7th Business Law Forum – September 11 – September 12, 2015

Private Equity – New Trends Tax Structuring of Deals Bijal Ajinkya Attorney-at-law Khaitan & Co., Mumbai

Jean-Jacques Bataillon

Dr. Daniel U. Lehmann

Alexander Pupeter

Avocat au barreau de Paris Bataillon & Associes, Paris Avocat au barreau de Luxembourg Etude BATAILLON, Luxembourg

Certified Tax Expert Bär & Karrer AG, Zurich

Attorney-at-law / Tax advisor P+P Pöllath + Partners, Munich

A. ACQUISITION STRUCTURE

Page 2

I. Interposition of AcquiCo

Page 3

Can you imagine this structure?

Purchase price

Bank loan

PE Fund

Target

Page 4

Ringfencing of Investment

•

Typically PE-Funds do not assume the bank loan (leverage) directly.

•

Bank shall not have access to other investments of the fund.

•

Each investment is ringfenced. PE Fund Purchase price

AcquiCo

Bank loan

Target

•

AcquiCo as single purpose vehicle will be interposed.

•

AcquiCo assumes bank loan and receives funds from PE-Fund.

•

AcquiCo purchases Target. Page 5

Location of AcquiCo

Cash flow of Target shall be channeled to AcquiCo to pay interest and principal of loan. Interest expenses of AcquiCo shall be offset with operational profits of Target.  AcquiCo should be located in the same country as Target.

Bank

AcquiCo

AcquiCo Border

Target

Target

Additional entities in other jurisdictions may be interposed above AcquiCo. Page 6

II. Share Deal vs. Asset Deal

Page 7

Share Deal vs. Asset Deal

PE-Funds typically prefer share deals

•

No established business structure in place where the new acquired business unit has to be integrated. (Exemption: Add-on transactions).

•

Seller prefer share deals for tax reasons, a PE-Fund asking for an asset deal has competing disadvantage.

Pros of a share deal as compared to an asset deal •

Relatively simpler documentation

•

Reduced possibility of creditors’ approval

•

Greater likelihood of tax treaty benefits

•

No indirect tax costs such as Value Added Tax etc.

•

Possibility of mitigating stamp duty costs (if in dematerialised form).

Cons of a share deal as compared to an asset deal •

Company may not be eligible to claim existing losses in case of change in shareholding

•

Revaluation of assets not possible. Page 8

Share Deal vs. Asset Deal

Purchasers perspective: Additional considarations - Example France Advantages of asset deal The purchaser has a greater ability to control its risk regarding past liabilities of the business because the pre-existing liabilities of the business being transferred are retained by the previous owner. Exceptions: liabilities of the existing employees and certain liabilities under specific contracts as the commercial lease  Consequently, because the transferred liabilities are limited, an asset acquisition should reduce time and cost involved in a legal due diligence excercise and the time and legal fees involved in negotiating warrantly agreements can be reduced. Drawbaks of asset deal -

French regulation duties at 3 or 5% are levied on the part of the purchase price in excess of €23.000

-

Uncertainities linked to the no precise legal definition of the going concerne and therefore the necessity to set out in the sale contract an exhaustive list of the elements which are being acquired Page 9

Share Deal vs. Asset Deal

Sellers perspective: General preference for share deals over asset deals Example Switzerland •

Corporate Sellers: Participation relief for capital gains realized upon the sale of shares, if shares sold represent at least 10% of the share capital of the target company, which was held for at least one year. At the cantonal/communal tax level, the gain either benefits from the participation relief (same as at federal level), or it may be completely tax exempt due to a cantonal holding or mixed company tax privilege (to be abolished in some years).

•

Private individual Sellers: In principle, realization of tax-free capital gains from the sale of shares. However, numerous pitfalls for the seller to be considered. Special tax rules that limit this benefit are (see below): •

"Indirect Partial Liquidation"

•

"Qualification as a "professional trader"

•

Employment income Page 10

III. Sellers side to be considered Example CH

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Private sellers to be considered Example of Switzerland Background In Principle, capital gains realized by individuals on privately held movable assets are exempt from personal income taxes at the federal, cantonal and communal level. Since Tax exemption of private capital gains is generally seen as an exception to the general principle that all income and gains of a taxpayer are taxable, the exemption rules are given a narrow interpretation by the tax authorities. Pitfalls for the seller to be considered: •

"Indirect Partial Liquidation"

•

Qualification as a "professional securities trader"

•

Re-characterization as employment income, e.g. if the seller remains

employed by the target company and gets an earn-out payment Conclusion: Special requirements to the SPA for Private Equity Transactions with Swiss private Individuals Page 12

"Indirect partial liquidation" -

Re-characterization of capital gains from the sale of shares as taxable dividend income (deemed partial liquidation) Shares that represent a participation of at least 20% in the capital of the target company and which are privately held by a Swiss resident individual are sold into the business proproperty of a Swiss or foreign resident buyer.

