Monday, November 16, 2009

What the hell were we allowing the foreign equity fund owners of Myer et al to do?


Here's how Stephen Bartholomeusz puts the question:

The real question posed by the scale of the tax-free profits earned by the private equity firms in Myer and other buy-outs is whether the policy of allowing foreigners tax-free gains is appropriate.

His full article is here and worth reading.

An extract:

The major mystery surrounding the Australian Tax Office’s too-late attempt to prevent the shifting of the $1.5 billion capital gains tax-free profits made by the former private equity owners of Myer Holdings offshore is not that the profits were tax-free but that the ATO took the action in the first place.

Since December 2006, when the Howard government amended the Tax Act, foreign residents have been exempt from capital gains tax on investments other than Australian real property.

The motivation for the amendments was straightforward. They were designed to improve the attractiveness of Australia as a destination for foreign investment at a time when all the major economies in the OECD, other than Australia, provided capital gains tax exemptions for foreign investors...

Local private equity firms, and other collective investment vehicles aren’t, of course, exempt from CGT, although that might depend on the extent to which the investments in their funds have been made by foreigners rather than locals.

Gittins makes a similar point today:

That brings us to... another businessman's special - the unstated assumption that the more foreign investment we attract the better.

Tell that to the countries that fell victim to the Asian financial crisis of 1997-98 because they let doctrinaire economists talk them into opening their economies to ''hot money'' flows they didn't have the institutional arrangements to cope with.

Or tell it to the Irish, who slashed their taxes to attract foreign investment. For a few decades this strategy looked fabulously successful, but it led to an inflationary boom in wages and asset prices. The bubble was pricked by the global financial crisis and now Ireland's woes are exceeded only by Iceland's.

It is possible to have too much of a good thing and to attract rubbish foreign investment that's more trouble than it's worth.

Below, Michael Pascoe pulls it together:

Australia: tax-free for foreigners

November 16, 2009

Don't blame TPG's various lawyers and loophole-seeking accountants for not paying any tax on its share of the $1.4 billion Myer booty – blame Peters Costello and Dutton instead.

They were the relevant politicians responsible for Tax Laws Amendment (2006 Measures No. 4) Bill 2006, which effectively made capital gains tax optional for foreign entities investing in Australia, other than in real estate.

A Parliamentary Library bills digest sums up what the government of the day, with the support of the then-opposition, thought it was doing: improving "Australia's status as an attractive place for business and investment" and, secondly, improving "the integrity of the capital gains tax base".

Looks like they scored top marks on the first count but failed miserably on the second.

"These changes will mean that foreign residents who invest in shares in Australian companies or holding interests in certain trusts will benefit significantly," says the library. No doubt about that.

Without having the Myer deal specifically in mind, it's easy to draw a general picture of just how appealing that bill can make the typical private equiteer raid on an Australian entity.

Let's say Company W, purveyor of fine widgets and wing nuts, comes into play. W makes an annual pre-tax profit of $100 million and pays income tax at the usual corporate rate of 30 per cent, so $30 million a year flows to the Commonwealth. We won't complicate matters by going into the number of employees W might have and the income tax they pay on their salaries.

Foreign private equiteers, Swarm X, run the numbers: buy W for a billion, employing gearing so that the tax-deductible interest bill exactly matches the operating profit, ensuring no income tax has to be paid and minimal equity is required.

Strip the company down to its leanest and most profitable core, flogging off sundry assets such as the real estate and sharply reducing costs by sacking half the workforce – not that we're getting into the tax that might have been paid by employees.

This process may take a couple of years, but it results in a sharp increase in W's EBIT (earnings before interest and tax). Thus, having dressed up W as a company that makes $200 million (at least for the time being), Swarm X offloads the thing for $2 billion, pays off the loans and makes a clear and clean $1 billion profit capital gain. Nice.

And if Swarm X has been structured correctly, that $1 billion profit is tax-free. Very nice indeed.

That's the theory. To work really well, the game required easy "covenant-light" loans from particularly stupid banks – the sort of loans that were lined up for the TPG/Allco/Macquarie/Onex tilt at Qantas – but that sort of financing isn't as easy to come by any more.

The lack of easy money caused a halt in what was for a while a growing game of "let's go raid Australia – it's free". In time, as the financial markets continue to thaw and the current prudence dissipates, the game will re-emerge.

And that's just one more thing for Ken Henry's tax review to contemplate.

Michael Pascoe is a BusinessDay contributing editor.



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