PRINT THIS PAGE Tax deductions for the cost of borrowing02/05/2007. Source: SJ Berwin. Simon Witney 
In recent weeks, says SJ Berwin, the private equity industry has faced the full glare of the media spotlight, particularly in the UK - and much of this has been unsympathetic. Unfortunately, the press has often compounded the negative image propagated by trade unions by repeating inaccurate assertions about the tax treatment of private equity. In particular, they have focused on shareholder debt - finance provided by investors by way of loan rather than equity - which was mentioned in an important speech last month. In fact, that speech - by the UK’s Economic Secretary to the Treasury, Ed Balls - was actually very good news: it confirmed that the ability to deduct interest on loans taken out for business purposes from taxable profits is regarded as an industry norm, not only in the UK but internationally, and it confirmed that that principle is not under scrutiny in Britain.
It is important to emphasise - as did Mr Balls, but not many in the press - that, far from benefiting from any special tax breaks, buyout deal structures are subject to the UK’s “transfer pricing” rules, the tightening of which, in March 2005, had a particular impact on the industry.
Essentially, where there is coordinated action by investors (who may be companies, partnerships or individuals) to provide finance to companies of whom, collectively, the investors share control, interest payable by those companies will only be deductible for tax purposes if the finance provided does not exceed an arm’s length amount (namely, the equivalent finance which an unconnected third party lender would provide to that company).
Those rules have applied to any new arrangements put in place from March 2005 onwards, but will apply to all finance arrangements, no matter when entered into, from 1 April 2007. These rules have restricted deductions available for interest paid in many private equity structures, with more structures likely to fall within the rules from next month.
Mr Balls confirmed that a government review will examine the use of shareholder debt, particularly in highly leveraged deals, and the tax rules which apply to it, and we must wait until the late autumn to find out whether the government is intending to take any action. It seems likely that the review will focus on the operation of the new rules in practice, rather than attempt to re-write them.
The issue is, of course, a Europe-wide concern, and it is not only in the UK that private equity has been the focus of attention. In Germany, draft legislation has just been published which, from 1 January 2008, could introduce rules to restrict the deductibility of interest payable by a business (if it exceeds €1 million in any year) to 30% of that business’s taxable income before interest expenses.
This will clearly affect buy-out structuring and cash-flows, and for companies whose income consists mainly of dividend income (largely tax exempt in Germany), this could result in no interest deduction at all, with excess interest having to be carried forward to future years. Even more restrictive rules are being introduced in Denmark, from 1 April 2007, specifically aimed at countering what has been termed aggressive (although legitimate) tax planning carried out by private equity funds and which will, in the future, all but prevent the use of leveraged acquisition financing structures.
At present, it is clear that the UK government is not minded to take such drastic action to protect the tax base. But, especially in these uncertain times for the private equity industry, it is important to be clear about its current tax treatment and to dispel the myth that private equity enjoys special tax privileges for interest costs.
Simon Witney
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on our services to the private equity industry please contact Simon Witney in our London office 020 7533 2222 or visit our website at www.sjberwin.com.
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