-

Provided that: 1) Within five years of the sale, the target company makes a distribution of "nonoperating-substance" (cash or other non-operating assets of the company), and 2) This substance was available at the time of the sale of shares and would have been available for distribution according to the last balance sheet of the target company prior to the sale, and 3) The private seller has "co-operated" with the buyer of the shares in connection with the reduction of substance (this "co-operation" is legally assumed as a fact when the seller knew – or must have known - that this substance would be taken out of the target company for the purpose of re-financing the payment of the purchase price).

-

Consequences: Private seller is taxed on a deemed dividend from the target company.

-

Requirements to the SPA: Often, under the SPA, the buyer has to commit himself not to take any action triggering an "Indirect partial liquidation" event. Page 13

Re-characterization as employment income if the seller remains employed by the target company

New practice (Decision of the Swiss Federal Court 2C_618/2014 dated 03 April 2015) indicates more rigorous practice. -

Facts: SPA stipulates that the continued employment of the private individual seller in the target company is "conditio sine qua non" for payment of the full purchase price, combined with an earn-out provision.

-

Consequences: Provision in the SPA is seen as atypical : Tax authorities claim that, from an economic point of view, this condition makes the earn-out look as performance and loyalty bonus (i.e. as compensation for future work) rather than as part of sale price for the shares. Thus, as far as the sale proceeds exceed a certain value of the shares, they are treated as ordinary taxable employment income, which is also subject to social security contributions.

-

Requirements to the SPA: Clear distinction in the SPA about which part of the purchase price is paid because of the value of the target company, and which is due to the continuation of the employment. Advance tax ruling request recommended. Page 14

Qualification as a "professional securities trader” ("gewerbsmässiger Wertschriftenhändler")

-

Re-characterization of capital gains from the sale of shares as taxable income Any capital gain realized in a context that goes beyond "mere administration" of private wealth may be considered taxable income from self-employed activity. Case law indicates relatively low threshold at which individuals become "professional securities traders".

-

Indications for professional trading in securities: • • • •

-

Volume and frequency of purchasing selling transactions Use of debt leverage Use of sophisticated risk hedging techniques Strong link to the taxpayers professional activity

Strong relevance placed upon by the Federal Supreme Court

Consequences: Taxation of capital gains as ordinary income, subject to social security contributions, realized losses are deductible from income.

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B. POST ACQUISITION STRUCTURING

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Main important issues: 

Structuring of securities/collaterals for bank financing.  see session Deal Financing



Interest deduction from operational profits for tax purposes.

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I. Interest expenses - setoff

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Interest deduction for tax purposes

General acceptance / not acceptance •

D

Yes, with certain limits. •

CH Interest deduction is generally allowed. However, due to the participation relief of an acquiring operating company and/ or the holding privilege of the acquisition vehicle, the effect of deductibility of the interest may become minor.

•

India Interest on loans obtained for regular business activities eligible for deduction.

•

France

Yes, but subject to limitations. •

Luxembourg Yes to the extent that linked to taxable operations. Page 19

Interest deduction

Bank

AcquiCo Technical aspects: •

Two separate entities

Profit

Target

Without further steps: Separated assessments, no setoff. •

Exemption in Germany: Target is a limited partnership (KG). Interest expenses are directly allocated to partnership.

•

India: Shareholder would not usually be eligible to claim a deduction of interest expense incurred on loan taken for the purposes of making investments in shares. Interest on loans obtained for regular business activities eligible for deduction.

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Merger

•

Merger of AcquiCo and Target.

•

One merged entity  immediate setoff of profit and interest expenses.

