Private equity's tax model under scrutiny

While there have not been any notable signals of reforms to carried interest in Europe outside of Sweden's high-profile tax court cases, recent events in the US could prompt European authorities to review the current situation. The debate around carried interest has been ongoing for many years across the Atlantic without any dramatic changes; however, this year many commentators are confident that taxes will be raised.

In February 2014, former House Ways and Means Committee chairman Dave Camp, writing in the Wall Street Journal, urged Congress to overhaul carried interest, as it enables "private equity firms to get the investment income tax rate on what anyone else would call a normal wage income".

Since this call for action, the Tax Reform Act of 2014 includes a proposal to "tax a partner's share of income as ordinary income". At the beginning of this year, reports have surfaced that 75% of the US Congress would vote to raise taxes on the industry. The reasoning behind this change of heart is simple: based solely on the US's biggest listed private equity firms – KKR, Apollo, Blackstone and Carlyle – if carried interest were taxed at 42%, the tax revenue generated would total $2.2bn over the next five years.

Preferential treatment
In the 2016 Green Book, the US Federal Reserve's outlook for the coming fiscal year, the proposed action on carried interest is made clear, labelling it as "an unfair and inefficient tax preference". It goes on to say: "The recent explosion of activity among large private equity firms and hedge funds has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefiting from the preferential treatment."

The Green Book proposes that to retain carried interest, the partner's invested capital must be a qualified capital interest; that it must be significant. Furthermore, the proposal also sets out that invested capital must not come from loan proceeds or any other form of advance made by the GP.

This proposal strikes at the heart of the carried interest debate: substantial GP contributions. Despite the UK's tendency to follow trends in the US, local practitioners are not worried: "Carry doesn't seem to be driving the debate in the UK as it is in the US," says David Thompson, a partner at DLA Piper with a focus on tax.

But GPs are rarely confined to one country, especially when raising new vehicles. And it would seem that activity in the US reflects the current feeling among LPs in general. Speaking about Terra Firma's new strategy, in which it is investing from a $1bn pool of capital comprising its own money as well as third-party cash, Guy Hands says: "Terra Firma is going back to basics. A lot of private equity firms don't put much of their own money into their funds or investments. But if the fund or the investment is good, they should be putting their money where their mouth is."
Hands points out that to ensure alignment with private equity sponsors, managers of target companies are asked to put in a substantial part of the cash to fund the buyout. "It is only right that we live by the same rules."

Hands suggests that the UK government returns to the original agreement set up between HMRC and the BVCA, where tax relief is granted on "material" commitments. "It wouldn't be difficult to change back to this system. The current situation where private equity firms are simply seen as management companies rather than entrepreneurial businesses isn't good and has made private equity a pariah."

However, Robert Young, a partner in the corporate tax practice at Taylor Wessing, says: "For there to be a wholesale change to the tax treatment of carried interest in the UK, tax authorities would have to effectively withdraw adherence to the BVCA's Memorandum of Understanding (MoU), which, in any event, just validates the application of normal capital gains tax principles to tax-transparent vehicles in enabling carried interest holders to benefit from CGT treatment on their returns."

Looking to the MoU itself, the document states: "Investors require individual fund managers (or the management company) to make a material investment in the fund, in addition to their contribution to the capital of the fund, so that those managers expose their own money to the same commercial risks as those to which the investors are exposed."

Defining how much a partner should contribute to the fund was a central issue of the tax court cases in Sweden last year. The Swedish tax authority had launched cases against around 70 individuals, which could have seen retroactive charging of income tax where carried interest had been taxed as capital gains. The claims totalled nearly SEK 5.3bn.

Nordic Capital was the first firm to face trial and, in November 2014, the GP won its case against the tax authority, with Sweden's Supreme Administrative Court denying tax authority Skatteverket's appeal. When Nordic Capital won its case against the tax authority in December 2013 (prior to Skatteverket's appeal), the resulting document stated that key executives receive carried interest as a reward for personal investments and therefore defined carried interest as capital gains.

Speaking anonymously, one GP tells unquote": "Carried interest at its purest form involves a GP making significant investments into its funds – ensuring alignment with its investors. Across Europe, the situation has been made more difficult by the growth of mega funds." Indeed, the larger the fund, the bigger the management fee.

