The chaos surrounding the Australian Tax Office’s desperate bid to tax the profits earned by Texas Pacific Group (TPG)  after its successful float of Myer continues. Earlier this week, the tax office released a series of draft rulings specifying that gains made by private equity firms are taxable as ordinary income and that it would apply the general anti-avoidance provisions to prevent “treaty shopping”. The ATO is endeavoring to prevent companies from avoiding the intent of international tax agreements by setting up complicated offshore holding company structures in tax havens such as the Cayman Islands or Luxembourg.

The taxation of private equity has long been a controversial topic. As this column has pointed out, private equity firms are able to profit (on behalf of investors) from two means; first, the incompetence and inefficiency of many publicly run companies; and second, from the enormous tax advantages that private equity is able to access. Because private equity tends to use a very high amount of leverage, they earn minimal “accounting profits” during their ownership of businesses and therefore pay virtually no income tax during that time. Upon an eventual trade sale or initial public offering, any gains were treated as “capital” and receive concessional tax treatment. (The private equity firm itself earns income by usually charging investors 2% of funds under management and 20% of any out-performance, so the tax advantages are critical to the earnings of private equity firms).

When TPG, the world’s largest private equity firm, is able to make a $1.58 billion profit in three years from investing in Myer, naturally, the fact that no tax is paid on this profit is going to raise the ire of the revenue office. The ATO argued (quite legitimately) that private equity firms exist to purchase assets (usually businesses) for a relatively short period of time (say 3-5 years) and sell them for a profit. This means that gain is not “capital”, but actually represents “ordinary income”.

To compare, say an antique shop buys an artefact for $10,000 and sells it three years later for $20,000 — few would dispute that the $10,000 profit made is ordinary income, rather than capital. In a sense, what the ATO is claiming is that for private equity, “businesses” or “assets” are effectively a form of inventory. (PE would claim their business is running and growing the capital value of the businesses, but given they pay minimal dividends and are not long-term holders, this appears an illogical argument).

The implications of the ATO’s draft rulings mean that foreign PE investors would need to pay tax on any profits they reap from the sale of the business. TPG (and every other PE firm) claim that the profits are capital gains (which are not payable by foreign entities).

The ATO ruling has understandably raised great panic among private equity and the highly paid lawyers, accountants and bankers’ advisers who charge millions in fees to facilitate PE transactions. The Financial Review reported yesterday that Nick Humphrey, the head of private equity at law firm Deacons, claimed that the ATO determinations conflicted with the government’s efforts to attract more foreign capital and overseas funds would be even more likely to invest elsewhere.

Such fear-mongering is presumably done in the hope that no one actually gives Humphrey’s far-fetched claims the slightest moment of consideration. In reality, when a private equity firm  makes an investment it uses very little equity — the vast majority of its investment is funded by debt. Instead of attracting wads of “capital” to Australia, private equity does little more than increase the levels of indebtedness among Australian businesses. Anyone who witnessed the global financial crisis of the past two years would be well aware that excessive leverage is not necessarily a good thing.

In fact, in recent times numerous private equity transactions have collapsed — leading to widespread job losses. Earlier this year Bloomberg reported that:

Of 86 US companies rated by Standard & Poor’s that filed for bankruptcy last year, 22 were controlled by private-equity firms, according to the Private Equity Council, the Washington-based industry lobbying and research group. Among them were Apollo’s Linens ‘n Things Inc. and Mervyn’s LLC, a mid-market department-store chain owned by Sun Capital Partners Inc. in Boca Raton, Florida.

Even in Australia, which has remained somewhat immune from the global meltdown, private equity has suffered substantial losses in its investment in Channel Seven, PBL Media and Australian Discount Retail. It is also almost de rigueur for private equity firms to slash payroll, which is not considered ideal for those who find themselves without a job.

The head of the Australian Private Equity Venture Capital Association, Katherine Woodthrope, also criticised the ATO, alleging that:

If the tax office rulings/determinations are allowed to stand … there is likely to be a significant, long-term detrimental impact on a range of sectors including private equity and infrastructure.

Woodthrope’s comments are not exactly convincing — in fact, most taxpayers would be somewhat aggrieved to know that their monies are effectively subsiding wealthy private equity bosses. (Those monies are then put to great use, such as when Steven Schwarzman, the chief of Blackstone, a US-based private equity firm, threw himself an infamous $US3 million birthday party in 2007 with performances by Rod Stewart, Martin Short and a life-sized portrait of himself). Similarly, infrastructure is arguably an asset ill-suited to private ownership — as had been well proven by the likes of Babcock & Brown, MFS and Allco, and their suite of collapsed infrastructure funds.

Even the IMF has warned of the dangers of private equity, way back in 2007, when it noted “financial market investors may be giving insufficient weight to downside risks [to private equity deals], assuming that low-risk premia and low volatility are a more permanent feature of the financial market landscape. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved.”

Despite the claims of self-interested private equiteers and their hired help, the ATO’s decision to tax TPG’s billion dollar Myer windfall was the right one. It’s just a shame it came a few weeks too late.