United States

Sometimes – and only sometimes – new financial regulations are actually greeted enthusiastically by the groups affected. Private equity practitioners have welcomed the news (at press time) that the Pension Protection Act of 2006 has been forwarded to President Bush for enactment, having finally moved from the US House of Representatives and through the Senate. Bush will almost certainly sign this sweeping new set of rules into law.

Among provisions of the Act is a rule change that will make it easier for private equity funds to accept capital commitments from corporate and private pension funds, which are subject to regulation under the federal Employee Retirement Income Security Act of 1974. (Government plans, non-US plans and church plans are not subject to ERISA). Although the new Act didn't go as far as some in private equity had hoped, the changes it will bring about are ?nothing but good news? for the industry, says Jonathan Zorn, a partner in the Boston office of law firm Ropes & Gray.

Specifically, the Act will allow private equity (and hedge) funds to accept up to just under 25 percent of capital commitments from ERISA plans, and not be penalized for taking in capital from government plans, non-US plans or church plans. This could have the effect of expanding the territory in which private equity GPs fundraise.

ERISA was created in 1974 as a way to protect the assets of defined-benefit pension funds and pensioners. In 1978, the Labor Department opened the floodgates of pension capital to private equity managers when it ruled that earlier stage investments are indeed appropriate for ERISA plans so long as they didn't endanger the entire portfolio.

However, further regulations made tapping ERISA money more difficult. If benefit plan investors held 25 percent or more of any class of equity interest in a fund, the fund itself was considered to hold plan assets and thus become potentially subject to burdensome ERISA rules. (Under both the new rules and existing regulations, equity interests held by the fund managers and related parties are disregarded, which of course can have the effect of pushing a pension plan's to a higher percentage of ownership.)

Few private equity funds would welcome having any one investor constitute a quarter of committed capital, but the ERISA rules included an odd convention – non-ERISA plan money such as capital from governmental or non-US plans is lumped together with ERISA plan money in applying the test, so that a fund with just one dollar of ERISA money might have to limit other benefit plan investor participation to stay under the 25 percent threshold.

In other words, a $100 million US private equity fund with $1 million from an ERISA plan and $24 million from a Dutch pension would have to treat an undivided interest in each of its assets as subject to ERISA, unless another exemption applied.

In other words, a $100 million US private equity fund with $1 million from an ERISA plan and $24 million from a Dutch pension would have to treat an undivided interest in each of its assets as subject to ERISA, unless another exemption applied.

A private equity firms could avoid becoming subject to ERISA rules by setting up shop as a ?venture capital operating company? or a ?real estate operating company? – which brings with it a different set of paperwork and compliance requirements. But many simply had to carefully track pension commitments to their funds, or simply banned ERISA plans altogether.

The new Act changes the rules such that ERISA commitments are counted in what has to be described as a more normal fashion. Non-ERISA pension capital is no longer combined with ERISA capital in determining the 25 percent threshold.

Being tagged an ERISA fund manager is not disastrous but also not fun.

In addition, says Zorn, the Act provides relief for funds of funds and other pooled capital that commit to private equity funds, although the new statutory language on this is less clear. In general, congress appears to have concluded that even where ERISA plan investment in a fund of funds is substantial enough to subject that fund of funds to ERISA, any dollars invested by the fund of funds in another fund will only count on a prorated basis in applying the 25 percent test. In other words, a $10 million commitment from a fund of funds that has 50 percent ERISA money should count as $5 million toward the threshold test. Previously, the entire $10 million would have been added toward the 25 percent limit.

An earlier version of the Act would have been cause for even greater celebration among GPs. It would have raised to 50 percent the amount of ERISA capital a fund could take before being falling under ERISA regulations.

Fortunately for participants in the current private equity market, supply of capital is not a major problem. Although ERISA plans represent a truly gigantic source of investment capital, there are many other willing limited partners to round out the 75 percent of a fund that can't be ERISA money.

