Tax developments in private equity. 5 th July 2004 pwc

Transcription

1 Tax developments in private equity 5 th July 2004 pwc

2 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 2

3 Structuring Private Equity in Luxembourg Laurent de La Mettrie 5 th July 2004 pwc

4 Agenda Introduction Structuring investments in Luxembourg Structuring the PE fund in Luxembourg The SICAR Conclusions 4

5 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 5

6 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 6

7 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 tax efficient vehicle 7

8 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 8

9 SICAR Key terms Interest holders must be professional investors ( investisseurs avertis ), 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 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 9

10 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 10

11 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 11

12 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 12

13 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 13

14 SICAR repatriation of income to nonresident 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 14

15 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 15

16 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 16

17 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 17

18 The impact of Schedule 22 of the Finance Act 2003 Tim Hughes 5 th July 2004 pwc

19 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 19

20 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 20

21 Schedule 22 High level changes Slices up a share or security between income and capital components Portfolio Co shares Income tax value 20 Focuses attention on the total value of the share Security provided by employer or associate is always by reason of employment Economic Value 90 Restricted Market Value 100 Unrestricted Market Value 120 Issue Price 10 21

22 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 22

23 Schedule 22 An example UMV % Restrictions Good/Bad Leaver Non-Transferable Voting RMV Income 37.5% 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 % Capital 62.5% Any discount to RMV on purchase price chargeable to income and payable at entry Entry Values 23

24 Due diligence / structuring issues Capital structures Ratchets Reorganisations PAYE Admin Elections Form 42 24

25 A typical deal structure pre Finance Act 2003 Mgt 2 nd Tier Ords 0.1m Options NewCo1 NewCo2 NewCo3 Ords 0.9m 8% Prefs 9m 8% Debt 40m PE House 15% Mezzanine + warrants - 50m 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 NewCo4 Target 6-7% Senior Debt 100m 200m 25

26 Capital Structures What is market value? Mgt Ords 0.1m Ords 0.9m PE House 8% prefs issued at 9m should have a 15% yield. Therefore market value on issue must be 4.8m 2 nd Tier Options NewCo1 NewCo2 NewCo3 NewCo4 Target 8% Prefs 9m 8% Debt 40m 15% Mezzanine + warrants - 50m 6-7% Senior Debt 100m 200m 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! 26

27 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 Value of Ratchet 1150 Possible 20% stake Issue Price 2,200 Overall 10% 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! Issue Price

28 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. 28

29 Reorganisations An example UMV % % UMV % % 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 Old Share New Share 29

30 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 30

31 Reorganisations continued Need to be careful of funny shares 900 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- 100 convertible OSC Post Conversion OSC 31

32 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 32

33 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 33

34 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 34

35 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 35

36 Typical deal structure post Finance Act 2003 Mgt 2 nd Tier Ords 10% 0.2m Options NewCo1 NewCo2 NewCo3 NewCo4 Ords 90% 0.9m PE House 11% Prefs 9m 15% Debt 40m 15% Mezzanine + warrants - 50m 6-7% Senior Debt 100m 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 200m 36

37 Comparison of exit proceeds pre and post Finance Act 2003 Pre FA 03 30% return after 3 years Shareholder Debt 50.5m Prefs 11.5m Ordinary Shares 48m Post FA 03 30% return after 3 years Shareholder Debt 61m Prefs 12.5m 80% 38.4m Ordinary Shares 36.5m 20% 9.6m 80% 29.2m 20% 7.3m 37

38 Schedule 22, carried interest and the MOU Investors Investors introduce 800Km of capital and 999m of loans Investors receive all realisations until Original investment plus hurdle returned Simplified Structure Fund target target target target target target target Execs Executives invest 200K, no return until investors loans fully repaid with hurdle 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 38

39 Schedule 22, carried interest MOU conditions 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 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 39

40 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 40

41 Co - investment Co-investment is within the schedule 22 rules Inland Revenue have historically challenged coinvestment, 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. 41

42 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 42

43 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 43

44 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 44

45 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 45

46 Value Added Tax Stuart Corp 5 th July 2004 pwc

47 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? 47

48 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? 48

49 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? 49

50 VAT: New VAT group conditions Changes to eligibility rules effective from 1 August 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 50

51 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 51

52 VAT Avoidance Disclosure 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 52

53 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 53

54 VAT Avoidance Disclosure 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? 54