What you should buy and how you should buy it

Author: | Published: 1 Jan 2006
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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 be critical.

What should you buy?

The difference between shares and assets

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 limited company.

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 provisions.

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 double taxation.

How should you buy it?

Table 1: Standard acquisition structure

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?

Tax objectives

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 share.

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 disallowed include:

  • where the interest represents more than a reasonable commercial return for the use of principal secured;
  • where the corporate debt is convertible into shares;
  • 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 stock;
  • 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) instrument.

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.

Transfer-pricing rules

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 borrower.

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 liabilities.

Isn't all private equity finance arm's length anyway?

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 notes.

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 payment.

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 this issue.

Withholding tax

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 critical.

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 undervalue.

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 shares.

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.

The future

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.

Author biographies

Kathleen Russ

Travers Smith

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 Committee.

Chris Hale

Travers Smith

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 matters.