The global tax landscape has changed significantly in the last decade in an attempt to keep pace with the global business environment. Broad-ranging legislation with an increased focus on transparency has been introduced to help tax authorities keep track of cross-border transactions.
Given the EU’s push for ever closer alignment, the EU’s Anti-Tax Avoidance Directive (ATAD) makes the adoption of the Organization for Economic Co-operation and Development’s (OECD) key base erosion and profit shifting (BEPS) measures mandatory for all 27 member states.
The ATAD provisions include five legally binding anti-abuse measures that seek to minimize aggressive cross-border tax planning and to create a more transparent and stable environment for cross-border business and limit the scope for arbitrage.
When do the Provisions Apply?
The ATAD provisions are split between ATAD I and ATAD II and impose different rules.
Whilst most of the provisions apply from January 1, 2019, some of the rules will be introduced in stages over the next few years (most relevant being the cross-border hybrid provisions). However, some countries may choose to adopt certain provisions into domestic legislation earlier, so it is essential that domestic implementation of these rules is carefully monitored on a country-by-country basis.
What are the Provisions?
ATAD includes five anti-abuse provisions that are summarized below.
- Interest limitation—This introduces a 30 percent EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) restriction on the deductibility of excess borrowing costs.
- Exit taxation—Imposes a tax charge as result of a transfer of a trade or business from EU member states.
- General Anti-Abuse Rule—Aimed at counteracting artificial or egregious tax arrangements.
- Controlled Foreign Corporation (CFC) rules—Deter profit shifting to low tax jurisdictions.
- Hybrid mismatches—Aimed at preventing double deductions or non-inclusion of income as a result of hybrid entities or hybrid instruments.
How will ATAD Impact Private Equity Structures?
Private Equity (PE) structures are generally established with a number of different entity types, both transparent (typically partnerships) and opaque (typically corporate entities). These are often treated differently for tax purposes in different jurisdictions. Further, it is common for PE houses to generally utilize high levels of leverage within the investment structure.
Based on the current drafting of the ATAD provisions, the legislation only applies to entities that are subject to corporation tax. As such, PE partnership entities should not fall within this scope, though this could be amended in the future. Therefore, the ATAD provisions are most likely to impact the holding/portfolio group and, to a lesser extent, corporate general partners.
The interest limitation provisions that apply from January 1, 2019 are likely to have the most significant impact on PE portfolio structures.
Under these rules where an entity’s annual interest expense is in excess of its borrowing costs, ATAD will limit any interest deduction to 30 percent of that entity’s “adjusted” EBITDA. In these circumstances, this would give rise to excess taxable income in the period and result in a materially less efficient tax structure.
A typical PE holding structure utilizes internal and external borrowing at Topco with back-to-back financing arrangement with Midco and/or Bidco to enable the group to acquire the target.
Where there are back-to-back financing arrangements in place, the introduction of the ATAD provision should not ordinarily result in excess taxable income, as the arrangement should give rise to matching interest income and interest expense such that there is no “excess” borrowing.
However, at the target company level, the ATAD provisions could give rise to a potential restriction because of the interest expense on the funding to Bidco, but no matching interest income. The rules should be critically reviewed when considering the relevant financing arrangements and when completing the entity tax filings.
Profit Participating Finance
Another typical way that PE acquisition structures are financed is by way of a profit participating loan/note.
Following the introduction of the ATAD provisions there is a question mark over whether the “profit” element of the loan will fall within the domestic definition of interest expense rather than dividend income (the alternative, non-deductible, position).
Where the “profit” element is “interest” it would result in “excess” borrowing costs and therefore an interest deductibility restriction. To the extent that PE structures use these instruments, they should critically review the local domestic tax treatment to determine how the ATAD provisions might apply.
