A Practical Guide to Private Equity Transactions
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Tax issues for the investor
Typical structures range from UK limited partnerships,
1
foreign partner-
ships, UK companies, venture capital trusts, tax haven companies and com-
panies, such as Luxembourg SICAVs, which are able to secure the benet of
double taxation agreements. The structure adopted will be inuenced by a
mixture of commercial factors (such as where the executives of the private
equity investor are based) and tax implications. The minimum aim from a tax
perspective will be to ensure that a person investing through an investor is in
no worse a position than if it invested directly in an investee company. The
type of structure used will vary signicantly, depending primarily upon the
tax residence and tax status of the underlying investors, the type of underlying
investment being made by the investor, and the place in which such invest-
ments are to be made.
An investment in a UK investee company may generate a coupon on any
debt provided, dividend returns and gains from realising the investment. Each
of these is considered in turn below.
2.2 Returns from debt: withholding tax
Generally, when a UK company pays interest in respect of debt, it is required to
withhold income tax from such payments
2
and to account for such tax to HM
Revenue & Customs (HMRC); this is subject to a number of exceptions, the
main one being referred to below. For the private equity rm (and its investors),
tax withheld from interest payments will, at the very least, represent a cash ow
cost, and in some cases it will represent an absolute cost (i.e. if the private equity
rm (and its investors) is unable to recover the tax from HMRC, or if they do not
have a UK tax liability against which to offset the withholding tax).
Save in limited circumstances, there is no requirement upon Newco to
withhold tax from payments of interest made to another UK company or to
non-UK companies which are liable to UK corporation tax in respect of such
interest.
3
Thus, if the investor is a UK company, there should be no withhold-
ing tax obligation in respect of interest payments upon the investor debt.
Typically, most investors cannot rely upon the exception referred to above
because they are not structured as UK corporation taxpaying entities. For such
investors, one of three strategies is generally adopted to avoid any UK with-
holding tax upon the coupon on the investor debt, as follows:
(a) To make use of what is known as the ‘Quoted Eurobond Exemption’.
4
Where this exemption is available, there is no requirement for tax to be
withheld from payments of interest. The main condition which must be
satised to obtain such treatment is that the debt instrument is listed on
1 For further details, see chapter 3, section 3.3.
2 Section 874 of the Income Tax Act 2007.
3 Sections 933 and 934 of the Income Tax Act 2007.
4 Section 882 of the Income Tax Act 2007.
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Tax on private equity transactions
a recognised stock exchange. For these purposes, a recognised stock
exchange is the Ofcial List of the London Stock Exchange and certain
other exchanges designated as such by HMRC. One such exchange is the
Channel Islands Stock Exchange, and this has been the exchange of choice
for these purposes, mainly on account of the relatively low cost and ease
of listing.
(b) To issue the debt as ‘deep discount bonds’. These are debt instruments
which generally do not carry interest, but which are issued at a price which
represents a discount to the face value of the bonds (e.g. bonds with a face
value of £100 are issued at a price of £90). Upon maturity of the bonds,
the face value (i.e. £100) of the bond is paid. The amount of the discount
paid is calculated to represent the interest which would be payable on a
typical debt instrument. This strategy is adopted because there is no obli-
gation to withhold tax from discount payments (as opposed to payments of
interest).
(c) To establish the investor in a jurisdiction which has a double taxation
agreement with the UK under which the requirement for the UK investee
company to withhold tax is reduced or eliminated. A favoured location for
such entities is Luxembourg.
2.3 Dividends from UK investee companies
There is no withholding tax in the UK in respect of dividends paid by a UK
investee company to an investor regardless of the structure or residency of the
investor. Accordingly, the receipt of any dividends from UK investee compan-
ies is not a signicant factor when determining the structure of an investor, or
the way in which it will make its investments in UK investee companies.
2.4 Gains on realising investments
Generally, non-UK tax residents will not be liable to UK taxation on any gains
realised from selling an equity stake in a UK investee company. The two prin-
ciple exceptions to this are:
(a) where the equity stake is held as an investment but the non-UK investor car-
ries on a trade in the UK through a permanent establishment and the equity
stake is used for the purposes of that trade or permanent establishment;
5
and
(b) where the equity stake is held as an asset of trade carried on in the UK
rather than as an investment.
