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Spain fights back

The legal environment in Spain has traditionally prevented the use of competitive private equity fund vehicles. But the country's new Private Equity Act has ushered in a very competitive regulatory and tax regime. By Javier Morera, Alejandro Hurtado, Isabel Rodríguez and Alberto Ruano

Countries have been competing hard for private equity business recently, and a number of new fund vehicles have emerged across Europe. And for good reason: it is clear that the legal and regulatory environment is a key factor in deciding where to locate a fund vehicle, and that there are significant economic advantages to being the country of choice for fund managers.

For some time, Anglo-Saxon jurisdictions have enjoyed a clear competitive advantage, due in part to their flexible legal framework and helpful tax rules. This could be contrasted with the position of Latin countries, including Spain. Its cumbersome legal framework, supervised by the securities watchdog (the Comisión Nacional del Mercado de Valores, or the ?CNMV?), was holding its private equity industry back.

The basic legal framework for Spanish private equity funds has existed for some time and has one important (though not widely known) plus point: it offers a very favorable tax treatment for domestic private equity fund vehicles (whether structured as companies or funds). But, although they were a good foundation, the (inflexible) rules were badly in need of an update. The main problem was the heavy-handed approach to investor protection, ignoring the sophisticated nature of the players involved.

Last December, a long awaited revised Private Equity Act came into force. This makes it much easier to establish and operate private equity entities.

Last December, a long awaited revised Private Equity Act came into force. This makes it much easier to establish and operate private equity entities (entidades de capital-riesgo or ?ECRs?), particularly for the brand new ?simplified ECRs? (ECRs de régimen simplificado).

The most important new features of the Private Equity Act are that it has introduced, for the first time in Spain: (i) a specific regulation for funds of funds; (ii) a tailor-made legal treatment for public to private transactions (aimed at enabling PTPs to benefit from the favorable tax treatment of ECR's investments); and (iii) a specific regime for simplified ECRs, which operate under a more flexible administrative framework not only in terms of its establishment requirements, but also in structuring carried interest.

Before the new Private Equity Act, Spanish funds of funds were possible – but they gave rise to so many practical obstacles and legal issues that most funds of funds preferred to fly to other jurisdictions in pursuit of a more appropriate legal framework.

Under the new regulation the funds in which a Spanish ECR may invest must meet various requirements. Among the most important are that the fund must: (i) be domiciled in an OECD country and (ii) not invest more than 10 percent of its assets in other private equity funds (i.e. the ECR could not invest in other funds of funds). As a result, those private equity funds wishing to attract Spanish ECRs should either abstain from being domiciled in most tax haven countries (though some of them qualify as OECD jurisdictions) or alternatively set up a parallel fund domiciled in an OECD country in which the Spanish ECR could invest.

In order to qualify as a simplified ECR, it is necessary to meet all the following requirements: (i) minimum commitments of €500,000 per investor; (ii) a maximum of 20 investors (excluding institutional investors for which such a number limitation does not apply); and (iii) abstain from carrying out any public marketing of the fund. Additional flexibility is granted in recognition of the higher degree of sophistication of the investors.

Simplified ECRs enjoy three main advantages vis-à-vis non simplified ECRs: (i) more flexible authorization procedures (the authorization may be obtained in one month – and, if within one month no response is obtained, the authorization is deemed to have been granted); (ii) the possibility to structure carried interest with different classes of shares/investment units to be subscribed by the promoters/founders (which makes carry structuring easier); and (iii) more flexible concentration rules (basically, an ECR may invest up to 40 percent of its assets in one target company).

In addition to the tax advantages (see below), Spanish institutional investors (e.g. pension funds and collective investment schemes) generally prefer to invest in ECR structures for the following reasons: first, Spanish institutional investors, as well as their relevant supervisory authorities, feel more comfortable with structures supervised in Spain by the CNMV; and, secondly, the regulatory treatment of an investment in an ECR is better than an investment in other foreign private equity vehicles (e.g. in terms of the number of requirements that they must meet so as to qualify as an ?eligible investment,? as well as of the percentages for the concentration rules).

Spanish ECR tax regime
ECRs are taxed under the general regime of the Spanish Corporate Income Tax (?CIT?) Act. However, the CIT, Value Added Tax and Capital Tax laws provide for some specific rules applicable to ECRs and their stakeholders that comprise a special tax regime: a very favorable one, for both nonresident ECRs are taxed under the general regime of the Spanish Corporate Income Tax (?CIT?) Act. However, the CIT, Value Added Tax and Capital Tax laws provide for some specific rules applicable to ECRs and their stakeholders that comprise a special tax regime: a very favorable one, for both nonresident

CIT exemption on 99 percent of capital gains obtained by ECRs:
Capital gains obtained by an ECR from the transfer of their interest in qualifying entities (generally speaking, Spanish and foreign non-listed and non-financial companies, as well as private equity funds meeting various requirements) enjoy a 99 percent tax exemption at the ECR level, provided that the investment holding period is longer than one year and does not exceed 15 years – in some cases, the top limit can be extended to 20 years. No minimum participation thresholds in the qualifying entities are required.

