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Taxing issues for private equity funds

Investors in private equity and venture capital funds come in all shapes and sizes. Some are wealthy individuals investing $1m or less. Others are major public sector pension funds that may invest $100m or more in a single fund. Their tax status also varies widely – Paul Megson from KPMG discusses the issues.

Some investors are taxable on all their income and capital gains. Some are tax-exempt on all investment returns, and some fall in between - investment trusts for example pay no tax on capital gains but are fully taxed on interest income. 

Private equity fund managers are happy to take investments from any of these. Their main objective, in order to maximise their own returns, is to maximise the - manageable - size of their funds by attracting investors with promises of consistently high gross returns and in particular, high internal rates of return (IRR).

Furthermore, their aim is to deliver a bottom line, which is as far as possible free of tax. They see investors as being primarily responsible for their own tax liabilities. They aim for structures, that leave investors in the same or better position, as they would enjoy if they were making their investments entirely independently - the principle of fiscal transparency.

Fund managers don't want to dilute their IRR performance by holding clients' money for a day longer than absolutely necessary. They want to draw down just in time to invest, and distribute immediately after disposal. Therefore they also need flexibility.

Private equity funds generally invest in a small amount of ordinary share capital, plus a much larger subordinated loan, on which interest is generally rolled up until disposal. This incentivises the investee's management and, through tax deductions on the loan interest, enhances free cash flow. It can also help to achieve a more highly leveraged balance sheet in the investee.

Finally, managers want to ensure that their own remuneration, especially the ‘carried interest' typically taken as a share in the returns made by their funds, is as lightly taxed as possible.
The tax issues impacting on all four sides of this equation - investors, fund managers, the fund itself and the investments and their management - are complex but they generally lead to a clear conclusion:
■ Corporate fund structures are inefficient, inflexible and lead to double taxation
■ Partnership structures are more flexible, are generally deemed fiscally transparent, and are more efficient for the managers
So, the main tax issues for investors in a private equity fund arise directly or indirectly from the way in which revenue authorities deal with partnerships.

Transparency, and accrued income

The British Venture Capital Association and the Inland Revenue long ago agreed that any income or capital gains earned by a partnership fund would be apportioned among the partners directly, and then taxed or not according to each partner's personal status. This avoids a second layer of taxation being imposed on the fund itself, but it accentuates some potential pitfalls. One of these is the discrepancy between the fund's and the Revenue's treatment of interest on loan investments. Funds normally account only for cash receipts due to the risk profile of venture capital investment, but UK taxpayers must generally report taxable income on an accruals basis. This implies that tax may be paid well before the income is received, and sometimes even if the loan and interest is ultimately written off (see below).  The BVCA has, from time to time, commented on this anomaly. Most recently in has responded to the Revenue's consultation paper on amendments to the corporate debt rules tabled for implementation in the 2002 Finance Bill.

Bad debts

The spirit of the original agreement between the Inland Revenue and the BVCA was that funds would be totally transparent - each investor would be viewed as though it had subscribed entirely independently, and not acting ‘in concert'. However, this principle has been seriously eroded by subsequent legislation and perhaps the starkest example is the treatment of bad debts written off by lenders who are ‘connected' with the borrower. These cannot be deducted for corporation tax.

In effect, the detailed rules treat investors who are banded together in partnerships, as though they were a concert party, which taken together may have a majority stake in the investment and thus trigger these rules. The Inland Revenue has made various not very successful attempts to excuse venture capital funds, but proposed changes due to be implemented in 2002 call all of those into question. Again, the BVCA has commented on the Revenue proposals and fortunately, the Revenue has at least hinted that it is sympathetic to the BVCA's arguments. Less fortunately, the Revenue, by their own admission, does not really understand how venture capital limited partnerships work.

However, the rules can normally be circumvented - quite legally - by adjustments to the detailed structures of the fund or of the investment itself. These techniques typically include a division of the fund into a half-dozen, or more separate limited partnerships, acting in parallel, and with some types of investors being carefully segregated. This separation and segregation is in any case necessary to deal with non-tax issues such as US pension funds rules. However, fund managers still need to pay careful attention to these rules, even where they appear to be relaxed, and to keep them under constant review.

Carried interest and ‘base cost shift'

One of the fundamental benefits of the limited partnership structures used by private equity funds is the treatment, agreed by the Inland Revenue, of the Fund managers' ‘carry'. This entitlement to a percentage of gains made by the fund is delivered to them as a re-attribution of the partnership's assets among the partners so that the managers, as partners in the fund, have an enhanced share. They are taxed on disposal of their new-found share of assets under capital gains tax rules, which are less onerous than income tax.

Furthermore, the re-attribution of assets transfers to the managers and therefore away from the investors, not only a proportion of the fund's assets, but also a similar proportion of the tax-deductible base cost associated with those assets. This ensures that the managers are liable to tax on rather less than the entire bonus they receive, but it also means that taxable investors are liable to tax on a little more than their actual share of the gain.
There are many other potential tax issues for investors in private equity funds, but these are the main ones. The Fund managers, together with the BVCA and professional firms, keep a constant watch on developments. With careful attention to detail, most pitfalls can be avoided. The overall conclusion remains that the limited partnership continues to be the most tax-efficient, and most flexible medium for professional investment into private equity.

Copyright © 2001 KPMG 

Paul Megson, Partner, KPMG Mergers & Acquisitions Tax, London
Paul joined KPMG in 1988 after 7 years with the Inland Revenue in London. He joined the Transaction Services group full-time in 1994, pioneering private equity as a specialist field in tax planning.  Paul has advised on a number of private equity transactions including the management buyouts of BP Nutrition,Inchcape Testing Services and Global Refund, and on the structuring of a number of European private equity funds.