Bulletin from BVCA Taxaction Committee on the funding of private equity portfolio companies post 4 March 2005

Introduction

The purpose of this paper is to provide some high level practical guidance to BVCA member firms on the impact of the announcement by Her Majesty's Revenue & Customs ("HMRC") on 4 March 2005 and the legislation which followed in Finance (No2) Act 2005, so far as they impact shareholder debt provided by private equity funds to their investee companies.

This note is not intended as a technical analysis of the new legislation and is not a substitute for BVCA member firms obtaining their own professional advice in respect of existing and future investments.

The note covers the following:

    * Overview of the changes
    * Evidence that may be relevant to support that debt provided is arm's length
    * Dealing with HMRC

Overview of the changes

The legislative changes potentially impact both the quantum of tax allowable interest deductions and the timing of those deductions. The changes are effective from 4 March 2005, but loans in place on 4 March 2005 and not varied after that date, will generally not be affected by changes until March 2007. HMRC has produced some guidance on the transitional rules, which is available on its website at www.hmrc.gov.uk/international/transitional-provisions.pdf. The BVCA Tax Committee provided input to HMRC on the content of this guidance.

In respect of the period back to the introduction of the transfer pricing rules in their present form (1998), HMRC has also indicated that they do not stand by the agreement which the BVCA believes it reached with them in 1998 that the transfer pricing rules would be applied on a look through basis. If this view prevails, it may have a significant effect on certain existing financing arrangements. However, this change of HMRC view is being challenged in the courts and the outcome may not become clear for some time. The BVCA believes that HMRC will generally not have grounds to reopen prior agreed tax returns solely for this issue. It may therefore be in the interest of PE portfolio companies to ensure their compliance is brought up to date

New transfer pricing legislation

With effect from 4 March (subject to grandfathering for existing loans, see above), loans are within the scope of UK transfer pricing rules wherever a lender has acted together with the controlling shareholders in connection with the financing arrangements for the borrower. This is an extremely widely-drafted provision, which catch many shareholder loans to PE portfolio companies. External loans (senior, mezzanine etc.) could also come within the scope of this legislation, although in practice tax relief for interest on such loans will generally not be restricted. In consultation with the BVCA, HMRC has produced guidance on this point, which is available on its website at http://www.hmrc.gov.uk/international/acting-together.pdf and http://www.hmrc.gov.uk/international/transfer-pricing.htm.

Where loans are within the scope of the legislation, interest will only be tax-allowable to the extent that it can be demonstrated that interest would have arisen on a loan from an unconnected lender. A variety of factors need to be considered in each case - see below.

Timing of interest deductions

The loan relationship rules that previously allowed a PE portfolio company a current tax deduction for accrued but unpaid shareholder debt interest has been changed significantly (but again with the "grandfathering" referred to above) and interest on most shareholder debt is now deductible only on a paid basis, even though it is arm's length in terms/amount. As a general rule, a deduction for accrued but unpaid interest will only be available if:

    * the portfolio company satisfies the definition of a Small or Medium Sized Enterprise ("SME"). Perversely, even early stage PE portfolio companies will generally not satisfy this definition as the test normally requires aggregation of all companies owned by the same PE fund or funds with a common manager (there is a similar SME exemption from the transfer pricing rules above, which will be of very limited use for these same reasons); or
    * the portfolio company is not close. Determining whether a portfolio company is close is generally not a straightforward exercise since the structure of the investing PE fund and the application of complex attribution rules will have a significant bearing on the outcome. As a very general guideline, it is likely that any PE fund that has private individuals as partners is likely to render its portfolio companies close.

In light of this change, PE funds with their advisers will need to consider the nature of the instruments they use in order to invest and the tax treatment that will follow from them.

Disclosure in tax returns

In light of all the above changes, and in particular the uncertainty of how much interest will be deductible in accordance with the transfer pricing rules, it will be important for portfolio companies and their tax advisers carefully to consider the extent of disclosure required in accounts and tax returns in order to avoid the possibility of a late "discovery" assessment (under HMRC's powers to raise tax assessments beyond the normal time limits where they "discover" information that has been omitted from a tax return) or penalties, as well as the level of transfer pricing documentation they need to support their filing position.

