On behalf of the Public Affairs Executive (PAE) of the EUROPEAN PRIVATE EQUITY AND VENTURE CAPITAL INDUSTRY 9 April 2014 To Re Organisation for Economic Co-operation and Development (OECD) Consultation on Public Discussion Draft BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances. Introduction: The Public Affairs Executive (PAE) of the European Private Equity and Venture Capital industry is pleased to provide its comments on the public discussion draft released by the OECD on Action 6 ( the Consultation Document ). We write on behalf of the representative national and supranational European private equity (including venture capital) 1 bodies. Our members cover the whole industry, from the institutional investors who provide the capital for investment to the private equity firms who invest the capital in European companies at all stages of their development. Importance of Private Equity in Financing the Real Economy: Private equity provides patient and engaged investment for the long-term, providing finance to businesses across OECD countries, and particularly to SMEs. The private equity industry participated in the process that led to G20/OECD High-Level Principles of Long-term Investment Financing by Institutional Investors in 2013. 2 As set out in Principle 1.4, a pre-condition for long-term investment is tax neutrality towards different forms and structures of financing. This Principle also adds that investment frameworks should as far as possible be made consistent across countries to facilitate the cross-border flow of long-term financing. Any standards for addressing the issue of Treaty Abuse under the BEPS Action Plan must also be examined against this backdrop therefore. 1 The term private equity is used in this paper to refer to all segments of the industry, including venture capital. The term venture capital is used in specific contexts where there are issues that relate particularly to this segment. 2 G20/OECD High-Level Principles of Long-term Investment Financing by Institutional Investors, September 2013.
As confirmed in the recent European Parliament Report on Long-term Financing of the European Economy 3, private equity firms can provide valuable non-financial support, including consultancy services, financial advice, advice on marketing strategy, and training to investee companies. This sentiment has been echoed in the recent European Commission Communication on Long-term Financing 4, which acknowledges the private equity industry as an important source of financing to pension funds and SMEs. Private equity represents all these qualities on a global, not just European basis. We would also like to highlight Principle 6.2 which states that governments should avoid introducing or maintaining unnecessarily barriers to international investment inward and outward by institutional investors, especially when targeted to long-term investment. They should cooperate to remove, whenever possible, any related international impediments. How Private Equity Operates: Private equity funds raise capital from institutional investors such as pension funds, insurance companies, or family offices These private equity funds are managed by specialist investment managers who invest the capital in companies across a wide variety of sectors, including consumer, industrial, engineering, life sciences, bio-technology, computer software, infrastructure, etc, at various stages of the life of the company. Most private equity funds have an international investor base. The investors are either subject to corporate income tax in their country of residence (insurance companies, family offices), or are exempt from such tax by their nature (pension funds, charities). The choice for the private equity fund s location is normally made on the basis of various factors (residence of the management team, investment objective, regional focus). From a tax perspective, it is key that the location and structure of the fund is tax neutral for the investors. In other words, the pooling of the investments via the fund entity should not trigger additional tax for investors when compared with a situation in which the investors invest directly in those companies. 3 European Parliament Own-initiative Report on Long-term Financing of the European Economy, 26 February 2014. Paragraph 38. 4 European Commission Communication on Long-term Financing of the European Economy, 27 March 2014, pp 6 & 13 2
Context of the Consultation: The private equity industry fully appreciates the concerns of the OECD that action is needed to effectively prevent double non-taxation, as well as cases of no or low taxation associated with practices that artificially segregate taxable income from the activities that generate it. We also support a coordinated and comprehensive international approach to tackle these important issues. We note that the Consultation Document refers to the 2010 OECD Report 5 on the treatment of Collective Investment Vehicles (hereinafter: the CIV Report ) and the Commentary to article 1 of the OECD Model Convention regarding the Application of the Convention to CIVs. The policy objective in this provision is to achieve tax neutrality between direct investment versus investment via funds, also referred to as collective investment vehicles or CIVs. The OECD made several proposals to grant