At a glance
- In Sweden, France and Belgium, tax authorities wish to combat "thin capitalisation" – financing a business with more debt than it can reasonably support
- The cost of debt is tax-deductible; the cost of equity is not. "Thin capitalisation" rules would push up efective tax rates
- Governments in Belgium and Sweden are also looking to rewrite tax anti-avoidance rules to limit what they see as aggressive tax planning
Towards the end of 2007, as bonuses were peaking but the economy was already teetering on the brink of crisis, the private equity industry found itself at the centre of vehement attack from numerous quarters, including governments and the press.
At that time, it was management and private equity executives who were in the firing line. They were criticised not just for their opportunities to earn substantial rewards from the businesses they were acquiring and running for their private equity investors, but also for the very favourable rates at which such rewards were likely to be taxed in many jurisdictions.
Despite the uproar, the measures ultimately taken by governments in response to the criticisms were relatively benign. Although far-reaching changes to the taxation of carried interest were proposed in the US, such changes have still not been enacted. In the UK, there were some changes to the remittance basis of taxation which benefits "non-domiciled" UK residents, but the system survives largely intact and continues to apply to many UK-based private equity executives who have settled in the UK from abroad. The taxation of carried interest and management equity incentives generally within the private equity industry, both in the UK and elsewhere in Europe, emerged relatively unscathed.
The latest onslaught on the private equity industry looks set to be more far-reaching. The weeks leading up to Christmas saw a series of proposals by governments across Europe which, directly or indirectly, could undermine what has become the cornerstone of private equity deal structuring – the leveraging of acquisitions and buyouts. Naturally in straitened economic times, governments are looking to all means available to them to raise revenues, but it is difficult to avoid the conclusion that it is private equity which is once again in the firing line.
In Sweden, France and Belgium, within the space of just two or three weeks, proposals were announced aimed at countering so-called "thin capitalisation". According to the tax authorities, thin capitalisation means financing a business with more debt than it can reasonably support. A business will generally be regarded as thinly capitalised if it is financed with more debt than a bank would be prepared to lend the business – in other words, where the shareholders are funding the business with debt when they should, in the eyes of the tax authorities, be providing equity funding. The tax authorities' objection, of course, is that the cost of debt is tax-deductible whereas the cost of equity is not. Thin capitalisation rules will typically restrict interest deductibility (on shareholder debt in particular) and thus push up effective tax rates.
A familiar target
In France and Sweden at least, it is clear that the proposed new rules are specifically targeted at private equity. The French rules will restrict interest deductibility where a French company is set up to acquire a target using debt but management and decision-making in relation to the acquired target are deemed, in reality, to be exercised outside France (such as by the management team of a private equity house).
In Sweden the proposed rules will similarly restrict the deductibility of interest on shareholder debt, clearly impacting private equity investors. In addition, in a more politically inspired move, the government has suggested it may seek to impose further restrictions on private equity investments in the care and education sectors. Management of businesses in these sectors has come in for widespread criticism in Sweden, with part of the blame at least being placed at private equity’s door.
More generally, governments and courts are moving to tighten up anti-avoidance rules in their tax systems and clamp down on what they perceive as aggressive tax planning. In Belgium, proposals for the rewriting of the general tax anti-avoidance rule look likely to lead to a tightening of the law, and in the UK proposals have now been put forward for the introduction of a general anti-avoidance rule. In Sweden a series of decisions by the courts shortly before Christmas also looks set to limit the scope of what will be regarded as legitimate tax planning. So have the favourable tailwinds which have buoyed private equity for so long finally swung round? The answer will depend on how governments and tax authorities choose to implement their latest raft of proposals.
A question of balance
It is possible that we may see a reprise of 2007/2008. Private equity has become a mainstay of the US and the major European economies. It cannot be in the best interests of governments to force private equity to the point of near extinction. "Thin capitalisation" and "tax avoidance" are to some extent subjective concepts. No one is expecting governments to perform U-turns and withdraw their latest proposals, but it will certainly be open to them to implement their new measures in such a way that they do not deliver a mortal blow to leveraged acquisition structuring. Otherwise we will indeed see margins severely squeezed and perhaps fewer deals reaching ever higher viability thresholds.
Aggressive tax planning is a legitimate target for governments, at no time more so than when raising revenues is paramount, but encouraging investment and economic activity is of paramount importance too. Governments will surely recognise the role of private equity in enabling them to achieve these goals.
Elizabeth Conway is a partner in the tax team at Linklaters.