SWF Replace: Tax Features of Non-public Fund Investments: Chosen US, EU and UK Concerns within the Present Setting

Despite the market disruption caused by the COVID-19 pandemic, sovereign wealth funds continued to make significant capital commitments to private funds around the world in 2020. As the world emerges from the pandemic, similar or greater investment activity from SWF investors is expected in 2021 and beyond.

In making a commitment to invest in a private fund, a non-US investor must consider a number of tax structuring, operational, risk allocation and economic considerations in order to fully appreciate the potential risks and benefits of that particular private fund investment. This can be a daunting task, especially as private funds increasingly pursue global investment strategies and consequently implement increasingly complicated structures in order to achieve optimized tax results across a wide range of investor profiles and tax jurisdictions.

In this update, we focus on a handful of US, EU and UK tax issues that arise in connection with a private fund investment that we believe will be of particular relevance to a sovereign wealth fund investor in the near future becomes. While this is not an exhaustive list of all of the tax aspects of a private fund investment that need to be assessed upon commitment, we believe that the issues covered in this update will remain a key issue for SWF investors as the market moves forward from the current one Pandemic phase to a post-pandemic phase. While we focus on sovereign wealth fund investors in this update, many of our observations will be relevant to global pension fund investors and other institutional investors outside of the United States.

United States

In addition to the direct relevance for private funds that pursue a US-oriented investment strategy, many private fund structures that are sponsored by non-US managers or have a non-US investment focus also have US tax considerations. This is due to the fact that many fund vehicles are organized and operated as tax-transparent "partnerships" for US tax purposes. Therefore, even when considering an investment in a private fund that allegedly has no US affiliation, it remains important to consider the tax aspects of the US tax structure and relevant documents in order to fully understand the operation and risk profile of the investment understand.

Possible Changes in US Tax Law – Uncertain Economic Impact on Fund Investments

As a result of the 2020 presidential and congressional elections, it has become more likely that the U.S. will make significant changes to federal tax law in the near future. Due to pandemic fiscal stimulus measures and other factors, the US is currently under fiscal pressure that will need to be addressed if the US enters the post-pandemic era. While the details of a possible tax bill are still unclear, many observers believe the Biden administration will seek to raise the federal corporate tax rate as part of a comprehensive tax package. Many observers also believe there will be a drive to increase US federal tax revenues to fund other legislative priorities for the Biden administration (such as laws to encourage infrastructure investment). Additionally, US states may also seek increases in the corporate tax rate under their own fiscal pressures.

When assessing the expected after-tax return of potential private fund investments, it is important for investors to consider the potential impact of changes in US tax law. For example, a possible increase in the US corporate tax rate would affect after-tax returns for an investor in a private fund that employs US corporate blockers as part of its structure. A US corporate blocker is currently subject to a US corporate tax rate of 21%. An increase in this rate would have a direct impact on the effective after-tax return an investor would receive relative to the profits from the underlying investment, which are subject to US corporation tax at the blocker level, even if typical mitigation strategies are in place (e.g. partial capitalization of the U.S. corporate blockers with shareholder loans) are deployed as part of the overall structure.

In practice, with potential increases in US federal and state corporate tax rates, it is even more important for an investor to evaluate the manner in which a private fund intends to structure its investments in order to increase the likelihood of tax efficient property and goes . For example, if a US-facing private equity fund intends to invest in tax-transparent US portfolio companies, the fund uses a structure that allows non-US investors to enter each underlying tax-transparent through a separate US corporate blocker Investing in portfolio companies is “dedicated” to the portfolio company should it increase the likelihood that the fund could structure an exit to include a sale of the US corporate blocker. Such an approach can result in a superior economic outcome for the non-US investor compared to an exit transaction in which a US corporate blocker would be forced to sell its stake in the underlying portfolio company and, as a result, would be fully taxable Company level on the profit from the sale. As part of their investment process, investors may want to obtain informal representations from sponsors or negotiate more formal obligations (including covenants in limited partnerships or cover letters) that require a sponsor to make commercially reasonable efforts to implement an investment structure that contemplates the sale of a U.S. Corporate blockers on exit.

U.S. Partnership Audits – Protection against indirect tax costs and expenses

As noted above, many private fund vehicles (including many non-US residents) are treated as tax-transparent "partnerships" in the US for tax purposes. The rules governing U.S. federal income tax audits of tax partnerships allow the Internal Revenue Service (IRS) to evaluate and collect tax underpayments directly from partnerships at the corporate level. These rules enable a partnership to hold elections that would require the partners, not the partnership, to consider adjustments in tax liability. The rules also allow the partnership to achieve a reduction in the amount of tax payable at the partnership level by taking into account the tax characteristics of the partners to whom the adjustment is attributable (e.g. sovereign wealth funds or non-US partners generally classified as tax exempt) . In their authoritative documents, most private funds appoint the general partner or an affiliate as a "partnership agent" and give the partnership agent broad authority to make decisions about how and in which a US partnership tax audit will be conducted Elections connection with the audit.