treaty benefits to CIVs in their own right. This is because it is recognised that it is not obvious to expect that treaty benefits are being granted to the investors in a CIV on a transparent or look through basis in practice. The private equity industry is concerned that the BEPS Action 6 Draft Plan (the Treaty Abuse Draft ), if implemented, will disallow treaty access to many CIVs (and their holding entities) used in the private equity industry. The Abuse Draft is likely to affect many funds that invest cross border because most CIVs will simply not pass the proposed Limitations on Benefits (LOB) test. As a result, the tax burden of investing via funds is likely to substantially increase. This would clearly bring the investment environment further away from the policy objective - adopted by the OECD Council - of tax neutrality between direct investments and investments via a CIV. Disallowing funds from treaty access may easily result in double (or even triple) taxation. As a result, institutional investors may stop investing in private equity if the tax burden associated with cross-border investing becomes too high. The application of the Treaty Abuse Draft would be a major setback for the aim of creating a level playing field. 5 The Granting of Treaty Benefits with respect to the income of Collective Investment Vehicles, public discussion draft 9 December 2009 to 31 January 2010, released by the CFA-OECD (2010) and the Commentary to the OECD Model Convention regarding CIVs. 3
Proportionality & Impact on Collective Investment Vehicles: Many of the challenges presented to the private equity industry by the Consultation Document are borne of the fact that the document does not consider the position of CIVs to any extent (private equity being one of many classes of CIV). This is perhaps to be expected, given that CIVs are not a particular focus of BEPS, but it remains the case that the failure to consider the position of CIVs has directly led to many of the issues noted in this response. It is clear from previous OECD publications such as the 2010 OECD Report on the treatment of collective investment vehicles 6, and the January 2013 TRACE implementation package 7, that the OECD is aware of the particular challenges faced by CIVs in relation to treaties. This recognition is to be welcomed, but we strongly urge the OECD to turn this recognition into a workable plan for the treatment of CIVs. We see two alternatives in this regard: Firstly, CIVs of all descriptions can be explicitly excluded from the current Treaty Abuse Draft, and provision made in the proposed amendments to the model treaty to make clear that the LOB provision and/or purpose test will not act to restrict the ability of a CIV (or associated investment structure) from accessing treaty benefits. A new work stream could be created to address the particular circumstances of CIVs, building on the past OECD CIV initiatives. This is our preferred approach. Alternatively, the position of CIVs of all descriptions could be taken into account as part of the Action 6 work, and actions to address the particular circumstances of CIVs should be adopted at the same time as and as part of the output of the Treaty Abuse Draft work. Limitation on Benefits (LOB) Test: The private equity industry does not consider that the LOB provision is proportionate or necessary to meet the policy objective of preventing treaty shopping. As such, we are of the view that the LOB provision should be abandoned. Not least, this is in recognition of the significant cost and complexity which will arise if new arrangements have to take into account both an LOB provision and a main purpose provision (in addition to existing concepts such as beneficial ownership). Taken together, these provisions would represent a considerable burden and will ultimately act as a disincentive to international investment. 6 The Granting of Treaty Benefits with respect to the Income of Collective Investment Vehicles, 23 April 2010. 7 Treaty Relief and Compliance Enhancement (TRACE)- January 2013 4
As currently drafted, many private equity funds and holding companies owned by such funds would not meet the LOB test for several reasons: (i) the fund and the holding companies will not be listed,; (ii) neither the fund nor the holding companies will be treated as carrying on an active trade or business for the purposes of the proposed LOB test. Under the formulation of the LOB test currently proposed, the making or managing of investments will be deemed not to satisfy this test unless carried on by a bank, insurance company or securities dealer. (iii) the derivative benefits provision as currently proposed is very narrow. The proposed LOB test, as drafted, would disqualify a fund entity (including holding companies of a fund entity) as a qualified person, and would therefore deny tax treaty protection to the fund. This is because at least 50% of the beneficial interests in a fund are often not owned by persons that are resident in the country where the investment vehicle is resident. This is inherent to the nature of many private equity funds that raise capital from investors in many different jurisdictions. Holding companies in certain jurisdictions can ensure that CIV investors are afforded greater certainty regarding insulation from legal liabilities