The following article is reprinted from The M&A Tax Report, Vol. 13, No. 9, April 2005, Panel Publishers, New York, NY.


By Robert W. Wood

Despite the worldwide uptick in M&A activity, there are at least a few clouds on the horizon that may affect particular types of transactions or particular segments of the market. One market segment that is continually evolving is the private equity transaction. With the large number of private equity firms in the U.K. (and the phenomenal growth of London as a financial center), there's reason to think the market may be badly hurt by a current tax proposal appended to the U.K.'s pending finance bill. This could be passed into law as early as this summer. If it is, it will require some retooling at a bare minimum.

Debt vs. Equity

The proposed tax change would adversely affect the way in which debt structures are used in private equity deals. Indeed, it goes back to the age-old dichotomy between debt and equity, something of nearly universal application. In the typical private equity deal in the U.K., much of the so-called equity really isn't equity at all.

The true debt is bank debt, bonds, etc. The other debt is of an inside nature, typically put up by shareholder loans from the private equity firm's limited partners. Of course, these loans are subordinated to the outside debt. Although these loans to private equity partners carry an interest rate, the interest is usually not currently payable, but rather accumulated or "rolled up." It is then eventually paid on certain specified events (such as a sale or recapitalization).

That means the company does not need to have the current cash flow to make the sometimes substantial interest payments on these shareholder loans. The shareholder loans can comprise a huge part of the deal in the typical highly leveraged transaction. There's outside debt, and then there's inside leverage in the form of shareholder loans, so "true" equity in the deal may be almost nonexistent.

While the interest is being accumulated, U.K. tax rules currently allow the company to deduct the interest payments (basically as it is accrued, even though it is not yet paid). This gives the portfolio company within the private equity firm a hefty tax deduction for the interest payments. Deductions are always nice in reducing the effects of leverage and allowing the company to expand, while at the same time reducing current taxes.

This rule doesn't seem extraordinary. Indeed, for many years, its presence didn't seem to prompt any fuss, despite concerns voiced about the thin capitalization of companies in certain other European countries. However, just recently, U.K. Inland Revenue announced that it was going to extend the scope of its transfer pricing rules to private equity structures. The big shocker: this change in policy would be effective immediately.

Killing the Deduction

It is not clear (to me at least) whether the real concern is the advance deductibility of the interest (as it accrues), or rather is the fact that these private equity loans are typically at above-market interest rates. The latter concern is mostly a question of degree. Capitalizing on a mismatch between tax and cash, the high interest rate loans effectively pad the private equity partners' wallets with interest payments when they are eventually paid, meanwhile exploiting the immediate tax deduction for the accrual.

Obviously, this game is exacerbated by a high interest rate, but on a theoretical level, the cash vs. accrual mismatch arises no matter how high or low the interest rate might be. Perhaps this new development is merely one more manifestation of the global governmental witch hunt for tax shelters and tax evasion. Under every rock, there seems to be something worth targeting.

The flap over the implementation of this kind of change via the transfer pricing rules might continue. Readers who are involved with U.K. private equity firms should probably stay closely tuned in to this evolving issue. My guess (but it is only a guess) is that Inland Revenue might be quashed in its attempts to make this pretty significant change by administrative fiat, especially with an immediate effective date. Given that the government has rattled its saber, though, and that it is rattling its saber to put this "proposed" change into the new finance bill, the writing may be on the wall for an end to this particularly well-worn structural path.

Wait and See

M&A Tax Report readers should watch for news of the U.K. bill this summer, not to mention the continuing flap over the U.K.'s administrative developments. Meanwhile, there is a trend in some other countries to address this problem, too, notably in Germany, Italy and the Netherlands. Those proposals and/or changes, though, seem to focus only on excessive debt-to-equity ratios, where the supposed potential for abuse of income tax deductions by the recharacterization of equity-to-debt seems rife. Definitions for what constitutes an excessive debt-to-equity ratio vary (3:1, 4:1 or 5:1, etc.).

The current U.K. approach, if this change by administrative fiat sticks, seems even more aggressive, focusing on whether the private equity owners hold a 40% stake in the portfolio company. If there is less than a 40% stake, the interest tax deductions might have less chance of being attacked.

U.K. Private Equity Tax Problems, Vol. 13, No. 11, The M&A Tax Report (June 2005), p. 6.