As long as the CIT standard rate is 35 percent, the effective CIT rate on gains for the ECR would never be more than 0.35 percent – and, in most cases, it will be an effective zero percent CIT rate, since the management fee payable to the fund manager would be fully tax deductible.

The special tax regime approved by the new Act provides for some anti-abuse rules that are basically intended to avoid the misuse of ECRs for personal purposes that are not real private equity business.

CIT tax credit/tax exemption on dividend and profit distributions received by ECRs:
Dividends and profit distributions received by ECRs from qualifying entities enjoy a full (100 percent) tax credit/tax exemption, depending on whether the ECR receives Spanish/ foreign source dividends and profits. That full tax credit/tax exemption is not subject to minimum interest thresholds or holding periods.

As a result, these dividends or profits distributed to the ECR will not be taxed at the ECR level.

Dividends/profit distributions and capital gains obtained from ECRs by non-resident investors:
Non-Spanish investors – other than tax haven investors – are not taxed in Spain on the dividends/profit distributions and gains they obtain from the ECR. Thus, as a rule, non-resident investors who are not tax haven residents and invest in private equity through an ECR would obtain their private equity income with no tax levied in Spain. This, together with the tax advantage for Spanish resident corporate investors described below, makes the ECR a very competitive private equity vehicle from a tax viewpoint, both at domestic and international levels.

Dividends/profit distributions and gains obtained from ECRs by Spanish resident corporate investors:

As a general rule, dividends/profit distributions made by ECRs to their Spanish resident corporate investors – CIT taxpayers under the general CIT regime – will enjoy a full (100 percent) dividend tax credit at the Spanish resident corporate investors' level, regardless of their holding period and percentages of participation in the ECR. These dividends/profits will therefore not be taxed at the Spanish resident corporate investors' level.

Gains obtained by Spanish resident corporate investors on the transfer of their interest in the ECR enjoy a full (100 percent) tax credit, regardless of their holding periods and percentages of participation, on the capital gains realized corresponding to non-distributed profits – attributable to the shares/participations transferred – generated during the time they held the ECR shares/participations transferred.

As a result of what is described above, ordinary Spanish corporate investors have, in general terms, an effective zero tax rate on the income they obtain if they invest in private equity (in Spain or abroad) through Spanish ECRs – whilst, if they invest via other normal international vehicles (such as Anglo-Saxon Limited Partnerships), they will usually be taxed on their income at the standard CIT rates (35 percent). This equates to an important competitive advantage for Spanish ECRs vis-à-vis Limited Patnership vehicles, if one wishes to raise relevant funds from Spanish investors.

Other ECR tax issues
As regards Capital Tax, the incorporation and capital increase of ECRs is exempt from Spanish Capital Tax – which normally amounts to one percent and applies to capital increases/decreases.

From a VAT standpoint, management services rendered by Spanish ECR Management Companies (Sociedades Gestoras de Entidades de Capital-Riesgo) to ECRs are exempt from Spanish VAT.

Finally, Spanish ECRs are Spanish CIT payers and, therefore, may benefit from the wide Spanish Tax Treaty network. In addition, ECRs in the form of SCRs (corporations) may get a further advantage if they try to benefit from the favorable ?Spanish holding company? tax regime (régimen de entidades de tenencia de valores extranjeros or ETVEs) with regard to their foreign non-qualifying investments (if any).

Conclusions
Following the new Private Equity Act, the ECR has become a very competitive vehicle for investing in private equity either as a fund or fund of funds, both for Spanish as well as for non-Spanish investors. Although a non-Spanish investor – particularly if it is Anglo-Saxon – may still regard ECRs with some reluctance, currently an ECR is the preferred private equity vehicle for Spanish investors. This is illustrated by the fact that one of the very first questions that private equity fund raisers are encountering when approaching Spanish investors is whether they have an ECR structure available. As a result, a good number of private equity houses attempting to raise significant funds in Spain are effectively offering an ECR (or are at least seriously considering doing so).

It is expected that the future development of the Private Equity Act, in which the CNMV plays the major role, will make it even more flexible (e.g. by extending the additional flexibility to all types of ECRs, and not only ECRs de régimen simplificado). This flexibility would enable ECRs to become an even more competitive option when structuring private equity products (including funds of funds) across Europe, alongside those already established in other jurisdictions.

Javier Morera is a tax partner of the SJ Berwin Madrid office and member of its private equity team.

Alejandro Hurtado is a corporate senior associate of the SJ Berwin Madrid office and member of its private equity team. Isabel Rodríguez is a corporate senior associate of the SJ Berwin Madrid office and member of its private equity team. Alberto Ruano is a senior tax associate of the SJ Berwin Madrid office and member of its private equity team.