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A paper on private equity funds: tax issues affecting organisation and investment

Ireland's tax laws have been formulated to attract inward investment and improve the environment for setting up private equity funds. Here, David Glynn of A&L Goodbody explains private equity fund structures in Ireland from an Irish tax perspective.

Introduction
I propose considering the case study from an Irish tax perspective under the following headings.
· Structure
· General background
· Taxation
· Organisation
· Operation
· Foreign investors
· Tax advantaged structures
· Tax haven funds
· Treaty benefits
· Non-Irish investments
· Value-added tax
· Conclusion

Structure
My understanding is that the structure for the case study is as follows:-

Investment professionals will secure that investors acquire through an Irish fund (mainly) Irish equity investments. The investors will be Irish and foreign pension funds, insurance companies, charities, foundations, individuals, government entities and other funds. The fund could take several forms, for example, a unit trust or an investment limited partnership. For the purpose of this case study it is assumed to be a non-UCIT's Irish resident company (referred to as "the fund" from now on). The fund will be managed for a fee. The equity investments will be in a broad range of businesses.

General background
The funds that can be established in Ireland are of two types. They can be UCITs, which are funds authorised in accordance with the UCITS EU directive, or a variety of other Irish investment funds. All funds must be approved by the Central Bank of Ireland (the Central Bank) (the regulatory authority in Ireland). It is likely that the Central Bank will only approve funds where the promoters (the investment professionals) themselves are regulated. The factors which influence the choice of fund include location of the investors and the proposed investment policy of the fund. In the case study a group of investors will be organised to invest in a fund which is an Irish-resident company. The fund will make equity investments in Ireland. I am assuming that the fund will not be open-ended but it will be available to the public. I am also assuming that the minimum subscription for each investor is E250,000. On that basis the fund will be a Qualifying Investor Fund (QIF). The income and gains of funds approved by the Central Bank are exempt from Irish tax. Because the fund will not be subject to the constraints of the UCITS EU Directive it will be permitted to have a much wider and more flexible range of investment and borrowing strategies than allowed by the UCITS regulations. The Central Bank has more flexibility in such cases regarding the imposition or relaxation of conditions generally. It has drawn a distinction between different categories of investors in terms of level of "sophistication".

The Central Bank's requirements are relaxed considerably for QIFs where, as mentioned earlier, there is a minimum subscription of at least E250,000 per investor and each investor has certified in writing at the time of making the investment that he/she is either an institutional investor or a high net-worth individual (as defined). In those cases Central Bank does not require the normal investment and borrowing restrictions.

Further description/analysis of the legal and regulatory environment is outside the scope of this brief talk.

Taxation
Turning to the questions raised in the case study:-

How would such a fund be best organised in Ireland?
The fund should be organised as a QIF to avoid borrowing and investment restrictions which would otherwise be imposed by the Central Bank.

Should the fund be a transparent entity for Irish tax purposes, for example, an investment limited partnership or should it be a non-transparent entity such as a limited company.
If the fund is approved by the Central Bank no Irish tax will be imposed on the income and gains of the fund. No Irish withholding tax will be imposed on payments to non-resident investors (who have made the appropriate declaration).
The choice of transparent versus non-transparent will be driven by the different consequences under two headings:
(a) how does the choice affect the foreign taxation of the income flowing from the foreign country to the Irish fund; and
(b) how does the choice affect the taxation of the foreign investor in respect of losses from the investments, the availability of foreign tax credit etc.

In relation to (a) this depends on the jurisdiction in which the investment is located. The Revenue Commissioners of Ireland can issue a letter to the effect that the fund is resident in Ireland. Some jurisdictions accept this as a basis on which the applicable benefits of the treaty can be given.
In relation to (b) the laws of the jurisdiction of the investor requires examination. Does that jurisdiction allow second tier relief for foreign tax credit so that one can go below the Irish entity for the purposes of credit relief or is such relief available under the terms of the treaty between Ireland and the jurisdiction? Does the jurisdiction of the investor allow relief for losses incurred in the Irish entity? If either answer is negative, then, perhaps, a transparent Irish entity such as an investment limited partnership is required.

