By Novella De Renzo
The OECD’s Base Erosion and Profit Shifting (BEPS) agenda is fundamentally disrupting the way the Private Equity (PE) sector has always worked – but with change comes opportunity.
Each of the 15 BEPS actions are important, but here is just a taster to illustrate how just a few of them will impact the PE sector:
Action 4, which limits the amount of net interest expense that a business can deduct against profits (in most countries to 30% of taxable earnings before EBITDA)
Action 7, designed to prevent the artificial avoidance of ‘permanent establishment’ status,
Actions 8, 9 and 10, which collectively align transfer pricing with value creation, and
Action 13, which requires companies to prepare new transfer pricing documentation and, if consolidated revenue of more than €750m, CbCR (Country by Country Reporting) as well.
Each of these, and others, have huge consequences for the PE sector and are rapidly approaching. For instance, the new transfer pricing compliance requirements have already been adopted by a number of countries, and Action 4 has already been adopted by the UK.
In a nutshell, BEPS greatly increases the tax, regulatory and reputational risk for PE houses. The traditional PE model, tended to use significant debt to finance acquisitions. Of course, in a post-BEPS world, that approach will not necessarily be the most appropriate or the most tax efficient. In other words, BEPS will completely change the PE landscape – the way in which PE houses operate and extract value will have to change with it.
The question is, how? The Global Operating Model Advisory team at PwC think of this in terms of value chain transformation. Aligning operating, tax and financial models allows PE houses and PE-backed businesses to reduce their exposure to tax risk in a post-BEPS world – but it brings many other advantages too.
Looking closely at a target’s business model at the earliest stage of a deal, for example, means it can be optimised to bring both operating and tax efficiencies. Above-the-line EBITDA is improved and value-added functions can be centralised in an appropriate jurisdiction, with fewer cross-border transactions and costs that are better controlled because functions are not duplicated.
But aligning models makes business sense too; lines of communication tend to be better, the management structure is simpler and clearer, rationalising the supply chain brings cost savings, and management time can be focused on commercial activities.
We have seen clear and quantifiable benefits from value chain transformation. But this is a cultural as well as a structural change – it means, essentially, that the tax and operating functions work much more closely together, and from an early stage. Traditionally, in both PE backed and corporate world, the tax function tended to follow wherever the business led (usually with a time lag attached). But this is definitely a time when the tax function needs to keep up to speed; the tax function should partner with the business to design a sustainable operating model that’s tax aligned, to deliver value and to manage old and new risks.
BEPS is a game-changer for private equity but value chain transformation is a powerful tool that not only helps manage risks but brings the potential for even greater value.