TAX NEWS - June 2010

Buyout firms braced for tax hike

The private equity industry is braced for a "draconian" Budget today, with executives focused on the details of a hike in capital gains tax and possible changes to taxation of debt.

Paul Marson-Smith, chief executive of UK mid-market private equity firm Gresham, said: "There are concerns that this will be a draconian Budget. The government has one chance to blame everything on its predecessor, and any good chief executive would seize that opportunity. But I hope there is not a kneejerk reaction against private equity in pursuit of good politics."

Attention will focus on plans outlined last month to increase the 18% rate of capital gains tax to "closer to" the 40% income tax rate. Such a move is likely to hit the buyout industry hard because firms pay capital gains tax on carried interest – the performance pay worth 20% they receive on successful investments.

Jeremy Bell, a partner at law firm Ashurst, said: "This Budget is a key moment for the private equity industry due to the issues around capital gains tax and, in particular, tax treatment for carried interest. If carry is to be taxed at or near income tax rates, that will have a significant effect on planning."

Marson-Smith said: "Capital gains tax is one of the biggest issue for private equity in today's budget. There is a big chance that the government may stifle entrepreneurialism with a large increase."

The British Private Equity & Venture Capital Association, the trade body for UK private equity firms, this year slammed Liberal Democrat proposals to increase capital gains tax as "completely dotty" and "damaging".

It is not yet clear how private equity firms would be affected by a higher capital gains tax. The government has said the change will not apply to "business" assets, which it has yet to define, and has promised "generous exemptions for entrepreneurs." Advisers said the government was likely to launch a consultation on this issue today rather than laying down firm terms.

Another big concern is that capital gains tax might be raised immediately, leaving firms no time to benefit from the existing rate. That fear has driven a number of firms to offload businesses before tomorrow, according to Edmund Reed, a partner with law firm Travers Smith. He said: "Quite a few deals are being driven by the need to close today. Even if shareholders do not cash out completely, they are looking to crystallize gains."

However, a tax hike tomorrow is unlikely, according to Russell Warren, a solicitor with law firm Travers Smith. He said: "There is a concern that the increase could be effective from tomorrow. Although [such a move] may be difficult to implement practically midway through the tax year, it cannot be ruled out. Whether the rate rise comes into play tomorrow or in April 2011, details on the reliefs and exemptions that have been previously trailed are keenly awaited."

The tax treatment of debt will be another focus for private equity firms, which have traditionally used leverage to boost returns. Marson-Smith said: "Less favourable treatment of debt could be the last nail in the coffin for big leveraged buyouts, which were predicated on large amounts of cheap debt. But traditional development capital, reliant on operational changes to drive performance improvement, would be less affected."

Simon Skinner, a partner with Travers Smith, said: "The Tory party raised the issue in opposition and may claim it is trying to prevent a credit bubble."

However, radical change is unlikely. Skinner said: "It is too simplistic to blame tax relief on debt for high levels of leverage, with commercial and legal reasons as important for using debt funding instead of share capital. Moreover, the current regime is already very complex, and further changes would only make it more so."

As with other areas of the financial industry, buyout firms will have an eye on the top rate of income tax, currently 50%. Marson-Smith said: "Income tax is also an issue. In general, Britain has gone from a low-tax to a high-tax economy very quickly, which will act as a brake on economic activity and discourage entrepreneurs."

However, an exodus of buyout firms remains unlikely because the UK is a key location for private equity deals, according to Reed. He said: "Investors want managers to have a strong presence wherever deals are; they cannot easily source deals from abroad."

Other important topics include changes to bankruptcy rules, after the UK regime was criticised in the wake of Lehman Brothers' collapse. Efforts by the government to crack down on offshore tax havens, where many private equity funds are domiciled, could cause further headaches for the industry.