5th July 2004 pwc · • Today most transactions on large and medium LBO’s ... • To promote...

5th July 2004 pwc

Tax developments in private equityTax developments in private equity

2Tax Developments PricewaterhouseCoopers

Agenda

• Introduction and welcome – Mark Pugh• Structuring private equity in Luxembourg – Laurent de La Mettrie• The impact of Schedule 22 of the Finance Act 2003 – Tim Hughes• Value Added Tax – Stuart Corp

5th July 2004 pwc

Structuring Private Equity in LuxembourgLaurent de La Mettrie

Structuring Private Equity in LuxembourgLaurent de La Mettrie


Agenda

• Introduction• Structuring investments in Luxembourg• Structuring the PE fund in Luxembourg

– The SICAR• Conclusions


Structuring investments in Luxembourg

• Luxembourg is well known in the PE community as “the” jurisdiction where the investments are structured (so-called “SOPARFI’s”)

• The objectives are to minimise the tax burden on– Investing in Target Co– Receiving income from Target Co (dividend or interests)– Divesting (sale/liquidation)

• Today most transactions on large and medium LBO’s are structured through Luxembourg


Incorporating the fund in Luxembourg

Overview of the structures available in Luxembourg• UCITS incorporated under the law of 20 December 2002 or IML

Circular 91/75• “Fund-like” companies• SICAR


SICAR – Law of 12 May 2004

Purpose of the SICAR• To promote Luxembourg as a jurisdiction for venture capital and

private equity investments through a regulated, flexible and taxefficient vehicle


SICAR – Key terms

• Business purpose = capital risk investments (but not exclusively)• Capital risk investment

The (direct or indirect) contribution of all categories of assets representing an interest in non-quoted companies (equity, loan, mezzanine….)

– Direct investment into such companies or– Investment into other VC/PE vehicles

=>Possible to have a SICAR organised as a FoF

• No risk spreading requirements


SICAR – Key terms

• Interest holders must be professional investors (“investisseursavertis”), i.e.

– Professional investors (as defined in the Annex to CSSF Circular 2000/15); or

– Institutional investors (1991 law); or

– Any investor who has confirmed in writing that he is an experienced investor and invests at least EUR 125 000 in the SICAR, or provides a certificate established by a financial professional certifying his or her skills permitting to adequately judge an investment in venture capital


SICAR

Regulatory & legal considerations

• Statutory seat, central administration located in Luxembourg (substance purpose)

• The SICAR must appoint a custodian to safe-keep its assets

• CSSF must approve

– The incorporating documents of the SICAR

– The Directors of the SICAR

– The custodian

– The external auditor

• There is no need for a promoter nor a need for approval of the investment manager, if any


SICAR

Regulatory & legal considerations

• Publication of an offering memorandum and its subsequent update

• Publication of the annual accounts on a yearly basis

• The SICAR must calculate a NAV at least twice a year

• Assets valued in “good-faith” at the estimated realization value

• Need for an annual audit by an approved external auditor. Obligations of the auditor include reporting of non-compliance of investments with by-laws or with SICAR law


SICAR - Taxation

• A SICAR set up as a Luxembourg corporation– No general tax exemption (e.g. management fees, directors

fees), but– No taxation on income derived from securities– No taxation on income derived from the sale, the

contribution or the liquidation of securities (i.e. no taxation of built-in and/or realized capital gains)

– “Cash on hold”– Exemption from municipal business tax and– Exemption from net wealth tax


SICAR - Taxation

• A SICAR set up as a limited partnership– Not considered as Luxembourg PE of non-resident partners– No taxation of non-resident partners on income derived from

securities– “Cash on hold”– Exemption from municipal business tax– Exemption from net wealth tax


SICAR – repatriation of income to non-

resident investors

• No WHT on distribution of income by a SICAR to its interest holders

• In general, no taxation of income distributions to non-residents interest holders

• No capital gains taxation for non-resident unit holders of a SICAR– No “tax leakage” for income repatriation to non-resident

investors regardless of the personal tax status of such investors


SICAR – Capital Duty / VAT

• Capital duty

– Lump-sum EUR 1,250 capital duty upon incorporation for contribution to a SICAR (upon establishment, during the lifetime)

– No subscription tax (“taxe d’abonnement”)

• VAT

– Services provided for the management of one or several SICAR are exempt from Luxembourg VAT


SICAR - Summary

Pro’s• Regulated vehicle meeting current trends (pension funds,

(U)HNWI)• Flexible vehicle with very light regulatory constraints (no on-going

supervision, no risk spreading requirements,..)• Listing on the stock exchange• Attractive tax regime

