Private Equity Group
Exploring changes in the fiscal
environment and their impact on
Private Equity
27 January 2004
kpmg
Private Equity Group
Exploring changes in the fiscal environment
Private Equity Group
 The scope for debt push-down in leveraged investments
 Investor issues
 A trend back to preference shares?
 Executives’ share incentives and carried interest
 New fund vehicles?
 Country summaries
 Germany
 Netherlands
 Italy
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A “typical” leveraged buyout
Private Equity Group
Fund
Buffer company,
eg Luxco
Shareholder loans £25
Institutional ordinaries £9
Management ordinaries £1
Newco 1
Bank/mezzanine £65
Newco 2
Target
(£100)
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The scope for debt push-down
Private Equity Group
 Thin capitalisation
 Permitted debt/equity ratios come down in Germany to 1.5:1, and limits now also apply to commercial limited
partnerships (KGs)
 Italy, formerly without formal limitations, has a 3:1 limit from 2004
 Some signs of the UK Inland Revenue getting tougher
 Following the Langhorst case, most EU countries are now introducing restrictions for local, as well as foreign,
lenders. Spain is the notable exception
 All points to climate for ultra-leveraged structures become more hostile
 “Churning”
 France has long prohibited relief for interest on internal pushdowns. Netherlands, and now Italy and Germany,
have followed suit
 Efficient tax leverage of secondaries and former family companies becomes more difficult
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The scope for debt push-down (2)
Private Equity Group
 Tax Grouping
 Introduced in Italy from 2004
 Netherlands (like UK) now permits tax grouping immediately on acquisition
 Marks & Spencer case threatens tax grouping throughout EU, unless the proposed EC grouping directive
is revived
 Conclusions
 Mixed messages, but fund managers may have to accept that leverage will not be entirely tax-effective
in future in some European countries
 Could this drive a move back to preference shares in MBO structures?
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Investor issues
Private Equity Group
 US Investors
 Old issues (Unrelated Business Taxable Income for tax-exempts etc) remain
 Non corporates now pay 15% instead of 35% on capital gains and qualifying dividends
 Funds are becoming increasingly sensitive to US taxable investor issues eg ‘dry income’
 German investors
 Germany joins US and UK as a constituency for whom funds take more care over tax issues
 Official view of what makes an ‘asset management’ fund reconfirmed
 Funds may now plan short-term holds eg strategic stakes for P to Ps, syndications, through SPVs
 Others – dividends and gains generally more favourable than interest
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A trend back to preference shares?
Private Equity Group
 Earlier leveraged deals generally used preference shares to deliver the hurdle return to investors
 Use of loan notes now commonplace, due partly to corporate law (redeemability) but also interest deductions enhance
cashflows of investee and facilitate increased leverage
 It is becoming harder to deduct interest on shareholder loan notes – why give investors taxable, ‘dry’ income, if there is no
benefit to the investment?
 Investors generally enjoy lower, or no taxation, and on a cash-received basis, on dividends or capital gains
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Executive share incentives
Private Equity Group
 Major new rules in the UK, aimed at abuse of listed company share schemes
 Management now automatically assumed to have invested by reason of employment
 If “Initial Unrestricted Market Value” (IUMV) of management shares exceeds subscribed price, the excess is subject to
income tax and NIC
 Manager can either elect to pay tax and NIC on this excess now, or
 Pay it on a proportion of the ultimate capital gain
 Example
 If IUMV is valued at £1.50, and manager subscribes £1, income tax and NIC will apply to 0.50/1.50 of the total gain
at exit.
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Executive share incentives (2)
Private Equity Group
 Situation led to discussions between the BVCA and the Inland Revenue, culminating in the “Memoranda of
Understanding” (MOUs)
 Under the Management MOU, managers can now enjoy CGT treatment (10% minimum rate, no NIC) only if they meet
both of the following conditions:
 Institutional preference dividend/loan note interest is ‘commercial’, ie exceeds highest third party finance rate
borne by investee
 Price subscribes reflects the full potential of any ratchet
 Example
 If management have 10% of ordinary shares, and are entitled to share 10% of institution’s proceeds in excess of 2x
investment, they must subscribe 20% of total ordinary equity subscription monies for a 10% holding
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Carried Interest
Private Equity Group
 Major developments in UK and Germany
 UK
 Fund managers could be taxed on a portion of their carry gains in a similar fashion to management’s shares
 A second MOU provides considerable comfort, where carry arrangements are market-standard (20% after 8%
hurdle) and entitlement acquired before fund makes first investment
 New joiners, or old hands benefiting from reallocation of a leaver’s entitlement, may have an income tax liability,
but the principal treatment remains hugely beneficial
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Carried Interest
Private Equity Group
 Major developments in UK and Germany contd
 Germany
 Finance ministries (Federal and Lander) have for some time been arguing that carry should be taxed fully as
professional income, instead of exempted or subject to half-income basis as investment gains
 Current official position remains as above but
 Rumours of draft law which largely reinstates the original half-income proposition
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Germany – key features
Private Equity Group
 Tough new thin capitalisation rules coming in
 Debt/equity ratio being limited to 1.5:1 for all companies (formerly 3:1 for holding companies)
 Limits will apply to KG holding structures, previously unlimited
 Limits apply to all related party debt (including German) and to third party debt covered by guarantees.
Subordination of shareholder debt to senior will for these purposes be a ‘guarantee’
 Restrictions on use of pre-acquisition losses – max 50% of annual profit can be sheltered
 5% of dividends received effectively taxed, by equivalent disallowance of related expenses
 Official view of ‘asset management’ fund reconfirmed - average holding 3-5 years, no active management, no fund-level
borrowing
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Germany – key features contd
Private Equity Group
Potential fix for guarantees
Fund
Subordination of loan note to bank debt
would be construed as a guarantee for
thin cap purposes, but if notes are
structurally subordinated into a higherlevel company, this is not a guarantee
for thin cap purposes
Loan notes
Newco 1
Bank/mezz
Newco 2
Target
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Netherlands – key features
Private Equity Group
 Tax grouping for 95% + subsidiaries
 From day one after acquisition
 No deduction for interest on debt pushed down through an internal restructuring
 Tough new thin capitalisation rules coming in
 Debt/equity ratio being limited to 3:1, from 6:1
 Further restrictions may apply where lender has >33% of shares, through deduction deferral rules
 But old restrictions on deducting interest relating to loans financing foreign shareholdings have gone
 No withholding tax on interest
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Italy – key features
Private Equity Group
 Tax grouping from 2004
 From first full year after acquisition
 Previously had to rely on mergers, or on refund claims for dividend tax credits
 New thin capitalisation rules coming in
 Debt/equity ratio being limited to 3:1, previously no limit
 Can no longer deduct interest on loans to finance foreign shareholdings ie ones which cannot be tax-consolidated
with the Italian parent
 New anti-avoidance provision to prevent debt push-down by internal restructuring
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