Leveraged buy-outs face legal scrutiny

TAX planners at private-equity firms are having an unusually busy summer. A fiscal ruling in Sweden and a court case in America are threatening to upend the arrangements that buy-out firms use to minimise their tax bills.

• Both cases relate to a tax loophole used by private-equity firms in America and much of Europe. Under “carried interest” rules, buy-out executives pay (relatively low) capital-gains taxes on profits made from buying and selling companies, in the same way investors or entrepreneurs do. This is odd, given that the money wagered on private-equity deals comes overwhelmingly from outside investors, not the executives themselves. It would make more sense for these profits to be taxed like salaries, or bankers’ bonuses, at the (higher) income-tax rate.

 

That is exactly what Sweden’s tax administration has decided. In a ruling on August 20th it demanded SKr647m ($99m) of back taxes from EQT, a local private-equity fund, and its executives. The amount covers the difference between the 25% capital-gains rate and the 57% income tax for 2007-09, plus interest and penalties. EQT is not alone: dozens of other executives at other firms have been handed multi-million-kronor bills as a result of the tax authorities’ change of heart. The potentially impoverished bosses say they are confident courts will find in their favour on appeal.

The American case, decided on July 24th, chips away at carried interest from another angle. An appeals court in Boston ruled that Sun Capital, a private-equity fund that specialises in turning around distressed companies, is liable for some pension obligations of a firm it bought in 2006, and which subsequently went bust.

The case is limited to pensions (and is being contested by Sun Capital) but the precedent could have a wider tax impact, says Jon Zorn of Ropes & Gray, a law firm. The core of the ruling blows away a legal fiction that private-equity funds are passive investors who do not actively control the companies they buy. That premise is also used to justify putting profits into the lower tax bracket.

Executives in Sweden and America complain about the uncertainty created by the cases. They have a point. It would be better to make clear that private-equity profits should be taxed as income, and carried interest done away with.