SWF-friendly tax reforms come with caution

Sovereign wealth funds concerned with losing their tax-exempt status when making certain US private equity investments will find favour with relaxed IRS rules, but that gain may be lost under certain circumstances, warn legal sources.

It is not clear if sovereign wealth funds that take a position on the advisory board of a private equity fund stand to benefit from relaxed Internal Revenue Service rules designed to encourage foreign investment, warned law firm Pepper Hamilton in a client memo. 

As PE Manager reported late last year, the US tax office will no longer strip foreign governments of their tax-exempt status should one of their private equity fund investments engage in any “commercial activity”. Unusually, the IRS said the proposals could immediately be relied upon even though final rules have not yet been issued.

The industry welcomed the tax revision, with many predicting a rise in private equity investments made by sovereign wealth funds, which collectively manage some $5 trillion in assets, according to the Sovereign Wealth Fund Institute.

However unless the IRS elaborates on its definition of a limited partnership, sovereign wealth funds that take on a relatively active role in the fund may be interpreted as breaking their limited partner status, warned Steve Bortnick, a Pepper Hamilton tax partner, in an interview with PE Manager.

Concerning co-investment opportunities, Bortnick warned that the burden is on sovereign wealth funds to avoid engaging in any commercial activity, as the more lenient rules applicable to partnership investments do not apply to direct investments. Which non-business activities (for example the receipt of isolated commitment fees) will constitute commercial activities is another area in need of clarity under the proposals, Bortnick elaborated.