•

Direction: upstream or downstream

Bank

Bank

AcquiCo

AcquiCo

PE Fund

Bank

Target

upstream

Target

AcquiCo/ Target

downstream

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Merger of AcquiCo and Target in Switzerland

Generally, the merger of an operating company with the target is unproblematic. Problem: Acquisition with acquisition vehicle

•

Generally, Swiss tax authorities qualify the up-stream or down-stream merger of AcquiCo and Target as tax avoidance (abuse of law), the assumption being that the sole purpose of the merger is the tax-effective set off of acquisition debt.

•

Set-off is generally not allowed during five years.

Possible solutions •

Tax Ruling before the acquisition that confirms possibility of future set-off and argues against the assumption of tax avoidance. Restrictive attitude of the tax authorities.

•

"equity-debt swap". However, possible pitfalls include: 1) Thin capitalization rules 2) The "Indirect partial liquidation"- case

•

Staggered acquisition: Company 1 buys company 2, which buys company 3, etc.

•

Post-acquisition sales of companies (similar effect as staggered acquisition) Page 22

Merger of AcquiCo and Target in India

Losses can be carried forward in certain circumstances Expenses incurred by the amalgamating entity before the effective date of merger will not be eligible for set off against the amalgamated entity‘s profits Outbound mergers not permitted whereas inbound mergers are permitted Domestic Indian holding – subsidiary companies can merge into each other Certain conditions prescribed for tax neutral merger Offshore mergers resulting in transfer of Indian assets exempt subject to conditions Specific exemptions also available to shareholders of merging entities

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Merger of AcquiCo and Target in France

•

In theory, tax leverage may also be achieved through a merger between the AcquiCo

and

the

target

company

since

mergers

qualify

as

tax

free

reorganizations in France. •

Such reorganization, usually referred to as “quick merger” (TUP) must however be analyzed very carefully : The French tax administration sometimes considers that

the timing between the acquisition and the merger is abusive and may therefore disallow the deduction of the interest expenses. Legal Risks : •

Interdiction of L225-216 Commercial Code: A company cannot give a security on its

asset to the buyer for the purchase of its shares •

Abuse of majority rule: if the merger serves only the interest of the majority shareholders of the target

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Merger of AcquiCo and Target in France

Tax Risks

•

Qualification of the merger by the Tax administration as a « irregular management act » or an « abuse of law » : indicators are the time between the acquisition and the merger, the debt ratio of the AcquiCo, an operational activity of the AcquiCO…

•

For the judges, such qualification by the tax administration presumes that the merger has only a tax purpose.

•

Solutions : Economic motives, management facilities created by the merger and a real development project of the business are possible arguments.

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Merger cont’d

•

Restrictions

•

Advantage

•



Simplified structure



Banks prefer merger

Disadvantage 

Spoiled balance sheet: Acquisition financing in balance sheet of operating entity



No dissolution possible (scrambled egg effect)

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Tax Unity / Group taxation •

Most countries provide an option for group taxation within the country: Germany: India:

Majority of shares and profit/loss pooling agreement required. No concept of tax unity or group taxation.

PE Fund

Switzerland: No tax consolidation available. France:

Option with 95% owned domestic subsidiaries, allowing the offset of losses

AcquiCo

against the profits (and EU ones but tax unity

subject to conditions) •

Cross border group taxation Germany: No France: Possible in France if the head entity is a French

NewCo

resident •

Advantage of group taxation 

No transfer of goods, assets, contracts, employees



dissolution possible.

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Tax Unity / Group taxation cont´d

•

Disadvantage 

Liability of AcquiCo for debt of Target (at least in Germany) (relevant when AcquiCo is no SPV)



More difficult to handle.

Page 28

Debt push down Bank old

Target assumes part/all liabilities from

AcquiCo Repayment

acquisition financing.

Cash Dividend

•

Leveraged dividend distribution. Bank new

Target

Bank

AcquiCo •

Assumption of debt as loan/dividend

assumption of debt

Dividend/ loan

Target Bank

Page 29

Debt push down cont’d

Advantages •

Banks like it

Disadvantage •

Very complicated

•

Restrictions due to financial assistance and equity protection rules

•

Additional tax may be triggered also by dividend distributions in kind

•

Balance sheet of target spoiled

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Cross border debt push down

If Target has subsidiaries in other countries and Targets “debt capacity” is not sufficient  Cross border debt push down might be required.

