Private equity industry braces for tax changes

The private equity industry is bracing itself for several changes to UK tax rules, which could affect how deals are structured and be “very damaging” for private equity portfolio companies.

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Many lawyers and the industry’s trade body expect the government to make an early-stage announcement on changes to the tax deductibility of debt in the Budget on March 16, as part of global plans by the Organisation for Economic Co-operation and Development to crack down on tax avoidance by multinational companies.

Under existing UK rules, the cost of interest payments on debt can be deducted from corporate tax, which reduces the cost of debt and can help cut overall tax bills for companies that are financed using high levels of debt.

But the OECD wants to introduce rules that make it harder for companies to finance subsidiaries in high-tax jurisdictions with loans from group entities based in low-tax jurisdictions.

The UK government consulted on changing the tax treatment of debt in October, proposing a rule that would only allow a company to deduct net interest of between 10% and 30% of a company’s earnings before interest, tax, depreciation and amortisation.

Another proposal is to limit the use of intra-group loans, which could make it difficult for private equity firms to use ‘shareholder loans’ – this is a common practice where private equity firms structure their equity to fund a buyout through a funding vehicle that issues the loan and receives interest payments from the portfolio company.

The British Private Equity & Venture Capital Association said in response to the consultation that it disagreed “as a matter of principle” with changing the tax treatment of debt and said that the changes could be “very damaging to the UK economy”. The BVCA added that it “could have a significant effect on business cashflows and forecasts” and might lead to cost cutting and job losses at private equity-owned companies.

The Budget is likely to provide some limited guidance on the changes, with more detail likely to emerge later this year as the government further consults on the issue, executives said. Simon Letherman, a partner at law firm Shearman & Sterling, said HM Revenues & Customs had not “really nailed their colours to the mast on what things will look like, bar saying ‘we are keen to do this’.”

It is unclear exactly when the changes will kick in or whether the rules would be applied to companies that already have financing packages in place when the rules take effect, known as grandfathering.

Heather Corben, a partner at law firm King & Wood Mallesons, said: “I think clients are certainly looking at this closely but it’s difficult to have contingency plans at the moment because it’s not known quite what is going to happen and it depends to a large degree on what grandfathering is allowed.”

A further change that is due to come into effect in the UK on April 6 is to the tax treatment of deal profits, known as carried interest. The changes, which were agreed in December, have introduced the concept of ‘good carry’ and ‘bad carry’.

The new rules mean that private equity firms will have to prove that their funds own businesses for four years or more, on average, before their executives can qualify for the tax break, which allows them to pay capital gains tax at 28% rather than income tax at 40% on their deal profits.

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