From a SWF investor's perspective, it is important to understand how these rules work and to ensure that they are not managed in a way that is detrimental to the investor. For example, an investor in a sovereign wealth fund may invest in a private equity fund that uses a parallel fund structure, with the parallel fund for non-US investors being operated to only generate income and profits that are in the US from the US – Tax exempt would be in the hands of the investor in a sovereign wealth fund under Section 892 of the Internal Revenue Code or otherwise. The IRS could consider this partnership, propose an upward adjustment of income at the partnership level, and then claim that the partnership must pay a tax liability related to the upward adjustment directly as an "imputed underpayment" (rather than trying to collect an increased tax liability related the upward revision from each partner, which would take into account some of the adjustment). In this example, if the partnership-level income increase consists of income that would be exempt from tax in the hands of the investor (e.g. an increase in the amount of a corporate dividend due to a portfolio company's dividend recapitalization, what dividend that would be under Section 892 ) is exempt from tax, the investor would like the representative of the partnership to use the procedures available under the rules for examining the partnership to reduce the imputed underpayment so that the investor does not indirectly bear any tax expense resulting from the upward adjustment results.

In practice, sponsors and investors have negotiated agreements in fund documents and cover letters that offset the sponsor's need to have the flexibility to conduct tax audits in a way that is both economically feasible and fair for all partners with the investor's needs to ensure that it will not bear indirect tax costs that it does not have to bear for US tax purposes given its profile or otherwise exposed to unacceptable administrative risks, burdens, or costs. As discussed above, the United States is under fiscal pressure which, along with changes in policy, may cause the IRS to step up its partnership enforcement efforts. We anticipate that these factors will focus both sponsors and investors more on the contractual features of fund documents dealing with the conduct of US tax audits. As these rules are still relatively new (as they apply to partnership tax years beginning on or after January 1, 2018 and for many partnerships not yet checked), further developments in market practice may occur as market participants gain more experience with the practical application of these rules.

Private Loans – An Opportunity with Tax Complexity

The market dislocations caused by the COVID-19 pandemic have given private fund sponsors the opportunity to raise capital to pursue private credit strategies. The pace of private loan fund launch has accelerated in 2020, and we expect this trend to continue into 2021 and beyond, as the United States and other markets emerge from the pandemic and companies of all types change their capital structures Rethink and revise the framework of adapting to the “new normal” of post-pandemic life.

From a federal income tax perspective, private lending activities present particular challenges for non-US investors. Trade or business is dealt with, a non-US affiliate is generally also treated as being involved in that US trade or business.As a result, a US federal (and possibly state or local) tax return would arise and the US federal (and possibly state or local) are subject to income tax in relation to their share of lending income. In addition, in the case of a sovereign wealth fund, such activities could result in the sovereign wealth fund being treated as “commercially active” within the meaning of Section 892.

Because these consequences are often unacceptable to a non-US investor, private loan fund sponsors employ a variety of structures and approaches to enable non-US investors to participate indirectly and tax-efficiently in a private loan strategy. These include so-called “season and sell” approaches, lever blocker structures, so-called “contract fund” structures, REITs (in the case of real estate loan activities), insurance-specific fund structures and other approaches, sometimes in combination. Each of these structures and approaches are inherently complex from a tax perspective in the United States, and SWF investors will typically want to study them in depth to understand their practical economic ramifications and associated tax risks. Despite their greater structural and operational complexity compared to a typical private equity strategy, we believe that private loan funds will remain an important part of the U.S. private fund market in the near future and that sponsors of these funds will continue to seek commitments from sovereign wealth funds and other institutional investors outside of the US.

Secondary distribution – planning ahead

For many sovereign wealth fund investors, it is important to have as much flexibility as possible in order to sell units in private funds (especially closed-end funds) through secondary sales of fund units. In addition to commercial restrictions on secondary sales typically imposed by fund sponsors, the US federal income tax law can create additional practical procedural difficulties. For example, Section 1446 (f) requires a purchaser of an interest in a tax partnership that generates “effectively connected income” to withhold a portion of the purchase price and remit it to the IRS unless a withholding tax exemption may be established. From the buyer's point of view, the preferred way to justify an exception is to obtain certification in a specific format from the seller or the partnership that the buyer can rely on. In the case of a sovereign wealth fund seller, it is not always possible for the seller to provide the required certification. In certain circumstances, the only certification available would need to be provided by the fund sponsor on behalf of the fund. To avoid a technical obstacle to a future secondary sale, many sovereign wealth fund investors are requesting side letter covenants from fund sponsors that oblige the fund sponsor to provide reasonable assistance based on the facts in delivering certificates that they can deliver at the time pass the proposed transfer.