There are, however, a number of exceptions to these rules:
- any excess borrowing costs up to 3 million euros ($3.4 million) are fully deductible;
- any loans which give rise to an interest expense, where concluded before June 17, 2016, and no changes have made to the terms of the original loan since this date, are not caught by these provisions;
- where a corporate taxpayer is a member of a consolidated group, it may be able to:
- fully deduct excess borrowing costs where it can show that the equity to total asset ratio is within 2 percent group equity to total asset ratio; or
- under the Fixed Ratio Rule, it can show that it has an equivalent ratio of interest expense as the consolidated group based on third-party borrowing only;
- to the extent that the “excess” interest is not able to be deducted in the current year, this may be carried forward.
As the reader will recognize, these exceptions are unlikely to provide much comfort for substantial investment structures.
Whilst the ATAD interest restriction provisions apply from January 1, 2019, the U.K., in response to the BEPS project, adopted equivalent provisions into domestic legislation applying to arrangements in place as of April 1, 2017.
As such, U.K. entities should have already been reviewing the impact of the rules on existing arrangements. Note that the U.K. provisions do not fully mirror the ATAD provisions (e.g. the U.K. has a de minimis threshold of 2 million pounds ($2.6 million) rather than 3 million euros under ATAD provisions) therefore, for multi-jurisdiction arrangements, all sets of rules should be carefully considered.
As set out above, PE structures have a number of different types of entities that may be transparent or opaque under domestic legislation. In addition, there may be instruments that are treated as debt in one jurisdiction but equity in another. Therefore, it is important to consider the impact of the hybrid mismatch rules for PE structures.
ATAD provides that:
- to the extent that a hybrid mismatch results in a double deduction, then the deduction will only be available in the member state where the payment originates;
- to the extent that a hybrid mismatch results in a deduction without inclusion, then the member state will deny the deduction.
The implementation date for the majority of the ATAD minimum standards for hybrid mismatches is January 1, 2020.
Hybrid mismatches may arise as a result of a hybrid instrument or a hybrid entity. Within a PE structure there are numerous cases where instruments (e.g. Preferred Equity Certificates) are drafted so that they are treated as debt in one jurisdiction but equity in another. The result sought is a deduction without inclusion. Where this is the case, the deduction will be denied under the ATAD provisions.
In addition, PE structures may have a number of hybrid entities (i.e. where a fund entity is considered to be a transparent entity in one jurisdiction, but a corporate entity in another). It is important that the investment structure from the fund to the holding company structure is carefully and critically reviewed to determine whether the provisions adversely impact the structure and investors.
Note that the U.K. already has comprehensive hybrid mismatch provisions that apply to arrangements in place as of January 1, 2017. However, the U.K. will also introduce some changes to ensure that its legislation is fully compliant with the ATAD provisions applying from January 1, 2020.
The ATAD provisions should be carefully reviewed by all PE houses.
Some of the more mature tax jurisdictions (e.g. the U.K.) already have legislation that covers the issues identified by ATAD, so the ATAD provisions will likely have minimal impact at a domestic level.
However, a larger number of EU jurisdictions will be required to play catch up, such that implementation could result in significant changes to the way historic arrangements have been taxed. This could have significant impact on investor returns.
Given the way in which PE structures have traditionally been established and funded, it is likely that the ATAD provisions will impact all PE structures. It is important that, without delay, PE houses:
- review their current structures and analyze which provisions are likely to impact their current operations;
- review intra-group financing arrangements to ensure that from a group perspective, they are comfortable with the current group interest deductibility;
- identify where they have hybrid entities or hybrid instruments in the structure and understand how the ATAD provisions in each relevant jurisdiction will apply;
- keep a watchful eye on how the specific ATAD provisions have been adopted on a country-by-country basis, as domestic implementation may be different;
- when setting up a new fund or holding structures, consider these rules at the outset (including modeling cash inflows and outflows) to ensure the exact implications are known; and
- consider the impact of the ATAD provisions on arrangements which have been put in place based on historic tax rulings.
Dhara Soneji is Vice President and Andy Murray is Managing Director at Duff & Phelps, U.K.
Duff & Phelps has a considerable amount of experience assisting clients with the above and would be delighted to help you review your current structures and determine how these provisions may impact them.