The base erosion and profit shifting framework is about to spur a significant and material change in the way private equity funds are structured and staffed. And it’s a change that tax lawyers warn will not be cheap.
BEPS was initiated by the G20 in 2012 and taken up shortly afterwards by the OECD, with the goal of tackling ‘double non-taxation.’ This clunky phrase refers to moving profits from a jurisdiction governed by one tax treaty, usually where the primary economic activity of an entity is taking place, to another, usually an offshore or low-tax jurisdiction, to drastically lower or wipe out the entity’s income tax bill.
A rash of high-profile cases involving companies such as Apple and Alphabet, plus leaked documents that revealed lawyers were advising clients to use mismatched regimes, kicked politicians into action and the rules are now due to come into force in 2019.
But less than a year ago the private equity industry had little idea where it stood. In the first drafts of BEPS there was almost no mention of private funds – non-collective investment vehicles in the terminology – and it failed to address the treaty entitlement of non-CIVs. Could private funds continue to exercise treaty benefits (ie, domicile themselves in low-tax jurisdictions regardless of where other business activity is taking place), or were they going to be denied?
The private funds industry demanded answers, so the OECD devised three fund examples to demonstrate how the rules could apply. In the battle to interpret BEPS for private equity one of these examples has been declared the winner: the regional investment platform.
A model structure
How the regional investment platform is likely to work for private funds
Fund is an institutional investor, tax resident in State T.
A holding company, Master HoldCo, is subject to tax and regulation in State R.
Master HoldCo is a regional investment platform holding a diverse portfolio. It employs a local team of investment managers.
State R is chosen due to the availability of knowledgeable directors, skilled workforce, membership of a regional group and use of a regional currency, and an extensive treaty network.
In reviewing its investment, MasterHoldCo considers the benefit under the State R/State S tax treaty (5 percent withholding in contrast to 10 percent withholding between State S and State T.) OECD concludes that ‘this alone would not be sufficient to trigger the application of the principle purpose test.’ Instead ‘it is necessary to consider the context in which the investment was made, including the reasons for establishing [MasterCo] in State R and the investment functions and other activities carried out in State R.’
“We are seeing a real movement in the market here with fund managers looking to align their holding company structures in Luxembourg with the ‘regional investment platform’ example given by the OECD in the context of how the anti-treaty shopping provisions of BEPS might apply to ‘non-CIV’ funds,” says Laura Charkin, tax partner at law firm Goodwin.
“This means in practice a movement toward using master holding company structures and for those with sufficient scale, moving more business functions to be run from Luxembourg.”
For the funds, that means additional costs as they create a meaningful presence in certain countries. And for low tax jurisdictions that means plenty of change.
“Funds are going to be moving out of locations where they had no ‘substance’ [as defined by BEPS rules] or moving people in to beef up those functions. For example, we are seeing funds hiring locals in jurisdictions such as Luxembourg to beef up their ability to monitor investments and evaluate potential investments [from there],” says Harold Adrion, partner at tax and consulting firm EisnerAmper.
Standing on principle
The issue of ‘substance’ or ‘principle purpose’ are the keys to understanding BEPS. Funds must be able to demonstrate that profits are being taxed where the economic activities generating the profits are being performed.
“I have a rule of thumb,” says Prabhu Narasimhan, a tax partner at law firm White & Case. “If it’s a warm, sunny island with a nice seashore, it’s hard to demonstrate substance. In contrast, onshore jurisdictions have a real depth in human, technical and economic resources to go with a varied economy, and are therefore more likely to be aligned to commercial reality.”
In Europe, “the relevant test in most EU treaties will be one of the ‘principle purpose’ of an entity and not of its substance per se. As such we expect to see more focus on adding additional functions to holding companies in the coming years,” Charkin says.
So key domiciles are likely to see additional staff brought on. And as Adrion says: “The costs of doing this are going to be substantial.”
But funds will bear these costs because they are more economical than the alternative – bringing the fund back to the manager’s home base. It looks as if Luxembourg will benefit. Ireland could too. Adrion says it “has been promoting itself recently” and he has seen “an uptick” in fund structuring activity.
And as for the losers: “Malta. Have you ever been there? There’s not a lot going on. It’s hard to get people there,” Adrion says.
Serving the purpose
Depending on the size of the fund, Charkin says different approaches could be taken to address the issue of principle purpose. “Larger scale businesses may set up their own service company in Luxembourg to provide staff and premises to various entities within their structures.”
For smaller fund management groups with fewer resources, “it is still very common to use two externally sourced directors, with perhaps one ‘house’ director also on the board of Luxembourg holding entities. That house director is now much more likely to travel to attend quarterly board meetings in Luxembourg and avoid taking board-level decisions or signing resolutions outside Luxembourg than a few years ago.”
As well as additional spending on personnel and functions, the proposed BEPS rules are prompting investors to commission external reviews that test a fund’s substance. “We have had more than one situation where a large tax-exempt investor has demanded an annual external substance review should be carried out and any recommendations arising from that adopted,” according to Charkin.
The regional investment platform is the front-runner as the model for private equity funds, but Narasimhan says BEPS is still a work in progress with “much debate” regarding its precise application.
“The global inter-governmental desire to introduce restrictions on claiming tax treaty benefits in what are widely perceived to be ‘inappropriate circumstances’ is proving to be easier to conceptualize than conclusively implement and police,” Narasimhan says. “However, what is becoming increasingly clear is that, whatever the detail, commercial reality and substance needs to be strongly demonstrated to justify the use of particular corporate structures, jurisdictions and tax treaties.”