Podcast transcript: How PE can manage COVID-19 tax implications in the US and Europe
25 min approx | 16 Apr 2020
Hello, and welcome to EY NextWave Private Equity Podcast. In our series, we explore the impact that private equity can have on the economy and society, capturing insights from industry thought leaders and private equity practitioners from across the globe. I’m Winna Brown from EY and I’m your host.
Hi everyone, and welcome to the latest in EY NextWave PE Podcast Series. As we continue in our new normal with COVID-19, impacting all of our lives both professionally and personally, we, the NextWave Podcast teams, wanted to bring you a number of topics and insights, which we hope will be of value to you as you navigate through these times of uncertainty.
Today, we’re joined by two EY professionals on global tax, Jennifer Shearer and Alexander Ludwig Reiter. Jennifer is based in the US and Alex is based in Germany and leads European private equity EY tax teams. Thank you both for joining us today.
It’s a pleasure to be here.
Clearly, these are interesting times that we’re living in, and from my discussions with PE fund leaders and portfolio companies, I know there’s been an immediate and urgent focus on analyzing the financial health of individual portfolio companies and their respective ability to weather the economic impact that COVID-19 is having. Are you able to share how you’re seeing how private equity leaders are tackling this challenge?
Alexander Ludwig Reiter
Sure. Especially on the short term, all of the private equity clients are focusing on liquidity build task force to analyze the impact for their portfolio companies. And as I mentioned, liquidity is key, which means that all people we see in the market are drawing all of their credit lines. This is right for the US but also for Europe. And a lot of banks around the world are supporting this.
Nevertheless, there are also some sectors where we see some issues in this regard because banks are refusing to provide additional loans. And tax can support these liquidity measures because governments around the world are setting programs to support liquidity because countries have identified that liquidity is a current key crisis. That is, in particular, cash tax deferred programs where payments can be postponed or prepayments which have to be made around the world on a monthly or a quarterly basis can be used.
The next focus is really state aid programs, which are basically most countries beside any kind of incentives, loan programs, which again support things like liquidity. In addition to this, they must deal with salaries which have to be paid, all the revenues may not come in are very relevant and the focus is here especially on reduced working hour compensations which are available around the world.
As you’ve highlighted, Alex, a critical part of this analysis has been for companies to really understand the various government aid programs that are available to portfolio companies, both in the US. and importantly, globally. Are you able to give us a little bit more of a flavor of some of the measures countries in EMEA are putting in place that portfolio companies can access in the short term?
Yes. And for Europe, also the programs are very country specific, which means that each country set up different programs and accessibility requires different applications and also different types of programs. However, I think what we are seeing on the cash tax deferral programs, all of these programs are in the focus to defer tax payments.
The only difference between the countries is basically a question how long it could be deferred, so three, six or nine months or even to next year, and which taxes are covered. In in other countries, wage tax and also Social Security contributions and custom duties are able to be postponed.
On the state aid programs, it’s really a difference between small and mid-sized companies because with these companies, really incentives and state aid is available in some countries, but for the larger companies, which is true for most portfolio companies, it’s not really state aid, but it’s rather guarantees for loans granted by the banks. And the difference, is how much of the loan is then from a risk perspective, covered by the government, which in Europe is between 70 and 90 percent.
And also about whether it’s only liquidity which is required due to the COVID crisis, or in addition, what is also needed to get this is especially the questions around whether the companies have a business model going forward. And that is one of the critical parts in the current application process with the banks because they retain a certain risk and for this background the companies want to really understand how are the requirements of this government guarantee fulfilled and would the company be able to repay the loans because they’re on the hook for a certain amount of risk and the company has a business model going forward.
In many countries, there’s really this reduced working hour compensation and other measures available to reduce the liquidity outflow from salaries to the employees, especially for such companies which are currently due to lockdown, not able to generate any revenues.
Wow. There’s a lot there that’s on offer in Europe. Jennifer, what about the US? The CARES Act got approved on Friday night. Are you able to share some of the key elements of this package that companies in the US can access?
