Several questions will arise on any private equity
acquisition. They will inevitably include:
- what should you buy;
- how you should buy it;
- how will you fund it; and
- how can you keep management motivated.
In each case tax (as well as commercial) considerations will
What should you buy?
The difference between shares and
Most target businesses will be owned by a limited company. A
buyer will need to consider whether it should:
- buy the shares in the limited company, in which case the
seller will be the shareholder of that company; or
- buy the business, in which case the seller will be the
The chosen route can have quite different tax implications
both for the buyer and the seller.
As a result of tax legislation introduced in 2002, there can
be big tax advantages for a company that buys a business rather
than buying the shares in the company. This is because a UK
company that buys a business can claim relief against its
corporation tax bill on the amortization of intellectual
property, goodwill or other intangible assets. The deduction is
generally calculated by reference to the rate of amortization
in the accounts and can provide a substantial saving against a
mainstream corporation tax rate of 30%.
By contrast, no such relief will be available for the
acquisition of shares (whether or not that company holds a lot
of goodwill in its balance sheet). Unlike some other
jurisdictions, in the UK you cannot elect to treat a share
acquisition as an asset acquisition for the purposes of these
There might be advantages for a buyer who acquires a
business rather than shares, but this route will often have tax
disadvantages for a seller. This is because a corporate seller
will commonly suffer a tax liability on the disposal of the
assets that comprise the business, and the tax liability will
be calculated on the difference between disposal proceeds and
the base cost in the assets. By contrast, a sale of shares will
often fall within an exemption from corporation tax (the
substantial shareholding exemption). In addition, if a company
is to sell assets it will be left with a large cash receipt. If
it then wishes to extract that cash in favour of shareholders,
this process can lead to further tax liabilities for the
shareholders. As a result, a sale of a business can lead to
How should you buy it?
|Table 1: Standard acquisition
A private equity acquisition almost invariably involves the
incorporation of a new company - Newco - to acquire the target.
Funding is provided to Newco or a newly established subsidiary
of Newco to enable it to buy the target.
The use of a Newco is driven in part by commercial
considerations. It has also become a standard structure because
its use is compatible with tax objectives. In particular, using
a Newco is compatible with obtaining a tax deduction for the
acquisition funding and with the share incentives for
management (see further below). A standard acquisition
structure is set out in Table 1.
How should you fund it?
As set out in Table 1, the acquisition funding will
generally comprise a mixture of senior bank debt, mezzanine
lending and shareholder finance. The shareholder finance will
normally comprise a small strip of equity, the balance being
provided in the form of a shareholder loan note or a preference
The main tax objective is to ensure that the taxable profits
of the target group are sheltered to the maximum extent
possible by the financing costs.
Is grouping available?
As Table 1 shows, the acquisition finance is provided to the
acquisition group rather than to the target group directly.
Although the finance is not provided direct to the target
group, the target group is generally able to secure a tax
deduction by reference to the financing costs. This is because,
in principle, the financing costs of one group company are
capable of being set off against the profits of other group
companies. This set off is effected through the surrender of
group relief. Surrenders must be made on a current year basis
only - you cannot set off a loss that has been carried forward
in an acquisition company (a carried-forward loss) against the
profits of the trading companies.
As will be seen from the acquisition structure in Table 1,
it is also common to use a double or treble Newco structure.
This structure is in part to avoid a potential tax problem (see
the point on stapling in Table 2). However it is also largely
driven by the debt provider's desire for more junior debt and
equity to be structurally subordinated.
|Table 2: Tax risk areas
Circumstances in which interest payable may be
- where the interest represents more than a
reasonable commercial return for the use of principal
- where the corporate debt is convertible into
- where the amount of interest payable is linked to
the amount of profits made by the borrower;
- where the loan stock carries an entitlement for
the lender to be issued with further shares or loan
- where the corporate debt has an indefinite life
or a life of more than 50 years; and
- where any shares and loan notes are stapled.
The stapling provision in particular can be
problematic. But its application can generally be
avoided if a different company from the company that
issues the shares issues the loan notes. A double Newco
structure is generally preferred for this reason.
