The emerging stoush between the Australian Tax Office and the former private equity owners of Myer should warm the cockles of the hearts of every long-suffering Australian taxpayer. And while the ATO freeze and inquiry into TPG, and its partners Blum Capital and the Myer Family Office, may not yield many dividends, it may at least prompt legislators to act to restrict the abhorrently favourable tax treatment received by private equity and foreign businesses. (The ATO issued TPG with a $452 million tax assessment and an additional $226 million in penalties last week relating to proceeds from the float of Myer).
As this column has noted in the past, private equity investments make their money largely though two factors. First, they are able to utilise an efficiency arbitrage when acquiring public companies. That is, most public companies are poorly managed, inefficient and pay their managers high remuneration that is rarely linked to company performance. Second, they are (legally) able to pay virtually no tax on any profits they ultimately reap.
There are few better examples of that than of Myer itself, which paid its former boss, American Dawn Robertson, more than $18 million for three years work between 2002 and 2006. During that time, Myer’s earnings and EBIT margins slumped. (Robertson later departed Myer to briefly run the largest division of US clothing retailer Gap, called Old Navy. Robertson barely last a year at Old Navy before departing, with some Wall Street analysts describing that business as a disaster). Robertson’s successor, Bernie Brookes, received more money from his time running the company (Brookes now owns almost $45 million in Myer shares and about $9 million worth of options) but also had to mortgage his house and invest more than $8 million in the company so he had real skin in the game.
Under Brookes’ and TPG’s careful management, Myer’s costs were slashed, inventory cleared and valuable real estate sold, with the company’s EBIT margins rocketing from 2.3% to more than 7% (Myer’s prospectus optimistically claimed that the margin may rise to 10% in the coming years).
Superior management, however, was only part of the reason that TPG, Blum and the Myer Office were able to reap more than $1 billion from a few years owning the department store.
However, cutting the fat is only half the story of private equity. The real kicker is its structure, designed for the dominant purpose of legally minimising tax. That is not to say that private equity operates illegally, in fact, private equity firms will employ the best and brightest tax accountants, solicitors and tax havens to ensure that they follow the letter of the law. The problem is: the law is an ass.
Incorporating a maze of companies through various exotic jurisdictions such as the Cayman Islands, Luxembourg and the Netherlands, isn’t done because accountants like to work on their tans. Creating a complex trail of ownership also isn’t able to be concocted by the local H & R Block — it requires a detailed knowledge of tax laws and is done by very expensive accounting and legal experts. It, of course, is hardly unique to private equity — there wouldn’t be too many members of the BRW Rich List who don’t carefully manage their tax affairs through such means. (The Lowy family is believed to be being investigated by the US Internal Revenue Service for its alleged involvement in various secretive havens).
Private equity has a double benefit — not only will PE firms try to avoid paying capital gains tax on exit (although the ATO is doing its best to prevent that), but they generally pay little or no income tax along the way either.
This is the second real kicker of private equity — the utilisation of different tax treatments for debt and equity. When private equity acquires a company, it will usually use only a sliver of equity combined with a large about of borrowed monies. This necessitates very large interest payments, especially during its early years of ownership. As a result, companies such as Myer, will generally report very little “taxable income” during the early years of private ownership — that is because any free cash flow is used to pay interest, which, unlike dividend payments to ordinary shareholders, is fully tax deductible.
Eventually, when the investment is realised, the private equity firm (if all went well) will make a capital gain. Courtesy of Australia’s tax laws, capital gains are generally taxed at half the rate of income. For foreign-owned companies, with less than a 10% interest in an Australian asset, there are no capital gains taxes levied at all. That is the loophole that Myer’s owners (and to be sure, many other businesses) have been trying to squeeze through and that the ATO is desperate to prevent.
But don’t blame private equity for this. They are simply adjusting to the laws that already exist. Private equity should not be criticised for incorporating in a tax haven any more than they are at fault for buying Myer from a poorly managed public company. Instead, blame should shift to our law makers, so desperate to encourage foreign capital that they allow loopholes so large that a Myer truck could be driven right through them.
Instead of freezing bank accounts after a float, the government should act to tax private equity capital returns as income (as has long been suggested in the United States) and remove the disparity between foreign owners of capital and local ones. Otherwise, billions of tax dollars will continue to be legally handed to the shrewd owners of capital.