Evolution of tax considerations in private markets

Tax considerations in private markets have increased significantly over the last decade. This article traces their evolution from the early days of fund investing through BEPS, FATCA, and today's standards.

For all institutional and best-in-class investors within the last decade, tax considerations in private markets have increased significantly and more rapidly than ever over recent years. Around 10-to-20 years ago, carrying out proper tax due diligence before committing to a private equity fund was not a standard approach. Nowadays it is, and not performing tax due diligence in parallel with the commercial and legal due diligence would label the investor as unprofessional and open up the possibility of being materially criticised if something were to go wrong on the tax side.

Most private equity funds have a cross-border investment mandate, and investors are joining in from multiple jurisdictions. The fund manager requires full flexibility with respect to financing and structuring based on the so-called 'fund as a whole' concept, i.e., the manager does not take the investor's individual tax positions into consideration, but instead structures the investments with the purpose of generating the highest possible return at fund level, which often includes tax expenses being deemed as distributed to the investors, i.e., a phantom profit not seen by the investors.

Tax rules are complex in nature: the multiple jurisdictions involved in the investments made, as well as those on the investor side, combined with the fund manager who requires full flexibility with regard to unknown investments to be made, plus the investor's concern in being involved in tax-aggressive investment structures, are the core ingredients behind today's need for proper tax due diligence to always be performed before making commitments in private markets. This article is about how some of these tax considerations have evolved over time and ends with a look to the future as well.

Early and Happy Days (2000 – 2008)

Shortly after crossing the millennium, there began to be an increased appetite for institutional investors committing to classic buyout private equity funds. Large investors also started looking internationally, especially to the US with it being one of the most significant economies in the world (particularly at that point in time).

The most common issues for tax due diligence in these early and happy days were:

Foreign net income tax filing exposures;
Finding out if the announced net IRR was a pre- or post-tax IRR;
Making sure that withholding taxes were minimised; and
Identifying the future income components coming out of the fund in order to assess the taxation in the investor's own jurisdictions.

Tax due diligence was generally uncontroversial and walking away from an investment due to tax reasons was a rare thing to see.

The OECD BEPS, US FATCA, and EU anti-tax-avoidance tsunami (2008 – 2022)

Following the announcement of the game-changing standard by the OECD BEPS and US FATCA as one of the lessons learnt from the financial crisis of 2008 to 2010, the requirements for proper tax due diligence changed.

Investors started to ask questions like: Why are we invested in private equity funds in the Cayman Islands or Mauritius? What is the impact of that? Are we sure that everything going on in these private equity funds is ok from a tax perspective?

The old investor requirements for making sure that everything was tax-optimised began to fade out and were replaced with questions such as: Is this a normal investment structure? Is this a tax-robust investment structure? The concern among professional investors regarding being involved or being accused of being involved in tax-aggressive structures spread as fast as a virus.

The paradise and panama papers (2018 – 2020)

In Denmark, the Paradise and Panama Papers had a huge impact. Many institutional investors were criticised in the press for having investments routed through so-called tax havens, and the Cayman Islands were often mentioned.

Plenty of hours and resources were dedicated to educating journalists, politicians, the public opinion, and investors' decision-makers about tax regimes and how many tiers the same profit is sometimes subject to taxation, and that no tax benefits or tax avoidance was achieved or carried out solely as a result of the private equity fund being registered in the Cayman Islands.

In addition to this, when the US introduced FATCA and the OECD CRS, the Cayman Islands and most other so-called tax havens cleverly decided to work with international society with regard to exchange of information with tax authorities in other jurisdictions, and today the Cayman Islands are rated as compliant by OECD's Global Forum on Transparency and Exchange of Information for Tax Purposes and are no longer on the EU's blacklist for non-cooperative tax jurisdictions. Nevertheless, the Cayman Islands are still not free from their former tax-haven shadow.

Tax code of conduct (2019)

Most journalists and politicians had, for some years, simply been shaming investors because the private equity fund itself did not pay tax, and it was seen as a tax-aggressive approach if the fund were registered in the Cayman Islands (today, most journalists and politicians have a more varied and educated approach when debating tax-aggressive behaviour). Because of the prevalent tax debate up to 2019, it became clear to the pension fund industry that there was a need for a standard to be set for private market investments, and so the Tax Code of Conduct was developed. This code of conduct is today applied by a clear majority of the Danish pension fund industry and is adhered to by some large private corporate investors, investing side-by-side with the pension funds.

The thinking behind this decision by the pension funds was that if we can succeed in setting our own high standard for not being involved in aggressive tax planning, the pension fund industry will hopefully avoid having to stop these front-page newspaper stories from coming out, and, more importantly, will avoid being regulated by politicians striving to satisfy public opinion.

The Tax Code of Conduct sends a clear signal to investors within private markets that they must behave responsibly when it comes to tax structuring, and that they need to act in line with the word of applicable tax law, as well as in the spirit/intention of the law while following internationally recognised guidelines such as OECD BEPS.

In connection with that and for all private equity fund managers, I would like to encourage all private market investment managers to develop their own tax policy, tax strategy, or tax code of conduct. It makes the due diligence process much simpler, and it sends a clear signal to society and the investors that this fund is not making tax-aggressive investment structures but is being prudent and robust when it comes to tax planning, which commercially-speaking is the correct approach. Especially when it comes to investing in developing countries, it is important to behave in a responsible manner with respect to tax matters too.

What's to come?

Proper tax due diligence is much more detailed today compared to the past, and covers at least the following topics:

Available investment routes;
Foreign net income tax filing exposure;
Tax leakage analysis;
Tax policy and responsible approach to tax; and
Tax reporting and income components.

It is still rare to walk away from an investment for tax reasons, but on the other hand, it is not uncommon if the manager is not willing to listen to the investor's tax needs and concerns. Finally, it is now standard to have several tax provisions in the side letters, whereas tax was barely mentioned in the side letters in the early happy days.

In the future (in fact, we're already there), we will see taxation of carried interest being added as a sixth topic within the scope of proper due diligence. The carried interest earnings are derived from the investors' commitment, and often involve large amounts. The investors also need to be assured that carried interest is not structured in a tax-aggressive way.

A new and seventh topic could relate to a requirement for the manager to clear up material tax findings in tax due diligence reports during the take-over of portfolio companies. If the amounts are of relevance and rated as high risk in the tax due diligence report, and are being secured through an escrow account, it does not seem an unreasonable requirement to approach the tax authorities to have these issues resolved instead of the vendor having a tax saving due to the statute of limitation crystalising down the road.

Soon, we will also see an evolution of the toolbox for carrying out tax due diligence. We will in the near future see the task being performed by a sophisticated dynamic digital software solution, making it easier for both the investor requiring the tax due diligence and the fund managers being subjected to the proper tax due diligence.