Basic Tax Planning for Private Equity Funds and Hedge Funds I. Facts Generally speaking, a private equity fund is a fund (i.e., an ownership arrangement involving central management and control of a set of assets and liabilities) that: (1) primarily invests in start-up companies and/or distressed companies and sells them once a significant return is obtainable; (2) primarily has investors consisting of wealthy individuals, pension funds, and governments; and (3) is generally not subject to securities regulation by a government body. A group of individuals is planning to set up a private equity fund (PEF), which will have the following investors (where their nature as either a Host Country or foreign person is as defined under Host Country’s income tax law): HI, a Host Country wealthy individual; FI, a foreign wealthy individual; HPEN, a Host Country pension fund and tax-exempt entity under Host Country’s income tax law; FPEN, a foreign pension fund; and FGOV, a foreign government. PEF will be making investments both in business entities formed and operating in Host Country (“Host Country business entities”) and in business entities formed and operating abroad (“foreign business entities”). PEF will fund its investments only with contributed capital and not with any borrowings. “Savvy”, an individual who is considered a Host Country person for purposes of Host Country’s income tax law, will be making the investment decisions for PEF and will be compensated with a 20 percent “carried interest”, i.e., a 20 percent interest in the profits of PEF. THE FORUM BELGIUM Howard M. Liebman and Olivier Rousselle ..... 4 CANADA Jocelyn Blanchet ....... 12 DENMARK Christian Emmeluth ...... 17 FRANCE Stéphane Gelin and Johann Roc’h ....... 20 GERMANY Dr. Rosemarie Portner ..... 24 ITALY Carlo Galli .......... 31 THE NETHERLANDS Carola van den Bruinhorst and Dennis Langkemper.... 35 SPAIN Javier Martín Martín and Montserrat Turrado Alonso . . 39 SWITZERLAND Walter H. Boss ........ 47 UNITED KINGDOM Robin Vos and Tracey Neuman ........ 52 UNITED STATES Herman B. Bouma....... 57
THE NETHERLANDSCarola van den Bruinhorstand Dennis Langkemper. . . . 35
SPAINJavier Martín Martín andMontserrat Turrado Alonso . . 39
SWITZERLANDWalter H. Boss . . . . . . . . 47
UNITED KINGDOMRobin Vos andTracey Neuman . . . . . . . . 52
UNITED STATESHerman B. Bouma. . . . . . . 57
1
2
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MEMBERS
CHAIRMAN &CHIEF EDITOR
Leonard L. SilversteinBuchanan Ingersoll PCWashington, D.C.
BELGIUM
Howard M. LiebmanJones DayBrussels
Jacques MalherbeLiedekerkeBrussels
CANADA
Heather KerrCouzin Taylor LLP/Ernst & Young L.P.
Toronto
Jay NiederhofferDeloitte & Touche LLPToronto
CHINA
Qinghua XuErnst & YoungParis
Anthony M. FayWhite & Case LLPBeijing
DENMARK
Christian EmmeluthCopenhagen
FRANCE
Stéphane GelinCMS Bureau FrancisLefebvre
Paris
Henri de FeydeauPaul, Hastings, Janofsky &Walker LLP
Paris
GERMANY
Dr. Jörg-Dietrich Kramer
Dr. Rosemarie PortnerPricewaterhouseCoopersDüsseldorf
HONG KONG
Susan LeungHerbert SmithHong Kong
Debbie AnnellsAzure Tax LtdHong Kong
IRELAND
Joan O’ConnorDeloitteDublin
ITALY
Paolo MariottiStudio Legale MariottiRome
Carlo GalliMaisto e AssociatiMilan
JAPAN
Yuko MiyazakiNagashima Ohno andTsunematsu
Tokyo
Masatami OtsukaJones Day Showa LawOffices
Tokyo
THE NETHERLANDS
Carola van den BruinhorstLoyens & LoeffAmsterdam
Peter LierKPMG Meijburg & Co.Amsterdam
SPAIN
Luis F. BrionesBaker & McKenzieMadrid
Javier MartínErnst & YoungMadrid
SWITZERLAND
Dr. Peter R. AltenburgerAltenburgerZürich
Walter H. Bossvon Meiss Blum &Partner
Zürich
UNITED KINGDOM
Peter Niasand Nicola Purcell
McDermott, Will &Emery, London
Ashley GreenbankMacfarlanesLondon
UNITED STATES
Patricia R. LesserBuchanan Ingersoll PCWashington, D.C.
2
II. Questions
A. Basic Host Country tax planning for a private equityfund
1. Investment in a Host Country business entity
With respect to an investment by PEF in a Host Country
business entity (HBE), describe, separately with respect to
each investor, how HBE, PEF, and the investor’s investment in
PEF should be set up so as to minimise taxation under Host
Country’s income tax law. In particular, discuss: (1) how HBE
should be set up for Host Country income tax purposes (for
example, as a corporation or a partnership); (2) how PEF
should be set up for Host Country income tax purposes (for
example, as a corporation or a partnership); (3) whether PEF
should be formed under Host Country law or a foreign law; (4)
whether PEF should have its management office in Host
Country or elsewhere; and (5) whether the investor in PEF
should make its investment in PEF directly or through a
special entity.
2. Investment in a foreign business entity
With respect to an investment by PEF in a foreign business
entity (FBE), describe, separately with respect to each
investor, how FBE, PEF, and the investors investment in PEF
should be set up so as to minimise taxation under Host
Country’s income tax law. Consider the same issues as set
forth under Section II.A.1., above.
3. Overall preferred structure
In light of the answers to the questions at Sections II.A.1.
and 2., above, what is the overall preferred structure for
purposes of minimising taxation under Host Country’s
income tax law, taking into account all of the investors and
PEFs investments in both HBE and FBE? For this purpose,
consideration may be given to the use of one or more
special entities and the use of one or more private equity
funds in a “parallel” arrangement.
B. Basic Host Country tax planning for a hedge fund
Suppose the individuals were setting up a hedge fund (HF)
rather than a private equity fund. Generally speaking, a
hedge fund is similar to a private equity fund except that a
hedge fund invests in marketable stocks, securities, and
other financial instruments (“passive assets”). Types of
assets may include stocks, fixed income securities,
futures, forwards, swaps, options, and other derivatives.
Assume that HF will fund its investments not only with
contributed capital but also with substantial borrowings.
Perform the same analysis as required under Section II. A.,
above but, instead of assuming investments in HBE and
FBE, assume investments in passive assets generating
Host Country-source income and investments in passive
assets generating foreign-source income.
C. Host Country income taxation of income from acarried interest
How will Savvy be taxed on income from his carried interest
under Host Country’s income tax law?
3
Basic Tax Planning for Private Equity Funds and Hedge Funds
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Howard M. Liebman and Olivier RousselleJones Day, Brussels, Belgium
Howard M. Liebman is a partner of the Brussels office of
Jones Day. He is a member of the District of Columbia
Bar and holds A.B. and A.M. degrees from Colgate
University and a J.D. from Harvard Law School. Mr.
Liebman has served as a Consultant to the International
Tax Staff of the U.S. Treasury Department. He is
presently the EC correspondent for European Taxation,
an IBFD publication, and Chairman of the American
Chamber of Commerce in Europe Legal & Tax
Committee. He is also the co-author of the BNA Portfolio
999-2nd T.M., Business Operations in the European
Union, (2005).
Olivier Rousselle is an associate in the Brussels office of
Jones Day. He received his law degree from the
Université Catholique de Louvain-La-Neuve, an LL.M
from Hamline Law School and a Master of Tax
Management from the Solvay Business School.
I. Preferred structure of a private equity fundfor Belgian income tax purposes
Private equity investors may invest in Belgium either through a
holding company subject to the normal tax regime (including
the benefits of the participation exemption) or through a
closed private collective investment vehicle for private equity
purposes (PRICAF Privée/Private PRIVAK). In both cases, the
investment vehicle would have legal personality. Both tax
regimes are described in detail below.
A. Standard holding company tax regime
Traditionally, special purpose vehicles are often established in
the country of the target in order to obtain the benefit of the
domestic tax consolidation in place in most European
countries.1 This allows the acquisition vehicle to deduct the
interest on any debt contracted for the purpose of acquiring
the target company against the operational income of that
target. As Belgium has not yet introduced a tax consolidation
regime, the establishment of an acquisition vehicle in Belgium
is not necessary for that purpose (although there have been
discussions as to the possibility of introducing such a regime
in the future).
That being said, the general Belgian tax regime that applies to
holding companies remains favourable to private equity
investment for the following key reasons:
1. Dividend withholding tax
Dividends paid by a Belgian company are subject to a 15
percent or 25 percent withholding tax in Belgium, unless
otherwise provided for in a tax treaty entered into by Belgium
with the country in which the recipient shareholder resides.
For example, Belgium signed a tax treaty with the United
States on November 27, 2006, that provides for 0 percent
withholding tax in certain circumstances. Zero percent
dividend withholding tax is also provided for in the tax treaty
signed with Hong Kong on December 10, 2003, and in
Belgium’s treaties with San Marino and Singapore.
In addition, as a matter of domestic law, Belgium now
exempts from withholding tax dividends distributed by a
Belgian company to a qualifying parent company resident in
the European Union, or in any other country with which
Belgium has signed a tax treaty.2 For this purpose, the parent
company must hold at least 15 percent (to be reduced to 10
percent as of January 1, 2009) of the capital of the Belgian
company for an uninterrupted period of at least one year. It is
also required that the parent company, if it is a resident of an
E.U. Member State other than Belgium, be in a form listed in
the E.C. Parent-Subsidiary Tax Directive or, if the foreign
parent is resident in a non-E.U. tax treaty country, that it be in
a form analogous to one of the corporate forms listed in that
Directive. Finally, the parent company must be subject to
corporate income tax (or analogous taxation) and not benefit
from a tax regime that is out of the norm for its country of
residence.
2. Dividend participation exemption
Under Article 202 of the Belgian Income Tax Code, 95 percent
of the dividends received by a Belgian parent company are
exempt from tax in Belgium, provided that: (1) the parent
company has held or has committed to hold the shares
relating to the dividends received for at least one year; (2)
those shares are considered to be financial fixed assets (i.e.,
shares held for the purpose of creating a “lasting link”, as
defined under Belgian law); (3) the parent company holds (at
the time of the distribution of the dividends) a participation in
the subsidiary of at least 10 percent or €1,200,000; and (4)
the subsidiary has been subject to normal taxation in
accordance with Article 203 of the Income Tax Code
(basically, the subsidiary is not located in a tax haven).
3. Deduction of interest
In principle, interest paid on debt for the acquisition of shares
is deductible in Belgium. This is based on the general rule
applicable to the deduction of expenses, to the effect that
“the costs made or borne by the taxpayer during a given
taxable period for the purpose of acquiring or maintaining
professional income” are deductible. However, a few
restrictions on the deductibility of interest payments need to
be borne in mind, even if their scope is quite limited:
4
4
■ Any interest paid must be at arm’s length and fixed by
reference to the market rate, taking into account the
specific risk elements of the transaction (including the
financial situation of the debtor and the duration of the
loan);
■ Interest is not deductible if it is paid to a non-resident
lender that is not subject to income tax in its country of
residence or that is subject to a tax regime significantly
more favourable with respect to interest income than the
tax regime applicable in Belgium;
■ Interest paid or granted to an effective beneficiary that is
not subject to tax in its country of residence or that is
subject to a tax regime significantly more favourable with
respect to interest income than the tax regime applicable
in Belgium is not deductible, if the total amount of the
loans (other than bonds or analogous instruments issued
by public offering) exceeds seven times the sum of the
taxable reserves at the beginning of the taxable period
plus the paid-up capital at the end of that period (in other
words, a 7:1 debt-to-equity ratio is enforced); and
■ Interest paid to a Belgian individual who is also a director
or a shareholder of the Belgian debtor, or to a foreign
corporation acting as a director of that Belgian debtor, is
considered to be and treated for tax purposes as a
dividend, and hence as non-deductible, either if the
interest is not fixed at market rates or if (and to the extent
of the excess) the total amount of loans exceeds the sum
of the taxable reserves at the beginning of the taxable
period plus the paid-up capital at the end of that period (a
1:1 debt-to-equity ratio).
4. Interest withholding tax
Interest paid by Belgian debtors is subject to a 15 percent
withholding tax. The recipient of the interest may, however,
benefit from a reduced rate (generally as low as 5 percent), or
even be entirely exempt, under the terms of an applicable tax
treaty. For example, Belgium’s tax treaties with Germany,
Hong Kong, Luxembourg, The Netherlands and Switzerland
provide for exemptions from withholding tax on interest in
certain circumstances. There are also a number of exceptions
to the 15 percent withholding tax provided for under Belgian
domestic law, the key exceptions being for:
■ Interest paid to a Belgian resident financial institution or to
a foreign credit institution established in the European
Economic Area (EEA) or in a country with which Belgium
has signed a tax treaty;
■ Interest arising from Belgian registered bonds subscribed
by non-resident investors;
■ Interest paid to a Belgian resident creditor;
■ Interest paid by certain qualifying Belgian “holding
companies” that are listed on a recognised stock
exchange (or part of a quoted group) to a foreign creditor;
and
■ Interest paid to an associated company resident in
Belgium or in another E.U. Member State.
A company is deemed to be an associated company of
another company if both are established in the European
Union and: (1) one of them holds directly or indirectly at least
25 percent of the capital of the other for an uninterrupted
one-year period; or (2) a third company established in the
European Union holds directly or indirectly at least 25 percent
of the capital of each of those two companies for an
uninterrupted one-year period.
5. Exit tax
Proceeds from liquidations and share buy-backs are
considered to be dividends in Belgium and are therefore
subject to a 10 percent withholding tax. No such withholding
tax is levied if the shares of the Belgian company being
liquidated are held by a qualifying entity located in another
E.U. Member State or in a country with which Belgium has
signed a tax treaty (as liquidation and share buy-back
proceeds are eligible for the same withholding tax exemptions
as other dividends). Traditionally, in order to avoid the 10
percent liquidation (or exit) tax (if it were to apply
notwithstanding the aforementioned exceptions), practitioners
have recommended that the shares of the Belgian company
be held by (usually) a Luxembourg entity. Other alternatives
can be thought of, but the need for these should decrease in
the future, in view of the recently introduced exception from
withholding tax for dividends (including liquidation proceeds)
paid to a resident of a country with which Belgium has signed
a tax treaty, as discussed above.
6. Capital gains tax
Capital gains realised by a legal entity on the sale of shares
are tax exempt in Belgium, provided the subsidiary is subject
to tax as set forth in Article 203 of the Income Tax Code.
There is no minimum participation threshold – as is the case
in Luxembourg (where a participation of at least €6 million or
10 percent is required) – for benefiting from this regime.
Following a recent modification of the Income Tax Code, the
exempt capital gain is the net gain realised after deduction of
the sales costs relating to the shares from which the capital
gain has arisen (for example, financial costs, bank fees,
consulting fees, etc.).
Conversely, capital losses on shares are not deductible,
unless the losses are incurred in the context of a liquidation,
and then only to the extent of any loss of paid-up capital. In
order to benefit from that exception, and bearing in mind the
existing anti-abuse provisions, a private equity investor might
consider setting up an intermediary holding company, the
paid-up capital of which would then solely be used to acquire
shares in the target company. If the value of the shares of the
target company has fallen below the price paid for their
acquisition (which, by hypothesis, is equal to the paid-up
capital of the holding company) by the time of the holding
company’s liquidation, the loss would become deductible for
the private equity investor, since it would then be a loss
incurred in the context of a liquidation. Of course, any interest
in using that approach will depend on the existence of profits
against which the loss may be deducted, which might not
always be the case in the context of private equity
transactions.
B. Belgian holding company v. PRICAF privée/privatePRIVAK
Private equity investors may establish their acquisition vehicle
in Belgium either as a holding company subject to the
standard corporate income tax (but benefiting from the
participation exemption for dividends and the tax-exempt
treatment of capital gains on shares, as described above) or
as a closed private collective investment vehicle for private
equity purposes (a PRICAF Privée/Private PRIVAK). Aside
from the PRICAF Privée/Private PRIVAK, it is also possible to
5
Belgium
5
create a closed public collective investment vehicle for private
equity purposes (a PRICAF Publique/Publieke PRIVAK), which
is governed by the Royal Decree of April 18, 1997.3 Although
the purpose of both vehicles is to invest in unquoted
companies, PRICAF Publique/Publieke PRIVAK are listed on
stock markets, whereas PRICAF Privée/Private PRIVAK are
not. To date, only two entities are reported by the Belgian
Banking, Finance and Insurance Commission to have taken
the form of a PRICAF Publique/Publieke PRIVAK. This paper
does not seek to describe this vehicle in any further detail, as
it does not come within the scope of the facts presented, but
focuses instead on the PRICAF Privée/Private PRIVAK.
The possibility of establishing a PRICAF Privée/Private PRIVAKfor private equity purposes was introduced by the Belgian
legislature on April 22, 2003, in an effort to promote venture
capital investments in Belgium. To that end, Belgium has
accorded a favourable tax regime to such entities, the key
aspects of which can be summarised as follows:
■ PRICAF Privée/Private PRIVAK are subject to the
standard corporate income tax (at the normal rate of
33.99 percent), but their taxable base is limited to the
“abnormal and benevolent advantage” they have received
(essentially any reallocated income as a result of transfer
pricing) and any disallowed expenses (except capital
losses and depreciation on shares).4
■ The entity qualifies for tax treaty protection. In addition,
and even if no treaty applies, there is no Belgian
withholding tax on dividends, interest and royalties paid
to a PRICAF Privée/Private PRIVAK, unless the dividends
derive from a Belgian source (in which case, the
investment vehicle can claim a refund of such withholding
tax from the competent tax authorities).5
■ No withholding tax is levied on dividends distributed by a
PRICAF Privée/Private PRIVAK, provided that: (1) the
dividends arise from capital gains on shares realised by
the latter; or (2) if the beneficiary of the dividends is a
foreign company, the dividends arise from dividends paid,
in turn, by foreign companies.6 In addition, there is no
withholding tax on the proceeds distributed on the
liquidation of a PRICAF Privée/Private PRIVAK (nor is any
withholding tax levied in the event of a redemption of
shares).7
Despite the existence of this favourable tax regime, private
equity investors have, to date, preferred to establish a
standard form of company (which may be called a holding
company if its activities are limited to the ownership of shares)
for the purpose of making their investments, rather than
utilising a PRICAF Privée/Private PRIVAK. This is because the
use of a PRICAF Privée/Private PRIVAK is subject to some
rather substantial regulatory requirements and restrictions.
First, until recently, 80 percent of the shares of a PRICAFPrivée/Private PRIVAK had to be held by at least five and no
more than 20 investors. This requirement has now been
repealed by Royal Decree of May 23, 2007, which only
requires that the shares of a PRICAF Privée/Private PRIVAKbe held by at least six investors. In addition, leaving aside any
other investment conditions that must be met to benefit from
the favourable tax treatment, PRICAF Privée/Private PRIVAKmay not, in principle, hold a participation where they have
power to influence the management of the company or the
appointment of its directors.8 Finally, although they are only
subject to limited prudential control by the Belgian Banking,
Finance and Insurance Commission, PRICAF Privée/PrivatePRIVAK must be registered with the Ministry of Finance and
may not remain in existence for more than 12 years.
Therefore, even though the conditions for benefiting from the
favourable tax regime have been somewhat relaxed by the
Royal Decree of May 23, 2007 (especially for management
buy-out transactions), private equity investors are likely to
prefer using a standard holding company for their investments
rather than a PRICAF Privée/Private PRIVAK (especially since
the introduction of the 0 percent withholding tax on dividends
paid to a parent company residing in a tax treaty country, as
described below).9
C. Legal form of private equity fund
When private equity investors decide to establish their Belgian
acquisition vehicle as a holding company, their next choice
concerns what type of company to incorporate. The primary
legal forms are a joint stock company (SA/NV), a limited
liability company (SPRL/BVBA) or a partnership limited by
shares (SCA/CVA).
The choice of legal form can be influenced by various criteria,
including foreign tax rules such as those in the United States
motivating many U.S. controlled groups to “check-the-box”
and thereby elect to be treated as a partnership (for U.S. tax
purposes only). However, joint stock companies (SAs/NVs)
may not “check-the-box”, as they are considered per secorporations. One of the other available forms must,
therefore, be used instead.
There may be other reasons justifying the choice of one legal
form over another. Both a joint stock company (SA/NV) and a
partnership limited by shares (SCA/CVA), for example, allow
for the issuing of profit participation certificates (participationbénéficiaire/winstbewijzen), warrants, convertible bonds, and
tracking stock,10 which is not possible when using a limited
liability company (SPRL/BVBA).11 On the other hand, a
partnership limited by shares (SCA/CVA) and a limited liability
company (SPRL/BVBA) offer greater security to their
management than a joint stock company (SA/NV) offers to its
directors, who can be dismissed at any time by the
shareholders.12
D. Structuring a business entity for Belgian income taxpurposes
Only a very limited number of entities qualify as partnerships
under Belgian corporate law (i.e., a société de droitcommun/maatschap, a société momentanée/tijdelijkehandelsvennotschap and a société interne/stille venootschap).
These entities do not have legal personality and are, therefore,
transparent for tax purposes.13 In addition, some entities
considered to have legal personality from a corporate point of
view are deemed to be transparent for tax purposes, such as
European Economic Interest Groupings (EEIGs), Belgian
Economic Interest Groupings and commercial companies that
are not validly incorporated (these are known as “translucent
entities”). Such entities are, however, rather rare in practice.
By contrast, the Belgian Company Code accords legal
personality to a variety of other legal forms, such as the joint
stock company (SA/NV), the limited liability company
(SPRL/BVBA) and the partnership limited by shares
(SCA/CVA).
Belgium
6
6
It is generally best for a target company of a PEF (HBE) to be
incorporated as a company with legal personality, if only for
the purpose of obtaining beneficial capital gains or dividend
treatment.
First, capital gains realised by a Belgian legal entity, such as
PEF (if incorporated as a Belgian holding company), on the
sale of shares of another Belgian company, such as HBE, are
tax-exempt in Belgium, provided the subsidiary is subject to
tax as set forth in Article 203 of the Income Tax Code.14
Partnerships and “translucent entities” are not subject to tax,
as they are transparent for tax purposes. Thus, the sale of an
interest held by PEF in a partnership or a translucent entity
would normally not qualify for the capital gains tax exemption,
unless it could be demonstrated that the assets of the
partnership included shares that themselves qualified for a
capital gains tax exemption. But even in that case, it is not
certain that the tax authorities would allow the capital gains
tax exemption for the sale of an interest held in a partnership.
Indeed, the tax authorities have traditionally denied such a
benefit in the case of the sale of any interest in collective
carried-forward profits, and subsidies) less a number of
technical deductions, specifically:
■ Any re-evaluation gains;
■ Subsidies;
■ Tax credits for research and development;
■ The net tax value of the company’s own shares held in its
books;
■ The net tax value of shares issued by investment
companies (in certain circumstances);
■ The net tax value of the shares held in other companies
as a financial fixed asset;
■ The net equity of any foreign permanent establishment
(PE) that is exempt from tax in Belgium pursuant to an
applicable tax treaty;
■ Real estate located abroad that is exempt from tax in
Belgium pursuant to an applicable tax treaty; and
■ Certain miscellaneous items for anti-abuse purposes (i.e.,
the book value of those items that, by their nature, are
not designed to generate taxable income; the net book
value of assets the costs of which unreasonably exceed
business needs; and the book value of real estate used
by managers).
In sum, HF’s tax burden will vary depending on its investment
policy and the assets derived from those investments.
III. Belgian taxation of income derived from acarried interest
There are various alternatives available under Belgian law
allowing the manager, i.e., Savvy, an interest in the profits
of the company it manages, i.e., PEF. Of course, one of the
alternatives is to grant Savvy a bonus equal to 20 percent
of the profits of PEF. However, any such bonus will be
considered normal remuneration subject to progressive
income tax rates of up to 50 percent (plus provincial and
communal surcharges) and social security contributions.
Indeed, pursuant to Articles 30.2° and 32 of the Income Tax
Code, any and all sums or benefits-in-kind paid or granted
to an individual acting as a manager of a company21 are
considered management remuneration, and hence taxable
at progressive rates.
According to the Official Administrative Commentary on the
Income Tax Code, the intent of the legislator was to include
any and all payments that constitute, in the hands of the
beneficiary, a return for the performance of management
functions. The debtor, the qualification and the method of
calculation or payment are not relevant in determining that
income is to be deemed to constitute management
remuneration.22 For that reason, management participation
in the profits of a company has usually taken one of the
forms briefly described below.23
A. Stock options/warrants24
Following the entry into effect of the Law of March 26,
1999, stock options granted for no consideration are
taxable in Belgium on the date on which the options are
deemed to have been granted to the beneficiary.25 Under
Belgian law, an option is deemed granted 60 days after the
offer, provided the beneficiary accepts the offer in writing
within that 60-day period.26 Otherwise, the option is
deemed to have been rejected by the beneficiary for
Belgian tax purposes. If the option is nevertheless accepted
by the beneficiary after the 60-day period, the option will no
longer qualify as an option for the purposes of the Law of
March 26, 1999 and taxation will take place on the exercise
of the option, based on the difference between the fair
market value of the underlying shares and the exercise
price of the option.27 This provides a certain flexibility to
management, which can decide to be taxed at the moment
of grant or at the moment of exercise simply by accepting
the option before or after the 60-day deadline.
Under the Law of March 26, 1999, the taxable income
relating to the grant of the option varies, depending on
whether the option is quoted or not.28 If the option is not
quoted (which is the most likely scenario in the context of a
private equity transaction), the taxable income is calculated
Belgium
8
8
by reference to the value of the underlying shares. Again,
there is a split decision-making tree. If the underlying
shares are quoted, their value is equal to, at the choice of
the grantor, the average closing price of the shares during
the 30-day period before the offer or the closing price of the
shares on the day before the offer. If the underlying shares
are not quoted, their value is determined by the grantor and
must be approved by the Statutory Auditor of the company
issuing the underlying shares (with some limitations set by
law).
The taxable income will then be equal to 15 percent of the
value of the underlying shares as determined using the
rules described above, to be increased by 1 percent per
year (or part thereof) in excess of five years if the exercise
period exceeds five years from the offer date.29 Those
percentages will be reduced, respectively, to 7.5 percent
(increased by 0.5 percent for each year, or part thereof,
exceeding five years following the offer) if the following
conditions are fulfilled:
■ The exercise price must be definitely fixed at the moment
of the offer;
■ The option may not be exercised before the end of the
third year following the year in which the offer occurs nor
after the end of the 10th year following the year of the
offer;
■ The option may not be transferable, except in the case of
death;
■ The risk of a reduction in value of the underlying shares
may not be covered, directly or indirectly, by the grantor
or by any other person with which the grantor has a
relationship of interdependence; and
■ The option must relate to shares in the company for
which the beneficiary exercises his employment or in a
company that has a direct or indirect participation in that
company.30
If the beneficiary is required to pay a price for the option,
the amount paid may be deducted from the taxable
income. There will be an additional element of taxation
should the exercise price be lower than the value of the
underlying shares at the moment of the offer (i.e., if the
exercise price is “in-the-money”). In that case, the
difference between the exercise price and the value of the
shares must be added to the taxable amount. The taxable
income so determined will then be subject to taxation at the
normal progressive tax rate.
Interestingly, the grant of stock options is not considered a
benefit-in-kind from a social security point of view, and
hence does not trigger any social security contribution,
provided the exercise price of the option is not less than the
value of the underlying shares at the moment of the offer
(and there is no “certain” advantage).31
The exercise of stock options does not trigger any tax for
the beneficiary (provided the option is accepted within the
60-day period following the offer, as indicated above).
Dividends received by managers (in the present case,
Savvy, who will receive a 20 percent share of the profits
through dividend distributions upon exercise of the option)
will be subject to a 15 or 25 percent dividend withholding
tax in Belgium. No other tax should be levied thereon in
Belgium.
That being said, if the shares acquired upon the exercise of
the stock option are shares in a foreign company, the
management may be subject to withholding tax abroad, in
addition to the Belgian withholding tax. (It should be noted
that foreign dividend withholding taxes will normally not be
creditable against Belgian withholding tax; they are
deductible, but only for the purposes of computing the net
amount of the 15 percent or 25 percent Belgian withholding
tax that is to be paid). Admittedly, this must be reviewed in
light of the applicable tax treaty (for example, some
taxpayers have argued, with success, that Belgium is
required to accord a foreign tax credit based on the terms
of the relevant tax treaty).32 In order to avoid potential
taxation abroad (or having to argue a case for tax credits
based on the text of an applicable tax treaty), Belgian
resident managers are instead likely to request that they
obtain shares in a Belgian company upon the exercise of
their stock options.
Capital gains realised on the sale of the shares obtained
upon exercise of the stock option should be exempt from
tax in the hands of Belgian resident individuals, such as
Savvy, provided the gains are deemed to result from the
normal management of the managers’ private assets and
wealth (patrimony). Under Article 90(1) of the Income Tax
Code, an individual is taxed on the profits arising from any
services, operations or speculative activities at the rate of
33 percent (plus local tax), unless such services, operations
or speculation fall within the normal management of the
individual’s private wealth. Whether the acquisition and
subsequent sale of shares would qualify as speculation,
triggering taxation at the rate of 33 percent (plus local tax)
is a matter of facts and circumstances, primarily depending
on the level of risk undertaken. This, however, is assessed
based on factual elements such as the managers’
knowledge of the activities of the company the shares of
which are being acquired, how the acquisition is being
financed, the financial situation of the individual in question,
and various other criteria. Interestingly, the Tribunal of First
Instance of Brussels has refused to tax a manager of an
unquoted company who had bought shares therein, using
financing granted by a financial institution, and then sold
them a few years later to the acquirer of the majority stake
in the company in question. The Court considered that this
operation remained within the scope of normal
management by that manager of his private assets.33
B. Shares
If shares are acquired at their market value, there is no
taxable benefit-in-kind for the acquirer. By contrast, if
shares are acquired for a discounted price, the discount will
be viewed as a benefit-in-kind taxable in the hands of the
beneficiary.34 Unfortunately, there are no guidelines under
Belgian tax law as to how such a benefit-in kind should be
calculated. However, the tax authorities accept that if the
underlying shares are quoted on a stock market, the value
of the benefit-in-kind may be limited to the difference
between 100/120ths (or 83.33 percent) of the market value
of the shares acquired and the price paid for them,
provided the shares cannot be transferred for a period of
two years after their acquisition.35 In practice, a similar
discount is generally considered acceptable for unquoted
shares.36
9
Belgium
9
An even higher discount could be claimed, depending on
the restrictions built into the shares so acquired (such as
the requirement not to transfer them for a certain period of
time, their vesting conditions, any restrictions as to voting
or dividend rights, good or bad “leaver” provisions or
tag-along or drag-along rights).37 Indeed, a wide range of
rights and restrictions can be attached to the shares
granted to a manager of the funds such as Savvy.38 For
example, Savvy’s rights to obtain dividends can be
subordinated to the payment of a dividend equal to, for
example, 15 percent per annum to the other investors
(taking into consideration a “hurdle rate”). The transfer of
the shares could also be prohibited for a certain period of
time, combined with a forfeiture period during which the
shares granted will be forfeited on the occurrence of certain
events such as the termination of the management
agreement/employment. In this respect, it might be noted
that independent studies have valued illiquidity discounts at
20 to 35 percent of the value of the underlying shares of
stock.39 Managers may also subscribe to a special category
of shares, pursuant to which they would obtain additional
shares in the target company if a given hurdle rate is
reached (an “equity ratchet”). This allows management to
increase its participation if the company performs well. But
it may also provide for the opposite effect and trigger a
reduction in the management’s participation if the company
performs poorly (a “reverse equity ratchet”).40 Those
restrictions or preferred rights, depending on how they are
structured, could not only affect the value of the
benefit-in-kind, but also, in our view, influence the timing of
taxation, i.e., at grant or upon vesting.
The tax treatment of dividends and capital gains received or
realised by Savvy in connection with the shares obtained,
whether for a discounted price or not, is the same as that
described above in connection with the shares obtained
upon the exercise of a stock option.
C. Restricted Stock Units (RSUs) and Profit Units(Participation Bénéficiaire/Winstbewijzen)
The acquisition for no consideration of RSUs and profit
units is not regulated under Belgian law (as opposed to the
granting, for no consideration, of stock options and
warrants). It would of course be considered a taxable
benefit-in kind in the hands of Savvy, but whether taxation
would take place at grant or upon vesting (if restrictions are
built in to the instrument granted) and the valuation of the
taxable benefit-in-kind depends on the terms and
conditions of the relevant profit unit or RSU, and is likely to
remain rather uncertain in the absence of a specific ruling
or more general pronouncements by the Belgian tax
authorities.
The jurisprudence relating to unregulated stock options
(i.e., stock options offered before the entry into force of the
Law of March 26, 1999) could, in the authors’ view, offer
some guidance as to the tax treatment of profit units and
RSUs.41 Unfortunately, this jurisprudence is not as clear as
might have been wished. Indeed, there is a decision of the
Brussels Court of Appeal, dated May 21, 2003, that
stipulates that the tax treatment of convertible profit units
should be the same as the tax treatment of non-regulated
stock options. It refers, in turn, to a Supreme Court case of
January 16, 2003, stipulating that non-regulated stock
options are subject to tax at grant.42 There is also a
Supreme Court case dated February 4, 2005, however, in
which the Court follows the reasoning of the Antwerp Court
of Appeals developed in a decision of February 19, 2002, to
the effect that if the stock options are forfeited upon
termination of the employee, their grant was “continuously
uncertain” until they had been exercised and, hence, the
moment of taxation should only be on exercise.43 Since
then, however, the Court of Appeals of Antwerp has issued
four judgments, all dated September 20, 2005, in which it
abandons this position and considers non-regulated stock
options to be taxable at grant, independent of the fact that
they are forfeited if termination of employment takes place
before their exercise.44 And this reasoning has, in the
meantime, been followed by the Court of Appeals of
Brussels in its judgment of December 13, 2006.45
Again, the proper tax treatment of the RSUs and profit units
will depend on the terms and conditions thereof, and
whether their vesting is made conditional upon certain
events, such as the termination of the management
agreement of Savvy, as well as how such conditions are
structured (condition precedent v. condition subsequent).
Some authors consider that if the restrictions built into the
granting of profit units are such that any valuation thereof is
not possible, no tax or social security contribution should
be levied on the granting thereof, but in that case, the risk
is that the dividends distributed subsequently in connection
with those profit units could be deemed to be remuneration
subject to the progressive tax rate (and not to the 15/25
percent final dividend withholding tax).46
1 Some European countries, such as Denmark, France and Italy,even provide for a worldwide tax consolidation system, subject tocertain conditions.
2 In the latter case, the tax treaty in question must provide for anadequate exchange of information procedure. Article 106 §§5 & 6of the Royal Decree implementing the Belgian Income Tax Code1992, as amended (BITC or Income Tax Code). See Ch. Chéruy,“Belgium extends dividend withholding tax exemption”, 2007Worldwide Tax Daily 11-3 (January 17, 2007).
3 Moniteur Belge of June 24, 1997. This Royal Decree also makes itpossible to create a transparent closed public collective investmentvehicle (a Prifonds). To date, no entity is reported by the BelgianBanking, Finance and Insurance Commission to have taken thatform.
4 PRICAF Privée/Private PRIVAK are also excluded from the dividendparticipation exemption regime and the foreign tax credit for taxpaid on interest and royalties pursuant to Article 185bis §2 of theIncome Tax Code (which might be in violation of certain taxtreaties). The impact of these restrictions is de minimis, however,given the limited tax base.
5 Royal Decree implementing the BITC, Articles 116, 117 §9, 118§1, 6° & 119
6 Royal Decree implementing the BITC, Article 106 §9
7 BITC, Article 21.2°
8 There are some exceptions, however, such as: (1) if theparticipation is not held for more than two years or if the influencedoes not arise from the direct or indirect holding of more than 50percent of the shares with voting rights of the company in question;or (2) if the participation arises from a management buy-outtransaction (Royal Decree of May 23, 2007, Article 14, Moniteur
Belge of June 12, 2007).
