The OECD’s International Tax Avoidance Project and Private Equity
The OECD, backed by the G20, has been working on an initiative to crack down on tax avoidance by multi-national companies since July 2013 under its so-called base erosion of profits (or BEPS) project. While aimed principally at international profit allocation and repatriation by multi-nationals, its potentially broad scope means that it has caused a stir in the wider private equity industry with fears that the consequences of the project could be damaging for funds and their investors.
The aim of the project overall, elaborated on by a paper issued by the OECD in March 2014, is to create a generally accepted set of international tax rules, particularly by adopting a consistent approach to double tax treaties and their implementation, to address concerns that taxpayers are able to avoid paying their “fair share” of tax in the appropriate jurisdictions where the economic activities that generate the profits are carried out and the value is created by moving their profits to low tax jurisdictions.
The OECD has identified 15 action plans, each dealing with a perceived weakness in the international tax system. Of these, four are likely to be of particular interest to the private equity industry:
(i) Preventing Double Tax Treaty Abuse – Action Plan 6;
(ii) Assessment of What Should Constitute a Permanent Establishment – Action Plan 7;
(iii) Limiting Interest Deductions – Action Plan 4; and
(iv) Addressing Hybrid Mismatch Arrangements – Action Plan 2.
The OECD published consultation papers on Action Plans 2, 6 and 7 in September and are starting to discuss Action Plan 4, with a view, in each case, to finalizing their recommendations in 2015.
The action point which has had the most focus to date from the private equity industry has been the double tax treaty proposals. Put simply, the OECD wants to stop taxpayers using intermediate vehicles inappropriately to bridge the gap on payments between residents of two countries which do not have a double tax treaty with each other in order to reduce the tax (generally withholding tax) due in the source country of the payment. For instance, a taxpayer located in Country A may be able to reduce or even eliminate tax on income generated in jurisdiction B in circumstances where there is no double tax treaty between Countries A and B by paying and receiving the income through an entity in Country C which does have a double tax treaty with Country B. If jurisdiction C does not apply withholding tax on outbound payments under its domestic law or if it does have a double tax treaty with Country A, the taxpayer may be able to receive the payment without suffering the Country A tax that it would have suffered had it received the payment directly.
The emerging market private equity industry does use intermediate vehicles, but typically for different reasons to those in respect with which the OECD has raised concerns. For example, a fund which has investors from, and itself invests in, a wide range of countries might save itself a compliance burden by holding investments through a central treaty-eligible structure. The concern in this area was, however, that the initial approach taken in the proposals for the “antiabuse” terms to be included in double tax treaties included,as one alternative, a standard “limitations of benefits”provision, which presupposes that the (treaty jurisdiction) Country B entity has a relatively simple set of shareholders (or owners). These proposals, if adopted, would have made it unlikely that any private equity fund would be able to rely on what would otherwise be treaty eligible investment vehicles to minimise the withholding taxes on their receipts. This would be so even where all (or a large majority) of the fund's investors were themselves tax exempt or eligible for treaty relief, as is often the case. This would undermine the central tenet of private equity fund investments, that the investors should not be any worse off in tax terms than if they had invested directly.
After engagement with the ECD on this, the OECD have recognized that they had not taken the particular structures of private equity funds into consideration when rafting the proposals. Industry bodies are now engaging with the OECD in this regard, and further proposals on how the abuse principle might apply to private equity funds are expected in the early part of 2015. The OECD’s September paper recognized that policy considerations will need to be addressed to ensure that the new rules do not unduly impact collective investment vehicles and other funds and makes it clear that this is an area which requires further work. It is likely that the OECD's final recommendations will include various options for efining the ways in which the new rules will apply to fund vehicles.
While of less immediate importance, the other action plans on nsuring hat the current OECD Model Tax Treaty approach to permanent establishments does not allow the artificial avoidance of PEs and the local jurisdiction tax that goes with them and on investment company interest deductions will also be of interest to the industry. While the latter might affect the effective tax rate of a fund's investments, the former might lead to structural changes being required to a fund's management arrangements, if the current arrangements might result in profits of the fund and/or the investors being brought into the cope of tax in a wider range of jurisdictions.
Although, as stated, the final proposals are unlikely to be known under mid to late 2015, what is clear from the materials and discussions so far is that the BEPS project will have a long lasting effect on the tax arrangements and consequences for private equity funds across the industry. It is extremely important that the industry bodies and other interested parties remain (or get) engaged in the process of discussions with, and responses to, the OECD and local governments and tax authorities to try to ensure that the particular characteristics of private equity funds are fully considered before any decisions are taken that could operate as a deterrent to investors with the overall adverse effect on investment and development that would result.
About the Authors
Stephen Pevsner is a Tax Partner at King & Wood Mallesons LLP
Laura Charkin is a Tax Partner at King & Wood Mallesons LLP
Andrew Pollock is a Trainee Solicitor at King & Wood Mallesons LLP