Fortune: IRS Scrutinizes Certain Corporate Buyouts Involving Debt, by Lynnley Browning:
Private equity firms, buffeted by challenges to long-held tax breaks and growing scrutiny from regulators, have an ugly new headache: a wary look by the IRS at one of their preferred acquisition techniques. The technique involves loaning cash stockpiled in a fund's offshore affiliate to a related U.S. holding company set up to acquire a separate firm, a multistep move that typically generates lucrative tax deductions and boosts returns to fund investors.
Few, if any, private-equity firms publicly disclose details on how they fund acquisitions, making it tough to determine what role related-party debt plays in buyouts or refinancings. The details can be found only in confidential corporate tax returns. But tax experts say that in recent years, a growing amount of that debt begins life as related-party cash held in fund affiliates. ...
The IRS wants to know whether private equity funds and their portfolio companies, meaning firms they acquire, are skirting so-called interest-stripping rules by disguising taxable equity investments as tax-deductible loans, according to senior tax lawyers and accountants working for firms and companies under the microscope and to persons close to the IRS. "There is no doubt that the IRS is putting significant emphasis on this, and that audits of P.E.-backed firms have increased, in particular on vetting loans from foreign parents to U.S. subsidiaries," says Joan Arnold, a tax lawyer focused on private equity at Pepper Hamilton in Philadelphia. Robert Willens, a tax and accounting expert in New York, says the scrutiny means that one of the most widely used techniques in the private equity industry is now under the microscope.
The scrutiny, which has picked up pace this year, signals a fresh front in a wider IRS investigation across all industries of intercompany lending and other cross-border financing techniques that have exploded in use over the past 10 years. It comes amid headline-grabbing deals, like the $24.4 billion proposed buyout of Dell by its founder and Silver Lake Partners and the $6.9 billion buyout of BMC Software in May by a consortium including Bain Capital and Singapore's GIC Special Investments.
At issue is which whether the related-party loans constitute true debt, with legitimate tax deductions for interest payments and no 30% withholding tax owed by the U.S. fund -- and its investors -- or disguised equity, in the form of loans converted into preferred stock or other ownership stakes in the U.S. holding company. ...
Donald Korb, a tax lawyer with Sullivan & Cromwell and a former IRS chief counsel, who has represented several companies in debt-equity disputes before the IRS, said the agency "is clearly taking a close look at the issue of whether an instrument is equity rather than debt, and not just in the context of large corporate transactions but also including private equity."