These "Final Reports", marking the culmination of the OECD/G20 BEPS Action Plan set out in 2013, made many recommendations for significant changes to the international tax environment. Apart from in the USA, the work of BEPS implementation has since late 2015 proceeded at a steady and unhesitating pace in many countries, with the EU in particular pressing for concrete action and progress.
Some of these BEPS-driven measures are important issues for Private Equity fund managers simply because the businesses that their funds invest into face the same issues in reporting group effective corporate tax rates as do all other companies that operate internationally, and so historically such businesses have used many of the same approaches taken by other multinational groups in managing and controlling these rates.
However, some of the BEPS measures are especially relevant to the ways in which Private Equity fund vehicles hold and finance their investments. Other measures are particularly applicable to the internal operating model of the fund manager’s own business.
For Private Equity funds, the use of financing techniques resulting in interest expenses has historically been prominent. The potential impact the BEPS measures restricting the tax deductibility of interest expenses (now part of an EU Directive, to be brought into effect by all EU Member States by 1 January 2019), may thus be particularly important for Private Equity-controlled groups.
To the extent a fund vehicle provides internal debt, the BEPS measures concerning "hybrid mismatches" (again, mandated by an EU Directive effective for 2019), are likely to both further affect the deductibility of interest, and also potentially to require fund managers to have a full understanding of the tax attributes and filing positions of every investor in a fund - an extremely tough administrative burden.
The strong anti-treaty shopping measures in the BEPS package (many countries have now signed the Multilateral Convention that will from 2019 onwards bring into effect the relevant tax treaty changes) will mean that operating models will probably need to continue to evolve significantly, as a greater degree of operational activity in any holding company location, as well as a principally commercial case for having chosen this location, will usually be essential if tax treaty benefits are to be retained.
Turning to the fund management business itself, this is likely to have been set up and run in ways aimed at managing tax burdens at both business and owner levels. The BEPS measures strike at this - notably by sharpening the focus both on the transfer pricing used, and how it is documented. How fee income from funds being managed is allocated between the countries where fund manager activity takes place, and how internal service fees are set, will both be increasingly scrutinised. A genuine alignment between where profits are taxed, and where real value creation takes place, will be critical.
The BEPs measures also target groups of businesses that have tried to organise their operational footprint in countries so that this does not cause the core profit-making part of their business to have a taxable presence there. Although the new approach calls for tax treaty changes, and it is not yet clear that most countries will make these, what is clearer is that tax authorities are now far more sensitive, wanting to apply existing rules more rigorously. Private Equity deal teams and capital-raising groups need to be increasingly careful in ensuring that their precise pattern of activity does not give rise to a "permanent establishment".
While many of the measures above will not take effect until 2019 or 2020, fund managers need already to anticipate their consequences, and in some areas begin immediately to make operational changes. Also, in structuring new funds for launch between now and 2019, investors will expect to see the structure chosen as having been, to the greatest extent possible, "future-proofed" for the post-BEPS world.
Tax audit activity in the sector is already growing sharply. Aided by calls for action in the media (and in some cases also by increased government funding), tax authorities will be increasingly confident and assertive in challenging what funds are doing, even when this involves considerable financial and organisational complexity spread over several countries.
Conversely, an important outcome of the BEPS Project that is only now emerging is the recognition of the need for greater "tax certainty". This, combined with the clearer legislative framework and enhanced levels of official guidance that can be expected as the BEPS Project is implemented, may eventually reduce the scope and size of areas for dispute. In the short to medium term this seems much less likely.
Consequently, Private Equity fund managers are, as a generalisation, going to have to be much more mindful of tax issues, and areas for potential challenge, when planning their fund structuring. Also, the need for added tax function management resources, and the costs of resolving increasingly more tax disputes (even if little or no tax is eventually conceded as due), will both need to be paid for – with the question arising of how such expenses should be allocated between fund managers and investors.
In summary, BEPS should be regarded as "climate change" for tax. The environment for Private Equity funds and their managers is becoming harsher, and many investors are now more concerned that their capital is invested in a socially responsible way. BEPS is increasingly having a significant behavioural impact, and fund managers who ignore this will suffer a growing number of unpleasant and potentially costly tax challenges and disputes, and a loss of attractiveness to investors.
Partner, PwC Luxembourg
Tel: +352 49 48 48 3193
Tax Partner, PwC Luxembourg
Tel: + 352 49 48 48 3122
Tax Partner, PwC Luxembourg
Tel: +352 49 48 48 5843
Director, PwC Luxembourg
Tel: +352 49 48 48 3057