08 October 2015

The OECD and private equity tax

As previously reported in Private Equity Comment, the Organisation for Economic Co-operation and Development (OECD) and the G20 have, for the last two years, been pursuing an international initiative to crack down on perceived tax avoidance by multi-national companies. Known as BEPS (the acronym for “base erosion and profit shifting”), the aim is to create a single set of tax rules to address concerns that large companies (among others) are able to avoid paying their "fair share" of tax by moving profits to low tax jurisdictions. And although private equity is not the main target of the initiative, it has inevitably been caught in the cross-fire.

This week, the OECD released its final reports (click here for our summary), and work will now begin on implementing the proposals which will depend to a large extent on whether and how individual countries decide to take them forward. Of particular interest to the private equity industry are the proposals relating to treaty abuse and interest deductions.

In relation to treaty abuse, the OECD wants to stop the use of intermediate vehicles in countries with a wide tax treaty network to artificially bridge the gap between two countries which do not have a double tax treaty with each other. This is to be achieved by changes to the relevant tax treaties. Unfortunately, as drafted, the proposals could impact private equity funds which have investors from, and themselves invest in, a wide range of countries if (as many do) they use a central treaty-eligible structure to minimise compliance burdens. Fortunately, following intensive discussion with industry participants, the OECD has acknowledged the economic importance of private equity and similar funds, recognised that the proposals do not currently cater appropriately for them, and confirmed the need to ensure that treaty benefits are granted where appropriate. It is now intended that further work will take place in the first half of 2016 to try to find a solution, and it is important that the industry continues to take an active part in this process to ensure that the final proposals are workable. However, whatever the ultimate solution, some disruption to existing structures, or changes to past practices, seems likely.

In relation to interest deductions, the OECD has recommended that countries should introduce domestic rules providing for a fixed ratio rule, which would limit an entity’s net tax deductions for interest (and payments “economically equivalent” to interest) to between 10 and 30 per cent of EBITDA. While it is proposed that there will be an exception for interest paid to third party lenders on loans used to fund public-benefit projects, which may be of benefit to infrastructure funds, if such rules are introduced there are likely to be significant implications for private equity and real estate funds. These rules are intended to be introduced on a jurisdiction by jurisdiction basis and, while it is envisaged that there will be some transitional grandfathering provisions, it should not be ruled out that these proposals will have some effect on investments made before the rules are changed.

It is true that there is a head of steam building around limiting interest deductibility, with proposals emanating from US presidential candidates and the European Commission, as well as the OECD. However, it is not clear whether or how national governments will implement these latest proposals, which could lead to very significant changes to very long standing tax rules and consequent business disruption, and some countries have already ruled out further changes to their existing restrictions. No doubt, the debate on interest deductibility is far from over, and the OECD’s “final report” is unlikely to be the last word.

While the OECD proposals requiring treaty changes are unlikely to take effect before the end of 2016, and more likely later than that, some jurisdictions have unilaterally sought to pre-empt them; for example, the UK has already introduced a “diverted profits tax” in advance of the final BEPS proposals. Further national changes are likely (although these may not necessarily be in full accordance with the OECD recommendations), and the tax regime looks increasingly unstable in many key countries. Fund managers will have to pay close attention to further developments.

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