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Private equity industry looks strong but tax challenges loom Back  
The private equity industry looks to be booming across Europe, but Terry O'Driscoll writes that a number of tax issues need to be addressed if the future growth of the industry is not to be undermined and the levels of returns for investors not significantly lowered.
<Is all well with the private equity industry?
The European private equity industry is booming, continuing to generate huge growth and significant returns for investors. Closer to home, the ISEQ is at record highs, a trend which is matched by a growing Irish appetite for private equity investment. All appears to be well with the private equity industry. However, in a recent PricewaterhouseCoopers’ (PwC) study of over 50 of the top private equity houses in Europe, it was found that recent tax reforms in many European countries are causing concern for the sector, with the threat that they could potentially impact on the growth of the industry in the medium to long term.

The importance of tax in private equity transactions
Private equity investments rely on achieving and maintaining strong cash flows. Tax is a major cash outflow which may ‘make or break’ a private equity transaction. This was recognised by 74 per cent of the respondents to the survey, who rated tax as a key value driver on private equity transactions. Achieving this value, however, is not always easy, with those surveyed by PricewaterhouseCoopers acknowledging that it is becoming increasingly complex to structure and manage tax in European private equity deals.
Private equity transactions and the European tax environment

The private equity industry has seen a raft of tax reforms during 2004. These have added to existing burdens and created extra costs for private equity houses. Indeed, nearly half of those approached by PricewaterhouseCoopers believe that the corporate tax climate in their territory does not encourage private equity investment. The tax change causing most anxiety, as identified by 80 per cent of the respondents, relates to reforms in local tax laws on the tax deductibility of interest. Traditionally, private equity deals are more highly leveraged than comparable corporate acquisitions. Accordingly, the ability to bring the tax cost down through interest deductions has been a key mechanism for private equity houses to manage this major cost of the deal. Other areas of concern identified by the PricewaterhouseCoopers’ survey included reform of thin capitalisation across Europe and transfer pricing rules.

Thin capitalisation provisions seek to deny relief on related party borrowings where companies have insufficient funds contributed by way of permanent capital when compared to the level of debt in the company. Transfer pricing (or inter-company pricing as it is sometimes known) refers to the pricing practices adopted by related parties for the transfer of goods, services, intangible property, etc. Because of the opportunities available to groups of companies to shift profits from one jurisdiction to another through PricewaterhouseCoopers’ transfer pricing policies, the domestic legislation of most developed countries applies special rules to related party transactions.

Private equity transactions and the Irish tax environment
By comparison, the relative stability of the Irish tax system should come as a welcome relief to private equity houses who may be becoming disillusioned by what appears to be a changing and indeed unfavourable corporate tax climate in many other European territories. Despite having to contend with stamp duty (at a rate of 1 per cent on share acquisitions), capital duty (at a rate of 0.5 per cent on share issues) and an income tax climate which does not lend itself to tax efficient management incentivisation, the Irish tax system should still recommend itself to private equity houses.

Advantages to Ireland from the point of view of private equity houses include the capital gains tax exemption for non-resident shareholders on the disposal of most Irish shares, the capital gains tax exemption for disposals by Irish shareholders of qualifying (generally trading) shareholdings, the existence of legislation which allows for the tax efficient repatriation of dividends to Ireland and the extensive tax treaty network, which is critical to avoiding withholding on most interest, royalty and dividend payments. In addition, Ireland enjoys a corporate tax rate of 12.5 per cent on trading income, while the rates applicable to other tax heads, such as capital gains tax, have proven to be relatively static over the years. Furthermore, Irish tax legislation does not contain any significant thin capitalisation rules or transfer pricing restrictions, although interest deductibility rules for corporate investments can be problematic.

Management of tax
The corporate tax stability in a particular territory, as well as the tax incentives offered by that jurisdiction, will only yield results for the investors to the extent that there are effective tax management controls in place, both with regard to the initial transaction and the ongoing investment. Notwithstanding this, the survey found that there does not appear to be any consistency with regard to how, and indeed by whom, control over tax is achieved. PricewaterhouseCoopers questioned whether management of tax in the underlying portfolio companies was effective. In response, 92 per cent of houses surveyed believe that they do have effective controls for managing tax in their portfolio companies. Significant importance is placed on the role of tax advisers at the portfolio level, with 80 per cent saying that they rely on tax advisers to monitor changes in tax regimes that protect portfolio companies. However, on closer inspection nearly half of participants stated that they did not have internal controls at the fund level which would ensure that the fund’s requirements are being met.

Considering the importance of tax in private equity transactions and the acknowledgment by the majority of respondents of the increasingly complex nature of tax structuring in European deals, private equity houses need to consider how effective the control functions they have put in place actually are. For instance, only 45 per cent of the staff of the private equity houses or individuals recruited specifically to work in portfolio companies were considered to have the tax knowledge that private equity houses would expect of a chief financial officer.

Of the respondents who placed control functions in the hands of deal executives, 44 per cent felt that their deal executives do not always monitor that the deal structure has been properly implemented. Finally, only 38 per cent of management teams are incentivised to save tax within the portfolio group, simply due to the way that they are remunerated. Does this augur well for the management and control of what has been identified as a key value driver for private equity investments?

All signs point to a burgeoning private equity industry across Europe, which is generating high levels of returns for investors. However, from a tax perspective the future growth of this industry appears to be at the mercy of a number of factors which could conspire to materially lower the levels of return to which investors have become accustomed. The continued strength of the industry is dependent on a number of sectors getting a number of things right:

- Firstly, governments must acknowledge that private equity has been a real driver in the European market and reflect this acknowledgment in legislation introduced.
- Secondly, private equity houses must work with their tax advisers to ensure that the correct tax structure is initially put in place from the perspective of the portfolio company, the investors and the private equity house itself.
- Finally, private equity houses must ensure that they have effective tax management controls in place to monitor what, after all, has been acknowledged to be a key value driver in private equity transactions. Only then will the serious concerns identified in the PricewaterhouseCoopers’ survey be addressed.

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