That said, an interesting and related issue has to do with the reason the Pension Protection Act was created in the first place – defined benefit pension plans are an endangered species. Because of the liability that these plans pose to corporations, many are replacing defined-benefit plans with 401(k)-style defined-contribution plans. The latter compartmentalizes retirement benefits for individuals, and does away with the large pools of capital the characterize defined-benefit plans. If current trends continue, there could come a day when ERISA plans are no longer available as limited partners.

But this decline is expected to happen over decades. As Zorn observes: ?Even if every ERISA pension plan in the US were to get frozen tomorrow, you still have these huge pools of capital supporting the pensions that have already accrued. The fiduciaries of these funds will conclude that some portion of the assets should be allocated to private equity.?

In other words, ERISA plans have suddenly emerged as sought-after LPs after years spent on the private equity B-list.

Canada
A beauty way to take over
While legal experts in Canada admit that regulatory change in this area may be far away, many are eager to see the results of an ongoing review by Canada's several provincial securities commissions with regard to takeover bids.

The effort is part of a larger move by the commissions to harmonize securities rules across the country. Currently, the commissions are taking comment on rules surrounding the financing of ?takeover bids? and issuer bids. A legal source says: ?It's unclear where this is all headed, or how the commissions will react to the comments.?

At stake is a proposed rule that, according to the Ontario Securities Commission, ?financing arrangements may be subject to conditions if, at the time the bid is commenced, the offeror reasonably believes the possibility to be remote that the offeror will be unable to pay for securities deposited under the bid solely due to a financing condition not being satisfied.?

The rule is in reaction to a recent judgment that ?accurate, clear and unequivocal assurance? be in place with regard to the financing of a bid.

The proposed rule is designed to help ?bidders and lenders? be able to tailor their conditions to the specific circumstances of the transaction?Greater efficiencies will be achieved through reduced transaction costs??

Comments please.

United Kingdom
Catch 22
The UK private equity market is acknowledged to be the most mature and active in Europe, accounting for almost half of deals done within the region in a typical year. This leads many observers to assume – and, in many respects, with justification – that the UK is also a benign environment in which to operate for private equity funds and the managers they back. Hence, it came as something of a surprise, to say the least, when a new regulation appeared out of the blue, threatening to destroy the favorable and much-cherished tax status of private equity executives and managers.

Schedule 22 was first introduced three years ago as part of the UK's Finance Act 2003. However, many practitioners say the intervening period has failed to provide much clarity on the circumstances in which the provisions of Schedule 22 apply. In this sense, it is as much an issue for the future as one being tackled in the present.

The new rules are designed to clamp down on the massive profits.

The Schedule challenges private equity firms in the UK to find more sophisticated ways of structuring deals than has traditionally been the case in order to avoid creating liabilities to income tax and national insurance tax rather than the less costly capital gains tax that they have normally paid. It has, in essence, left the UK industry hovering over the precipice of a potentially far more punitive tax regime.

Schedule 22 decrees that employment-related securities (such as shares in a company) become subject to a tax charge when certain events arise (including disposal) on the difference between the unrestricted market value of the securities (their value in an open and unrestricted sale involving willing parties acting independently of each other) and the actual amount paid. The charge is based on higher rate income tax at 40 percent (plus national insurance contributions) rather than capital gains tax, which – if full relief applies – can be as little as 10 percent.

One observer says the new rules are designed to clamp down on the massive profits sometimes made by private equity-backed management teams that have invested only small sums in deals. Says Gregory Morris, a UK-based director of tax consultancy services at law firm DLA Piper Rudnick Gray Cary: ?HM Revenue & Customs (HMRC) points out that the total return to the VC is often dwarfed by the return to the managers. As a consequence, the Revenue is keen to argue that the managers' return is in part employment-related income and as such, should be subject to income tax.?

As you'd expect, lawyers have honed various responses to Schedule 22, including suggesting that clients elect to pay an upfront charge: which, while still a charge, is designed to circumvent the possibility of nasty shocks down the line.

Industry body the British Venture Capital Association (BVCA) thought it had arrived at a solution to the problem in the form of two so-called memoranda of understanding (MOU) it struck with the HMRC: one dealing with manager shares and the other with carried interest. The MoUs allowed securities to be treated as if acquired at an unrestricted market value providing certain conditions were met.