6
This tax treatment has two main impacts in the context of private equity inves-
tors. First, the investment policies of most investors are established with a view
5 Section 10B of the Taxation of Chargeable Gains Act 1992.
6 Section 19 of the Corporation Tax Act 2009.
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Tax issues for the investor
to maintaining that their activities amount to an investment activity rather than
that of trading or dealing in equity stakes and securities. To the extent that
there is any activity which might be construed as trading or dealing this is
often carried out through a separate vehicle established by the investor for
the purpose. It is beyond the scope of this chapter to provide a comprehensive
analysis of the so-called ‘badges of trade’ which are used to indicate whether
an activity is trading or investment in nature. However, one of the factors is
the length of time the equity stakes and securities are held prior to a sale (the
longer the stake is held, the more indicative it is likely to be of investment).
Typically, the investment policies of investors indicate that stakes are likely
to be realised in a three-to-ve-year timescale, which is helpful in establish-
ing that the activities of the investor are of an investment nature. In the recent
past, when the private equity market was more buoyant, there were a number
of investors which consistently realised their equity stakes on a much shorter
timescale. There have been persistent rumours of HMRC scrutinising such
investors’ activities closely to determine whether they may amount to the car-
rying on of a trade in the UK rather than an investment activity. However, to
date we are not aware of such an argument being actively pursued by HMRC
in the context of a signicant investor.
Secondly, this is the reason that most investors will be established either as
non-UK tax resident vehicles (such as a tax haven company or a Luxembourg
SICAV), or as tax transparent vehicles (such as a UK limited partnership). As
mentioned in chapter 3, for investors investing solely in UK investee compan-
ies, the UK limited partnership is generally the preferred vehicle, as there is
no UK tax at the level of the fund and each underlying investor in the fund is
subject to UK tax on its share of the income and gains of the fund according
to its own personal circumstances. Further, the UK tax rules do not gener-
ally impose any fetters on how the limited partnership can operate in the UK
(this is to be compared, say, with a tax haven company, where to maintain its
non-UK tax resident status it will be necessary for it to be managed and con-
trolled outside the UK).
There are generally two classes of investors which are established as
UK tax resident companies. The rst are retail funds such as venture cap-
ital trusts or investment trusts, each of which are generally exempt from
UK tax on gains realised from selling equity stakes held as an investment.
7
The second are the captive private equity arms of UK nancial institutions
(such as one of the large UK banks) and other corporates. For this latter
category, UK corporation tax (currently at 28 per cent) is payable upon any
gains realised, subject to specic reliefs such as the substantial shareholding
exemption.
8
7 Section 100 of the Taxation of Chargeable Gains Act 1992.
8 Schedule 7AC of the Taxation of Chargeable Gains Act 1992.
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Tax on private equity transactions
2.5 Incentives for the executives of the investor
It is often the case that the executives of the investor will have an indirect or
direct interest in Newco (often held through a nominee) by reason of his or her
participation in the investor’s carried interest or co-investment schemes. The
executives’ tax concerns in relation to their interests in Newco will largely
mirror those of the managers (see section 4 below), namely:
(a) they will wish to ensure that there is no income tax or NIC charge on
acquisition of the interest in Newco; and
(b) they will wish to ensure that, upon a sale of their interest in Newco, they
are subject to capital gains tax rather than income tax and NIC.
Accordingly, it would usually be the case that any participation in the carried
interest will be structured, so far as possible, to fall within the terms of the
HMRC/BVCA Memorandum of Understanding in relation to carried interest
arrangements.
9
This remains an area of signicant political scrutiny in the UK
following the Treasury Select Committee’s probing of the industry in June
20 07.
10
3 Tax issues for Newco
There are usually deal-specic tax issues which affect Newco in relation to its
acquisition of Target. However, in addition to these specic issues, the follow-
ing issues commonly arise:
(a) whether Newco will obtain a tax deduction for interest payable upon the
investor debt;
(b) assuming a deduction is available, when it will be available;
(c) understanding the tax deductions available to Newco in respect of fees
incurred during the acquisition of Target; and
(d) the VAT recoverability position in respect of fees incurred during the
acquisition of Target.
3.1 Tax deductions for interest
When carrying out its nancial modelling in respect of an investment,
11
the
investor will make certain assumptions regarding whether interest payable
upon the investor debt will be tax deductible for Newco. For advisers it is
important to understand the assumptions that have been made regarding the
tax deductibility of such interest, as the failure to obtain anticipated deductions
may affect the economic viability of the investment. There are a number of
9 Issued on 25 July 2003.
10 See also chapter 1, section 2.2.
11 See further chapter 1, section 3.3.
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Tax issues for Newco
bases upon which HMRC could seek to deny a tax deduction in respect of the
interest upon investor debt.