Bank loan

NewCo Repayment

Target purchase price

New Bank loan

New SubCo

SubCo Page 31

II. Shareholder loans

Page 32

Shareholder loans partially replacing equity funding

•

Appropriate equity quotas to mana-

PE Fund

gement (sweet equity). •

Repatriation

of

liquidity

without

SL

dividend taxation/withholding tax. •

Bank

AcquiCo Increased

interest

deduction

at

AcquiCo/Target level. (But

interest

taxation

instead

dividend taxation at PE-level!)

of

Target

Page 33

Anti-avoidance schemes

Tax authorities do not like reduction of tax base by shareholder loans.  Anti-avoidance legislation: Typical thin-capitalization rule: Interest deduction denied, if shareholder loans (and shareholder related bank financing) is to high.

India:

No thin capitalization norms in India. However, General Anti

Avoidance Rules to be in force from 1 April 2017. Also, certain Specific Anti Avoidance Rules in place in the form of Transfer Pricing Regulations [covering both, domestic (in a limited fashion) and international transactions] are in place.]

Germany: Interest barrier Interest expenses of max. 30% of EBITDA is deductible. No distinction: Shareholder (related) loan - true bank loan.

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Thin-capitalization rules: Switzerland

•

For purposes of the federal direct tax, the Swiss Federal Tax Administration laid down detailed safe harbor rules. These rules can

be overruled by an arm's length assessment, whereby the burden of proof lays upon the taxpayer. •

Total debt provided by shareholders should not exceed the aggregate market value of the following assets, as the case may be, reduced by the total interest-bearing debt capital from independent third parties at

the end of the year (examples): –

100% of cash

–

90% of Swiss and foreign bond issued in Swiss Francs;

–

70% of participations (shareholdings representing at least 20% of the capital of another corporation or a fair market value of at least CHF 2 million);

–

60% of Swiss and foreign shares listed on a stock exchange;

–

70% of operating real estate;

–

70% of private real estate, holiday homes and zoned land

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Thin-capitalization rules: France Under current rules, the tax deduction of interest paid by a French company to its shareholders is subject to the following restrictions: •

Interest rate limitation Tax deduction of interest paid to related parties is limited to the higher of –

the average annual interest rate applied by credit institutions to companies for medium-term variable rate loans. This rate is 2.79% for financial years ending on 31 December 2014.

or – •

the interest that the borrowing company could have obtained from independent banks under similar circumstances.

Debt ratio To be deductible, the interest paid can not exceed the three following limitations during the same financial year: –

Interest relating to financing of any kind granted by related parties, within the limit of 1.5 times the net equity of the borrower.

–

25% of adjusted net income before tax.

–

Interest income received from related parties.

The portion of the interest that exceeds the three limits is not deductible, except if lower than EUR 150,000 . =>

That part of the interest that is not deductible immediately can be carried forward, without time limit, for relief in subsequent years, provided there is an excess capacity during such years. The amount in excess is, however, reduced by 5% each year. Page 36

C. EXIT STRUCTURE

Page 37

Sale of AcquiCo

PE Fund

PE

Fund

prefer

capital

gain

to

dividend

distribution. AcquiCo

Bank

AcquiCo has to be sold, not Target. Reasons:

Target



Withholding tax and dividend taxation.



Restriction of capital transfer.

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LuxCo - Structure

PECS /CPECS are hybrid financial instruments which are considered as debt for the company which borrows and as equity for the lender.

Equity return

FUND

The (fixed) interests paid by the company will be fiscally deductible for itself. The PECs concede no voting right to the

PECs/CPECs

creditor who will be subordinated to all other creditors. LuxCo CPECS are PECs convertible into shares.  Those schemes are now under high

Interests

scrutiny

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D. TAX ISSUES OF PRIVAT EQUITY IN EMERGING MARKETS EXAMPLE INDIA

Page 40

INDIA

Vodafone case • The famous ‘Vodafone’ tax controversy related to an indirect transfer of Indian assets resulting from an offshore deal. • Post the ruling of the Supreme Court, which decided in favor of Vodafone and held such a transfer to be not taxable in India, the Indian Government made a retrospective amendment making such transactions taxable in India. • However, certain issues left open post the amendment and lacked clarity. • Some of them clarified by way of amendments in February 2015:

 Threshold for determining ‘substantial value’ – 50%  ‘Value of assets’ means “fair market value” (FMV);  manner of determining the FMV to be prescribed  Gains taxed to be proportionate to value derived from Indian assets  Exemptions provided for:  Transfers by small shareholders (