As we reported earlier this year, the ongoing Base Erosion and Profit Shifting ("BEPS") initiative led by the OECD is targeting the use (and abuse) of mismatched international tax rules by big corporate groups looking to minimise their tax bills. However, some of the areas of focus have the potential to impact the private equity and venture capital industry.
Four key areas covered by the BEPS project are the prevention of treaty abuse, the clarification of the "permanent establishment" concept, the limitation of interest deductions and "hybrid mismatch" arrangements. These will mainly be relevant to fund managers who use international structures
in their deals and funds, but some areas, such as the proposals on interest deductibility, could be relevant to all buyout fund managers.
Of the four areas, the proposals relating to interest deductibility and hybrid mismatch arrangements are firmly in train: final recommendations are expected in September. But in the last few weeks, the OECD has published new discussion drafts on the permanent establishment and prevention of treaty abuse proposals. The private equity industry's interest in the much broader debate on permanent establishment focuses on whether some of the proposed changes could lead to an increased risk that investment advisers
could create a taxable permanent establishment in some jurisdictions.
And the publication dealing with 'treaty abuse' proposals is of particular interest in that it has responded to previous submissions and concerns raised by the industry over the use of a tightly drafted "Limitation of Benefits" ("LOB") mechanism. The primary concern for private equity houses in this area has been that the OECD's initial proposals had appeared (perhaps unintentionally) to restrict the ability of many funds (and the companies used in their deal structures) from qualifying for treaty benefits
altogether. Industry bodies had put forward proposals to simply carve funds out of the proposed restrictions, but unfortunately these have not been taken up. The OECD cites concerns that this could allow investors in funds to have access to treaty benefits to which they are not otherwise entitled, and also to defer recognition of income on which treaty benefits had been granted. Instead, an alternative test, which would be used together with the proposed 'purpose test', has been favoured in the new discussion
draft. The suggestion is that, provided that 75% of the direct or indirect beneficial ownership sits with 'good' investors, then treaty relief should be available, provided the purpose test is also passed.
That being said, the OECD have not simply swept this under the carpet. They continue to adopt a constructive approach to working on possible solutions in this difficult area, acknowledging the industry's concerns and expressing a wish to continue to explore solutions. Options still on the table include adding a specific provision on the position of funds into the new rules, or adding specific examples to the guidance. It is also worth noting that even if adopted by the OECD, only a limited number
of states (such as the US and Japan) are likely to incorporate this type of detailed provision into their double taxation treaties in any case, as there is another pure purpose test option that is favoured by most jurisdictions involved in the process.
There are very tight deadlines for responses: 12 June 2015 in respect of the permanent establishment proposals and 17 June 2015 in respect of the treaty abuse recommendations. The industry bodies who have been working hard to date in this area will, no doubt, respond to these latest developments and continue a productive dialogue with the OECD, which is expected to extend into 2016, in the hope of producing a result that is supportive of the aims of the BEPS initiative, whilst being workable for the private
equity and venture capital industry.