3.2 Distribution treatment
To the extent that the interest upon the debt represents more than a reason-
able commercial return, the excess will be treated as a distribution for tax
purposes and therefore not tax deductible.
12
The question of reasonableness
falls to be applied at the time the debt instrument is issued and takes account
of all circumstances including the creditworthiness of the borrower and the
quality of any security. To the extent that this provision is found to apply it
is only the excess which is treated as non-deductible. Given the other provi-
sions available to it (and in particular the transfer pricing provisions referred
to in section 3.3 below), this provision is not generally the rst line of attack
by HMRC.
Where there is a connection between the shares held by the investor and
the debt instrument (and in particular where there are features which suggest
that they are stapled together) then the whole of the interest upon the debt may
be treated as a distribution and hence not tax deductible.
13
It is commonly con-
sidered that this provision is company-specic (i.e. in order for it to bite, the
shares and debt must be in the same company). This is one reason for a double
(or more) Newco structure being used (i.e. to ensure that the investor’s shares
are held in a different company to that in which it holds the debt).
14
In this way,
it is considered that this provision is of no application.
3.3 Transfer pricing
UK transfer pricing rules
15
apply where a provision between two persons who
satisfy a statutory connection test differs from what would be the arm’s length
provision between two independent enterprises. Where the rules apply, the
prots and losses for the purposes of corporation tax are adjusted to reect
the prots and losses that would have resulted had the provision been at arm’s
length. For the transfer pricing rules to apply, it is necessary for the provision
to have been made or imposed as between any two connected persons. Persons
are connected for these purposes where:
(a) one of the persons is directly or indirectly participating in the manage-
ment, control or capital of the other; or
(b) the same person or persons is or are directly or indirectly participating in
the management, control or capital of each of the affected persons.
12 Section 209(2)(d) of the Income and Corporation Taxes Act 1988.
13 Section 209(2)(e)(vi) of the Income and Corporation Taxes Act 1988.
14 See also chapter 3, section 2.3, in relation to multiple Newcos.
15 Schedule 28AA of the Income and Corporation Taxes Act 1988.
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Tax on private equity transactions
As a result of the statutory connection test, generally the rules apply in the con-
text of transactions within a group, certain joint ventures, or other transactions
between parties under common control or where one controls the other.
Until 2005, it was commonly considered that in most cases the transfer
pricing rules had no application in relation to the debt nancing of Newco by a
private equity investor where the investor was structured as one or more limited
partnerships, due to there not being the requisite degree of connection between
the investor and Newco, although HMRC now disputes this view. However,
the debt nancing of Newco by the investor in most private equity transactions
will now fall within the transfer pricing rules because, with effect from 2005,
the rules were extended to apply to nancing arrangements where;
(a) the lender and other persons acted together in relation to such arrange-
ments; and
(b) the requisite degree of connection would be satised if all the rights and
powers of the other persons are attributed to the lender.
16
In the context of a typical private equity transaction, it is likely that all the
shareholders of Newco and all its nance providers will be regarded as so act-
ing together, with the result that the transfer pricing rules are applicable to the
debt nancing provided by the investor.
Where transfer pricing legislation applies in respect of the investor debt,
Newco will be unable to obtain a tax deduction for any interest which is con-
sidered to be in excess of an arm’s length amount. In the context of private
equity transactions, this has two potential applications as follows:
(a) to the extent that the rate of interest charged is in excess of an arm’s length
rate that amount of interest is not tax deductible – the arm’s length rate is
the rate at which a third party lender (with no equity interest in Newco)
would lend to Newco; and
(b) more importantly, to the extent that the debt itself would not have been lent
by an independent third party, then the interest upon such debt is not tax
deductible at all. This is the so-called ‘thin capitalisation’ rule; i.e. where
there is a highly leveraged Newco, HMRC may argue that an independent
third party (such as a bank) would not have lent some or all of the debt to
Newco, and to the extent it would not have lent such amount, the interest in
respect of that debt is not tax deductible.
3.4 Timing of any interest deduction
Where Newco is entitled to a tax deduction, the timing of such deduction is very
important. Whenever Newco obtains a tax deduction in respect of the interest
on the investor debt, this will generally result in Newco incurring a taxable loss
16 Paragraph 4A of Schedule 28AA to the Income and Corporation Taxes Act 1988.
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Tax issues for Newco
in the relevant accounting period (as the amount of such interest often exceeds
the taxable prots of Newco for that period). In such circumstances, Newco will
be able to surrender such loss against the prots of Target by way of group relief
on a current year basis.
