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The marketing of participations in foreign private equity funds from an Austrian tax perspective

Investment in the Austrian private equity market is on the rise, say Gerald Gahleitner and Gerald Toifl of Leitner & Leitner. But there are tax issues that investors should be aware of when marketing their funds. Toifl and Gahleitner outline the relevant tax implications for Austrian private and institutional investors and discuss various tax issues that might arise from investments by foreign funds in Austrian target companies.

Although Austria is geographically a small market it seems to be an attractive market for foreign private equity and venture capital firms. The number of firms trying to market investments to Austrian residents or investing through their funds in Austrian target companies is constantly rising. Not only Austrian institutional investors but also (high net wealth) private individuals diversify their portfolios by investing in local and/or foreign private equity funds. Both, investors and private equity firms (including foreign investors holding stocks in private equity funds) are facing several tax implications. This article summarizes some of them providing foreign private equity firms with the Austrian regulatory and tax framework for a successful structuring of their Austrian activities.

The Austrian investor's perspective

1.     General income tax principles

The tax treatment of an Austrian investor's participation in a foreign private equity fund depends on the legal structure of the fund. Foreign funds are usually organised in the form of a partnership, they may, however, also be set up in the form of a corporate entity. The Austrian tax rules differ in this respect as described below:

1.1.   Corporate investors

Austrian corporations are generally taxed on their worldwide income at the rate of 34%. Income derived from a unit in a transparent or non-transparent foreign fund is generally categorized as business income and taxed accordingly. However, if the foreign fund is organized in the legal form of a EU company listed in the Parent-Subsidiary Directive or in a legal form that is comparable to the Austrian GmbH (limited liability company) or AG (stock corporation), the international participation exemption might apply. Under the participation exemption, dividends derived from and capital gains arising from the alienation of such a participation (which could also be unit in a foreign fund) are exempt from corporate income tax provided that the Austrian corporate investor holds at least 25% of the capital of the foreign fund for an uninterrupted period of 2 years.

Special rules exist for private foundations (Privatstiftungen) set up in accordance with Austrian legislation. Private foundations are generally taxed at the rate of 34% whereas special rates and several exemptions are available depending on the category of income. Thus, dividends and capital gains derived by the private foundation in respect of domestic or foreign companies are tax exempt under certain conditions.

1.2.    Private investors

Private individual investors can dispose of or redeem their units in a foreign fund that is organised in the form of a corporation tax free provided that they hold a participation of less than 1% and the holding period exceeds one year. Dividend distributions by a foreign corporation (fund) would be subject to income tax at progressive rates of up to 50%.

This high tax burden has been criticised as contradicting the free movement of capital under the EC Treaty since dividends paid by Austrian companies are taxed at the rate of 25% only. As in the meantime a preliminary ruling concerning the discrimination against foreign dividends has been submitted to the European Court of Justice changes to the tax rules are very likely. Although no draft law has been made official yet it can be expected that dividends will be subject to final (with-holding) tax at the rate of 25% regardless of its domestic or foreign source from 1 January 2003.

The tax treatment of income from participation in a foreign private equity pool that is organised in the form of a partnership depends on whether the foreign partnership is carrying on a trade or business in the meaning of Sec 23 Income Tax Act or whether it is only engaged in asset management, thus managing participations in the target companies.

If the private equity fund is regarded as carrying on a trade or business, its income (including any capital gain from the disposal of shares) will be attributed pro rata to the Austrian private investors and taxed in its hands as business income at progressive rates up to 50%. Tax treaties may, however, change this result (see paragraph 1.3).

In the case that the object of the foreign partnership is limited to asset management any capital gain received by this partnership is taxable in the hands of the Austrian private investor only if

      the percentage of the investor's pro rata participation in the target company
      amounts to at least 1 %, or
      if the foreign fund disposes of such shares within a one-year holding period.
 
The question as to whether the foreign partnership is to be regarded as carrying on a trade or business or whether it can be treated as a pure asset management company depends on various criteria including the following:

      A trade or business is assumed if the activities of the partnership are
      directed towards the sale 
      (purchase) and resale (repurchase) of assets and if the activities of the  
      foreign fund in respect of the
      acquisition of assets are financed with debt.
      The sale and purchase of shares by the Austrian private investor is regarded as a trade or business if the
      activities of the partnership are similar or comparable to banking activities.
      The establishment of specific organisation and offering (banking) services to the public in some cases 
      followed by the sale and purchase of stock for the account of third parties is indicative for the existence   
      of a trade or business.

