Tuesday, April 13, 2010

Private equity and debt interest taxation

Problem: Tax rules that allow debt interest to be offset against profits create a preference for debt over equity funding, which contributes to over-gearing and systemic risk and encourages financial engineering and short-termism, especially in private equity

Solution: Equalise the tax treatment of debt and equity, instead of the current system where dividends are taxed but interest can be deducted from taxable profits. Policy Exchange (p60-66) estimates that if debt and equity were taxed equally at 10%, headline corporate tax could be reduced from 28% to 17% for the same tax revenue. The idea has many supporters including John Plender at the FT, Bank of England, IMF, Institute of Fiscal Studies and Conservative Party.

Private equity benefits include:

• Modernizing investee companies
• Helping industry to shed non-core assets
• Challenging PLC management
• Sheltering companies in transition from quarterly public reporting
• Restoring bankrupt companies with fresh capital
• Providing an alternative source of returns for diversity-seeking investors
• Adapting PE business model with the economy and needs of their investors (or limited partners, LPs)

Problems from PE reliance on financial engineering:

• Makes unviable LBOs viable purely for tax reasons
• Transfers wealth from taxpayers through interest deductibility
• Diverts R&D spend and capital investment to service debt
• Miss-allocates resources as buyout firms target cashflow companies instead of turnarounds
• Increases bankruptcy risk through unsuitable capital structures, eg high gearing against cyclical earnings, adding to welfare costs from unemployment and inequality
• Reduced customer service has economic costs, especially in infrastructure and health
• Distribution of PE-related leveraged loans increases financial systemic risk, especially as PE refinancing peak in 2012 approaches
• Transfers equity yields from future pension savers to current PE investors
• Distorts the tax system by blurring income and capital, allowing inefficiencies such as the taxation of carried interest as capital

General policies against short-termism:

• For executives, make share-based incentives vest over longer periods to reduce gearing incentives, link executive pay also to non-financial measures related to delivery of the corporation’s purpose such as customer ratings, market position and market share
• For equity owners, equalize the time horizons of asset managers and their underlying investors to remove the pressure for short-term gains, such as geared dividends or takeovers
• For lenders, restore discipline to securitisation through higher disclosure, retention of risk by originators, independently funded credit ratings and more buy-side diligence.

Reforms to the PE industry:

• For the General Partners, or managers, of PE firms, improve transparency on the true origin and extent of returns, including effects of fees and tax subsidies, and extent of true risk taken by GP after fees.
• Reward operational turnarounds through long-term tax incentives, while discouraging financial engineering through higher taxes on debt.
• Exclude PE firms from tax grouping rules (as with OEICs) and keep liability for acquisition debt and the risks from over-gearing at bidder level
• Extend the “Source of Strength” doctrine from bank holding companies, requiring PE firms to provide assistance for subsidiaries at risk of bankruptcy. Rank GPs with LPs so that financial assistance is funded with clawbacks on PE management fees and carried interest as well as investor funds

Problems with tax reform of debt interest:

• Abolishing debt interest deductibility could push firms into bankruptcy, needs transitional implementation
• May not stop excessive gearing through sale-and-leasebacks, needs coordinated provisions
• Does not address credit bubbles caused by low interest rates and excess savings in China and Germany
• Could reduce investor returns if profits are retained

The EC’s proposed Directive on Alternative Investment Fund Managers is pushing for measures...

Monday, April 5, 2010

Global bank levy I

Problem: taxpayer funded bail-outs (or private gains and social losses; or bank “pollution”)

Proposed Solution: Countries would impose a bank levy to recover past and future bail-out monies. It may be charged on banks, insurance companies, PE and hedge funds, depending on local preference. Could be applied to ‘risky activities’ as in the US by wholesale funding, or on turnover, profit or remuneration. Currently under discussion in the US, Germany, France and the UK, with implementation possible in other G20 countries.

Benefits: Repays bail-out money to the taxpayer. Helps restore public finances. Pays for future bail-outs in advance. Changes banks’ social and economic contract with society. Promotes social and financial stability by reducing excess bank profits. Could reduce systemic risk if levied on wholesale funding. Could address bonus culture if levied on remuneration. Incentive for banks to self-regulate if levy is set according to peer group risk levels, or banks’ individual systemic importance. Could lead to voluntary structural reform (eg narrow banking) by penalising bank holding companies. Could lead to international cooperation in other areas of financial reform.

Disadvantages: Only recovers a portion of public losses as it excludes GDP costs of recession. Slows down the rebuilding of bank balance sheets and their ability to lend. Worsens moral hazard by making the public guarantee explicit. Easy to pass through to bank customers and shareholders. Implementation could favour bigger banks and discourage new entrants to the industry. Needs agreement on what constitutes systemic importance or risky activity. Needs agreement on whether the purpose is to raise revenue or change behaviour. Encourages regulatory arbitrage between countries. Does not address rentier behaviour or agent/principal problems. Dissipates the momentum for structural reform of finance.

Suggestion: Implement primarily as a revenue-raising measure with a sunset clause after ten years. Separate the levy entirely from structural reforms, to avoid wasting political momentum, but leave it as a bargaining chip against the bank lobby for structural reform if needed. Implement with resolution and recovery regimes (living wills) to contain moral hazard, and with a competition review to minimise pass-through to customers and shareholders. Implement unilaterally with scope for subsequent coordination with other countries.