The UK's tax conundrum

It’s too simplistic to call ‘compensating adjustments’ a loophole. But is the industry really well-advised – particularly in the current climate – trying to defend a tax advantage that seems to have arisen by mistake?

The UK private equity industry was forced on the defensive last week when Treasury Secretary Danny Alexander launched a stinging attack on its use of the ‘compensating adjustment’ tax structure, explicitly calling it a “loophole” for GPs.  
The British Private Equity and Venture Capital Association (BVCA), a trade body, said this was just political grandstanding, insisting that the practice has long been approved by the UK tax authorities. 

Danny Alexander

That may be true. But it doesn’t make this a fight worth picking.

In the private equity context, compensating adjustments occur when interest is paid on shareholder loans made by fund managers to the firm or its portfolio companies, often in the acquisition of portfolio companies. 

Tax lawyers say there are legitimate commercial reasons for fund managers to use shareholder debt when acquiring companies. For instance, it is easier to repay the shareholder debt and accrued interest than it is to repay share capital and dividends (due to restrictions on the repayment of equity under UK company law). And the industry argues that GPs have a responsibility to return cash to their investors as efficiently and quickly as possible. So this is a legitimate tactic.

The significant point is that if the tax authority agrees that the loan is a genuine loan – i.e. made at arm’s length, on commercial terms – it qualifies for tax-deductible interest payments. Sometimes, the tax authority will argue that only a portion of the loan should qualify as arm’s length. In this case, both borrower and lender will only be taxed on the non-qualifying portion – and a compensating adjustment may be claimed by the lender so that its position mirrors that of the borrower.

The issue – and the reason Danny Alexander is taking umbrage – is that when it comes to the non-qualifying portion, an individual lender would be taxed at a rate of 45 percent, while the company would be taxed at a rate of 23 percent. This discrepancy creates an incentive for GPs to arbitrage the rates by channeling their income into shareholder loans to avoid tax, the government believes.

On the one hand, there’s nothing illegal going on here; the industry is just following the rules as written. “There is a problem when these rules apply to individuals because they produce a better result than HMRC intended. But it’s not abusive; it’s how the rules work,” says one UK-based tax lawyer.   

Equally, changing the rules will be very difficult in practical terms. Alexander has promised a consultation period, during which the BVCA hopes not only to present the industry’s case but also educate the authorities that a replacement set of rules will need “sufficient flexibility and subtlety.” This is not a “black and white question”, BVCA director general Tim Hames told PE Manager.

(One UK-based tax lawyer suggested compensating adjustments in the hands of UK individuals should be treated as a dividend – the tax rate for which is 30 percent – instead of allowing it to be completely tax deductible. Since there’s no dividend tax between UK companies, it wouldn’t affect the tax neutrality there.)

At a time when scrutiny is tightening and political pressure is growing, is it really worth the industry trying to defend a practice that is apparently just an unintentional consequence of existing legislation? 

On the other hand, it also seems clear that the tax authority didn’t mean this to happen, according to attorneys. “The intent was to create tax symmetry between two inter-related companies, and because both use the same tax rate, no arbitrage exists,” says one UK tax lawyer.

Equally, this is the second consultation the UK has issued concerning private equity tax practices in recent months (it’s also trying to stop fund managers using limited liability structures to reinvest any profits the partnership makes at the corporate tax rate, via a corporate member, rather than the higher income tax rate as individual investors). 

So at a time when scrutiny is tightening and political pressure is growing, is it really worth the industry trying to defend a practice that is apparently just an unintentional consequence of existing legislation? Especially since the sums involved are relatively minor, private equity’s long-term interests might be better served by letting this one go – and avoiding accusations of special pleading – in order to focus on the bigger battles that may be to come, where it has a more legitimate case to make.