By applying these criteria to foreign private equity partnerships, one may conclude that the way a private equity fund generally structures its activities will prevent a classification as a partnership carrying on a trade or business in terms of Sec 23 Income Tax Act.

1.3.    Applying tax treaties

Generally, private equity firms are set up in the legal form of a partnership that will be considered as transparent for Austrian and foreign income tax purposes. In such a case, income derived by the private equity fund will be attributed to and taxed in the hands of the Austrian private or corporate investor. The tax treatment will depend upon the classification of the activities of the fund as well as the residence of the target vehicle.

In general, the two following situations have to be distinguished:

      The private equity fund is considered to carry on a trade or business: The Austrian investor will be
      deemed as having a permanent establishment in the state of the fund's residence. In a treaty situation, the
      income of the fund attributed to the Austrian investor will generally be exempt in Austria as most of its 
      tax treaties provide for the exemption with progression method. In a non-treaty case, tax authorities might
      under certain conditions provide for a unilateral relief.
      The private equity fund is engaged in asset management activities: The look-through approach will be 
      applied to the foreign partnership. Thus, the investor will be taxed according to its participation on capital
      gains derived by the private equity fund from the alienation of target companies. The treatment of a
      particular portion of the capital gain will depend on the residence of the target company. Under a tax
     treaty between the residence state of the target com-pany and Austria, such gain will, in most cases, be
     seen as taxable in Austria only, but will in general not be taxed under Austrian domestic rules.

In the case of a characterization conflict that might arise from different treatment of partnerships in Austria and the state of their residence, Austrian tax authorities committed themselves to the proposals made by the OECD Partnership Report in 1999. If different tax treatment results in double taxation of income, Austria will follow the classification of the source state and grant exemption for foreign source income. On the other hand, Austrian tax authorities will be reluctant to provide for an exemption of foreign income that is either non-taxed or considered as dividends or interest that is taxable at source only. In such a case, the exemption will be re-placed by a foreign tax credit.

2.      The application of Sec 42 Investment Fund Act (InvFG)

2.1.   The InvFG constitutes the legal framework for Austrian investment funds. Its Sec 42 contains special rules as to the tax treatment of income derived from a foreign legal entity that is considered as falling within the scope of this provision. Thus, it is potentially applicable to foreign private equity funds and may have negative tax consequences for Austrian investors.

2.2.   The special tax regime applies if the foreign entity, in which the Austrian investor holds a participation, is classified as a foreign investment fund. Such a fund is deemed to exist if the foreign entity by law, statutes, or actually structures its in-vestments under the principle of risk diversification. The legal form of the entity is of no relevance. Undertakings for investments in real estate are generally exempt from the application of this provision. It should be noted, however, that the Austrian government has prepared a draft law that provides for a similar tax regime applicable to collective investments in (foreign) real estate.

2.3.   The Ministry of Finance has issued various guidelines and rulings from which it could be concluded that tax authorities assume foreign private equity funds as gen-erally being covered by Sec 42 InvFG. In its view, the application of Sec 42 InvFG is not excluded by the fact that the foreign private equity fund primarily invests in participations, in which an Austrian investment fund is generally not allowed to invest. For instance, an Austrian investment fund may not invest in limited liability companies or the investment in such a company may not exceed a certain threshold. If a foreign private equity fund structures its investments in various participations (e.g. in more than five target companies as exemplified in a ruling issued in 2001 by the Ministry) it is very likely that provisions of the Investment Fund Act will be applicable. However, local tax authorities are sometimes willing to grant rulings that exclude the application of Sec 42 InvFG if the foreign investment fund has a certain influence on the management of the target companies.