9 The use of a PRICAF Privée/Private PRIVAK might becomeinteresting if the investment made by that vehicle in other entitiesdid not qualify for the dividend participation exemption, (e.g., if the€1.2 million or 10 percent participation threshold was not reached).But even in that case, the complexity of the regime and theregulatory restrictions might outweigh its benefits.
Belgium
10
10
10 W. Heyvaert & B. Springael, “Het gebruik van de Belgische
holdingvennootschap als persoonlijke houdstermaatschappij door
Belgische ingezetenen en voor “private equity” investeringen door
buiten België gevestigde investeerders”, Fiscale Studies, 2004, atp. 26.
11 Belgian Company Code, Article 232
12 Belgian Company Code, Article 518 §3, which is a matter of publicorder according to the Belgian Supreme Court (Judgment ofJanuary 22, 1981, Pas., 1981, at p. 543).
13 BITC, Article 29
14 BITC, Article 192
15 Article 119 of the Law of July 20, 2004
16 Open and closed public collective investment vehicles that aretransparent are designated, respectively, by the terms open andclosed collective investment funds (fonds commun de placement à
nombre variable de parts/gemeenschappelijk beleggingsfonds met
een veranderlijk aantal rechten van deelneming and fonds commun
de placement à nombre fixe de parts/gemeenschappelijk
beleggingsfonds met een vast aantal rechten van deelneming).
17 Articles 10 & 17 of the Law of July 20, 2004, Moniteur Belge ofMarch 9, 2005. (See Article 185bis of the Income Tax Code for thespecial tax regime applicable to open and closed public collectiveinvestment vehicles.)
18 Articles 97 et seq. & 113 et seq. of the Law of July 20, 2004. Seenote 17, above
19 Article 240 the Law of July 20, 2004
20 Article 29 of the Income Tax Code provides a tax “fiction” to theeffect that the profits derived by a partnership are deemed to beprofits of the partners for tax purposes and may not be otherwisequalified (e.g., as dividends or real property income). If thepartnership does not realise benefits or profits, the Belgian TaxAdministration considers that the income collected by thepartnership retains its initial characteristics and qualification in thehands of the partners. This tax “fiction” could have a substantialimpact on the Belgian tax treatment of the income derived byindividuals in their capacity as partners of the partnership.Unfortunately, the interpretation of this tax “fiction” is somewhatcontroversial among legal commentators, and this paper does notattempt to describe the particulars of the controversy. See generallyPh. Hinnekens, “Le régime fiscal international des sociétés de
personnes en matière d’impôt sur le revenu”, (1995) J.D.F. at p. 209et seq.; M. Van Keirsbilck, “Internationale samenwerkingsbverband
tussen fiscaal transparente maatschap”, (January 2001), T.F.R. at p.193 et seq.
21 For tax purposes, an individual is considered to act as the managerof a company if: (1) he exercises a mandate of Director(bestuurder/administrateur or zaakvoerder/gérant) or liquidator or asimilar function; or (2) he carries out a management functioninvolving the daily management or the commercial, technical orfinancial management outside the scope of an employmentagreement. It is assumed for purposes of this paper that Savvy willexercise a mandate of Director of PEF, as it will make theinvestment decisions.
22 Tiberghien, Manuel de droit fiscal (2006), at p. 126
23 Only the key forms of management participation traditionally usedin practice have been (briefly) described. Other forms ofmanagement profit participation techniques can be devised,depending on the specifics of the deal in question. For example,management’s participation in the future profits of the company cantake the form of an earn-out clause providing for deferredcompensation depending on the results of the acquired company.Such clauses are traditionally used to incentivise the vendor(s) toremain with the target company for at least a certain number ofyears (especially in deals where the management is key to theoperation of the acquired company), and the deferredcompensation arising thereunder could qualify as an exempt capitalgain on shares if properly structured. No attempt has been made toprovide further details, as Savvy is not the vendor in the presentfact pattern, and would therefore not, in any event, be eligible forsuch a capital gains tax exemption.
24 Warrants differ from stock options, as they include the right of theholder to subscribe to newly-issued shares. Although both aresubject to the same tax regime under the Law of March 26, 1999,warrants are more frequently used than options since they offergreater protection (as they are embedded in the Articles of
Association) whereas stock options are mere contractualcommitments (See H. Lamon, “ Financial Buy-Outs: Structuring theManagers’ Participations”, May/June 2005 Derivatives & Financial
Instruments 123). Warrants may only be issued by joint stockcompanies (SA/NV) and partnerships limited by shares (SCA/CVA).
25 Article 42 of the Law of March 26, 1999, Moniteur Belge of April 1,1999
26 Id.
27 Response to the Parliamentary Question No. 228 of January 20,2004; Circ. No. 2005/0652 of May 25, 2005
28 Article 43 §§ 1, 2, 3 & 4 of the Law of March 26, 1999, see note25, above
29 Id., Article 43 §5
30 Id., Article 43 §6. Options on shares issued in accordance with aspecific procedure provided for in Article 609 of the CompanyCode will not be subject to tax. Id., Article 49. This procedure mayonly be used for those members of the workforce who qualify asemployees, and it is subject to stringent conditions (such as arequirement that the company has distributed at least twodividends during the three previous fiscal years). It is therefore notrelevant for a private equity transaction in which the managementtakes a participation, whether directly or indirectly, in the targetcompany.
31 Article 19 (18) of the Royal Decree of November 28, 1969,Moniteur Belge of December 5, 1969
32 Court of Appeal of Liège of March 10, 2006, (2006) T.F.R. at p. 670(pursuant to which a foreign tax credit should be available fordividends received from the United States based on the provisionsof the Belgium-United States tax treaty).
33 J. Pattyn, “Aankoop aandelen vennootschap door bedrijfsleider:
geen diverse inkomsten bij veredere verkoop”, 11 Fiscale Actualiteit
(March 2006) at p. 5
34 Belgian Commentary to the BITC, No. 36/14
35 Belgian Commentary to the BITC, No. 36/16. Shares can also beobtained under a favourable regime pursuant to the proceduresprovided for in Article 609 of the Company Code or in the Law ofMay 22, 2001, Moniteur Belge of June 9, 2007, but the benefit ofthose procedures is limited to employees and does not extend toself-employed persons such as managers (see note 21, above).
36 H. Lamon, note 24, above, at p. 120. If the shares are not quoted,the Administrative Commentary provides that the benefit-in-kind isequal to the difference between the book value (by reference to thenet equity) and the price paid for the shares. The reference to thebook value seems contrary, however, to the language of theBelgian Income Tax Code, which refers to the “real value” of theshares. It is therefore safer, in the view of the authors, for ataxpayer to use the market value of the shares as a reference (ifsuch market value is higher than the book value), especially as areference to book value could be challenged as contrary to Belgiantax law, which is of public order.
37 Id., p. 118
38 Taking into account the limits set by law such as, for example, theprohibition of “leonine” clauses, the requirement to set up a legalreserves, the net asset threshold below which dividends may notbe distributed, the prohibition of super voting stock, the limitationon the issuance of non-voting shares, the rules relating to theprotection of capital, etc.
39 A. Damodaran, “Valuing Private Firms”,http://pages.stern.nyu.edu/~adamodar/
40 H. Lamon, supra note 24, at p. 123; V. Simonart & T. Tilquin, “LeRatchet”, (2004) Mélanges John Kirkpatrick at p. 875 et seq.
41 E. De Plaen, “L’actionnariat salarié”, (January 2007) R.G.F. at p. 6
42 Court of Appeal of Brussels of May 21, 2003, (2003) Courr. Fisc. atp. 533
43 Belgian Supreme Court of February 4, 2005, (2005) T.F.R. at p. 540
44 To which the decision of the Court of Appeal of Brussels ofDecember 13, 2006 refers (see note 45, below).
45 Court of Appeal of Brussels of December 13, 2006,www.fisconet.fgov.be
46 C. Chevalier, Vennootschapsbelasting (2007) at p. 293; P. DeKoster & I. Vanderreken, Financiële participatie voor werknemers:
Resultaats, deling, opties en aandeelhouderschap (2001) at p. 9& 10
11
Belgium
11
Host CountryCANADA
Jocelyn Blanchet, MAcc, CADeloitte & Touche LLP, Toronto
Jocelyn Blanchet is a partner in the Mergers &
Acquisitions Tax Group at Deloitte & Touche LLP and
has worked extensively with Canada’s largest and most
successful private equity funds. Jocelyn has significant
experience in the design and structuring of investment
funds, developing tax-efficient structures for investors in
private equity and venture capital, and for their
management teams. He has authored numerous articles
and contributed to several publications and has also
lectured for the Canadian Institute of Chartered
Accountants, teaching investment dealers about tax
concepts relevant to their business.
I. Basic Canadian tax planning for a privateequity fund
A. Investment in a Canadian business entity
The discussion that follows describes the preferred structure
for Canadian income tax purposes of an investment by PEF in
HBE (a Canadian business entity) with respect to each
investor.
1. Preferred structure for a Canadian individual
The preferred structure for an investment by HI would be for
HBE to be formed as a corporation resident in Canada, and
for PEF to be formed as a partnership. In this fashion, the
income earned by HBE would be subject to federal and
provincial income tax at rates ranging from 32.02 percent to
38.16 percent (depending on the provinces in which HBE
conducts business), which is lower than the top marginal
rates of income tax applicable to business income allocated
by partnerships to individuals (which range from 39.00
percent to 48.25 percent depending on the province of
residence). If HBE were to distribute all of its after-tax income
to PEF by way of dividend, the total tax paid by HBE and HI
would be greater in this structure (compared to a situation
where HBE is formed as a partnership), but by a modest
amount, a difference that is expected to decline gradually until
2010,1 at which time individuals are expected to be largely
indifferent between earning income directly or through a
corporation. Historically, the amount of extra tax payable on
income earned by a corporation and distributed to
shareholders that are individuals was much greater and
alternative structures that resulted in the payment of less
corporate income tax were preferable. However, amendments
to the dividend tax credit applicable to dividends received by
individuals from Canadian corporations enacted on February
21, 2007 result in more parity between these alternatives.
PEF should be formed as a partnership so that HI is allocated
his share of income earned by PEF, including gains realised
on the disposition of PEF’s investments (such as HBE). In
such a structure, PEF’s income retains its character for
income tax purposes when allocated to HI,2 so that HI may be
entitled to claim the capital gains exemption with respect to
qualifying gains realised by PEF. As an individual, HI is entitled
to a lifetime cumulative deduction3 from taxable income with
respect to capital gains realised on the disposition of qualified
small business corporation shares so that $500,0004 of
qualifying gains are not subject to income tax. Qualified small
substantially all of the operations are conducted in Canada)
that have been held for at least 24 months.5 If PEF were to be
formed as a corporation, it would not be entitled to this
deduction, nor could qualifying gains be allocated to HI.
PEF could be formed under the laws of Canada or of another
country; Canadian tax law does not differentiate between
partnerships formed under Canadian law and those formed
under foreign law. Furthermore, HI should be indifferent, from
a Canadian income tax perspective, as to whether PEF
conducts its operations through an office in Canada or
abroad. HI would be allocated his share of the income of PEF
and would be taxable on such amounts in Canada,
irrespective of the location of PEF’s management office.
However, as discussed in more detail below, a foreign
partnership would be subject to withholding tax with respect
to HBE’s dividends and thus an HI would ordinarily invest
through a Canadian partnership.
2. Preferred structure for a foreign individual
The preferred structure for an investment by FI would be
largely the same as that for HI with respect to an investment
in HBE; HBE should be established as a Canadian
corporation and PEF should be established as a partnership.
Provided that PEF is not considered to be carrying on
business in Canada, investors in PEF that are not resident in
Canada would generally not be subject to Canadian income
tax on income earned by PEF and allocated to the investors
(although there are certain exceptions; see below).
The position is generally adopted that a private equity fund
makes investments in capital property and does not carry on
business in Canada under general principles. However, the
Act expands the meaning of the term “carrying on business”
to include situations where a non-resident of Canada “offers
anything for sale in Canada”, which could potentially
encompass the sale of shares of private corporations.6 Even
though most income tax treaties would establish a much
12
12
higher threshold before a non-resident could be subject to
Canadian income tax, a private equity fund is usually
designed to benefit from the “safe harbour” of section 115.2
of the Act, which ensures that a non-resident of Canada is not
considered to be carrying on business in Canada solely
because of the provision of certain services by a Canadian
service provider irrespective of whether the investor is resident
in a treaty partner country. Accordingly, PEF’s management
office may be located in Canada provided that the services
rendered to PEF are limited to certain delineated services
(which include providing investment management and
administration services relating to qualified securities, which
includes most types of shares and indebtedness), provided by
certain providers (which includes Canadian corporations but
excludes individuals).
FI may consider investing through another entity in certain
circumstances. Under domestic Canadian law, non-residents
of Canada are liable to pay income tax with respect to gains
on the disposition of “taxable Canadian property”. Taxable
Canadian property includes, among other things, shares of
private corporations resident in Canada and shares of public
corporations resident in Canada where the taxpayer owned
25 percent or more of the issued shares of any class of
shares of the corporation within the 60-month period
immediately preceding the disposition.7 Many of the bilateral
income tax treaties to which Canada is a party include
provisions that eliminate this tax where the investor is a
resident of the other country.8 Accordingly, if FI is not a
resident of a country with which Canada has concluded an
income tax treaty that would eliminate this tax, and FI is not
entitled to a full foreign tax credit for any Canadian income tax
paid, then FI may consider investing in PEF indirectly through
an entity that is resident in a treaty country.
It is important to note that the Canada Revenue Agency (CRA)
does not currently view a U.S. limited liability corporation that
is treated as a partnership or that is disregarded for U.S.
income tax purposes (a popular investment vehicle for many
U.S.-resident individuals) as being a resident of the United
States for purposes of the Treaty9 and such vehicles may not
be a suitable vehicle through which FI would invest in PEF.
If PEF were to have both resident and non-resident investors,
a separate partnership should be established for the
non-resident investors. A partnership that has even a single
member that is a non-resident of Canada (i.e., FI) is not
considered to be a “Canadian partnership”10 and is treated as
a non-resident of Canada for many purposes. For example, all
interest and dividends paid to such a partnership by HBE
would be subject to domestic withholding tax even if a
majority of the members of PEF are resident in Canada and
not otherwise subject to such a tax.
3. Preferred structure for a Canadian pension fund
The preferred structure for HPEN would be for both PEF and
HBE to be formed as partnerships. HPEN would not be
taxable on any income allocated by PEF, including business
income generated by HBE’s commercial activity, and there
would be no entity level tax (as a partnership is not a taxable
entity).
4. Preferred structure for a foreign pension fund
If HBE were formed as a partnership, FPEN would be subject
to Canadian income tax with respect to business income
allocated to it by HBE. The amount of tax payable would
depend on HBE’s legal form; if FPEN were considered a trust
(as determined under Canadian legal principles); it would be
subject to income tax at the rate applicable to individuals,
which typically exceeds the rate of tax applicable to income
earned by corporations. If FPEN were considered a
corporation, FPEN could be largely indifferent from a
Canadian tax perspective as to whether HBE is formed as a
corporation or as a partnership (since either HBE or FPEN
would be subject to corporate income tax at the same
effective tax rate in Canada).11 However, if any of the other
members of a PEF or HBE partnership were resident in
Canada, the participation by FPEN in the same partnership
would “taint” the partnership for withholding tax purposes (as
discussed in Section I.A.2., above). Accordingly, the preferred
structure for FPEN is likely for HBE to be formed as a
corporation and for PEF to be a partnership for non-resident
investing, including the FPEN.
The considerations described above in connection with an
investment by FI (i.e., the use of separate partnerships, and
the situs of PEF’s management office) would similarly apply to
FPEN.
5. Preferred structure for a foreign government
The preferred structure for FGOV is the same as for FPEN
with respect to an investment in HBE.
B. Investment in a foreign business entity
The discussion that follows describes the preferred structure
for Canadian income tax purposes of an investment by PEF in
FBE (a non-Canadian business entity) with respect to each
investor.
1. Preferred structure for a Canadian individual
Since HI is likely subject to income tax at a rate of 39 percent
or higher, and few countries would impose a higher tax rate
on income allocated to HI, the preferred structure for HI is
probably for FBE to be structured as a corporation not
resident in Canada, and for PEF to be a partnership. In this
fashion, income earned by FBE should not be subject to
Canadian income tax.
If it is anticipated that FBE would pay significant dividends
during PEF’s holding period, PEF could consider making the
investment in FBE indirectly through a Canadian corporation
(“Holdco”). If FBE is a foreign affiliate of Holdco (which
generally requires, among other conditions, that Holdco own
greater than 10 percent of the issued and outstanding shares
of FBE)12 and is resident in a country with which Canada has
concluded an income tax treaty, dividends paid by FBE to
Holdco out of its earnings could be non-taxable to Holdco for
Canadian income tax purposes. Holdco could distribute such
amounts to HI (through PEF) by declaring dividends, which
would be subject to income tax at rates as low as 17.23
percent to 30.63 percent. Dividends paid by FBE to HI
through PEF without the use of a Canadian holding company
would be subject to income tax at full rates (of between 39.00
percent and 48.25 percent, as noted above).
Provided Holdco is a Canadian-controlled private
corporation, the realisation of capital gains by Holdco on
the disposition of the shares of FBE should not result in
significantly more income tax payable to HI than if PEF had
realised the gain directly. That is, the total corporate and
personal income tax payable with respect to such gains
(i.e., the corporate tax payable on the capital gain, and the
13
Canada
13
individual level tax payable by HI on dividends declared by
Holdco) should approximate the amount of tax that HI
would have paid had he realised the capital gain directly.
2. Preferred structure for a foreign individual
The preferred structure for FI with respect to an investment in
FBE is for PEF to be established as a partnership. In such a
structure, whether FBE is established as a corporation or as a
partnership should not affect FI from a Canadian income tax
perspective (subject to the comments above with respect to
the location of PEF’s management office).
3. Preferred structure for a Canadian pension fund
The preferred structure for HPEN would be for PEF to be
established as a partnership. The ideal structure for FBE
would then largely be driven by the tax regime in which FBE
is resident and where it is liable to pay income taxes; HPEN
should not be subject to Canadian income tax whatever
FBE’s legal form.
4. Preferred structure for a foreign pension fund and aforeign government
The preferred structure for FPEN and FGOV with respect to
an investment in FBE, from a Canadian income tax
perspective, would be the same as for FI (with PEF formed
as a partnership).
C. Conclusion as to the overall preferred structure
The structure that has the broadest appeal to all classes of
investors is for PEF to be formed as a partnership and for
HBE and for FBE to be formed as corporations. This
structure is generally optimal for all investors except HPEN
(which would, as a result of this structure, be liable for a
greater amount of income tax than it would were HBE to be
formed as a partnership). If any non-residents of Canada
were to invest in PEF (such as FI, FPEN, or FGOV), a
separate partnership should be formed for such investors
so that PEF is not “tainted” for Canadian withholding tax
purposes. Furthermore, the exact structure of the
partnership established for these investors could differ
slightly from that of the partnership established for HI and
HPEN in order to ensure that the “safe harbour” benefits
discussed earlier are available to these investors
(particularly if these investors are not resident in a country
with which Canada has concluded an income tax treaty).
Historically, pension funds (HPEN) have been the most
significant participant in private equity investments made in
Canada,13 and their preferences can have a significant
influence on the structure of private equity funds and the
businesses in which they invest. Where a majority of the
investors in PEF are tax-exempt for Canadian income tax
purposes, an investment in HBE would ideally be formed as
a partnership, even if this structure is less-than-optimal for
other investors in PEF.
By adding other vehicles, an alternative (albeit slightly more
complex) structure could be used to improve the structure for
a greater number of investors. For example, HBE could be
formed as a partnership, and FI would invest in PEF through a
Canadian corporation, effectively achieving the preferred
structure with respect to HBE and FBE with respect to its
proportionate investment in PEF. If desirable, the partnership
formed for non-resident investors in Canada could invest in
HBE through a Canadian corporation “underneath” the
partnership (while still making investments in FBE directly), so
that the income derived by HBE as a partnership and
allocated to its partners is nevertheless subject to Canadian
income tax at corporate tax rates.
II. Basic Canadian tax planning for a hedgefund
One of the principal differences between PEF and HF is that
HF is less likely to conduct its activities in a fashion that would
give rise to capital gains. For example, gains realised in
connection with securities sold short and with derivatives
(including futures, forwards, swaps, and related instruments)
are likely to be viewed as being on income account for
Canadian income tax purposes.14 If HF were to conduct its
activities in a fashion similar to PEF (for example, by
purchasing common shares for longer periods of time), the
preferred structure for HF could be similar to that for PEF
described above, except that additional consideration might
have to be given to withholding tax considerations since the
receipt of interest and dividends may be more prevalent with
such portfolios. Accordingly, the discussion that follows
considers the appropriate structure for HF on the assumption
that HF’s activities are to be treated on income account for
Canadian income tax purposes.
A. Investment in assets generating Canadian-sourceincome
The discussion that follows describes the preferred structure
for Canadian income tax purposes of an investment in assets
that generate Canadian-source income by HF with respect to
each investor.
1. Preferred structure for a Canadian individual
With the recent amendments made to the Act (as described
in more detail above), it is intended that HI should ultimately
be largely indifferent between earning income from such
assets directly or through a corporation, whether the activities
are considered to generate business income or income from
property (provided the corporation is a Canadian-controlled
private corporation for Canadian income tax purposes).
Accordingly, HF could likely be structured as either a private
corporation or a partnership. However, there may be slight
advantages to structuring HF as a partnership, including: (i)
the fact that the rate of tax ultimately borne by HI would be
slightly higher until the integration mechanism has been fully
enacted; and (ii) the fact that HI should obtain a “deduction”
for dividend compensatory payments made with respect to
borrowed Canadian securities whereas such a deduction is
prohibited for a corporation unless the corporation is a
registered securities dealer.15
Since the activities of HF may not give rise to capital gains
under first principles, consideration should be given to the
making of an election pursuant to subsection 39(4) of the Act.
This election would be made by HF (if HF is formed as a
corporation), or by HI (where HF is a partnership)16 and deems
every Canadian security17 held by the taxpayer to be a capital
property, and every disposition of such Canadian securities to
be a disposition of a capital property, thereby giving rise to
capital gains and losses even if such gains and losses would
otherwise be considered to be on income account, absent
the making of the election. In short, the making of such an
election could “convert” income gains generated by HF to
capital gains, which are taxed more favourably. The election
does not apply to dispositions made by a trader or dealer in
Canada
14
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securities, or a taxpayer whose principal business is the
purchasing of debt obligations.18 Accordingly, HF could be
precluded from making the election if it is a corporation
(depending on its activities). A separate evaluation would be
required in the event that the election is made by HI.
However, because the election can be made by a mutual fund
trust irrespective of its level of activity (and whether or not it
could be considered a trader or dealer in securities), a mutual
fund trust is an alternative and attractive structure for HF.
Such structures are not common because numerous
conditions must be met in order for a trust to be considered a
mutual fund trust for Canadian income tax purposes,
including the requirement that the trust must have at least 150
unit holders and that either the issued units must be
redeemable at the demand of the holder or the trust must
comply with certain investment restrictions.19
2. Preferred structure for a foreign individual
The preferred structure for FI would likely be for HF to be
structured as a partnership or as a corporation resident in a
foreign country that is subject to a low rate of tax (and
ideally benefits from a tax treaty with Canada). If HF were
structured as a corporation resident in Canada, HF would
be subject to corporate income tax with respect to its
profits and dividend distributions to FI would be subject to
a further withholding tax. If HF were to be formed as a
partnership, a separate partnership should be established
for investors that are not resident in Canada (for the
reasons described in Section I.A.2., above).
Whether HF is a partnership or a foreign corporation, it
should be formed to respect the conditions of 115.2 of the
Act (as described in Section I.A.2., above), so that neither
HF nor FI is subject to Canadian income tax with respect to
the profits generated by HF.
FI may prefer HF to be formed as a partnership, particularly
if FI is resident in a country with which Canada has
concluded an income tax treaty, in order to reduce
Canadian withholding tax. Although many debt instruments
issued by Canadian-resident persons are designed to
benefit from domestic withholding tax exemptions,
dividends paid to HF would be subject to a 25 percent
withholding tax, which could be reduced through the
application of an income tax treaty. As a partnership, HF
would likely not benefit from any tax treaties, but the CRA
has indicated that, in applying Canadian withholding tax,
one should look through partnerships and determine the
appropriate amount of withholding tax based on the
residence of the partners.20
For similar reasons, the formation of HF as a mutual fund
trust may not be optimal for FI. Income allocated to
non-residents of Canada by a mutual fund trust would be
subject to withholding tax (except for allocations of capital
gains not arising from the disposition of taxable Canadian
property), whereas interest earned by HF as a partnership
and allocated to FI could benefit from domestic exemptions
from withholding tax.
3. Preferred structure for a Canadian pension fund
The preferred structure for HPEN would be for HF to be
formed as a partnership. HPEN would not be taxable on any
income allocated by HF.
4. Preferred structure for a foreign pension fund and aforeign government
The preferred structure for FPEN and FGOV from a Canadian
tax perspective would likely be for HF to be formed as a
partnership (with a separate partnership established for
investors not resident in Canada as discussed in Section
I.A.2., above). The Act contains additional exemptions from
withholding tax on interest for non-resident pension funds
(that would serve to eliminate withholding tax with respect to
obligations that do not benefit from other domestic
exemptions) that would not apply if HF were formed as a
corporation.21 Furthermore, certain treaties provide further
exemptions from which FPEN or FGOV could benefit. For
example, the treaty exempts foreign pension entities from
Canadian withholding tax on interest and dividends, and
exempts certain foreign governmental entities from
withholding tax on interest.22
B. Investment in assets generating foreign-sourceincome
The discussion that follows describes the preferred structure
for Canadian income tax purposes of an investment in assets
that generate foreign-source income by HF with respect to
each investor.
1. Preferred structure for a Canadian individual
The preferred structure for HI with respect to HF making
investments in assets that generate foreign-source income is
likely the same as for assets that generate Canadian-source
income (as described above), with HF being formed as either
a Canadian corporation or as a partnership. Both alternatives
would result in the income generated by HF being subject to
Canadian income tax on a current basis.
If HF were to be formed as a corporation in a zero-tax
jurisdiction, HF would likely be considered a foreign affiliate of
HI (if HI owned more than 10 percent of the issued shares of
any class of HF) or a foreign investment entity of HI.23 Both
regimes would likely operate to eliminate any deferral of
taxation to HI with respect to HF’s activities and would serve
to include in HI’s income either his proportionate share of HF’s
income (as computed for Canadian income tax purposes), or
a notional return based on the amount invested.
2. Preferred structure for a foreign individual
The preferred structure for FI would be for HF to be formed as
either a partnership or as a corporation in a zero-tax
jurisdiction. Neither structure should affect FI from a Canadian
income tax perspective (subject to the comments above with
respect to the location of HF’s management office).
3. Preferred structure for a Canadian pension fund
The preferred structure for HPEN from a Canadian income tax
perspective would be for HF to be formed as a partnership.
HPEN would not be taxable on any income allocated by HF
and could potentially benefit from income tax treaties between
Canada and the country in which the payer of the income is
resident.
4. Preferred structure for a foreign pension fund and aforeign government
The preferred structure for FPEN and FGOV from a Canadian
tax perspective would likely be the same as that for FI above.
Neither structure should affect either investor from a Canadian
income tax perspective (subject to the comments above with
respect to the location of HF’s management office).
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Canada
15
C. Conclusion as to the overall preferred structure
The overall preferred structure from a Canadian tax
perspective for each of the investors, with respect to a
portfolio that generates both Canadian-source and
foreign-source income, is for HF to be established as a
partnership with a management office located either in
Canada (provided that the conditions of section 115.2 of
the Act are respected) or in another country. This structure
is optimal for each of the investors, other than potentially HI
who could benefit from making the investment through a
mutual fund trust (provided the numerous applicable
conditions could be achieved). If any non-residents of
Canada were to invest in HF (such as FI, FPEN, or FGOV),
a separate partnership should be formed for such investors
so that HF is not “tainted” for Canadian withholding tax
purposes.
III. Canadian income taxation of income froma carried interest
The carried interest with respect to a private equity fund is
usually paid as a distribution on a partnership interest
(where PEF is formed as a partnership), often held by the
general partner (in this case, Savvy).
A distribution made to a partner with respect to that
partner’s interest does not, in and of itself, result in any
taxable income to the partner but reduces the adjusted
cost base of the partner’s interest in the partnership.24
However, every fiscal year, the partnership must calculate
its income or loss for tax purposes and allocate such
income or loss to its members (including the general
partner) consistently with the terms of the partnership
agreement, whether or not distributions are made to the
partners. As noted above, the character of the income or
loss allocated to the partners maintains its character for
tax purposes; that is, where PEF realises capital gains and
allocates such gains to its partners, the partners are
considered to have realised capital gains. The partnership
agreement for PEF would likely provide that the recipient
of the carried interest would be allocated income for tax
purposes approximately corresponding to the amount of
distributions made to that partner (or the amount of
carried interest earned). Accordingly, provided that PEF
realises capital gains and allocates such gains to Savvy,
Savvy should be taxed on his carried interest at the rates
applicable to capital gains.
The granting of the carried interest to the general partner
on the formation of a private equity fund is generally not
treated as a taxable event. Furthermore, it is generally
believed that the value of the carried interest is low if
acquired by the general partner before the fund has
obtained commitments from investors.
1 The 2006 Federal Budget proposed to reduce gradually the federalincome tax rate applicable to corporations. This trend wascontinued with the Department of Finance’s news release2006-061, dated October 31, 2006, which announced a proposalto further reduce the corporate tax rate to 18.5 percent effectiveJanuary 1, 2011. Once these rates have been enacted, thisdifference should be minimal.
2 Paragraph 96(1)(f) of the Income Tax Act (Canada), RSC 1985, c. 1(5th Supp.), as amended (hereinafter referred to as “the Act”).Unless otherwise stated, statutory references in this paper are tothe Act.
3 The deduction is provided by subsection 110.6(2.1) of the Act.
4 The 2007 Federal Budget proposed to increase the exemption to$750,000 with respect to dispositions occurring on or after March19, 2007.
5 In order to qualify for the capital gains exemption, numerousconditions must be met by the individual and the corporation,which are beyond the scope of this article. For a detaileddiscussion of the rules, see Craig K. Hermann, “The Capital GainsExemption: A Comprehensive Review”, Report of Proceedings ofFifty-Second Tax Conference, 2000 Tax Conference (Toronto:Canadian Tax Foundation, 2001), 29:1-54
6 Paragraph 253(b) of the Act
7 Definition in subsection 248(1) of the Act
8 For example, Article XIII of the Canada-United States TaxConvention (1980) (the “Treaty”) exempts residents of the UnitedStates from this tax with respect to most forms of property that aretaxable Canadian property.
9 See, for example, CRA document 9417505, dated October 25,1994. In the 2007 Federal Budget, the Department of Financesuggested that the Treaty was being renegotiated so as to extendthe benefits of the Treaty to U.S. limited liability companies.Whether this will occur, or what will be the effective date ofimplementation, is not yet known.
10 Section 102 of the Act
11 There could be a slight advantage to FPEN bearing the corporatetax liability since corporations not resident in Canada are liable topay federal tax at a rate of 10 percent in lieu of provincial incometax, a rate that is lower than the rate of income tax levied by mostprovinces.
12 Definition in subsection 95(1) of the Act
13 See Private Equity Canada Report 2006, (Toronto: ThomsonFinancial Canada and McKinsey and Company, 2007) and PrivateEquity Canada Report 2002, a research report by Macdonald &Associates Ltd. (Toronto: Goodman & Carr LLP and McKinsey andCompany, 2002)
14 The CRA’s interpretation bulletin IT-479R Transactions in securities(dated February 29, 1984) contains a good description of the CRA’sview with respect to the treatment of numerous different types oftransactions in securities.
15 An individual is generally entitled to reduce the amount of Canadiandividends included in income by the amount of compensatorydividend payments made with respect to securities lendingarrangements by virtue of clause 82(1)(a)(ii) of the Act. Subsection260(6) otherwise prohibits a deduction with respect to suchpayments unless the taxpayer is a registered securities dealer.
16 Subsection 39(4.1) of the Act ensures that an election made by amember of a partnership is effective with respect to the activities ofa partnership of which it is a member.
17 Canadian securities are defined in subsection 39(6) of the Act andinclude shares of Canadian-resident corporations, units of a mutualfund trust, and many types of common debt instruments issued byCanadian-resident persons.
18 Subsection 39(5) of the Act
19 Definition in subsection 132(6) of the Act. An evaluation of all of theconditions that must be met in order for a trust to be considered amutual fund trust is well beyond the scope of this article. For amore comprehensive summary of the conditions to be met, see P.Botz, “Mutual fund trusts and unit trusts: Selected tax and legalissues” (1994). vol 42, no. 4 Canadian Tax Journal 1037-1058
20 For example, CRA document 2004-0074241E5 dated July 19,2005, which affirms the CRA’s long-held view.
21 Paragraph 212(1)(b)(iv) of the Act enables organisations that obtaina certificate of exemption to eliminate withholding tax on interest.Such certificates may be granted to foreign pension entities,charities, and certain other tax-exempt entities, as provided insubsection 212(14) of the Act.
22 Paragraph 2 of Article XXI and paragraph 3 of Article XI,respectively
23 The foreign investment entity regime is contained in section 94.1 ofthe Act.
24 Subparagraph 53(2)(c)(v) of the Act
Canada
16
16
Host CountryDENMARK
Christian EmmeluthCopenhagen, Denmark
Christian Emmeluth obtained an L.L.B.M. from
Copenhagen University in 1977 and became a member
of the Danish Bar Association in 1980. During 1980-81,
he studied at the New York University Institute of
Comparative Law and obtained the degree of Master of
Comparative Jurisprudence. Having practised Danish law
in London for a period of four years, he is now based in
Copenhagen.
I. Introduction
For purposes of the discussion below, it is assumed that the
private equity fund (PEF) is treated as a partnership and, as
such, as a transparent entity, for Danish tax purposes.
Otherwise the PEF will be subject to taxation under the
Corporate Tax Act, which contains specific provisions for the
taxation of investment funds established under Council
Directive 85/611/EEC on the co-ordination of laws,
regulations and administrative provisions relating to
undertakings for collective investment in transferable
securities (UCITS) and other investment funds and
associations. Generally, a PEF will be treated as a partnership
if the members are jointly and severally liable for the
obligations of the partnership, the number of members is
limited, the number of members remains basically unchanged
during the term of the partnership, and any admission of new
members and/or significant changes of the articles of
association require the unanimous consent of all the
members.
II. Basic Danish tax planning for a privateequity fund
A. Investment in a Danish business entity
1. Preferred structure for a Danish individual
From the perspective of HI (who is a Danish person), the most
tax-efficient structure for Danish income tax purposes would
be to set up HBE as a limited company. HI will in this case
incorporate his own holding company through which the
investment in HBE will be made.
Capital gains realised on the disposition of the shares in HBE
will be exempt from Danish corporate income taxation
provided the shares in HBE have been owned for more than
three years at the time of sale.1 There is no requirement as to
the percentage of shares that the holding company must own
in HBE. Gains realised before the three-year ownership
requirement is met are subject to ordinary corporate income
taxation at the rate of 25 percent.
These beneficial rules do not apply if the shares in HBE are
considered to be shares in an investment company.2 An
investment company is defined as:
■ A company covered by Council Directive 85/611/EEC of
December 20, 1985 on the co-ordination of laws,
regulations and administrative provisions relating to
UCITS;
■ A company investing in securities where, upon demand
from the bearer, shares are redeemed by funds from the
company at a price that is not significantly lower than the
intrinsic value of the company. A purchase of shares by a
third party that has undertaken vis-à-vis the company an
obligation to purchase the shares at a price that is not
significantly less than the intrinsic value of the company,
is considered a redemption by the company. Goodwill,
know-how, and similar intellectual property rights are
disregarded for purposes of calculating the intrinsic value.
