Managing the tax profile of portfolio investments

Jan 22 2008 By The Journal

WE are all well aware that the private equity market is an increasingly tough place to be. The recent cooling down in the deal market provides an ideal opportunity to turn attention to tax matters, especially given the increased focus which HM Revenue & Customs (HMRC) is now subjecting portfolio companies to.

Some crucial questions to ask include:

Are you up to date on tax compliance?

• Have you tackled tax exposures highlighted in your due diligence?

• Have you checked on the residency of holding companies?

• Have you checked compliance with the conditions of any rulings you rely on?

• Do you know whether HMRC views you as low or high risk?

These are simple steps where a bit of effort now can reduce the identification of potential tax issues by a future purchaser.

In addition:

Consider VAT recovery on deal fees and appropriate VAT groupings

• Identify all costs relating to the raising of any loan finance and agree with your auditors the period over which they will be expensed and therefore tax relief obtained

One specific area where problems typically arise is the application of withholding tax on bank interest payments. Although various exemptions are available there is a prima facie obligation to deduct withholding tax on payments of interest. Payments can be made for years before the issue is identified, often by HMRC, leading to an unexpected and unwanted tax demand.

On syndication of loans the lenders change (even though the agent bank may remain the same) and this may give rise to unexpected withholding tax obligations which can also result in penalties and interest if not dealt with on a timely basis.

It is not just about housekeeping – a bit of careful tax planning can drive real value for you by minimising cash tax costs and securing value for your tax assets. There are several current opportunities that should be on your radar screens:

Where interest costs arise in a non-tax paying territory but tax is paid in other territories, significant benefits could be available by reallocating group debt.

In the UK, “trapped losses” can arise where current year interest costs in the holding company exceed current year profits in the trading companies. Such ‘trapped losses’ can be minimised by actively reviewing the level of capital allowances claimed in a period.

Alternatively more effective planning is possible which can allow interest costs to be deferred so they accrue in later periods when they can best be utilised, that is, the taxpayer is in control of the timing of the tax deduction.

Often the portfolio company may be cash constrained and struggling to pay its interest liability arising on debt lent from shareholders. In certain circumstances if this interest liability is not paid within 12 months of the year end then no tax deduction is available on the interest unless it is cash settled. It is, however, often possible to review the terms of such debt in order to ensure a tax deduction can be obtained.

HMRC is also increasingly focusing on the tax deductibility of debt in portfolio companies. To avoid prolonged HMRC queries and avoid a potential “price chip” on exit, companies are increasingly working with us to agree the level of debt that is acceptable in the business both at the time of “doing the deal” and monitoring the position afterwards

Pressure in certain territories on the deductibility of interest means it may be time to consider an “entrepreneur” model. The entrepreneur company undertakes the majority of strategic functions and risks and so accrues most of the group profits. Locating the entrepreneur in a low tax territory can minimise the group tax cost, potentially resulting in significant value at exit.

In short, engaging with your portfolio companies on tax can deliver benefits.