2.4.   The tax treatment under Sec 42 InvFG depends on whether the fund has disclosed its overall income to the Austrian Ministry of Finance. If proof on actual income of the fund is submitted to the Ministry and if the foreign fund is admitted to and ac-tually offered for public subscription (i.e. a white fund) the Austrian investor will be taxed on actual profits derived by the fund and attributed to him. Only 20% of the capital gain would be taxable. In the case that the fund is not admitted to or actually offered for public subscription, but actual profits are disclosed to the Ministry (i.e. a grey fund), the overall income of the fund would be taxable. Thus, capital gains will be included in the tax base. In the remaining cases, the Austrian investor is deemed to receive the higher of the 90 % of the difference between the first and the last repurchase price fixed in the calendar year and 10 % of the last repurchase price fixed in the calendar year as taxable income (i.e. a black fund). If the unit is sold the difference between the repurchase price fixed at the time of sale and the last repurchase price fixed in the past calendar year but at least 0.8 % of the repur-chase price fixed at the time of sale for each month commenced in the calendar year is to be declared as taxable income.

As difficulties will arise in practice with respect to the necessity to disclose income or to be admitted to public offering, the foreign investment fund will be generally characterized as a black fund.

2.5.   The income determined in such a way and attributed to the corporate investor is taxed as business income at the rate of 34%. The international participation exemption is neither applicable to the distributions made by the fund to the corporate investor nor to the capital gains derived from the alienation of the participation units.

Private investors are considered as deriving interest income in respect of securities. According to the existing rules, progressive tax rates up to 50% apply. As a result of the developments on the EU level (i.e. pending case on discrimination against foreign dividends, proceedings initiated by the European Commission against Austria on the tax treatment of foreign investment funds), discussions have started towards equal treatment of certain income from capital derived from domestic and foreign investment funds. Among others, proposals have been made to tax such income at a final (withholding) rate of 25%. Such developments might, in certain cases, eliminate or mitigate detrimental tax treatment of investments in black funds.

3.     The establishment of an Austrian parallel fund (side-pool)

3.1.  In order to avoid disadvantages for the Austrian investor resulting from characterization of the foreign entity as an investment fund followed by the application of Sec 42 InvFG, the activities of the investor could be structured by setting up an Austrian parallel fund. Such a parallel fund could be established in the legal form of a limited partnership (Kommanditerwerbsgesellschaft) that invests into target companies parallel to the main fund.  In such a structure, no unit in the main foreign investment fund as required by Sec 42 InvFG will be held by the Austrian investor. The structure is, however, feasible only if the parallel fund does not qualify as fund-of-funds as in such a case the issue of Sec 42 InvFG would again arise. Regulatory issues will further have to considered when implementing a parallel fund structure.

3.2.   The Austrian limited partnership will, under an appropriate structuring, generally not be treated as carrying on a trade or business under the principles described above (see para 1.3 ). Thus, capital gains derived by an Austrian private investor will be tax exempt provided that the investor's pro rata participation in the target company is less than 1% and the one year holding period has expired.

3.3.   As the Austrian limited partnership will not be qualified as carrying on a trade or business the Austrian side-pool could also be used as an attractive investment vehicle for foreign investors or private equity firms. As long as the Austrian limited partnership does not maintain an office in Austria foreign investors would not be subject to any tax liability. It is, nonetheless, recommendable to obtain a ruling from the competent tax authority in order to confirm that in a specific structure the Austrian limited partnership does not result in a (limited) tax liability for foreign investors.

3.4.   However, the Austrian parallel fund structure seems to be acceptable to private equity firms only if the carried interest can be withdrawn without triggering Austrian tax. Various techniques can be used to reach this aim. For instance, the private equity firm might enter into a silent partnership agreement with the Austrian parallel fund. As alternative, the latter may issue participation rights to the foreign fund. Under either agreement, the private equity firm would receive a remuneration for its services provided to the Austrian side-fund, which is determined by a certain percentage of the partnership's profit or the amount of carried interest. Under certain conditions, no tax liability will arise in Austria. As re-characterization of profits arising from participation rights or from a silent partnership into tax exempt capital gains is common in some jurisdictions, detailed examination of tax consequences at the level of each partner of the private equity firm is necessary.

3.5.   In principle, services offered by the foreign private equity fund may constitute taxable events for Austrian VAT purposes or result in a source taxation if the fund or the person carrying out such services is resident in a non-treaty state. In most cases, the VAT and income tax liability might be, however, avoided by careful tax planning.

The penetration of the Austrian market by foreign private equity firms

1.   Typical structures

Foreign private equity firms may choose to set up a local business in Austria in order to evaluate the market, to negotiate with the target companies or to advise the foreign head office on suitable targets. Instead, the firm may decide to operate in the market from a base outside of Austria (e.g. Switzerland or Germany).