The requirement concerning redemption on demand will
be deemed to have been met even if the demand is met
over a certain time period rather than immediately.
Capital gains on investment shares are taxed at the corporate
rate of 25 percent, irrespective of the length of time for which
they have been owned.3
Dividends received from HBE will be tax free provided the
holding company owns more than 10 percent of HBE4 and
provided the dividends are not received from an investment
company (i.e., provided HBE is not deemed to be an
investment company). Distributions from an investment
company must be included in the taxable income of its parent
company. For the tax years 2007 and 2008, the holding
requirement is 15 percent. If the holding requirement is not
met, then only 66 percent of the dividends received form part
of the taxable income of the holding company, again provided
the dividends are not received from an investment company.
Whether PEF is established under Danish or foreign law would
not be significant for HI, provided, if PEF is a foreign
partnership, it is treated for Danish tax purposes as a
transparent entity.
2. Preferred structure for a foreign individual
Where the investment in PEF is to be made by a foreign
individual, the preferred form for PEF would again be a
partnership which, as noted above, is transparent for Danish
tax purposes. HBE should be established as a limited
company under the laws of Denmark.
Gains realised on the disposition of shares in HBE will not be
subject to Danish income taxation. If HBE is liquidated, a
distribution made to FI in the year in which HBE is finally
17
17
dissolved will be treated as a dividend distribution subject to
withholding tax but only if:
■ FI owns more than 10 percent of the shares in HBE
through a company; and
■ The company is a resident of an E.U. or European
Economic Area (EEA) Member State or a country with
which Denmark has concluded a double taxation treaty.5
In order to avoid or mitigate withholding tax on distributions of
dividends from HBE, FI should make his investment in
Denmark through a foreign company incorporated in another
E.U. or EEA country or a country with which Denmark has
entered into a double taxation treaty providing for a reduced
rate of withholding tax on dividends. Otherwise such
distributions will be subject to withholding tax at the rate of 28
percent.6
According to circular letter No. 12 of April 28, 1993, foreign
investors holding Danish listed shares deposited with a
Danish bank may apply to benefit automatically from the
reduced rate provided for under an applicable treaty. If
permission is granted, it will not be necessary to apply for a
refund of withholding taxes.
3. Preferred structure for a Danish pension fund
Danish pension funds are subject to taxation under the
Pension Fund Tax Act.7 Tax is imposed at a rate of 15 percent
and the taxable basis is the net income of the fund and all
realised and unrealised gains and losses on the assets of the
fund. The tax year is the calendar year and taxable income is
computed annually. Investment in certain bonds and certain
real property is exempted from tax and a credit is granted for
foreign taxes paid by the pension fund. The European Court
of Justice (ECJ) found in its decision C-150/04 that the denial
of the right of residents of Denmark to deduct contributions to
foreign pension plans was a violation of E.C. law.
Consequently a bill has been submitted to the Danish
parliament that introduces major changes to the Pension
Fund Tax Act. The bill is expected to undergo significant
amendments on its way through the Danish Parliament.
Basically, the new pension fund tax will be imposed at the
level of the individual investor rather than at the level of the
pension fund itself, and will allow Danish resident individuals
establishing plans with foreign pension funds to deduct
contributions to such plans for Danish income tax purposes.
Under current law, because of the scope of a pension fund’s
taxable basis under the Pension Fund Tax Act, the way in
which an investment in PEF is structured will not have any
impact on how HPEN is taxed.
4. Preferred structure for a foreign pension fund
FPEN would structure its structure its investment in the same
manner as FI (see Section II.A.2., above) in order to limit its
exposure to Danish withholding taxes.
5. Preferred structure for a foreign government
FGOV would not be subject to taxation in Denmark.
B. Investment in a foreign business entity
1. Preferred structure for a Danish individual
As long as the foreign company does not fall within the scope
of the Danish controlled foreign company (CFC) legislation, HI
will use the same structure as for the investment in a Danish
subsidiary as described under Section II.A.1., above.
Under the CFC legislation, a Danish parent must include in its
taxable income its proportionate share of the CFC income of
a foreign subsidiary.8 A company is considered a parent
company if it:
■ Owns the majority of the shares in the subsidiary;
■ Is a shareholder in and has the right to appoint the
majority of the members of the board of the subsidiary;
■ Is a shareholder in, and may exercise significant influence
over the running and financial affairs of, the subsidiary
under an agreement;
■ Is a shareholder in, and controls the majority of the votes
with respect to, the subsidiary under an agreement; or
■ Is able to exercise control over the subsidiary through
another company.
A parent company must include its subsidiary’s CFC income
(as defined) in its own taxable income if the subsidiary’s CFC
income is more than 50 percent of the subsidiary’s total
income and the financial assets held by the subsidiary
constitute more than 10 percent of the subsidiary’s total
assets. CFC income is mainly passive income, such as
dividends, interest, royalties, and leasing income.
HI will seek to ensure that the thresholds for the application of
the CFC regime described above are not exceeded. If this is
achieved, the shares in the foreign company will be subject to
the tax treatment applying to shares in a non-CFC company,
(i.e., gains on the disposal of such shares will be tax-exempt)
provided the foreign company does not fall within the
definition of an investment company set out at Section II.A.1.,
above.
2. Preferred structure for a foreign individual
The preferred structure for FI will depend on the local tax law
of FI’s home country.
3. Preferred structure for a Danish pension fund
Whether HPEN invests in foreign or domestic assets does not
affect its taxation treatment, so that the position is as
described at Section II.A.3., above.
4. Preferred structure for a foreign pension fund
As in the case of FI, the preferred structure for FPEN would
depend on the local tax law of FPEN’s home country.
5. Preferred structure for a foreign government
Again, the preferred structure for FGOV depends on local law.
C. Overall preferred structure
From the point of view of HI and FI (where PEF is to invest in
HBE), structuring the investment through a local holding
company would be the most attractive route. Danish pension
funds are not subject to corporate income taxation but to
taxation under a special Pension Fund Tax Act that does not
distinguish between foreign and domestic investments.
III. Basic Danish tax planning for a hedge fund
A. Investment in passive assets generatingDanish-source income
1. Preferred structure for a Danish individual
As income is taxed in the hands of individuals at the rate of 59
percent, HI will most likely seek to postpone taxation until the
date the holding company is liquidated by employing the
Denmark
18
18
structure described under Section II.A.1, above. The capital
gain on shares realised on liquidation is taxed at the rate of 43
percent.
2. Preferred structure for a foreign individual
In order to mitigate withholding taxes, the rate of which would
exceed the corporate tax rate of 25 percent, FI would
structure his investment in HF in the same way as is
described under Section II.A.2., above in relation to an
investment in HBE through PEF. As described above,
dividends may in many instances be received tax free if the
pertinent holding requirement is met. The use of a holding
company would enable dividends to be paid on free of
withholding tax to a company resident in another E.U. or EEA
Member State or in a country that is party to an applicable tax
treaty providing full relief from withholding tax.
As the withholding tax on dividends paid to individuals is 28
percent (and on royalties 30 percent), the only investment that
FI would hold directly would be an investment in interest
yielding instruments, no withholding tax being imposed on the
return on such investments.
3. Preferred structure for a Danish pension fund
The same considerations as described under Section II.A.3.,
above would apply.
4. Preferred structure for a foreign pension fund
The position would be as described in Section II.A.4., above.
5. Preferred structure for a foreign government
FGOV would not be subject to taxation in Denmark.
B. Investment in passive assets generatingforeign-source income
1. Preferred structure for a Danish individual
Again HI would seek to postpone taxation by setting up a
holding company structure as described under Section II.A.1.,
above.
2. Preferred structure for a foreign individual
The preferred structure for FI would depend on the local tax
law of FI’s country of residence.
3. Preferred structure for a Danish pension fund
Under current law, no distinction is made for tax purposes
between domestic and foreign source income, all taxable
income being taxed in the same manner. Thus, the position
will be as indicated at Sectioh III.A.3., above – i.e., HPEN
would structure its investment as described in Section II.A.3.,
above.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would depend on the local
tax law of FPEN’s home country.
5. Preferred structure for a foreign government
FGOV would not be subject to taxation in Denmark.
C. Conclusion as to the overall preferred structure
A holding company is the most useful vehicle for postponing
and, in certain instances, reducing the taxation of passive
income, except in the case of returns on investments in
interest-bearing instruments, which should be held directly by
foreign individual investors.
IV. Danish income taxation of income from acarried interest
The “carried interest” will be deemed to be compensation for
the advice rendered by Savvy. As the “carried interest” is a 20
percent interest in the profits of PEF, unless the agreement
with Savvy stipulates a specific date of payment different from
that on which the profits are realised by PEF, the time when
the investors realise the profits on their investments will
determine the time at which Savvy must include his “fee” in
his Danish taxable income.
1 Section 9 of Act No. 1017 of October 10, 2006 on the Taxation onGains on Shares (TGA) (aktieavancebeskatningsloven)
2 TGA, section 19
3 TGA, section 9.1
4 Section 13.2 of Act No. 1745 of December 14 2006 on theTaxation of Companies (CTA) (selskabsskatteloven)
5 Section 16 A 1 of Act No. 1061 of October 24, 2006 on theAssessment of Tax (ligningsloven)
6 Section 65 of the Act No. 1086 of November 14, 2005 on theTaxation at Source (kildeskatteloven)
7 Act No. 1075 of November 5, 2005(pensionsafkastbeskatningsloven)
8 CTA, Section 32
19
Denmark
19
Host CountryFRANCE
Stéphane Gelin, Avocat associé and Johann Roc’h, AvocatCMS Bureau Francis Lefebvre, Paris
Stéphane Gelin is an attorney, Tax Partner with CMS
Bureau Francis Lefebvre, member of the CMS Alliance.
He specialises in international tax and transfer pricing.
Johann Roc’h is an attorney with the International Tax
Department of CMS Bureau Francis Lefebvre.
I. Basic French tax planning for a privateequity fund
A. Investment in a French business entity
With respect to an investment by PEF in a French business entity,
there follows a discussion, separately with respect to each of the
investors, of the preferred structure for French income tax purposes.
For the purpose of this analysis, we have assumed that HBE
would be structured as a limited liability company such as a
Société par Actions Simplifiée (SAS) or a Société àResponsabilité Limitée (SARL), HBE consequently being subject
to corporate income tax. Indeed, in France, businesses are not
often structured as partnerships for several reasons, in particular
because: (1) the partners are jointly and severally liable for the
obligations of the partnership; and (2) the significant registration
obligations triggered by the sale of partnership shares.
For the purposes of this study, we have focused on investment
vehicles that are considered to be “private equity funds”. Other
investment vehicles are available, such as the Sociétéd’Investissement à Capital Variable (SICAV), a tax exempt
investment company that generally provides the same tax
benefits as a Fonds Commun de Placement (FCP – see Section
I.A.1., below). We have also assumed that HBE and FBE mainly
carry on commercial activities, thus excluding from consideration
predominantly real estate holding entities for which specific tax
structures may be set up.
1. Preferred structure for a French individual
From the perspective of HI (who is a tax resident of France), the
usual structure for French income tax purposes would be to set
up PEF as a French FCP. The FCP is an investment fund that
consists of a co-ownership of securities without legal personality.
It is set up by a French management company approved by the
Autorité des Marchés Financiers (AMF), the French equivalent of
the U.S. Securities and Exchange Commission (SEC).
HI would hold the shares in PEF directly, and PEF would invest either
directly in HBE, or through a holding company that would acquire
HBE, the acquisition preferably being funded by equity (a mix of hard
equity and shareholder loan)1 and bank debt (the holding company,
together with HBE, would subsequently set up a fiscal unity for
corporate income tax purposes). Having HI invest in HBE through
an FCP would not give rise to any additional taxation as compared
to HI investing directly in HBE, the position being as follows:
■ The issuance and transfer of shares in an FCP is not
subject to registration tax.
■ A holder of FCP shares is not liable to taxation with
respect to dividends or interest received, or capital gains
realised,2 by the FCP, if the FCP does not distribute such
income or gains.
■ HI will generally3 be subject to standard taxation on
dividends or interest received, or capital gains realised, by
the FCP, if the FCP does distribute such income or gains.
■ HI will be subject to standard taxation on the disposal of
FCP shares.4
To optimise the structure from a tax standpoint, instead of an
FCP, HI could set up PEF as a French Fonds Commun dePlacement à Risques,5 (FCPR or Venture Investment Fund). Like
an FCP, an FCPR is a co-ownership of securities without
separate legal personality.6 An FCPR is set up by a French
management company approved by the AMF and by a
custodian.7 The additional advantages it has over an FCP can be
summarised as follows:
■ HI will be exempt from income tax on income or gains
received by HI through the FCPR (such income would only
be subject to social contributions at the rate of 11
percent, the contributions being withheld by the FCPR’s
management company), provided certain conditions are met.
■ HI will also be exempt from capital gain tax on the disposal
of FCPR shares if the same conditions are met (social
contributions would still apply at the rate of 11 percent).
■ HI will be entitled to a tax reduction equal to 25 percent
of the FCPR subscription, up to a maximum subscription
of €12,000 per person per year. HI may also be exempt
from French tax on distributions from the FCPR
reinvested in the FCPR and on capital gains realised
when the FCPR shares are sold or redeemed after the
initial five-year blocking period.
Under French law, an FCPR must meet several requirements:
■ Its investments must be predominantly in private equity
(the investment quota is 50 percent);8
■ Shareholder loans granted and financial investments
made by it must be limited;9
■ Its equity in listed companies must be limited.10
Also for the tax exemptions/reductions listed above to be
granted, not only must the taxpayer meet a five-year holding
period requirement, but further conditions must be met as to the
investment quota of 50 percent (which will normally be met
where HI invests in HBE through an FCPR):
■ The companies in which the FCPR invests must have
their registered head office in a Member State of the
European Union, or in another Member State of the
European Economic Area (EEA) that has signed a tax
20
20
treaty with France that contains an administrative
assistance clause for the prevention of tax fraud or evasion;
■ The companies must carry on a commercial or industrial
activity; and
■ The companies must be subject to French corporate
income tax (CIT) under ordinary conditions (or would be
subject to French CIT under the same conditions if their
activity was performed in France).
2. Preferred structure for a foreign individual
FI is a non-resident of France. For FI also, PEF could be set up as
a French FCPR with the following French tax consequences:
■ There would be no supplementary registration tax.
■ French-source income and gains11 distributed by the
FCPR would be subject to withholding tax to the extent
the underlying income received was subject to
withholding (for example, dividends paid to non-resident
shareholders are subject to French domestic withholding
tax at the rate of 25 percent). Such withholding could be
reduced under the provisions of a tax treaty (if any)
between France and the country of residence of FI12 (no
social contributions would be due); and
■ Capital gains on the disposal of the FCPR shares13 would not
trigger any withholding tax or any other taxation in France.
PEF could also be set up as a foreign partnership. According to
recent administrative guidelines issued by the French tax
authorities, a foreign partnership that is treated as tax transparent
in the country in which it is established, whether or not it has
separate legal personality, and whether or not its partners have
unlimited liability, must be looked through for the purposes of
applying the treaty(ies) signed by France with the country(ies) in
which its partners are resident. Such transparent treatment
applies provided the following conditions are met:
■ The partnership must have its seat of management in a
country that has signed a tax treaty with France
containing an administrative assistance clause for the
prevention of tax fraud or evasion;
■ The partners must themselves be resident in a country
that has signed a tax treaty with France containing an
administrative assistance clause for the prevention of tax
fraud or evasion;
■ The French-source income flowing through the partnership
must be treated for tax purposes as the income of the
partners as residents of their relevant county(ies), and be
effectively subject to taxation in that country (those
countries) without benefiting from any exemption; and
■ None of the partners may be a partnership.
Provided the conditions set out above are met, the
French-source income would be deemed to be attributed directly
to the partners of the foreign partnership, so that the provisions
of the tax treaty between France and the country of residence of
the partners would apply. Irrespective of any tax treaty provisions,
potential withholding tax on interest paid to FI could be avoided if
the conditions for benefiting from France’s domestic exemption
from withholding tax were met.14
Finally, the foreign partnership should not be deemed to have a
permanent establishment (PE) on the sole ground that it has
entered into an agreement with a French company with respect
to the management of its portfolio investments. No such PE
should be recognised in France provided the administrative and
commercial management of the fund is handled abroad, at the
level of its seat.15
3. Preferred structure for a French pension fund
France has no equivalent of a pension fund.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that for
FI with respect to an investment in HBE, provided FPEN does not
have a PE in France. Depending on the specific constraints
applying to FPEN, a corporation benefiting from an advantageous
tax regime may be interposed between HBE and PEF.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that for
FPEN with respect to an investment in HBE, provided FGOV
does not have a PE in France.
B. Investment in a foreign business entity
1. Preferred structure for a French individual
If FBE is resident in an E.U. Member State or another EEA
Member State that has signed a tax treaty with France containing
an administrative assistance clause for the prevention of tax fraud
or evasion, HI could invest in FBE through an FCPR, FBE being a
limited liability company.
Provided the FCPR qualifies as a fiscal FCPR, HI would benefit
from the tax exemptions described above in connection with HI
investing in HBE (see Section I.A.1., above).
Since an FCPR has no legal personality and is not subject to tax
in France, under the provisions of the applicable tax treaty,16 the
FCPR may not be regarded as a French resident for tax
purposes. On the other hand, the transparent character of an
FCPR may not be recognised by all foreign jurisdictions, so that:
(1) withholding tax could be levied on its foreign-source income;
and (2) the investors could be denied tax credits for any foreign
withholding tax so levied.
These problems could be remedied by interposing between PEF
and FBE, a foreign corporation, such as a Luxembourg SARL
that is eligible for the “SOPARFI” regime,17 which would benefit
from an advantageous local tax regime (i.e., the exemption from
tax of dividends and capital gains) and would be regarded as a
Luxembourg resident for tax treaty purposes.18 The income
received by this entity would, therefore, benefit from the
provisions of the applicable tax treaties and could be ultimately
repatriated free of taxation to the investors by way of regular
dividend distributions or the use of hybrid instruments (for
example, convertible bonds redeemed by the issuer at fair
market value, once a capital gain is derived on the sale of FBE at
the end of the investment term).19
Alternatively, HI could invest in FBE through a foreign partnership,
for example, a foreign limited partnership,20 in which case the
comments at Section I.A.2., above would apply.
Finally it should be emphasised that French individuals (residents
of France) are taxed on both their French and foreign-source
income. In this respect, attention should be paid to the tax
regime applicable to the entities constituting the chosen
structure. Specifically, Section 123 bis of the French Tax Code
provides that where a French individual (a resident of France)
holds, directly or indirectly, a participation of at least 10 percent in
an entity formed under a foreign jurisdiction that benefits from a
privileged tax regime as defined in the French tax regulations,21
any profits of the entity are to be regarded as passive income
21
France
21
directly attributable to, and accordingly taxable in the hands of,
the French individual in proportion to his participation in the entity.
2. Preferred structure for a foreign individual
In view of the features of an FCPR and the withholding tax issues
that the use of an FCPR may give rise to in foreign jurisdictions, FI
would not gain any particular advantage from investing in FBE
through an FCPR. However, should FI make his investment through
an FCPR, the FCPR’s foreign-source income would not be
subject to any income or withholding tax in France when it was
redistributed by the FCPR to FI. If any withholding tax was levied
in the source country, FI might be entitled to a reimbursement of
such tax under the tax treaty (if any) between FI’s country of
residence and the source country (this would depend on the
source country recognising the tax transparency of the FCPR).
Preferably, FI should invest through a foreign limited partnership,
FBE being structured either as a corporation or as a partnership,
depending on the constraints on the local business and on the
specific constraints applying to FI.
As noted at Section I.A.2., above, the fund should not be
deemed to have a PE in France as long as the administrative and
commercial management of the fund remains with the seat of
management located abroad.
3. Preferred structure for a French pension fund
As noted above, France has no equivalent of a pension fund.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that for
FI with respect to an investment in FBE, i.e., for PEF to be set up
as a foreign partnership (see Section I.B.2., above). Depending
on the specific constraints applying to FPEN, a corporation
benefiting from an advantageous tax regime could be interposed
between FBE and FPEN.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that for
FPEN with respect to an investment in FBE (see Section I.B.4.,
above).
C. Conclusion as to the overall preferred structure
Considering all investors and investments in both HBE and FBE,
the preferred structure would require the setting up of a FCPR in
which: (1) HI would invest directly; (2) FI, FPEN and FGOV would
invest either directly or through a corporation or a partnership
benefiting from an advantageous tax regime, which would be
interposed between the investors and PEF. Depending on the
predominant character of the investments in HBE or FBE,
consideration could also be given to setting up a parallel structure
alongside the FCPR in which FI, FPEN and FGOV would invest
directly or indirectly, depending on their specific tax constraints.
PEF would itself invest directly in HBE and FBE, although PEF
could alternatively invest in FBE through an interposed
corporation benefiting from an advantageous tax regime (see
Section I.B.1., above).
II. Basic French tax planning for a hedge fund
A. Investment in passive assets generatingFrench-source income
There follows a discussion, separately with respect to each of the
investors, of the preferred structure for French income tax
purposes with respect to investments by HF in passive assets
generating French-source income.
1. Preferred structure for a French individual
French investment vehicles such as basic FCPs, FCIMTs22 and
SICAVs23 are strictly regulated by French law (particularly in terms
of creation and investment quotas) and do not offer full flexibility
in terms of investments.
In light of the above, France has been trying to improve and
develop the legal framework for the activities carried on by hedge
funds, such activities being commonly referred to in France by
the general term “gestion alternative”. This recently resulted in the
creation of three specific investment vehicles: the “OPCVM24 àrègles d’investissement allege” (known as an RIA), the “OPCVMde fonds alternatifs” and the “OPCVM contractuels”.25 Any other
investment vehicle not within the scope of the domestic
regulations would have to be approved by the AMF. These
investment vehicles fall under the umbrella term “Undertakings for
Collective Investment in Transferable Securities” (UCITS), their
legal framework deriving from the E.C. UCITS Directive.26
As such vehicles would benefit from the same tax treatment as a
basic FCP, the rationale guiding the tax structuring of the HEF
investment would be the same as that guiding the structuring of
the PEF investment.
In light of the above, the preferred structure for HI would be the
same as that set forth in Section I.A.1., above, for HI investing in
HBE through PEF, with HEF being set up as a basic FCP or as a
specific investment such as an RIA.
2. Preferred structure for a foreign individual
The preferred structure for FI would be the same as that set forth
above for FI investing in HBE through PEF (the FCPR being
replaced by a basic FCP or a specific investment such as an RIA).
3. Preferred structure for a French pension fund
As noted above, France has no equivalent of a pension fund.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that for
FPEN investing in HBE through PEF (see Section I.A.4., above).
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that for
FI investing in HBE through PEF (see Section I.A.2., above).
B. Investment in passive assets generatingforeign-source income
1. Preferred structure for a French individual
The preferred structure for HI would be the same as that
described at Section I.B.1., above for HI investing in FBE through
PEF (the FCPR being replaced by a basic FCP or a specific
investment such as an RIA).
2. Preferred structure for a foreign individual
The preferred structure for FI would be the same as that for FI
investing in FBE through PEF (see Section I.B.1., above).
3. Preferred structure for a French pension fund
As noted above, France has no equivalent of a pension fund.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that for
HI investing in FBE through PEF (see Section I.B.4., above).
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that for
FI investing in FBE through PEF.
France
22
22
C. Conclusion as to the overall preferred structure
Considering all investors and investments in both passive assets
that generate French-source income and passive assets that
generate foreign-source income, the overall preferred structure,
from a French income tax perspective, would be the same that
for the investors in the PEF scenario (see Section I.C., above).
III. French income taxation of income from acarried interest
Savvy’s “carried interest” constitutes a 20 percent interest in the
profits derived by PEF. The carried interest is actually
compensation to Savvy for the advice he provides to PEF.
As discussed at Section I.A.1., above, in the case of a PEF
investment, a structure using an FCPR would be one of the most
advantageous structures from a French income tax perspective.
Should PEF be structured as an FCPR, Savvy would be a
member of the management company of the FCPR. Provided
certain requirements27 were met, carried interest distributed to the
management team28 would be taxed at the reduced rate of 16
percent (plus social contributions at the rate of 11 percent)
instead of the progressive income tax rate (maximum effective
rate of 40 percent plus 11 percent social contributions).
Other structures offer different possibilities for structuring the
carried interest that can result in the gain on the sale of the
carried interest shares being treated as a capital gain for income
tax purposes (and taxed at the reduced rate of 16 percent plus
social contributions at the rate of 11 percent). However, care
must be exercised in setting up such structures, since the French
tax authorities are increasingly focusing on carried interest
distributed to management teams. The tax authorities frequently
attempt to challenge the capital gain treatment of the carried
interest, particularly on the grounds that the carried interest is
actually compensation for services, and as such, should be taxed
as salary or non-commercial profits at the progressive income tax
rate.
1 In order to comply with the French thin capitalisation rules
2 There is no taxation on gains realised by an FCP provided noindividual, acting either directly or through interposed persons,holds more than 10 percent of the units of the FCP (Code Général
des Impôts (the French General Tax Code or FTC), Section92-D(3)). If the 10 percent threshold is exceeded, the gain realisedby the fund would be taxed at the rate of 16 percent (plus socialcontributions at the rate of 11 percent) in the hands of eachinvestor in proportion to its investment.
3 Except where the investment is lodged in a life insurance contract(in which case favourable tax treatment applies).
4 Capital gains tax would apply at the rate of 16 percent plus socialcontributions at the rate of 11 percent; FTC, Section 150-0A,however, provides that capital gains on securities and similarinstruments are taxed only if the “tax household’s” proceeds fromthe sale of such instruments exceed an annual threshold amount of€20,000 (amount for 2007, revised each year).
5 Funds may take any of a number of forms in France such as anFCP, an FCPI, or an SUIR (an FCPR designed for a sole investor).The FCPR is, however, the vehicle most commonly used to set upa fund in France for a number of reasons, in particular because ofthe tax exemptions granted to French investors in an FCPR wherecertain conditions are fulfilled.
6 See The Guide to Private Equity Fundraising, Private EquityInternational, September 2005
7 Provided the subscription and acquisition of units in the FCPR arerestricted to “qualified investors” (as defined by French law), theFCPR can benefit from a simplified procedure pursuant to which itdoes not itself need to be approved by the AMF.
8 At least 50 percent of the assets of the FCRPR must consist of:■ Quasi-equity or securities of companies (or securities giving
access to the equity of companies) that are not traded on a
financial instruments market operated by a market undertakingor an investment services provider; or
■ Shares of SARLs (limited liability companies) or comparableforeign companies.
9 The limit is 15 percent for shareholder loans granted, for the term ofthe investment made, to companies in which the FCPR holds atleast 5 percent of the equity.
10 The assets of the FCPR can comprise, but only up to a limit of 20percent of the total, equity securities (or securities giving access toequity) issued by companies with a market capitalisation of lessthan €150 million that are traded on a market of the EEA.
11 If the investors hold, as of the date of the sale of the shares of aFrench company, or have held at any time in the past five years,directly or indirectly, shares entitling them to more than 25 percentof the profits of a French company (FTC, Section 244 bis C),withholding tax would apply at the rate of 16 percent, subject tothe application of the provisions of an applicable tax treaty that mayreduce or eliminate such taxation. Recent Administrative guidelines,however, have indicated that, subject to the fulfilment of specificconditions, a favourable tax regime (partial or total exemption ofcapital gains on the sale of shares, depending on the period forwhich the participation is held by the investor, the gain being fullyexempt after an eight-year period) is available not only to Frenchresidents but also to foreign residents.
12 The tax is withheld by the management company and, wheneverpossible, limited to the reduced rate provided for by the applicabletax treaty provided adequate documentation is provided to themanagement company. It should be noted that in this case a foreignresident could, subject to the application of the provisions of anapplicable tax treaty, suffer withholding tax while a French residentwould be tax exempt. To this extent, such taxation could be regardedas discriminatory from the point of view of the foreign resident.
13 Either a disposal of shares by the FCPR when distributed to theforeign investor or a disposal of FCPR shares by the investor.
14 FTC, Section 131 quater. In particular Section 131 quater, providesthat the loan must be concluded abroad, prior to the remittance of thefunds, and that the written loan agreement must expressly provide fora fixed loan amount, the maturity date of the loan and the interest rate.
15 Ministerial Answer to the Senate, Jean Chérioux, Session datedDecember 15, 2003
16 Certain tax treaties, e.g., the France-United Sates tax treaty,expressly address the tax treatment of FCPRs. For U.S. taxpurposes, the FCPR may thus be treated as a partnership provideda proper election is filed.
17 SOPARFI stands for “Société de Participations Financières”.
18 Subject to the provisions of the applicable tax treaty, and inparticular the beneficial ownership requirements of the treatyconcerned
19 When setting-up such a structure, attention should be paid to theprovisions of the E.C. Savings Directive. A ruling should also beobtained from the Luxembourg tax authorities to confirm thetaxation regime that will apply in the case concerned.
20 U.K. limited partnerships are frequently used in this context.
21 FTC, Section 123 bis refers to a privileged tax regime as defined byFTC, Section 238A, i.e., a regime under which the tax that isimposed is less than 50 percent of the tax that would have beenimposed in France (the maximum corporate income tax rate inFrance is currently 34.43 percent).
22 FCIMT stands for “Fonds Commun d’Intervention sur les Marchés
à Terme” (the French equivalent of futures market funds).
23 Unlike an FCP, a SICAV has a separate legal personality.
24 OPCVM stands for “Organisme de Placement Collectif en Valeurs
Mobilières”.
25 Loi sur la Sécurité Financière, dated August 3, 2003 and guidelinesissued by the AMF
26 E.C. Directive 85/611/CE (UCITS I), amended by E.C. Directives2001/107/CE and 2001/108/CE (UCITS III)
27 Finance Law for 2002, Article 78, IV 2001-1275 dated December28, 2001; FTC, Section 163 quinquies B and C; Administrativeguidelines dated March 28, 2002, n° 5-I-2-02
28 All income derived upon the “carried interest” shares (dividend,capital gains) fall into the scope of the distributions eligible to thisregime.
23
France
23
Host CountryGERMANY
Dr. Rosemarie Portner, LL.MPricewaterhouseCoopers, Düsseldorf
Before Dr. Rosemarie Portner, LL.M. joined private
practice as a lawyer and tax adviser in 1993 she worked
as a civil servant for several State and Federal tax
authorities, most recently the Federal Ministry of Finance
in the Tax Counsel International’s office. Her areas of
practice comprise in particular employee benefits and
pensions with a focus on cross-border transactions, as
well as international taxation (at the time she worked as
a civil servant she was member of the German
delegation which negotiated the German/U.S. Treaty of
1989). She has published numerous articles and lectured
frequently in German and English language in her
practice areas.
I. Introduction
A. Current debate
Germany is currently in the throes of a debate as to whether
private equity investments and more precisely, venture capital,
should be promoted. The two political parties forming the
current German government agreed in their Coalition
Agreement of November 11, 2005 (Koalitionsvertrag) to
improve the framework conditions for private equity investors,
management and target companies. However, the trade
unions have attacked the draft Act for the Modernisation of
the Framework Conditions for Equity Investments (Gesetz zurModernisierung der Rahmenbedingungen für Kapitalbeteilig-ungen or MoRAKG), which the German Government
submitted on June 29, 2007. The draft Act is based on a
research study entitled “Acquisition, and Take-Over of
Companies by Financial Investors (in particular Private Equity
Companies)” (“Erwerb und Übernahme von Firmen durchFinanzinvestoren (insbesondere Private Equity-Gesellschaften)”)
prepared by the Technical University of Munich (TU München)
on behalf of the German government. The German
government sees the potential for the development of private
equity investment in Germany in terms of the ratio of the
volume of venture capital investments to the volume of gross
domestic product and refers to research carried out by PwC
that ranks Germany fifth in an international survey in terms of
investment volume attributable to venture capital. The draft
Act takes into account the amendments to individual and
corporate income tax and the trade tax contained in the
Business Tax Reform Act 2008.
The trade unions are concerned that the draft Act may afford
opportunities for the adoption of sophisticated schemes
allowing (ordinary) middle market companies to deploy tax
privileges in an unintended manner. In the trade unions’ view,
tax privileges should, therefore, be expressly confined to
venture capital companies while all other capital investment
companies should be subjected to the general tax provisions.
B. Rationale behind the Government initiative
The German Government explained the rationale behind its
initiative to promote private equity in a paper of May 9, 2007
as follows:
The draft Act has three aims: (1) to enact the Venture Capital
Act (Wagniskapitalbeteiligungsgesetz or WKBG)); (2) to
revise the existing Private Equity Act (Gesetz über
Unternehmensbeteiligungsgesellschaften or UBGG); and (3)
to take measures to limit the risks associated with the
activity of financial investors.
Unlike venture capital companies, private equity companies
are permitted to invest in target companies, whether listed on
a stock exchange or not, that do not have to meet further
requirements with regard to their age or the volume of their
equity capital, and are also permitted to invest in any type of
company, including commercial partnerships. As private
equity funds (as the term is understood for purposes of this
article) rarely make use of this form of company, preferring
instead to use the form of a venture capital company, the
following summary of the draft Act does not address the
measures intended to revise the existing Private Equity Act.
Nor does the summary deal with part three of the draft Act,
which introduces measures designed to eliminate, or at least
minimise, the harmful effects on financial investors by
addressing, among other things, persons “acting in concert”,
transparency relating to security lending , security trading
notices and information on substantial shareholdings. These
measures are directed particularly at hedge funds, which in
Germany have been admitted for public offering to private
investors, generally as umbrella funds (and under certain
circumstances, single hedge funds) since January 1, 2004.
Such funds are covered by the Investment Act and the
Investment Tax Act.
C. Summary of the draft Venture Capital Act
To qualify as a “venture capital company” (Wagniskapital-
beteiligungsgesellschaft), a company must have a purpose
that is confined to the holding of shares in corporations.
More precisely, a venture capital company must invest at
least 70 percent of its funds in target companies that are:
(1) not listed on a stock exchange; (2) are no older than 10
years (a former version of the draft Act provided for a
maximum age of seven years); and (3) have equity capital of
not more than €20 million (a former version of the draft Act
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provided for a maximum equity capital of €500,000) at the
time the shares are acquired. The shares must not be held
for more than 15 years; after an Initial Public Offering (IPO)
shares must not be held for more than three years. Further,
the shareholding of the venture capital company in the
target company is limited to 90 percent. No specific
requirements apply to the target company in terms of
company purpose (for example, new technology).
The draft Venture Capital Act contains the measures that
apply at the level of: (1) the venture capital company; (2) the
management of the venture capital company; and (3) the
target company.
1. Level of venture capital company
a. Legal form
Private equity funds (PEFs) are mostly organised in the form
of a limited liability partnership with a corporation as
general partner, the investors being limited liability partners
(GmbH & Co. Kommanditgesellschaft, KG). To avoid liability
to trade tax being triggered merely because of the
participation of the GmbH, the statutes generally provide
that a limited liability partner may manage the partnership
instead of or in addition to the GmbH. If the management
were left exclusively to the GmbH or a third party, merely
because of its legal structure, the partnership would be
deemed to be carrying on commercial business irrespective
of whether it actually administered property.
If a limited liability partnership is not deemed to be carrying
on commercial business because of its legal structure, the
activity of the partnership may be regarded as either the
administration of property (Vermögensverwaltung) or
commercial business (gewerbliche Tätigkeit). The criteria for
determining whether a partnership is to be deemed to be
administering property or carrying on commercial business
are set out in the administrative ordinance of December 16,
2003 (Einkommensteuerliche Behandlung von Venture
Capital und Private Equity Fonds; Abgrenzung der privaten
Vermögensverwaltung vom Gewerbebetrieb). A partnership
is deemed to be administering private property if its activity
is concentrated on the generation of capital yields. The
assumption that a partnership is carrying on a commercial
business, on the other hand, requires the existence of an
ongoing activity undertaken to generate profits and
participation in the market. This requirement is deemed to
be met, for example, if an office is maintained and funds
are loaned rather than capital being used. Accordingly, if
PEF finances the acquisition of the shares in the target
company out of its own funds it may qualify as
administering property if certain other conditions are met.