Questions ?• Credibility of Luxembourg expertise in PE (service providers,

regulators,…) • Open question on tax treatment by third countries


Conclusions

• Luxembourg is a highly attractive jurisdiction for structuring PE funds

• The “cluster” theory: Luxembourg as a European center of excellence for the administration and distribution of saving products

• BUT…– Lack of experienced service providers (PE fund

administration is a totally different business)– Lack of attractiveness as a place for setting up the fund

management Co– Regulated environment (UCITS, SICAR) may frighten some

managers

5th July 2004 pwc

The impact of Schedule 22 of the Finance Act 2003Tim Hughes

The impact of Schedule 22 of the Finance Act 2003Tim Hughes


Agenda

• Schedule 22 – an overview • Due diligence/structuring issues

– Employees i.e. management• Other issues for the private equity industry

– Carried interest– Co-investment

• Wrap up


Schedule 22 - An overview

• Most significant tax change for the private equity industry since 1987

• Previously profits of shares were within the capital regime or the income regime

• Now, disguised employment reward will be taxed as income• Affects portfolio company management and executives at private

equity houses


Schedule 22 – High level changes

Portfolio Coshares

• Slices up a share or security between income and capital components

• Focuses attention on the total value of the share

• Security provided by employer or associate is always by reason of employment

UnrestrictedMarketValue£120

Income taxvalue£20

Economic

Value£90

RestrictedMarketValue£100

Issue Price£10


Schedule 22 – High level changes

• Very broad definition of security including shares/securities but also– Contracts for differences or something similar– Interest in a collective investment scheme

• New anti avoidance rules– Convertibles (much broader)– Things done– Post acquisition benefits (now actually attempting to invoke it)– Securities options- unilateral cancellation route blocked

• Schedule 23 re corporate deductions


Schedule 22 – An example

£0.40

£0.40

£0.40

Restrictions

£3.20

UMV

100%

• Pay the income tax on 37.5% of the exit values

• OR pay UMV • OR pay the income

tax on 37.5% of total entry values

• Any discount to RMV on purchase price chargeable to income and payable at entry

Capital

Income

62.5%

37.5%

Good/Bad Leaver

Non-Transferable

Voting RMV

£2.0062.5%

Entry Values


Due diligence / structuring issues

• Capital structures• Ratchets• Reorganisations• PAYE• Admin

– Elections– Form 42


A typical deal structure pre Finance Act

2003

• Ratchet in place– Performance targets

with ceiling giving 20% ordinary shares

• Good and Bad leaver provisions in place

• Voting restrictions • Shares non-transferable• Tag Along / Drag Along

Target

NewCo4

NewCo2

NewCo1

PEHouse

Mgt

2nd

Tier

Ords £0.1m

Ords £0.9m

8% Prefs £9m

8% Debt £40m

6 - 7% Senior Debt£100m

£200m

Options

NewCo3 15% Mezzanine + warrants - £50m


Capital Structures

What is market value?

Target

NewCo4

NewCo2

NewCo1

PEHouse

Mgt

2nd

Tier

Ords £0.1m

Ords £0.9m

8% Prefs £9m

8% Debt £40m


£200m

Options


• 8% prefs issued at £9m should have a 15% yield. Therefore market value on issue must be £4.8m

• 8% debt issued at £40m will have a market value of £21.3m

• Immediate transfer to equity of £22.9 of which managements share is £2.29m

• Tax on that undervalue is £930K as compared to £100k investment !


Ratchets

How do we take the ratchet into account?

• To be paying UMV, management must pay a price which reflects the maximum economic entitlement (i.e. post ratchet)

• If not, Revenue likely to seek to charge to income tax the reward element

• Can either pay for the shares and be diluted downward OR pay a premium for the possible positive ratchet effect

Issue Price£100

Issue Price£2,200

Overall 10% stake

Value ofRatchet£1150

Possible 20% stake

So instead of paying 100, individual return will need to be squeezed not only

to reflect benefit of capital structure ( £2200) but also value of ratchet which may never be

received !


Ratchets

How do we take the ratchet into account?

• Pre May 2004 Inland Revenues view was that pre 16 April 2003 ratchets were liable to income tax.

• Indeed some people paid tax on this premise.

• In May 2004 The Inland Revenue published a new FAQ and backed down

• For post 16 April 2003 ratchets where the individual has paid something reflecting hope value of the ratchet, only a proportion will be chargeable to income tax.

• In the example given where the person where the maximum value of the ratchet is £1150 then if he only pays 1/3 of this for the hope value at exit 1/3 will be within the CGT regime and 2/3 will be liable to income tax.


