Looking back, moving forward

Author: | Published: 1 Apr 2007
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Highlights of last year

The Indofoods case

Private equity-backed deals are often implemented using structures including a Luxembourg holding or finance company. This has a number of advantages. In particular, Luxembourg company law permits the use of more flexible equity-type interests than many other jurisdictions (the so-called alphabet stock and CPECs), which facilitate tax planning for US investors in particular. Luxembourg also has an extensive tax treaty network (including a treaty with the UK which, being old, does not contain a treaty shopping provision restricting benefits where an entity is established in Luxembourg purely to take advantage of the treaty).

In February 2006 the Appeal Court gave its judgment in the case of Indofoods, which raised questions as to whether taxpayers could rely on tax treaties in some circumstances. This case concerned a company's ability to invoke an early repayment provision in some issued bonds, but it turned on the question of whether it was reasonable to require the issuer to carry out a hypothetical restructuring of the bonds, routing funds through a conduit company in a treaty jurisdiction. Indofoods held that it was not reasonable as, under Indonesian law, treaty relief would not have been available on the hypothetical transaction because the conduit company would not beneficially own any interest paid to it as required by the relevant tax treaty. It introduced the concept of an international fiscal meaning of beneficial ownership that was rather more restrictive than tax professionals had generally previously considered was correct.

The Indofoods decision caused great concern in the securitization markets, where the use of conduit companies is widespread (and great delight at HM Revenue & Customs, which had not even been aware that the case was proceeding until taxpayers began to ask it about the judgment). However, it is also potentially relevant in the private equity sphere due to the popularity of Luxembourg holding companies. If a Luxembourg company lends funds into a UK group, it will be important to ensure interest can be paid without withholding tax, and reaching this position might require a treaty claim. HMRC has now published guidance on what it considers the ambit of the Indofoods decision to be.

HMRC's guidance essentially focuses on whether there has been what it perceives as treaty abuse. If this is the case, HMRC might seek to apply the international fiscal meaning of beneficial ownership and argue that beneficial ownership was not established (and so treaty relief was not available) if interest was effectively earmarked for onward payment. This position is controversial in a number of ways, not least in that the court in Indofoods was considering what the Indonesian legal position might be and that most treaties now contain anti-abuse provisions (although the UK/Luxembourg treaty does not), which might be considered as implying that there is no general anti-abuse principle within the meaning of beneficial ownership to be relied upon in the absence of express provision.

It is not entirely clear that HMRC could seek to invoke Indofoods against many private equity structures, although it does seem that there will be some structures with a degree of vulnerability. Among the examples given by HMRC of abusive cases was a loan by a Luxembourg entity established or maintained so that the source of the loan was an entity that could not have received interest gross directly from the UK. This might be the case in some private equity transactions. On the other hand, the guidance can be seen as helpful in indicating the structuring steps that might be required to fall outside HMRC's interpretation of treaty abuse. For example, the guidance explicitly identified as non-abusive a Luxembourg entity raising the funds to lend on into the UK by way of a quoted Eurobond, so withholding would not have been due on a direct issue of that instrument from a UK borrower.

Before the Indofoods decision, industry practice was not to rely solely on treaty relief but rather to list private equity debt on the Channel Islands Stock Exchange and rely on the quoted Eurobond exemption. Since Indofoods, it is likely to become the norm to list even if the lender is Luxembourg resident, to prevent the question arising in cases where the withholding cost is not acceptable.

HMRC reverses on ratchets

On a happier note, the year past saw a helpful development in relation to the taxation of ratchets. These are arrangements where the proportionate share of exit proceeds to which managers are entitled increases as the amount of those proceeds passes certain milestones.

HMRC's Memorandum of Understanding with the British Venture Capital Association (the MoU) covers the tax treatment of ratchets in some detail. In particular, in the broadest terms, it provides that the proceeds of sale of shares with a ratchet entitlement will not be taxed as income under the restricted securities legislation as long as the managers have paid a price per share reflecting the maximum equity value that they could receive on exit if the company performs at the top of the ratchet.

Until August last year, HMRC had however indicated that it believed it was able to impose an income tax charge on managers' extra entitlements under a ratchet by virtue of the special benefit provisions that apply when value is injected into shares held by managers after acquisition. If correct, this would have meant a portion of any proceeds would be subject to income tax and National Insurance contributions (at a total rate of 53.8%) rather than capital gains tax (at an effective rate of as little as 10%). This view was widely considered to be wrong, as long as the ratchet operated in accordance with rights already inherent in the shares when acquired (as was almost invariably the case) – the inherent rights should only be taken into account for the upfront tax charge, if any, on issue.

Additionally, HMRC previously indicated that it would seek to apply the special benefits charge if a company was thinly capitalized, that is, if it had debt levels from connected party lenders that would be unavailable from third parties, on the basis that this could lead to managers receiving a disproportionate return on equity. This view was also widely believed to be wrong. While clearly high gearing is capable of resulting in large equity returns, it also reduces the likelihood of any equity return. This is the nature of an equity investment that is subordinated to a high level of debt.