It is also important to understand whether the relevant documents of a private fund contain restrictions that could restrict secondary sales and what practical implications those restrictions are likely to have. For example, a fund that is treated as a tax partnership for US tax purposes will typically restrict the transfer of interests to prevent the fund from being classified as a “publicly traded partnership”. Similarly, a US real estate fund may impose transfer restrictions designed to protect REIT status for all REIT vehicles in the investment structure. While such restrictions are common and important safeguards for all investors, a sovereign wealth fund investor who is otherwise negotiating solid secondary transfer rights should not overlook the potential impact of such tax restrictions.

European Union

The European Union (EU) recently carried out a significant tax reform, each of which member states had to implement with localized nuances. This includes the implementation of many recommendations from the OECD project on erosion and profit shifting (BEPS), which were passed EU-wide through guidelines for avoiding taxes. In addition to having an impact on the underlying tax expense of portfolio investments, these rules have led to recent shifts in market practice for private investment funds established in the EU or the United Kingdom (UK) or with investment focus in the EU or the UK and their relationships with their investors. Many of these changes date from before Brexit and therefore apply, at least in part, to both the UK and the EU.

Anti-hybrid rules

One of the most important tax reforms concerns the tax consequences of structures that include hybrid companies and / or hybrid instruments, such as partnerships that are treated as transparent in one jurisdiction, opaque in another, or a debt instrument that qualifies as a deductible debt the borrower, but as equity for the creditor. Historically, funds with a European focus have used holding structures that regularly incorporate hybrid instruments or companies, and sponsors have had to rethink how to ensure investments are tax efficient. Investors often seek formal or informal comfort from sponsors who have adapted them to these changes.

In addition, the fund vehicles can themselves qualify as hybrids. This may be because there is a partnership out there that checked the box to have U.S. tax purposes treated as opaque, or simply because some investors treat a fund vehicle differently than what is treated in the fund (or in a portfolio company). Jurisdiction. The use of such hybrids can result in portfolio companies having to pay additional taxes. As a result, it has become common for sponsors in European or Europe-focused funds to require investors to provide information on how they would treat certain vehicles and / or instruments for tax purposes. With this information, fund vehicles and portfolio companies in Europe can assess the extent to which such hybrids can adversely affect their own tax position (e.g. refusing to allow a tax deduction for payments to some hybrid vehicles). Failure to provide this information may result in various remedial actions, including associated costs, which will be passed on to the investor concerned. One of the reasons for this is that in some countries, including the Netherlands and Denmark, and to some extent the UK, a portfolio company may have to assume that there is a hybrid in a structure if it cannot be certain that it does exist not and therefore suffer from additional taxes. Investors need to better understand how their jurisdiction deals with different types of vehicles. For tax-exempt investors, this can be a novel and sometimes challenging experience.

Another aspect of these rules is that usually (though not always) when the end investor is tax-exempt, the hybrid risk under the hybrid rules is minimal. It is becoming increasingly common for sponsors to pass on hybrid costs to the investor whose characteristics or jurisdiction give rise to such costs (in addition to passing on costs to investors who do not provide specific information). For a tax-exempt investor, it is generally in the investor's interest to promote such a position to cover costs that may be caused by other non-tax-exempt investors.

Trust in contracts

Another aspect of the tax avoidance guidelines is that it is becoming increasingly difficult for structures to rely on double taxation treaties – this is usually a problem in a much wider range of jurisdictions than just Europe. Although in the past there has been a dependency on contracts within the fund structure itself (e.g. between a holding vehicle and a portfolio company), this is becoming increasingly difficult and there may be situations where the investor may have to rely on contracts themselves for to minimize withholding taxes. Investors can also obtain confirmation from sponsors that their structures are tax-efficient and do not result in tax losses for the investor.


The EU recently introduced a rule that requires disclosure of certain “tax regimes” to its tax authority. If information is required, substantial details can be provided and in some cases it can include the names of the investors. The aim of these rules is to provide tax authorities with timely information on the assumption of aggressive tax planning, although in practice the rules can be much broader. Although the information disclosed should not be published under any circumstances and there should be no direct associated tax costs for non-European companies, many investors are sensitive to the fact that their data is made available to the tax authorities as parties to aggressive tax planning. Investors may prefer to be notified if the sponsor expects the investor's name to be included in a DAC 6 report.

The UK

The problems described above also apply to funds that are incorporated in the UK or have an investment focus in the UK

In addition, the UK recently introduced (in the Criminal Finances Act) a corporate offense that did not prevent tax evasion facilitation. The offense can be committed when an employee or employee of a company facilitates tax evasion by third parties. The only defense is that the company has an adequate policy in place to prevent such facilitation and is complying with it. The rules are pretty broad and if a company outside the UK has another company acting on its behalf in the UK, such as an investment manager who is authorized to make fund investments on behalf of a fund and its investors, there is some Risk that the UK person could bring the non-UK entity within the scope of UK corporate crime. Since investment managers in the UK are regulated and take this crime seriously, the risk is low. Nonetheless, investors can seek formal or informal consolation that the GP and / or the investment manager have appropriate guidelines in place to ensure this does not prevent tax evasion relief.

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