The following description of tax consequences is based on the following situation: A foreign private equity fund that is organised in the form of a limited partnership (LP) and thus, deemed transparent for income tax purposes invests into Austrian target companies. It is further assumed that the private equity firm becomes a limited partner in the foreign fund. The following focuses on tax issues arising for partners of the limited partnership.

2.   Austrian source taxation

Foreign investors are, in their capacity as partners of the LP, subject to Austrian income tax if they derive certain income from Austrian sources. In particular,

2.1  Capital gains are in general taxed if

      such gains are treated as income from a trade or business and attributed to the permanent establishment 
      or the permanent agent that the LP may have in Austria, or 
      such gains originate from the sale of a participation in a resident company provided that the investor's pro
      rata share amounts to at least 1% or is held for less than 1 year.

2.2   Passive income

Any dividends distributed by an Austrian company to the foreign LP are treated as being distributed to the foreign investor according to its foreign pro rata share. The investor is subject to a withholding tax at the rate of 25% that might be, however, reduced by a tax treaty between Austria and the state of the investor's residence.

Interest is generally not subject to any income or withholding tax according to Austrian domestic law.

3      Permanent establishment or permanent agent

As mentioned above, a foreign investor holding a participation in the foreign LP will be taxed in Austria if the investor carries out a trade or business through an Austrian permanent establishment or an Austrian permanent agent.

The decision as to whether the foreign investor carries out a trade or business depends mainly on the activities of the LP as well as other activities of the investor. Based on the guidelines described above, a private equity fund mainly engaged in asset management will not be regarded as carrying out a trade or business. However, the activities of the investor might themselves qualify as business activities. In such a case, the investor would be subject to Austrian tax only if an Austrian permanent establishment or a permanent agent is maintained in Austria for the acquisition or sale of participations in Austrian companies.

Private equity firms having an office in Austria for purposes of evaluating the market and potential target companies will usually avoid the permanent establishment issue by reducing the functions of the local office to pure advisory activities. Neither should the staff of the foreign private equity firm have the authority to dispose of the local premises of the Austrian entity nor should it be granted any authority to negotiate contracts concerning the acquisition or the sale of participations in the name of the fund. In such a case, the local staff would only provide auxiliary services to the foreign head office, which has the power to decide on the acquisition or on the sale of a specific participation in a target company. The taxable income of the local entity is then calculated on a cost-plus basis. In addition, a situation should be avoided such that employees of the head office negotiate contracts at premises of local target companies. In other words, the employee having an authority to bind its head office shall not physically act on the Austrian territory otherwise a permanent establishment will be created.

4.    Application of tax treaties

If a foreign private equity fund is set up in a state having a tax treaty with Austria the question arises as to whether the LP will be granted protection under the tax treaty. In such a case, Austrian tax authorities will follow principles developed in the OECD Partnership Report. Thus, the tax treatment of the partnership in the state of its establishment as well as the attribution of partnership's income under the domestic rules of the state of the partners' residence will have to be considered.

If the LP is treated as transparent for tax treaty purposes and its income is attributed to partners under the domestic rules of their residence state Austria as a source state will have to consider its treaties with the residence states of the partners. If the LP is treated as a corporation and thus, non-transparent entity for income tax purposes Austria as a source state will apply the tax treaty with the state of the LP's establishment. In the case that a tax treaty contains a provision similar to Art 13(4) of the OECD-Model Convention, Austria would have to exempt such capital gains from taxation even though the foreign investor's pro rata share in the Austrian target company exceeds 1%.

Copyright © Leitner & Leitner

Gerald Gahleitner, LLM (London) is a tax lawyer in the Linz office and can be contacted at +43 732 7093-303 or Gerald.Gahleitner@leitner-leitner.com. Gerald Toifl is tax lawyer in the Vienna office and can be contacted at +43 1 7189890-531 or Gerald.Toifl@leitner-leitner.com.

Leitner & Leitner was established in 1959 as a certified public accountants and tax con-sulting company. It currently employs a staff of around 300 employees and has offices in Vienna and Linz as well as subsidiaries in Czech Republic, Slovak Republic, Hungary and Slovenia. For futher information please visit www.leitner-leitner.com