Sure. And keeping in mind that this is the third round of stimulus that Congress has actually provided, and there’s certainly an expectation that round number four is coming, although I think Congress is going to wait to see exactly how this CARES Act is impactful for businesses. But some of the key elements in what we’ve gotten are first of all, government loans for a lot of the distressed industries. Obviously, the airlines are suffering, hospitals, transit.
The key though on those government loans is that they come with strings attached. And this is coming from really lessons learned by Congress as part of the great recession in 2008, where we saw a lot of stock buybacks and executive compensation bumps. And so, there are limitations on whether there can be stock buybacks or increases in executive compensation post people taking these kinds of loans.
In addition, there are small business loans of up to $10 million. They’re based on, you can’t just immediately get $10 million, it’s based on a calculation around your payroll spend. Those loans actually can ultimately turn into grants and be forgiven in certain circumstances. And so those might have some pretty good opportunities there. But you have to have under 500 employees in that situation. So again, it may or may not be beneficial for a lot of portfolios.
There are also tax credits that are being provided for just keeping people on a payroll, even if a business is shut down or has significant losses in revenue. But if you take those credits, then you have to pick between the credits and the small business loans. So that’ll have to be something that’s considered if you’re trying to take advantage of one or the other opportunity.
One of the big, I’d say gifts, that people are seeing and Alex had sort of alluded to this as well in Europe, is that Congress has provided a deferral of the employer portion of the Social Security payments for 2020, so that’s the 6.2 percent employer tax on the first 130 or so thousand dollars of compensation for each employee. Those payments will be due, if you take advantage of this, 50 percent at the end of ’21 and 50 percent at the end of ’22. So that actually is real immediate cash tax savings for a lot of companies.
In addition, there are some income tax benefits. So, a lot of people are familiar with the 30 percent EBITDA limitation on interest deductions. That’s been increased to 50 percent for 2019 and 2020, which will be very helpful for a lot of companies. And then also the Tax Cuts and Jobs Act of 2017 removed the ability to use net operating loss carrybacks. That has actually been suspended so you can now carry back NOLs for 2018 through 2020 back five years, so there’s an opportunity there.
Although, I would caution folks to really take advantage of doing modeling on those NOL carrybacks because you could disturb tax positions in those prior periods that might be not as advantageous as you would think.
So, Jennifer, we spoke a lot about the CARES Act and the provisions that it provides, but within the US, there’s obviously a whole number of states that are enacting their own policies and their own plans. Can you give us a little bit of flavor of that?
Sure, it starts at the federal level amusingly enough because a lot of states just adopt the entire Internal Revenue Code as part of their own taxation code. But a lot of states don’t. Or other states can actually pick and choose which components they actually choose to use. So, you have to go state by state to determine what portions of the CARE Act will actually be applicable in any of the states that you’re operating in.
But in addition, a lot of the states are trying to do their own thing in helping out. So, we know that I mentioned that the federal government is allowing folks to defer their estimated tax payments, their extension payments with respect to ’19, but we also have a number of states that are doing that as well. Not all states, so you have to go again state by state, and that seems to depend on how far along the states are with their COVID-19 response.
So, for example, California was an early adopter of the deferrals for estimated payments. Another area is also sales tax abatement, or not abatement, but at least deferrals of payments. So, you really have to kind of look in every state that you’re in, especially if you’re in a significant state to see if there are special provisions that are being provided locally.
So, there’s a lot of detail and a lot of nuance for companies and private equity owners to really understand before they jump in and take some of the aid that is available. For example, I mean I’ve been hearing that in the US, many portfolio companies may not actually be eligible for the small business loans, as they’re considered an affiliate of their broader PE fund. I know that’s a question that many private equity funds are still looking into.
Alex, are you seeing similar examples in Europe where there’s no free money, right? So, there’s a lot of different programs, but you really need to understand the detail before you jump in. Can you give us a flavor of that?
Yes. And then, as you mentioned, I think also in most of the European countries there is not an affiliated concept like in the US, which means that PE portfolio companies can apply for such a loan on a stand-alone basis. But whatever would have to be really the key point to get this in a European market is we have to see that it’s really country by country and the loans are to support, let’s say the local business, and many of the portfolio companies are not like operating only in one country but rather operating across Europe in many countries.