On the other hand, PEF will be deemed to carry on a
commercial business if it participates in a partnership that
itself carries on a commercial business (a “double layer”
partnership). From this it follows that PEF should acquire
shares in a corporation rather than a commercial
partnership, which would “taint” PEF.
b. Exemption from trade tax
To encourage investment in German target companies,
venture capital companies are to be exempted from
German trade tax irrespective of whether they administer
property or carry on a commercial business. Under existing
law, companies that carry on commercial business activities
are subject to trade tax whether they are organised as a
corporation or a partnership. However, trade tax does not
apply to partnerships that merely administer property. The
exemption from trade tax of all partnerships, whether they
administer property or carry on a commercial business,
would be an important improvement. In that respect, the
draft Venture Capital Act would follow the
recommendations of the research paper prepared by the
University of Munich, but only for venture capital companies
organised as partnerships and not for other private equity
companies or corporations.
c. Avoidance of taxation at partnership level – transparency
principle
Venture capital companies are not taxed if they are
organised as a partnership that, in accordance with
German tax principles, is not treated as a taxable subject
but as a transparent entity. Income generated by
partnerships that qualify as administering property is taxed
in the hands of their partners and according to the tax
status of the partners, i.e., as either private capital gains,
dividends or business income. On the other hand, if a
partnership carries on a commercial business, the income
attributable to its partners and taxable in their hands is
always regarded as income from trade or business. This
means, for example, that capital gains from the sale of
shares are taxable, currently at the rate of 50 percent and,
after 2008, at the rate of 60 percent. Under the draft
Venture Capital Act, a venture capital company organised
as a partnership would always be deemed to administer
property.
d. Exemption for corporations
Under existing law, capital gains from the sale of a
shareholding in a corporation are exempt from tax, except
that 5 percent of the income is deemed to be
non-deductible expenses related to tax exempt income if
the seller is a corporation. Dividends distributed by one
corporation to another are taxed in a similar manner.
Consequently, 95 percent of capital gains from the sale of
shares in a corporation and 95 percent of dividends are tax
exempt. In this respect, the draft Act provides no additional
relief.
2. Level of management
Under the existing rules, profits distributed by the target
company to the managers of a PEF (that qualifies as
administering property) after profits are distributed to the
remaining shareholders (“carried interest”) are 50 percent
tax-exempt. The draft Venture Capital Act reduces this
exemption to 40 percent. However, the 40 percent
exemption is not confined to managers of companies that
qualify as administering property, but is also available to
managers of partnerships that carry on a commercial
business.
3. Level of target company
The draft Company Tax Act 2008 (Unternehmenssteuer-
reformgesetz 2008) provides for a further tightening of
the provision governing corporations’ utilisation of
losses, in particular through the acquisition of shell
companies. Currently, a corporation can no longer use its
losses to offset profits if it loses its identity. A loss of
identity is assumed to occur if more than 50 percent of
the shares in the corporation are transferred and the
corporation continues or restarts its business with
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predominantly new business assets. Generally, as of
2008, merely the direct or indirect transfer of the
requisite percentage of shares and similar transactions
will prevent losses being utilised. Because the intended
amendment of the loss utilisation rule would affect
start-up companies, the draft Venture Capital Act
excludes target companies from its scope of application.
If a venture capital company acquires shares in a target
company, losses are not forfeited but can be used over a
period of five years if the venture company holds the
shares for at least four years.
To prevent the abuse of the new rules, the draft Venture
Capital Act requires formal admission of venture capital
companies by the Federal Agency for Financial Services
Supervision (Bundesanstalt für Finanzdienstleistungs-
aufsicht or BaFin) and control.
Lobbying groups (including the Liberal Party), and the
research paper of the Technical University of Munich,
argued for the extension of the tax privileges described
above, in particular the general exemption from trade tax,
to all private equity funds, including those that do not meet
the requirements for qualifying as venture capital
companies. This demand is not (currently) met in the draft
Venture Capital Act because of the estimated loss of tax
revenue. However, the tax allowance granted with respect
to capital gains from the sale of shareholdings amounting to
1 percent or more of a corporation’s capital is to be
increased from €9,060 to €20,000 for “business angels”.
Finally, it should be noted that, on May 31, 2007, the
Federal Ministry of Finance published a decree explaining
that management services would be subject to German
value added tax (VAT). This administrative decree has,
however, been revoked.
II. Basic German tax planning for a privateequity fund
A. Investment in a German business entity
With respect to an investment by PEF (which is not a
venture capital company) in a German business entity
(HBE), there follows a discussion, separately with respect to
each of the investors, of the preferred structure for German
income tax purposes. The discussion takes into account
the amendments to the Income Tax Act made by the
Business Tax Reform Act 2008. The Business Tax Reform
Act 2008 has been approved by the two chambers of
German Parliament and will become effective as of January
1, 2008.
The preferred structure and its tax implications can be
summarised as follows:
■ HBE should be organised as a corporation.
■ PEF should be organised as a partnership that
administers property instead of carrying on a commercial
business.
■ Assuming that PEF receives capital gains, dividends or
interest from the sale of shares in HBE it does not
matter whether PEF is formed under German law or
foreign law.
■ If PEF administers property and does not carry on a
commercial business, it does not matter whether PEF
has its management office in Germany or elsewhere.
■ A German individual (HI) or a foreign individual (FI) should
make investments in PEF directly and not through a
corporation.
■ If a corporation is interposed between HI/FI and PEF
(indirect investment), it no longer matters whether PEF is
organised as a partnership that administers property or
one that carries on a commercial business. Retaining
profits at the level of the interposed corporation could be
used to defer tax, particularly from 2008, when the
corporate tax rate will be reduced.
■ FI may prefer to invest in a PEF that administers property
in order to avoid any tax liability in Germany as a partner
in a commercial partnership who is deemed to have a
permanent establishment (PE) in Germany, as well as the
withholding tax on dividends that would be imposed were
PEF to be organised as a corporation or were a
corporation to be interposed. Capital gains and dividends
will generally be taxable abroad and not subject to tax in
Germany (subject in the case of dividends, to the
imposition of withholding tax) if there is an applicable tax
treaty between Germany and FI’s country of residence.
■ If the investor is a corporation, including a pension fund
that is organised as a German stock corporation, and
PEF a partnership administering property, capital gains
and dividends are 95 percent tax exempt. In applying a
fractional approach, the assets of a partnership that
administers property are attributed to the partners in
proportion to their interests in the partnership, so that a
corporate investor, including a pension fund, may also
prefer to have the PEF organised as a partnership
administering property rather than as a corporation or a
commercial partnership.
■ If the investor is a foreign corporation and there is a tax
treaty between Germany and the foreign corporate
investor’s country of residence, capital gains and
dividends will generally be taxable in the foreign country
and not in Germany (subject in the case of dividends to
the possible imposition of German withholding tax) if
PEF is organised as a partnership administering private
property or as a corporation. Such an investor may
therefore prefer PEF to be structured as a partnership
that administers private property or a corporation rather
than as a partnership carrying on a commercial
business.
■ Assuming that the investment does not constitute
governmental activity, the same rules will apply to an
investment of the government in PEF as would apply if
the investor were an individual holding a participation in a
PEF that carries on commercial business.
■ The remarks in the previous bullet will also apply if the
investor is a foreign government (FGOV).
In light of the above, the overall preferred structure for the
purpose of minimising taxation under Germany’s income
tax law and taking into account all the different kinds of
investors would be to have PEF organised as a
partnership that administers property. If PEF were so
organised, there would be only one level of tax, the nature
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of that tax being determined by the individual tax status of
each investor.
1. Preferred structure for a German individual
a. Private equity fund is a partnership administering property
German individual holds a direct interest in private equity fund
In such a structure there would be only one level of tax – at
the level of HBE, which is taxed as a corporation.
HBE is currently subject to corporate income tax at the rate
of 25 percent (plus 5.5 percent solidarity surcharge) and to
trade tax, the rate of which varies depending on the
leverage rate applied by the respective municipality where
HBE has its registered seat. The combined tax burden is
40.863 percent if one assumes a municipal leverage rate of
490 percent (which applies, for example, in Munich) and
34.263 percent if one assumes a municipal leverage rate of
240 percent (which applies for, example, in Grünwald, a
small town just outside of Munich).
Under the Business Reform Tax Act, the corporate tax rate
will be reduced from 25 percent to 15 percent, so that the
rate of corporate income tax including the solidarity
surcharge will be 15.83 percent. Unlike under the current
law, from 2008 trade tax will no longer be treated as a
deductible business expense but the basic trade tax
multiplier will be reduced from 5 percent to 3.5 percent.
Thus, the total tax burden will be 32.975 percent (assuming
a municipal leverage rate of 490 percent) and 24.225
percent (assuming a municipal leverage rate of 240
percent).
If PEF disposes of its participation in the target company,
the capital gains thereon are tax exempt under the existing
law, assuming that HI’s indirect shareholding in HBE is less
than 1 percent of HBE’s equity capital, is held as private
property and is held for more than one year.
Under the Business Tax Reform Act 2008, as of January
2009, “private” capital gains will no longer be tax exempt.
Instead, a flat 25 percent rate of taxation of (plus 5.5
percent solidarity surcharge, giving an effective rate of
26.375 percent) will apply to a shareholding acquired after
December 31, 2008 if there is a shareholding of less than 1
percent held as a private asset. The flat rate taxation does
not require the asset to have been held for a particular (for
example, one year) period.
In the scenario envisaged, no trade tax is levied on PEF
because PEF administers property and does not carry on a
commercial business.
Interest would, generally, be subject to the same flat rate
taxation of 25 percent (plus solidarity surcharge). However,
under anti-abuse rules, flat rate taxation does not apply in
certain circumstances (for example, if the interest is paid in
connection with a loan agreement among related parties, if
the interest is paid by a corporation to a shareholder
holding 1 percent or more of the corporation’s capital, or if
the interest is attributable to independent services, letting
or renting, etc.) In such circumstances, interest payments
made by HBE to PEF would be taxed at the regular tax
rate, which is currently 45 percent (plus solidarity
surcharge, giving an effective rate of 47.475 percent).
If PEF is a foreign partnership that, after being evaluated by
the German revenue authorities, is deemed to administer
property and that does not have a PE abroad, the tax
consequences for HI would be the same as the
consequences of investing in a domestic PEF. Capital gains
from the disposal of a shareholding are generally taxed in
the alienator’s country of residence (in accordance with
Article 13(5) of the OECD Model Convention), in this case
Germany. The same rule generally applies to dividends. If
dividends are subject to withholding tax in the country of
source, the foreign tax paid is generally creditable against
the German tax payable on the (foreign-source) dividends.
German individual holds an indirect interest in private equity fund
The interposed corporation is currently subject to corporate
income tax and trade tax at the combined effective rate of
40.863 percent (490 percent municipal leverage rate) or
34.263 (240 percent municipal leverage rate). With effect
from 2008, these rates will fall to, respectively, 32.975
percent and 24.225 percent, as explained above.
The income received by the interposed corporation is also
subject to trade tax; the trade tax exclusion which applies
to a shareholding in a commercial business does not apply
because the PEF is structured as a partnership which
administers property and does not carry on a commercial
business.
Capital gains derived by the interposed corporation from
the alienation of shares in HBE held indirectly by PEF are
tax exempt to the extent of 95 percent (see above). The
exemption also applies for trade tax purposes. Capital
gains are thus currently taxed at the effective rate of 2.043
percent (490 percent municipal leverage rate) or 1.713
percent (240 percent municipal leverage rate), and will be
taxed with effect from 2008 at the rate of 1.649 percent
(490 percent municipal leverage rate) or 1.211 percent (240
percent municipal leverage rate). Interest received is
currently taxed at the rate of 40.863 percent (490 percent
municipal leverage rate) or 34.263 percent (240 percent
municipal leverage rate) and will be taxed at the rate of 32.
975 percent (490 percent municipal leverage rate) or
24.225 percent (240 percent municipal leverage rate) after
the Business Tax Reform Act 2008 enters into effect. Thus
it can be seen that the amendments made by the Business
Tax Reform Act 2008 are beneficial to the interposed
corporation. Because of the reduced tax burden on
corporations, retaining profits in the corporation will have a
tax deferral effect.
Distributions made on or after January 1, 2009 will no
longer be subject to the “half income” regime under which
the tax rate is effectively 23.738 percent (investor’s marginal
tax rate of 45 percent plus 5.5 percent solidarity surcharge
on half of the dividends) but to a flat rate of 26.375 percent
(25 percent income tax plus 5.5 percent solidarity
surcharge on the full amount of the gross dividends). From
this it follows that, when the interposed corporation
distributes capital gains to HI, there will be an increase in
HI’s tax burden from 25.296 percent (490 percent municipal
leverage rate) or 25.044 percent (240 percent municipal
leverage rate) to 27.589 percent (490 percent municipal
leverage rate) or 27.267 percent (240 percent municipal
leverage rate), respectively.
Interest payments derived by the interposed corporation will
benefit from the amendments made by the Business Tax
Reform Act. Such payments are currently taxed at the rate
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of 54.901 percent (490 percent municipal leverage rate) or
49.868 percent (240 percent municipal leverage rate) and,
as of 2008, will be taxed at the rate of 50.653 percent (490
percent municipal leverage rate) or 44.211 percent (240
percent municipal leverage rate).
If the interposed corporation were to hold an interest in a
foreign PEF that is organised as a partnership that
administers property and does not have a PE abroad, the
tax consequences would be the same as described above
(i.e., where the interposed corporation holds an interest in a
domestic PEF), assuming that generally no taxes are levied
in the foreign country where the foreign PEF is resident.
b. Private equity fund is a partnership carrying on commercial
business
German individual holds a direct interest in private equity fund
Unlike a partnership that administers property, a German
commercial partnership is subject to trade tax which,
however, can be offset against the income tax payable by
HI as an investor.
Unlike those derived by a partnership that administers
property, capital gains derived by a commercial partnership
are not exempt from tax but (currently) are taxed under the
“half income” regime. Interest is fully taxable. As of 2008,
dividends will be exempted to the extent of only 40 percent
(“partial income” procedure) instead of, as currently, to the
extent of 50 percent, to take into account the reduction in
the corporate income tax rate from 25 percent (plus
solidarity surcharge) to 15 percent (plus solidarity
surcharge).
The result is that capital gains will be taxed with effect from
2008 at a rate of 30.356 percent (490 percent municipal
leverage rate) or 28.208 percent (240 percent municipal
leverage rate) (as compared with the current rate of 23.821
percent or 20.900 percent, respectively).
Interest is currently taxed at a rate of 47.643 percent (490
percent municipal leverage rate) or 41.799 percent (240
percent municipal leverage rate). As of 2008, the tax rate
increases to 50.594 percent (490 percent municipal
leverage rate) or 47.013 percent (240 percent municipal
leverage rate). The reason for the rate increase is that, as of
2008, a marginal income tax rate of 45 percent applies not
only to high net worth individuals but also entrepreneurs
(“Reichensteuer” or the “rich persons’ tax”), instead of the
regular marginal income tax rate of 42 percent.
If PEF were a foreign partnership, it would not be subject to
German trade tax. With effect from 2008, the rate of tax on
capital gains in the hands of HI would increase from 22.155
percent by 6.33 percentage points to 28.485 percent, as
only 40 percent of the capital gains would be exempt from
tax (as opposed to the current 50 percent). With effect from
2008, interest would be taxed at the rate of 47.475 percent
as compared to the current rate of 44.31 percent, an
increase of 3.165 percentage points, attributable to the
increase in the marginal tax rate applying to high net worth
individuals from 42 percent to 45 percent (see above).
German individual holds an indirect interest in private equity fund
The tax consequences would be the same as those where
an indirect investment is made in a PEF that administers
property, because the interposed corporation is subject to
corporate income tax and trade tax (see Section II.A.1.a.,
above).
c. Private equity fund is a corporation
German individual holds a direct interest in private equity fund
Where PEF is organised as a corporation, capital gains that
it derives from the alienation of shares in HBE are tax
exempt to the extent of 95 percent (see Section II.A.1.a.,
above). The exemption also applies for trade tax purposes.
The total tax burden, depending on where the company has
its registered seat, is currently 40.863 percent (490 percent
municipal leverage rate) or 34.263 percent (240 percent
municipal leverage rate) and will be 32.975 percent (490
percent municipal leverage rate) or 24.225 percent (240
percent municipal leverage rate) respectively, when the
Business Tax Reform Act 2008 enters into effect. Capital
gains are thus currently taxed at the rate of 2.043 percent
(490 percent municipal leverage rate) or 1.713 percent (240
percent municipal leverage rate) and, with effect from 2008,
will be taxed at the rate of 1.649 percent (490 percent
municipal leverage rate) or 1.211 percent (240 percent
municipal leverage rate) respectively.
Interest is currently taxed at the rate of 40.863 percent (490
percent municipal leverage rate) or 34.263 percent (240
percent municipal leverage rate) and, with effect from 2008,
will be taxed at the rate of 32.975 percent (490 percent
municipal leverage rate) or 24.225 percent (240 percent
municipal leverage rate) respectively.
Because of the reduced tax burden on corporations,
retaining profits in the corporation will have a tax deferral
effect.
Distributions made on or after January 1, 2009 will no
longer be taxed using the “half income” procedure, but will
be taxed at the flat rate of 26.375 percent (25 percent
income tax plus 5.5 percent solidarity surcharge on the full
amount of the gross dividends). From this it follows that,
when the corporation (PEF) distributes capital gains to HI,
there will be an increase in HI’s tax burden from 25.296
percent (490 percent municipal leverage rate) or 25.044
percent (240 percent municipal leverage rate) to 27.589
percent (490 percent municipal leverage rate) or 27.267
percent (240 percent municipal leverage rate), respectively,
as explained above.
In certain circumstances (i.e., where there is a low level of
taxation in the corporation’s country of residence and it has
“income with a capital investment character” – “Einkünfte
mit Kapitalanlagecharackter”), German sub-part F-type
legislation (Hinzurechnungsbesteuerung nach AStG) may
apply to interest payments derived by PEF, if PEF is a
corporation not resident in the European Union or the
European Economic Area; this legislation does not,
however, apply to dividends.
German individual holds an indirect interest in private equity fund
An interposed corporation would benefit from the reduction
of the trade tax with effect from 2008 with respect to
distributions made to it by a PEF organised as a
corporation, as generally it would not meet the requirement
for such dividends to be exempt from trade tax (i.e., holding
a participation of at least 10 percent in PEF). Dividends are
currently taxed at the rate of 40.303 percent (490 percent
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municipal leverage rate) or 33.376 percent (240 percent
municipal leverage rate) and, with effect from 2008, will be
taxed at the rate of 40.007 percent (490 percent municipal
leverage rate) or 33.215 percent (240 percent municipal
leverage rate) respectively. However, as capital gains would
constitute the main part of the corporation’s income, the
benefit from the decrease in the rate of trade tax would be
minor.
2. Preferred structure for a foreign individual
a. Private equity fund is a partnership administering property
Foreign individual holds a direct interest in private equity fund
Assuming that FI’s indirect shareholding is less than 1
percent of HBE’s equity capital, neither capital gains arising
from the sale of shares by PEF nor interest paid by HBE to
PEF are subject to German tax, irrespective of the
existence of an applicable tax treaty, because there is no
provision allowing such income to be taxed within the
framework of limited tax liability.
The introduction of the flat rate taxation of capital gains as
provided for in the Business Tax Reform Act 2008 should
not have a negative impact on foreign investors. In addition,
the reduction of the corporate income tax rate from 25
percent (plus solidarity surcharge) to 15 percent (plus
solidarity surcharge) should make investment more
attractive to foreign investors after the Business Tax Reform
2008 takes effect.
Foreign individual holds an indirect interest in private equity fund
FI should be able to benefit from the lower tax burden to
which the interposed corporation is subject. The
disadvantages resulting from the abolition of the “half
income” regime and the introduction of flat rate taxation
should generally not affect FI, who will be taxed on
dividends and interest in his country of residence if there is
an applicable tax treaty between Germany and that country,
unless FI’s shareholding in the interposed corporation were
to be attributable to a German PE of FI.
However, dividends distributed by the interposed German
corporation would be subject to German withholding tax,
currently at the rate of 20 percent (plus 5.5 percent
solidarity surcharge) and, with effect from 2008, at the rate
of 25 percent (plus solidarity surcharge). Where there is an
applicable tax treaty between Germany and FI’s country of
residence, the withholding tax rate will generally be reduced
to 15 percent (including solidarity surcharge) and the
withholding tax will generally be creditable against FI’s tax
liability in his country of residence.
b. Private equity fund is a partnership carrying on commercial
business
Foreign individual holds a direct interest in private equity fund
FI would be subject to German tax irrespective of the
existence of an applicable tax treaty between Germany and
FI’s country of residence, because FI would be deemed to
have a German PE. In these circumstances the tax
consequences would be the same as those for HI (see
Section II.A.1.b., above).
Foreign individual holds an indirect interest in private equity fund
The tax consequences would be the same as those where
an indirect investment is made in a PEF that administers
property, because the interposed corporation is subject to
corporate income tax and trade tax (see Section II.A.2.a.,
above).
c. Private equity fund is a corporation
Foreign individual holds a direct interest in private equity fund
FI should be able to benefit from the lower tax burden to
which a PEF organised as a corporation is subject. The
disadvantages resulting from the abolition of the “half
income” regime and the introduction of flat rate taxation
should not affect FI, who will be taxed on dividends and
interest in his country of residence if there is an applicable
tax treaty between Germany and that country.
However, dividends distributed by a PEF organised as a
corporation would be subject to German withholding tax,
currently at the rate of 20 percent (plus 5.5 percent
solidarity surcharge) and, with effect from 2008, at the rate
of 25 percent (plus solidarity surcharge). Where there is an
applicable tax treaty between Germany and FI’s country of
residence, the withholding tax rate will generally be reduced
to 15 percent (including solidarity surcharge) and the
withholding tax will generally be creditable against FI’s tax
liability in his country of residence.
Interest payments derived by a PEF organised as a
corporation would benefit from the amendments made by
the Business Tax Reform Act 2008. Currently, such
payments are taxed at the rate of 54.901 percent (490
percent municipal leverage rate) or 49.868 percent (240
percent municipal leverage rate). As of 2008, they will be
taxed at the rate of 50.653 percent (490 percent municipal
leverage rate) or 44.211 percent (240 percent municipal
leverage rate).
3. Preferred structure for a German pension fund
German pension funds are generally organised as stock
corporations. If HPEN is organised as a German stock
corporation and PEF as a partnership administering
property, capital gains and dividends will be 95 percent tax
exempt. In applying a fractional approach, the assets of a
partnership that administers property are attributed to the
partners in proportion to their interests in the partnership,
so that HPEN may prefer to have the PEF organised as a
partnership administering property rather than as a
corporation or a commercial partnership.
4. Preferred structure for a foreign pension fund
The tax consequences would be the same as those where
the investment is made by FI (see Section II.A.2.a., above).
5. Preferred structure for a foreign government
A distinction is made between the circumstances in which
FGOV is carrying on governmental activities and those in
which it is participating in the market in the same way a
private company would. Assuming that the investment does
not constitute governmental activity, the same rules will
apply to an investment of FGOV in PEF as would apply if
the investor were a foreign individual holding a participation
in a PEF that carries on commercial business.
B. Investment in a foreign business entity
Assuming FBE is organised as a corporation, the tax
consequences would be the same as those described at
Section II.A., above. Capital gains from the sale of shares in
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a corporation are taxed in the same manner, irrespective of
whether the corporation is a domestic or a foreign
corporation, provided there is an applicable tax treaty
between Germany and the foreign country concerned. The
same holds true in relation to the taxation of dividends. The
foreign withholding tax would be creditable against the
German tax liability. Interest would also be taxable in
Germany as the investor’s country of residence. The tax
consequences would therefore differ, depending on
whether PEF was taxed as a German property
administering partnership or as a commercial partnership or
was organised as a corporation.
If FBE were to be organised as a partnership, the German
investor or, respectively an interposed corporation, would
be deemed to generate foreign-source business income
that would generally be taxable abroad and exempt in
Germany as the investor’s country of residence.
C. Overall preferred structure
In light of the above discussion, the overall preferred
structure for the purpose of minimising taxation under
Germany’s income tax law, taking into account the various
investors and PEF’s investments in both HBE and FBE,
would be to have PEF organised as partnership that
administers property. If PEF were so organised, there would
be only one level of tax, the nature of that tax being
determined by the individual tax status of each investor.
III. Basic German tax planning for a hedgefund
The rules for the taxation of income derived through hedge
funds are set out in the Investment Act and apply to
domestic and foreign funds alike.
There are three distinct levels relevant to the taxation of the
holder of a unit in a fund: (1) the capital investment
corporation (Kapitalanlagegesellschaft); (2) the special fund
(Sondervermögen); and (3) the unit holder
(Anteilscheininhaber).
A special fund qualifies as corporation but is exempted
from corporate tax, so that capital gains and dividends
derived by the special fund are taxed in accordance with
the rules that would apply had the unit holder invested
directly and derived the income himself (transparency
principle). The same rules apply where the investor returns
or sells the units he holds, so that in these circumstances
the investor will be taxed on an “intermediate gain”
(Zwischengewinn), which has the effect of taxing interest
that the fund received during the fiscal year concerned.
The investor is taxed on distributions and on distributable
income that is deemed to have been received at the end of
the fiscal year in which the income was generated; the
latter, however, currently does not include capital gains
from the sale of shares. Similarly, capital gains are exempt
from tax if actually distributed to the unit holder. However,
unit holders who hold their investment as a business asset
(i.e., single entrepreneurs, partnerships or corporations) are
excluded from the exemption for capital gains. Such unit
holders are taxable on capital gains in accordance with the
generally applicable rules, (i.e., they are taxable on half
(after the entry into effect of the Business Tax Reform Act
2008, 60 percent) of the capital gains, or in the case of
corporations, they are entitled to an exemption to the
extent of 95 percent of the capital gains). The receipt of
taxable income triggers trade tax.
Where a fund derives foreign-source income, such income
is tax exempt at the level of the fund if it would have been
exempted from German tax under an applicable tax treaty
had the unit holder derived the respective income directly.
Foreign taxes paid by the fund can be credited by the unit
holder against his income tax payable, except to the extent
that the income concerned is exempt from German tax;
thus, foreign withholding tax on foreign-source dividends
only 50 percent of which are taxable is only creditable at
the rate of 50 percent.
The income constitutes either business income or
investment income in the hands of the unit holder. Where
the fund is a foreign fund organised as a corporation, the
income would be taxed as either dividends or capital gains.
To summarise, although the fundamental rules governing
the taxation of hedge funds are similar to those governing
the taxation of a PEF organised as a partnership
administering property, there are some disadvantageous
differences, for example, in relation to the deductibility of
expenses.
IV. German income taxation of income from acarried interest
With regard to income from a carried interest that exceeds
the profit share attributable to Savvy’s interest in PEF, Savvy
cannot benefit from the (current) exemption of capital gains
from the sale of private assets (as of 2009, flat rate
taxation) or the (current) “half income” procedure (as of
2009, “partial income” procedure) or the 95 percent
exemption applying to dividends. Currently, 50 percent of
income from a carried interest is taxed at the ordinary rate;
the 50 percent exemption will be reduced to 40 percent as
of 2008, but the exemption will apply (under the draft
Venture Capital Companies Act) irrespective of whether
Savvy manages a PEF that is organised as a partnership
that administers property or as a partnership that carries on
a commercial business. This rule would not apply to income
from services Savvy renders to a hedge fund (i.e., as
counsel). Consequently such income would be fully taxable
at the ordinary rate.
Germany
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30
Host CountryITALY
Carlo GalliMaisto e Associati, Milan and London
Carlo Galli is a partner with Maisto e Associati and has
been practising Italian tax law in the Milan and London
offices of the firm since 1995, after having worked for
two years as a research associate at the IBFD in
Amsterdam.
I. Introduction
This paper will discuss possible structures involving the
establishment of domestic and “foreign” investment vehicles.
In relation to a “foreign” investment vehicle, it is important to
be aware of who makes the necessary investment decisions
and where those decisions are made, as these factors can
have a significant impact on where the vehicle is regarded as
a resident for tax purposes. In the scenario under
consideration, it is assumed that Savvy is an Italian person
and that Savvy makes the investment decisions for PEF. For
performing this function, Savvy is remunerated by way of a 20
percent carried interest.
Where Italy is the host country and PEF is structured as a foreign
investment vehicle, the question arises whether the residence of
PEF for tax purposes would be deemed to be in its jurisdiction of
establishment or in Italy, where the effective place of
management of PEF would be located. In this connection, it
should be noted that, under Italian tax law, a foreign entity (such
as a private equity fund established under foreign law) that
controls an Italian entity (such as HBE) will be deemed to be a
resident of Italy for tax purposes, unless proof to the contrary is
provided, if it is either: (i) controlled, directly or indirectly, by an
Italian resident person; or (ii) managed by a management body,
the majority of which consists of Italian resident persons.
Applying this rule to the scenario under consideration, if PEF is
established under foreign law and actually managed and
controlled by Savvy and if PEF holds the majority of the voting
rights in HBE, PEF may be regarded as a resident of Italy for tax
purposes unless proof to the contrary is provided. Such proof
could take the form of documentation showing that PEF is
actually managed and controlled outside Italy, but this would not
be the case if Savvy were to make the investment decisions.
Traditionally, in cases where the investment knowledge was (at
least partially) derived from individuals operating in Italy, their
contribution would be provided in the form of an advisory
function carried out for the benefit of the body that had the actual
power to make the investment decisions (typically the governing
body of the management company). The governing body would
normally convene outside Italy to make necessary investment
decisions. However, it should be noted that such arrangements
have sometimes been misused to conceal the reality that what is
labelled an advisory function is, as a matter of fact, a
decision-making function. The Italian tax authorities are aware of
such practices and are increasingly challenging the foreign
residency status of vehicles used to invest into Italy.
Notwithstanding the above discussion, unless otherwise
specified, it should be assumed for purposes of this paper that,
where a foreign investment vehicle is referred to, the relevant
investment decisions are actually and predominantly made
outside Italy.
II. Basic Italian tax planning for a privateequity fund
A. Investment in an Italian business entity
1. Preferred structure for an Italian individual
From the perspective of HI, the main alternatives would be to
invest in HBE through a domestic or foreign entity or through a
domestic or foreign collective investment undertaking.
If the investment is made through an entity (including a
partnership), the tax consequences for HI will normally be the
same whether the entity is domestic or foreign (provided it is not
established in a tax haven jurisdiction). It would be unusual for
PEF to be structured as a domestic partnership since domestic
partnerships are treated for tax purposes on a look-through
basis. Foreign partnerships, on the other hand, are invariably
regarded as “opaque” entities, and thus treated for tax purposes
in the same way as foreign companies with legal personality.
If PEF is structured as an Italian company (or as a foreign
partnership or company), HI will be subject to the following tax
regime:
■ If HI’s investment interest does not represent more than
20 percent of the voting rights or 25 percent of the capital
of the investment vehicle, both dividends and capital
gains derived by HI would be subject to a 12.5 percent
substitute tax (the rate of the substitute tax may be
increased to 20 percent under the reforms that are to be
introduced by the current Government).
■ If HI’s investment interest exceeds the above percentage
thresholds, dividends and capital gains derived by HI
would be included in HI’s taxable income subject to
individual income tax at progressive rates (of, currently, up
to 43 percent), but only to the extent of 40 percent of the
respective amount of such dividends and gains, resulting
in a maximum effective rate of 17.2 percent (again, the
projected reform of the taxation of the investment income
of individuals might harmonise the taxation of dividends
and gains at a flat rate of 20 percent).
As noted earlier, the above regime applies regardless of whether
the entity is established in Italy or abroad (provided it is not
established in a tax haven). Hence, any additional layer of
taxation (for example, at the level of PEF on gains and
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31
distributions derived by the PEF with respect to its investment in
HBE) would constitute tax leakage from the perspective of HI. If
PEF is structured as an Italian company, any gains realised on the
disposal of its shares in HBE, assuming that the shares qualify for
the participation exemption, will be subject to corporation tax (at
the rate of 33 percent) on 16 percent of the amount of the gains,
resulting in an effective rate of 5.28 percent. Dividends distributed
by HBE to PEF will be subject to corporation tax (at the rate of 33
percent) on 5 percent of the amount of the dividends, resulting in
an effective rate of 1.65 percent. Distributions made by PEF to HI
will not be subject to withholding tax, dividends and gains at the
level of HI being subject to the tax regime described above. For
this reason, having PEF organised as an Italian company might
create tax leakage for HI.
For the same reason, it might be advisable to have PEF
organised as a foreign entity established (and resident for tax
purposes) in an E.U. jurisdiction that has concluded a tax
treaty with Italy. In principle, this would have the effect that
dividends and gains derived with respect to PEF’s investment
in HBE would be exempt from Italian tax, and that PEF would
benefit in its country of residence from a participation
exemption regime. For this reason, Luxembourg is often the
jurisdiction of choice for establishing a PEF the purpose of
which includes investing in Italian target companies, although
in these circumstances due care needs to be exercised with
regard to the potential withholding tax on distributions made
by PEF to its investors (for example, HI).
Having PEF structured as a company or partnership in a tax
haven jurisdiction would be detrimental for HI if his share of
the (direct) participation in PEF was in excess of 20 percent,
since: (1) the controlled foreign company (CFC) rules would
apply; and (2) the exemptions referred to above would not be
applicable, with the consequence that distributions made by,
and gains on the disposal of the shares of, the PEF would be
fully subject to individual income tax at progressive rates (of
up to 43 percent) in the hands of HI.1
The tax regime described above applies provided the foreign
PEF is regarded as a foreign “entity” and not as a foreign
collective investment undertaking (such as a mutual fund).
The distinction is significant because, if the investment is
regarded as parts of a collective investment undertaking, and
if, as is assumed, the vehicle does not fall within the scope of
the EC “UCITS” Directive:2
■ Income derived from distributions and the portion of the
gain arising from the sale or redemption of the units
corresponding to an increase in the net asset value of the
fund, would be fully subject to personal income tax in the
hands of the investor at progressive rates (of, currently,
up to 43 percent); and
■ To the extent they are not covered by the previous bullet,
capital gains would be subject to a 12.5 percent
substitute tax.
For tax purposes, no specific characterisation rules apply in this
context. In the case of Italian vehicles, the position is
straightforward, as the tax characterisation follows the legal
system, which clearly identifies what types of vehicles are to be
treated as collective investment vehicles for legal and regulatory
purposes. The position is more complicated in the case of certain
foreign established vehicles. Foreign vehicles legally set up as
collective investment undertakings and subject to regulatory
control in their jurisdiction of establishment will be treated as
collective investment undertakings for Italian tax purposes and
the relevant income and gains taxed accordingly. On the other
hand, foreign holding companies will be treated as entities. The
characterisation is not so straightforward in the case of a foreign
vehicle that combines the features of an entity (such as a
company or partnership) with those of a collective investment
undertaking (for example, the investors having very limited
powers as compared to shareholders in a company or the
existence of some degree of regulatory control) – for example, a
foreign partnership acting as an investment fund or a
Luxembourg SICAR. In such cases, as a matter of practice,
reference is made to the regime that would apply for regulatory
purposes to the placement of the investment units of such
vehicles on the Italian market. If, based on a regulatory analysis,
the marketing of the units (or shares, or partnership interest, etc.)
would be subject to the regime applicable to the marketing of the
units of a collective investment vehicle, the units would also be
regarded as units in a collective investment vehicle for tax
purposes. If, conversely, the marketing of the units would be
subject to the regime applicable to the marketing of shares of
companies, the same characterisation would be followed for tax
purposes.
Another alternative that might be considered would be to have
PEF established as an Italian (regulated) closed-ended
investment fund3 (a “Closed-Ended Fund”). Such a fund would
be subject to regulatory control and would be managed by a
qualified management company (società di gestione delrisparmio) that would also be subject to regulatory control. Such
features and the associated costs have traditionally dissuaded
sponsors from arranging a private equity fund using a
Closed-Ended Fund, although resistance to such arrangements
has progressively been disappearing and this form of collective
investment undertaking is being increasingly used for private
equity initiatives managed by Italians.
