The structuring of a management buyout is highly tax-driven. The
focus is often two-fold. First, a tax deduction of finance costs
must be achieved to the maximum extent possible. Secondly, the
structure should provide for a tax efficient exit strategy. This
article will first summarize the most relevant rules in the
Netherlands and Belgium regarding the tax deduction for interest on
acquisition debt, including the new developments for 2003. The
article continues with the structuring of the exit. It will be
explained that Luxembourg can be used to create a tax efficient
exit for foreign investors in a Dutch and Belgian buyout
investment.
HOW TO CREATE A TAX EFFICIENT LEVERAGE
Netherlands
Tax consolidation: rules and pitfalls
In a leveraged
buyout, the financial investors and management often participate in
the company to be acquired (the target) through a newly
incorporated Dutch acquisition holding company. The holding company
is highly leveraged with various types of debt, and with a
relatively small amount of equity. This can be illustrated as
follows:
The priority from a tax perspective is to achieve a tax
deduction for the interest payable by the holding company. This tax
deduction can be realized only to the extent the interest can be
offset against taxable income of the target. In the Netherlands,
this goal can be achieved by forming a fiscal unity between the
holding company and the target.
The fiscal unity between the holding company and the target sets
up a consolidation for tax purposes. The aim is that the interest
paid by the holding company can be deducted from the taxable profit
of the target. There is an important restriction on the tax
deductibility of the interest paid by the holding company: if the
loan to the holding company is granted directly or indirectly by a
related entity or a related individual, the interest expense on
such a related party debt cannot be offset against the profits of
the target during the first eight years after the acquisition of
the target.
The debt is considered to be borrowed from a related entity if
the provider of the debt (the bank) and the holding company are,
directly or indirectly, an affiliated company for one-third or more
(see below).
As the above illustration points out, if the investment fund and
bank are considered to be related parties for Dutch tax purposes
(in practice, this situation typically arises in the situation of
captive funds whereby the investment fund is a private equity fund
sponsored by a bank as the cornerstone investor), it is very
important to borrow from third-party financial institutions rather
than from bank.
Tax consolidation: new rules for 2003
From January 1
2003, the current fiscal unity regime will be revised. Some of the
amendments are of particular importance for leverage buyouts in the
Netherlands. First of all, the scope of the above-described
limitation of the interest deduction on acquisition financing will
be extended, and will also apply to a related party debt entered
into by the holding company to finance a capital increase of the
target. Consequently, the limitation not only potentially comes
into play when the holding company borrows from related parties in
connection with the acquisition of the target, but also when the
holding company borrows in order to increase the target's capital
once the acquisition has been made.
On the other hand, to a certain extent, the restrictions on the
tax deductions become less tight. The restrictions will not apply
if the loan is raised from a related party if it can be shown that
this related party in turn borrowed the funds from a non-related
entity, provided that the interest is subject to tax in the hands
of the recipient of the interest (the so-called indirect
third-party loan exception). This exception is not applicable with
respect to financing raised by the holding company to increase the
capital of the target, but applies to an acquisition financing
only. It is crucial that the third-party debt can be traced and
linked to the loan provided to the holding company - for the full
term of the loan provided to the holding company.
The new law will also relax the ownership conditions that must
be satisfied to form a fiscal unity. Under current law it is
required that 99% or more of the shares of target are held by the
holding company. This requirement is generally recognized as a
complication. For example, in the event of buyouts where not all of
the shares can be acquired and in the case of employee
participation. Under the amended rules, it will be possible to form
a fiscal unity if at least 95% of the shares in the subsidiary are
owned by the holding company.
Another bottleneck for buyouts is that under current law, the
fiscal unity regime can start to apply only from the beginning of
the financial year. This often means that interest expenses
incurred by the holding company cannot be offset against profits of
the target if the first year of acquisition. Under the new fiscal
unity regime it will be possible to form a fiscal unity during the
course of the financial year. In effect, the holding company can
file a request to form a fiscal unity with the target immediately
after the date of acquisition. Such a request must be filed within
three months of the desired starting date.
Acquisition debt related to foreign sources
To the
extent that acquisition expenses are related to the purchase of a
(direct or indirect) foreign subsidiary of the target, the
deduction of the expenses is not allowed. In other words, if the
Dutch target owns foreign subsidiaries, Dutch tax law prescribes
that the interest on the part of the acquisition debt attributable
to the foreign subsidiaries, is not deductible. Whether or not
(part of) the debt is attributable to foreign subsidiaries, is
determined at the time of the acquisition by the target. Also,
there is only one relevant moment that determines which part of the
acquisition debt is deductible: the moment of acquisition. The
yardstick employed to determine the deductible and non-deductible
portion of the financing costs, is the relative fair market value
of the Dutch and non-Dutch subsidiaries as a part of the total. A
solution to avoid the non-Dutch part of the interest expense not
being deductible, is a push down of the debt. This can be
illustrated as follows: (see box below)
Part of the loans are provided to the target, and part of the
loans are provided directly to the newly formed foreign holding
company, which is set up to purchase the non-Dutch foreign
subsidiaries of the target directly from the vendor. When such a
structure is created, two points must be taken into account:
- it should be established, obviously, that under local tax
law the interest expense at the level of foreign holding
company can be deducted and set off against profits of the
foreign target operating company; and
- for Dutch tax purposes, it is recommended to purchase in
two steps: first, the foreign holding company borrows from the
bank and buys the shares of the foreign target operating
company. As a second step, the holding company borrows and buys
the shares of the target that owns the Dutch operating
companies.
