As merger and acquisition activity begins to pick up, it’s worth revisiting recent changes in tax legislation and anti-avoidance developments that are of particular relevance to deal structuring. In this edition of Tax Advisor Update, Ian Fleming and Jonathan Hornby consider the issues in a private equity context, but also raise technical points of equal relevance to corporates of all sizes, particularly those contemplating M&A activity and transactions involving debt.
Deductibility of Financing Costs
The state of the external debt markets of recent times has had adverse implications for the amount of shareholder debt that can be introduced into the typical PE structure, whilst remaining within the arm’s length limit of borrowing. The rules require that borrowing capacity is assessed at arm’s length when the original financing packaging is agreed, and so many taxpayers believe that this is only an issue for new deals. This is true to a certain extent, but any adjustment to the terms of the shareholder debt used to fund existing deals can effectively ‘reset the clock’ for these purposes, and the original lending multiples determined in a more buoyant market may no longer be appropriate.
Whilst traditional bank debt is still not as freely available as we would like, there has been a three-fold increase in the issuance of high yield debt in 2009 compared to the previous year, albeit still significantly down from 2007 levels. This should now foster an environment for increasingly favourable comparators for transfer pricing purposes when evaluating the amount of shareholder debt that is appropriate in a structure.
Much has been written on the new corporate debt cap rules, which potentially restrict a deduction in the UK for interest expenses. The general position is that if the aggregate of the UK net financing expenses exceeds the worldwide group’s gross financing expenses, the excess is disallowed. In a private equity context, it might be expected that this would not have significant application on the basis that the portfolio group has a large amount of external debt comprising shareholder and bank debt. However, care must be taken to determine what the relevant group is for these purposes. Whilst in the vast majority of cases, it is expected that the ultimate parent company would be the top portfolio holding company, this might not always be the case. The fund vehicle and the rights and powers of the general partner will need to be carefully evaluated on a case-by-case basis to confirm the position. There have also been changes to the late paid interest rules. Historically, in private equity structures, interest on shareholder debt would only be deductible for tax purposes when actually paid. This debt would be structured as a ‘payment in kind’ (PIK) instrument so that the interest could be paid for tax purposes by issuing further loan notes in satisfaction of the interest payment. The recent changes provide for such interest to be deductible for tax purposes on an accounts accruals basis when the lender is in a treaty friendly jurisdiction.
Whilst an accruals basis looks more attractive at first glance, the ability to plan the timing of the tax deduction (for example, to avoid stranded losses) will be lost when the lender is a limited partner in a treaty-friendly jurisdiction or when the debt is lent via a treaty-friendly jurisdiction, such as Luxembourg.
When a fund has a large number of investors, it might not be practical or possible to determine their tax residence and, therefore, their entitlement to treaty benefits. In these circumstances, HMRC has stated that it will take a pragmatic approach and continue to apply the late paid interest rules, so that the timing of deductions can continue to be managed by issuing PIK notes.
The general position in which a lender forgives its debt or a group buys back its debt at a discount to face value is that the amount of the forgiveness or discount is taxed on the borrower. In the current climate, we have seen an increasing number of groups buying back their debt from financial lenders at a discount. Planning was available to mitigate the taxation of the discount by taking advantage of legislative exemptions for corporate rescues. HMRC has recently deemed this planning to be abusive and has issued draft legislation containing a new corporate rescue exemption. Unfortunately, this new legislation contains very high threshold tests in order to apply. One of the more onerous tests is providing substantial evidence that a change of ownership of the borrower needed to take place to prevent insolvent liquidation. The subjective nature of this test could create significant uncertainty and, as such, may be an area in which we see increasing use of the non-statutory clearance process.
In the current environment, we have seen acquisitions in which the target company’s results have deteriorated to the extent that the tax value of its fixed assets is more than their market value. This can arise due to the fact that the target has deferred its claim for tax depreciation, given that a company that is incurring losses has no need to take a current year deduction. The deferred tax depreciation would be available in later years and can be surrendered to other group members. Historically, it was possible to acquire a company with previously unclaimed tax allowances and use them to shelter either the profit of other companies in the purchaser’s group or against the profit of a ‘new’ trade carried on in the target company.
HMRC has announced new anti-avoidance legislation aimed at restricting the use of these allowances in such circumstances in which the acquisition was part of arrangements to avoid tax. When evaluating acquisitions of companies with such excess tax allowances, the availability of these post-completion requires consideration in the context of the new rules.
HMRC is currently making a concerted effort in challenging VAT recovery on deal fees and a number of cases are progressing. Generally, these investigations focus on who is receiving the supplies. In a private equity context, engagement letters should be carefully considered to ensure services are seen as provided to the company, rather than other parties, for example, the lending banks. Furthermore, when a ‘newco’ is being set up to make an acquisition and receive the supplies, the set-up should be executed expeditiously to avoid any disputes around the inability to receive supplies because the entity did not exist.
In times of greater HMRC scrutiny, it is also wise to ensure that, where a fund is considered to be offshore by virtue of the general partner being offshore, there is sufficient substance in the general partner’s offshore location to support this. The general partner should actually be performing activities consistent with the role of a general partner in order to avoid the risk that it is merely acting through the onshore management company.
50 Per Cent Tax Rate
Planning opportunities in regards to the soon-to-be introduced 50 per cent top rate of income tax were covered in November’s issue of . It will become increasingly important in transactions to consider options for portfolio company management teams, so that they may take advantage of planning opportunities such as share incentive schemes and deferral planning. Again, HMRC has announced the introduction of anti-avoidance legislation to attack the most aggressive deferral planning, often involving offshore trusts, so care must be taken in this area. The rate change once again increases the differential between income tax treatment and capital gains, which are taxed at 18 per cent and ensure that management’s exit is taxed as capital is more important than ever.
From a private equity executive point of view, investing via a carried interest scheme to achieve 18 per cent on exit is also more significant. Careful planning on exits ensures investments are disposed of efficiently to create the most beneficial position for carried interest holders.
As the deal market picks up, it is still as important as ever to ensure that the structuring of a deal maximises any tax advantages. However, new and complex tax rules require careful consideration and navigation.
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