BVCA Taxation Committee Bulletin on deal structures and tax deductibility of financing costs

1. Purpose of Briefing

1.1 The purpose of this briefing is to update members on what appears to be a fundamental difference of opinion between the Revenue and the BVCA as to the potential application of certain anti-avoidance provisions known as the transfer pricing rules to UK companies funded by private equity. If the transfer pricing rules were to apply to private equity investments there could be a significant increase in the tax payable by private equity backed groups.

2. The Issue in Outline

2.1 Venture capital partnerships ("VCPs") often invest into investee groups in a mixture of debt and equity. One consequence is that a UK investee group is generally able to obtain a tax deduction in respect of the VCP debt unless one of the specific anti avoidance provisions applies. One such anti avoidance provision is the transfer pricing legislation. Since 17 March 1998 (when the relevant transfer pricing legislation was introduced) it has been the BVCA's view that VCP debt will generally fall outside the scope of the transfer pricing legislation. Indeed, amendments were made to the legislation whilst it was still in draft in response to the BVCA's requests. As such the BVCA's view was that the transfer pricing rules should not (generally) apply to disallow the deduction in respect of the VCP debt.

2.2 However, the Revenue has recently taken issue with the BVCA's view. If the Revenue's view were to prevail there would be a significant risk that the Revenue would seek to apply the transfer pricing rules in respect of the whole or part of the VCP debt. If the Revenue were to attempt to apply these rules they may seek to have regard not just to interest rates and discount, but to the quantum of debt provided by the VCP to the investee company compared with what the company could have borrowed on arm's length terms from an independent third party lender. This risk relates to financing costs of VCP debt lent since 1998 and to current debt being made available by VCPs.

3. The Technical Issue

3.1 For the transfer pricing rules to apply the person lending the VCP debt must (broadly) have more than a 50% direct or indirect interest in the investee company, or be one of two persons who each hold a 40% interest. The issue in dispute is whether, in the case of a VCP lender, one regards the partnership as the person lending the debt or instead treats a partnership as tax transparent. The answer to this point determines whether the 50% or 40% holding is measured by reference to the partnership's holding in the investee company or by reference to the effective holdings of any particular partner, or group of associated partners, in the investee company.

3.2 The BVCA believes that the correct position is that partnerships are transparent. Thus schedule 28AA only applies (and then only to the extent of the relevant partners' interest) if a partnership has a dominant partner whose indirect participation in an underlying investee company exceeds 50 per cent or where the partnership has two dominant partners each of whose indirect interest exceeds 40 per cent. The BVCA's view was confirmed in dealings with the Revenue in 1998 and is supported by contemporaneous documentation and subsequent correspondence.

3.3 If, in contradiction to the BVCA's view, the relevant "person" were the partnership, the transfer pricing rules would apply to a far greater number of cases. To ensure the tax deduction, investee companies may then need to establish that the VCP debt could have been borrowed on the same terms from an independent lender. This would result in a significant risk that the Revenue would seek to apply schedule 28AA to deny a tax deduction for all or part of the financing costs of the VCP debt.

4. The Revenue's Position

4.1 In the course of 2004, the BVCA became aware that the Revenue was seeking to apply schedule 28AA to a small number of private equity backed companies on grounds which the BVCA believed were at odds with the 1998 agreement. In subsequent discussions with the BVCA, the Revenue made clear that, in its view (with which the BVCA strongly disagrees) it was entitled to view the partnership as the relevant person for transfer pricing purposes. This was the case notwithstanding that the partnership may be a widely held partnership comprised of investors with no connection other than happening to be members of the same investment partnership. The Revenue has now also changed its published practice (the relevant change being made on 20 December). In one of its Manuals (paragraph 432060 of the International Tax Manual) the Revenue now state that, for transfer pricing purposes a partnership can control a company even if, individually, none of the partners controls the partnership or company. This appears to be at odds with paragraph 1659 of the Revenue's International Tax Handbook which deals with the outcome of the 1989 case IRC v Padmore.

5. The BVCA's Position

5.1 The BVCA has made clear to the Revenue that it believes the Revenue's current position to be contrary to the position reached in 1998 and also to be unjustifiable in law. Additionally, in light of these developments the BVCA sought the following specific confirmations, namely that:-

    * investee companies that have issued or may issue prior to 5 April 2005 debt instruments to VCPs where there is no "dominant partner" will not face a challenge under Schedule 28AA for accruals/payments of interest/discount arising/paid merely because the VCP has a controlling interest(s) in them;

    * the Revenue will provide certainty for investors as regards new deals so that an up-turn in the UK market is not retarded by what the BVCA sees to be a change of practice under Schedule 28AA, not justified as a matter of law, which will have significant impact on the pricing of deals in the UK and the number of deals done in the UK.

5.2 However, members should be aware that the Revenue has not thus far provided either requested confirmation. As such there appears to be a fundamental disagreement between the BVCA and the Revenue on this issue.

5.3 There is ongoing dialogue between the BVCA and the Revenue on this issue and the Revenue is well aware of the importance of the issue to private equity backed companies. Members should however be aware that progress may be complicated for a period pending the outcome of an existing judicial review case. The case relates to an investee company which has been refused a tax deduction for interest on VCP debt. The investee company has been granted leave for judicial review of the Revenue's actions but it is possible that the hearing may not take place for some months. The BVCA will keep members informed of developments. However in the meantime members are encouraged to meet with their advisers to consider what impact, if any, such developments have in respect of any VCP debt provided since 1998 and in addition to consult with advisers as to optimum deal structuring in the current environment.