A Closed-Ended Fund organised in the way envisaged would be
subject to a 12.5 percent substitute tax on the yearly
appreciation in its net asset value (i.e., on distributions and gains
on investments, including its investment in HBE).4 Distributions
made by the fund to HI would not be subject to tax in the hands
of the investor. Moreover, capital gains on the disposal of the
units in the fund would not be subject to tax to the extent they
represent appreciation in the fund that has already been
subjected to a 12.5 percent substitute tax imposed at the level of
the fund. Any excess gain would be subject to a 12.5 percent
substitute tax.
2. Preferred structure for a foreign individual
As the Italian tax system does not “look through” PEF (unless
PEF is organised as a domestic partnership, which would not be
tax-efficient), the choice of structure for an investment of FI to
invest in HBE must be optimised at the level of PEF.
Because of the tax leakage discussed at Section II.A.1., above,
using an Italian company as PEF would not be the most efficient
structure for FI. Moreover, if FI were to invest directly in PEF
where PEF was an Italian company, distributions made by PEF to
FI would be subject to withholding tax. Such withholding tax
might be reduced, but would never be entirely eliminated, under
an applicable tax treaty.
An alternative that might be considered would be to structure
PEF as a Closed-Ended Fund (see Section II.A.1., above). In
this case, if FI was resident for tax purposes in a “white-listed”
jurisdiction (which includes all Italy’s treaty partners, with the
exception of Switzerland), FI would be entitled to a (tax-free)
Italy
32
32
payment by the management company equal to 15 percent of
the amount of the distribution made by PEF to FI, the
payment to compensate for the 12.5 percent substitute tax
imposed at the level of the fund.
3. Preferred structure for an Italian pension fund
Italian pension funds are subject to an 11 percent substitute
tax on their income and gains, without any specific relief being
provided for either dividends or capital gains. The best
structure for an investment of HPEN would, therefore, be one
that eliminates any tax leakage between HBE and HPEN. It
should be noted, however, that a pension fund may be
subject to strict limitations as to the types of investment it can
make, so that in these circumstances there may be limited
scope for planning.
If PEF is organised as a Closed-Ended Fund, HPEN will be
entitled to a tax credit equal to 15 percent of the amount of
distributions made to it by PEF (and of the portion of a gain
realised upon the disposal of its investment in the
Closed-Ended Fund corresponding to the appreciation in the
net asset value of the fund, which will already have been
subject to the 12.5 percent tax at the level of the fund), which
is meant to compensate for the 12.5 percent tax imposed at
the level of the fund.
4. Preferred structure for a foreign pension fund
There are no special provisions applying to a foreign pension
fund investing (indirectly) in an Italian business entity. The best
structure for FPEN would, therefore, be the same as that for
FI described in Section II.A.2., above. If the investment is
made through a Closed-Ended Fund, FPEN will be eligible for
the 15 percent refund, even if FPEN is not regarded as a
“resident” for local tax purposes of the state where it is
established (because, for example, it is not subject to tax
therein), because it would most likely be regarded as an
There are no special provisions applying to a foreign
government investing (indirectly) in an Italian business entity.
Hence, the best structure for FGOV would be the same as
that for FI described in Section II.A.2., above. It should,
however be noted that, if the investment is made through a
Closed-Ended Fund, FGOV will be eligible for the 15 percent
refund only if it regarded as a “resident” for local tax purposes
of the state of which it is a government.
B. Investment in a foreign business entity
1. Preferred structure for an Italian individual
From a tax perspective, it makes no difference whether FBE is
organised in the form of a partnership or a corporation. The
same structuring considerations as were discussed in Section
II.A.1., above, in connection with an investment of HI in HBE,
would also be applicable in the case of an investment in FBE.
If, however, FBE (or any intermediate holding company) is
established in a tax haven, under the CFC rules HI may be
taxed on his proportionate share of FBE’s income if his
entitlement to the profits of FBE is equal to at least 20
percent.
2. Preferred structure for a foreign individual
The same considerations apply as those discussed in relation
to an investment of FI in HBE (see Section II.A.2., above). It
would not be advisable to have PEF organised as an Italian
company (or partnership) because, in addition to tax leakage,
there could be a detrimental effect in the shape of the
application of the CFC legislation if FBE (or any intermediate
holding company) is established in a tax haven. If PEF is a
foreign entity with no presence in Italy, it does not matter how
PEF is organised for Italian tax purposes.
If PEF is organised as a Closed-Ended Fund, it will not be
entitled to a foreign tax credit; the 12.5 percent substitute tax
will be imposed on PEF’s foreign income (i.e., distributions
made by FBE and gains on the disposal of the FBE’s shares)
net of foreign taxes.
3. Preferred structure for an Italian pension fund
The same considerations apply as those discussed in relation
to an investment of HPEN in HBE (see Section II.A.3., above).
If PEF is a foreign entity with no presence in Italy, it does not
matter how PEF is organised for Italian tax purposes, except
that HPEN will not be entitled to any foreign tax credit for
foreign taxes imposed on distributions made by PEF.
4. Preferred structure for a foreign pension fund
The same considerations apply as those discussed in relation
to an investment of FI (see Section II.B.2., above). If PEF is a
foreign entity with no presence in Italy, it does not matter how
PEF is organised for Italian tax purposes.
5. Preferred structure for a foreign government
The same considerations apply as those discussed in relation
to an investment of FI (see Section II.B.2., above). If PEF is a
foreign entity with no presence in Italy, it does not matter how
PEF is organised for Italian tax purposes.
C. Conclusion as to the overall preferred structure
From an Italian tax perspective, the most efficient structure for
all the categories of investors under consideration would be to
have HBE established as a corporation. It would not matter in
which form FBE was established. The use of an Italian
company or partnership to act as PEF would not normally be
advisable. A Closed-Ended Fund might be considered as an
alternative, as such a fund would (in most cases) constitute a
tax-exempt vehicle for eligible foreign investors, but would not
entail additional benefits or burdens for HI or HPEN.
III. Basic Italian tax planning for a hedge fund
A. Investment in passive assets generating Italian-sourceincome
1. Preferred structure for an Italian individual
From the perspective of HI, the most tax efficient structure
would be to have HF set up as a foreign entity (established in
a white-listed jurisdiction) the organisation and operation of
which does not result in it being characterised as a collective
investment undertaking for Italian regulatory (and hence tax)
purposes. If such a structure is employed, HF is more likely to
be eligible for domestic and treaty-based reliefs from taxation
at source on its Italian-source income. Income and gains
derived by HI from such an investment will be subject to
substitute taxes levied at a rate of 12.5 percent (assuming
that the interest held by HI does not exceed 20 percent of the
voting rights or 25 percent of the capital of HF).
Consideration may also be given to having HF set up as a
Closed-Ended Fund. The tax regime would be the same as that
described in relation to PEF in Section II.A.1., above. Specifically,
33
Italy
33
Italian-source passive investment income received by the fund
would, with few exceptions, not be subject to tax at source
(being subject only to the 12.5 percent substitute tax at the level
of the fund).
2. Preferred structure for a foreign individual
It would not be advisable to have HF organised as an Italian
company or partnership. The most tax efficient structure would
therefore be to have HF set up as a foreign entity (established in a
white-listed jurisdiction in order to benefit from a range of
exemption regimes provided under Italian law for Italian-source
income).
Having HF set up as a Closed-Ended Fund alternative, on the
other hand, would (in most cases) produce exempt income for FI
(taking into account the 15 percent refund for eligible foreign
investors).
3. Preferred structure for an Italian pension fund
The preferred structure(s) would be the same as that (those)
described in relation to an investment of HI (i.e., a foreign HF
established in a white listed jurisdiction or an Italian
Closed-Ended Fund), except that income and gains derived by
HPEN from its investment in a foreign entity would be subject to
the 11 percent substitute tax at the level of HPEN (without any
foreign tax credit but imposed on the income net of any foreign
taxes) regardless of the size of HPEN’s participation.
4. Preferred structure for a foreign pension fund
The same considerations apply as those discussed in Section
III.A.2., above in relation to an investment of FI.
5. Preferred structure for a foreign government
The same considerations apply as those discussed in Section
III.A.2., above in relation to an investment of FI.
B. Investment in passive assets generatingforeign-source income
1. Preferred structure for an Italian individual
From the perspective of HI, the most tax efficient structure would
be to have HF set up as a foreign entity (not established in a tax
haven) the organisation and operation of which does not result in
it being characterised as a collective investment undertaking for
Italian regulatory (and hence tax) purposes. Income and gains
derived by HI from such an investment will be subject to
substitute taxes levied at a rate of 12.5 percent (assuming that
the interest held by HI does not exceed 20 percent of the voting
rights or 25 percent of the capital of HF).
Consideration may also be given to having HF set up as a
Closed-Ended Fund. The tax regime would be the same as that
described at Section II.A.1., above in relation to a PEF (and at
Section III.A.1., above in relation to HF, where the passive assets
generate Italian-source income), although it must be borne in
mind that a Closed-Ended Fund would not be eligible for a credit
for foreign taxes.
2. Preferred structure for a foreign individual
It would not be advisable to have HF organised as an Italian
company or partnership. The most tax efficient structure would
therefore be to have HF set up as a foreign entity with no Italian
presence.
3. Preferred structure for an Italian pension fund
The preferred structure(s) would be the same as that (those)
described in relation to an investment of HI (i.e., a foreign HF not
established in a tax haven), except that income and gains derived
by HPEN from its investment in a foreign entity would be subject
to the 11 percent substitute tax at the level of HPEN (without any
foreign tax credit but imposed on the income net of any foreign
taxes) regardless of the size of HPEN’s participation.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that
discussed in Section III.B.2., above for an investment of FI.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that
discussed in Section III.B.2., above for an investment of FI.
C. Conclusion as to the overall preferred structure
Where Italian-source passive investment income is generated,
the most efficient structure for all the categories of investors
considered would be to set up HF as a foreign company
established in a white-listed jurisdiction. The use of an Italian
company or partnership to act as HF would not normally be
advisable. As an alternative, consideration might also be given to
setting up a Closed-Ended Fund, as such a fund would (in most
cases) constitute an exempt vehicle for eligible foreign investors,
but would not result in additional benefits or burdens for HI or
HPEN.
IV. Italian income taxation of income from acarried interest
Savvy’s “carried interest” comprises a 20 percent interest in
the profits derived by PEF. IF PEF is organised as a foreign
company, the most efficient structure would be to have PEF
issue a special category of shares embodying the carried
interest rights with a very low face value entitling the holder to
no more than 20 percent of the voting rights and 25 percent
of the capital of PEF (as would normally be the case with
shares to be held by managers and advisors). Savvy would
buy the shares at their fair market value. Because of the
uncertainty attaching to the realisation of the carried interest,
the fair market value would be reasonably close to the face
value of the shares (which is assumed to be very low).
Assuming that PEF is not established in a tax haven, income
and gains on such shares would be subject to a 12.5 percent
substitute tax in the hands of Savvy.
If PEF is organised as a Closed-Ended Fund, the same structure
may be achieved by having the carried interest embodied in a
special category of units (rather than shares). The same tax
regime (i.e., 12.5 percent substitute tax) would apply.
1 While the threshold for the application of the CFC rules is a director indirect entitlement to the profits of the foreign entity of not lessthan 20 percent, the detrimental effect on distributions and capitalgains would be triggered by a participation representing more than20 percent of the voting rights or 25 percent of the capital of theforeign entity. For the sake of completeness, it should be noted thatthe above limitation does not apply in the case of listed shares.
2 Council Directive 85/611/EEC of December 20, 1985 on theco-ordination of laws, regulations and administrative provisionsrelating to undertakings for collective investment in transferablesecurities (UCITS), as subsequently amended and supplemented
3 Regulated under Law 344 of August 14,1993
4 The substitute tax is levied at the rate of 27 percent on income andgains from participations in unlisted entities representing an interestof more than 50 percent of the capital of the company concerned.This regime, which is intended to prevent the abusive use ofClosed-Ended Funds applies only to funds with fewer than 100investors, but not to such funds the majority of whose investorscomprise qualified investors (i.e., institutional investors) other thanindividuals.
Italy
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Host CountryTHE NETHERLANDS
Carola van den Bruinhorst and Dennis LangkemperLoyens & Loeff N.V., Amsterdam
Carola van den Bruinhorst is a Partner and has been
practising Dutch tax law since 1990 with Loyens & Loeff
in their offices in Amsterdam, Rotterdam and New York.
I. Basic Netherlands tax planning for a privateequity fund
For purposes of the discussion of the various preferred structures
that follows, it is assumed that PEF is established in the
Netherlands. In the Netherlands, the most common legal forms
available for structuring PEF would be a limited liability company
(besloten vennootschap or BV), a co-operative association
(coöperatie or Co-op) and a limited partnership (commanditairevennootschap or CV). A BV and a Co-op are legal entities and as
such subject to Dutch corporate income tax. A CV can either be
transparent for Dutch tax purposes (a “closed CV”) or be treated
as an entity subject to corporate income tax (an “open CV”).1 A
CV is considered tax transparent if the admission or replacement
of a limited partner requires the prior consent of all partners (both
limited and general). If this requirement is not met, a CV will
automatically be considered an entity subject to corporate
income tax (i.e., an open CV).
For Dutch tax purposes, PEF is considered to carry on an
enterprise.2 If PEF were to be structured as a (tax transparent)
closed CV, this would mean that a foreign corporate investor
investing in PEF would be deemed to be engaged in the conduct
of a business through a permanent establishment (PE) in the
Netherlands. Consequently, such a foreign investor would – in
principle – be subject to Dutch corporate income tax. The equity
investments held by PEF (in HBE or FBE) would be considered to
belong to the business assets of the PE of the foreign investor
(allocated in proportion to the percentage interest held by the
investor in PEF).
As HBE would not usually be structured in the Netherlands as a
partnership, and as foreign partnerships are often treated as
corporations for Dutch tax purposes, it is assumed for purposes
of this paper that both HBE and FBE are structured as limited
liability companies (with a capital divided into shares).
A. Investment in a Netherlands business entity
If PEF were structured as a BV, a Co-op or an open CV,
dividends and capital gains derived from HBE would be exempt
from corporate income tax if the participation exemption applied.3
As a general rule, the participation exemption will apply if PEF
has a participation of 5 percent or more in the aggregate issued
nominal share capital of HBE, and HBE is not considered a
“low-taxed investment participation”. HBE is not considered a
low-taxed investment participation if:
■ No more than 50 percent of the assets of HBE consist of
passive portfolio investments; or
■ HBE is subject to tax to an effective rate of at least 10
perc7ent levied on its profits calculated in accordance
with Netherlands standards.
As HBE is a resident of the Netherlands, it will be subject to
Dutch corporate income tax. From this it follows that the
requirement in the second bullet above will be met. Therefore, the
participation exemption would apply with respect to dividends
and capital gains from HBE, provided PEF owns at least 5
percent in the share capital of HBE.
Provided PEF’s actual place of management is within the
Netherlands, all the conclusions drawn in this paper will apply
equally if PEF is formed under foreign law. If PEF has its
management office outside the Netherlands, it is likely that PEF
will also be considered to have its residence outside the
Netherlands. If so, PEF may be subject to Dutch corporate
income tax (25.5 percent) on a capital gain realised on the
alienation of HBE if: (1) PEF owns an interest of at least 5 percent
in HBE; (2) the participation in HBE cannot be allocated to the
assets of an enterprise carried on by PEF; and (3) PEF is not
entitled to relief under a tax treaty concluded between its country
of residence and the Netherlands. Taking into account the basic
assumption that PEF is considered to be carrying on an
enterprise for Dutch tax purposes, the second requirement would
not be met and would prevent PEF from being subject to
corporate income tax in the Netherlands.
1. Preferred structure for a Dutch individual
The Netherlands Income Tax Act 2001 distinguishes three different
components of income. These components of income are allocated
to separate “Boxes” to which special tax rates apply. Income
allocated to Box I (such as employment income and income from a
trade or business) is taxed at progressive rates of up to 52 percent.
Income from a “substantial interest” (an equity participation of 5
percent or more)4 is allocated to Box II and is taxed at a rate of 25
percent. Income from “savings and investments” (such as less than
5 percent shareholdings, bonds, etc.) is allocated to Box III. The
taxable benefit in Box III is calculated as a deemed 4 percent yield
on the fair market value of the assets that are allocated to Box III.
This 4 percent yield is subject to an income tax rate of 30 percent (as
such, the annual income tax due would equal 1.2 percent of the fair
market value of the assets).
From the perspective of HI (a Netherlands resident individual), the
most tax efficient structure would be to establish PEF as a BV, a
Co-op or an open CV, provided HI owned an interest of less than 5
percent in PEF.5 HI would then be taxed annually on his participation
in PEF at a rate of 1.2 percent on the fair market value of his interest
in PEF. Any income (dividends and capital gains) actually received by
HI from PEF would not be subject to any further taxation.
If HI owned a substantial interest in PEF, any income received
from PEF (dividends and capital gains) would be subject to the
Box II tax rate of 25 percent. As the 25 percent Box II taxation
35
35
would only become due when the benefits were actually received
by HI, the Box II taxation could be deferred if HI were to hold its
participation through an intermediate holding BV.
Fifteen percent Dutch dividend tax is due on profit distributions
made to HI by PEF, where PEF is structured as a BV or an open
CV. This dividend tax can be fully credited against HI’s Dutch
income tax liability, regardless of whether income from the
participation in PEF is allocable to Box II or Box III. If PEF were
structured as a Co-op, no dividend tax would be due as, under
the Netherlands Dividend Tax Act 1965, a Co-op is not required
to withhold dividend tax when it makes a distribution of profits.
2. Preferred structure for a foreign individual
If FI owns an interest of less than 5 percent in PEF, the preferred
structure for HI described in Section I.A.1., above, will also be
suitable for FI, provided, if PEF is a BV or an open CV, FI is able
to credit any Dutch dividend tax withheld by PEF against its
income tax liability in his country of residence. However, if the
Dutch dividend withholding tax would represent an additional tax
burden for FI, PEF should be structured as a Co-op. If on the
basis of the tax laws in FI’s country of residence an investment in
a transparent structure is more suitable (in order to have the
income from PEF treated as capital gains income), an open CV
would most probably be preferred as, unlike a BV or a Co-op, a
CV is often considered transparent from the perspective of
foreign tax law.
If FI holds a substantial interest in PEF, FI will be subject to Dutch
income tax at a rate of 25 percent (Box II) on income (dividends
and capital gains) from PEF. This tax burden may, however, be
reduced to 15 percent (in the case of dividends) or fully
eliminated (in the case of capital gains) if FI is entitled to benefits
under a tax treaty concluded between his country of residence
and the Netherlands. In this situation it will make no difference
whether PEF is structured as a Co-op or as a BV.
If Netherlands Box II taxation will be an actual burden,
consideration could be given to having FI invest in PEF through a
foreign limited partnership (FLP) that is non-transparent for Dutch
tax purposes,6 and to PEF being structured as a closed CV (of
which the FLP is the sole limited partner). In this structure, the FLP
would be subject to corporate income tax in the Netherlands, but
would be able to apply the participation exemption in relation to the
benefits derived from HBE, provided its owned an interest of at
least 5 percent (on a look through basis) in HBE.
3. Preferred structure for a Dutch pension fund
As HPEN is exempt from Dutch corporate income tax, the legal
structure of PEF generally has no relevance. However, if PEF is
structured as a BV or an open CV, it will have to withhold Dutch
dividend tax on profit distributions to HPEN. HPEN will be able to
obtain a full refund of this dividend tax,7 but as some time may
lapse until the refund is actually received this could result in a
cash-flow disadvantage.
4. Preferred structure for a foreign pension fund
If FPEN is considered a qualifying foreign tax-exempt pension
fund for Dutch tax purposes, the preferred structure for PEF
would be a closed CV or a Co-op. It is true that, if it holds a
participation in a closed CV, FPEN will be subject to tax in the
Netherlands, but it will be entitled – upon request – to the same
exemption8 from Dutch corporate income tax that applies to
HPEN. If PEF is structured as a Co-op, no Dutch tax liability
arises if FPEN owns an interest of less than 5 percent in PEF. If
FPEN’s participation exceeds 5 percent, FPEN will, in principle,
be subject to Dutch corporate income tax, but will nevertheless
be able to benefit from the above-mentioned exemption for
pension funds.
If FPEN is a resident of the United States or an E.U. Member
State, PEF could also be structured as a BV or an open CV. This
is because an exemption from dividend tax applies to dividends
distributed by such an entity to a foreign pension fund that is
resident in the United States, and a full refund of dividend tax can
be obtained by a foreign pension fund resident in an E.U.
Member State.9
5. Preferred structure for a foreign government
If FGOV is resident in an E.U. Member State, it will generally be
able to obtain a refund of dividend tax on dividends distributed by
PEF, if PEF is structured as a BV or an open CV.10
If PEF is structured as a closed CV, FGOV will in principle be
subject to Dutch corporate income tax. There is no provision in
Dutch law that would protect FGOV from such taxation. Dutch tax
liability could also arise if FGOV were to own 5 percent or more in
PEF structured as a BV, a Co-op or an open CV. In such a situation
it would remain to be seen if, and to what extent, FGOV would be
able to obtain relief from Dutch taxation under a tax treaty
concluded between its country of residence and the Netherlands.
FGOV can, however, avoid Dutch taxation, if the preferred structure
for FI is used (i.e., FGOV invests in a closed CV through an FLP).
B. Investment in a foreign business entity
1. Introduction
If PEF is structured as a BV, a Co-op or an open CV and makes
an investment in FBE, income from FBE (dividends and capital
gains) will only be exempt from Dutch corporate income tax in
the hands of PEF if the participation exemption applies. The
exemption will apply if PEF has a participation of 5 percent or
more in the nominal paid-up capital of FBE, and FBE is not
considered a “low-taxed investment participation”. As discussed
in Section I.A., above, FBE is not considered a low-taxed
investment participation if:
■ No more than 50 percent of the assets of FBE consist of
passive portfolio investments; or
■ FBE is subject to tax at an effective rate of at least 10
percent levied on its profits calculated in accordance with
Netherlands standards.
Unlike in the situation applying to HBE, it will not always be
certain that the requirement in the second bullet will be met with
respect to FBE. Therefore, in order to ensure that FBE is not a
low-taxed investment participation, FBE should meet the
requirement in the first bullet.
Whether more than 50 percent of the assets of FBE consist of
passive portfolio investments is to be determined on an indirect
basis – i.e., if FBE owns shareholdings of 5 percent or more in
subsidiaries, the assets of the subsidiaries will be “fictitiously”
attributed on a pro rata basis to the balance sheet of FBE. On the
basis of this “attributed balance sheet”, it will be determined
whether 50 percent or more of FBE’s assets consist of passive
portfolio investments.11 Passive portfolio investments are
investments that are not held in line with the business carried on
by FBE (this could, for instance, be more than 5 percent holdings
of stock, bonds or group receivables). For purposes of
determining the 50 percent threshold, the fair market value of the
assets is decisive.
For purposes of this discussion, it is assumed that FBE does not
fail the 50 percent passive portfolio investments test.12 Therefore,
if PEF is structured as a BV, a Co-op or an open CV, benefits
The Netherlands
36
36
derived from FBE will be exempt from Dutch corporate income
tax, provided PEF owns at least 5 percent of the nominal paid-up
capital of FBE.
2. Preferred structures for a Dutch and foreign individual,a Dutch and foreign pension fund, and a foreigngovernment
In the Netherlands, if PEF is structured as a tax transparent
partnership (a closed CV), HI, FI, FPEN and FGOV will be
deemed to receive income from a Dutch enterprise, and as such
will be subject to Dutch (corporate) income tax.13 Consequently,
as the income distributed by PEF will be deemed to be
Dutch-source income, it will not matter to the investors envisaged
in this paper whether the income originates from HBE or FBE.
Further, as it is not possible in the Netherlands to have
corporations treated as tax transparent entities, it will make no
difference to HI, FI, HPEN, FPEN or FGOV whether PEF, whether
structured as a BV, a Co-op or an open CV, invests in HBE or
FBE. To summarise, all conclusions reached in Section I.A.,
above with respect to an investment by PEF in HBE will in
principle also apply for HI, FI, HPEN, FPEN and FGOV with
respect to an investment by PEF in FBE.
If local withholding taxes are levied on capital gains (or dividends)
in FBE’s country of residence, it should be determined whether
PEF will obtain relief with respect to such taxes under a tax treaty
concluded between FBE’s country of residence and the
Netherlands. Such relief may not be available if PEF is structured
as a closed CV, as PEF would then not be considered a resident
of the Netherlands for tax treaty purposes. In such a situation,
consideration could be given to interposing an intermediate
holding BV between PEF and HBE.
C. Overall preferred structure
In light of the conclusions reached above, and to suit each of the
investors taken into consideration, the overall preferred structure
for PEF in the Netherlands would be a parallel structure
consisting of a closed CV and a Co-op. In order to avoid Dutch
(corporate) income tax liability, the investors in the closed CV (FI,
FPEN and FGOV) should hold their participation through an FLP
that is non-transparent for Dutch tax purposes (see the
discussion at Section I.A.2., above). The FLP would be subject to
corporate income tax in the Netherlands, but, provided the FLP
owned (on a look through basis) an interest of 5 percent or more
in HBE/FBE, the income (capital gains and dividends) derived
from HBE/FBE would be exempt under the participation
exemption (see Structure 1, above).14
If FI is also able to invest tax-neutrally in a Co-op,15 consideration
could also be given to not interposing an FLP between the
investors and the closed CV. FGOV and FPEN would then invest
directly in the closed CV, and would be subject to Dutch
corporate income tax on income derived from PEF (capital gains
and dividends from HBE/FBE). FPEN, would however, be eligible
for the subjective exemption for pension funds (see Section
I.A.4., above). In order to ensure that the income received by
FGOV is also exempted (by virtue of application of the
participation exemption), a Co-op should be interposed between
PEF and HBE/FBE (see Structure 2, above).16
The above structures provide for tax neutrality at the level of
PEF and the tax-free repatriation of profits to HI, FI, HPEN,
FPEN and FGOV.
II. Basic Netherlands tax planning for a hedgefund
As HF will invest in a great variety of assets, such as marketable
stocks, securities and other financial instruments, HF, unlike PEF,
will not primarily own 5 percent or more equity participations. A
regular corporate structure (BV or Co-op) or having HF structured
as an open CV, would therefore not be preferred, as most of HF’s
income derived from its investments would probably not be
eligible for the participation exemption. Nevertheless, to the
extent HF has taxable income, it could consider being financed
by its investors with substantial borrowings in order to claim an
interest deduction that would reduce HF’s taxable income.
Provided none of HF’s investors is considered a related entity of
HF for Dutch tax purposes17 and the loans do not have to be
reclassified as equity,18 the Dutch thin capitalisation rules and/or
other anti-abuse provisions would not, in principle, restrict the
deduction of interest. However, a discussion of structures in
which HF is debt-financed by its investors is beyond the scope of
this paper. It is, therefore, assumed that HF is primarily financed
with capital contributions from its investors.
Given the more “passive” character of HF’s investments, the
question could be raised whether HF is to be deemed to be
carrying on an enterprise for purposes of Dutch tax law. This is a
question of fact that would depend on, among other things, the
extent of the involvement of the HF managers with HF’s
investment portfolio and the level of risk that is incurred. If it is
assumed that HF is not considered to carry on an enterprise for
purposes of Dutch tax law, HF could be structured as a closed
CV. If so, FI, FPEN and FGOV would not be subject to (corporate)
income tax in the Netherlands on income from their investments
in HF. For HI, it would mean that he would not be deemed to
derive income from a trade or business (Box I); instead income
from his investment in HF would be allocated to the favourable
Box III tax regime. Nevertheless, a closed CV may not be the
preferred structure for HF as, in order to ensure the tax transparency
of the CV, prior consent is required from all the partners for the
admission or replacement of a limited partner. As hedge funds
typically are open ended, in practice, the prior consent
requirement would definitely represent an awkward obstacle.
37
The Netherlands
37
In July 2007, the Netherlands legislator adopted a new tax regime
(the Exempt Fund Regime) for investment funds such as HFs.19
The Exempt Fund Regime provides for a full exemption from
Dutch corporate income tax, as well as an exemption from Dutch
dividend withholding tax on profit distributions. If HF invests solely
in financial instruments such as shares, bonds, options and
similar securities,20 it will be eligible for the Exempt Fund Regime.
One of the conditions that must be met for HF to apply the Exempt
Fund Regime is that HF should take the legal form of either: (1) a
public limited liability company (naamloze vennootschap or NV); or
(2) a mutual fund (fonds voor gemene rekening or FGR).
The preferred structure for all the investors envisaged in this
paper (HI, FI, HPEN, FPEN and FGOV) would be to have HF take
the form of an NV or an FGR subject to the Exempt Fund
Regime, because: (1) there would be no taxation at the level of
HF; (2) no Dutch dividend tax would be due on profit distributions
made by HF; and (3) investors would not be subject to Dutch
(corporate) income tax.21
If HF is subject to the Exempt Fund Regime, all its income is
exempt from taxation regardless of whether it is Dutch source or
foreign source. However, as a result of the tax exemption, HF will
not be considered a Dutch resident for tax treaty purposes and
will therefore have no access to the Netherlands’ tax treaties. As
such, HF will not be entitled to a refund or exemption of withholding
taxes on income received from foreign-source investments.
Further, HF will not be entitled to a refund of Dutch dividend tax
withheld on dividend distributions made by Dutch investments.22
III. Dutch income taxation of income from acarried interest
As discussed in Section I.A.1., above, the ITA distinguishes separate
components of income, each component of income being
allocated to a separate “Box” (for which a special tax rate applies).
If it is assumed that the carried interest entitlement of Savvy
should simply be regarded as compensation for the activities
performed by Savvy for PEF, the carried interest will be
considered employment income and as such be allocated to Box
I (progressive rates of up to 52 percent). The basic assumption in
the Netherlands is therefore that a distinction should be made
between: (1) Savvy performing activities for PEF for which he
receives a salary; and (2) Savvy making an at risk investment in
PEF on the basis of which his carried interest entitlement will be
paid out. Savvy’s salary will obviously be taxed in Box I. The
carried interest entitlement should be allocated to Box II or Box III
(depending on whether Savvy holds a substantial interest in PEF).
The most common structure would be for Savvy to hold his
carried interest entitlement through equity instruments in PEF
(either shares in a BV, or a membership interest in a Co-op, or a
limited partnership interest in an open CV). If PEF takes the form
of a closed CV, Savvy should preferably hold his carried interest
through a holding BV (the latter being a limited partner of the CV).
In each of these scenarios, the respective equity instruments are
likely to constitute a Box II investment for Savvy,23 meaning that
distributed carried interest will be taxed at a rate of 25 percent at
the moment it is actually received by Savvy. Any Dutch dividend
tax due on the distribution of the carried interest may be fully
credited against the income tax due.
Ideally Savvy would want to create a structure where his carried
interest entitlement would be subject to the favourable tax regime
of Box III (savings and investments). As previously discussed,
Savvy would then be taxed annually at the rate of 30 percent on
a deemed 4 percent yield on the fair market value of his carried
interest entitlement (effectively equivalent to a net wealth tax of
1.2 percent). Structuring Savvy’s carried interest as a Box III
investment would be possible if PEF took the legal form of a BV,
and Savvy granted a profit sharing loan (PSL) to the BV. The
principal of the PSL would equal the capital contribution that
Savvy otherwise would have made on its carried interest
entitlement had it been structured using equity instruments. Any
carried interest to be distributed to Savvy by PEF would be paid
out to him in the form of interest on the PSL. In this situation,
Savvy would be taxed annually on 1.2 percent of the fair market
value of the PSL, while the interest received on the PSL would
not be subject to any further taxation.
The Dutch tax authorities take the position that the proceeds
derived from carried interest schemes should mostly be treated
as employment income (Box I), irrespective of whether the carried
interest is structured as a Box II or a Box III investment. As some
Dutch private equity managers have structured their carried
interest entitlement as a Box II or Box III investment, the position
taken by the Dutch tax authorities may lead to disputes that may
eventually be taken to tax court. So far, however, no cases have
been taken to court.24
1 This only applies to the share attributable to the limited partners. ACV is always tax transparent for its general partner(s).
2 This has been confirmed in a decision of the Netherlands SupremeCourt (October 25, 2000, BNB 2000/388).
3 Pursuant to Corporate Income Tax Act 1969 (CITA), Article 13
4 A shareholder holds a “substantial interest” in a BV if he owns 5percent or more of the paid up capital of the BV or 5 percent ormore of the paid up capital of a separate class of shares of the BV.A participant in a Co-op holds a substantial interest if he owns atleast 5 percent of the voting rights or is entitled to at least 5 percentof the Co-op’s profits. A limited partner in an open CV holds asubstantial interest if he is entitled to at least 5 percent of the CV’sequity belonging to the limited partners. It should be noted that the5 percent threshold for purposes of determining whether asubstantial interest is present differs from the 5 percent thresholdapplying for purposes of the participation exemption in the CITA (5percent or more in the aggregate of issued nominal share capital).
5 If PEF were structured as a tax transparent partnership (CV), theincome received by HI from PEF would be likely to be allocated toBox I as it would be considered income from a trade or businessand as such would be subject to progressive rates of up to 52percent. No exemption could be obtained for this income (incontrast to the position of limited partners subject to corporateincome tax, which, if all the relevant conditions are met, maybenefit from the participation exemption).
6 FLP could, for instance, be structured as limited partnershipincorporated under the laws of Delaware and managed by ageneral partner resident in a tax haven jurisdiction (e.g., Guernsey).In order to have FLP classified as non-transparent for Dutch taxpurposes, it must be evident that on the admission or replacementof a limited partner no prior consent is required from all partners.
8 CITA, Article 5, paragraph 1-b, in conjunction with Resolution ofJanuary 26, 2000, nr. DB99/3511M
9 For U.S. pension funds this exemption follows from Netherlands –United States tax treaty, Article 35 and for E.U. pension funds therefund entitlement originates from Dutch domestic law (DTA, Article10, paragraph 4).
10 DTA, Article 10, paragraph 4
11 In this respect, it should be noted that this test must be applied ona continuous basis, and that the asset test must be executedthroughout the chain of ownership below FBE; i.e., if a subsidiary ofFBE itself owns participations of 5 percent or more, the assets ofthese participations will also be included on the “attributed balancesheet” of FBE.
12 Taking into account the investment focus that generally applies toPEFs, in practice, their portfolio companies should always pass thepassive portfolio investments test.
13 See the discussion at Section I
The Netherlands
38
38
14 A variation on Structure 1 would be to establish PEF as a closedCV, with the FLP and the Co-op as its limited partners. Thisstructure offers more simplicity (as PEF consists of only one entity),but may not be preferred if a substantial number of US residentswho are subject to ERISA are to invest in PEF.
15 If FI owns less than 5 percent in Co-op, no Dutch tax liability will arise.
16 FGOV may not own (on a look-through basis) an interest of 5percent or more in the interposed Co-op. However, unlike in thecase of a participation in any other corporate entity, the 5 percentthreshold test does not apply to participations in a Co-op. Thus,provided all other requirements are met (i.e., no low-taxedinvestment participation), any interest in a Co-op would qualify forthe participation exemption.
17 In general terms and in the context of the case at hand, an investorwould be a related entity of HF if the investor held an interest of at leastone-third in HF, or if a third party held an interest of at least one-third inHF and also held an interest of at least one-third in the investor.
18 Loans that are not considered “sham loans” or “bottomless pitloans” (the definition of such loans can be found in a SupremeCourt decision of January 27, 1988, BNB 1988/217) and have aterm of less than 50 years, should, in principle, not be reclassifiedas equity.
19 In the legislative history it has been confirmed that hedge funds inprincipal are eligible for the Exempt Fund Regime. The legislatornevertheless has explicitly excluded investment funds that carry onan enterprise from the Exempt Fund Regime. PEF would, therefore,certainly not qualify for this regime. This conclusion is reinforced bythe fact that the Exempt Fund Regime may only be invoked byinvestment funds that are open ended. Unlike HF, PEF wouldgenerally not meet this requirement.
