Publish Date
Sep 10, 2024
Australia Bulletin
Recent legislative changes to Australia’s taxation system, coupled with current market conditions, present a unique set of tax and commercial considerations for Private Equity (PE) fund CFOs. In this update, A&M analyses these factors and explores effective strategies to navigate them.
The new thin capitalisation rules, effective from 1 July 2023, present challenges for PE portfolio companies receiving capital through shareholder loans or traditional third-party acquisition financing, particularly in multi-jurisdictional investment structures.
These new rules specifically limit the tax deductibility of interest when the interest cover exceeds 30 percent of tax EBITDA (which broadly includes taxable income adjusted for net debt deductions, tax depreciation, and certain other adjustments).
Amendments to the thin capitalisation regime are particularly relevant to PE-backed and owned businesses. These businesses often rely on optimised capital structures, which may involve substantial debt. Historically, many have depended on the asset-based safe harbour limits. However, the transition to earnings-based limits under the new regime could negatively affect their ability to continue deducting debt-related costs for tax purposes.
If a taxpayer group exceeds the 30 percent interest cover, the most common alternative test is the Third-Party Debt Test (TPDT), which replaces the pre-existing arm’s length debt test. However, the TPDT has stringent eligibility criteria, making it difficult to apply. Notably, the TPDT is unavailable where a loan agreement provides the lender with recourse over non-Australian assets of a borrower (or an obligor), including shares in a company that directly or indirectly owns non-Australian assets.
The TPDT prohibits a borrower from using credit support from a foreign associate to back their loan. Additionally, if a borrower opts to rely on the TPDT, they cannot use the loan to fund commercial activities or investments outside of Australia. This restriction effectively nullifies the relevance of Section 25-90, along with its Taxation of Financial Arrangements (TOFA) equivalent, within a TPDT context. Despite this, the Government’s intent to repeal Section 25-90 has not yet been officially rescinded.
The Debt Deduction Creation Rule (DDCR), effective from 1 July 2024, imposes a positive obligation on taxpayers to scrutinise the purpose of leverage within new and existing capital structures. The DDCR broadly applies where an entity incurs debt deductions on a related party loan used to fund an acquisition from an associate or certain payments and distributions made to an associate, as illustrated below.
Determining the original purpose of the debt is crucial, as a prior use could now be deemed ‘inappropriately applied’ under the new rules, potentially making the interest permanently non-deductible in future years. The DDCR denies deductions ‘to the extent’ that they are incurred, or related-party debt funding is used, for one of the two adverse purposes mentioned earlier. As a result, if any related-party debt funding has been used for an adverse purpose, debt deductions must be apportioned between what is denied and what is allowed (subject to the other thin capitalisation tests that further limit those deductions) under the DDCR.
Given the range of changes, it is essential for PE funds to consider these new rules in their future M&A activities. It may also be prudent for PE funds to conduct a comprehensive, portfolio-wide review to ensure that the changes to the thin capitalisation rules and the DDCR do not compromise the deductibility of debt in the capital structures of existing portfolio companies.
PE fund managers may have a need to move assets between fund vehicles for various reasons, which can trigger potential tax consequences. A common scenario is when an asset is moved out of a Venture Capital Limited Partnership (VCLP) to avoid compromising the partnership’s VCLP status. In such cases, how the fund documents are drafted becomes crucial. When the other fund vehicle involves the same investors, the documents may be drafted to allow asset transfers at cost, provided it serves the best interests of the Limited Partners (LPs).
If an asset threatens the VCLP status, transferring it out of the vehicle may indeed be in the best interest of the LPs. When the fund documents and any subsequent restructuring are negotiated between the LPs and the General Partner (GP) of the VCLP on an arm’s length basis, the market value substitution rule may not apply, thus avoiding adverse tax consequences. In the recent case of Kilgour v. FCT [2024] FCA 687, the Federal Court highlighted that the statutory criterion focuses not merely on whether the parties were at arm’s length but on whether they dealt with each other at arm’s length in relation to the disposal.
