UK tax body deals blow to buyout funds

Britain’s Inland Revenue has unexpectedly unveiled new laws relating to tax deductions available in private equity deals in a move described as severely damaging by industry participants.

The UK Inland Revenue has extended existing restrictions on tax relief available to private equity firms and their investee companies in connection with interest payments on loan stock. 

The move, which according to industry practitioners will have serious implications for the UK private equity industry, relates to the Revenue’s interpretation of anti-avoidance provisions on tax deductibility. The provisions were introduced in Schedule 28AA of the Income and Corporation Taxes Act 1988 – the so-called “transfer pricing” regulations.

Following a surprise announcement last Friday, private equity portfolio companies will no longer be able to deduct the interest they pay on specific loan stock debt instruments from their tax bills. Previously, portfolio companies were able to claim tax deductions on interest payments on loans from private equity investors.

The Revenue has been debating a change of its position on the issue for some time. The British Venture Capital Association (BVCA) was lobbying against such a change arguing that the transfer-pricing regulations should not be applied to private equity-backed companies in the UK, warning of a significant impact on the number and pricing of private equity transactions in the UK. According to people familiar with the situation, the BVCA was caught off-guard by the Inland Revenue’s Friday announcement.

SJ Berwin, the London-based law firm, sent a memo to clients last week explaining that although tax deductibility had been at risk for some time, certain types of private equity deals such as club deals had looked safe. Under the Inland Revenue’s new stance, however, these deals are now also going to be affected, the firm wrote.

SJ Berwin also noted a passage in the Revenue’s announcement indicating that rules governing the timing of a deduction for accruing discounts and rolled-up interest at large portfolio companies would also change. “That could mean that the cash flows on larger deals will need to be reviewed.”

Estimates vary as to how much the move will end up costing the UK private equity industry. BVCA chief executive John Mackie described the new rules as an “attack on an industry that makes a major contribution to the UK economy”, adding that “if that is Government policy then we must work within it or seek to get the policy changed.”

Pip McCrostie, a private equity tax specialist at Ernst & Young, said the new rules would undermine the UK private equity industry’s competitiveness: “The Inland Revenue’s decision to change the position they have adopted since 1998, and subsequently reaffirmed, is a severe blow for the private equity market. Private equity houses are now a major UK employer through their numerous UK acquisitions and investments. The Revenue’s decision will reduce the attractiveness of the UK for private equity investment and is therefore likely to have an impact on domestic employment.”