that might flow out of a domestic structure to non-domestic parents. This matter is particularly relevant where shareholder consent outside of the investee jurisdiction is given, or entities are deemed to be subject to a controlling parent which can give rise to liabilities arising in the controllers hands. An intermediate holding jurisdiction can often provide the only meaningful shield to these risks. Investors in private equity funds are often entitled to treaty benefits in their home jurisdiction. We believe that an expanded derivative benefit provision could afford some relief from the double taxation which certain investors in private equity are likely to suffer should the proposals proceed as drafted. However, there will be significant challenges to applying a derivative benefits provision in certain circumstances, for example, in the case of investment into private equity funds by other fiscally transparent funds such that the treaty status of ultimate beneficiaries is not apparent to the private equity fund. It is important to note that the implementation of FATCA will not result in fund managers having access to information about the treaty status of each ultimate beneficiary of investment returns from the fund. 5
Even if it were decided to include a so-called derivative benefits test, there would still be uncertainty in many cases whether the LOB clause would allow treaty access. We provide some examples below to illustrate these problems. Example 1: A venture capital fund ( VC fund ) is organized as a limited partnership in country X. Among its investors are pension funds, endowments, family offices and insurance companies from 10 different countries, all of which are OECD member countries. The VC Fund invests in expansion capital of a start-up company in the life sciences business ( Target ) established in country Y. The VC fund owns all its investments, including the equity interest in Target, through a wholly-owned holding company ( Holding ) in country Z. After 6 years of growth and development, the VC fund s investment in Target is sold successfully. Under its domestic tax law, country Y imposes a capital gains tax on the disposal of shares by foreign shareholders. Generally, this capital gains tax cannot be imposed on foreign shareholders under article 13 OECD Model Treaty if the foreign shareholder of Target is a tax resident of a country with which country Y concluded a tax treaty based on the OECD Model Treaty. Country Z and Country Y concluded such a tax treaty which is in effect. Under the proposed LOB test however, the VC fund and Holding would be disqualified from obtaining treaty benefits. If the investors in the VC fund would have invested directly in Target however, it is likely that all investors would have qualified for treaty benefits under the proposed LOB test. This demonstrates that the proposed LOB affects many CIVs and the wholly-owned holding companies through which the CIVs make their investments. In addition, the proposed LOB test works out even worse as it may create triple taxation because the investee companies in which the VC fund makes investments may be denied treaty benefits as well as a result of the proposed LOB. Example 2: In the same scenario as Example 1 above, let us consider what happens when the VC fund invests together with another (similar) VC fund established in country A in the life sciences business of Target, established in country Y. The two VC funds jointly acquire 60% of the shares in Target. The business of Target is developing very successfully and it is going to license patents to unrelated parties worldwide, receiving royalties in return. Target wants to claim tax treaty relief for withholding tax on the royalty payments. If Target were domestically owned by 6
investors established in country Y, it would qualify for treaty benefits under Article X(2)(e) of the proposed LOB. Target, however, needed funding from the VC funds for the development of its business to the next stage, including further development of the patents. As a result of the funding by the VC funds, Target cannot rely on article X(2)(e) anymore, and can claim treaty benefits only if it passes the substantial business test of Article X(3) of the proposed LOB. There are however too many uncertainties to rely on the substantial business test. We foresee a lot of discussion and debate as to the question of what exactly qualifies as substantial in relation to the trade or business activity carried on by the resident or associated enterprise in the other Contracting State? If a multinational pharmaceutical in country B pays royalties to Target, the business activity of Target must be substantial in relation to the trade or business of the multinational in order to pass the test. This will mean that Target will often be disqualified and face full withholding tax liabilities. Given the above, while we do not support the concept of an LOB provision, if this aspect of the proposals does proceed then we would urge the OECD to include specific provision for CIVs (including the holding entities through which CIVs invests if such holding entities are controlled by the CIV) in the derivative benefit concept, recognising that this would have to work as part of a wider framework for treaty access for CIVs. In particular, consideration should