Accordingly, when LPs and GPs negotiate restructuring documentation at arm’s length, this approach can serve as a more cost-effective and time-efficient alternative to other methods. It provides fund managers with the flexibility to transfer assets at cost between fund vehicles with the same investors if the need arises.
Another example is when assets need to be transferred into a continuation fund with new investors. This situation often arises when an expiring fund makes an outright disposal impractical, such as during periods of weak IPO markets, low M&A activity, or a lack of a ready market for the asset (common in venture capital). In these cases, moving the asset to a continuation fund allows the fund managers and investors to retain exposure to the asset rather than sell it in a challenging market. This also offers an opportunity for certain investors to exit or rebalance their ownership stake while new investors can be introduced to the continuation fund.
When transferring a fund asset into a continuation fund with new investors, the transfer is typically done at market value, rather than at cost, to accommodate changes in the investor core. Existing investors may seek to exit and realise value at this stage, while new investors may want to join the continuation fund. However, this can create a “dry tax” charge (i.e., a tax liability without corresponding cash to cover it) for existing investors who want to stay exposed to the asset. This is often problematic, as Capital Gains Tax (CGT) rollover relief is generally not available for such transfers. Additionally, the GP must carefully consider the tax implications of crystallising carried interest entitlements, which can be complex if the carry recipients receive their entitlement in the form of an interest in the continuation fund.
To address these issues, it is important for fund managers to structure the fund from the outset in a way that allows carry recipients’ entitlements to be rolled over into a continuation fund without triggering a tax liability.
In recent years, we have observed a significant trend in Europe and North America: the consolidation of fund managers, where larger firms acquire medium and smaller ones. Notable examples include AXA’s acquisition of US-based W Capital Management, General Atlantic’s acquisition of UK-based Actis, and BlackRock’s agreement to acquire US firm Global Infrastructure Partners. While this trend has not yet reached the same scale here in Australia, we anticipate that it may reach Australia’s shores at some point in the near future, given the typical lag in global trends between Europe/North America and Australia.
Australian fund managers should prioritise preparation for this development. This involves assessing whether their structure is positioned to acquire or be acquired in a manner that ensures tax efficiency.
Fund managers often incentivise their investment teams by awarding equity in the Manager Company (ManagerCo). However, this can present tax challenges, as investment team members are typically employees of the ManagerCo or a related party. As a result, awarding equity to these team members can raise tax issues similar to those that arise in portfolio company management equity plans, such as the granting of stock through shares or options at a discount to market value.
For a PE portfolio company, an exit or liquidity event is usually on the horizon, allowing the PE-style management equity plan to be exited or cashed out. In contrast, a fund manager itself typically does not have a foreseeable exit event. However, as discussed earlier, the potential trend of consolidation in the Australian fund management industry could create opportunities for equity plans in the ManagerCo to be cashed out, similar to those in portfolio companies.
Where a PE fund manager is considering awarding equity in the ManagerCo to its investment team, careful consideration should be given to the tax implications. If the ManagerCo becomes involved in future consolidation activities, it is also important to assess whether the investment team can benefit from discounted capital gains on the consolidation event, including whether the12-month holding requirement has been met.
The Australian Taxation Office (ATO) has recently indicated that it will allocate resources to begin reviewing PE funds. These reviews are expected to follow a similar approach to the 190 assurance-based reviews conducted by 30 June 2023, covering financial services institutions, including investment and superannuation funds and financial corporates, as part of the ATO’s Top 1,000 Income Tax Assurance Program.
A key focus of these reviews will be governance and tax risk management. The ATO expects robust governance mechanisms to be in place for managing inherent risks within fund structures, and these mechanisms must be well-documented and demonstrable during a review. While many funds may already have risk management procedures, proper documentation and ongoing refinement of these procedures will be essential for a successful outcome in the event of an ATO review.
Current market conditions combined with recent legislative changes, have created a range of tax challenges for PE fund and CFOs. A&M has extensive experience in helping fund managers navigate these complexities. Please contact us if you would like to discuss any of these issues further.
https://www.alvarezandmarsal.com/insights/private-equity-tax-update-september-2024