However, fears are spreading that the MoU's might soon be the subject of a government U-turn. Says Jill Hallpike, a professional support lawyer in the London office of SJ Berwin: ?Much uncertainty remains, and as HMRC have publicly stated that they want to revisit both MoUs, everyone in the private equity community will be looking out for further developments with interest.?

The European Commission
Miffed about MIFID
As it bids to ensure that certain standards are applied to the conduct of financial services, business across the European Union, the European Commission (EC) may feel it deserves approval and support. But from a private equity industry that finds itself caught in the web of sweeping new regulations, it will struggle to elicit any emotion other than a grumble of discontent.

In drawing up a draft version of its Markets in Financial Instruments Directive (MIFID), EC internal market commissioner Frits Bolkestein said the organization was seeking to allow ?reputable investment firms to work anywhere in the European Union with a minimum of red tape while bolstering our defenses against dodgy operators.? A noble ambition: but the private equity industry is rapidly discovering the devil is in the details.

The basic problem, says one interested observer, is that rules such as these tend to get drawn up by ?people who don't understand private equity.? Citing an example, the same source says: ?MIFID demands that managers must have huge capital requirements [the amount a firm must hold to cover potential liabilities to clients] because it's seen as a dangerous industry.? For an average private equity firm, says the source, this might means hundreds of thousands of euros having to sit idly in a bank account rather than just a few thousand.

A further example, according to Sue Woodman, partnership counsel at London-based GP Alchemy Partners, relates to the issue of conflicts. Previously, the industry dealt with potential conflicts – for example between manager and adviser – simply by disclosing them. She says: ?All private equity firms have a conflicts policy but typically it simply involves disclosing conflicts to the advisory board and asking whether they are okay with them or not.? Instead, MIFID demands that any conflicts be dealt with up front: though details of how exactly this is expected to be achieved remain sketchy.

Practitioners in some EU member states claim that domestic regulations already do the job that MIFID is trying to do. For example, one UK professional says: ?We are already thoroughly regulated by the Financial Services Authority (FSA) but these new rules will come along and change everything. They will cost a huge amount to implement but without much benefit.?

What is more, time to put in place the necessary measures is running short. Currently in draft form, MIFID as a whole has a final implementation date of November 2007, while the capital requirement rules need to be complied with by the beginning of next year. Like it or not, the clock is ticking.

Germany
Gesetz ready to go
Unlike in certain other European countries, in Germany a new regulatory initiative targeted at the private equity industry is being awaited with enthusiasm.

A proposed new ?Private Equity Act? (Private Equity Gesetz) is one of the by-products of the Coalition Agreement struck between the Christian Democrats and Social Democrats in November 2005, which set out the agenda for a grand governing coalition led by Chancellor Angela Merkel. In the words of Martin Schulte, a partner in the corporate practice group of law firm DLA Piper Rudnick Gray Cary in Germany, the agenda ?recognizes the important role that private equity and venture capital have in the German economy of today.?

Details of the proposed Act are as yet scant, but it is understood that it will focus in particular on increasing the access that Germany's Mittelstand (small and medium-sized companies) have to private equity, venture capital and mezzanine financing. It is not surprising that the Mittelstand appears to have been singled out for special attention, accounting as it does for the vast majority of the country's workforce.

The beauty of the new Act will lie in the simplicity that it will offer investors and investees. At present, the tax laws applicable to private equity funds are spread across a large number of statutes and rulings drawn up by the German tax authorities. Regulatory aspects applicable to special German private equity vehicles – Unternehmensbeteiligungsgesellschaft – are currently set out in a special act, the Unternehmensbeteiligungsgesetz. But the number of funds that have been set up under this framework has remained small.

Through the new Private Equity Act, it is understood that the government will make moves to simplify tax laws and regulatory issues relating to the asset class by completely overhauling the existing statutory provisions.

