News & Events

Private Equity Tax Becomes More Onerous

As we all know, the complexity and administrative burden of the global tax systems facing tax directors is at an all-time high and continues on the ascent. With deficits increasing in most parts of the world, in part due to the global financial crisis, governments are focusing on expanding revenue streams and on greater regulation and transparency. A key industry that governments around the world are looking for 'donations' from is private equity.

A typical private equity fund may be based in one country, have offices in several different countries and own portfolio companies, with operations spanning the entire globe. At the same time, the fund may have deal and operational personnel working in every time zone. General Partners (GPs) and their tax directors must be attentive to fund, portfolio company and management company matters, in addition to staying abreast of ever-changing tax and regulatory rules. This is no small task.

When operating a fund, keeping track of fund staff and the activities they are performing all over the globe is critical. Many taxing jurisdictions are tightening the requirements for having a 'permanent establishment' or 'trade or business' in the jurisdiction (ie, being subjected to tax in the jurisdiction).

Having an unintended permanent establishment, trade or business in a particular jurisdiction can have disastrous economic and reputational results for a fund as it may subject fund-level capital gains and/or fees to taxation in the jurisdiction, and then there is the attendant publicity which follows.

An increasing number of jurisdictions around the world have rules that result in less favourable tax treatment based upon threshold limits of ultimate ownership by domestic versus foreign limited partners, levels of real estate owned by portfolio companies, etc. Accordingly, it is critical that the private equity deal teams (and their advisors) who execute new portfolio company acquisitions are up to speed on the tax profile of the limited partners and any limiting tax provisions in the fund documents. Proper and timely coordination between the fund's tax director and the deal/operational teams on these issues continues to be critical to ensure that unsuitable transactions do not inadvertently result in unnecessary tax surprises. It is no longer reasonable for deal teams to assume that we live in a zero-tax environment or that historical tax norms will continue to apply.

United States

Recently enacted and proposed legislation in the United States will directly affect private equity funds. Smaller firms will feel the greatest impact of increased costs and compliance obligations. The recently enacted Foreign Account Tax Compliance Act (FATCA) rules will place significant burden on private equity funds and their tax directors, making additional resources and technology likely necessary. Proposed legislation to tax carried interest as ordinary income and subject to self-employment tax will have a profound impact on the industry; tax planning and alternative structuring will be necessary to consider as the proposals progress. Increasing tax rates on individuals is inevitable. Financial regulatory reform could lead to additional considerations for tax directors in the private equity industry as well. Proposed legislation to require private equity fund advisors to register with the SEC will increase costs and possibly require additional reporting. The 'Volcker Rule', which would force banks to exit proprietary trading businesses, including private equity, could create additional buying opportunities but will also impact tax department infrastructures. Proposed regulation of swaps could alter their tax treatment, requiring tax directors to deal with a different taxing regime.

United Kingdom

The UK has a long history of supporting the private equity industry dating right back to the original 1987 Memorandum of Understanding (MOU) between the industry and the government on the standard UK private equity fund model, the nature of carry and the taxation treatment of the flows under the private equity model. A similar MOU process was undertaken when the UK tightened its treatment of the taxation of Employment Related Securities (ERS), which once again clarified the treatment of carry in the hands of the employees within private equity houses.

There is a potential risk, however, that this consensus will break down – especially in the case of carry if the US moves to treat this as employment or ordinary income. Even if carry retains the potential for capital gains tax treatment (depending upon the actual flows through the fund), we have already seen in recent times one hike in the rate of capital gains tax (which itself was partially inspired by media and political commentary on the relative effective tax rate which carry holders were achieving). It must potentially be the case that UK capital gains tax (CGT) rates will increase under the new government, both to close the gap between headline personal tax rates of 50% and CGT rates of 18%, and to increase tax take.

The private equity industry in the UK is certainly experiencing an uptick in tax authority audit activity, ranging from VAT issues on structures using offshore general partnerships to VAT challenges on the recoverability of transaction-related VAT costs to transfer pricing.

The recent tightening of the taxation rules for non-UK domiciled persons over the last few years and the higher personal tax rates have led to some private equity houses re-evaluating the UK as the best location for their activities, especially if their investment strategies or portfolios are predominantly outside the UK. Locations like the Channel Islands and Switzerland are attracting an increased level of interest as possible business locations.

One of the biggest concerns for the UK and European private equity industry, however, comes from the EU regulatory legislation in the form of the Alternative Investment Fund Managers Directive (AIFM) which will, in its current draft form, impose a whole new layer of costs and restrictions.

Asia Pacific

The Asia Pacific region is similar in terms of challenges facing tax directors. China, Indonesia, Australia, Japan, Korea and India have all recently taken an aggressive stance on tackling perceived tax avoidance arrangements. This is especially the case for holding company structures seeking to take advantage of tax treaties where there is no or little substance in the holding company.

In May, for example, Indonesia confirmed it would effectively prevent persons other than 'beneficial owners' of income from claiming treaty protection under their respective treaty arrangements. And in late 2009, the Australia Tax Office denied treaty benefits in relation to a Dutch holding company owned by a private equity fund disposing of an Australian company in an initial public offering. Korea (the Lone Star case) and India (the Vodafone case) have also had notable recent court cases that have addressed the substance issue.

The majority of Chinese companies have Hong Kong holding companies, where under the Hong Kong/China Tax Arrangement, PRC dividend withholding tax can be reduced to 5% (normally 10%) for shareholdings of 25% or more, and capital gains tax (normally 10%) could be exempt if the shareholdings are under 25% in a non-land rich PRC company.

In late 2009, the Chinese tax authorities issued Circular 698 to combat capital gains tax avoidance, which usually takes the form of indirectly disposing of Chinese companies by selling the shares of an immediate or a higher-level holding company. Under Circular 698, non-resident investors disposing of offshore special purpose vehicles with Chinese investments may have reporting requirements.

Due to the Asia Pacific tax authorities' more stringent reviews of treaty-linked holding structures, it is becoming increasingly difficult to structure investments to take advantage of favourable treaty benefits by the use of a mere 'shell' holding company structure. Genuine substance in the holding company incorporated in the relevant tax treaty country is now required. A number of private equity funds have been reviewing their holding company structures to ensure that treaty benefits should apply.

There are varying degrees of substance requirements in different countries and the landscape is constantly changing. As a result, advice in relation to investing into Asia Pacific countries (and on disposition) should always be sought.


Running a private equity fund in normal times requires a significant amount of time – yet, we are not in normal times. An enhanced effort, and level of resources, is needed in the current environment as well as thorough and thoughtful analysis and monitoring of the myriad tax rules. Accordingly, it is critical that fund management, deal teams and portfolio company management all operate in an integrated fashion with the tax function to minimise the impact of the new world order.

This article first appeared in the Asset Management News of PricewaterhouseCoopers (June 2010 issue). To learn more and view the full edition, please visit