Private Equity European Bulletin - Thin Capitalisation Across Europe

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					Private Equity
European Bulletin
February 2006

Thin Capitalisation Across Europe
Private Equity European Bulletin                                                                                     February 2006

                                                       UNITED KINGDOM
 Recent changes to the UK tax regime may deny or defer tax deductions for financing costs on loans made by investors to
 private equity bid vehicles, and will increase the on-going UK tax burden suffered by investee companies after acquisition.
 The changes impact in three areas:
 Loans made by partnerships and other co-investors
 Previously, the UK thin cap rules treated a partnership fund as transparent with the result that the fund was not caught by
 the rules. Now, this has changed and persons “acting together” in relation to a financing of a company will be treated as a
 single person. Impacts include:
 >   Interests of all investors in a fund will be aggregated. So if the fund controls Bidco, the thin cap rules will apply.
 >   Parallel fund structures will also be caught, with interests aggregated if acting under control of same manager.
 >   Consortium bids likely to be caught in many cases, but will require scrutiny.
 >   Useful to get bank quotes to show that loan comparable to arm's length loan.
 Zero coupon and other yield roll-up debt
 The general position remains unchanged – where a loan is made by a controlling fund, tax deductions for rolled up interest
 are deferred until the interest is paid. Exemptions that were previously utilised by funds have effectively been removed, with
 the result that interest deductions will be deferred (possibly indefinitely) on many private equity transactions. It may be
 possible to avoid these rules by using PIK notes.
 Hybrid debt / equity instruments
 Cross-border acquisition structures sometimes use hybrid instruments – eg. where interest paid on a loan to a UK Bidco
 is deductible, but the overseas lender receives a tax-free receipt of dividend income. The new rules generally result in the
 interest no longer being deductible, unless Bidco can demonstrate that UK tax avoidance is not one of the main purposes
 of the structure.

 The Finance Bill 2006 has deeply modified the French thin capitalisation regime. The new regime will come into effect for
 financial years starting on or after 1 January 2007 and is expected to impact materially on the structuring of investments in
 France. The main features of this new regime are as follows:
 >   Scope: The new regime will apply to all debts owed by a French company to group-controlled entities, regardless of
     where those entities are located (France, EU or outside EU). Loans made by third parties (banks, etc.) should generally
     remain outside the scope, even if such loans are guaranteed by any entity in the borrower's group.
 >   Disallowance or deferral of the tax deductible interest:
     -   Tax deductible interest will be assessed by application of (i) an interest rate limitation based on market practice, (ii)
         1.5:1 debt-to-equity ratio and (iii) a 25% interest-to-operating profit ratio.
     -   Interest disallowed pursuant to the first limitation will definitely be lost for tax purposes.
     -   Interest disallowed under limitations (ii) and (iii) for a given financial year may be deducted in the following financial
         year or, subject to a yearly 5% reduction, the financial years thereafter.
 >   Safe harbour: Limitations (ii) and (iii) do not apply if the borrower can demonstrate that its own debt-to-equity ratio
     does not exceed the debt-to-equity ratio of the group to which it belongs.
 >   Exemptions: These may apply under specific circumstances (cash pooling agreement, finance lease transactions, etc.).
 >   French tax consolidation: Favourable rules apply to a French tax consolidated group which will be deemed to form a
     single entity for the assessment of the 25% interest-to-operating profit ratio.
 >   Disallowed interest: This will not be treated as a deemed dividend, so that the French withholding tax exemption that
     usually applies to interest paid to foreign lenders should remain applicable, despite the non-tax deductibility of the interest
     at the level of the borrower.
Private Equity European Bulletin                                                                                     February 2006