Viewed in conjunction with the German Takeover Directive, which was introduced in July 2006 and which removes a number of the obstacles to completing public-to-private buyouts quickly and efficiently, the Private Equity Act promises to make Germany a far more user-friendly environment for private equity pros than it has been in the past.

Australia
Beware the TARP traps
Being a foreign investor in Australia is about to become even more pleasant. The Australian Parliament has received draft legislation that will abolish capital gains tax for most foreign investors. This will come as welcome news to the small but growing population of foreign private equity firms active in the region who are currently required to pay a 30 percent capital gains tax upon exit of an investment.

According to commentary from Deloitte Touche Tohmatsu, the new rules will require capital gains tax only in relation to assets that are deemed ?taxable Australian property.?

The Deloitte Touche Tohmatsu analysis predicts that the new tax rules will have several positive impacts on the Australian financial market. Most obviously, more foreign investors, especially private equity firms, will come to Australia looking for deals, encouraged by the better economics and by the less complex nature of exit planning. The country may also become more attractive as a domicile for holding companies. Corporations may use Australia more frequently for subsidiaries, as opposed to branches. Finally, business units could be set up via different entry points and later sold without incurring capital gains tax.

Taxable Australian property falls into five categories. The first is ?taxable Australian real property? (TARP), meaning property, land, mining rights, etc., located in Australia. Also covered in the definition are investments in entities that hold real property, whether Australian or foreign. Business assets used in Australian branches, the right to acquire real property, indirect holdings in real property or business assets in Australian branches are covered. Finally, individuals who cease to be Australian residents while having elected to defer recognition of a gain or loss on an asset may be taxed.

Investors need to be aware of potential ?traps,? warns the commentary, including the sale of a company that owns taxable Australian real property (TARP), and other complexities surrounding the treatment of real property. A lot to be careful of, for sure, but a world without capital gains tax will make the effort that much of a happier exercise.

China
Heaven is lower and the emperor is closer
New rules in China give the national government greater scrutiny over deals done by foreign investors. Through much of 2005, uncertainty over investor registration requirements issued by China's State Administration of Foreign Exchange caused a deep freeze in private equity and venture capital activities in the Chinese market. Later, as authorities provided clarification, GPs' unease seemed to be soothed and many firms appeared bullish on the Chinese government's willingness to consider their input in constructing a fair and usable regulatory framework for foreign investment.

Fast-forward to August 2006, when a band of six high-level Chinese regulatory authorities – the Ministry of Commerce, the State Administration of Foreign Exchange, the State Administration of Taxation, the State Administration of Industry & Commerce, the China Securities Regulatory Commission and Stateowned Assets Supervision & Administration Commission – teamed up to promulgate ?Measures on Acquisitions of Domestic Enterprises by Foreign Investors.?

Being a foreign investor in Australia is about to become even more pleasant.

The new M&A law, effective September 8, 2006, amends an earlier set of provisional regulations that were issued in 2003 and gives the central government greater control over transactions. Interestingly, the CSRC and SASAC are both new issuing authorities – neither having been promulgators of the 2003 provisional regulations.

The new law resonates strongly for foreign private equity firms, as it, among other changes, imposes greater restrictions on inbound investments to China and on IPOs of foreignowned Chinese companies compared to the rules issued in 2003, says Howard Chao, the partner in charge of law firm O'Melveny & Myers' Asia practice.

One effect of the new foreign takeover law is that private equity firms seeking to set up an offshore holding company that owns a Chinese subsidiary (eg, in a ?red chip? structure) will likely need to obtain approval from the Ministry of Commerce, rather than just the local government authorities, particularly if Chinese resident shareholders are involved.

According to Chao, the new rules also lay out stricter disclosure requirements surrounding the sale of a Chinese domestic company that relate to ?key industries,? ?national economic security,? and ?actual controlling power? of ?famous trademarks? and ?Chinese traditional brands? – which are left undefined. MOFCOM has the authority to halt or unwind transactions for which it does not receive notification. That the new rules lack clarity on certain terms will likely to slow the pace of private equity transactions, says Chao.