Other anti-avoidance provisions might also be
relevant in certain circumstances (including, in
particular, various new and wide-reaching
anti-arbitrage rules that are of particular application
to private equity transactions).
Debt or equity?
A tax deduction may be available for interest payable on
debt but not for dividends payable on shares. It is,
at least in part, for this reason that until recently the
equity provider generally used to provide a large proportion of
its finance in the form of a debt (or loan note)
As well as ensuring the instrument is debt rather than
equity, it is also important to ensure that the interest is not
re-characterized as a distribution for tax purposes with the
effect that the interest deduction is lost.
Assuming the finance is in the form of debt and the
anti-avoidance rules set out in Table 2 do not apply, you then
have to consider the transfer-pricing legislation. This
legislation applies where the borrower and lender are
connected, as defined in the legislation. While most
advisers previously took the view that the transfer-pricing
rules did not apply to private equity investments (see Table
3), the rules were changed in 2005. As a result of those
changes the transfer-pricing legislation will now apply to
most, if not all, private equity investments.
Under the transfer-pricing legislation, it is only possible
to obtain a deduction on debt to the extent that that debt
would have been provided on an arm's length transaction. The
arm's length concept requires you to consider whether the debt
would have been lent at all, or on those terms, if the
transaction was between independent enterprises. Under the
current legislation this is the only relevant test.
Compared with many other jurisdictions, the legislation neither
provides any fixed debt to equity ratios nor any acceptable
interest cover ratios. Moreover, there is no clear guidance
from UK customs (HMRC) as to how the transfer-pricing rules
will be applied to private equity transactions.
|Table 3: The historic position -
periods before March 2005
For periods before March 2005 the British Venture
Capital Association (and the industry as a whole)
operated on the clear understanding that the
transfer-pricing legislation did not apply to standard
private equity structures. This was on the basis that
the private equity fund was not connected to the
borrower so that the legislation had no application.
The analysis was broadly that, in considering
connection, you could look through the fund (a
tax-transparent entity) to the individual partners.
This generally allowed you to conclude that the
transfer-pricing rules did not apply, even if the fund
as a whole held a majority interest in the
The position on historic deals has given rise to
considerable controversy between the private equity
industry and HMRC. In late 2004 HMRC updated its
published manuals in a manner that made clear it
disputed the BVCA's view of the transfer-pricing
legislation, and instead believed that the
transfer-pricing legislation could properly apply to
certain private equity investments made before 2005.
The position adopted by HMRC is being contested by the
BVCA and by the industry as a whole and a test case on
the point is scheduled for early 2006. In the unlikely
event that HMRC is found to be justified in taking this
position, thousands of private equity-backed companies
could be at risk of substantial historic tax
Isn't all private equity finance arm's length
In private equity investments, the biggest risk area for tax
deductibility relates to the shareholder debt. To be confident
that the interest was allowable on the shareholder debt, you
would have to show that the shareholder would have provided the
loan note funding even if they had not taken equity. There are
often reasonable arguments that the issue of loan notes by the
shareholder is an arm's length provision, but shareholder debt
may in certain circumstances be susceptible to some
disallowance. At worst this could result in a disallowance of
the whole of the interest deductions on the shareholder loan
As a result of these changes, UK transactions now involve
careful consideration as to the arm's length nature of the
shareholder debt. This might involve obtaining opinions from
credit rating agencies, credit committee approved offers from
independent third-party lenders or the syndication of a part of
the shareholder debt post transaction.
The transfer-pricing rules may, in principle, apply to any
bank debt even if the lender has no shares and no equity
entitlement. However in such cases it should, in practice,
generally be accepted that the banking package has been
negotiated on arm's length terms.
Mezzanine providers are in a slightly more difficult
position than a senior lender if they obtain an equity warrant.
However, even in the case of warranted mezzanine, it is
ordinarily possible to show the bank would have lent that same
level of debt even on an arm's length basis. As such this risk
will often be theoretical rather than real.