20 The Exempt Fund Regime is not available for: (1) (direct)investments in Dutch real estate and (mortgage) loans; or (2)investments in rights, other than through securities, to profits of abusiness conducted in the Netherlands.
21 This would also be true if a foreign investor were to own an interestof 5 percent or more in HF.
22 The Netherlands does not levy a withholding tax on interestpayments and capital gains.
23 If PEF is structured as a BV, a person owning 5 percent or more ofa separate class of shares of PEF will be considered to hold asubstantial interest and thus be taxed on income arising from thisshareholding in Box II. In practice it is very difficult to create a sharestructure for carried interest where the carried interest shares donot constitute a separate class, as different profit rights attach tosuch shares as compared to the shares owned by the investors (forinstance, catch-up rights). As a result, the PEF managers will own100 percent of a separate class of shares. This means that anumber (if not all) of them will own 5 percent or more of theseshares. Opinions vary as to whether this “separate class” analysisshould also be followed with respect to a membership right in aCo-op or a limited partnership interest in an open CV.Unfortunately, it is not possible to provide unequivocal guidance onthis issue. It should, however, be noted that if catch-up paymentsare not paid out as part of the carried interest (but as a bonus or asa part of the management fee), it might be possible to avoid thePEF managers having a substantial interest; i.e., the 80:20 divisionof excess profits could then be paid out on the same class ofshares held by the investors and the PEF managers. The PEFmanagers would then jointly hold 20 percent of one class. On anindividual basis, the managers may then hold less than 5 percent.The disadvantage is that the catch-up payments will be taxed at ahigher rate (paid as bonus: Box I (52 percent), paid as part of themanagement fee: corporate income tax (25.5 percent) at the levelof the management company and Box II (25 percent) in the handsof the PEF managers).
24 If the tax court were to decide in favour of the Dutch tax authorities,the question of when the carried interest becomes taxable in Box Iwould also have to be answered. The tax authorities argue thateach payment of carried interest is taxed at the moment it isactually received. However, there are strong arguments forsuggesting that the carried interest should be taxed at the momentthe entitlement thereto is (unconditionally) obtained. In suchcircumstances, a valuation of the carried interest rights would haveto be made. The taxable amount (in Box I) would then be thedifference between the value of the carried interest rights and theamount invested therein. Any actual payments to be received in thefuture would then not be taxable.
39
The Netherlands / Spain
Host CountrySPAIN
Javier Martín Martín and Montserrat Turrado AlonsoErnst & Young, Madrid
Javier Martín is a tax adviser with the Madrid law firm
Ernst & Young Abogados. He is a licenciate in Law and a
graduate in Business Administration (Universidad
Pontificia de Comillas). He received a Diploma in
Taxation from the Centre of Tax and Economic Studies.
In 1982, he was admitted to the Madrid Bar. Before
joining Ernst & Young, Mr. Martín was an auditor, then a
tax adviser, with Arthur Young (now Ernst & Young) and
then a tax adviser with Estudio Legal. He is the author of
the Spanish chapter of the book Value Added Taxation in
Europe, published by the International Bureau of Fiscal
Documentation.
Montserrat Turrado Alonso has more than fourteen years
of professional experience, including two years working
in the banking industry and 12 years providing tax
advisory services. Working in the Madrid office, she has
a broad experience in providing tax advisory services to
banking institutions (commercial and private banking),
broker and dealer firms, investment funds and asset
management firms, as well as co-ordinating specialised
teams (transfer pricing, indirect taxation, etc.)
39
I. Background
In Spain, both venture capital funds and venture capital
companies may be used for investing in start-up companies or
companies with financial or management difficulties, with a view
to selling them after a significant return is achieved.
From a tax perspective, these entities are efficient vehicles for
making such temporary investments. However, it is important to
note that, from a regulatory perspective, because these entities
are controlled and supervised by the Spanish Stock Exchange
Commission (Comisión Nacional del Mercado de Valores or
CNMV),1 they are subject to a number of investment and equity
ratio requirements. Because of these regulatory/control
constraints, many investors have opted historically to carry on
such investment activities using “traditional” companies that are
subject to the general corporate regime, even though this
involves a higher tax burden (i.e., corporate income tax at a rate
of 32.5 percent).2 It is principally for this reason that most venture
capital vehicles have traditionally been owned by Spanish
government bodies.
However, the climate has recently begun to change and venture
capital vehicles are increasingly used by all sorts of investors. This
can be attributed to a number of factors: the higher degree of
flexibility provided by the new legal framework for such vehicles
introduced by Law 25/2005, the new economic/investment
opportunities in the Spanish market and the growing skills and
experience of Spanish investors in this area, as well as the
increasing desire to seek out suitable new vehicles/procedures
on the part of those with funds available to allocate to sectors
where they feel profitable opportunities exist, in particular in
relation to many small and medium-sized companies.
Spanish venture capital entities are now governed by Law
25/2005 of November 24, 2005, which constitutes the regulatory
framework applicable both to the venture capital entities (VCEs)
themselves, whether in the form of venture capital companies
(VCCs) or venture capital funds (VCFs), and to their management
companies, which carry out their management, representation
and administration functions. This new VCE law, which repeals
the previous Law 1/1999 of January 5, 1999, is designed to
provide VCEs with a more flexible and modern legal framework in
order to boost the development of the venture capital sector, in
recognition of the vital role this sector plays in the financing of
companies involved in innovative business projects.
Specifically, the amendments to the VCE regime introduced by
Law 25/2005 focus on such essential issues as: (1) speeding up
administrative procedures; (2) providing flexibility in the context of
the investment rules; and (3) introducing mechanisms generally
accepted in the venture capital sector in most advanced
countries.
An alternative to VCEs is provided by hedge funds (HFs) , for
which Spain has for the first time only recently introduced a legal
framework. Like VCEs, HFs are controlled by the CNMV and,
while HFs are exempted from some of the investment
requirements applying to other collective investment schemes,
such as investment funds or Sociedad de Inversión de CapitalVariable (SICAVs), they must still meet certain asset and equity
ratio requirements.
The incorporation of HFs into the Spanish system is in response
to the enormous demand for products enjoying greater flexibility
as to the types of underlying assets in which they are allowed to
invest than the traditional collective investment schemes.
Specifically, HFs are allowed to invest in assets carrying a greater
level of risk as well as being more highly leveraged for investment
purposes, although it must be acknowledged that such vehicles
are not permitted the degree of flexibility enjoyed by HFs
incorporated or located in offshore jurisdictions.
Until the new Spanish HFs were available, Spanish investors
wishing to make HF investments had to invest abroad in one of
the offshore jurisdictions where such products are available.
However, because most offshore HFs are incorporated in
jurisdictions that are regarded as tax havens for Spanish tax
purposes, Spanish demand for them has been limited.
While the new Spanish HFs offer Spanish investors fresh
opportunities and widen the range of available investment
products, it is still too soon to evaluate their success and to know
whether they will be able to compete with HFs located abroad.
Because of the importance and relative novelty of HFs and the
new rules applying to VCEs, this paper considers in some depth
the procedures for setting up such vehicles and their tax
treatment.
II. Spanish venture capital vehicles
A. Setting up a Spanish venture capital vehicle
Venture capital entities are defined in Law 25/2005 basically as
entities the main activity of which consists of acquiring
participations in non-financial entities that do not qualify as real
estate companies and that are not listed on a regulated stock
exchange. Under Law 25/2005, VCEs may be incorporated as
either venture capital funds or venture capital companies.
In determining whether a VCE may be regarded as governed by
Law 25/2005, the following must be taken into consideration.
Law 25/2005 applies to a VCE, whether as a VCF or a VCC, that
complies with Title I of the Law, which deals with “Conditions
relating to the carrying on of VCE activity”, “Investment regime”
and “Reporting and audit obligations”.
Prior to commencing operations, a VCE must:
First, obtain prior administrative authorisation from the CNMV.
To obtain the relevant authorisation from the CNMV, a VCE must
meet the criteria set forth in Law 25/2005, which, broadly
speaking, are as follows:
■ Limit its activities to those within the corporate purpose
specified in the Law;
■ Have assets with a minimum value of €1,650,000, which
must be contributed in cash; and
■ Appoint a management company to carry out the
management, representation and administration functions
of the VCE.
To obtain the required authorisation, the VCE’s management
company must also prepare and submit to the CNMV the
following documents:
■ A report on the VCE’s project of incorporation;
■ A prospectus covering the internal regulation of the VCE
and the main financial and legal aspects; and
■ Any other document or information the CNMV may
require in order to verify that the requirements set forth in
Law 25/2005 are met.
Secondly, be incorporated as a VCE.
In this context, it should be noted that under current legislation,
the public deed of incorporation and further registration with the
Mercantile Registry have become discretionary.
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Thirdly, be registered with the relevant CNMV Official Register.
The principal investment criteria are as follows:
■ A VCE is only allowed to invest in non-listed, non-financial
companies.
Exceptionally, a VCE is allowed to participate in a
non-financial company that is traded on the stock market,
provided the company is excluded from trading in the 12
months following the acquisition of the participation. This
represents a major advance for the venture capital market in
Spain, as it affords access to a new type of investment, albeit
one to which foreign competitors already had access.
■ Investment in stocks issued by companies more than 50
percent of whose assets consist of real estate will qualify
as acceptable investment activity provided that at least
85 percent, by accounting value, of the total real estate of
the company in whose stock the investment is made is
connected with the development of an economic activity.
■ A VCE is allowed to invest up to 20 percent of its assets
in other Spanish or foreign VCEs provided that the
investments of the latter in other VCEs are not higher
than 10 percent. (At least 60 percent of the VCEs’ assets
must consist of shares or similar shareholding rights in
other companies. The 20 percent limit applies to this 60
percent compulsory investment.)
B. Taxation of venture capital vehicles
Spanish venture capital vehicles benefit from a special, favourable
tax regime. One feature of this regime is an exemption from tax of
99 percent of the income and gains derived by Spanish VCEs
from the transfer of shares and participations in the capital of
companies (targets) in which they invest, provided the transfer
occurs more than one year but less than 15 years (in certain
circumstances 20 years) after the date of acquisition. 1 percent of
such income and gains, as well as other non-exempt income, is
subject to taxation at the general rate (30 percent from 2008
onwards).
This special treatment described above is subject to the following
limitations:
■ Real estate companies: where 50 percent or more of the
assets of the company whose shares are transferred
consist of real estate assets, the exemption is only
available if at least 85 percent of the real estate assets are
used in an economic activity, not including a financial
activity.
■ Related parties and tax havens: for the exemption to be
available, the purchaser must not be considered a related
party (subject to some exceptions) nor be resident in a
territory qualifying as a tax haven.3
■ Related parties: the exemption is not available if the
participation transferred was acquired from a related
party.
Relief from the domestic double taxation of dividends received
from Spanish companies is provided to Spanish VCEs by way of
a tax credit and relief from the cross-border double taxation of
foreign-source income and gains by way of an exemption,
irrespective of the percentage interest held in the paying
company and the length of the period for which the interest has
been held.
The taxation treatment of the income (dividends) and gains
received by the investors in a Spanish VCE varies depending
on the nature of the investor:
1. Dividends
A Spanish resident entity or a non-resident entity with a PE in
Spain may claim relief from Spanish double taxation by way of a
full deduction for dividends received from a Spanish VCE,
irrespective of the percentage interest it holds in the VCE and the
length of the period for which the interest has been held.
Dividends received by a Spanish resident individual are tax
exempt to the extent they do not exceed €1,500, any dividends
in excess of this amount being taxed at a fixed tax rate of 18
percent.
Dividends received from a Spanish VCE by a non-resident
without a PE in Spain are not regarded as Spanish-source
income and, therefore, are not subject to Spanish taxation.
However, this treatment does not apply if the income of the VCE
is derived from a jurisdiction qualifying as a tax haven (see
above).
2. Gains
A Spanish resident entity or a non-resident entity with a PE in
Spain may deduct in full from any gain arising to it on the transfer
of units of or shares in a Spanish VCE, the non-distributed
earnings to which the gain is attributable, irrespective of the
percentage interest it holds in the VCE and the length of the
period for which the interest has been held. In other words, gains
arising on the transfer of units/shares up to the amount of the
non-distributed earnings of the VCE are tax-exempt.
Gains derived from the transfer of shares in or units of a Spanish
VCE by a non-resident without a PE in Spain are not regarded as
having a Spanish source and, therefore, are not subject to
Spanish taxation. However, this treatment does not apply if the
income of the VCE is derived from a jurisdiction qualifying as a
tax haven (see above).
Spanish investors in a non-Spanish VCE are not entitled to the
tax treatment described above. Instead they are subject to the
general taxation rules, which essentially has the following
implications:
■ Individual investors: dividends (in excess of €1,500) and
gains from the VCE are taxed at the rate of 18 percent.
■ Corporate investors: dividends and gains from the VCE
are taxed at the rate of 32.5 percent (30 percent from
2008 onwards).
■ As an exception to the above rules, where the VCE does
not have separate legal personality, the Spanish investors
(both individual and corporate) are taxed annually on the
worldwide income and gains derived by the VCE in
proportion to the interest they hold in the VCE, as if the
income/gains were derived by them directly.
It is open to debate and a matter for further analysis whether
there is discrimination where a Spanish investor holds an interest
in a foreign VCE located in another European country and the
foreign VCE operates in a manner similar to that in which a
Spanish VCE operates. Should the European Court of Justice
(ECJ) find discrimination to exist in this context, Spanish investors
may find themselves free choose among all European VCEs
without being influenced by tax considerations, rather than being
obliged to invest in Spanish VCEs because of the tax advantages
involved.
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C. Conclusions
The following conclusions can be drawn from the above analysis:
■ A private equity fund (PEF) will qualify as a VCE regulated
by Law 25/2005, of November 24, 2005, provided it
obtains prior administrative authorisation from the CNMV
and is registered with the relevant CNMV Official Register.
■ The tax advantages available to a VCE (i.e., 99 percent
tax relief with respect to income/gains derived on
disinvestment in the target(s)) would automatically be
available to a PEF, provided it met the regulatory
requirements referred to in the previous bullet and
provided the stock held by the PEF meets the temporary
investment and other criteria.
■ The tax advantages available to VCE investors (i.e., tax
relief with respect to the dividends received from and
gains arising from the transfer of units/shares in the VCE)
would automatically be available to PEF investors.
III. Spanish hedge funds
A. Setting up a Spanish hedge fund
Like other collective investment schemes (CISs), hedge funds or
hedge companies are open-ended investment vehicles or UCITS.
The new Spanish hedge fund rules establish a special status for
hedge fund/hedge company type products that are known as
“Institucion\r the sake of convenience, both forms will be referredto as hedge funds (HFs) throughout this paper. The main featuresof an HF are as follows:
■ The sole object of an HF is the collective investment in
transferable securities and/or other liquid financial assets
of capital raised from the public, on the principle of risk
spreading.
■ The units/shares of an HF are, at the request of the unit
holders/shareholders, re-purchased or redeemed, directly
or indirectly, out of the HF’s assets. In this regard, an HF
must take the actions necessary to ensure that the stock
exchange value of its units/shares does not significantly
diverge from its net asset value.
■ An HF may be constituted in accordance with EC
Directive 85/611/EEC and its implementation into national
law, which, in Spain, was accomplished via Law
35/2003, of November 4, 2003 and Royal Decree
1309/2005 of November 4, 2005. Specifically, an HF may
be incorporated either under the law of contract (as a
common fund or FIM, managed by a management
company) or under statute (as an investment company,
known as a SICAV).
The special regulatory framework governing HFs has now been
established by the enactment of two pieces of secondary
legislation: (1) a Ministerial Order from the Ministry of Economy
and Finance, dated April 25, 2006; and (2) a Circular approved
by the CNMV on May 3, 2006, which came into force on May 17,
2006.
■ An HF is free to invest in any kind of financial assets and
is not constrained by the investment concentration limits
imposed by law on other CISs. The allowable level of
borrowing against assets is also higher than in the case
of other CISs.
■ An HF may be marketed only to “qualified investors”, as
defined in the relevant provisions. Broadly speaking,
qualified investors are legal entities that are authorised or
regulated to operate in the financial markets (for example,
credit institutions and investment service firms), national
and regional governments, high net worth companies
and certain Spanish individuals (who have some
connection with the securities market).
■ The minimum number of unit holders/shareholders of an
HF is 25 (other CISs must have at least 100 unit
holders/shareholders). This quota must be met within one
year from the date on which the HF is officially registered
with the CNMV.
■ The minimum subscribed capital of an HF is €50,000.
■ To commence business an HF must obtain prior official
authorisation from the CNMV. To obtain the relevant
authorisation, the HF must meet the requirements set
forth in the applicable regulations, which, broadly
speaking, are as follows:
■ The minimum capital is €3,000,000 in the case of an HF
established as a fund and €2,400,000 in the case of an
HF incorporated as a company.
■ The HF must appoint a management company to carry
out management, representation and administration
functions with regard to the HF.
■ The HF (or its management company) must prepare and
submit to the CNMV the following documents to obtain
the authorisation referred to above: (1) a prospectus
setting out the internal regulation of the HF and its main
financial and legal aspects; (2) any other document or
information that the CNMV may need to verify that the
requirements set forth in the applicable regulations are
met.
■ The HF must be incorporated as an HF. It should be
noted that, pursuant to current legislation, the public
deed of incorporation and further registration with the
Mercantile Registry are discretionary in the case of an HF
that takes the form of a fund. Conversely, when the HF
takes the form of an investment company, the public
deed of incorporation and further registration with the
Mercantile Registry are compulsory.
■ The HF must be registered with the relevant CNMV
Official Register.
■ The main investment requirements applying to the HF
are: (1) the HF is allowed to invest in all categories of
financial assets, although the investment strategy must
meet the basic liquidity, diversification and transparency
requirements laid down by the law for collective
investment generally; (2) the HF is subject to a maximum
leverage limitation of five times net asset value; and (3)
there are no restrictions as to the proportion of the HF´s
assets that may be pledged.
B. Taxation of Spanish hedge funds
Spanish HFs (and any other Spanish CISs that meet the
requirements set out above) are subject to corporate income tax
at the reduced rate of only 1 percent.
Under Spanish tax law, Spanish HFs are not eligible for any tax
credit (either foreign or domestic). However, foreign tax credits
would probably be available to CISs in general and to HFs in
particular where there is a tax treaty between Spain and the
source country providing for a mechanism for the avoidance of
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double taxation. In this regard, it should be noted that HFs (and
all Spanish CISs generally) are corporate income taxpayers, and
as such, entitled to treaty protection. If double taxation relief were
available under an applicable treaty, an HF would presumably
apply for it, although, in most cases, the low level of Spanish
taxation (i.e., 1 percent) would function as an upper threshold.
Generally, gains are taxed in the hands of the unit
holders/shareholders on the reimbursement or transfer of
units/shares of a Spanish HF. In other words, the gains/losses
accrued at the HF level are not taxed at the unit
holder/shareholder level until the date on which they crystallise as
a result of the corresponding transfer or redemption of
units/shares. This rule applies even if the HF is incorporated as a
fund and thus lacks legal personality or legal presence (as
opposed to an investment company, which has legal personality
per se).
Spanish investors in receipt of dividends from a Spanish HF are
subject to tax on the date of accrual or the date of payment,
whichever is earlier.
The taxation regime applying to investors in a Spanish HF may
be summarised as follows:
■ Spanish individual investors: gains are taxed at the rate of
18 percent, being subject to withholding at the rate of 18
percent.4 The law provides a special, tax deferral
mechanism for switches between qualifying funds.
Specifically, the deferral is available with respect to gains
arising from the transfer of units/shares of registered
funds and certain investment companies (SICAVs),
provided the amount obtained on the
transfer/reimbursement (transfer price) is re-invested in
another fund/SICAV. Thus, the gain arising does not
trigger capital gains tax, the “old” acquisition value and
“old” acquisition date being “inherited” by the new
units/shares acquired when the re-investment takes
place. Dividends received are taxed at a fixed tax rate of
18 percent. The tax law specifically provides that
dividends payable by an HF (and, in general, by any CIS)
do not qualify for the annual €1,500 tax exemption
granted for other dividend payments. Dividends are
subject to withholding tax at the rate of 18 percent.
■ Spanish corporate investors: dividends and gain are
taxed at the rate of 32.5 percent (30 percent from 2008
onwards).
■ Non-Spanish investors (whether individuals or entities):
gains derived from the transfer or redemption of
units/shares of a Spanish HF are exempt from Spanish
tax. Dividends, however, are subject to withholding tax at
the general rate of 18 percent or at the reduced rate
provided for by an applicable tax treaty.
The tax treatment provided by Spanish tax law5 for Spanish HFs
applies to both Spanish and other European UCITS (i.e., UCITS
established in accordance with EC Directive 85/611/EEC – see
above) that are duly registered for distribution purposes with the
CNMV.6 On the other hand Spanish tax law is silent on the
subject of other funds that do not qualify as UCITS, so that both
European non-UCITs and non-European funds are governed by
the general tax provisions applying to any investment vehicle. In
this regard, assuming that such vehicles (funds, trusts,
partnerships) do not have separate legal personality and are not
directly taxed, their Spanish investors will be taxed on the
world-wide income/gains derived by the vehicles annually in
proportion to the interest they hold, as if the income/gains were
derived by them directly. This regime is known as the “régimende atribución de rentas” (transparency regime).
More specifically, a special provision applies to income and gains
arising from funds incorporated in tax haven jurisdictions. This
provision attributes an annual taxable deemed gain of 15 percent
(unless otherwise credited) to the fund’s units/shares, the
deemed gain being subject to annual taxation at the investor’s
marginal tax rate (rates of up to 43 percent, in the case of
individuals, and a fixed rate of 32.5 percent (30 percent from
2008 onwards), in the case of entities).
Thus, for Spanish purposes, a UCITS is considerably more tax
advantageous to investors than a non-UCITS fund (whether
European or not) because, in the case of a UCITS, the investors
are taxed only when the fund income/gains are realised (i.e., on
the payment of a dividend or the reimbursement of units) while, in
the case of a non-UCITS fund, the investors are taxed as though
they are investing directly in the underlying assets held by the
fund, even if the fund has not distributed its earnings among its
unit holders.
From a withholding tax perspective, it should be borne in mind
that the entity obliged to withhold tax (at the rate of 18 percent)
on the gains arising from the transfer of units/shares of an HF,7
whether Spanish or non-Spanish, is:
■ Generally, the Spanish management entity.
■ In the case of gains from a foreign HF distributed in
Spain, the Spanish distributor.
■ In the case of a foreign management entity rendering
services in Spain under the free provision of services
principle (with a “European passport”), the Spanish tax
representative that must be appointed by such an entity.
■ In other cases, the investors themselves, by way of a
self-withholding mechanism.
From a regulatory perspective, it should be noted that it is almost
impossible for non-UCITS funds (whether from a European
country or elsewhere) to obtain registration with the CNMV
(although feasible in theory, in practice, this is very difficult in
practice because of the restrictions imposed on the CNMV),
which may have adverse tax (i.e., the transparency regime would
apply to the Spanish investors in such a fund) and distribution
consequences (i.e., the fund would not be able to carry on
solicited/active selling operations in Spain). That being said, as a
result of the recognition of domestic HFs, it is probable that
foreign HFs will now be able to be registered with the CNMV,
provided they can prove that they are equivalent to Spanish HFs,
i.e., if they comply with similar leverage thresholds, minimum
subscription requirements, etc. However, it remains unlikely that
an HF domiciled in an offshore jurisdiction such as the Cayman
Islands would be allowed by the regulatory bodies to carry on
distribution/marketing activities in Spain.
Spanish investors may still have the opportunity to invest in a
non-Spanish unregistered HF through a Spanish “fund of hedge
funds” (i.e., a fund that mainly invests its assets in other HFs) or
by directly asking the fund or its manager to buy units/shares
(using a procedure known as an “unsolicited sale”).
C. Conclusion
The main points of the analysis above may be summarised as
follows:
■ In order to become a “qualified” HF, that is an HF as
described above, an HF must obtain prior administrative
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authorisation from the CNMV and be registered with the
relevant Official Register of the CNMV.
■ Beneficial tax treatment (i.e., 1 percent corporate income
tax) is automatically available to an HF, provided it meets
the regulatory requirements referred to in the previous
bullet and provided the stock held by the HF meets the
investment and other criteria.
■ Beneficial tax treatment is automatically available to an
HF’s investors (i.e., deferral of taxable gains on transfers if
proceeds are reinvested).
The use of an HF, which enjoys more investment flexibility and a
greater leverage threshold than a traditional Spanish CIS, is now
a viable alternative for investing in a wide range of transferable
securities. However, it should be noted that Spanish HFs are still
subject to certain risk-spreading, liquidity and other requirements
and constraints established by their regulating body, the CNMV.
This tends to result in their adopting somewhat “conservative”
investment policies and to prevent them from taking as much risk
as HFs located offshore.
IV. Other Spanish and non-Spanish investmentvehicles
A VCE or an HF that did not meet the regulatory requirements
discussed above would constitute a “traditional” investment
vehicle, and as such would be able to invest freely in whatever
assets it might consider appropriate in the course of its business.
Such an entity would not, however, enjoy the special tax
treatment available to a VCE or an HF and would be taxed as
follows:
■ Vehicle itself: worldwide net income would be taxed at
the rate of 32.5 percent (30 percent from 2008 onwards).
■ Individual investors: dividends (in excess of €1,500) and
gains would be taxed at the rate of 18 percent.
■ Corporate investors: dividends and gains would be taxed
at the rate of 32.5 percent (30 percent from 2008
onwards), although the taxation of dividends could be
reduced or eliminated by way of a tax credit.
Because no exchange control or other restrictions apply, it would
also be possible to invest in the contemplated targets (i.e.,
start-up companies and companies in difficulty) through a
non-Spanish vehicle that might or might not be similar to a
Spanish VCE or HF. However, it should be noted that such a
vehicle would not enjoy the favorable tax treatment enjoyed by a
VCE or an HF and it investors would be taxed as follows:
■ Individual investors: dividends and gains would be taxed
at the rate of 18 percent.
■ Corporate investors: dividends and gains would be taxed
at the rate of 32.5 percent (30 percent from 2008
onwards).
In the case of both Spanish and non-Spanish vehicles, where the
vehicle concerned does not have legal personality, its Spanish
investors (whether individuals or entities) will be taxed annually on
the world-wide income and gains derived by the vehicle, as if the
income and gains were derived directly by them in proportion to
the interest they hold in the vehicle.
A summary in tabular form of the consequences of using the
various kinds of investment vehicle is provided at the end of this
paper.
V. Basic Spanish tax planning for a privateequity fund
A. Investment in a Spanish business entity
Where PEF wishes to invest in a Spanish target (HBE), purely
from a tax standpoint, and assuming that PEF is a VCE subject
to a reduced corporate tax burden, HBE would ideally be set up
in any legal form qualifying as a transparent entity for tax
purposes and thus subject to look-through treatment. If this
structure were employed, the transparent vehicle’s income and
gains would not be directly taxed but instead would be allocated
to its unit holders/shareholders. Thus, the dividends and gains
derived by the HBE would not be taxed at the level of the HBE
and would be tax-exempt or taxed at a very low rate at the level
of the VCE.
It should, however, be stressed that most targets conduct
business in a form that provides limited liability (i.e., as
Sociedades Anónimas (SAs) or Sociedades de ResponsabilidadLimitada (SLs), in order to avoid further claims against unit
holders/shareholders. It is, therefore, unusual for a Spanish target
to adopt a legal form, such as a partnership or a SociedadColectiva, that is subject to the tax look-through regime and thus
taxable at the level of its unit holders/shareholders.
In light of the above, it will be assumed for purposes of this
discussion that the Spanish target would carry on business in the
form of an SA or SL and thus, automatically be subject to the
general corporate tax regime. As noted above, this would mean,
in essence, that its net income would be subject to corporate
income tax at the rate of 32.5 percent (30 percent from 2008
onwards).
PEF itself could be incorporated either as a VCF or as a VCC,
both vehicles being subject to the same tax regime (i.e., 99
percent tax relief with respect to gains arising from an interest
held for a period of between 2 and 15 years and a full tax credit
with respect to domestic dividends received) and to similar legal
requirements. Any other income derived by PEF would be
subject to the general corporate income tax rate of 32.5 percent
(30 percent from 2008 onwards).
For PEF to be able to enjoy favourable VCE tax status, it would
have to be incorporated in Spain under Spanish law as either a
qualifying VCF or a qualifying VCC, i.e., as a VCE subject to the
control and supervision of the CNMV that meets the
requirements laid down for such entities.
The tax advantages provided in Spanish law for unit
holders/shareholders of a Spanish VCE would make it advisable
for the investors to invest directly in PEF. The advantages
concerned may be summarised as follows:
■ Dividends received by Spanish individual investors would
be tax exempt up to an annual amount of €1,500, while
dividends received by Spanish corporate investors would
qualify for a full tax credit eliminating any tax liability with
respect to such dividends. Dividends received by
non-resident investors not engaged in a business in
Spain (i.e., without a Spanish PE) would not be taxed in
Spain.
■ Gains derived by Spanish individual investors would be
taxed at a fixed rate of 18 percent, while gains derived by
Spanish corporate investors would qualify for a full tax
credit eliminating any tax liability with respect to such
gains.8 Likewise, gains received by non-resident investors
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not engaged in a business in Spain through a PE would
not be taxed in Spain.
B. Investment in a foreign business entity
In general terms, the tax status provided for in Spanish tax law for
a VCE applies on a world-wide basis, i.e., the tax relief with
respect to a VCE’s income and gains is available whatever the
source of the income and gains, unless the source country
qualifies as a tax haven jurisdiction.
Thus, dividends and gains derived from a foreign business entity
(FBE) would be 99 percent tax relieved provided: (1) FBE is
located in a non-tax haven jurisdiction; (ii) FBE’s profits are
subject to a corporate income that is similar to Spanish corporate
income tax; and (3) the profits giving rise to dividends and gains
received by the VCE arise from a business activity9 mainly carried
out abroad (i.e., outside Spain) by the foreign (underlying) entity.
It is important to note, however, that any foreign withholding tax
paid on the income and gains would be a final (i.e.,
non-refundable) tax burden.
Notwithstanding the above, it should also be noted that where
FBE does not have legal personality per se and is not taxed
directly, the transparency regime would apply and all FBE’s
income and gains would be attributable to the VCE as if the VCE
had derived them directly. As special VCE tax status, as provided
for in Spanish tax law, only concerns the dividends and gains
referred to above (i.e., gains arising from the transfer of units or
shares), any other income derived by or attributed to the VCE (for
example, income from a manufacturing business allocated to the
VCE under the transparency regime) would fall within the general
tax regime and be taxed at the rate of 32.5 percent (30 percent
from 2008 onwards). A Spanish VCE should, therefore, avoid
investing in an FBE that does not have legal personality.
From the perspective of VCE’s investor, the position will be the
same whether the VCE invests in HBE or FBE.
C. Overall preferred structure
As discussed in Section V.A., above, the preferred structure
would be achieved by setting up a qualifying VCE (i.e., either
a VCF or a VCC that meets the legal and regulatory
requirements applying to its incorporation and investments).
A qualifying VCE may invest in any (non-listed) business target
located either in Spain or abroad. If the target is located
abroad: (1) the jurisdiction in which the target is incorporated
should not be a jurisdiction qualifying as a tax haven for
Spanish tax purposes; and (2) the target should carry on a
business activity abroad. Otherwise, the dividends and gains
arising from the FBE will not qualify for the favourable tax
treatment provided for certain types of income derived by a
Spanish VCE.
When choosing between local and foreign investments, the
impact of any foreign withholding tax payable should be taken
into account, as such tax may represent a final (i.e.,
non-refundable) tax burden.
A Spanish VCE may make certain kinds of investment via an
intermediary vehicle, although it should be borne in mind that
the intermediary, like other VCE investments, should meet the
risk-spreading and other investment requirements established
for Spanish VCEs by the Spanish regulatory body.
From an indirect tax perspective, it may be noted that:
■ Neither the incorporation nor any subsequent increase in
the share capital of a VCE is subject to capital tax (unlike
similar transactions carried out by other Spanish entities,
which are subject to capital tax at the rate of 1 percent).
■ As the holding and management of the underlying assets
qualify as exempt activities for value added tax (VAT)
purposes, no VAT would be charged on the activities
carried out by a VCE or its management company. This
means, however, that the VCE would not be entitled to
recover or deduct any input VAT incurred in the course of
its business (for example, with respect to advisory
services or external audit services).
VI. Basic Spanish tax planning for a hedge fund
The benefits of a favourable tax regime are also available
where the chosen investment vehicle is an HF rather than a
VCE.
A Spanish HF that meets the requirements laid down by the
CNMV (the relevant regulatory body) is subject to corporate
income tax at the reduced rate of 1 percent, but is not entitled
to any tax credit. All the HF’s “passive income” (dividends,
interest, capital gains, etc.), is taxed at this reduced rate
regardless of its source, although when a foreign investment
is contemplated, it is important to remember that foreign
withholding tax paid would be a final (non-refundable) tax
burden.
From the point of view of the investors, the salient tax
considerations would be as follows:
A. Spanish individual investors
■ Gains would be taxed at the rate of 18 percent, being
subject to withholding tax at the rate of 18 percent.10
■ The special tax deferral mechanism for switches between
qualifying fund would apply, so that gains arising from the
transfer of units/shares of qualifying HFs would not be
taxed, provided the proceeds obtained from the
transfer/reimbursement (transfer price) were re-invested in
another fund/SICAV.
■ Dividends received would be taxed at a fixed tax rate of
18 percent.
B. Spanish corporate investors
Dividends and gains would be taxed at the rate of 32.5
percent (30 percent from 2008 onwards).
C. Non-Spanish investors (whether individual orcorporate)
Gains derived on the transfer or redemption of units/shares of
the Spanish HF would be exempt from Spanish tax. Dividends
would, however, be subject to withholding tax, either at the
general rate of 18 percent or at a reduced rate provided for in
an applicable tax treaty.
From an indirect tax perspective, it may be noted that:
■ Neither the incorporation nor any subsequent increase in
the share capital of an HF is subject to capital tax.
■ As the holding and management of the underlying assets
qualify as exempt activities for VAT purposes, no VAT
would be charged on the activities carried out by an HF.
This means, however, that the HF would not be entitled
45
Spain
45
to recover or deduct any input VAT incurred in the course of
its business.
VII. Spanish income taxation of income from acarried interest
Fees received by Savvy as compensation for his activities in
relation to the investment decisions of PEF (whether
calculated as a fixed amount or as a percentage of the
profits obtained by PEF) would be taxed at the progressive
tax rates under the Personal Income Tax Law, 43 percent
being the maximum rate. For the purpose of determining
Savvy’s net profit attributable to such activities, certain
expenses incurred in the course of those activities would be
deductible.
1 These vehicles were initially under the supervision of the SpanishCentral Bank.
2 For 2008 onwards, the corporate income tax rate has been set at30 percent. For 2007 only, following the repeal of the “traditional”rate of 35 percent, a transitional 32.5 percent rate applies.
3 Royal Decree 1080/1991, of July 5, 1991 specifies the 48jurisdictions that qualify as tax haven jurisdictions for Spanish taxpurposes.
4 There are some exceptions to the withholding tax rule, which apply,inter alia, to gains arising from exchange traded funds (ETFs) orgains arising from the transfer of CIS units/shares where theconsideration is in the form of new CIS units/shares.
5 For both personal and corporate income tax purposes
6 Whether these rules might apply to UCITS not registered with theCNMV needs to be examined further, although such applicationmight contravene the freedom of establishment principle in thecase of UCITS within the European Union.
7 There are special withholding tax rules that apply with respect togains from SICAV shares.
8 Provided the gains arise from the undistributed profits derived bythe VCE during the holding period.
9 As opposed to a mere holding activity that gives rise to passiveincome (i.e., interest and dividends).
10 There are some exceptions to this withholding tax rule, whichapply, inter alia, to gains arising from ETFs and gains arising fromthe transfer of CIS units/shares whose sale price is reimbursed innew CIS shares/units.
