Capital gains tax uncertainty creates anxiety

While tax treatments remain favourable to private equity GPs in some jurisdictions, a number of recent changes in tax law could impact investment strategies.

Changes to capital gains tax treatment and beneficial ownership issues are likely to remain two of the key areas of tax for private equity firms to grapple with in the coming months. When combined with governments looking to challenge tax structures and possibly introducing new rules, tax advisors face the possibility of having their hands tied in reducing the tax burden of investing.

Many jurisdictions treat capital gains on equity investments favourably, applying some form of “participation exemption” to dividends and or gains on significant shareholdings.

The theory is that the underlying profits already have been taxed at the level of the company.

This means a lot of grey matter is going into constructing the right platform to invest in assets in order to escape being taxed too highly on the expected pick-up in values.

Though huge profits have been made in the past, the additional challenge of real estate investing is that domestic tax laws and regulatory frameworks have been changed, and in some cases delayed.

Carrying on 

The US has been faced with much back and forth regarding a tax hike on carried interest.
However, the conversation came to a grinding halt after contentious debt ceiling negotiations failed to include carried interest tax changes, a victory for private fund managers.

Debate over carried interest tax designation has raged over the past few years with Republicans defending the capital gains rate and Democrats arguing a carried interest tax hike could help address the deficit. In 2009, the government estimated that taxing carry as ordinary income would raise nearly $26 billion in tax revenue. While that would be a drop in the bucket in terms of paying down the $14 trillion national debt, Congress remains under intense pressure to increase revenue by all means necessary.

In April, Obama unveiled his budget proposal, which directed Congress to require executives of private equity firms to pay ordinary income tax rates as high as 35 percent (39.6 percent after 2012) on the profits they receive as compensation. Carried interest currently qualifies for lower capital gains tax rates of 15 percent (20 percent after 2012).

Many industry players were sure the momentum in the US for a carried interest tax increase picked up

as Republicans were being forced to make difficult decisions during ongoing debt ceiling negotiations. Indeed, Congress and President Barack Obama were locked in a bitter battle, with various tax increases expected to be part of the final agreement. After several attempts to put carried interest tax on the table, however, the debt ceiling negotiations closed with capital gains firmly off the table.

“The discussion around capital gains has indeed been part of the larger tax debate,” says Frank Walker of Taxand US. “However, an observer might say that Congress has bigger issues to deal with now.”

As a result, private equity managers have nothing to fear – until the next round of discussions in the fall.

Reworking the system 

Proposals underway in India to rework the nation’s domestic tax system could lead to a 30 percent tax on carried interest. India is about to change its domestic tax code, replacing the current law with a new direct taxes code, which will go into effect in April 2012.

What does this mean for the private equity real estate managers? Unlike most other countries, India taxes even non-residents on the sale of Indian shares, therefore this change could impact all offshore funds whether investing directly into India or through an onshore fund. The apprehension has been that once this new tax code comes into effect, all the structures set up in low tax jurisdictions such as Cyprus and Mauritius, where the primary motive is to avail a favourable tax treaty with India, could come under detailed scrutiny.

At present, the ordinary income tax rate is 40 percent for foreign companies and 30 percent for others, whereas the capital gains tax is 20 percent, so there is a 10 percent differential.

Under the new tax code, there will be a uniform 30 percent rate for all taxpayer on all income, as per the current proposal.

There will be certain deductions, however, for capital gains. For example, if one were to sell listed company shares on the floor of the stock exchange after holding them for one year, then there will be 100 percent deduction from the capital gains tax. So essentially, there will be zero tax.

The impact on fund managers has been swift. Fund managers are now exploring alternative jurisdictions where they have a better chance of meeting the substance test.

Many fund managers are exploring Singapore because India also has a favourable treaty with the Asian city-state, the difference being that the Singapore treaty already has some anti-treaty shopping provision built into it. So, somewhere there is an expectation that it might sustain even after the new tax code comes in.

Secondly, Indian fund managers are more concerned if they are controlling the fund from India. In such cases, the protocols that are put in place for the investment decisions are likely to face more scrutiny. Many fund managers also have started exploring structures where they can pass on the tax credit to their investors.

A UK exemption 

Meanwhile, UK tax authorities made it easier in May for offshore private equity real estate investors to preserve returns as capital gains after once fearing an income tax rate treatment. Indeed, realisations made by funds in investments structured offshore will be treated as capital gains and not as offshore income.

Without the exemption, UK-based private equity real estate investors and GPs potentially faced an income tax rate as high as 50 percent on their returns generated from investments held through offshore entities.

The UK capital gains tax rate for high earners currently is 28 percent.