So you have to see how to manage this to get loans in different countries and you have to not forget that you have to deal with the existing lenders because the question is what is allowed to lend in addition to the existing financing because a lot of PE portfolio companies are highly leveraged and what waiver you need from the existing lenders to access these loan programs.
And again, where there could be some issues with let’s say with the banks to get access to those loans, could come from the fact that a lot of companies are already over leveraged and you have to deal with it that maybe some of the PE portfolio companies are more leveraged than the rest of the corporate market, which is also currently applying for the loans and we will have to see over the next weeks how successful private equity portfolios are to get access to such loan programs.
The alternative is always to get additional loans either from the existing financing parties or also from their sponsor, because then you are not limited in what you are doing after the crisis because all of these loans always go with some restrictions, especially around when you have to repay it, or how many employees you have to retain in the respective country, so it has to be evaluated and it’s important to do this on a coordinated approach, especially if the PE portfolio is not only operating in one country.
Yes, and I guess there’s a sense of urgency right now, because everyone is trying to scramble and work out what all the different programs mean and what they offer, and they all want to make sure that their businesses have the best chance of making it through the economic disruption and obviously want to take care of their employees. But before jumping in there, to your point, they need to really understand the implications. Do both of you have some advice as to what you think portfolio companies and PE leaders should be doing before they jump in and enter some of these arrangements so that they’re really going in there with their eyes wide open.
And from my perspective it’s important to have a concept to do this, for it to be coordinated and analyze it from the top, so either on a PE portfolio basis, so for each PE portfolio company, or like for a number of PE portfolios in a country or in a region, and check what programs are available and which programs might be the best outcome.
And my advice would always be, especially if it’s loan programs, to consult always with your existing financing parties, because without them you cannot request it And that will all take time and as you mentioned, timing is key, and so my experience here is that the process in Europe is at least four to six weeks.
And Jennifer, any thoughts about US?
Yes, in the US, I think we’re seeing similar things where there needs to be a coordinated effort. We are seeing that a lot of the PE houses –the deal professionals --are basically no longer spending a lot of time looking at additional investments, ways to use their money with their LPs, but instead are really shoring up the existing portfolios. And those deal professionals can work with their credit teams, et cetera to make sure that there’s a seamless analysis and they apply kind of a similar thought process across the entire PE complex.
That tends to really help because people get really smart really fast and each of the portfolios can take advantage of that experience that the executives are using across the entire complex.
So, we’ve covered a number of short-term measures that companies need to consider addressing the immediate concerns that they have around the impact COVID-19 is having on their companies. What are some examples of the medium-term actions that companies are either starting to take right now, or are considering taking?
So in the United States, I think one of the big things that a lot of people are talking about are debt buybacks, especially if you have a reasonably healthy company, but because of just how the entire system has sort of blown up, their debt might be trading at a significant discount and this is a great opportunity then to take advantage of bringing some of that debt back into the company and basically retiring it.
The trouble with that though is that if the portfolio itself buys back its own debt, it’s highly likely that creates cancellation of indebtedness income and unless the portfolio is insolvent or in bankruptcy, that COD is going to be considered taxable. And so, a lot of companies are spending time thinking about ways to buy back that debt, not necessarily directly into the portfolio itself, but within the broader PE complex in ways that do not trigger those cancellation of indebtedness income problems.
The structures to do that are varied based on either the portfolio’s own ownership, so if you have just one PE owning the entire company, or if you have co-investors in the system, or we also have to look at the mix of the PE’s own limited partners. Do you have a lot of foreign investors, do you have a lot of domestic investors, those kind of issues have to be taken into account as you think about how to build a structure to actually buy back that debt without triggering the COD.
And in Europe, in addition, it’s equally important, I think is cancellation of debt income is likely mainly in the US, but in Europe it has to be carefully structured and as there are structures available to avoid at least the immediate income, which is taxable.
However, the structures have been changed over the years, and especially if you compare it like to the structures used in the financial crisis, because we have to due to the BEPS initiatives, introduced anti-hybrid rules and the consequences of these anti-hybrid rules as well as at lender perspective, so the entity who is acquiring this loan, that this income is not sheltered by interest because otherwise, it’s a 30 percent limitation which is not implemented across Europe. So, I think that’s the key topics from a European perspective.