 According to the thin capitalisation rules, financing expenses for certain shareholder loans may be non-deductible and re-
 characterised as deemed dividends. Withholding tax will arise and may be refunded to certain shareholders.
 General scope and safe harbour
 >   The rules apply to loans (excluding short term loans) made by a significant shareholder (or related persons), irrespective
     of whether such shareholder is tax resident in Germany or not. They do not apply if the aggregate consideration (i.e. total
     return) on the shareholder loans is less than € 250,000 per annum.
 >   A significant shareholder must hold directly or indirectly (e.g. via a partnership), alone or jointly acting in association with
     other shareholders, more than 25% of the capital of the borrower.
 >   Fixed interest will not be treated as a deemed dividend if it can be demonstrated that the loan would also have been
     made by an independent party. Further, the rules provide for a safe harbour for shareholder loans where the debt-to-
     equity ratio is 1.5:1 or better.
 >   Safe harbour is provided only for fixed interest loans; variable interest and hybrid loans are excluded.
 Loans made by third parties (banks etc.)
 Loans made by a third party may also fall under the rules. This should only apply to “back-to-back” financing structures
 where the significant shareholder (or an entity affiliated thereto) maintains a long-term deposit and (i) such deposit is given
 as a security for the loan or (ii) the holder of the deposit provides a guarantee for the loan and agrees to restrictions on the
 disposal or forfeiture of the deposit. The borrower would have to prove by a certificate issued by the lender that no “back-
 to-back” financing exists.
 Loans made for an intra-group acquisition of shares
 The thin capitalisation rules disallow the deduction of interest payments on certain loans made for an acquisition of shares
 from a related party, notably in cases where the lender is a significant shareholder of the acquiring company.

 Tax reforms in 2004 introduced two sets of rules limiting the deductibility of interest expense for Italian companies.
 Thin cap rule
 The rule provides for the non-deductibility by a borrower of interest on loans received from or guaranteed by “qualified
 shareholders” and “related parties” when the amount of indebtedness of such borrower in a given taxable year exceeds four
 times its “equity”.
 >   A “qualified shareholder” is a shareholder that holds directly or indirectly the majority of the voting rights or at least 25%
     of the share capital in the borrower.
 >   Companies in which a qualified shareholder holds a controlling interest are considered “related parties”.
 >   Here “equity” means the net equity of the previous financial period reduced by (i) unpaid capital; (ii) book value of own
     shares; (iii) uncovered operating losses, and (iv) a further amount related to the value of participations.
 Non-deductible interest is treated as a dividend in the hands of the qualified shareholder or related party lender. Banks and
 other financial companies are not subject to thin cap rules.
 “Assets ratio” rule
 The rule (so called “pro rata patrimoniale”) limits the deductibility of interest on loans obtained to finance the acquisition
 of shares qualifying for the participation exemption. If the book value of the investment in subsidiaries qualifying for the
 participation exemption regime exceeds the net equity, interest deduction will be limited on the basis of a specific formula.
 For this purpose net equity is adjusted to account for unpaid capital and uncovered operating expenses.
 Impact on private equity investments
 No exceptions to the rules exist for private equity investments made through Italian companies. However, the above rules
 do not apply to funds making private equity investments.
Private Equity European Bulletin                                                                                     February 2006

 Under the Spanish thin capitalisation rules, interest paid on loans made by non-resident related private equity funds (or other
 companies or individuals) may be considered dividends and therefore be treated as non-deductible for Corporate Income
 Tax purposes.
 >   Scope: The thin capitalisation rules apply to interest paid by Spanish resident companies on loans made by non-resident
     related entities or individuals. Interest paid on loans made by EU related entities or individuals is excluded from this
     regime (except for entities or individuals resident in a territory listed in Spanish law as a tax haven).
     A thin capitalisation situation exists when, at any time during the financial year, the net interest-bearing debt, direct or
     indirect, of a Spanish borrower (other than a financial institution) to non-resident related parties exceeds three times
     the equity of the Spanish company (excluding the profit/loss of the current year). This equates to a debt-to-equity ratio
     that exceeds 3:1.
     In order to calculate the thin capitalisation of a borrower, both the net interest-bearing debt and the equity shall be taken
     at their average figure over the financial year.
 >   Tax consequences: Interest related to the portion of debt in excess of the 3:1 debt-to-equity ratio shall be deemed a
     dividend and therefore shall not be deductible for Corporate Income Tax purposes.
 >   Safe harbour: The borrower may submit a proposal to the Tax Administration for the application of a higher debt-to-
     equity ratio. The proposal must show that the same level of indebtedness and similar conditions could be obtained from
     non-related third parties (except for loans granted by entities or individuals resident in a country or territory listed in
     Spanish law as a tax haven).
 Withholding tax
 As a general rule, interest derived in Spain by non-resident entities or individuals is subject to a final withholding tax at a
 rate of 15% (possibly reduced by a double taxation treaty). Interest derived by EU residents (not acting in Spain through a
 permanent establishment and not resident in a tax heaven) is exempt from withholding.

