Alternative Insight – November 2014

OECD’s tax reforms (base erosion & profit shifting)

This Insight, prepared by MJ Hudson in consultation with KPMG, focuses on the OECD’s Action Plan on Base Erosion and Profit Sharing, which proposes major reforms to the international tax rules, and the issues they raise for private equity firms and fund structures.

The leaders of the G20 have repeatedly signalled their intention to update the international tax system to reflect the new realities of international business – in particular, the globalisation of companies, the falling away of national barriers to trade and the fast-increasing digitisation of the world economy. In June 2013, acting at the G20’s behest, the OECD drafted and put out to wide-ranging international consultation an ‘Action Plan on Base Erosion and Profit Sharing’ (BEPS Action Plan).

The Action Plan lays out 15 reforms to the international tax system, which it calls “Actions”. The reforms are wide-ranging enough for the OECD’s secretary-general, Angel Gurria, to have predicted that the BEPS Action Plan will lead to the “most fundamental change to the international tax rules since the 1920s”.

Two key themes have emerged from the detail of the Actions:

  • Substance – ensuring that tax liability is aligned with economic substance. In practice, this means that profits located in a given jurisdiction should reflect the actual business activities taking place in that
  • Transparency – for the most part, this means greater collaboration and information-sharing between national tax

The Actions are scheduled to be rolled out in stages during 2015. When fully implemented, they are intended to make it harder for a global business to artificially reduce its taxes, such as by “treaty-shopping”.

How are PE funds affected by the BEPS Action Plan?

The probable main targets of the BEPS Action Plan are large multinational enterprises (MNEs), rather than PE, VC or hedge funds. Perhaps unsurprisingly, then, the BEPS Action Plan doesn’t directly address private fund structures or the way in which they usually operate.

Although they are not specifically targeted, private equity funds and their portfolio companies will still be impacted by some of the reforms identified in the BEPS Action Plan. Industry groups like the EVCA and BVCA have been on the case ever since the reforms were first mooted, making detailed submissions to the OECD during the consultation process on Actions that concern private equity managers.

Access to tax treaty benefits

The private equity industry is particularly concerned about BEPS Action 6. As currently drafted, this Action could prevent funds (or their holding companies) from obtaining treaty access because of the application of a broad new anti-abuse rule, the objective “limitation on benefits” rule, which is similar to those found in U.S. tax treaties. This would have the effect of increasing the tax cost of investing via funds – which inadvertently contradicts one of the OECD’s other policy objectives, of achieving tax neutrality between  direct  investments and investments via funds.

Responding to feedback, the OECD have acknowledged that further work is needed to assure that the draft rules do not unduly impact on funds. But the final outcome is not certain, and the challenge now is to ensure that the reforms do not compromise the certainty and flexibility that is so essential to the long term success of the private equity industry.

Country-by-country reporting

The private equity industry is also concerned about Action 13. This is a broader initiative to ensure that governments are provided with accurate information on the global allocation of the profits, economic activity and taxes of MNEs.

The Action toughens the transfer pricing documentation requirements and requires MNEs (which may include some fund structures) to report total employment, capital, retained earnings and tangible assets on a country-by-country basis (CBC) and for each group entity. This is meant to allow tax authorities to assess whether businesses are using transfer pricing or other schemes to artificially shift substantial income from high to low tax jurisdictions.

The Action is even more significant when  considered in the context of other Actions that cover permanent establishment and transfer pricing methodologies more broadly. CBC and other new reporting obligations could, for the first time, give governments substantial insight into how MNEs are structured, where their profits are made, how much profit is made in each relevant jurisdiction, where management takes place and where the workforce is located.

Conclusion

The EVCA, BVCA and others are keen to assure that the final form of the BEPS Action Plan takes account of the unique features of, and drivers behind, private equity structures. They will want to secure the necessary carve-outs so that private equity structures are not penalised mistakenly or more than other businesses by governments trying to clamp down on tax avoidance by multinationals. Other Actions in the BEPS Action Plan are also potentially relevant to the industry – for instance those concerning hybrid instruments, interest deductibility and the digital economy.

It is clear that the BEPS Action Plan will significantly impact the way in which private equity funds are structured, how they operate, and the information that may need to be supplied to tax authorities. Managers should ideally exercise caution and take appropriate advice to ensure that their existing and future funds are structured and operated in a manner consistent with the incoming rules.


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.