While taxes have always tended to attract a certain degree of controversy, the subject has never been more hotly debated than today. Interestingly though, private equity has so far had little involvement in the debate.
The tax debate shows up in many ways. The European Commission increasingly focuses on fiscal state aid aimed at ensuring a level playing field for tax payers within the European Union and the OECD has started a challenging project on base erosion and profit shifting (BEPS). In addition there is the increase in regulation affecting tax payers. Last but certainly not least, even television shows have picked up on the debate, as a result of which reputational damage for the tax payers involved is a distinct possibility.
THE TAX DEBATE SO FAR
In the cases where private equity has been involved in the tax debate, the debate has tended to focus on the carried interest structures, rather than on the tax structure of a private equity fund and its portfolio investments as a whole. But it is exactly the fund's position in the changing tax and regulatory landscape that we would like to focus on here.
It is our view that there is a first mover advantage to be gained for private equity funds that adapt to the increasing demand for transparency and accountability from limited partners and regulators.
From a historical perspective, the position of private equity funds in the tax debate was based on the so called tax neutrality theory. This theory implies that investors should not be treated differently merely on the basis of whether they invest via an investment fund or directly. It assumes that an investor could base his choice between a direct investment in a portfolio company and an investment via a private equity fund on a difference in the tax treatment of those two options. Under this assumption, the function of the fund itself is very limited or even absent, in that it merely pools funds and serves as an intermediary that offers economies of scale and some financial expertise.
Over the last few years private equity has been experiencing an increased emphasis on operational improvements, with a view to achieving an increase in value within its investments and the portfolio company's strategy. As such, the potential extra layer of tax is no longer the only differentiator between a direct investment and an investment via a private equity fund, and it should therefore no longer be the decisive one.
Simultaneously, we expect that tax, as a trend linked to ESG (environmental, social and governance) criteria is more and more going to be embedded in ESG policy or within the corporate social responsibilities policy.
This trend is relevant for private equity funds in their fundraising process because pension funds, which account for a very large part of the investor base for private equity funds, are looking for and will be demanding more transparency from their managers. Transparency on returns but also on the tax contribution of the fund and its portfolio companies is gaining importance, either as a result of the public asking for more transparency or caused by the national regulators.
As mentioned private equity is increasingly being confronted with the tax debate and the changing tax and regulatory landscape already. This being said, we do acknowledge that private equity still has and will continue to have a special status within the tax debate: where other businesses trade in goods or services and pay taxes on the profits derived by this trade, private equity trades in individual tax subjects (portfolio companies). Generally, tax is not levied on the profits derived as a result of the trade in these portfolio companies, but on the profits derived within these portfolio companies.
DIFFERENT SPEEDS IN THE TAX DEBATE
Further, we acknowledge that the tax debate is not moving at the same speed when comparing Europe with the United States or Asia.
Given the above, how should private equity funds react to this changing landscape?
We argue that the response of the private equity funds in the debate should also differ from the regular response: multinationals tend to respond to the tax debate with reference to their effective tax rate as shown in their consolidated annual accounts. Private equity funds tend not to consolidate at the level of the fund, and tend not to pay taxes themselves as a result of their tax transparency. So the commonly used tax indicator, i.e. the effective tax rate, cannot be used by private equity. We feel that the industry is in need of an alternative indicator.
On the basis of the BEPS action plan, such an alternative indicator could be developed. With this indicator, private equity should be able to measure and account for its tax responsibility. This indicator should be a hard number, which can be compared with the BEPS standard, but also benchmarked with other private equity funds. It could serve as a quality mark for regulators, media and potential investors, but it could also form part of the internal risk management process and potentially also serve for AIFMD purposes. ?
Vanessa Broeders is a Senior Tax Manager in the Private Equity Tax team of PwC (Netherlands). She graduated from the University of Leiden and has previously worked as in house senior tax counsel with PGGM Investments.
Femke van der Zeijden is a Senior Tax Consultant in the Private Equity Tax team of PwC (Netherlands) and a PhD candidate at the University of Tilburg.