According to another unnamed source, there has recently been a situation where a major LP wanted to see a 6% GP contribution, but the issue was ignored and went away because there was enough demand for the vehicle. "We are likely to see pressure on carried interest going forward," continues the source. "Quarter by quarter, the industry's clients (LPs) will put more pressure on fees and performance-related pay. Where performance is not good there will be an issue."

Guy Eastman, chief investment officer and co-head of private equity fund investment at Aberdeen SVG, says: "GP contributions vary from firm to firm. But it is more a question of what motivates people; not everyone is motivated by money." Eastman says that part of Aberdeen SVG's diligence process looks at what motivates teams.

However, Eastman believes that if there were to be changes to carried interest, everyone would be in the same boat. "A change could mean that funds move offshore, or people move offshore. The smart guys are flexible and people are mobile," he says.

Interest deductibility
While changes to carried interest might not be at the top of European tax authorities' agendas just yet, there is already action underway when it comes to interest deductibility.

In 2013, the G20 mandated the OECD to find ways of preventing base erosion and profit shifting (BEPS). The resulting action plan puts interest deductibility under the spotlight. This is an issue close to private equity's heart. As the majority of deals are financed with a substantial level of debt, the industry has arguably benefited from not having to pay tax on debt interest.

A 2013 study by the Financial Times, which reviewed tax contributions of New Look, Iglo and Merlin Entertainment, found these groups paid less than 11% of their operating profits in corporate taxes since 2007 on a cumulative basis, thanks to interest deductibility.

The industry has done well in defending its use of interest deductibility. In response to the FT's research, Tim Hames, director general of the BVCA wrote: "The tax deductibility of debt interest encourages growth and investment, and it is wrong to suggest this policy is used for tax avoidance."

Now, with the topic under discussion as part of the OECD's BEPS Action, practitioners are becoming concerned about potential changes. Says Nikol Davies, a partner in the tax practice of Taylor Wessing: "Some of the recommendations coming out of the BEPS Actions for best practice are worrying as the proposals would cut across the UK's long-established rules, particularly regarding areas relating to application of double tax treaties and the tax deductibility of interest on third-party debt."

The BVCA has responded to the OECD as part of the BEPS Action consultation. Its response again highlights the "important role debt plays in helping business to invest in new lines and geographical areas and employ more people." The BVCA believes that "interest should continue to be regarded as an ordinary business expense and generally deductible for tax purposes."

The EVCA also responded to the OECD, working alongside US association Private Equity Growth Capital Council, in a similar vein. "The EVCA is engaging with the OECD very actively. We jointly responded to the consultation and a large part of that was to explain how private equity works," EVCA public affairs director Michael Collins tells unquote".

Collins highlights that a number of the BEPS Action points appeared to have overlooked private equity. When reflecting on its original proposals on treaty abuse, the OECD seemed to accept that it had not properly considered the impact on collective investment vehicles. "We have spent a lot of time explaining how private equity uses debt and how essential it is. This is really to reassure them that the industry does not do anything untoward," explains Collins.

The EVCA is optimistic about the final outcome of the OECD's review of interest deductibility. "Unlike other action points it is likely that at the end of the process there will be some high-level recommendations for best practice, rather than strict global standards. There will probably be a menu of possible actions and it will be up to each member state to decide on how to treat them. There will be a margin for interpretation," predicts Collins.

At the time of writing, despite the rumblings around carried interest and interest deductibility, the outlook for private equity is fairly clear. We will have to wait and see what happens across the pond but, for the time being, Europe appears to be supportive of the industry and its treatment of tax – the Swedish court cases have done a huge amount to discourage other national tax authorities from looking into the issue. And those closest to the OECD's work on BEPS are confident that any new measures will be left to individual finance ministers to implement as they see fit. With many European jurisdictions tending to support business and investment, we can be fairly certain that there are unlikely to be any industry-threatening changes in the short term.

However, the underlying reason behind current reviews of tax treatment still holds – Europe has a major welfare problem and something has to give. Private equity is a maturing industry, making it an easy target for authorities and mainstream media. And given the European Commission's view that the current tax regime is not significantly encouraging to equity, the final result of the OECD's BEPS Action will be interesting.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Regulation
• Nordics
• France
• UK / Ireland
• Benelux
• CEE
• Southern Europe
• DACH
• tax
• Top story
• EVCA
• BVCA
• Taylor Wessing
• DLA Piper
• SVG Capital
• Unq2015Mar