The last two decades have witnessed a substantial growth in debt funds. That growth has been fueled by a heady combination of a preference for leveraged finance, extraordinary macroeconomic conditions and traditional lenders withdrawing from certain sectors of debt capital markets. The boom has also been helped in part by the global tax bias for debt finance.
This article addresses this market sector and raises the question—will the recent raft of domestic tax changes, particularly those for interest deductibility, slow activity?
Debt Capital Markets—Some Context
The mergers and acquisitions boom since the mid-1980s has been largely fueled by leverage. The first major foray into leveraged buyouts was RJR Nabisco (and the rise of the junk bond) with further rapid growth in the activity of private equity funds in the early 2000s.
Asset acquisition and investment was and continues to be heavily leveraged. The upside, for investors, was a dramatic reduction in taxable income in the investment structure and the return of increased investment yields. It is little wonder the proliferation of the private equity model is strongly correlated with the substantial increase in global debt levels.
Traditional direct lending by banks was given support by investment bank participation and the ability to deleverage into the secondary markets. This led to a propagation of debt funds across a broad-spectrum asset class (at the risk of oversimplification, we are talking here about origination, primary, secondary and distress).
The Global Tax Bias
This growth in debt capital markets has been greatly assisted by the global tax bias for debt finance. Until recent amendments, most jurisdictions allowed a full domestic deduction against taxable profit for interest expense when undertaking a trading activity.
This domestic bias is coupled with the international withholding tax bias—generally nil rates of interest withholding tax. The tax bias for debt financing clearly illustrates the way in which the domestic and international tax framework failed to keep pace with globalization.
Traditionally, a full deduction for interest expense was less problematic as the lender and the borrower were in the same jurisdiction. The result, viewed holistically, was that the tax base was largely unaffected by a financing structure. In stark contrast, the situation is different for cross-border lending activity and, more so where the lender is in a low or no tax environment. The result in most circumstances is a substantial and adverse impact on domestic tax revenues.
Those standards and assumptions have created instances where cross-border debt financing has been undertaken with limited regard for the immediate or prevailing tax consequences.
The immediate risk can perhaps loosely be described as the Google Rates Table Myth (the “Google told me it was nil” excuse).
The second, and perhaps less obvious risk, is the introduction of increased avoidance measures, such as the Organization for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) Actions and the EU’s Anti-Tax Avoidance Directive (ATAD).
These domestic restrictions could, apart from distress situations, potentially slow the continued growth in this sector.
The Google Rates Table Myth
“I checked Google and it clearly states withholding tax is zero.”
It’s a surprisingly common misconception for debt funds. But, as fantastic as Google is, a rates table summary does not provide a definitive answer. In the absence of a domestic exemption (think Luxembourg) reliance on the specific exemption in a tax treaty is critical to ensure investment yields are preserved.
A summary table cannot highlight that some treaty benefits are curtailed depending on an entity’s legal form or are adversely affected by the underlying security package. Caution is advised.
BEPS and ATAD
Of greater significance to debt capital markets are BEPS and the ATAD.
In addition to the general decline in tax revenues because of globalization, the 2008 global financial crisis further starved domestic treasuries of tax revenue. It was clear that the traditional siloed approach to taxation required wholesale change to restore domestic finances.
The OECD’s BEPS project, a plan with a five-year gestation, was the global response. BEPS proposed 15 Actions that domestic authorities could introduce to promote coherence and transparency. The Actions seek to limit arbitrage opportunity and strengthen domestic avoidance rules.
However, BEPS is a voluntary measure. To limit European arbitrage opportunity, the EU passed ATAD, generally effective from January 1, 2019. ATAD provides for the mandatory adoption of five BEPS initiatives though with some domestic flexibility for legislative implementation. In the current context, the most critical is that for limiting tax deductible interest expense.
The interest limitation (30 percent adjusted earnings before interest, tax, depreciation and amortization (EBITDA)) substantially changes the domestic tax profile of debt financing. In the absence of a full interest deduction, the financing structure of any acquisition will likely look remarkably different. It’s here that domestic implementation flexibility may provide some relief.
We’ve seen examples (Luxembourg and Ireland) where the definition of “interest income” (one of the components of the interest limitation test) is drafted to include profit participating notes—a common planning tool in both jurisdictions. Should that definition be amended, the impact on deductibility (and taxable income) would be severe. The ATAD changes are recent and their full impact is yet to be seen. However, the extensive use of debt finance may start to slow.
We await with interest the financing package adopted for the next major European private equity acquisition.
Coupled with the BEPS and ATAD initiatives is the approach of domestic tax authorities to private equity financing structures more generally.
Two recent European Court of Justice (ECJ) rulings on a Danish tax authority request for a preliminary ruling illustrate the changing tide. The two cases (that consider several joined matters) examine the use of financing vehicles in the context of a cross-border private equity investment structure.
The ECJ was clear that EU law cannot be used to facilitate tax avoidance and that companies with limited physical local presence and beneficial entitlement to the economics of the financing flows ought not be entitled to domestic or EU exemptions. The ruling shows a clear change in attitude to tax structured/beneficial arrangements.
The ruling is relevant in current circumstances. To the extent domestic or EU exemptions are being utilized to transfer financing yields within (and out of) the EU, tax authorities are likely to want solid commercial rationale for the inclusion of a vehicle. The result could be a curtailing of traditional “tower” structures or increased costs for operating and managing the arrangements. The flow on effect will potentially be a decline in the use of leverage. The impact on debt capital markets could be profound.
This article raises a cautionary tale for debt investment. The rampant use of leverage and the corresponding growth in debt funds is likely to meet some headwind generated by domestic tax policies that make debt financing much less attractive. Investor challenges to historic assumptions and beliefs will be critical in considering the future yields available in this sector.
The effects of the ATAD and BEPS changes on debt markets is likely to be felt in debt capital markets from 2019. As a priority, debt funds should:
- carefully and critically review the financial models underpinning investment activity;
- critique the financial assumptions being made in acquisition structures on debt service headroom; and
- undertake tax treaty review for investments to ensure benefits are available.
Andy Murray is Managing Director at Duff & Phelps, U.K.