Can such a fund operate in Ireland without the imposition of incremental taxes?
Since the Finance Act, 2000 all Irish investment funds (approved by the Central Bank) which are available to the public are exempt from tax on their income and gains. This treatment does not depend on the jurisdiction of residency of the investors and it is not dependent on whether the fund is managed in the International Financial Services Centre or in Ireland. However, as a matter of practice the Central Bank will not approve a fund unless certain administrative functions are carried out in Ireland.
At least two direct tax issues arise from this:-
(1)  The payment by the fund of a management fee (for example one per cent of committed capital and a percentage of profits above a certain level) will not be deductible against profits chargeable to Irish tax and;
(2)  If the recipient of the management fee is resident in Ireland Irish tax will be payable on the fee. It is worthy of note (and it is highly relevant to any potential inward investment project into Ireland) that the standard rate of corporation tax on trading income is currently 20 per cent. It will reduce to 16 per cent next year and will be 12.5 per cent as and from the 1st January, 2003. The rate of corporation tax on non-trading income is, and will remain at, 25 per cent. Though the above rates are not relevant to the fund they are of significance to taxable Irish investors and to Irish resident managers of the fund.

If the Irish activity was not a fund and was liable to tax, the distinction between trading income and capital gains tax would be relevant. At the moment the standard corporation tax rate is 20 per cent on trading profits. The capital gains tax rate is 20 per cent. Whether the profit on the sale of an investment is trading profit or capital gains is presently not relevant to the rate of tax payable though it can be significant in relation to other matters, for example, the use of losses, indexation of cost price etc. When the rate of corporation tax on trading income has fallen to 12.5 per cent (and the capital gains tax rate has remained at 20 per cent) the issue of whether profits are trading income or capital gains will come more sharply into focus.

The indirect tax treatment of the fund will be considered separately later.

What is the treatment of foreign investors investing in the case study fund? For example, pe issues, withholding taxes etc.
As noted above there is no tax on the income or gains (whether realised or unrealised) in the fund. There is no Irish stamp, capital or other duties on the issue, transfer or redemption of shares/units in the fund.

Ireland recently introduced a dividend withholding tax at the standard income tax rate (currently 20 per cent). However exemption from the withholding tax is granted to funds so that dividends received by the fund from Irish resident companies will be free of withholding tax.

Payments by the fund to non-resident investors, who have produced the relevant non-resident declaration to the fund, are made without withholding tax. The legislation provides that withholding tax must be deducted by a fund on payments to Irish residents. The rate of withholding tax is the standard rate of income tax (currently 20 per cent) where the payment is made annually or at more frequent intervals and the standard rate plus three per cent on other payments to the investor whether those payments be dividends or payments arising on the redemption of an Irish residents units or shares. Certain types of Irish investors such as pension funds, charities etc. can avoid the withholding tax.

The structure is most unlikely by itself to give rise to pe issues for the investors. The fund into which they have subscribed is being managed in Ireland by third party professional managers. The fee which the latter receives is fully taxable in Ireland (assuming the professional managers/ company is resident here). The income and gains of the fund are specifically exempt from Irish tax. It is difficult to see, in those circumstances, how the investors could be regarded as having a taxable pe in Ireland.

Does Ireland offer any special tax advantaged structures or treatment for Private Equity investors?
The fund in which the private investors participate (assuming that it is available to the public) is exempt from tax on its income and gains irrespective of where the investors are resident and whether or not the fund is managed in the International Financial Services Centre or in Ireland (though it will be found to be necessary that certain administrative functions be carried on in Ireland). No withholding tax applies to distributions to non-Irish resident persons once they have complied with administrative requirements in relation to declarations. In effect this means that the non-Irish resident private equity investor can (through the fund) receive income and gains from Irish assets without being subject to Irish tax in respect of them.

As indicated earlier QIFs are not subject to the investment and borrowing restrictions normally imposed by the Central Bank. There is another type of fund of interest to the private equity investor. To qualify as a Professional Investor Fund the minimum subscription per investor must be at least E125,000. In such funds the investment and borrowing restrictions are not disapplied but they are relaxed.

How would a fund organised in a tax haven be treated in Ireland?
The relevant issues would be whether or not withholding tax applied on the payment of dividends/interest from equity investments in Ireland. Non-residents are not within the charge to Irish capital gains tax except in relation to certain specified assets such as land in Ireland.