Spain
46
VCC (qualified) HF (qualified) Other Spanish vehicle Other non-Spanish vehicle
Controlled byregulatory body?
Yes (CNMV) Yes (CNMV) No N/A
Target Non listed equity Transferable securities Any Any
Legal form • Fund (no legal personality)
• Company (legal personality)
• Fund (no legal personality)
• Company (legal personality)
• Fund (no legal personality)
• Company (legal personality)
• Fund (no legal personality)
• Company (legal personality)
Investment/equityrequirements
Yes Yes No No
Taxation ofvehicle
• 99% of gain derived is taxexempt, depending onholding period.
• Dividends are generally taxexempt.
• Other income is subject totax at general rate (32.5%/30%).
1% CIT • 32.5% (2007).
• 30% (2008 onwards)
N/A
Taxation over theinvestors
• Spanish individualinvestors: dividends (over€1,500 per year) and gainsare taxed at 18%.
• Spanish individualinvestors: dividends andgains are taxed at 18%.
• Spanish individualinvestors: dividends (over€1,500 per year) and gainsare taxed at 18%.
• Spanish individualinvestors: dividends (over€1,500 per year) and gainsare taxed at 18%.
Taxation ofinvestors
• Corporate investors:dividends and gains areexempt from CIT.
• Non-Spanish investors:dividends and gains are notbe subject to Spanish WHT.
• Corporate investors:dividends and gains aretaxed at 32.5% (30% from2008 onwards).
• Non-Spanish investors:dividends are subject to18% WHT or reducedtreaty rate. No WHT ongains
• Corporate investors:dividends and gains aretaxed at 32.5% (30% from2008 onwards).
• Where vehicle does nothave legal personality,Spanish investors (whetherindividuals or entities) aretaxed annually onworld-wide income/gainsderived by vehicle, as ifdirectly derived by theinvestors, in proportion tointerest held.
• Non-Spanish investors:dividends and gains subjectto 18% WHT or reducedtreaty rate.
• Corporate investors:dividends and gains aretaxed at 32.5% (30% from2008 onwards).
• Where vehicle does nothave legal personality,tSpanish investors (whetherindividuals or entities) aretaxed annually onworld-wide income/gainsderived by vehicle, as ifdirectly derived by theinvestors, in proportion tointerest held.
46
Host CountrySWITZERLAND
Walter H. BossBLUM Attorneys at Law, Zürich
Walter H. Boss was born in Bern in 1952. He is a
graduate of the University of Bern and also graduated
from New York University School of Law with a Master
of Laws (Tax) Degree. Mr. Boss was admitted to the bar
in 1980. Until 1984 he served in the Federal Tax
Administration (International Tax Law Division) as legal
counsel; he was also a delegate at the OECD Committee
on Fiscal Affairs. He then was an international tax
attorney with major firms in Lugano and Zürich. In 1988,
he became a partner at Ernst & Young’s International
Services Office in New York. After having joined a major
law firm in Zürich he is now with the law firm von Meiss
Blum & Partners, Zürich, where he heads the tax
department. His areas of concentration are national and
international tax law, mergers and acquisitions and
corporate restructurings. He practices in German,
English, French and Italian and has published extensively
both in Switzerland and in the United States. He is a
member of the Swiss and Zürich Bar Associations, the
American Bar Association, the International Bar
Association and the International Fiscal Association. He
also served as Chairman of the Tax Chapter Board of the
Swiss-American Chamber of Commerce and is a
member of the Chapter Doing Business in Switzerland.
I. Introduction
The Swiss Federal Act on Collective Capital Investments (CCIA),
which replaced the former regulations on investment funds,
came into force on January 1, 2007. The CCIA, which contains a
comprehensive set of rules, follows the “same business, same
rules” principle and provides, generally speaking, that all forms of
collective invest-ment schemes are governed by the CCIA and
are supervised by the Swiss Federal Banking Commission (FBC).
The previous law on investment funds allowed only open-ended
investment funds based on collective investment agreements
concluded by the fund management and the custodian bank
with the investors. These investment funds were subject to the
supervision of the FBC and were entitled to use the term “fund”
in their name and to solicit fund investors publicly. Other types of
collective capital investment funds existed but were not subject
to the previous law on investment funds. Contempo-rary types of
collective investment schemes such as Sociétésd’Investissement à Capital Variable (SICAVs) and limited
partnerships did not exist.
The CCIA specifies three criteria that are decisive for determining
whether a scheme constitutes a Swiss collective investment
scheme: (i) an investment in the scheme must qualify as a capital
investment; (ii) the capital investment must be made by a number
of investors; and (iii) the capital invest-ment must be made in a
collective manner.
The CCIA distinguishes between open-ended and closed-ended
collective capital invest-ments,1 the distinction depending on
whether the investor has the right to have his shares repaid at
their net asset value. In the case of an open-ended collective
capital investment, the investor has the right to have his shares
repaid at their net asset value.2
Open-ended collective capital investments comprise: (i)
investment funds set up as con-tractual schemes,3 which were
also permitted under the previous law; and (ii) investment
companies with a variable capital (i.e., SICAVs),4 which are a new
investment vehicle.
Closed-ended collective capital investments comprise: (i) limited
partnerships for collective capital investments (LPs),5 which are a
newly created form of partnership; and (ii) investment com-panies
with fixed capital (Sociétés d’Investissement à Capital Fixe orSICAFs).6
Investment companies in the form of stock companies, whose
shares are either traded on a Swiss stock exchange or held
exclusively by qualified investors, are outside the scope of the
28 Federal Withholding Tax Act of October 13, 1965 (as amended)(FWHT), Article 4, paragraph 1, lit. c and Article 5, paragraph 1,lit. b
51
Switzerland
51
Host CountryUNITED KINGDOM
Nicola Purcell and Amy ManchiaMcDermott Will & Emery U.K. LLP, London
Nicola Purcell is a partner in McDermott, Will & Emery’s
London tax group. She regularly advises on a broad
range of domestic and cross-border commercial tax
issues, including corporate reorganisations, corporate
and structured finance projects, transfer pricing and thin
capitalisation issues. In addition, Nicola also advises on
U.K. value added tax, particularly in the context of
e-commerce.
I. Introduction
The reader is asked to note that a discussion of any potential
stamp duty, stamp duty reserve tax, stamp duty land tax or
value added tax issues arising from the proposed PEF/HF
investments is beyond the scope of this response.
Given HI is “a Host Country wealthy individual”, we have
assumed for the purpose of this paper, that HI is a U.K. higher
rate income tax payer subject to a 32.5 percent rate of tax on
dividend income and a 40 percent rate of tax on other
income.
We have also assumed that neither the PEF nor the HF would
be investing in real estate through a special purpose vehicle,
for example, a real estate investment trust (REITs).
II. Basic U.K. tax planning for a private equityfund
We have been asked to consider the PEF structure on the
assumption that the PEF will fund its investments only with
contributed capital and not with any borrowings. We
understand this to mean that PEF will not borrow funds from
third parties nor from investors in the fund in order to acquire
investments. We also assume that any intermediate
acquisition vehicle interposed between PEF and the foreign or
home country business entity investment would not borrow
funds from PEF or any other party to make these investments.
It should be noted, however, that in the U.K. market, a private
equity fund will ordinarily fund its investments with a high level
of debt to capital. This generates interest deductions at the
level of the portfolio companies or special purpose corporate
acquisition vehicles thus sheltering PEF profits from local
taxation.
Where a private equity fund finances its investments with
debt, issues arising include the United Kingdom’s transfer
pricing legislation,1 which requires that such debt is entered
into on arm’s length terms. Also, withholding tax planning
strategies (involving debt/hybrid instruments and acquisition
structures in foreign jurisdictions) may be relevant.
However, given the factual assumption we have been asked
to make that the PEF does not fund any of its investments
with borrowings, we have not discussed the issues described
above.
For the purposes of this paper, we assume that the PEF will
participate 100 percent in the foreign and home country
business enterprise.
A. Investment in a U.K. business entity
1. Preferred structure for a U.K. individual
The preferred structure for HI would require that PEF is
constituted by a fiscally transparent partnership,
non-corporate entity with limited liability. This is to ensure that
there is no taxation at the fund level on returns from
underlying investments and hence no tax leakage which
would impact on HI’s overall return on the PEF investment.
Furthermore, HI’s liability will be limited to the capital
contributed to the fund.
For U.K. private equity houses, these objectives are typically
achieved via constitution of the fund by a U.K. established
limited partnership formed under the Limited Partnerships Act
1907 (“LPA”), (“LP”).2
An LP is a tax transparent entity for U.K. tax purposes and
governed by a relatively light regulatory regime which has
made the LP the vehicle of choice for certain types of funds,
especially private equity funds.3
An LP must include one or more general partners, who have
the responsibility for managing the business of the
partnership. The general partners have unlimited liability for
the debts of the partnership.4 The general partner will typically
be a corporate partner which itself has unlimited liability. The
remaining partners are limited partners, who elect not to take
a positive role in the operation of the partnership in exchange
for limited liability. The investors, HI in this scenario, will be
limited partners.
The LP would invest directly in a portfolio U.K. incorporated
company, HBE.
Accordingly, given the fiscal transparency of an LP, profits,
gains and losses arising from the operations of PEF would be
treated as arising directly to the investors of PEF according to
their allocation rights pursuant to the partnership agreement.
HI, being a U.K. tax resident individual, would be subject to
U.K. tax on the returns from the investment in HBE.
The taxation of HI on such returns from the PEF investment
will depend on whether the PEF is carrying on a trade or an
investment business (see below).5
52
52
Provided that PEF is carrying on an investment business, not
trading, the return received by HI on the sale of HBE should
be treated as a capital return and chargeable to capital gains
tax. Similarly, a sale of his interest in PEF should be treated as
a capital transaction.
HI would be subject to income tax in respect of income profits
such as interest and other income distributions (e.g.,
dividends) arising from the PEF’s investment in HBE (although
interest income may not be likely given the factual
assumptions relevant to Section II. mentioned above).
Income (except dividend income) and capital gains tax is
chargeable at a prevailing rate of 40 percent. Dividend income
is taxable at 32.5 percent. However, dividend income carries a
tax credit of 10 percent and is, therefore, taxed at an effective
rate of 25 percent. Reliefs may be applicable for capital gains
tax purposes and, as a result, the effective tax rate of tax on
capital gains can be as low as 10 percent (provided the
statutory conditions for business asset taper relief are
satisfied).6 Generally, it is preferable for an individual to
achieve capital gains rather than income treatment.
To complete the picture, as HBE is a U.K. corporation,
income and capital profits arising to HBE would be subject to
U.K. corporation tax at 30 percent (reducing to 28 percent
which effect from April 1, 2008). Lower rates are applicable to
companies/groups with chargeable profits for the accounting
period in question of £1,500,000 or less.
2. Preferred structure for a foreign individual
The preferred structure for FI is the same as stated at Section
II.A.1. above for HI.
No U.K. tax is payable at the PEF level. PEF profits would be
treated as arising directly to FI for U.K. tax purposes.
FI is not U.K. tax resident and as such, assuming PEF is not
trading in the United Kingdom and the income does not
comprise interest, should not be liable to U.K. income or
capital gains tax.
FI should consider making a claim under the relevant double
tax treaty or FI’s domestic tax legislation for double tax credit
for U.K. withholding taxes suffered.
FI would, however, be within the charge to U.K. income tax
on any profits of a trade exercised by or on behalf of FI within
the United Kingdom. If the partnership were trading, FI would
be subject to U.K. income tax on FI’s share of the PEF profits.
However, as noted above, provided and on the basis that the
PEF is an investment, not a trading partnership, FI should not
be within this charge to U.K. tax. See footnote 5 regarding the
status of the PEF as an investment LP.
3. Preferred structure for a U.K. pension fund
The preferred structure for HPEN is as set out at Section
II.A.1. above for HI.
Provided that the PEF is not trading and HPEN is an HMRC
registered pension scheme,7 then HPEN should be exempt
from tax on income and capital gains arising on its investment
in PEF. Given that PEF is fiscally transparent, HPEN will be
treated as directly carrying on the operations of PEF in
partnership with the other partners. As discussed at footnote
5, in the context of the operations of a private equity
partnership, the partnership is likely to be considered to be
carrying on an investment not a trading operation.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN is as set out at Section
II.A.1. above for HI.
FPEN would be subject to U.K. tax in the same manner and
to same extent as FI.
5. Preferred structure for a foreign government
The preferred structure for FGOV is as set out at Section
II.A.1. above for HI.
In any event, where FGOV invests directly, it should not be
subject to any U.K. tax on the basis of sovereign immunity.8
B. Investment in foreign business entity
1. Preferred structure for a U.K. individual
The preferred structure would be the same as for HI investing
in HBE (as set out at Section II.A.1. above). That is, PEF
should be constituted as a U.K. LP investing in shares of the
FBE company. There need be no intermediate acquisition
vehicle subject to what we say below.
Foreign dividend income paid by FBE is treated, once
distributed, as accruing due to HI, not PEF, and would be
subject to U.K. income tax at 40 percent. Capital gains
realised on the sale of HI’s interest in PEF or, assuming PEF is
not trading, FBE should be subject to capital gains tax but
may benefit from more favourable reliefs (e.g., business asset
taper relief) if the relevant statutory conditions are satisfied.
HI should consider a claim for double tax relief for local taxes,
if any, borne on realisation of the investment in FBE and for
any local dividend withholding tax under the terms of the
relevant double tax treaty or, failing which, under U.K.
domestic legislation.
If FBE’s jurisdiction treats the PEF as a taxable entity and not
fiscally transparent, local taxes mentioned in the previous
paragraph would be treated as taxes borne by the PEF not
the individual investor. In this case, PEF would not be eligible
for treaty relief or unilateral relief under U.K. domestic
legislation in respect of those local taxes; the U.K. tax
authority, HM Revenue & Customs (HMRC), would consider
these to be the tax liabilities of the investors in the PEF. This
leads to effective double taxation of HI.
2. Preferred structure for a foreign individual
The preferred structure would be for PEF to set up as a
foreign partnership or corporation with no presence in the
United Kingdom. Care should be taken to ensure that any
foreign company in the structure is not centrally managed and
controlled from the United Kingdom9 to avoid the company
becoming U.K. tax resident. For the purposes of U.K. tax on
income, it would not matter how FBE is set up in these
circumstances.
Provided that PEF is an investment, not a trading, partnership
or corporation, FI should not be within the charge to U.K. tax
by reference to profits of a trade exercised within the United
Kingdom (see discussion at Section II.A.2. above).
Furthermore, even where management functions are carried
on in the United Kingdom, any foreign PEF corporation would
not be within the charge to U.K. corporation tax provided any
such U.K. established investment management function is
carried out on behalf of the corporation as described at
Section III.A.1. below.
On this basis, FI should not be subject to U.K. tax.
53
United Kingdom
53
3. Preferred structure for a U.K. pension fund
The preferred structure for HPEN is as set out at Section
II.A.1. above for HI.
Provided that the PEF is not trading, then HPEN should not
be subject to U.K. tax on its investment in PEF and assuming
HPEN is an HMRC registered pension scheme, HPEN should
be exempt from tax on income and capital gains arising on its
investment in PEF (see discussion at Section II.A.3. above).
4. Preferred structure for a foreign pension fund
The preferred structure would the same as for FI (see Section
II.B.2. above).
On this basis, FPEN should not be subject to U.K. tax.
5. Preferred structure for a foreign government
The preferred structure for FGOV is as set out at Section
II.B.2. above for HI.
In any event, regardless of the structure, FGOV should not
itself be subject to U.K. tax on the basis of sovereign
immunity.10
C. Conclusion as to the overall preferred structure
The overall preferred structure for cases where the
circumstances involve either (i) a U.K. established or U.K. tax
resident investor; or (ii) a U.K. source/situated investment is
as follows.
PEF should be constituted as an entity that is treated as tax
transparent for U.K. tax purposes and for tax purposes in the
jurisdiction of FBE/HBE (although the choice of which FBE or
HBE the PEF will invest in is unlikely to be decided on the
basis of tax considerations alone). A U.K. LP is frequently
used in these circumstances to ensure that tax charges on
returns realised from underlying investments of the fund only
arise at the level of the investors.
Where neither the investor nor the investment is established
or situated in the United Kingdom, no U.K. established
corporate or non-corporate entities should be used in the
structure to avoid subjecting the investor or any entity used in
the structure to U.K. tax. Foreign incorporated corporate
entities used in the structure should be managed and
controlled entirely outside of the United Kingdom to ensure
that the entity does not become U.K. tax resident (save to the
extent the U.K. Investment Manager Exemption applies).
III. Basic U.K. tax planning for a hedge fund
Given the various investment restrictions imposed on
Authorised Unit Trusts and Open-ended Investment
Companies by the U.K. Financial Services Authority (FSA) (in
particular they cannot short sell or be leveraged), fund
mangers wishing to offer investors a hedge fund investment
do not, in practice, establish themselves as a U.K.-regulated
vehicle.
Furthermore, a hedge fund will typically be considered to be
carrying on a trade rather than an investment business for
U.K. tax purposes (see above at footnote 5; on the basis that
the HF is taking short positions on the underlying assets
acquired). As a result, unauthorised unit trusts, investment
trusts and LPs are not tax efficient vehicles for hedge fund
investors, given the tax implications of these vehicles carrying
on a trade in the United Kingdom (discussed further below).
Unauthorised unit trusts and investment trusts are also likely
to give rise to some tax leakage at the fund level.
On this basis, the preferred structure, discussed below, would
be the same for all classes of investor and would be the same
whether or not the HF invests in assets generating host
country source income (“HCI”) or assets generating foreign
country source income (“FCI”).
A. Investment in assets generating host country sourceincome
1. Preferred structure for a U.K. individual
The preferred structure for HI would be to make investments
via an offshore company, e.g., incorporated in the Cayman
Islands (for the reasons set out above). There should be no
liability to U.K. tax imposed on the offshore company on the
basis that it is a foreign incorporated company which is
centrally managed and controlled outside of the United
Kingdom. The Cayman Islands is typically the jurisdiction
chosen for incorporation of hedge fund vehicles as a Cayman
Islands company, we understand, is tax neutral; there should
be no (or negligible) Cayman Islands’ taxation on the profits of
the HF.
Furthermore, use of a corporate vehicle rather than a tax
transparent partnership vehicle, will defer tax charges on the
investor until such time as profits from underlying investments
are distributed by the HF or the HF shares are disposed of by
the investor; returns on underlying investments (and
accompanying tax charges) would not accrue directly to the
investor.
It is important to ensure that any investment manager acting
on behalf of the HF and operating out of the United Kingdom
does not constitute a U.K. permanent establishment of HF. A
non-resident company is within the charge to corporation tax
if it is carrying on a trade in the United Kingdom through a
U.K. permanent establishment. Profits of the non-resident
company attributable to the activities of the U.K. permanent
establishment are so chargeable. However, provided either
that (i) the investment manager is an independent agent
acting in the ordinary course of his business of providing
investment management services,11 or (ii) the arrangements
between the investment manager and the HF satisfy the
conditions of the U.K. Investment Manager Exemption, then
the investment manager should not constitute the U.K.
permanent establishment of the HF and HF should not be
exposed to this charge to U.K. corporation tax.12
All returns for HI on the investment in the HF are taxed as
income subject to 40 percent income tax rate. Hedge funds
typically do not distribute income to investors; the investor
return is received on redemption of the investment in HF.
However, capital returns on realisation of the HF investment
are also taxed as income on the basis of the application of
anti-avoidance provisions applying to offshore funds that
accumulate distributable income rather than distribute that
income to investors. The anti-avoidance legislation seeks to
ensure that investors do not roll-up income offshore tax-free
and then realise their investments on redemption as capital
gain in order to gain the more favourable reliefs/effective U.K.
tax rates on capital gains.13
2. Preferred structure for a foreign individual
The preferred structure would be for HF to set up as a foreign
partnership or corporation with no presence in the United
54
United Kingdom
54
Kingdom. Care should be taken to ensure that any foreign
company in the structure is not centrally managed and
controlled from the United Kingdom to avoid the company
becoming U.K. tax resident. For the purposes of U.K. tax on
income, it would not matter how FBE is set up.
If the investment management function is to be carried out
from the United Kingdom, then provided that manager is an
independent agent or otherwise complies with the terms of
the U.K. Investment Manager Exemption (as referred to above
at Section III.A.1.), the investment manager would not
constitute a U.K. permanent establishment of the HF so as to
ensure that the HF does not become subject to U.K. taxation
on its investment returns.
On this basis, FI should not be subject to U.K. tax.
3. Preferred structure for a U.K. pension fund
The preferred structure for HPEN would be the same as for HI
described above at Section III.A.1.
Provided that HPEN’s acquisition of the shares of HF are for
investment purposes (so, applying the badges of trade
discussed at footnote 5 above, HF shares are to be held long
term for capital appreciation and not to be disposed of in the
short term for profit), HPEN will be considered to be making
an investment. If HPEN is an HMRC registered pension
scheme it is tax exempt on its income and gains realised from
investments.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as for FI
described above at Section III.A.2.
On this basis, FPEN should not be subject to U.K. tax.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as for FI
described above at Section III.A.2.
In any event, regardless of the structure, FGOV should not be
subject to U.K. tax on the basis of sovereign immunity.14
B. Investment in assets generating foreign countrysource income
The position is as set out above at Section III.A. in respect of
investment by HF in HCI.
C. Conclusion as to the overall preferred structure
The preferred overall structure is that set out at Section III.A.1.
for the reasons described there.
IV. U.K. income taxation of income from acarried interest
A. Private equity
In the context of a private equity fund, “carried interest” is
essentially a subordinated limited partnership interest in
respect of which a share of any remaining profits of the LP will
be paid to the carried interest limited partners (the founders,
sponsors and managers of the fund) after payment of a) the
management fee/profit shares of the general partner or
manager, b) the return of investors’ contributions (structured
as capital and debt), and, c) payment of the investors’ agreed
rate of return on contributions. The remaining profits are split
between carried interest partners and investors. Typically,
carried interest partners will receive a “catch-up” allocation
before the remaining profits are split between the carried
interest partners and the investors. This carried interest of the
carried interest partners is generally bought for a nominal
amount.
The taxation of carried interest is governed by a non-statutory
memorandum of understanding published by the BVCA on
July 25, 2003 and agreed with HMRC (the MOU). The MOU
applies to an investment partnership (which does not carry on
a trade) whose sole or main purpose is to invest in unquoted
shares or securities. Provided the conditions in the MOU are
satisfied15 the carried interest partner will be taxed on all the
returns on its carried interest as capital and not to any extent
as compensation income for any employment of the partner
on behalf of the fund.
Provided further additional relevant statutory conditions are
satisfied, Savvy will generally benefit from a lower overall tax
rate on the carried interest than he would if the carried interest
returns were taxed as income/employment compensation;
given the more favourable tax reliefs on capital returns as
compared to income profits. In certain circumstances, an
effective 10 percent tax rate can be achieved as compared to
40 percent income tax rate on employment compensation.
The taxation of carried interest is currently the subject of
HMRC review and may be reformed. The U.K. Government
has stated that possible proposals for reform include the
increase in the overall effective tax rate from 10 percent to 20
percent. Given the possible reform, there is evidence that
some fund management groups may be moving towards LLP
structures such as those used in the hedge fund industry and
described below.
B. Hedge fund
In the context of the U.K. established investment manager of
a hedge fund constituted by an offshore company, it is
common for the investment management function to be
carried out via a U.K. limited liability partnership (“LLP”). The
LLP contracts directly with the fund in relation to its provision
of investment management services.
Typically, the investment management fee is structured as a
management fee equal to 2 percent of the net asset value of
the fund and a performance fee of 20 percent of the annual
profits of the fund.
The investment managers who on a traditional private equity
structure would have been entitled to carried interest become
partners (referred to as “members”) in the LLP taking their
share of the management fee and performance fee by way of
a share in LLP profits instead of as employment income; the
partners are considered to be self-employed and not
employees. Accordingly, members are subject to capital gains
tax or income tax on their share of the income or capital gains
of the partnership. This also avoids the cost of employers’
national insurance contributions (NICs) which would be
payable by the LLP in addition to any employment
compensation if the partners were treated as employees of
the LLP.
In the context of hedge fund management, an LLP is used as
the fund management vehicle rather than an LP for general
corporate purposes rather than for tax reasons. Although both
entities are partnerships which offer members/partners limited
liability, the Limited Liability Partnership Act which governs the
constitution of LLPs is more comprehensive than the LPA
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55
and, accordingly, meets the commercial demands placed on
LLPs involved in fund management better than the LP.
1 Schedule 28AA, Income and Corporation Taxes Act 1988 (“TA”)
2 Other U.K. investment vehicles such as FSA regulated authorisedunit trusts and open-ended investment companies would not beappropriate because these are heavily regulated and are prohibitedfrom borrowing to purchase investments. U.K. investment trustsmust, inter alia, be listed on the Official List of the London StockExchange in order to obtain tax exemptions for capital gains andwould not therefore be appropriate given the nature of the privateequity industry. Other vehicles include U.K. unauthorised trusts butsuch entities are not ideal when dealing with counterpartiesestablished in civil law jurisdictions where trusts are an unfamiliarconcept. Furthermore, there are potential trust law issues withunauthorised unit trusts.
3 The limited liability partnership (“LLP”) is another U.K. partnershipwhich confers limited liability on its members and is treated asfiscally transparent for U.K. tax purposes. However, in the contextof private equity an LLP would not be a viable vehicle by which toconstitute a fund. This is because, as explained in this paper, apartnership carrying on private equity investment is likely to beconsidered an investment partnership, not a trading partnership.An investment LLP is subject to tax anti-avoidance legislationwhich provides that interest relief is denied in respect of loans toindividuals to purchase an interest in an investment LLP.Accordingly, we would recommend that the PEF in this scenario isconstituted via an LP to maintain maximum flexibility.
4 Sections 3 and 4(2) LPA
5 Whether or not a partnership is trading or carrying on investmentbusiness is determined according to U.K. case law which can besummarised as follows. The issue is decided by establishing thetaxpayer’s motive in conducting the relevant operations/activity(here, the acquisition of the investment in the PEF vehicle). Thetaxpayer’s motive must be objectively determined according to therelevant factual criteria, or indicia, as identified by the case law,know as the “badges of trade” (Marson v. Morton 1986 STC 463).In the context of an investor in a private equity fund the motive ofthe partnership as a whole in entering into the partnership businessis relevant. The following facts are commonly considered decisivein a private equity context: the making of investments with a view tolong term capital appreciation (investment) rather than short termturn-over of investments (trade), frequency of purchase and sale ofassets (the more frequent the more likely a trade exists, if only aone-off transaction is entered into this is more likely to be aninvestment activity).A statement of the British Venture Capital Association (BVCA) pub-lished in 1987 and approved by HMRC confirms that a fund that isset up through the medium of a limited partnership to purchaseshares with the intention of holding these as investments, would betreated for tax purposes as an investment partnership, not a tradingpartnership (provided the partnership was not also carrying on anyother trading activity). The fact that the general partner of the LPprovides management assistance to the companies in which in-vestments are held by the partnership would not, of itself, affect thematter and will be irrelevant; this is noteworthy because, ordinarily,the “badges of trade” provide that the management of an asset toenhance the asset value or returns from that asset usually suggestsa trading, not investment, activity. See paragraphs 1.4 and 1.5 ofthe BVCA statement.
6 Business asset taper relief (BATR) limits the proportion of a capitalgain which is chargeable to tax thereby reducing the effective taxrate on that gain. BATR is available on investments in shares of anunquoted trading company (see 2A, and Schedule A1, TCGA). Thecontinuing availability of BATR on its existing terms is understoodto be currently under review by HM Treasury as part of a broaderreview of the private equity sector.
7 Sections 186 and 187 Finance Act 2004. The tax treatment ofunregistered/unapproved pension schemes is unfavourable
compared to registered schemes; as a result very few have beenestablished. A detailed discussion of unregistered schemes isbeyond the scope of this paper.
8 “Sovereign immunity” is a principle of international law whereby onesovereign state does not seek to apply its domestic laws to anothersovereign state. Under this principle, the current practice of HMRCis to exempt from direct taxes all income and gains which arebeneficially owned by the head of state and the government of aforeign sovereign state. It should be noted that, as a matter ofinternational law, the United Kingdom does not recognise certainterritories as being foreign sovereign states (e.g., Taiwan), and insuch cases, the practice described above may not necessarilyapply.
9 Central management and control is defined by U.K. case law (De
Beers Consolidated Mines v. Howe (5 TC 198) and Bullock v. Unit
Construction Company (1959) 38 TC 712). The centralmanagement and control of the company is directed at the highestlevel of control of the business of a company and is to bedistinguished from the place where the main operations of thecompany are carried out. It is often determined by reference to theplace where the board of directors meets, if the board is themedium through which the central management and control of thecompany is in fact carried on. Central management and control isnot synonymous with control at shareholder level.
10 See footnote 8 above
11 Section 148(3) Finance Act 2003
12 The U.K. Investment Manager Exemption is specifically geared toproviding exemption in respect of investment managers servicesrelating to investments in, inter alia, shares, stock, futures contractsand certain securities. The exemption is particularly relevant in thecontext of the offshore funds industry. The statutory conditions forexemption are set out at section 152 and Schedule 26, Finance Act2003.Further guidance is provided in the form of a published statementof practice of HMRC (SP1/01 as revised on July 20, 2007) whichprovides guidance on HMRC’s interpretation of these conditions.The statement is intended to provide the funds industry with morecertainty that reliance can be placed on the investment managersexemption when establishing, marketing and operating funds.
13 Other tax anti-avoidance legislation is technically relevant to U.K.tax-resident individuals investing in offshore hedge funds, e.g.,section 13 TCGA (attribution of gains of non-resident company toparticipators) and sections 721, 728 and 732 Income Tax Act 2007(transfer of assets abroad).Section 13 should not apply provided that the HF would not be a“close” company were it incorporated in the United Kingdom(broadly, this would require that HF is widely held and not held byan irreducible number of unconnected investors numbering five orfewer).
Sections 721, 728 and 732 will not apply if the investor can showthat the purpose of its investment in HF was not to avoid U.K. taxa-tion or that the investment was undertaken for bona fide commer-cial reasons. Historically, HMRC has chosen not to invoke theseprovisions given that hedge fund investments are usually made forbona fide commercial reasons. However, this exclusion was re-cently redrafted to restrict its application so it remains to be seenwhether HMRC continues its former practice. If these provisionsapply, the income of the HF can be attributed to the individual as itarises and will be subject to U.K. tax accordingly.
14 See footnote 8 above
15 The conditions require, for example, inter alia, that the carriedinterest is acquired by the partner before the fund starts investingor before the value of the fund’s investments have increased invalue since the date of acquisition of those investments (paragraph3.1 of the MOU). Furthermore, the carried interest partner mustotherwise receive arm’s length compensation for his employmentduties as fund manager.
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Host CountryUNITED STATES
Herman B. BoumaBuchanan Ingersoll & Rooney PC, Washington, D.C.
Herman B. Bouma is Counsel with the Washington, D.C.
office of Buchanan Ingersoll & Rooney PC. Mr. Bouma
has over 25 years of experience in U.S. taxation of
income earned in international operations, assisting
major U.S. companies and financial institutions with tax
planning and analysis and advising on such matters as
the structuring of billion-dollar international financial
transactions, the creditability of foreign taxes, Subpart F
issues, transfer pricing, and foreign acquisitions,
reorganisations and restructurings. Mr. Bouma was
counsel to the taxpayer in Exxon Corporation v. Comr.,
113 T.C. 338 (1999) (creditability of the U.K. Petroleum
Revenue Tax under §§901/903), and in The Coca-Cola
Company v. Comr., 106 T.C. 1 (1996) (computation of
combined taxable income for a possession product
under §936).
Mr. Bouma began his legal career as an attorney-advisor
in the IRS Office of Chief Counsel, Legislation and
Regulations Division (International Branch) in
Washington, D.C. He was the principal author of the
final foreign tax credit regulations under §§901/903, and
participated in income tax treaty negotiations with
Sweden, Denmark, and the Netherlands Antilles. Mr.
Bouma is a graduate of Calvin College and the
University of Texas at Austin School of Law.
I. Introduction
The amount of assets under management by private equity
funds and hedge funds has expanded exponentially over the
past two decades. According to a report recently released by
the U.S. Joint Committee on Taxation, it is estimated that
private equity funds manage approximately $1 trillion of assets
globally and hedge funds manage approximately $1.46 trillion
of assets globally.1 Some of the better known private equity
funds are the Blackstone Group, Kohlberg, Kravis & Roberts,
the Carlyle Group, and Lone Star. The principal advantage of
private equity funds and hedge funds is that they are generally
free of securities regulation, including, in the United States,
the requirements of the Sarbanes-Oxley legislation, and thus
have substantially lower compliance costs and can operate
more freely and flexibly.2 In addition, because the ownership
interests are not publicly traded, managers can focus more on
the long term and less on each quarter’s earnings results.
Even foreign governments have not been able to resist the
allure of such funds. Recently it was announced that China
would be making a $3 billion investment in the New
York-based Blackstone Group.3 (It might also be noted, in the
words of one commentator, that “with some 9,000 funds now
managing more than $1.4 trillion in assets, hedge fund money
is creating new wealth for law firms”.)4
However, private equity funds are not without their detractors.
On March 16, 2007, union leaders urged the Group of Eight
countries to begin formulating a co-ordinated response to
“the growing influence” of private equity funds.5 According to
John Evans, General Secretary of the Trade Union Advisory
Committee to the Organisation for Economic Co-operation
and Development (OECD), which represents 66 million
workers that belong to 56 affiliated organisations across the
30-member OECD, and John Monks, the General Secretary
of the European Trade Union Confederation, private equity
funds pose a major threat to jobs, employee rights, company
pension plans, the normal functioning of capital markets, tax
revenues (because the funds are often based in offshore
low-tax jurisdictions), and the economy as a whole.6
According to Damon Silvers, Associate General Counsel for
the AFL-CIO, American unions “suspect private equity funds
of constructing new cash flow operations to shift income, and
tax liabilities, to low-tax jurisdictions” and are “calling for new
discussions on how private equity funds are using tax havens
and other offshore financial centres to avoid corporate
taxation liabilities”.7
However, others are equally strong in their defence of private
equity funds. In a speech on February 22, 2007, E.U. Internal
Market Commissioner Charlie McCreevy lauded the “proactive
oversight” by private equity funds and stated that “workers as
well as investors benefit from more active management
because more competitive companies expand faster, create
more jobs, and earn higher returns on investment”.8 He also
noted that “all taxpayers benefit from higher corporate tax
revenue from the profits of private equity portfolios”.9 It has
also been noted that private equity funds often help ventures
that are not able to obtain financing through more
conventional means and it is typical “for private equity firms to
invest in young companies that have great potential, but are in
need of capital and management expertise to help them
grow”.10 At a hearing before the U.S. House Financial Services
Committee on May 16, 2007, Douglas Lowenstein, President
of the Private Equity Council, cited the following benefits that
flow from private equity funds: (1) without the pressures from
outside public shareholders looking for short-term gains,
private equity funds can focus on what is required to improve
the medium- to long-term performance of a company and
institute a nimbler operating style that fosters greater
innovation, improved productivity, and competitiveness; (2)
according to a study done by the international management
(H.R. 2834) to treat as ordinary income (rather than capital
gain) income derived from a carried interest. (The taxation of
income from a carried interest is discussed in more detail in
Section IV. below.) H.R. 2834 would also tax publicly-traded
partnerships as corporations if more than 10 percent of their
income is derived from carried interests. On July 13, 2007,
Representative Levin stated that new information received
with respect to the Blackstone Group’s initial public offering
shows that private equity funds “are taking tax avoidance
efforts even further than lawmakers’ examination of carried
interests had indicated”.15 On July 17, 2007, Senate Majority
Leader Harry Reid (D-Nev.) stated that he supported the
Senate Finance Committee’s ongoing examination of the
taxation of private equity firms, saying it is “something we
need to take a look at”.16
On June 20, 2007, Secretary of the Treasury Henry Paulson
stated that the U.S. Department of the Treasury “has been
considering new rules affecting the taxation of private equity
firms for weeks”.17 However, at this point the Treasury
Department appears less than enthusiastic about the changes
being considered by Congress. On June 27, 2007, Secretary
Paulson voiced opposition to S. 1624, which would treat
certain publicly-traded partnerships as corporations.18
Moreover, on July 11, 2007, at a Senate Finance Committee
hearing on the taxation of income derived from a carried
interest, Assistant Secretary of the Treasury for Tax Policy Eric
Solomon stated that the Bush Administration opposes any
changes to the taxation of such income. Assistant Secretary
Solomon said that making a significant change “could undo
the work the federal government has done to support
entrepreneurship”.19 At this point, therefore, one might say the
U.S. taxation of private equity funds and hedge funds has an
unsettled future.
