Private equity funds have built up an arsenal of techniques that help minimise tax bills at the companies they own and in their own firms.
So much so that research in 2014 by Brad Badertscher of Notre Dame University in the US found that companies that were owned by US private equity firms, on average, paid less in foreign and state taxes and were more likely to use tax havens than companies that were owned by their management.
So how does it work? The structuring of private equity deals and funds is incredibly complex and involves a dizzying array of entities located in different parts of the globe, but we spoke to lawyers to find out a few of the basic techniques that private equity firms use to reduce their tax bills.
1) Go offshore
Tax avoided: Tax on profits in two countries
Many private equity funds use complicated offshore structuring, mainly to avoid their investors paying tax in two countries. If a private equity fund was based, say, in the UK, and one of its investors was based in Bulgaria, then the investor might find he or she ended up paying tax in both countries. There are other benefits to being offshore, for example, private equity funds can keep their affairs private and do not have to file as many documents publicly.
When it comes to deciding which offshore jurisdictions to pick, US investors tend to prefer the US state of Delaware and the Cayman Islands, while European investors tend to opt for Jersey, Guernsey or Luxembourg. There are tax treaties in place that are supposed to stop the problem of double taxation. As a result, some private equity funds now base their funds onshore.
2) Create a “VAT group”
Tax avoided: 20% VAT on management fees
Private equity firms get paid a fee by their investors to run their private equity fund, known as a management fee, it is usually 1.5% to 2% of all the money committed to the fund. In the UK, any company that provides a service to a client has to pay VAT of 20%. Most private equity firms would fall under these rules as they technically provide a service to their fund and are legally seen as independent. For managing a £1 billion fund, a private equity firm can make about £20 million per year in management fees, which would result in a £4 million annual VAT bill.
In order to avoid paying VAT on the management fee, private equity firms will usually set up a separate English entity and form a VAT group. The new entity says it provides advice to the private equity firm and, in return, gets paid the management fee. The management fee is usually termed an advisory fee for tax purposes and, because the two entities are now part of the same group, the fund does not have to pay VAT.
3) Use a sweetheart deal
Tax avoided: 45% on deal profits; lower rate of 28% paid
The private equity industry negotiated a sweetheart deal with HM Revenue & Customs in 1987 to allow executives to pay lower rates of tax on their fund profits. Trade body the British Private Equity and Venture Capital Association reached a deal with HMRC to ensure that the profits that private equity dealmakers earn are not taxed as income (currently at a top rate of 45%) but instead are taxed at the lower rate of capital gains tax (now charged at 28% for private equity executives).
To use this sweetheart deal, private equity firms usually set up a Scottish limited partnership to collect deal profits, known as carried interest, which then get paid out to private equity executives. Scottish entities are used because they have different legal characteristics to English partnerships. Carried interest is typically 20% of all profits made on deals after investors have received an 8% rate of return. If a buyout firm with 20 executives made a £100 million profit on a deal, each executive could be in line for a £1 million payout, which would be subject to the lower rate of tax.
Some private equity executives argue that this special tax treatment is justified because executives invest in their own funds and put in the hard work to build
up an asset, so the profits are a capital gain and not just an extra part of their income. But the deal is not without controversy. In 2007, Nicholas Ferguson of investor SVG Capital said that private equity deal-doers sometimes paid less tax than their cleaning ladies. And US presidential candidates Hillary Clinton and Donald Trump both say they want to reform the tax treatment of carried interest.
4) Set up an offshore “topco”
Tax avoided: 0.5% stamp duty when company is sold
When a private equity firm buys a company, it usually sets up three entities to own and control the company. There can be up to six entities if a company has been bought by one private equity fund from another private equity fund.
Private equity firms typically locate offshore the top company in this structure. They do this so that when the company eventually gets sold, the buyer does not have to pay stamp duty, which in the UK is 0.5% of the overall sale price. The average private equity-owned business in Europe was sold for €131 million in 2015, meaning a potential stamp duty bill of about €6.5 million on the sale of an average UK company.
There are valid reasons to set up several entities when buying a company. Private equity firms do this because banks and other lenders want to feel comfortable that, if the company goes bust, they will be the first in line to get paid.
Lawyers use “structural subordination” to make sure that this happens – in essence, the closer the holding entity is to the company, the more likely a lender is to get paid back its money if a company goes bust.
5) Use debt to fund purchase
Tax avoided: Corporation tax at 20%
Private equity firms typically fund their purchases using lots of debt. In an average deal in Europe, a private equity firm will put up about half of its own money to buy a company and borrow the rest. Debt is used as a way to boost returns but it also has the advantage of reducing the amount of tax a company pays.
The debt used for the purchase is put on the balance sheet of the company that has just been bought.
As businesses do not have to pay tax on the money they spend servicing debt, this can mean that companies owned by private equity firms pay little to no tax.
Odeon & UCI Cinemas paid no UK corporation tax in the 2015 financial year and £100,000 in foreign taxes, despite having a turnover of £747 million and earnings before interest, tax, depreciation and amortisation of £95 million. Odeon had net debt of £394 million in 2015 and made interest payments of more than £95 million. Odeon is currently owned by Terra Firma, a private equity firm run by Guy Hands, but the company announced in July that it was being sold to AMC Theatres. Terra Firma and Odeon & UCI declined to comment.
By comparison, rival cinema chain Cineworld, which is listed on the London Stock Exchange, paid £18.4 million in overall tax in the 2015 financial year on a turnover of £706 million and ebitda of £155 million. That gave the company an overall effective tax rate of 18.5%, according the company’s results. Cineworld did not respond to a request for comment.
There are changes under way that could affect this. The Organisation for Economic Co-operation and Development has drawn up plans that would restrict the ability of companies to deduct their debt payments from their profits.
6) Structure equity as debt
Tax avoided: Corporation tax at 20%
Another technique private equity firms can use is to structure the money they use to buy a company – their equity – as a loan to the portfolio company. These are called shareholder loan notes and make the portfolio company notionally further indebted, so reducing its corporation tax bill.
Lawyers say there are good reasons to structure equity in this way. If a company goes bust, the private equity firm is more likely to get paid back some of that equity if it is structured as debt, because debt is a higher priority for bankrupt companies to repay.
7) Employee Shareholder Status
Tax avoided: CEO avoids capital gains tax of 18% on shares sold
The chief executives and other senior managers of private equity-owned companies use other methods to reduce their own personal tax bills. The government introduced Employee Shareholder Status in 2013 to encourage workers to own shares in the small and medium-sized companies they work for.
But private equity-owned companies have started to use this scheme as a way for their CEOs to cut their tax bills. CEOs and senior managers are often given shares in a company when it is taken over by private equity. They can then use their Employee Shareholder Status to avoid paying capital gains tax (at 18%) when they eventually sell some of their shares. Snack company Whitworths, which is owned by Equistone Partners, used the scheme in 2013.
Lawyers say some private equity firms have vowed not to use the scheme, saying this was not how the government intended it to be used.