Threat on the horizon

After years of discussion, major governments around the world are now finally beginning to develop a coordinated response to what they perceive as tax avoidance by large multinational companies and other financial institutions with cross-border activity. For the most part these discussions haven’t really touched on the private funds industry; but the policy response in consideration may inadvertently bring GPs into the fold.

A paper published in March by think-tank the Organisation for Economic Co-operation and Development (OECD) appears to be a blueprint for how the G20 group of rich nations will tackle tax avoidance. The paper, which is on “preventing the granting of treaty benefits in inappropriate circumstances”, is part of the OECD’s broader Base Erosion and Profit Shifting (BEPS) Action Plan. And it’s here the private funds community discovered a major concern: the OECD’s proposals may prevent GPs from domiciling funds and holding vehicles in certain jurisdictions, like Luxembourg or the Netherlands, that feature extensive networks of double tax treaties.

The target of the OECD’s proposals is “double non-taxation” and it regards so-called “treaty shopping” as a key issue. Put simply, the OECD wants to stop companies and other financial firms from using special purpose vehicles to bridge the gap between two countries which do not have a double tax treaty in place.

Private funds use these types of structures but for different reasons from those the OECD has in mind. Take for instance a fund which has investors from, and invests in, a wide range of countries. It saves itself a compliance headache by channeling investments through a central treaty-eligible structure.

But the approach taken by the OECD during drafting of its anti-abuse tests – which would be used to determine whether an entity should have access to double tax treaty benefits – presumes that the beneficiary of these treaties must be a member of a multi-national corporation.

In other words the consultation “does not look at the position of collective investment vehicles to any extent,” says one UK-based private funds tax lawyer. “And the result is that it applies to collective investment vehicles in a very disproportionate manner.”

Testing the limits

One of the anti-abuse tests under consideration that is proving to be especially problematic for the industry is known as a “limitation on benefits provision”; this could strip funds of their pass-through tax status, meaning GPs could suffer double taxation on these intermediate vehicles. The thinking is these types of funds (or holding companies) are not listed and are not engaging in an active trade or business, which the test demands (and critics say is an unfair litmus test for why the private funds universe uses these vehicles). These types of anti-abuse tests are also especially complex and onerous to interpret, says Kevin Phillips, a corporate tax partner for accountancy firm Baker Tilly.

Under the OECD proposal private funds can also fall foul of an anti-abuse test known as the “main purpose test”, which asks if an entity is being set up in a jurisdiction primarily to take advantage of its tax treaties. Private equity’s argument that certain jurisdictions like Luxembourg are used to access high quality service providers or simplify compliance requirements probably won’t meet these particular test, according to multiple tax experts’ interpretation of the provision.

Aware of the issue, the European Private Equity & Venture Capital Association (EVCA) sent a letter to the OECD that outlined how the proposals would place private funds at what they suggested was an unnecessary disadvantage. Among its remedies the EVCA calls for funds to be “explicitly excluded from the current treaty abuse draft” and for it to be made clear that the limitation of benefits and main purpose tests “will not act to restrict the ability of a [fund] from accessing treaty benefits.”

There’s some hope the industry’s arguments will win out. In 2010 the OECD released a paper entitled, “The Granting of Treaty Benefits”, which said investing through a fund should not trigger more tax for an investor than if it were investing directly in a company. So the OECD has acknowledged private fund vehicles are not generally used to abuse tax treaties.

LPs will be a factor in all this too. Many tax exempt investors, such as public pension plans and endowments, will no doubt press national governments hard to make sure they are not caught in the crossfire of a war on tax avoiders, as they don’t want to be paying tax at the fund level. Their challenge, according to market sources, will be to counteract a strong will by the OECD to stop tax avoidance, even if that comes at the cost of a bit of collateral damage to the funds industry.

There’s also the concern that the OECD will feel uneasy about granting any wholesale exemptions to certain industries for fear of creating loopholes or pressure from other market players.

Next steps

Further consultation on the OECD’s paper is expected in September with a possible implementation as early as next year, according to legal sources. However, they add that in reality the current time frame is too ambitious and any changes are unlikely to occur at such a pace.

“I don’t think there has been much thought on worst case scenarios. Partly because these things are at an early stage and the OECD is known to take ages on things,” says one UK-based tax lawyer. “I don’t think anyone has thought of the worst because it is probably a long way off and the industry doesn’t want to do any planning if it might prove unnecessary.”

And another positive for the funds industry is that the OECD cannot actually make law; all it can do is recommend policy that can be either accepted or rejected by individual states.

At any rate, it seems the industry will continue its lobbying efforts. A reading of the current drafts being chewed over by the OECD would have an enormous impact on the funds industry. And according to Mark Stapleton, tax partner at law firm Dechert, not just with respect to future funds but with respect to existing funds too, unless grandfathering provisions were introduced. The industry’s next tax challenge is underway.