Until it is clear how HMRC will treat interest on
shareholder debt, some private equity fund managers are
assuming the worst in their modelling (that is, that no
interest will be tax deductible on that debt) and are pricing
transactions accordingly. This is resulting in the appearance
of preference shares, on some deals, in place of some or all of
the shareholder debt. Preference shares tend to be used when a
full disallowance is expected so that the issuing company will
have a neutral tax position as between preference shares and
loan notes. In these cases some investors might prefer to
receive a preference share on which they will receive a
dividend rather than a loan note on which they will receive
interest. This is because in many jurisdictions there will be a
lower tax charge for an investor on receipt of a dividend
rather than interest.
Timing of deduction
If interest is, in principle, deductible it is important to
consider when that deduction is available: is it
available only when paid or is it available as the interest
obligation accrues due? The accruing basis is generally
beneficial as it creates a cash flow advantage.
As a general principle, interest payable on debt provided by
UK lenders will benefit from the (beneficial) accruing
deduction. By contrast, an accruing deduction will not be
available for most shareholder debt provided by private equity
funds nor on certain debt provided by non-UK mezzanine
providers. (This is because private equity funds are generally
connected with the borrower by reason of changes in the law in
early 2005 as are some mezzanine providers). This means that,
without further planning, a deduction would only be achieved on
Losing the benefit of an accruing tax deduction can have
serious implications for certain borrowers. This can be the
case if loan stock is issued on a rolled-up basis with the cash
interest paid only on exit. In such cases securing a tax
deduction only on exit would result in, at best, a
material cash flow disadvantage. At worst it could involve the
borrower group obtaining no value for the tax deductions;
either because a buyer is unwilling to place any value on the
existence of those tax losses, or because those tax losses
become stranded. Stranding of this sort can happen if the loss
is generated in a non-trading (acquisition) company and is so
large that it can not be set off, in full, against profits of
the trading group in the current year. Carried forward losses
cannot be set off against group profits in this way.
The importance of securing an accruing tax deduction in such
cases means that much time is expended in finding a solution to
Withholding tax is in principle payable on interest at 20%,
although there are some exceptions for payments made to UK
corporates and banks. While there is an exemption from
withholding tax in respect of interest paid to certain
partnerships, this exemption is unlikely to assist on payments
to private equity funds, participants of which normally include
a myriad of separate UK and overseas investors. Tax withheld
may be reclaimed in certain circumstances, and in particular
can be reclaimed by non-resident investors if the terms of a
double-tax treaty permit.
There is no withholding obligation in respect of interest
payable on Eurobonds. Eurobonds are bonds issued by a company
where the bond is listed on a recognized stock exchange. A
Channel Islands listing is increasingly common if a relevant
double-tax treaty does not enable relief to be claimed.
There is no obligation to withhold on discount. This has
meant that, historically, deep discount bonds were often used
in preference to loan notes. However, for various reasons these
instruments are now less common.
Tax risk on acquisition
In a private equity transaction, the success of the
investment will be largely driven by management, so the
commercial and tax issues affecting management are often
Management will wish to have the opportunity to acquire
Newco shares at an affordable price. Generally speaking the
equity strip in a Newco is small. As a result the price a share
will ordinarily be set at a level that enables management to
obtain equity in the Newco for an affordable price.
Management will also wish to ensure that they do not suffer
any tax liability when they acquire their shares. But there is
a risk that management will suffer an income tax charge (at
40%) on receipt of their shares. This tax liability will arise
in any case where management acquire their shares for less than
their market value and would be payable on the extent of that
undervalue. In determining whether management have given full
value for their shares it is not enough to show that they have
paid the same price a share as the investor.