Reorganisations – An example

£0.90

UMV

90%

£0.10 10%

Old Share

£0.9090%

£0.10 10%

UMV

New Share

• Swap old share for new shares • Same rights and restrictions• Impact : • Tax payable either at exchange on

10% OR 10% of eventual exit proceeds subject to income


Reorganisations continued

• In a FAQ published in May the Inland Revenue attempted to deal with rollovers– Post 16 April without

election– Post 16 April with election– Pre 16 April condition

shares– Pre 16 April swapped for

post 16 April

• Rollover but in relation to restrictions and only provided those restrictions are not lifted

• FAQ not entirely clear but Inland Revenue have confirmed that it will not be an acquisition for the purposes of chapter 2.

• Still need to be concerned– Restrictions lift– Other chapter


Reorganisations continued

• Need to be careful of funny shares

• For example a CPEC is a convertible debt instrument

• The new convertible legislation is a disaster for UK individuals with employment connection holding CPECs

• Inland Revenue may agree if employee holds a strip in proportion to other shareholders-

OSC

100

900

Post C

onversion

convertible

OSC


PAYE

• Tax charges under these provisions may be PAYEable– For most private equity backed companies undervalue

charges and Schedule 22 charges typically PAYEable

• Exceptions include PE houses which are part of a group listed on a recognised stock exchange

– For non-private equity backed companies, PAYE will depend on corporate structure and nature of security

• Tax charges also bring a potential exposure to NICs – EEs and ERs


Admin

• Elections– Must be signed within 14 days of acquisition – Joint election between employee and employer– Irrevocable

• Form 42– Disclosure to the Inland Revenue each July– Penalties (£3,000) for incorrect returns– Penalties £300 for each employee for each chargeable

event omitted


Where are we now?

• BVCA and Inland Revenue have reached an agreement as to what is UMV

• Set out in MOU (Memorandum of Understanding) – July 2003• Main conditions are:

– Leverage is on commercial terms– Price paid by management not less than price paid by VC– Shares with substantially same rights, acquired at same time– Any possible ratchet impact is accounted for at acquisition

• If conditions met, price paid is considered to be UMV– All future profits chargeable to capital rather than income


What are commercial terms?

• Any preferred capital – equity or debt – must be on commercial terms

• Coupon must be not less than the coupon on the most expensive financing provided by third parties

• Equity kickers on debt can be ignored when calculating overall coupon on that debt

• All coupons are judged after CT deductions (if applicable)• All coupons are expressed as annualised percentage rates


Typical deal structure post Finance Act

2003

• Coupons increased on shareholder debt and preference shares, otherwise would have to pay £2.29m more for equity

• Management paying proportionally more for ordinary shares to take into account ratchet

• Alternatively, will need to squeeze equity

Target

NewCo4

NewCo2

NewCo1

PEHouse

Mgt

2nd

Tier

Ords 10%£0.2m

Ords 90%£0.9m

11% Prefs £9m

15% Debt £40m


£200m

Options



Comparison of exit proceeds pre and post

Finance Act 2003

Shareholder Debt£50.5m

Prefs£11.5m

Ordinary Shares£48m

Pre FA’03 30% return after 3 years

20%£9.6m

80%£38.4m

Shareholder Debt£61m

Prefs£12.5m

Ordinary Shares£36.5m

Post FA’03 30% return after 3 years

20%£7.3m

80%£29.2m


Schedule 22, carried interest and the MOU

• Carry is similar to management investment ie small sliver of equity but with the hope of a monumental return!

• Similar to having paid £200k for an option, the investors preferred return is the strike price

• Inland Revenue wanted to tax gains as income!

• MOU issued Jul 03 to provide “safe harbour”

Fund

Investors Investors introduce£800Km of capital

and £999m of loans

Investors receiveall realisations until Original investment

plus hurdle returned

Execs

Executives invest£200K, no return until

investors loansfully repaid with hurdle

targettarget

targettarget

targettarget

target

Simplified Structure


Schedule 22, carried interest

MOU conditions

• Security for the purposes of sch 22 is the partnership interest.