Another eye-catching component of the rules is a section that addresses special purpose vehicles (SPVs), or overseas companies that are directly or indirectly controlled by companies or individuals in the territory of China for the purpose of realizing their interests in domestic companies by overseas listing, says Chao. To conduct an overseas IPO of a Chinese SPV now requires approval from the CSRC, the Chinese equivalent of the US' Securities Exchange Commission.

?Until this regulation came out, in recent years, the CSRC didn't try to exert approval [authority] over IPOs by offshore holding companies,? says Chao, asserting that this development provides further evidence that the new M&A rules are the single-most drastic change in the regulatory framework for private equity in China that has taken place in many years.

The Chinese authorities did hold meetings with members of the private equity and venture capital industry active in China, but it is not clear how much of firms' feedback was incorporated into the new rules. ?The thrust of the new regulations is that it is very clear that the government is concerned about foreign investors taking control of key sectors and companies in China,? says Chao. ?It is very clear that government authorities are reasserting control, and wanting foreign investors to obtain approval in Beijing.?

South Korea
Closing time for ?treaty shopping?
Tax treatment continues to present a looming shadow for private equity firms that are otherwise attracted to the gleaming investment opportunities in the Korean market. Under a new rule issued by the Korean tax authorities, private equity firms who have relied on domiciling holding companies in Labuan to protect their profits from Korean capital gains tax will now have a much tougher time doing so.

Through a special provision, Labuan – the popular locale for offshore holding companies – had originally been recognized by the Korean National Tax Services in 1999 as being part of Malaysia, and therefore covered by the Korea-Malaysia double taxation treaty. However, Korean authorities, in a move meant to tamp down on ?treaty shopping? by foreign investors, recently issued a ?confirmatory amendment? that as of July 1, 2006, designates Labuan as a ?blacklisted? tax haven and therefore does not fall within the tax treaty between Korea and Malaysia.

Labuan is the first foreign jurisdiction to be subject to Korea's new withholding tax rules, which were proposed last year and went into effect earlier this year. What this means is that for those foreign investors – including private equity firms – domiciled in Labuan, income received (including interest, dividends and royalty payments) will be subjected to a hefty 27.5 percent withholding tax. Meanwhile, capital gains from the sale of shares will be subjected to an income tax equivalent of either 25 percent of the capital gains or 10 percent of the gross sales amount of shares – whichever one is less.

In formulating the new rule, the Korean government had thought to include Belgium (where Lone Star's holding companies are set up), Luxembourg and the Netherlands as well under the new law. However, political considerations likely tempered Korean authorities' actions, and they thus far have not relegated these jurisdictions to the blacklist.

For foreign investors, the blacklisting of Labuan by Korean tax authorities feels like ?a change of rules in the middle of the game,? says Young Joon Kim, a partner based at the Hong Kong office of law firm Milbank, Tweed, Hadley & McCloy. (On a side note, foreign law firms are still not allowed to open offices in Korea, although a draft bill for changing the situation is expected to be presented to the Korean National Assembly later this year.)

Labuan has not been taken off the map altogether, however. The Korean government has allowed foreign investors two ways of obtaining capital gains tax protection by investing through Labuan. One method is by applying for pre-clearance from the government, which can take up to three months to obtain approval. The other route is to carry out a transaction without obtaining pre-clearance, allow the transaction be subjected to withholding. However, before making the first payment, the foreign investor can apply for post-closing approval, in which case the government has up to six months to approve.

How easily foreign investors can obtain these approvals is another question. ?If you look at the requirements for exemption, they are really onerous, and it would be really difficult for fund investors,? says Kim. He relates the situation to the favorable tax treaty between Korea and Ireland. In order for Korean authorities to approve the foreign investor's application, the investor would have to demonstrate that they have substantial infrastructure set up in Labuan – much more so than the mailbox companies that many investors currently have set up.

?There's a lot of misinformation floating around, and a lot of sophisticated investors are confused about what's going on,? says Kim.