EU developments
Under the Dutch participation
exemption regime, a difference in treatment exists between costs
incurred in connection with the acquisition of a domestic target
and a foreign target. The question is whether the distinction is in
violation of EU principles if the foreign subsidiary is a resident
of one of the EU member states. Recently, the attorney-general of
the EU Court concluded that this distinction indeed conflicts with
EU law. The final decision of the EU Court is expected at the end
of 2002 or early 2003.
History teaches that the EU Court generally adopts the
conclusions of the attorney-general. If that is the case, the Dutch
Ministry of Finance will probably enact counter measures to replace
the current discriminatory legislation. Simultaneously, it should
be expected that new legislation will be introduced that should
repair the deficit in the budget due to the possibilities for
taxpayers to claim a tax deduction for interest expense on a much
larger scale. In the worst-case, the new legislation will disallow
any interest expense for acquisition debt, regardless of whether
the target is a domestic or foreign entity.
Belgium
Deduction of interest expense on acquisition debt
A
similar acquisition structure can be set up for a leveraged
management buyouts in Belgium. In such cases the Belgian target is
acquired using a Belgian holding company. The holding company is
financed with funds borrowed from a bank. The target may hold
interests in other (Belgian or foreign) companies.
As a general rule, the interest payments by the holding company
are fully tax deductible in Belgium. Unlike the Netherlands, no
distinction is made in this respect between interest payments
relating to the acquisition of a Belgian company and interest
payments on debt that relates to the acquisition of foreign
companies. Consequently, in case the target holds shares in
non-Belgian companies, there is no need to push down the debt.
Creating a tax efficient deduction for interest
expense
Obviously, the deduction of financial expenses
related to the acquisition of the target is only efficient if the
holding company has taxable income from which the expenses can be
deducted. The income that the holding company will receive,
however, will consist primarily or solely of dividends (for 95%
exempt) and capital gains (fully exempt) on shares. Consequently,
the holding company will have an excess of deductible interest
payments that cannot be used to set off against taxable income from
the acquired operating companies. Unlike the Netherlands, this
issue cannot be solved by setting up a fiscal unity between the
holding company and the target; Belgian tax rules do not allow a
tax consolidation between affiliated companies
Merger
If the target is a Belgian operational
company, a solution for the excess of deductible interest payments
can be to merge the holding company and the Belgian target. After
the merger, the interest payments to the bank can be deducted from
the operational income previously generated by the target.
Such a merger can only take place free of tax on the condition
that the parties can show the tax authorities that there are
genuine financial or economic motives to the merger, that is, the
merger is not purely tax driven. An advance ruling can be sought
from the Revenue on this issue.
In a tax free merger, existing carry forward tax losses of the
target and/or the holding company can be used to offset income
derived by the surviving company, subject to certain
limitations.
Tax efficient exits
An investment fund that,
together with management, enters into a leveraged buyout in the
Netherlands or Belgium, will count on making a tax efficient exit.
In most situations, the exit will be realized through a trade sale.
The investment fund needs to be protected against local capital
gains tax. This is in particular true for a Dutch buyout.
The above chart shows a Luxembourg holding company (Luxco) that
owns the shares of a Dutch holding company. For most types of
investment funds, it is doubtful whether they are protected against
Dutch corporate income tax on the gain realized upon the sale of
the holding company if they own shares directly in the holding
company. For that reason, Luxco is interposed. If Luxco sells the
shares of the holding company in a trade sale, the tax treaty
between the Netherlands and Luxembourg protects against the Dutch
tax liability. If Luxco is later liquidated, the sales proceeds can
be distributed to the investment fund exempt from any Luxembourg
withholding tax because Luxembourg does not impose a withholding
tax on liquidation distributions. The capital gains derived by
Luxco upon the sale of the holding company, are generally tax
exempt under the rules of the Luxembourg participation exemption
(subject to certain conditions).
Likewise, a Luxembourg holding company may be recommended in
cases of a Belgian buyout through a Belgian holding company. This
makes it possible to liquidate the Belgian holding company in an
exit. Although under current legislation Belgium does not levy a
withholding tax on liquidation distributions, it is expected that
new legislation will introduce a 10% withholding tax on liquidation
distributions. This legislation is expected to be enacted before
the end of 2002, with retroactive effect from one January 2002. If
a Luxembourg holding company is interposed between the Belgian
holding company and the investment fund, the Belgian withholding
tax liability can be avoided.
Loyens & Loeff
Fred. Roeskestraat 100
1076 ED Amsterdam
The Netherlands
Tel: +31 20 578 57 85
Fax: +31 20 578 58 00
www.loyensloeff.com