To gain the exemption, at least 90 percent of the assets of the offshore special purpose vehicle (SPV) must be in unlisted trading companies. The exemption originally stated the SPV had to maintain the 90 percent threshold right up to the date of disposal, but UK tax authorities have since relaxed the standard to allow assets to be realized before then, even if doing so would mean the SPV dipped below the 90 percent floor.

The issue arose in late 2009, after the UK government devised new rules to clamp down on investors avoiding tax through the use of offshore investment vehicles. The revisions potentially could have captured private equity funds using offshore SPVs to structure their investments, which the new offshore funds tax regime will cover.

Dutch exemption upheld 

Positive developments continued in the Netherlands, as capital gains are mostly 100 percent exempt under the Dutch participation exemption. The participation exemption, which exists in a handful of European countries, relates to the exemption from taxation for a shareholder on dividends received and potential capital gains arising from the sale of shares. A Dutch Supreme
Court case reaffirmed that exemption.

“An interesting development in this respect is that, as a result of a Dutch Supreme Court decision, capital gains on certain derivatives on shares (convertibles, option rights and warrants) under certain circumstances also are covered by the participation exemption,” says Henk de Graaf of Taxand Netherlands.

Other capital gains that are taxable at the statutory rate have been consistent as well. “An important way of deferring taxable gains is contributing the gain to a so-called reinvestment reserve,” says de Graaf. “In broad terms, if a property held for investment is sold and one intends to replace this property by a new investment, the capital gain may be deferred by reducing the tax basis of the new property.”

Over the last few years, tax authorities have challenged the use of the reinvestment reserve by taxpayers, stating that all relevant criteria are not met. “This position was taken in respect of the requirement that the replacing property would not have the same economic purpose,” says de Graaf.

“However, the Dutch Supreme Court ruled in many cases in favour of the taxpayer stating that the reinvestment reserve should be applied broadly.”

Clarifying beneficial ownership 

The term “beneficial owner” has given rise to different interpretations by courts and tax administrations. Given the risks of double taxation and non-taxation arising from these different interpretations, several governments have developed proposals aimed at clarifying the interpretation.

For example, the Netherlands historically has applied a very legal interpretation to the term beneficial owner. In fact, the owner of the legal title is in principle also considered the beneficial owner.

However, the new Organisation for Economic Cooperation and Development (OECD) discussion draft on beneficial ownership may change this view since the Netherlands refers to the OECD commentary for the interpretation of its tax treaties. “Since the Netherlands applies a dynamic interpretation of their tax treaties, new commentaries may have an effect on how treaties are interpreted,” explains de Graaf.

The three key points in the discussion draft are as follows:

First, a treaty-based approach to interpreting the term is used, although it recognizes that a domestic law interpretation may be applicable if consistent with the general guidance of the commentary. A narrow technical interpretation of the term based on domestic law is not appropriate.

Second, the recipient of a payment is the beneficial owner if he has the full right to use and enjoy the income unconstrained by a contractual or legal obligation to pass the payment to another person. Such an obligation will normally derive from relevant legal documents, but it also may be based on facts and circumstances that show that the recipient does not have the full right to use and enjoy the payment. The use and enjoyment of a payment must be distinguished from the legal ownership.

Finally, the fact that the recipient qualifies as the beneficial owner does not guarantee reduced withholding tax rate based on the treaty. Other anti-abuse rules can be included in a treaty that may restrict the use of the treaty.

Taking the issue to court 

In the beneficial ownership debate, Denmark’s court system has taken centre stage. In January, a ruling from the Danish Tax Tribunal considering the concept of beneficial ownership was published. That ruling is the third from the tax tribunal regarding beneficial ownership rules, which initially were issued last year.

“There is a very aggressive stand on beneficial ownership in Denmark,” says Anders Oreby Hansen of Taxand Denmark. “There are a number of court cases running, and it will be a fierce battle for the next six to eight years.”

A recent tax case in Denmark considered the meaning of beneficial ownership of interest and dividends paid by Danish companies to Swedish holding companies, which then paid the interest to a Jersey holding company.

Danish tax law levies withholding tax on interest at a rate of 25 percent to payments made to non-resident holding companies unless the taxpayer can benefit from a reduced rate under a tax treaty, the EU parent subsidiary or the interest and royalty directives.

To benefit from the tax treaty, the taxpayer generally must be the beneficial owner of the interest income. “Clients are concerned about investing in Denmark,” says Hansen. “They are worried about being caught in the crosshairs.”

In the meantime, many will be keen to gauge the reaction of the large global firms, for which these tax rulings are intended. Whether their interest levels in certain markets will remain the same in the face of such uncertainty remains to be seen.