Japan
Gaijin get a break
Last year foreign private equity firms active in Japan were in an uproar over the imposition of the so-called ?Shinsei tax.? The nickname refers to the capital gains withholding tax that Japan began imposing last year on the income of investors in foreign partnerships made via the sale of shares in Japanese companies. More than a few investors interpreted the new tax as a retaliatory reaction to US private equity firm Ripplewood Holding's public listing of Shinsei Bank, from which the firm did not have to pay taxes in Japan on its profits from the sale of Shinsei Bank shares.

However, within the wider landscape, the overall regulatory environment for private equity investment in Japan has been moving in a positive direction.

?The extension of capital gains tax to foreign partnership interests has received a lot of attention from the financial media because of its immediate impact on returns for some categories of investors,? says Darrel Holstein, a partner at Milbank Tweed's Tokyo office. ?But it is somewhat misleading to view this particular issue in isolation.?

Holstein points out that, over the past several years, a number of important positive developments have taken place in the regulatory environment for investments. Despite the dampening effect of the Shinsei tax in the first half of 2005, interest in Japan and opportunities in the Japanese market remain strong. ?The fallout from the Shinsei tax could well have been considerably greater had it not been for the counter-balancing effect and general mood of positive momentum resulting from a series of reforms designed to stimulate investment and facilitate M&A activity,? says Holstein.

Investors have further cause for enthusiasm given Japan's new Corporation Law – enacted June 2005 and effective as of May 2006. The new law ?builds upon previous reforms over the last several years, to provide greater flexibility in terms of structuring M&A transactions and corporate governance arrangements,? says Holstein. For example, the new law simplifies merger procedures, as well as offers greater flexibility in the use of different classes of stock with different voting and economic rights. The Japanese government is also expected to introduce next year a set of new provisions that will give foreign acquirers the option to use cash or other assets, including shares of the foreign corporation in consideration of M&A transactions.

?These new flexibilities are significant foreign investors because they put foreign acquirers on equal footing as Japanese acquirers, in terms of flexibility in structuring actions,? says Holstein. He adds that the introduction of these provisions was deferred for a year so that Japanese companies would have the opportunity to develop takeover defense measures, before the new provisions come into effect in 2007.

As of yet, the full impact of the new Corporation Law is not fully known, particularly the practical implications of some of the statutory wording of within the law. ?Among other things, people are waiting to see if the 2007 tax legislation will address questions regarding the tax treatment of some of the transactions that are available or that will become available under the new law, and accounting issues are also generating a lot of debate,? says Holstein.

India
Mauritius intent
With the country's common law system, the regulatory issues faced by private equity firms active in India are less complex and more predictable than in other jurisdictions in Asia, such as China. However, India does have a handful of pending issues that are relevant to GPs, and similar to the current situation in Korea, one of the key concerns is over the application of tax treaties with offshore jurisdictions.

At present, three countries enjoy favorable tax treaties with India: Mauritius, Cyprus and Singapore. Mauritius and Cyprus have long held this status, and the treaties are structured so that investors from other countries that are non-Mauritian or non-Cyprian can take advantage of the treaty.

However, the amendments to the India-Singapore tax treaty that just came into effect in August 2005 exhibited a significant shift in the way the treaty was structured, causing alarm for foreign investors. ?The way the amended treaty is structured, it basically forces you to have a pretty substantial presence in Singapore, and as a result, Singaporeans can use it, but no one else can,? observes Raj Judge, a partner and head of Wilson Sonsini Goodrich & Rosati's India practice. ?The fear now is that the amended treaty would be a model for Mauritius and Cyprus, thereby cutting off the flow-through that has been going on with US money.?

With this situation, investors are even more jumpy when, from time to time, rumors arise and circulate among the press that the government in India is looking into certain modifications to its tax treaty with Mauritius

?At the end of the day, India has got to still recognize that predominately all of US investments in India are coming through Mauritius, and that's a lot of money,? says Judge, adding that investors from other countries who route their investments through Mauritius would be affected as well. ?So whether or not India is going to provide a solution to that first before it tries to amend any other treaties is the ten million dollar question.?