be given to including a CIV (and the aforementioned holding companies) in the definition of a qualifying person, provided that certain conditions are met (for example, that the CIV is not controlled by one or a small number of investors, and/or that the CIV is registered or is managed by a registered fund manager Main Purpose Test: Even if the LOB test is satisfied, the Main Purpose Test will be another major obstacle for claiming tax treaty protection by CIVs. The examples given at paragraph 33 of the Consultation Document make clear that it is acceptable to take treaty access into account when making investment decisions. On the face of it this would seem at odds with the paragraph 6 test. We agree with the text of paragraph 30 of the Consultation Document, which broadly explains that in order for the test to not apply, it is not sufficient to merely assert that access to treaty benefits was not a main purpose of an 7
arrangement; it must be so that all available evidence is taken into account in determining the purpose of an arrangement. However, we do not consider that the objective approach described under Paragraph 29 is appropriate. In answering the question of the main purpose of an arrangement, it is the facts and circumstances which the parties actually took into account in arriving at that arrangement - not what an independent third party believes that they should have taken into account - which should be relevant. To do otherwise would be disproportionate and likely to affect normal commercial arrangements as parties will have no appetite for engaging in protracted discussions over what facts and circumstances are relevant to establishing purpose. As such, the test should be subjective, not objective. Finally, it is unclear how the Main Purpose test, if applied objectively, would work out in practice for a typical European private equity fund. The Treaty Abuse Draft states that [t]o determine whether or not one of the main purposes of any person concerned with an arrangement or transaction is to obtain benefits under the Convention [a tax treaty], it is important to undertake an objective analysis of the aims and objects of all persons involved in putting that arrangement or transaction in place or being a party to it. In combination with the recommendation to confirm that a tax treaty will not prevent a state from applying its domestic anti-abuse rules, we fear that many countries may take the position that a typical investment vehicle of a fund is not entitled to treaty benefits, as not all of the investors in a given fund would be entitled to exactly the same treaty benefits, had they invested directly. Conclusion: Private equity funds are not in the business of treaty shopping. The primary purpose of private equity, just like other CIVs, is a business purpose, i.e. pooling of capital to make investments. As long as different countries interpretations of what constitutes a permanent establishment are not harmonised across the globe, tax treaty access will remain crucial in order to achieve tax neutrality for funds, and to avoid double or even triple taxation in otherwise genuine bona fide investment structures. The position of CIVs in relation to treaty access must be considered and addressed before the Treaty Abuse Draft work stream continues. We do not consider that the proposed LOB test is proportionate or necessary in order to meet the policy objective. 8
Contact Thank you in advance for taking our comments into account as part of the consultation process. We would be more than happy to further discuss any of the comments made in this paper. For further information, please contact Danny O Connell at the European Private Equity & Venture Capital Association (EVCA). Phone +32 2 715 00 35 Mobile +32 499 69 53 94 danny.oconnell@evca.eu www.evca.eu 9
The Public Affairs Executive (PAE) consists of representatives from the venture capital, midmarket and large buyout parts of the private equity industry, as well as institutional investors and representatives of national private equity associations (NVCAs). The PAE represents the views of this industry in EU-level public affairs and aims to improve the understanding of its activities and its importance for the European economy. About EVCA The EVCA is the voice of European private equity. Our membership covers the full range of private equity activity, from early-stage capital to the largest private equity firms, investors such as pension funds, insurance companies, fund-of-funds and family offices and associate members from related professions. We represent 650 member firms and 500 affiliate members. The EVCA shapes the future direction of the industry, while promoting it to stakeholders such as entrepreneurs, business owners and employee representatives. We explain private equity to the public and help shape public policy, so that our members can conduct their business effectively. The EVCA is responsible for the industry s professional standards, demanding accountability, good governance and transparency from our members and spreading best practice through our training courses. We have the facts when it comes to European private equity, thanks to our trusted and authoritative research and analysis. The EVCA has 25 dedicated staff working in Brussels to make sure that our industry is heard. 10