If an offshore transparent fund is in receipt of dividends from Ireland the question of withholding tax on dividends, from a strictly legal viewpoint, depends on the jurisdictions of the investors in the fund. As this is not practical in a large retail fund it would be worthwhile making a submission to the Revenue to treat the transparent fund as the entity to which the dividends were paid. If forthcoming, any concession is likely to be subject to conditions. Similar analysis applies to payment of interest.
The method of taxing Irish resident investors in offshore funds was changed in the Finance Act, 2001. Previously the gain on disposal of such an interest would have been liable to capital gains tax at 40 per cent or potentially to income tax at a person's marginal rate of income tax. As a result units in such funds were generally unattractive investments. This regime will continue to apply to interests in offshore funds not covered by the new regime. Offshore funds to which the new regime applies are those based in EU member states, EEA member states or member states of the OECD with which Ireland has a double taxation treaty. Provided that the appropriate returns are made to the Revenue Commissioners, Irish residents holding units in such funds will be liable to tax at 23 per cent on gains made and at 20 per cent on income payments. Thus, the effective rate of tax applied to holdings in domestic funds and offshore funds will now be the same. However a distinction will remain in that domestic funds will apply a form of withholding tax, whereas holders of units in offshore funds will be liable to tax under the self-assessment system.

Does Ireland have special rules for tax exempt investors or foreign governments?
Ireland does not have any special tax rules for foreign tax exempt investors or foreign governments other than those contained in the relevant treaty (if any). Outside of that the tax status of the investor in the investor's jurisdiction does not impact on the Irish tax treatment of the investor. Local exempt institutions can receive payments from the fund free of withholding tax.

Does Ireland grant tax treaty benefits to Private Equity fund Investors?
Ireland is an inward investment jurisdiction. Its laws, particularly its tax laws, are intended to attract inward investment. Under domestic law no withholding applies to payments by the fund to non-resident investors who have completed the appropriate non-resident declarations. Treaty relief would only be relevant to investors who have not made such declarations.

What special considerations, if any, arise from making and managing investments in entities outside Ireland?
The availability of treaty relief between the jurisdiction in which the investment is made and Ireland is of importance. If it is not available then the overseas jurisdiction could impose withholding tax.

The issue would arise where the Irish fund was in receipt of dividends/interest from other jurisdictions. The question would be whether those jurisdictions would accept that the benefit of the treaty (assuming there is one) between that jurisdiction and Ireland would apply. The obvious reasons why those jurisdictions might seek to disapply the treaty is that the fund is not resident in Ireland or the fund is not the beneficial owner of the shares or it is exempt from Irish tax. The Irish Revenue are prepared to issue a letter that funds are resident in Ireland. This is sufficient for many of Ireland's treaty partners. In general the question of treaty relief in any specific case needs to be examined in conjunction with the treaty, the domestic law of the relevant jurisdictions and the practice of the Revenue services.

If treaty relief is available in respect of the dividends flowing from the investment to the Irish company a further issue will be the relief (if any) available to an investor in respect of a dividend from the Irish company. The treaty between Ireland and the jurisdiction of the recipient together with the domestic law of the recipient and possibly the treaty between Ireland and the jurisdictions of the investment would be the relevant sources.
In the above context it is important to ensure that the fund is tax resident in Ireland. There are two tests of residence:
(i)  incorporation and;
(ii)  management and control.
Generally it is advisable that management and control be exercised in Ireland to avoid the company becoming resident elsewhere. In general a company is managed and controlled in Ireland if the board of directors meet in Ireland and make the substantial policy decisions in relation to the company at those meetings.

Value Added Tax
Value added tax is payable at the rate of 20 per cent on services. There are numerous VAT exempt activities including the management and/or administration of funds. In addition the services provided by an investment manager of a fund, where the Investment Manager is free to take investment decisions under guidelines laid down by the manager or board of directors of the fund, is exempt from VAT. Other services provided to a fund for example accountancy and legal costs may create an irrecoverable VAT liability.

Conclusion
A fund approved by the Central Bank is exempt from Irish tax on its income and gains. There is no withholding tax applied to payments to non-Irish resident investors who have completed the appropriate declaration.

Copyright © 2001 A&L Goodbody

The above paper was delivered to THE INTERNATIONAL BAR ASSOCIATION, CANCUN, MEXICO by DAVID GLYNN, A & L GOODBODY

David Glynn is a qualified solicitor, barrister and chartered accountant. He joined A & L Goodbody in 2000 as a partner in the Taxation Department. He advises on all aspects of corporate taxation with particular emphasis on inward investment, capital markets and financial services.

A & L Goodbody is Ireland's largest law firm. Based in Dublin, the firm has offices in London, Brussels, New York and Boston. For more information, please visit the firm's web site at www.algoodbody.ie