Caught in the net

The bad press created by multinationals shifting their headquarters to low-tax jurisdictions kicked the OECD into action, and now private equity managers could find themselves judged by the same standards. The organization’s Base Erosion and Profit Shifting project is the next regulatory headwind, and it’s coming soon.

Implementation of the initiative will vary across the 100 signatory nations because it will be executed by domestic law. In the UK, Action 4 on interest deductions – one of the two action points that has the biggest implication for private fund managers – will take effect on April 6.

But the industry is unhappy: the action point is seen as “insensitive” to the use of debt in private equity.

“The fact that interest is generally deductible does mean that in some circumstances the cost of capital can be reduced and the returns for investors improved… It does not, however, follow that this amounts to or causes base erosion and profit shifting,” the British Private Equity and Venture Capital Association told the OECD.

Accountancy firms are also getting in on the act: PwC identified Action 4’s ‘one size fits all’ approach as “highly dependent on the interaction between the accounting standards of a corporate group and the tax law of the territory where the interest is accrued,” meaning it is difficult to enforce for numerous financial industries.
A start date for the other big hitter in the project, Action 6, which covers the abuse of double tax treaties, is yet to be confirmed. It, too, was subject to industry lobbying, which will likely to continue “on a rolling basis” until implementation dates are confirmed, according to the BVCA.

PwC also lobbied on Action 6, requesting clarity on the principal purpose test – which determines why a taxpayer is using a certain arrangement – and the limitation on benefits tests, which are applied when establishing an entity’s presence in a jurisdiction to benefit from the tax treaties there.

BEPS will affect fund managers in two areas: fund structure and portfolio companies.
“For private fund managers, the biggest impact will be on fund structure and portfolio investments. How BEPS will impact fund managers will depend on the fund structure. If you’ve got an ‘offshore’ collective investment vehicle in Luxembourg for example, BEPS will apply the principal purposes test or limitation of benefits – establishing an entity’s substance in a jurisdiction in order to take advantage of Luxembourg’s tax treaties,” says Shawn Carson, director in the international tax services group at EisnerAmper, a US professional services firm.

“If it’s a PE firm taking a 100 percent stake in a portfolio company it’s no different to any other multinational corporate entity; the portfolio companies will be impacted by transfer pricing rules, financing rules, ‘thin cap’ [high leverage] rules, rules on how much of the purchase price is put as debt or equity and so on. And all funds will have to pay attention to profit allocation based on ‘permanent establishment’ rules and BEPS rules on returns on capital,” Carson adds.

One nation which will not be implementing BEPS is the US. The new administration has promised to make significant changes to US tax law, which puts the initiative on the backburner. the US considers its domestic law to be compliant or beyond compliant.
“In many areas the US is already BEPS compliant, so we wouldn’t introduce domestic legislation to implement BEPS. For example, three areas where we’re already complying are: transfer pricing rules, permanent establishment rules and regulating hybrid entities, through our ‘check the box’ rules,” says Joan Arnold, a tax partner at Pepper Hamilton, a US law firm.

“There are also areas where BEPS doesn’t comply with domestic US laws, so we won’t be implementing BEPS for that reason also,” she added.

But managers in the country will still be affected.

“BEPS will clearly have an impact on how a manager, especially private equity managers, are structuring their deals, especially if it’s cross-border. Using Luxembourg or Irish structures may no longer work once BEPS comes in,” says Stuart Rosow, tax partner at Proskauer, a US law firm.

“I think, to the extent a fund manager is earning fees in various jurisdictions BEPS will have an impact there. The question will be which jurisdictions can tax those fees,” he adds.

BEPS’s origins in bad press over multinationals’ tax affairs also has an impact for fund managers in the US. State-sponsored tax loopholes can be considered ‘state aid’ – the use of state resources to provide assistance that gives organizations an advantage over others.

“BEPS will also impact regarding target companies’ tax structures. Fund managers will ask questions about whether those are considered ‘state aid’ for a company. A ruling from a tax authority can be considered state aid on tax,” Rosow says. ?

Substance over style

Managers’ main BEPS project concerns

• Adequate substance: a fund must be able to demonstrate they have ‘real substance and clear control of important functions in the jurisdictions in which they operate.
• CPEC or ‘check the box’ elections: Funds with Convertible Preferred Equity Certificates or check-the-box elections may see interest deductions denied.
• Deductible interest: Action 4 recommends deductions will only be allowed for interest up to 10 percent to 30 percent of EBITDA.
• Principal purpose test: treaty benefits could be refused if a fund’s transaction or arrangement was undertaken with the principal purpose of obtaining a tax treaty benefit.
• Transfer pricing: Action 13 imposes new tax reporting requirements on multinational corporate groups to establish a reasonably complete picture of the global business.