Buyouts reassess their Australia risk

The $1.7 billion acquisition of Healthscope, Australia's second-largest hospital group, by The Carlyle Group and TPG Capital last summer was a timely reminder of the power of the foreign buyout. It was the standout deal of 2010, a year which saw overall buyout activity reach $10.6 billion, up 70% from 2009, according to AVCJ research.

One could almost have forgotten that Australia's tax authorities and private equity industry were busy debating a reinterpretation of the rules that mean offshore buyout funds no longer get to take their capital gains away tax-free. The tax debate rages on - although much-needed clarity is slowly appearing - and, in the meantime, the Australian dollar has rocketed, spurred on largely by the commodities demand that underpins rapid urbanization and industrialization in China and India. The currency reached a record high of 1.09 to the US dollar in May, having doubled its value in just over three years. Is foreign private equity still keen?

"We factor it into the deal," says one leading Asian GP, who thinks that Australia generally less friendly to foreign buyers than it once was. "In some cases maybe we could do a deal but we don't pursue it because the return doesn't justify the risk. But despite these issues we are still looking at more deals."

The currency issue is as divisive as the markets are potentially volatile. A US dollar-denominated fund that exited now from an Australian-dollar investment made in 2008 would likely be looking at a sizeable foreign currency gain on top of any perceived appreciation in asset value. But the reverse is also true: any fund looking for deals now must be wary that the chances of currency depreciation during the investment holding period are reasonably high. Australia's dependence on commodities, which are well known for price cycles, adds to the risk.

Andrew Thompson, head of private equity at KPMG Australia, notes that foreign buyout firms have been less active of late, but he sees little merit in tying this to currency concerns. "We think that is a strange view because when you look at the macro environment in Australia relative to other OECD nations it's a very good picture. It's fundamentally a great place to invest and the dollar is appreciating on the back of that."

Nevertheless, Katherine Woodthorpe, CEO of the Australian Private Equity & Venture Capital Association (AVCAL), agrees that currency and tax are playing an increasingly prominent role in due diligence. "A deal that might have stacked up one year ago before these concerns arrived might not stack up today given the other risks," she says.

Slow-burn concern

The issue of tax treatment for buyouts is more of a slow burner, but it is likely to bring out comprehensive change in how many private equity funds structure their investments.

The problems began in late 2009 when TPG exited its stake in leading Australian department store Myer through an IPO. The private equity firm realized a profit of $1.46 billion on its initial investment, and promptly received a $628 million bill from the Australian Tax Office (ATO).

This took TPG - and the entire buyout industry - by surprise. Until then it was assumed that the profits from private equity transactions were a capital gain and beyond the reach of the authorities if the fund in question was domiciled in a jurisdiction that has a double tax treaty with Australia. Now the ATO appeared to be saying that the profits were business income and therefore subject to local tax.

It is unclear why the ATO chose to act against TPG - once source says it was "sheer blind greed" - but the high-profile nature of the transaction couldn't have helped. "Myer was an old family-name company, a bit of an icon in Australia," says Karen Payne, a partner at Minter Ellison. "The size of the revenues also caught the authorities' attention. It was very much on their radar."

The upshot was a year's worth of lobbying and public debate, which resulted in the ATO issuing several determinations - some of which are still in draft form - intended to clarify its position.

As it stands, gains made on Australian investments by private equity firms that don't qualify for tax treaty coverage can in certain circumstances be treated as business income rather than capital gains, making them liable for local tax.

Cases will be dealt with on their merits, with particular attention paid to length of the investment. The ATO's view is that a private equity fund that seeks to exit within three years is unlikely to have significant returns - due to interest costs and management expenses - until it sells off the asset. The implication is that the authorities are drawing a line, and a tax policy approach, between short-term speculators and investors that add value to a business.

Further guidance emphasized that a private equity fund engaged in a leverage buyout could not argue that the source of its exit gains is not in Australia just because the paperwork for a deal is completed offshore. If a fund has people on the ground looking for and negotiating deals, and also managing investments, gains arising from resulting LBO activities are considered to be Australian by source and local tax must be paid.

AVCAL remains staunchly opposed to the determinations, arguing that the treatment of leveraged buyouts indicates a failure to appreciate the contribution private equity makes. Indeed, the Association recently released a study suggesting private equity-backed IPOs perform better than those without PE involvement. An analysis of all Australian offerings valued $100 million or above over a seven-year period found that those supported by private equity outperformed the field at all points up to three years after listing. Average returns ranged from 4% to 78% for PE-backed IPOs compared to -2% to 4% for non-PE backed IPOs. Furthermore, the average share price of PE-backed stocks rose by 1.78x over the three years subsequent to listing compared to 0.98x for non-PE backed stocks.

"We wanted to put robust and substantive data behind our claim that private equity leaves strong companies on the stock exchange," Woodthorpe says. "We wanted to dispute the myth about private equity. It does build value in these companies and in doing so adds to the economic value of Australia."