• Deemed to have paid UMV– If carried interest is

acquired before fund makes its first investment

– Where carry is acquired later if it can be shown no gain in aggregate value of investments

• Extends to– Non UK partnerships– Captive funds

• Arms length negotiations• Carry participant pays same

price per unit as LPs• Only restrictions are leaver,

vesting and transfer• Standard fund structure

– 20 % interest– Priority Profit share 1.5 % to 2.5%– Hurdle 8 to 10%– Proper salary


Schedule 22, carried interest

problem areas / solutions

• Catch up- position confirmed by recent FAQ

• Joiners- valuation issues in focus

• Description on 431 elections, form 42

• Reallocation of carry following leavers

• “Unallocated” carry

• May be worth looking at the use of LLPs– New funds where there is

no employment connection

– Potential issues arising as a result of portfolio company directorships to be clarified


Co - investment

• Co-investment is within the schedule 22 rules

• Inland Revenue have historically challenged co-investment , particularly leveraged schemes

• Different schemes– Partnership– Direct investment– Offshore corporate

• Do the MOUs apply– Carry– Management equity

• Hard to treat employees differently so in our view the MOU dealing with management teams will apply

• MOUs only cover chapter 2 provisions (restricted stock) and therefore other anti avoidance provisions are in point.


Co – investment continued

• Co-investors typically invest in a strip – variety of instruments– in the absence of leverage

more likely that participants have invested on arms length terms.

• Where a partnership structure is used it maybe possible to treat the interest in the partnership as the security

•BVCA currently negotiating with the Inland Revenue on these and other issues


How we can help

• Current market practice– Deal structures– Revenue attitudes– BVCA attitudes

• Structuring to meet management and PE House requirements• Experience in latest Revenue thinking - the “Frequently Asked

Question’s”


Management Team Advisory Group

recent deals

• Center Parcs – IPO

• Project Beacon – Refinancing

• Odeon Cinemas - Refinancing

• Project yellow Brick Road – Merger of 3i/VSS investments

• Fitness First – PTP

• Esporta -PTP

• Swiss Port LBO

• Sigma Kalon – LBO

• Change Capital – New fund


Final thoughts

• UK now has one of the most complex regimes for taxing employee securities

• As a result of the work over the last year Inland revenue are much more familiar with PE structures

• Not satisfactory to make law by FAQs• All areas of the PE industry affected by new legislation e.g.

– management equity– carried interest– co-investment

• Premium on good advice in this area in the UK and across Europe

5th July 2004 pwc

Value Added TaxStuart Corp

Value Added TaxStuart Corp


Venture Capital Funds: VAT Structure

• Business of Limited Partnership is carried on by the GP for VAT purposes

• Often GP is VAT grouped with a Manager

• Multiple GPs ?

• How much VAT can a PE/VC VAT group recover?


Typical transactions: VAT on supplies?

• Director’s fees? – Actively advising or “passive” ?– As a condition of loan finance – exempt

• “Success” fees charged to the target – exempt or taxable?

• Post-acquisition management advisory charges – taxable

• Placement fees – “exempt if an introductory fee for connecting the Limited Partnership with the investment fund” ?


VAT: Deal costs (due diligences)

• Customs’ view: no VAT recovery

– Recharges of due diligence costs by provider of loan finance -exempt ?

– Recharges by equity investor – no supply ?

• VAT recovery by investee

– Is target obliged to bear the economic cost?– Is business of Newco/Target the “primary interest”?– Does advice assist Newco/Target in conducting business

successfully and profitably?– Is benefit to investor secondary?


VAT: New VAT group conditions

• Changes to eligibility rules effective from 1 August 2004.

• Apply to a “specified body” – makes supplies to a VAT group member and VAT group is partly exempt.

• Is a VC Manager or a GP a “specified body” ?

• Additional conditions:– Benefits condition– Consolidated accounts condition


VAT Avoidance Disclosure

• Taxpayer must disclose any “designated scheme” or a scheme involving a “designated provision” and has the purpose of obtaining a tax advantage.

• Exemption from disclosure requirements:– Designated scheme: Turnover below £600K– Designated provision : Turnover below £10M



• Designated schemes listed by Customs:

– First grant of zero-rated major interest in a building– “merchant acquirer” – Debenhams– Sale or lease and leaseback– Value shifting by retailers– Extended approval periods by retailers– Transfers of training business to a non-profit making body– Supplies made by a “specified body” in a VAT Group– Transfer of educational or training activities to a non-eligible body


“Hallmarks” of VAT Avoidance

• “Hallmarks” of VAT avoidance:

– Sharing of tax advantage/contingent fees– Prepayments between connected parties– Funding by share subscriptions or loans– “off-shore loops”– Construction work associated with property transaction

between connected persons



• Penalties for failure to disclose:

– Designated schemes: 15% of the VAT saving– Other notifiable schemes: fixed penalty of £5K.

• Are LP funds affected?

• Are investee companies affected?

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5th July 2004 pwc · • Today most transactions on large and medium LBO’s ... • To promote...

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