By James Hamilton, J.D., LL.M.
The UK Treasury plans to review the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals in the light of market developments in order to ensure that existing rules are working as intended. The review is consistent with the Government's broader focus on ensuring that commercial decisions are taken on a level playing field, take a long-term view, and maximize opportunities for employment and investment. In announcing the review, Economic Secretary Ed Balls MP noted that rules have changed from time to time over many years to adapt to the development of new financial instruments and forms of debt. Similarly, the Wall Street Journal reported on March 9, 2007 (p.C3) that Senate aides were evaluating whether to change tax rules for hedge funds and other pools of private capital.
In remarks at the London Business School, the UK official noted concerns that the tax system gives an unfair advantage to private equity over other forms of ownership, particularly as a result of the tax deductibility of interest. While there is nothing inherently specific to private equity in the tax deductibility of interest, since any kind of company can claim it, concerns have been raised with the Treasury that shareholder debt is replacing the equity element in highly leveraged private equity funding arrangements.
This shareholder debt is a form of risk-bearing equity that is treated as debt for tax purposes, noted the Treasury official, giving these arrangements a tax advantage that is inconsistent with the principle that interest is a business expense. Tax legislation already distinguishes between debt and equity and contains detailed provisions to ensure that equity is not disguised as debt to obtain a tax deduction.