HMRC's position was also questionable on principle: there would be little point in offering the safe harbour under the MoU in respect of the restricted securities provisions if it intended to subject the same benefit to income tax under a different piece of legislation.

In August last year HMRC admitted defeat on these points, putting out a press release stating that, if the terms of the MoU were complied with, it would not seek to impose income tax on any part of managers' returns. This followed advice it had taken from external counsel. While this is immensely welcome, and clarifies an important area of uncertainty, it is clear that hostility to ratchets at a policy level remains and a number of advisers have found HMRC keen to find technical grounds for not applying the MoU. As such, and especially given the current level of media focus on returns in the private equity industry, it is possible that we will see a change either to the relevant law or to the MoU.

The road ahead

There are three aspects of private equity tax of general interest in the year ahead. The first is certain changes of law (relating to the transfer-pricing regime and the timing of interest relief) made in 2005, which come into effect for pre-2005 structures from April this year. The second is the review announced by the government on the tax deductibility of interest on shareholder debt, and the third is how tax legislation will apply to private equity investments on a market downturn.

End of grandfathering

On March 4 2005, HM Treasury announced a package of changes to the rules for tax relief on financing costs, under the (arguably misleading) heading Action Against Tax Avoidance. These changes have been an important consideration for UK private equity structures introduced since March 2005 (new structures). However, two main aspects of the changes only apply for accounting periods commencing after April 1 2007 to structures that were in place on (and have not been varied since) March 4 2005 (old structures). So old structures should be reviewed to consider whether the end to grandfathering justifies restructuring of financing arrangements and, if so, how this should be done.

The first change made in March 2005 was to the transfer-pricing rules. The transfer-pricing rules apply where two or more persons in a close relationship enter into a transaction on different terms to those that would have been adopted had the parties been unrelated and a tax advantage results for one of those persons. Where the transfer-pricing rules apply, the (tax) advantaged person is required to adjust its tax position (through its self-assessment to tax) to eliminate this advantage. For example, if a company receives debt funding of a greater amount than an unconnected funder would have been prepared to provide, the company should self-assess itself as if the relevant proportion of the interest were non-deductible distributions.

Before 2005, the relationship test required majority control – either the persons were in common control or one controlled the other, or, in the case of a company, two persons each had a 40% interest in it. It became clear before March 2005 that the private equity industry and HMRC interpreted this legislation in different ways in certain circumstances (in particular, in relation to the treatment of partnerships where none of the partners controlled the partnership). The 2005 changes to the relationship test put this beyond doubt, and indeed extended the test further.

The changes extended the required relationship in the case of financing arrangements. It is enough that the provider of the financing arrangements (the lender) acted together with other persons in relation to the financing arrangements and the lender would have control of the recipient of the financing arrangements (the borrower) if interests in the borrower held by those other persons were attributed to the lender. So, if the lender acts together with holders of a majority of the borrower's shares, the test would be satisfied even if the lender has no interest in the borrower beyond its loan.

The acting together test is broad (and deliberately so). HMRC considers that this covers collective or coordinated transactions without the need for equity involvement. It should, therefore, be prudently assumed that the transfer-pricing rules might apply to all financing arrangements in respect of acquisition finance in private equity.

In practice, tax relief on non-shareholder debt should not generally be restricted, as it should usually be possible to show that this is on arm's length terms. However, in some circumstances relief on non-shareholder debt might be restricted or the risk of HMRC challenge might be higher (such as where guarantees have been given by non-UK parent or sister companies).

It is principally shareholder debt that could be affected by the changes. Before these changes, in certain circumstances shareholder debt was not thought to be caught, but that will cease to be arguable for old structures from April 1.

However, will the changes justify a restructuring of old structures?

In most cases, probably not if the only exposure is thought to be on the quantum of shareholder debt being excessive, as it is difficult to see what the restructuring could achieve. The new relationship test is too broadly drawn to be sidestepped, and HMRC has previously confirmed that the actual blend of debt and equity is not crucial, so greater tax relief might not be secured by capitalizing part of the debt.

Financing in private equity will usually be for fixed terms, and generally the time to assess the arm's length nature of the financing will be the time the arrangements are put in place. Conceivably, there might be some benefit in refinancing if the current arm's length financing would be more advantageous than that at the time of the original financing (or perhaps that the arm's length nature can be more forcefully shown on a refinancing).

There might, however, be non-tax advantages to such a restructuring – for example, accounting advantages by improving the balance sheet.

The second change related to the rules deferring tax relief until payment in the case of discount and late paid interest in certain circumstances, including where the debtor company is a close company and the creditor is a participator in that company. Most (but not all) private equity acquisitions are close companies after acquisition, so potentially these rules would then be in point where the creditor is a participator. Participator is a broadly drawn concept, including any person who possesses or is entitled to acquire share capital and so, as well as shareholders, will extend to option holders including mezzanine with an equity kicker.

