For around 15 years now, limited partnerships (or, in some countries, entities with similar characteristics) have been the vehicle of choice for most European private equity fund managers accessing institutional investors. And high on most people’s list of reasons for choosing that structure – although by no means the only reason – has been their tax transparency, which has avoided double tax for investors and facilitated a performance incentive for managers.
In general, Governments across Europe are keen to provide suitable domestic vehicles for private equity funds. Most recognise that tax laws play a vital role in that, although some – like Germany – have not always properly reflected that when changing the rules. In the UK, the law reform body which has been charged with the task of modernising the law of limited partnerships has – quite rightly – recognised that preservation of their existing tax transparent status is critical, and vociferous lobbying in Germany may yet persuade the tax authorities there to reconsider their own position.
The UK’s tax authorities have, in the past, been guilty of tinkering with tax rules in a way which has unintended consequences for private equity partnerships, and tax transparency can create some odd results if the implications of anti-avoidance provisions are not carefully thought through in advance. But last month saw a development which is actually intended to be helpful.
Two years ago, Paul Myners was asked by the UK Treasury to look at institutional investment practices in Britain – particularly at a perceived under-allocation to private equity. When his report was published, it included a number of very specific recommendations for legislative changes, most of which the Government promised to make. One barrier to investment in private equity which Mr Myners thought should be swept away was a direct consequence of the tax transparency which makes partnerships such an attractive vehicle. For UK tax paying investors – especially life insurance companies – the regulatory burden of having to calculate and pay tax on the basis of their underlying interest in a number of ultimate investee companies was said to be inhibiting their investment decisions. And when they wanted to invest in a fund of funds, that burden was multiplied several times.
So last month, the Government published draft legislation which will change the law, and treat a life company’s investment in a venture capital limited partnership as a single asset for tax purposes, while preserving the existing position for other investors (most of whom will not pay tax in the UK, either because they are not resident there, or because they are tax exempt).
Whether this is good or bad news for private equity fund managers is difficult to assess. One result will certainly be an increased compliance burden on them and managers will be required to provide more information to life company investors than at present. But if the consequence is an increased flow of capital from these investors into European funds, managers may be happy to shoulder these extra burdens. However the new regime (which applies to accounting periods beginning on or after 1 January 2002) will only be applied where the fund meets certain conditions, relating to the investments it can hold and what it does with the proceeds when it sells them. Unfortunately, these restrictions do not entirely reflect the realities of the venture capital market, thus limiting the usefulness of the reforms. Representations to this effect have been made, and it is possible that the details of the new regime may yet be changed.
What is welcome about the rule changes is a recognition that the tax characteristics of these structures do matter. It is by no means the first time that the British tax authorities have been helpful in their approach to taxing private equity funds, but it is another positive sign that the Government is keen to stimulate investment in the asset class, and is willing to change the law to facilitate it. Whether the reforms as currently framed will prove sufficient to achieve this, remains to be seen. And whether the consequences of the change will go further than intended, and actually create some unforeseen negative effects, remains a concern.
SJ Berwin is a European law firm with a particular focus on private equity. The above comment is taken from the firm's weekly e-bulletin, Private Equity Comment, which provides commentary on legal and tax developments which affect the European private equity community. For comment or to subscribe to these bulletins, please email firstname.lastname@example.org.