SUPPORTING EVIDENCE THAT LOAN IS ON ARM'S LENGTH TERMS

As mentioned above, each case needs to be considered carefully on its own facts; there is no "safe harbour" for companies with particular debt:equity, interest cover, or debt:EBITDA ratios. Each year a portfolio company must decide how much interest is deductible on the arm's length principle (i.e. what would its financing costs have been had the loan provision been made by a third party). Relevant factors might include:

    * Prevailing market conditions; for example, the ease with which funding can be obtained, general economic sentiment, attitudes to the business sector concerned, etc;
    * The financial position (and prospects) of the borrower: private equity investments have a record of very strong financial performance within a relatively short time span and the equity house's projections and plans for the borrower might be such as would support a higher level of borrowing from a third party than would be the norm in the corporate market;
    * The terms of the loan. This would include the security and ranking of the loan. In return for a sufficient coupon/IRR third party lenders might be prepared to advance high risk, junior ranking debt.

HMRC guidance suggests that a business should approach its transfer pricing analysis "in accordance with the same prudent business management principles that would govern the process of evaluating a business decision of a similar level of complexity and importance". If the borrower has chosen to finance itself primarily with debt which possesses certain characteristics, it is to that transaction that the arm's length test should be applied and other than in exceptional cases, HMRC should not disregard the actual transactions or substitute other transactions for them. A careful and contemporaneous record should be made to demonstrate how the financing decision was taken and how it conforms to the arm's length standard. In particular cases, contemporaneous evidence of market comparability that could be collated might include:

    * firm, reliable quotations/offers of finance on similar (or more expensive, in terms of coupon /IRR) terms from reputable lenders;
    * expert advice from finance arrangers, including (subject to obvious points about objectivity and impartiality) the private equity house itself;
    * indications of comparables from auditors or others with experience of a wide spectrum of financings;
    * indications that a third party would have been prepared to provide debt equivalent in credit terms to the shareholder debt at the same (or indeed at a higher) interest rate;
    * indications from rating agencies that the shareholder debt could be given a credit rating that would enable it to be sold as a stand alone investment at a coupon/IRR equal to or above that being paid to the private equity fund.

HMRC CLEARANCE OPTIONS

Portfolio companies that have borrowed shareholder debt or other debt subject to Schedule 28AA may have to negotiate with HMRC whether the debt is arm's length and there are several different opportunities to do this.

   1. Pre-transaction clearances
      It is possible for proposed debt structures to be negotiated and cleared with HMRC before the private equity fund makes its investment.
   2. Post-transaction, pre-tax return, clearances
      Debt structures can be submitted to HMRC for clearance very soon after they have been implemented. This would be post-transaction but well in advance of filing the first corporate tax return. The BVCA believes that this will in general be a sensible approach: it is post-transaction so avoids the typical busy period immediately before an investment; it allows an earlier start to be made on settling the arm's length position (compared with #3 below); and it involves a balanced negotiation in that the portfolio company has recourse to the judicial process if agreement cannot be reached directly with HMRC.
   3. Clearance when filing tax return
      The arm's length position can be negotiated with HMRC in the usual fashion, after the portfolio company has filed its first corporate tax return and if HMRC choose to enquire into the application of Schedule 28AA to the loans. This should involve the same negotiation as #2 above, except it will typically start perhaps two years later because of the timing of the tax return process. For that reason alone, #2 above will often be preferred by portfolio companies and is understood to be preferred by HMRC.
   4. Treaty clearances
      Where interest is being paid on shareholder debt to a non-UK company based in a country with which the UK has a double tax treaty, clearance will normally be requested from HMRC to pay the interest without UK withholding tax. Under many treaties, the withholding tax relief is only available to the extent that the loan is on arm's length terms. Hence, the negotiation between the portfolio company and HMRC in the context of a tax treaty application for relief from withholding tax can amount in substance to the same negotiation as would occur under #2 or #3 above. Typically such tax treaty application would usually be filed soon after the portfolio company investment has been made, and therefore can amount to an alternative route to get the same outcome as #2 above.

It is not unusual for HMRC to seek to impose conditions (not unlike simplistic banking covenants) in their clearances, such that for example, the ability to deduct interest on a given amount of debt is contingent on the borrower meeting certain targets on interest cover. In reaching those agreements, companies may wish to consider whether they should also be seeking to agree upside covenants with HMRC in cases where they initially agree that not all the interest is deductible, so that if the business outperforms expectations more of the interest is deductible.