Wednesday, February 28, 2007

Private Equity And Gordo's Pensions Grab

Always keen to wreck our economy
One of the major charges against those unspeakable private equity firms is that they "pay too little tax".

Of course, as various sleek City moggies have pointed out, private equity firms operate under exactly the same tax rules as everyone else. Plus, they pay nearly £5bn pa in Corporation Tax.

The key issue is that when they acquire companies, they run them with much higher levels of debt than is typical among public companies. And interest on debt is tax deductible, whereas dividend payments are not. Hence for a given level of earnings, tax payments are less.

At the risk of stating the bleedin' obvious (again), let's remind ourselves of a few key facts.

First, companies belong to their shareholders, and at root, interest payments are an operating expense. Just like say the fuel bill. Nobody suggests companies should be taxed on other operating expenses, so why interest payments? No other major economy does that.

Second, interest payments are taxable- but in the hands of the recipients, not the paying company. When a company increases its leverage through taking on more debt, it may reduce its own tax liability, but it increases that of someone else.

Which brings us back to Gordo's Great Pensions Tax Rip-Off.

Readers of BOM will be familiar with the £6-7bn pa he stole from Britain's pension funds. And how he did it by abolishing the right of those funds to receive company dividends gross of tax (via the ACT tax reclaim).

One effect was to destroy our final salary pensions. But the other was to make it much more attractive for companies to issue debt rather than equity.

That's because when a pension fund invests in company debt, it receives the interest income gross of tax. In effect, no tax will be paid until the interest is eventually paid out in the form of a pension.

In sharp contrast, investing in equities means that the income- received in the form of dividends- is taxed before the fund gets it. And thanks to Gordo, there are now no refunds.

So Gordo made debt investment much more attractive relative to equity investment, which is reflected in the relative price of debt and equity issuance for companies.

And that's why there's been a surge in company debt issuance over the last decade (Tesco issued a highly successful 50 year bond just this last Monday), and why company leverage has increased markedly right across UK plc: since 1997, depending on how you measure it, it's up by around one-half.

So when all those appalling moral midgets vying for the Labour Party deputy leadership jump up and down screaming about private equity funds not paying enough tax, we should remember who made it happen.

1 comment:

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