II. Basic U.S. tax planning for a private equityfund
A. Investment in a U.S. business entity
With respect to an investment by PEF in HBE (which is a U.S.
business entity), there follows a discussion, separately with
respect to each of the investors, of the preferred structure for
U.S. income tax purposes (under existing law, of course).
1. Preferred structure for a U.S. individual
From the perspective of HI (who is a U.S. person), the most
tax-efficient structure for U.S. income tax purposes would be
to set up HBE as a partnership and PEF as a partnership
(with HI as a direct partner in PEF). With such a structure,
there would be only one level of tax on the income derived by
HBE (avoiding tax on distributions (if any) from HBE that are
attributable to income derived by HBE) and the tax rate
imposed on the income derived by HBE would be no higher
than the tax rate that would apply if HBE were a
corporation.20 HI would file a U.S. income tax return reporting
his/her (“his”) distributive share of the income derived by HBE
and also his share of any gain realised by PEF on the sale of
its interest in HBE. An additional advantage of this structure is
that, as HBE’s income is taxed to its partners (which, in the
case of PEF, would mean taxed to PEF’s partners), PEF’s
basis in HBE would be adjusted upward, thus reducing the
amount of capital gain on a subsequent sale of PEF’s interest
in HBE.
A U.S. Limited Liability Company could be used for HBE in
order to ensure that limited liability is provided to its owners.
(Hereinafter, any reference to a business entity will be to an
entity that provides limited liability to its owners.) Because a
U.S. Limited Liability Company is not a per se corporation,21
HBE could be treated as a partnership for U.S. income tax
purposes. Moreover, its default classification would be that of
a partnership22 and thus no election would be necessary
(unless its classification were being changed).23
Whether PEF was formed under U.S. law or foreign law would
not be significant for HI nor would it matter whether PEF
conducted its operations through an office in the United
States. This is because, as a U.S. person, HI would be taxed
on his distributive share of PEF’s total income, whether or not
PEF was a U.S. entity and whether or not it was engaged in a
U.S. trade or business.
If PEF were a foreign entity, its default classification would be
a corporation since all owners would have limited liability.24 In
that case, it would be necessary for PEF to file an election to
be treated as a partnership.
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2. Preferred structure for a foreign individual
The preferred structure for HI would also work well for FI
except for two concerns. The first relates to the fact that FI
would be considered to be engaged in a trade or business in
the United States (considered to be “ETB”) by virtue of his
indirect partnership interest in HBE. As a result, FI might be
exposed to taxation on other U.S.-source income derived by
him independently of his investment in PEF.25 This could be
dealt with by having HBE function as a corporation for U.S.
income tax purposes. Although this would eliminate the
possibility of PEF receiving a step-up in basis for its interest in
HBE as a result of income earned by HBE, this would not be
a concern for FI (from the U.S. income tax perspective)
assuming FI would not be subject to U.S. income tax on
income earned by PEF. This leads to the second, more
serious, concern – whether PEF might be considered ETB,
assuming it has a physical presence in the United States. If
PEF was ETB, then FI would be considered ETB and he
would be taxed on his proportionate share of all the income
earned by PEF (assuming all such income was effectively
connected with PEF’s U.S. trade or business). Such income
would include gain realised by PEF on the sale of its interest
in HBE. If PEF was ETB, FI might also be subject to U.S.
income taxation on gain realised on the disposition of his
interest in PEF. It is the position of the U.S. Internal Revenue
Service (IRS) that if a partnership is ETB, then gain realised by
a foreign partner on the disposition of his partnership interest
is income effectively connected with the conduct of a U.S.
trade or business (“effectively-connected income” or “ECI”).26
The conventional wisdom on Wall Street appears to be that,
even if PEF had a presence in the United States, it would not
be considered ETB because: (1) it would not be ETB under
the general rules for determining if a person is ETB; and (2)
even if it were to be ETB under the general rules, it would be
protected by the “trading” safe harbour in §864(b)(2)(A)(ii), a
special rule that provides that a foreign person is not
considered ETB simply by virtue of being in the United States
trading in stocks and securities for its own account. However,
there is an issue as to whether PEF would not be ETB under
the general rules (assuming it had a presence in the United
States) and also whether PEF would be covered by the
special trading safe harbour if it would otherwise be ETB.
Because of the substantial activities of PEF in finding
companies to invest in and in assisting the management of
those companies in getting the companies to a very
favourable profit position, it could be argued that PEF would
be ETB under the general rules and would not be covered by
the trading safe harbour because it is doing more than just
“trading”. This issue is similar to the issue of whether a foreign
person would be ETB and not covered by the trading safe
harbour if he is conducting a loan origination business in the
United States (involving solicitation and negotiation), as
opposed to trading in loans acquired on a secondary market.
In a speech on February 22, 2007, E.U. Internal Market
Commissioner Charlie McCreevy stated, “There is no room in
the modern world for hush-puppy fund managers watching
passively as complacent management teams erode
shareholder value and get bowled over by the competition”
and stated that “private equity firms’ ‘proactive oversight’ of
company management helps companies meet the challenges
of globalisation”.27 As stated earlier, a commentator has also
noted the importance of management expertise provided by
private equity firms, stating that it is typical “for private equity
firms to invest in young companies that have great potential,
but are in need of capital and management expertise to help
them grow”.28 Finally, in his testimony before the House
Financial Services Committee on May 16, 2007, Douglas
Lowenstein, President of the Private Equity Council, stated
that the best private equity firms “must bring to the table
much more than capital”; they offer “the management focus
and resources needed to achieve a new mission”, they
“deliver deep expertise in the sector in which the investment
is being made”, and “with infusions of capital, talent and
strategy, private equity firms improve the productivity,
performance and financial strength of the companies in which
they invest”.29 Thus, there are indications that private equity
funds may be doing more than just “trading” in stocks and
securities.
If PEF is a partnership with no presence in the United States,
then PEF would avoid the ETB issue.30 To be on the safe side,
it would be best to set up PEF as a foreign partnership. This
would reduce the reporting burden (for U.S. income tax
purposes) and would also reduce the possibility that a foreign
corporation in which PEF invests might be considered a
controlled foreign corporation (CFC).31
Another option would be to set up PEF as a foreign
corporation in a zero-tax jurisdiction (with no presence in the
United States). However, having PEF set up as a partnership
would be more tax-efficient for FI if FI is a resident of a foreign
country with which the United States has an income tax treaty
and FI would be entitled under the treaty to a reduced rate of
withholding tax on dividends received from HBE. (This
assumes that FI would qualify for the reduced withholding
under the regulations issued under §894(c).)32 It is unlikely that
PEF would qualify for any reduced withholding if it were a
corporation set up in a zero-tax country, and thus setting up
PEF as a partnership has the advantage of possibly allowing
FI to take advantage of a reduced treaty rate.33 Thus, the
preferred structure for FI is to have HBE set up as a
corporation and PEF set up as a foreign partnership with no
presence in the United States.
3. Preferred structure for a U.S. pension fund
If the preferred structure set forth above for HI were followed
for HPEN, then HPEN would have unrelated business taxable
income (UBTI) subject to U.S. income taxation.34 This is
because HPEN would be considered engaged in the business
in which HBE is engaged because HPEN would have an
indirect partnership interest in HBE. Having this UBTI would
not in itself be a negative since the tax burden on HPEN’s
share of the income derived by HBE would be the same
whether HBE was a partnership and HPEN had UBTI or HBE
was a corporation and HPEN received tax-exempt dividends.
However, HPEN may simply wish to avoid having to report
UBTI, in which case HBE could be set up as a corporation.
With respect to PEF, if PEF were set up as a partnership, its
income would not be UBTI to HPEN as long as PEF was only
receiving interest, dividends, and capital gains. This would be
true even if PEF were considered to be engaged in a trade or
business.35 Thus, assuming HPEN wishes to avoid having to
report UBTI, it would be best to follow a structure similar to
that for FI, i.e., with HBE set up as a corporation and PEF as
a partnership.36 Whether PEF is a U.S. or foreign partnership
or has or does not have a presence in the United States
would not have an impact on HPEN.
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4. Preferred structure for a foreign pension fund
If FPEN is considered a tax-exempt organisation for U.S.
income tax purposes, then the preferred structure set forth
above for HPEN would also be the preferred structure for
FPEN. If FPEN is not considered tax-exempt and is treated
as a foreign corporation, the preferred structure for HI (i.e.,
with HBE and PEF both set up as partnerships) would
result in FPEN being ETB, which would give rise to
exposure under the branch profits tax37 and also possible
exposure to taxation of U.S.-source income derived outside
of FPEN’s investment in PEF. Thus, if FPEN is treated as a
foreign corporation for U.S. income tax purposes, it would
be better for it to have the preferred structure for FI (i.e.,
with HBE set up as a corporation and PEF as a foreign
partnership with no presence in the United States). The
same would be true if FPEN were to be treated as a taxable
foreign trust for U.S. income tax purposes. By setting up
HBE as a corporation, the foreign corporation or foreign
trust would not be ETB even though PEF is set up as a
partnership and by setting up PEF as a foreign partnership
with no U.S. presence, FPEN’s distributive share of capital
gains would be exempt from U.S. income tax and its share
of any dividends received from HBE might qualify for treaty
relief.
5. Preferred structure for a foreign government
As a foreign government, FGOV is a tax-exempt entity
except with respect to income derived from the conduct of
a “commercial activity” or from a “controlled commercial
entity” or from the disposition of an interest in a controlled
commercial entity.38 In order for an entity to be a controlled
commercial entity, it must be at least 50 percent controlled
by the foreign government and thus it is assumed here that
neither HBE nor PEF would be controlled commercial
entities of FGOV. If both HBE and PEF were partnerships,
FGOV would be considered engaged in a commercial
activity and subject to U.S. income tax on its share of
HBE’s income. Assuming FGOV would not want to file a
return reporting such income, this could be avoided by
having HBE treated as a corporation. If PEF is set up as a
partnership and is not considered engaged in a commercial
activity, then dividends and capital gains that flow through
to FGOV would not be subject to U.S. tax. If PEF is set up
as a partnership but is considered engaged in a commercial
activity, then, if it has a presence in the United States to
which its income is attributable, FGOV would be subject to
U.S. income tax on its share of the ECI (including dividends
and capital gains). If PEF does not have a presence in the
United States, then FGOV would not be subject to tax on
its share of capital gains, but dividends received by FGOV
through the partnership might still be subject to U.S.
income tax (on a gross basis) because they are derived as
part of a commercial activity. An interesting question would
then arise as to whether the tax could be reduced under an
income tax treaty to which FGOV is a party. Would FGOV
be considered a resident of FGOV? In theory, a treaty
reduction should apply but, depending on the particular
language of the treaty, it might be hard to arrive at that
result based on a technical reading of the treaty.
In summary, the preferred structure for FGOV would be the
same as that for FI, i.e., with HBE set up as a corporation
and PEF as a foreign partnership with no U.S. presence.
B. Investment in a foreign business entity
1. Preferred structure for a U.S. individual
If FBE is operating in a high-tax country (i.e., is subject to an
effective foreign income tax rate equal to or higher than 35
percent), then the preferred structure for HI with respect to
the investment in HBE (i.e., with HBE and PEF both set up as
partnerships) would also be the preferred structure for HI with
respect to the investment in FBE. This is because HI would
receive foreign tax credits for the foreign income taxes paid by
FBE and thus, generally speaking, there would be no residual
U.S. income tax on HI’s distributive share of FBE’s income. HI
would also benefit from the upward adjustment to PEF’s basis
in FBE.
If FBE is operating in a low-tax country (i.e., is subject to an
effective foreign income tax rate lower than 35 percent), then
it likely would be preferable for FBE to be set up as a foreign
corporation in order to obtain deferral of U.S. tax with respect
to FBE’s income. PEF could be set up either as a partnership
or a foreign corporation in a zero-tax jurisdiction. If PEF is to
be set up as a partnership, it should be set up as a foreign
partnership in order to reduce the chances that FBE would be
a CFC and thus possibly yield Subpart F income for HI. If PEF
is set up as a partnership, HI would be immediately taxed on
his distributive share of capital gain realised by PEF on the
sale of its interest in FBE.
If PEF is set up as a foreign corporation in a zero-tax
jurisdiction, then PEF may or may not be a CFC, depending
on its other owners. If it is not a CFC, it is possible it is a
Passive Foreign Investment Company (PFIC), depending on
the type of income it derives. If all of its ownership interests in
corporations are substantial (i.e., over 25 percent), then it
likely would not be a PFIC.39 If it is a PFIC, then, under the
default PFIC regime, HI would have to pay an interest charge
to the United States with respect to the benefit he has derived
from deferring U.S. income tax on the income of PEF (for
example, dividends and capital gains).40
2. Preferred structure for a foreign individual
Since the United States would not tax income realised by FI
as long as there was no connection to the United States, the
preferred structure for FI would be for PEF to be set up as a
foreign partnership or foreign corporation, each with no
presence in the United States, and it would not matter how
FBE was set up. (This assumes that FBE has operations only
in its country of formation.) It must be emphasised that this
preferred structure is only for U.S. income tax purposes. The
way in which FBE and PEF are set up could be highly relevant
for foreign income tax purposes.
3. Preferred structure for a U.S. pension fund
Since FBE might be operating in a low-tax jurisdiction, HPEN
would definitely prefer that FBE be set up as a corporation so
that FBE’s income would not be UBTI to HPEN, assuming
PEF is set up as a partnership. If FBE is set up as a foreign
corporation and PEF as a partnership, dividends received by
HPEN through the partnership would be tax-exempt for U.S.
income tax purposes. Moreover, HPEN’s share of capital gain
realised by PEF on the sale of its interest in FBE would also
be tax-exempt. Thus, the preferred structure for HPEN would
be the same as that for HPEN with respect to an investment
in HBE, i.e., with FBE set up as a corporation and PEF as a
partnership.41
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United States
60
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that
for FI with respect to an investment in FBE, i.e., with FBE set
up as either a partnership or corporation and PEF set up as
either a foreign partnership or a foreign corporation, with no
presence in the United States.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that
for FI with respect to an investment in FBE.
C. Conclusion as to the overall preferred structure
Considering all investors and investments in both HBE and
FBE, the overall preferred structure, assuming no new entities
are introduced, would be to set up HBE and FBE as
corporations and PEF as a foreign partnership with no
presence in the United States.42 This would produce the best
results (from the U.S. income tax perspective) for all investors
except HI. An alternative structure that would improve the
situation for HI but not unduly hurt the situation of the other
investors would be the same as the preceding except that
HBE would be set up as a partnership and HPEN and the
foreign investors would invest in PEF through a “foreign
blocker corporation”. The foreign blocker corporation would
be a foreign corporation that is organised in a zero-tax
jurisdiction and has no presence in the United States. This
structure would allow HI to benefit from a basis step-up for
income earned by HBE but would not result in HPEN and the
foreign investors having UBTI or ECI. However, the foreign
blocker corporation would have ECI (as a result of its indirect
interest in HBE) and thus would need to file a U.S. income tax
return.43 Moreover, the foreign blocker corporation’s share of
an actual distribution from HBE (to the extent it constitutes a
“dividend equivalent amount”) would be subject to the 30
percent branch profits tax under §884 (which likely would not
be subject to reduction under an income tax treaty). However,
this last point would not be significant if HBE is not expected
to make any distributions. A potential defect with this
structure is that, when PEF sells its interest in HBE, the
foreign blocker corporation’s share of the gain might be taxed
as ECI because it is from the sale of an interest in a
partnership that is itself ETB. However, a reasonable
argument could be made that the gain on the sale of the
partnership interest is not ECI because PEF is not ETB.44
It should be noted that the preceding has assumed, pursuant
to the facts of the hypothetical, that PEF will not incur any
borrowings. As will be seen below, if the fund is to incur
borrowings, this would affect the analysis with respect to
HPEN and FPEN because of the special rules for “unrelated
debt-financed income” in §514.45
III. Basic U.S. tax planning for a hedge fund
A. Investment in passive assets generating U.S.-sourceincome
There follows a discussion, separately with respect to each of
the investors, of the preferred structure for U.S. income tax
purposes with respect to investments by HF in passive assets
generating U.S.-source income.
1. Preferred structure for a U.S. individual
If HF were set up as a foreign corporation in a zero-tax
jurisdiction, its U.S.-source income from passive investments
would typically be subject to a 30 percent U.S. withholding
tax and HI would then be subject to tax (generally at a 35
percent rate) on dividends received from HF (unless the
special rate in s 1(h)(11) for dividends from “qualified foreign
corporations” applied). Moreover, HF would likely be a PFIC
(in which case the special rate of 15 percent in §1(h)(11)
would clearly not apply)46 and, under the default PFIC regime,
HI would be subject to an interest charge with respect to the
deferral of U.S. tax on HF’s income.47
However, if HF were set up as a partnership, there would be
only one level of tax on the U.S.-source income derived by HF
(which tax would be imposed on HI) and tax would be
avoided on distributions from HF. Thus, from the perspective
of HI, the most tax-efficient structure for U.S. income tax
purposes would be to set up HF as a partnership (and HI as a
direct partner in HF). The partnership could be either a U.S. or
foreign partnership and the partnership could have a
presence in the United States. HI would file a U.S. income tax
return reporting his distributive share of the income derived by
HF.
2. Preferred structure for a foreign individual
The preferred structure for HI would also work well for FI. FI
would likely be subject to a 30 percent U.S. withholding tax
on his share of the income received by HF or possibly a lower
rate if FI is a resident of a country with which the United
States has an income tax treaty.48 In theory, FI might be better
off if HF were considered ETB since this would mean FI could
pay U.S. income tax on a net basis rather than a gross basis.
However, FI’s income tax rate would likely be 35 percent and
thus FI might not be better off even if he could pay on a net
basis. (Being ETB might also expose FI to taxation on other
U.S.-source income derived by him independently of his
investment in HF.) In any event, given the trading safe harbour
in §864(b)(2), it is unlikely that HF would be considered ETB
(even if it had a presence in the United States).49 Thus, the
preferred structure for FI would be the same as that for HI,
but with U.S. tax applied on a gross basis (through
withholding) rather than on a net basis as in the case of HI.
3. Preferred structure for a U.S. pension fund
Since HPEN is a tax-exempt pension fund, it would likely be
exempt from tax on most, if not all, of the income derived by
HF if HPEN derived that income directly. Thus, if HF incurred
no debt, the preferred structure set forth above for HI would
also be the preferred structure for HPEN since HF would be a
partnership and thus the income derived by HF would “flow
through” to HPEN. However, according to the facts of the
hypothetical, HF will in fact incur debt; pursuant to §514, this
will “taint” the income that would otherwise be tax-exempt to
HPEN. In order to avoid this problem, HF could be organised
as a foreign corporation in a zero-tax jurisdiction. Alternatively,
a foreign blocker corporation could be interposed between
HF (organised as a partnership) and HPEN. However, both
structures would produce exposure to the U.S. 30 percent
withholding tax since the income would be earned by a
foreign corporation that in all probability would not qualify for
any treaty relief. If instead HF were organised as a U.S.
corporation or a U.S. blocker corporation were used, then the
U.S.-source income would be taxed on a net basis, taking
into account the interest deductions, but generally would be
taxed at the 35 percent corporate rate. This may or may not
be advantageous. Moreover, all income realised by HF (if HF
were organised as a U.S. corporation) or by the U.S. blocker
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United States
61
corporation (if HF were organised as a partnership but a U.S.
blocker corporation was used) would be so taxed, including
foreign-source passive income derived by HF. Thus,
depending on the circumstances, it may be preferable to use
a foreign blocker corporation (with HF organised as a
partnership) and it is assumed that such is the case here.
4. Preferred structure for a foreign pension fund
If FPEN is considered a tax-exempt organisation for U.S. income
tax purposes, then the preferred structure set forth above for
HPEN would also be the preferred structure for FPEN.
If FPEN is not considered tax-exempt and is treated as a foreign
corporation or a foreign trust, the preferred structure set forth
above for FI (which is the same as the preferred structure for HI)
would also be the preferred structure for FPEN.
5. Preferred structure for a foreign government
Since FGOV is a tax-exempt entity except to the extent it is
engaged in a commercial activity (or deriving income from a
controlled commercial entity), the preferred structure for it
would be the same as that for HI, i.e., with HF set up as a
partnership, since HF would likely not be considered engaged
in a commercial activity and thus FGOV’s share of its income
should be tax-exempt.
B. Investment in passive assets generatingforeign-source income
1. Preferred structure for a U.S. individual
In the case of investments by HF in passive assets generating
foreign-source income, the preferred structure for HI would likely
be the same as that set forth above with respect to investments
by HF in passive assets generating U.S.-source income, i.e., with
HF set up as a partnership, either U.S. or foreign and either with
or without a U.S. presence. Such a structure would potentially
allow HI to benefit from an income tax treaty between the United
States and the country to which the income is sourced.
Another possibility is to set up HF as a foreign corporation in a
zero-tax jurisdiction. However, it likely would be treated as a PFIC
(if not a CFC), and, under the default PFIC regime, HI would be
subject to an interest charge with respect to the deferral of U.S.
tax. Assuming there is nothing to be gained by deferring the U.S.
tax but then being subject to the interest charge, setting up HF
as a partnership should work just as well.
2. Preferred structure for a foreign individual
With respect to the preferred structure for FI, HF could be set
up as a partnership or a foreign corporation in a zero-tax
jurisdiction, with or without a presence in the United States. In
either case, there would be no U.S. income tax on FI’s
distributive share of the foreign-source income because it is
foreign-source income and not ECI. (This assumes that HF
would not be considered ETB even if it had a presence in the
United States.)
3. Preferred structure for a U.S. pension fund
The preferred structure for HPEN would be the same as that
with respect to investments in passive assets that generate
U.S.-source income, i.e., to have HF set up as a partnership
and then have a foreign blocker corporation set up between
HF and HPEN.
4. Preferred structure for a foreign pension fund
The preferred structure for FPEN would be the same as that
set forth above for FI, i.e., to have HF set up as a partnership
or as a foreign corporation in a zero-tax jurisdiction, with or
without a presence in the United States.
5. Preferred structure for a foreign government
The preferred structure for FGOV would be the same as that
set forth above for FI.
C. Conclusion as to the overall preferred structure
Considering all investors and investments in both passive
assets that generate U.S.-source income and passive assets
that generate foreign-source income, the overall preferred
structure, from the U.S. income tax perspective, would be to
set up HF as a partnership, either U.S. or foreign, with or
without a presence in the United States, and then have the
investors invest directly in HF, except for HPEN (and FPEN if it
is tax-exempt for U.S. income tax purposes), which would
invest in HF through a foreign blocker corporation.50
IV. U.S. income taxation of income from acarried interest
Savvy’s “carried interest” constitutes a 20 percent interest in
profits derived by PEF. The carried interest is actually
compensation to Savvy for the advice he provides to PEF but
is structured the way it is in order to produce capital gain for
Savvy (taxable at a 15 percent rate) rather than ordinary
income (taxable at a 35 percent rate). Under current law, there
is an argument that the carried interest actually does yield
capital gain, notwithstanding it is actually compensation for
services. In Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS ruled
that the receipt of a partnership profits interest in exchange
for services rendered to the partnership is not a taxable event,
provided certain conditions are met.51
As discussed in the Introduction, fees received by fund
advisors are receiving more and more attention, both from the
U.S. Congress and the Bush Administration. In a report in The
Daily Tax Report for April 30, 2007, Associate Professor Victor
Fleischer of the University of Colorado Law School described
the carried interest issue as follows: “The private equity fund
managers are managing the fund and putting up only small
amounts of capital themselves and yet the returns from their
labour income are treated as capital gains. So that’s an
anomaly in the tax system. When you perform services you
normally get taxed at ordinary income rates, and so we have
some of the very richest labourers in our country being taxed
at a low tax rate.”52
On June 22, 2007, Representative Charles Rangel, Chairman
of the Ways and Means Committee, Representative Barney
Frank, Chairman of the Financial Services Committee, and
Representative Sander Levin introduced H.R. 2834 which
would treat income derived from a carried interest as ordinary
income, rather than capital gain. Leaders of the Senate
Finance Committee, however, are taking a more cautious
approach. Ranking Member Senator Charles Grassley has
stated, “If it’s earned income, it ought to be taxed at 35
percent instead of 15 percent. If it’s capital gains, then we’ll
just leave it the way it is right now.”53 Chairman Max Baucus
has stated, “I’ve got no legislation. I may, but I’m not close to
having legislation.”54 According to a report in Tax Notes Today,
Baucus stated “he was in ‘no great rush’ to address the
taxation of hedge funds through legislation but preferred
instead to study the issue thoroughly and speak to a variety of
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United States
62
people on the topic before acting. ‘This is a very complicated
question.’ he added”.55
On July 11, 2007, at a Senate Finance Committee hearing on
the taxation of income derived from a carried interest,
Assistant Secretary Eric Solomon asserted the Bush
Administration’s opposition to any changes to the taxation of
such income, contending that a significant change “could
undo the work the federal government has done to support
entrepreneurship”56
Thus, current law appears to support the treatment of income
from a carried interest as capital gain, but (notwithstanding
the Bush Administration’s opposition) change may be on the
horizon.
1 Joint Committee on Taxation, Present Law and Analysis Relating toTax Treatment of Partnership Carried Interests, JCX-41-07, July 10,2007, pp. 32 and 34
2 With respect to the impact of the Sarbanes-Oxley legislation onpublicly-traded corporations, see Thomas and Brill, “Public ‘Private’Equity: The Tax Puzzle”, June 22, 2007,http://www.american.com/archive/2007/june-0607/public-private-equity-the-tax-puzzle/
3 “China to Invest $3 Billion in Blackstone”, The Washington Times,p. C10 (May 21, 2007); “Fund Takes It Slowly, Chinese Seek toAvoid Backlash”, The Washington Times, p. C8 (May 22, 2007). Asnoted in the articles, China will acquire no more than a 10 percentinterest in the Blackstone Group.
4 Rosen, “Partners in Profit: The Lawyer-Hedge Fund Nexus”,International Herald Tribune, p. 15 (April 20, 2007)
5 Speer, “Unions Urge G-8 Nations to Study Tax Impact of PrivateEquity Funds”, 52 Daily Tax Report I-3 (March 19, 2007)
6 Id. At a hearing held by a U.K. parliamentary committee on June20, 2007, representatives of U.K. trade unions described privateequity funds as “raiders” and “asset strippers”, which have anadverse impact on employment. Goulder, “Private Equity BossesGrilled at U.K. Tax Inquiry”, 2007 WTD 121-1 (June 22, 2007)
7 Speer, “Unions Urge G-8 Nations to Study Tax Impact of PrivateEquity Funds”, 52 Daily Tax Report I-3 (March 19, 2007). Someforeign governments are cracking down on the taxation of funds.For example, South Korea has asserted a tax deficiency of morethan $200 million against five foreign investment funds, includingthe Carlyle Group and Lone Star. See Lim, “South Korea SlapsForeign Funds with $200 Million in Tax Invoices”, 190 Daily TaxReport, p. G-3 (October 3, 2005); Lim, “Finance Ministry IncreasesTax Pressure on U.S. Investment Fund, Rejects Appeals”, 131 DailyTax Report, p. I-2 (July 10, 2007). In addition, Russia has begun “acriminal investigation into alleged tax underpayments by OOOKameya, a company allegedly associated with Russia’s largestforeign portfolio investment fund, Hermitage Capital Management….” Nadal, “Russian Authorities Accuse Foreign Fund Manager ofUnderpaying Taxes”, 2007 WTD 122-2 (June 25, 2007)
8 Gnaedinger, “Private Equity Fund Growth and Policy Implications”,2007 TNT 53-5 (March 19, 2007)
9 Id.
10 Toomey, “Defending Private Equity”, The Washington Times, p. A21(June 22, 2007)
11 “Douglas Lowenstein, Private Equity Council President, PreparedRemarks before House Financial Services Committee May 16,2007, Hearing on Private Equity’s Effects on Workers, Firms”, 121Daily Tax Report (June 25, 2007)
12 “Schwarzman Earns $400 Million, Blackstone Boss Got NearlyDouble of 5 Wall Street Peers in ‘06”, The Washington Times, p.C8 (June 12, 2007)
13 Sheppard, “Blackstone Tells Two Different Stories”, 2007 TNT118-5 (June 19, 2007)
14 Most private equity funds and hedge funds are not publicly traded;the funds in the hypothetical are, by implication, not publicly tradedbecause they are generally not subject to securities regulation.
15 Glenn, “Levin Reacts to new Details on Blackstone’s IPO”, 2007TNT 136-2 (July 16, 2007)
20 Currently, the highest individual tax rate is 35 percent and thehighest corporate tax rate (after a “bubble” reaching 39 percent) is35 percent. See §§1 and 11(b). All “§” references are to the InternalRevenue Code of 1986, as amended (“the Code”), and all “Regs.§” references are to regulations issued thereunder by theDepartment of the Treasury (and set forth in 26 CFR).
21 A corporation is a per se corporation if it is described in Regs.§301.7701-2(b) other than (b)(2).
22 Regs. §301.7701-3(b)(1)
23 If the classification of HBE were being changed from a corporationto a partnership, that would be considered a liquidation of thecorporation under §331 and could give rise to a tax cost to HBEunder §336 (recognition of gain or loss on assets distributed incomplete liquidation).
24 Regs. §301.7701-3(b)(2)(i)
25 See §864(c)(3)
26 See Rev. Rul. 91-32, 1991-1 C.B. 107. For criticism of thisposition, see Blanchard, “Rev. Rul. 91-32: Extrastatutory Attributionof Partnership Activities to Partners”, 1776 Tax Notes 1331(September 8, 1997)
27 Gnaedinger, “Private Equity Fund Growth and Policy Implications”,2007 TNT 53-5 (March 19, 2007)
28 Toomey, “Defending Private Equity”, The Washington Times, p. A21(June 22, 2007)
29 “Douglas Lowenstein, Private Equity Council President, PreparedRemarks before House Financial Services Committee May 16,2007, Hearing on Private Equity’s Effects on Workers, Firms”, 121Daily Tax Report (June 25, 2007)
30 This, of course, assumes that PEF could actually avoid a presence inthe United States, notwithstanding its activities with respect to HBE.
31 A U.S. partnership is considered a U.S. person and thus, if PEF is aU.S. partnership, the full amount of PEF’s ownership interest in aforeign corporation is taken into account in determining if theforeign corporation is a CFC. If PEF is a foreign partnership, a“look-through” rule applies and only ownership interests in theforeign corporation that are attributable to partners in PEF that areU.S. persons are taken into account. See §958(a). For a discussionof the pros and cons of using a U.S. or foreign partnership, seeKlein, “Master-Feeder Funds: Domestic or Foreign Master?” 35 TaxMgmt. Int’l J. 522 (October 13, 2006)
32 See Regs. §1.894-1
33 It should be noted that the first meeting of the OECD’s InformalConsultative Group on Taxation of Collective Investment Vehicleswas held in May 2007. A principal focus of the group will be theapplication of income tax treaties with respect to income realisedby such vehicles.
34 See §512
35 See §512(b)(1) and (5)
36 If PEF were set up as a corporation, e.g., as a foreign corporationin a zero-tax jurisdiction, another layer of tax might be incurred,particularly with respect to dividends from HBE. Dividends paid byHBE to PEF as a foreign corporation would likely be subject to U.S.withholding tax but dividends paid by HBE to HPEN through apartnership (PEF) would be tax-exempt.
37 See §884
38 §892
39 See §1297(c)
40 See §1291
41 Alternative structures that would also be satisfactory are to have:(1) FBE set up as a partnership and PEF as a foreign corporation ina zero-tax jurisdiction; and (2) FBE set up as a foreign corporationand PEF as a foreign corporation in a zero-tax jurisdiction.
42 If one is comfortable with the position that PEF would be coveredby the trading safe harbour in §864(b)(2)(A)(ii), then PEF could havea presence in the United States.
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United States
63
43 The foreign blocker corporation’s share of HBE’s income wouldalso be subject to withholding under §1446 but a credit could beobtained for the tax withheld.
44 As mentioned earlier, it is the position of the IRS that the gain wouldbe ECI. However, there is a reasonable argument to the contrary.See Blanchard, “Rev. Rul. 91-32: Extrastatutory Attribution ofPartnership Activities to Partners”, 1776 Tax Notes 1331(September 8, 1997).
45 For an in-depth discussion of U.S. income tax issues involvingprivate equity funds, see Needham and Adams, 735 T.M., PrivateEquity Funds.
46 See §1(h)(11)(C)(iii)
47 If HF were a CFC, then HI would likely be currently taxed on hisshare of all of HF’s income. Obviously, setting up HF as a U.S.corporation would also be detrimental since HF would generally besubject to U.S. corporate income tax at a 35 percent rate and HIwould then be subject to U.S. tax on dividends received, althoughat the special lower rate for dividends from a U.S. corporation. See§1(h)(11)(B)(i)(I)
48 See §1441
49 Whether or not it is ETB would depend upon exactly what it isdoing in the United States. However, given the facts of thehypothetical, it is likely that HF would not be considered ETB. Thisat least appears to be the conventional wisdom on Wall Street. SeeNeedham and Brause, 736 T.M., Hedge Funds, §VII.D.1. However,Regs. §1.864-2(c)(2)(ii) states somewhat enigmatically that thetrading safe harbour does not apply with respect to “a partnership(other than a partnership in which, at any time during the last half ofits taxable year, more than 50 percent of either the capital interestor the profits interest is owned, directly or indirectly, by five or fewerpartners who are individuals) the principal business of which istrading in stocks or securities for its own account, if the principaloffice of such partnership is in the United States at any time duringthe taxable year”.
50 For an in-depth discussion of U.S. income tax issues involvinghedge funds, see Needham and Brause, 736 T.M., Hedge Funds.
51 The IRS also ruled in Rev. Proc. 2001-43, 2001-2 C.B. 191, thatthe determination of whether an interest constitutes a profitsinterest is made at the time the interest is granted, even if theinterest is “substantially nonvested” within the meaning of §83 andthe receipt of the interest will not be a taxable event when theinterest does become substantially vested.In 2005, proposed regulations were issued (Prop. Regs.§1.721-1(b)(1), Prop. Regs. §1.83-3(e), and Prop. Regs.§1.704-1(b)(4)(xii)) along with Notice 2005-43 (2005-1 C.B. 1221)that would repeal Rev. Proc. 93-27 (and also Rev. Proc. 2001-43)and provide that the receipt of a profits interest would be governedby §83, generally resulting in immediate income recognition basedon the fair market value of the interest. However, a safe harbour inthe proposed regulations would provide that the fair market valueof a compensatory partnership interest may be treated as beingequal to the liquidation value of that interest. Because the liquida-tion value of a profits interest is zero, under this safe harbour a car-ried interest could continue to be excluded from gross income atthe time of grant.
52 Joyce, “Treasury Scrutinizing Hedge Fund Treatment; Seen asPossible Source for Raising Revenue”, 82 Daily Tax Report GG-1(April 30, 2007)
53 Rothman, “Finance Committee Not Close to Drafting PrivateInvestment, Hedge Fund Legislation”, 88 Daily Tax Report G-2(May 8, 2007)
54 Elmore, “Baucus Sees No Rush to Act on Hedge Fund Legislation”,2007 TNT 89-1 (May 8, 2007)
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