The income tax risk has been highlighted by a change of
legislation in 2003 and a more aggressive HMRC attitude. HMRC's
concern is that shareholders (including the investor) are
underpaying for the Newco equity and overpaying for the
shareholder debt. In other words, HMRC would argue that
investors are sometimes given the opportunity to acquire their
shares cheaply because they are lending on soft terms. The HMRC
argument is that (if this were the case) management (who are
generally permitted to take equity without also taking loan
stock or other form of finance instrument paid up by the
private equity investor) are obtaining their shares at an
As a result of the income tax risk, it is imperative that
management can show that they are paying full market value for
their shares. In certain circumstances management will be able
to rely on the memorandum of understanding (MOU) agreed between
the British Venture Capital Association and HMRC in August
2003. Provided that the conditions of that MOU are met,
management will fall within a safe harbour whereby HMRC will
agree that they have paid full market value for their
Most of the MOU conditions are largely mechanical. However
one requirement of the MOU is that it can be shown that the
shareholder debt has been provided at an arm's length interest
rate. Where mezzanine finance is provided on a transaction,
this condition will require the interest on the shareholder
debt to equal or exceed the mezzanine interest rate. An
interest rate, at that level, on the investor loan notes is not
always commercially viable.
If the conditions of the MOU are not met, there is a risk
that HMRC would seek to charge income tax on the difference
between the price paid and the full market value of that share
as determined by HMRC.
How about the increase in equity value?
Management will wish to ensure that, when they sell their
shares, they pay tax at the 10% rate, being the capital gains
tax payable on shares in trading groups once the shares have
been held for two years. The 30% differential between the
capital gains tax rate and the income tax rate also makes it
crucial to ensure management receipts fall within the capital
gains, rather than income tax, environment. It is also in the
interests of the employing company to avoid income tax
treatment because, if income tax is payable, the employing
company will be obliged to pick up the associated employers
national insurance contributions at 12.8%. To fall into capital
gains tax you have to fall outside a myriad of anti-avoidance
provisions, which have been introduced to ensure that only
genuine share consideration attains the preferential (capital
gains tax) rates.
One particular issue of debate is the tax treatment of
ratchets. Ratchets are a mechanism under which the management's
percentage shareholding in a company can increase if various
targets are satisfied. The targets ordinarily relate to the
investors return. The ratchet rights are generally enshrined
into the managers' shares from the outset.
Until 2003 the increase in value resulting from the
operation of a ratchet was accepted as falling within capital
gains tax (potentially 10%) rather than income tax. However
HMRC's practice changed in 2003 (as did the underlying
legislation). HMRC now believes that ratchet increases are
susceptible to income tax.
HMRC has however agreed that income tax will not be
applied to ratchets if various conditions stipulated in the MOU
are satisfied. In particular, the MOU requires management to
pay a premium on the ratchet shares to ensure capital gains
treatment on exit.
It is clearly preferable to satisfy the requirements of the
MOU if it is possible to do so. However many advisers dispute
HMRC's right to lawfully charge income tax on ratchet
increases, even if there is no compliance with the MOU.
How about secondary buyouts?
If you have fallen outside the anti-avoidance provisions
then the increase in share value is not taxed as remuneration
and a management team can expect that capital gains tax will be
payable on their proceeds. But this will not always be
the case on a secondary buyout where management are required to
reinvest into shares in a Newco. In such circumstances there is
a risk that HMRC would seek to treat a proportion of the
management's consideration as if it were received as a dividend
and thus taxable at 25%. In essence HMRC is then taxing the
transaction as if the shareholders had continued as
shareholders of the target and had instead taken increased
value from the group by way of dividend.
As with any other sector, the private equity industry needs
to continually monitor developments in tax legislation and to
adapt to the challenges posed by those changes. There has been
a plethora of new tax laws affecting the UK private equity
industry since 2003 and the need to adapt to those challenges
has been particularly acute for that reason.
The success of the UK private equity market continues
unabated, with UK-based private equity funds raising several
tens of billion pounds during 2005 alone. The ongoing success
of this industry will ensure that tax-efficient structures will
continue to be of great importance for many years to come.
Kathleen Russ is a partner at Travers Smith in the
Tax department. She specializes in the provision of tax
advice in private equity transactions. She is a member
of the British Venture Capital Association Tax
Chris Hale is a partner at Travers Smith and is head
of the firm's Corporate department. He specializes in
UK and international buyout work and he acts for
institutional investors and management teams on
investments and divestments, as well as private
equity-backed companies on M&A and other corporate