Helpful exclusions previously existed that took almost all private equity debt out of the rules. The March 2005 change was greatly to reduce the extent of these exclusions, so that they will not be relevant to many transactions of any size undertaken by private equity.

Certain approaches have been adopted on new structures to ensure accruals-based tax relief. In particular, the use of payment-in-kind (PIK) notes has become common, although this gives rise to (mostly manageable) withholding tax issues. Also management taking loan notes will generally resist strongly the receipt of PIK notes as it creates a dry income charge.

Turning to old structures, whether the deferral of the financing costs is an issue will depend on the tax position of the relevant investment. Tax relief still arises on payment, so this gives some control over the timing of the deductions. Whether relief that is delayed until payment can then be effectively used will differ from case to case. If current relief is needed, a refinancing introducing PIK notes could be contemplated, but there is, to date, limited evidence of refinancing occurring. It is thought that this is largely because there is not enough tax capacity in target groups, or that the extent of the problem does not justify the cost (including the amount of executive time) required to restructure.

Interest deductibility

Over the past few months there has been increasing speculation that a review of the tax treatment of private equity transactions might be forthcoming. On March 8 the government announced a review into the deductibility of interest on shareholder debt on highly leveraged transactions (although explicitly ruled out reviewing interest deductibility in other circumstances). In one sense there is a measure of relief that the review has been announced and that its scope is more limited (at least for now) than might have been the case. However, the position has been made formally uncertain rather than just the subject of media speculation.

The financing of leveraged deals is crucial to their success (although interest relief on shareholder loans – the apparent target of the review – is rarely assumed in the financial modelling of transactions). An answer is needed from government as soon as possible.

Issues arising on market downturns

There has been some speculation as to how private equity-backed businesses (and indeed other highly leveraged businesses) might fare on an economic downturn. If such a downturn takes place, investors will want to try to achieve tax results that correspond to their commercial ones. They would hope for relief matching any loss sustained, and would certainly wish to avoid any charges arising when they made no profit.

The position in relation to share investments is not likely to be problematic. Where shares are entirely within the capital gains regime, subject to the substantial shareholdings exemption if relevant for UK resident corporate shareholders, capital losses should arise matching actual losses (although it is of course necessary to make a disposal of the shares to crystallize the tax loss unless HMRC can be persuaded that the investee company has fared so badly that the residual value in its shares is negligible – and in the case of many private equity deals the amount of share capital is limited).

Managers need to be aware that if they hold shares that they acquired at a discount, and did not elect to suffer employment tax on that discount at the outset, a sale of those shares at a loss will still give rise to an income tax charge on the proportion of the proceeds received matching the proportionate level of the initial discount. However, given that it is near-universal practice to elect to suffer any tax on acquisition, this point is not likely to arise often in practice.

More difficult issues arise in relation to debt, including shareholder loans. The basic rule for unconnected UK corporate parties to debt is that the creditor can claim tax relief in respect of any accounting provision it makes against a debt (although it is then taxed on principal repaid to the extent the provision turns out to have been excessive). The creditor making a provision has no tax consequences for the debtor. By contrast if a debt is waived, the creditor will obtain tax relief for the waived amount, while the debtor company will suffer a tax charge.

On the other hand, if the parties to the debt are connected, generally no relief is available for provisions made by the creditor, and a waiver leads to no tax consequences at all (that is, no relief for the creditor and no charge for the debtor). In many private equity deals, substantial amounts of debt will be provided by parties treated as connected to the investee companies.

The interaction of the connected and unconnected party regimes creates a number of oddities, in particular where the connection status of the parties changes (as might well take place on a rescue refinancing, where lenders might take equity). A number of provisions are designed to prevent disadvantageous tax results (or indeed advantageous tax results that HMRC thinks inappropriate) in these kinds of case, but it is far from clear that all function exactly as intended. In particular, for instance, relief for a provision made by a creditor might, in effect, be clawed back if that creditor later becomes connected to the borrower.

Where relief for accrued interest has not been given due to the rules that delay relief until payment of discount or interest to connected party lenders, a waiver of that interest or failure to pay the discount can in some circumstances give rise to a tax charge on the debtor despite no relief for the interest or discount ever being given. This appears an unduly harsh result and might not be intended.

Care is also needed if debt is capitalized to ensure that the capitalization process does not give rise to a tax charge for the debtor company. The legislation provides that a debt waiver in consideration of an issue of ordinary shares would not give rise to tax, but it is important to track this wording in any documentation effecting the capitalization. Likewise the full amount of the debt waived must be reflected in the company's books as consideration for the share issue. Even if the shares issued have a par value below that of the debt, the company's accounts must support the proposition that the consideration for the issue was the waiver of the full amount of the debt.