17
Thus, in effect, the interest costs incurred by Newco
are off-set against the trading prots of Target. Newco is only able to do this on
a current year basis. Thus, if in any accounting period the losses within Newco
exceed Target’s prots for that period, the excess cannot be offset against the
prots of Target for any other period. Whilst the losses can be carried forward
(and to a limited extent back) against the taxable prots of Newco, in reality
Newco will usually have very little by way of taxable prots. Hence, the losses
become trapped in Newco and are largely worthless.
There are two possible times at which interest may be deductible, namely:
(a) as the interest accrues; or
(b) when it is paid.
Where interest is paid regularly (i.e. it is not rolled up), then there should be
no practical difference regarding when the tax deduction may be taken. Any
deduction within Newco for such interest is likely to be of real benet to the
Newco group.
Where interest is rolled up then, even if Newco is entitled to a deduction in
respect of such interest, in certain circumstances that interest is only deduct-
ible in the accounting period in which it is paid, i.e. not when it accrues.
18
This
is likely to be highly disadvantageous because:
(a) in the meantime, taxable prots within the Newco group will be higher than
would otherwise be the case if the interest was deductible as it accrued;
thus, there will be a real cash ow cost during the life of the investment;
(b) if the interest is only deductible as and when it is paid, it is likely that at
the time of payment there will be a very large tax deductible amount which
may result in losses in Newco which exceed the taxable prots of Target
for the corresponding period. For the reasons outlined above, such excess
losses are likely to be trapped in Newco and to become worthless.
The rules which defer a tax deduction until such time as the interest is paid
do not apply to interest which is paid within twelve months of the accounting
period in which it accrues. Thus, where the interest is not rolled up, it will be
deductible as it accrues. Further, where the lender is within the charge to cor-
poration tax in respect of the interest, interest will be deductible as it accrues
even where the interest is rolled up. Subject to these exceptions, the rules which
defer a tax deduction generally apply where:
(a) the lender is a company and controls the borrower (or vice versa) or they
are under common control;
17 Section 402 of the Income and Corporation Taxes Act 1988.
18 Paragraph 2(2) of Schedule 9 to the Finance Act 1996.
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Tax on private equity transactions
(b) the borrower is a close company and the lender has the requisite degree of
connection with the borrower; or
(c) the lender is a company and has a major interest in the borrower (or vice
versa).
Until 2002, there was an exception which resulted in most investments made
by a private equity investor structured as a limited partnership being regarded
as not having the requisite degree of connection, with the result that there
was no deferral of the tax deduction for Newco in respect of rolled up interest
on the investor debt. However, the current exceptions are signicantly more
tightly drawn, with the result that in many cases they will not apply to prevent
the deferral of the tax deduction for rolled-up interest.
Subject to transitional provisions, in respect of accounting periods begin-
ning on or after 1 April 2009, the rules which apply to companies and which
defer a tax deduction for late paid interest have been narrowed. Broadly,
where the lender is a company, the rules will only apply if it is resident or
effectively managed in a non-qualifying territory. For these purposes, a quali-
fying territory comprises the UK and jurisdictions with which the UK has
a double taxation treaty which contains a non-discrimination article. Thus,
non-qualifying territories will mainly comprise tax havens.
As highlighted in chapter 3,
19
interest is often rolled up because Newco does
not have the cash ow to service the debt, particularly in the earlier years of an
investment. However, as noted above, rolling up interest may adversely affect
the timing of any tax deduction. One way commonly used to overcome this
issue is to satisfy the accruing interest by the issue of ‘payment in kind notes’
(‘PIK notes’). Rather than interest being rolled up, Newco will issue further
notes to the investor with a face value equal to the accrued interest. The issue
of PIK notes will be treated as payment for tax purposes
20
and thus, assuming a
tax deduction is available in respect of the interest, it enables Newco to obtain
such deduction in the accounting period in which the PIK notes are issued,
rather than when any cash is paid. However, issuing such notes has two other
consequences:
(a) It triggers the withholding tax issues referred to in section 2.2 above.
Where tax is required to be withheld, Newco is required to withhold PIK
notes with a value equal to income tax on the deemed interest at the basic
rate and pay them over to HMRC.
21
(b) It may trigger a tax liability for the private equity investor (or its investors)
in respect of that interest notwithstanding that all that has been received is
a further note rather than cash.