Woodthorpe cites rigorous strategic oversight and governance, speed of decision making and the freedom for senior management to concentrate on operational performance as some of the key benefits of private equity involvement in companies. She also highlights what she sees as a disparity in the treatment of hedge funds and private equity. Under Australia's capital gains tax rules, a hedge fund qualifies for a tax concession if its holds an asset, such as a stock, for more than 12 months. This is approach is not unique to Australia but it looks odd given that a private equity fund, having spent three years developing a company subsequent to a buyout, must now pay full business income tax on the profits accrued from selling the asset.

Others are more sanguine about the debate. The reality is that some private equity funds have bought and sold assets within one or two years, which hardly adds credence to claims that they are long-term investors.

As for those whose credentials do stand up, Larry Magid, a partner at Allens Arthur Robinson, says the comparison to hedge funds is not so clear cut. "The ATO says to the private equity funds, ‘you are not passive investors: You go in there with a view to taking control; you restructure, refinance, sell off non-core assets; you put in new management and then participate in management. You do all these things as part of concerted activities designed to create more income.'"

Tax-friendly structures

A second issue centers around whether a private equity fund qualifies for treaty benefits. TPG's investment structure was apparently flagged because the authorities saw it as being too complicated, and concluded that certain layers exist for the sole purpose of minimizing tax exposure.

The root structure is said to be a Cayman company owned by the US-based LPs. Capital from the Cayman company was routed through subsidiaries in Luxembourg and the Netherlands and from there into Australian investment targets. TPG took its money out the same way. The Netherlands entity minimized tax exposure thanks to that country's tax treaty with Australia, which includes discounts on dividend withholding taxes. Meanwhile, Luxembourg, with its own tax treaty network and participation exemption rules that can reduce withholding taxes to zero, has long been a preferred conduit for taking cash out of Europe.

Given the ATO's reassertion that funds will only be able to access treaty benefits by proving "significant commercial activity" in a treaty jurisdiction, this approach appears to be unsustainable.

"The use of a Luxembourg-Netherlands intermediary holding company structure is pretty much gone," says David Linke, tax manager at KPMG Australia. "There will be greater use of transparent vehicles, which could be in Cayman, Delaware, Ireland or Singapore."

The endorsement of transparent structures, typically LLPs, came in a determination published late last year. If a fund is structured as a Cayman LLP, for example, it won't be liable for Australian tax even though Cayman doesn't have a tax treaty with Australia. This is because the ATO is willing to look through the LLP entity to the investors participating in it - and should these investors reside in countries with treaty coverage they can access the associated benefits.

It is not a trouble-free solution. If tax treatments are based on the resident status of LPs rather than that of the structure they invest in, fund managers must find a way to distribute the financial burden. While some LPs won't be liable for withholding tax because they reside in countries with treaty coverage, others might not be treaty residents and therefore be subject to Australian tax. It is not unfeasible that a fund might have 80% US and European investors and 20% Middle Eastern investors, with the latter unable to call on treaty protection.

According to Linke, it comes down to the wording of an individual fund's documentation - some are thought to be sufficiently flexible that tax could be levied on non-treaty investors specifically, while others only allow for a tax to be imposed on all LPs, regardless of origin.

Short game, long game

There are obviously issues that still need to be addressed by the ATO and the private equity community, but they are not about to derail business.

While Woodthorpe describes the ATO's more opaque standpoints as "a dog's breakfast," she accepts the reality that people work around the issues, however difficult it might be. And Simon Pillar, managing director of Pacific Equity Partners, doesn't think it is difficult at all. "We have got a very straightforward fund structure and we have no concerns about how our funds work," he tells AVCJ. "None of the issues the ATO has raised in its recent rulings are issues for us."

But taken in the context of wider tax reforms, these determinations seem to point to a more nuanced relationship between investors, funds and regulators. In addition to the final guidelines on the tax treatment of buyouts, over the next 12 months Australia's tax authorities will address a number of issues that relate to private equity.

Managed investment trusts, a kind of collective investment vehicle that has proved popular among private equity firms as the profits are treated as capital gains rather than business income (although no more than 10% of the investor base may be foreign), are currently being reviewed by the tax authorities. A separate review is looking into collective investment vehicles more broadly and how they are defined.

Other proposals involve the tax treatment for an offshore fund run by an Australian manager - with a view to ensuring that the fund doesn't become subject to local tax - and the proper procedures for addressing uncertainty over a tax position.

To some extent, these measures are intended to bring Australia into line with international practice, but the underlying theme is one of providing investors with greater certainty.

"We are hopeful but there are still several areas of uncertainty," Payne says. "To some extent the tax office's default response is if you are uncertain you can come and get a ruling from us, but there are often time issues. In Singapore, you can put the paperwork in front of the authorities and get their blessing as part of the registration process."

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• Topics
• Australasia
• Buyouts
• TPG Capital
• The Carlyle Group
• Simon Pillar
• Pacific Equity Partners