FORTUNE — 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 Internal Revenue Service 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. “This is really new,” Arnold said.
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 (DELL) by its founder and Silver Lake Partners and the $6.9 billion buyout of BMC Software (BMC) 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.
Challenges to related-party debt transactions involving large multinationals are unfolding in Tax Court, including a $2.7 billion claim against Tyco International (TYC) that securities filings show could swell by another $6.6 billion, and a $400 million to $700 million claim, not including interest, against Ingersoll-Rand (IR). But no challenges involving private equity-backed deals have yet spilled into public venues, suggesting that the private-equity look is still in an early stage.
Chris Faiferlick, a principal in transfer pricing at Ernst & Young in Washington, D.C., says the agency’s wider scrutiny of intercompany loans could lead to “potentially tens of billions of dollars in adjustments” for companies and firms of all stripes. “They’re looking at all industries, including private equity,” says Faiferlick, a former IRS special counsel.
Portfolio companies that lose challenges could produce lower returns for investors due to higher tax costs from disallowed deductions. Lower returns mean that private equity funds could find it tougher to refinance related-party debt into arm’s length loans.
Noah Theran, spokesman for the Private Equity Growth Capital Council, the industry’s lobbying and trade group, says he is “unaware” of any particular IRS focus. An IRS spokesman declined to comment.
In a typical scenario under scrutiny, a private equity fund puts money into an offshore affiliate, which then loans the money to a related U.S. holding company set up to acquire a private firm. Separately, the offshore affiliate also pays cash for stock in the U.S. holding company, establishing ownership. The U.S. holding company then uses the borrowed money and cash to buy a private firm.
While the offshore affiliate could have put straight cash into the U.S. holding company, without making a loan, that move does not carry tax benefits. Under tax rules, the U.S. holding company can deduct interest when repaying the loan, typically via income from dividends at the acquired company that are sent up to the U.S. holding company and then on to the foreign affiliate. The deductions ultimately boost returns to fund investors. The U.S. holding company also avoids withholding taxes of 30% on loan repayment.
Another key tax benefit during loan repayment: the reduction or elimination of foreign taxes on interest income received by the offshore affiliate, typically housed in a low-tax jurisdiction such as Ireland, the Netherlands, or Luxembourg. “The idea is to get interest deductions in the U.S. with the corresponding interest income taxed, if at all, at very low rates in the creditor’s country,” Willens said.
Still another benefit comes when the U.S. holding company takes out a fresh bank loan, a standard private equity practice. If the fresh loan proceeds are used to pay back the original related-party loan from the foreign affiliate, those payments are tax-deductible — and the foreign affiliate gets back its cash tax-free to fund future acquisitions.
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.”
Arnold said that since January, her law firm had favorably resolved IRS audits of four private-equity backed portfolio companies on the debt vs. equity issue.
Treasury rules leave a wide berth for interpretation of the difference between debt and equity. The IRS has a mixed record in fighting disputes on the matter — last year it won a nine-figure claim against Hewlett-Packard (HPQ) but lost a $932 million claim against Scottish Power, a British utility company, and lost a $363 million case against PepsiCo (PEP) and its Puerto Rican subsidiary.
Potential red flags for an IRS audit include interest expense above 50% of taxable income and a debt–to-equity ratio in the acquisition company or portfolio company exceeding 1.5 to 1. Other key considerations, known in tax jargon as Mixon factors, include expectations of loan repayment and the intent of the parties involved.
Despite a recent downturn in the number of deals, private equity firms have used record levels of debt to finance acquisitions, refinance existing debt, and make special payouts to themselves. From 2005 through July 2013, they borrowed more than $872 billion of debt of all types for their companies and funds, according to Standard & Poor’s Capital IQ, which tracks the industry.
The IRS has been interested in the use of related-party debt and intercompany loans since at least 2007, when a Treasury report, building on a 2002 study, cited their aggressive use for interest deductions. The tax agency and, separately, the New York attorney general, are also probing whether some private equity funds are improperly converting management fees into lower-tax investment income. A recent court decision could put private equity funds on the hook for pension liabilities in portfolio companies. The Securities and Exchange Commission is probing how some funds value investments in private companies. And in its proposed budget for fiscal year 2014, the Obama administration took aim at tax rules favoring debt and carried interest, one of the main profit sources of private equity.
The tax benefits of debt are “a historic tax issue,” Korb said. “We will be seeing more cases.”