19 See chapter 3, section 2.2(b).
20 Section 413 of the Corporation Tax Act 2009.
21 Section 929 of the Income Tax Act 2007.
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Tax issues for Newco
Where the debt nancing is provided in the form of a deep discounted bond,
there are similar rules (to those which apply to interest) which may apply to
defer a tax deduction for the discount to when it is paid (rather than the deduc-
tion being available on an accruals basis).
22
3.5 Deductibility of fees
Newco will incur a substantial amount of fees in relation to the acquisition of
Target. It will wish to maximise the corporation tax deduction for such fees.
The basic position is as follows:
(a) To the extent that the fees relate to the debt issue, then such costs will gen-
erally be accounted for in accordance with FRS4 and the tax treatment
will follow the accounting treatment. This generally means that costs dir-
ectly connected with the issue of the debt instrument will be amortised for
tax purposes over the anticipated duration of the debt, and thus will give
Newco a tax deduction for such costs over the life of the loan. Such costs
will include the bank arrangement fees, due diligence fees incurred in rela-
tion to the raising of the debt and legal fees incurred in relation to the debt
instrument.
(b) Whether or not other expenses incurred by Newco will be tax deductible
will depend upon whether they are capital or income. Generally speaking,
expenditure relating to general consideration or appraisal of opportunities
will be tax deductible, but expenditure incurred once a target is identied
and the acquisition process begins will not be tax deductible.
Disputes with HMRC regarding the extent to which transaction fees incurred
by Newco are tax deductible are common. HMRC often disputes the avail-
ability of any deduction for the fees which relate to the transaction (other than
fees which relate to the debt instrument) on the basis that such fees have been
incurred once a target is identied and the acquisition process begins. The pre-
cise boundaries of this test have not yet been tested by the courts, but are likely
to be tested within the next few years.
3.6 VAT recovery
In order for the VAT upon deal costs to be recoverable by Newco, it must be
VAT registered, and therefore must be:
(a) carrying on a taxable business such as providing management services;
if this route is adopted, then the VAT recovery position of Newco will
depend upon being able to demonstrate that it is carrying on a taxable busi-
ness, and that the deal costs relate to such business; or
22 Section 407 of the Corporation Tax Act 2009.
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Tax on private equity transactions
(b) included within a VAT group with the investee company; if this route is
adopted, then the VAT recovery position of Newco will depend upon the
underlying VAT recovery position of the investee company.
It is generally the case that the latter approach is adopted, so that an application
is made for Newco to join a VAT group with the investee company with effect
from completion of the investment.
Where fees are incurred by other parties (e.g. the bank) and are being met
by Newco, then Newco will not be in a position to recover the VAT upon such
fees (this has been the settled position for some time, although it is considered
likely that this view may shortly be the subject of a test case). Accordingly,
the legal adviser who acts both for the investors on their investment and for
Newco on its acquisition of Target must raise distinct invoices for the two sep-
arate pieces of work, the former being an invoice addressed to the investor but
payable by Newco as a third party (and on which VAT is not recoverable by
Newco).
4 Tax issues for managers
There are a number of tax issues that arise on private equity transactions which
are relevant to the managers. The two most fundamental tax issues for the
managers subscribing for shares in Newco are:
(a) whether they are liable to income tax upon acquiring their Newco shares;
any such charge will be highly disadvantageous, not least as the managers
may not have the cash to meet the charge; and
(b) when selling their Newco shares will they be liable to income tax or cap-
ital gains tax (CGT) upon any gains. If the shares are within the CGT
regime, the rate of tax is 18 per cent and, where entrepreneurs relief is
available, the effective rate of CGT is only 10 per cent on up to £1 mil-
lion of gains.
23
If the shares are within the income tax regime, the rate of
tax will be higher (currently the higher rate is 40 per cent). In addition, if
income tax is payable, then generally employees NIC will be payable by
the managers (generally at the rate of 1 per cent) and Newco will be liable
to employers NIC (currently at the rate of 12.8 per cent).
The potential tax charges described below apply where a manager acquires
shares by reason of his employment or directorship or any prospective or
former employment or directorship. There are various deeming provisions
which have the effect that a manager will be deemed to acquire his Newco
shares by reason of his employment/directorship.
24
Thus the rules below apply
to all managers whether MBO or MBI candidates, if directors (whether they
are executive or non-executive), and even where the Newco shares are received
23 Chapter 3, Part V, of the Taxation of Chargeable Gains Act 2002.
24 Section 421B of the Income Tax (Earnings and Pensions) Act 2003.