Private Equity: Episode 17 – The Tax Leverage of LBO

In Episode 13, I explained the concept of the LBO and the leverage generated by the associated bank loan. An LBO structure also allows for the use of three additional types of leverage: fiscal, social, and legal. Let's dive into the tax leverage.

Tax leverage is realized through the tax consolidation system set up between the parent company (the holding) and the subsidiary, which is the target company of the investment.

As a reminder, the holding company has incurred debt to finance the acquisition, meaning it needs to cover interest expenses. Since it has no operational activity and generates no revenue, it is in a deficit and does not pay corporate tax – it’s fiscally negative.

The target company, on the other hand, is operational and was selected for its ability to generate profits. Therefore, it is profitable and subject to corporate tax.

By using the tax consolidation system, the holding company can deduct its interest expenses from the target company’s profits.

From a tax perspective, this results in the neutralization of the target company’s taxable income by the holding's tax deficit. This offset reduces the taxable base of the group.

Let's take an example:

• The holding company takes out a loan of €50,000 with 5% interest annually.
• The target company generates a taxable profit of €10,000.

In a normal situation, without tax consolidation, the holding would have a tax deficit of €50,000 * 5% = €2,500, with no corporate tax due.

Meanwhile, the target company would have a taxable base of €10,000 and a tax rate of 25% (simplified). It would owe €2,500 in corporate tax.

So, the total tax payable for both companies would be €2,500.

With tax consolidation, the holding’s fiscal deficit is deducted from the target company’s taxable base. This means:

• €10,000 – €2,500 = €7,500.
• The total tax payable becomes €7,500 * 25% = €1,875, which is lower than if the companies were taxed separately. Essentially, the tax rate drops from 25% to 18.75%.

However, this arrangement is only possible if the following conditions are met:

• The holding company owns more than 95% of the target company.
• Both companies close their accounts on the same date (for example, December 31).

Therefore, we can see how advantageous an LBO structure can be for a Private Equity fund.

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