the German government is considering further reforming debt tax shields – including changes to GPs’ ability to carry forward losses which can be set against income in future years (subject to the same 30 percent cap).

France hardened its stance through its 2011 Finance Law. The law extended the scope of French thin-capitalisation rules to include certain loans granted by third-party lenders which are guaranteed by a related undertaking. The rule means interest on any debt financing used in French acquisitions is now subject to new restrictions when offsetting a target’s profits, a fundamental shift in policy, explains Nadine Gelli, a tax-focused lawyer at Ashurst.

Prior to the reform, debt interest deduction rules were “rather favourable” in France, says Latham & Watkins tax partner Olivia Rauch-Ravisé. Ongoing market volatility however has meant a change in attitude, with France also considering “further restrictions on tax-deductible interest payments for next year as well”, adds RauchRavisé. Already “the second amended 2011 Finance Law voted in September placed tight restrictions on the use of carry-forward tax losses to offset future profits, impacting once again the tax leverage of many French private equity transactions”.

France and Germany are by no means an exception. Italy, the Netherlands, and the UK have all recently implemented or reformed their respective thin capitalisation rules in light of market developments.

Sweden in particular is becoming a more vocal critic of the tax benefits offered by leveraged buyouts. Sweden’s finance minister, Anders Borg, hinted the government would review debt tax shields in the near future, according to an October report from Sweden daily Dagens Industri. The finance minister buttressed the revelation with a scathing review of tax-deductible interest payments, saying buyout firms operating in critical sectors of society, including education and healthcare, were avoiding Swedish tax; with “taxes instead going to the Cayman Islands or other tax havens. This is simply unacceptable. We must put a stop to this.”

The right structure 

To that end tax authorities are taking a closer look into the substance behind intermediate holding companies used by GPs to acquire target companies; suspecting an element of tax avoidance at play in where GPs domicile their special purpose vehicles. In the UK for instance, a General Anti-Avoidance Rule (GAAR) is currently being considered that would effectively ban any accounting structure judged as a ploy to avoid taxes. Indeed GAARs are already present in most other common law jurisdictions, suggesting the UK may be compelled to do likewise as a way of protecting its own tax revenue. 

Until final rules are published it would be difficult to decipher how UK tax authorities might use a GAAR to target commonly used private-equity structures, says John Baldry, a London tax partner at law firm Ropes & Gray. However “there are some private equity structures which rely on being able to defer or roll up gains or income offshore –sometimes for re-investment – which might be attacked under a GAAR”.  Alternatively the UK may take its lead from Australian tax authorities who are now using anti-avoidance rules to target private equity structures involving offshore holding companies they believe are a result of treaty shopping, adds Baldry, citing TPG Capital’s well-reported confrontation with the Australian Taxation Office over its returns from the 2009 IPO of Myer Group as a prime example.

“It’s all illustrative of the main problem with a GAAR, which by its nature will introduce uncertainty into the tax system and introduce an artificial boundary between so called acceptable and unacceptable tax planning,“ Baldry continues.

The issue underscores a more general theme across the EU in which local tax authorities more openly question letterbox companies designed to provide GPs lower taxes. The idea is to create an intermediate holding company in a tax favourable country where a target’s parent government has signed a double tax treaty, as opposed to acquiring a target outright, subjecting the fund to local tax rates.

Holding companies structured in the Netherlands and Luxembourg are at the centre of this storm, with some EU states such as Austria and Germany providing their respective tax authorities new tools in denying the benefits GPs enjoy from special purpose vehicles.

Dutch co-operatives for instance, a legal entity originally designed for Dutch farmers and fishermen in mind, have proved extremely popular with GPs in recent years. The vehicle provides all the normal benefits of a limited company while simultaneously allowing LPs to avoid any dividend withholding tax on their investments. The Netherlands, encouraged by its EU neighbours, is looking to crackdown on fund managers exploiting this quirk in law. In a similar vein Luxembourg is reviewing its own vehicles used frequently by GPs looking for a way to slash their tax bill.

The effect of this trend requires GPs “to proactively review existing investment structures”, says Remco Smorenburg, a tax partner in Norton Rose’s Amsterdam office. And if “affected by the current legislative proposals [GPs should] consider, where feasible, to restructure or refinance to ensure compliance before the proposals take effect or start investigating alternative tax efficient cash repatriation options to avoid potential double taxation”, he continues.

International pressure 

A changing tax zeitgeist in Europe is not being shaped by domestic forces alone. Most importantly are tax reforms and policies underway in the US which are creating ripple effects across the Atlantic. Long-running debates in the US over the tax treatment of carried interest for instance may spur certain EU nations to examine their own treatment of carry. Current political headwinds and the need to plug budget deficits suggests Congress may finally redefine carried interest as income instead of as the more tax-favourable capital gains designation.

“The UK is certainly one country paying attention to the carry debate in the US,” notes Ropes’ Baldry. The danger in the UK following suit however rests in London losing its status as Europe’s private equity epicentre, argues Baldry. “Firms operating in Britain have easy access to numerous business centres in Europe, so if they find tax rates too high in the UK, they will move elsewhere. This contrasts to the US where it is not so easy to relocate.”

John Baldry

More provocative and game-changing for the EU has been US legislation designed to clamp down on tax dodgers. The Foreign Account Tax Compliance Act (FATCA), which takes effect in 2013, will among other things impose a 30 percent levy on certain types of distributions made by a US-based fund to foreign funds unless information exchange agreements are met. The legislation is in part the result of a White House now more keen to address tax avoidance – a cause central to President Barack Obama’s successful 2008 campaign.   

Consequently European firms will have to provide US tax authorities a look into the financial details of all their US-based limited partners. A difficult and time-consuming task, says John Challoner of Norton Rose. Moreover there is a general unawareness of FATCA’s reach, he continues. “Using a UK-based fund as an example, if that fund makes an investment in a UK institution which itself conducts investments in the US, then even in that situation FATCA could apply”.

In either case, GPs will be assessing the law’s scope in a tax environment undergoing fundamental changes