Is your firm too lax on tax?

When it comes to GPs’ list of priorities, tax concerns understandably fall under operational improvement or producing investor returns —but inseparable from these responsibilities is the omnipresent issue of tax.  

Barry Murphy

Imagine relocating links in a company’s supply chain to streamline the production of widgets only to later discover your achieved cost savings are handicapped by a jurisdiction with higher tax rates.

The above example is a simple one, but there are countless (and more complicated) ways a GP’s operational strategy can lead to a heavier tax burden, cautions Barry Murphy, a tax partner at PwC.

In an interview with Private Equity International, Murphy uses the term “strategic tax management” to describe the proactive approach taken by some GPs investigating everything from sales tax to payroll tax as a way of slashing their portfolio company’s tax bill. 

“It requires a hard look at a company’s operations, and further questioning if the company’s structure is to keep pace with best practice intact,” said Murphy.

Less than half (48 percent) of companies follow a strategic tax management policy, according to a recent PwC survey of private equity owned businesses. The slight majority of companies instead rely more heavily on debt tax shields for savings—a strategy made more difficult in a post-credit crunch world.

A private equity model less reliant on debt will find greater value in ensuring tax doesn’t become a drag on value, said Murphy. “GPs should be applying the same level of rigour to tax they do post-acquisition as they do in due diligence before a deal.” 

Unsurprisingly one option for GPs involves increased communication with tax authorities. In the UK (and other jurisdictions) GPs are able to speak with revenue authorities in advance to gain certainty their debt payments can be used to offset tax on profits, a benefit in certain circumstances sometimes ruled impermissible.

Tax collectors are being given more ammunition to demand evidence that profits are not just being shifted across borders to avoid tax Barry Murphy

The aforementioned PwC survey shows 68 percent of private equity-backed companies seek such clearances in the UK.

Likewise advance clearances on withholding tax can be achieved when a portfolio company needs to report a financial transaction (such as a loan) between subsidiaries operating in different countries. What GPs need to ask “is if the country I’m paying the interest from is going to levy withholding tax on that payment,” said Murphy, adding many jurisdictions allow managers to obtain clearance beforehand on this question. 

Murphy explained obtaining these clearances and seeking tax allowance means GPs will need to keep their house in order. “Revenue authorities will want to see the documents showing why an intra-company loan was issued and the economic rationale behind it. It can’t just be used to avoid taxes.”

Tax authorities are also tightening up legislation around transfer pricing (which is when companies under the same umbrella cross-service or trade). And here too “tax collectors are being given more ammunition to demand evidence that profits are not just being shifted across borders to avoid tax,” said Murphy.

Murphy stresses fund managers rightfully direct most of their attention to making companies more efficient and profitable in the long-term—a goal he says should be considered with strategic tax management in mind.