This article originally appeared in the November 2009 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.
It is August 26 in Luxembourg and Taxand’s global head of real estate, Keith O’Donnell, is getting animated. You see, he and other Taxanders (the name given to those that belong to the global Taxand
network), are increasingly seeing dealmaking activity among private equity real estate clients. This extends beyond Europe to the US and Asia too.
This is clearly good news. From his vantage point, more deals equates to more tax advice required. But before we delve too deeply into the machinations of structuring tax efficient vehicles for, say, cross-border distressed debt deals, there are more fundamental macro issues to discuss. The broad point is that private equity real estate firms can expect to come under greater pressure from the local taxman, something all real estate firms need to be aware of, and possibly act on. What hasn’t changed is that cross-border real estate investing can come with a major tax cost.
Taxand research has shown that without careful handling, taxes can exceed 80 percent of the return on
any given investment. To an extent, local tax jurisdictions were paying more attention to private equity
structures even before the credit crunch, says O’Donnell.
In a typical investor group, a large proportion of investors will consider foreign taxes as an absolute cost, requiring the private equity firm to avoid unnecessary local taxes as a fiduciary matter. Private equity houses have to strike a delicate balance between what is fair and reasonable in the local jurisdiction and the fiduciary duty to investors.
In the heyday of private equity from 2004 to 2006, the typical modus operandi for firms was to take the
tax-base down as low as possible in local jurisdictions. The typical model was to use debt funding as extensively as possible as it creates a deductible expense in the local country. The debt was a combination of third party debt and debt drawn from fund commitments – so called “internal debt”. This model was common to traditional LBOs of operating companies and to the private equity real
However, the problem is that success of some structures has become a slight curse. It has drawn the attention of governments, press and the tax authorities, exemplified by the takeover of telecoms company TDC by KKR and a consortium of fellow LBO titans. In this case, the extensive use of debt led to a disappearing tax base in what was a high profile local company. The reaction was swift with new “earnings stripping” legislation being introduced in June 2007. Germany and Italy followed with similar legislation. The UK and the Netherlands have proposed similar limits, adds O’Donnell.
But besides populist point-scoring, governments now have the added reason to watch private funds more closely: they need to replenish their cash vaults given the scale of the national bailout schemes put into place. Private equity real estate firms are unlikely to be key voters and do not win many popularity
contests either, so they are a soft target. To an extent, the evidence is already before us. Local jurisdictions in some parts of the world are increasingly challenging the “substance” of foreign entities
incorporated to take advantage of cross-border tax treaties. This can be seen in various jurisdictions, China included.
“It is a big issue for the private equity real estate world,” argues O’Donnell. “There have been several cases where private equity investors have been heavily challenged by local jurisdictions. The firms were expecting to exit from a particular investment without any tax, applying clear legislation, but the local tax authority has challenged the ‘substance’ of the foreign companies and treated it like a ‘letterbox company’. This happened in a very high profile manner to one of Lone Star’s real estate transactions in Korea recently, but for every case that hits the press there are many more that are not public. In addition, some of these cases can take on a political dimension that can be very tricky to manage.”
Why does this happen? By their nature private equity real estate houses are geographically dispersed and manage large amounts of assets with relatively small teams. Tax authorities frequently mount
challenges to investment structures using legislation and standards drawn from the industrial age,
arguing that because an individual legal entity does not have large offices, employees, or own infrastructure, it is not entitled to tax attributes. “This line of argument may ignore commercial
reality, but it has become a fact of life,” says O’Donnell.
The warning is clearly: get your house in order. Says O’Donnell: “Private equity real estate houses have to accept this fact of life and organise accordingly.”
Operating within this constraint is a real challenge and may require private equity real estate firms to organise themselves in ways that can feel “unnatural” at first, the typical example is the balance between insourcing and outsourcing of activities.
Taxing sitting ducks
While tax authorities are looking to ramp up efforts to enforce existing tax regimes and challenge cross-border structures, O’Donnell also says there is likely to be more competition between countries to pull tax revenue in from their own back yard at the expense of others. So select your jurisdiction with care.
Immovable objects such as offices and logistics facilities are sitting ducks for the taxman at the behest of political masters.
O’Donnell is at pains to point out that there is a dilemma here. In the eyes of many, real estate created the global credit bubble. Now that it has burst, governments do not want to further depress property values. Increasing tax barriers to cross-border investment could lower values further however. Yet on the other hand, governments understandably want to use real estate as a tool to boost revenue. Whether that comes through tax changes or just greater enforcement of rules, says O’Donnell, is a “moot point”. He argues: “I think it will be a blend of the two.” The signs are already there, though. They can be seen in more challenges to investment structures in Germany, France and Italy and legislative proposals around the globe from the US to the UK through to India.
If this all seems a little gloomy, then when the conversation returns to the theme of transactions, O’Donnell’s tone begins to lift. Taxanders are reporting from around the world signs of more activity than in the recent past, with an emphasis on core property assets. Taxand is increasingly busy advising
private equity clients on the acquisition of well-let buildings in prime locations whose values have already plummeted. Beside core property, the good news is that the opportunities for buying distressed assets, including distressed debt, are dumbfounding, as many GPs are aware.
If a firm is lucky enough to have a deal in front of it, the chances are that the discount is amazingly high. However, this raises the prospect of potentially huge capital gains tax bills being charged upon exit. Many jurisdictions treat such capital gains on equity investments favourably, applying some form of “participation exemption” to dividends and or gains on significant shareholdings. The theory is that the
underlying profits have been already taxed at the level of the company. But it is not the same for debt which tends to be subject to normal taxation. This means a lot of grey matter is going into constructing the right platform to invest in assets in order to escape being taxed too highly on the expected pick
up in values. Says O’Donnell: “This is a global issue because the typical profile of entities in these deals is private equity funds with investors in multiple jurisdictions.”
Though huge profits have been made in the past – think of the early 1990s and the RTC – the additional challenge of distressed real estate debt investing is that in the interlude, domestic tax laws and regulatory frameworks have been changed (and in some cases improved). The advice required is complex because advisors have to marry the tax analysis of legal and regulatory constraints with any analysis of bankruptcy issues. With some understatement, he says: “It gets challenging.”
This looks likely to remain one of the key areas of tax for private equity real estate firms to grapple with in coming months. When combined with governments looking to challenge tax structures and possibly
introducing new rules, real estate tax advisors might need to be wizards if they are to succeed in reducing the tax burden of investing. The wands are out.