 Sweden does not have any tax rules on thin capitalisation and interest is generally deductible without limitations. Case law
 makes it clear that debt cannot be recharacterised into equity because of a high debt-to-equity ratio. Sweden does not, under
 its domestic tax laws, impose withholding tax on payments of interest.
 Sweden has a system for group consolidation for tax purposes which effectively makes it possible to set off interest in a leveraged
 Swedish acquisition vehicle against profits arising in Swedish operating target companies. Since there are no limitations as to
 the deductibility of interest, the whole acquisition cost can in principle be pushed down to be off set against profits of the
 operating companies. Should the interest exceed the income, losses can be carried forward indefinitely.
 The absence of thin capitalisation rules, generous participation exemption rules on dividends and capital gains on shares,
 and the fact that Sweden does not levy stamp duty or any capital taxes on transfer of shares, makes Sweden an attractive
 jurisdiction for holding companies. It should be noted that the Swedish participation exemption rules on dividends and capital
 gains also apply to investments in foreign companies, and that there is no requirement as to the taxation in the state of
 source. In addition, there is generally no withholding tax on dividends paid by Swedish companies (unless paid to a tax haven
 etc.). Thus Swedish holding companies are often advantageous even if the target company is foreign.
 Hybrid debt/equity instruments
 There are certain limitations as to the deductibility of interest on participating debentures (loans where the interest depends
 on the profits and/or distributions of the borrower) if the lender and the borrower are affiliated. Unless these restrictions
 apply, interest on hybrid debt is normally tax deductible and not subject to withholding tax.
 Since dividends from a Swedish entity paid to a tax haven are subject to Swedish withholding tax at a rate of 30%, it may be
 attractive for a foreign investor to invest through hybrid debt instead of equity. However, there are other structures available
 to avoid Swedish withholding tax, such as interposing a foreign company.
Private Equity European Bulletin                                                                            February 2006

This Bulletin is a joint product of the European Private Equity Group of our network of leading independent firms in France,
Germany, Italy, Spain, Sweden and the UK.

france                                      germany                                      italy
Bredin Prat                                 Hengeler Mueller                             Bonelli Erede Pappalardo
Olivier Assant                              Peter Weyland                                Giorgio Fantacchiotti
130 Rue du Faubourg                         Bockenheimer Landstrasse 51                  Via Barozzi, 1
Saint-Honoré,                               60325 Frankfurt                              20122 Milano
75008 Paris                                 Postfach 17 04 18
                                            60078 Frankfurt
+33 (0) 1 44 35 35 35                       +49 (0) 69 1 70 95 336                       +39 (0) 2 771 131               

spain                                       sweden                                       uk
Uría Menéndez                               Mannheimer Swartling                         Slaughter and May
Christian Hoedl                             Peter Alhanko                                Mark Horton
Jorge Juan, 6                               Norrmalmstorg 4                              One Bunhill Row
28001 Madrid                                Box 1711                                     London EC1Y 8YY
                                            SE-111 87 Stockholm
+34 (0) 915 860 096                         +46 (0) 8 505 765 00                         +44 (0) 20 7090 3138