So really, very important that companies take their time and really understand their structures and understand the different steps they’re going to take in order to either engage in debt buyback or use other measures as they move forward to help them in this time, because rushing in sounds like they could actually do more damage than good?
Yes, makes sense.
As we think ahead to beyond the current crisis, I mean we talked about short-term measures that obviously companies and PE complexes need to think about straightaway and we talked about some of the medium-term measures that companies can implement and will need to start planning for. And I know sometimes it feels like we’re never going to get to the other side of this, but what are some of the long-term drivers at the portfolio level that will really need to be addressed as the portfolio companies come out the other side of this economic crisis?
The main topic from my perspective is really and it’s depending on the industry where the portfolio company is in, but clearly what we see here in Europe, it’s really broken supply chains, which means that especially if companies are in the production business, and get lots of supplies like from China or from other countries, because basically all borders are closed at the moment, which means that people have to think about how to fix the supply chains. They have to think about their sourcing concept, which means in the past, it was really rather viewed as a global sourcing structure.
And I think in many instances, people will rethink about how to have at least a second source which is rather locally, to ensure that the supply chains are not broken again. I think overall this will be a catalyst out there for companies to think forward and to fix all of the supply chains. I think from now onwards, for the next three or four months, I think this is a key topic.
And Jennifer, anything additional from the US?
I think that broken supply chain point is really valuable. I mean one of the things we’re certainly hearing about are how global companies really embraced the “just in time” inventory management system, and that’s obviously not worked out as well as they’d hoped as part of this crisis. And so, thinking through whether or not they need to have more supplies on hand will be very interesting to see what people do.
Clearly, supply chain is critical to the future and coming out on the other side, there are changes to the way companies are working and dealing with their global supply chains that you think they need to perhaps rethink. What are some other lessons that perhaps have been learned or can be learned through this crisis and ways that companies can protect themselves against future potential global disruptions?
From my perspective, really digitalization is a key word, because if you see the companies which may be in the crisis now are more easily handling all of those aspects are really, if you see it from a retail perspective, which are multichannel, so having not only stores, but also able to sell things through the Internet and so the entire process leads to more digitization and again, if you combine it with supply chain and assuming that more sourcing will happen again locally, where the labor costs are higher, I would say there’s not an option not to digitize some processes because otherwise, the cost would be too high for local sourcing.
And I think some of the things that we’re hearing, especially from my tech private equity clients is really thinking about things that are just good corporate hygiene, so cybersecurity, making sure that you have enough bandwidth for your private networks to make sure that if your employees have to work from home that your systems can actually handle that, because you could find a situation where especially some of the portfolios conclude that they don’t necessarily need everyone towork in an office space, and actually taking advantage of people learning how to work from home, not necessarily needing as much real estate, things of that nature that might be kind of interesting to see what happens next.
That actually is a really interesting point. When we reflect on the time that we’re going through today, it’ll be interesting to see what changes that companies implement in the way that they do business, the way all of us do business as a result of having lived through this economic disruption and COVID-19.
I’m sure it’s going to manifest itself in many different ways that we’ll only find out the true impact of COVID-19 on our lives and on our business lives in the years to come. And some of that I think is probably going to be some really good business practices, perhaps in some areas such as supply chain or the slowness to adopt digitalization, it’ll actually prompt companies to take a different view around business and perhaps adopt practices that will only make them stronger down the track.
So, Alex and Jennifer, thank you so much for joining us today. We really appreciate you sharing your insights, exploring some of the real ways that portfolio companies and PE complex leaders have been working through the challenges of the short-term impact of COVID-19 and the economic disruption and exploring some of the medium- and long-term areas that they’ll need to explore and consider and adopt to address the impact of COVID-19 and get to the other side. So, thank you, again, both of you for your time. It’s really appreciated.
To our audience, I hope you enjoyed this episode of the NextWave Private Equity Podcast. We trust you found it informative and valuable as you navigate these unusual times. Please subscribe, review and, of course, share it with your colleagues and friends. To find out more about the topics we discuss, check out EY.com/private equity. I’ll see you on the next episode. And in the meantime, please stay safe and healthy.
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