Tax planning for private equity (PE) funds presents unique challenges and opportunities, due to the (at times) competing tax priorities of the PE fund, its investors, and its portfolio investment companies. The tax priorities of the affected stakeholders have only grown in complexity because of the daily upheaval in tax legislation being enacted across the globe.
A critical aspect of tax planning for PE funds presents itself when a PE fund acquires a portfolio investment company. Acquisition structuring is complex, and getting the “right” structure in place is critical to facilitate tax efficiencies going forward. An ill-conceived tax structure not only leads to inefficiencies in tax but also can present business and operational challenges.
One of many significant decisions to be made as part of acquisition structuring is whether to utilize a holding company when acquiring a target company and, more importantly, the jurisdiction of such holding company. The utilization of a holding company in a tax structure can streamline cash repatriation to investors, repayment on debt financing, and cash deployment throughout the portfolio investment structure. It can also, in certain instances, provide additional tax benefits, such as reduced withholding tax rates on various payment flows and reduced tax on exit.
It is critical that holding company structuring occur in conjunction with acquisition structuring. Interposing a holding company post-acquisition only increases the complexity of a company’s tax structure and is often more difficult to effectuate once the structure has been formed.
Where to form a holding company is a complex decision and depends on various factors including the location of the target portfolio company and the objectives of the PE fund and its investors. Depending on the circumstances, forming a holding company in the same jurisdiction as the target portfolio company may be prudent, while at other times it may be ill-advised.
Numerous countries have enacted tax policies to incentivize stakeholders to establish their holding companies there. When choosing a holding company jurisdiction, consider the following.
Dividend incomeDoes the jurisdiction provide for a 100% tax exemption on dividends received from subsidiaries? Many jurisdictions across Europe provide for a full or partial exemption on dividends received from subsidiaries. However, it’s important to read the fine print. Is there a minimum period of ownership? Is there an ownership percentage or size threshold required to meet the exemption?
Capital gainsDoes the jurisdiction provide for a 100% exemption on gains realized from the disposition of shares in subsidiaries? In many jurisdictions, this is commonly referred to as participation exemption. It’s important to consider whether there are any restrictions in qualifying for the exemption, such as holding period requirements and ownership percentage thresholds.
Dividend withholding rates
PE funds may want earnings generated from the underlying portfolio investment to be distributed to its investors. Dividend distributions are a valuable tool for repatriating earnings to shareholders but may also present tax leakage consequences. If the payor’s country levies withholding tax on dividend payments, the tax cost may be permanent. For example, U.S. tax exempt investors will be adversely impacted by withholding taxes because generally speaking, such distributed earnings would not be subject to tax in the U.S. Taxable investors may be able to claim a credit for the withheld tax, but this is dependent on numerous factors and complex calculations.
There are limited jurisdictions that provide a 0% withholding tax on dividend payments, such as the U.K. If a holding company can’t qualify for treaty benefits (see discussion below), forming a holding company in a jurisdiction with no withholding tax on dividend payments may be prudent.
Tax treaty networkAn important factor in deciding where to form a holding company is the tax treaty network of such jurisdiction. Tax treaties generally provide numerous tax benefits, including reduced withholding tax rates on interest, dividend, and royalty payments. They could also provide for exemptions on business profits in cases where no permanent establishment of such entity exists in such other jurisdiction. However, qualifying for treaty benefits is not as simple as incorporating a company in a jurisdiction. A certain level of substance in the holding company is required in most jurisdictions, and the degree of necessary substance varies by jurisdiction. Prodded by the OECD through its Base Erosion and Profit Shifting (BEPS) initiative, many jurisdictions have increased the level of substance requirements, which could include physical presence, local employees, and payroll disbursements. Substance requirements should be vetted before implementation to ensure that the envisioned holding company can meet them.
Capital gains for non-residentsIn the likely event that an exit of the portfolio investment is effectuated through a sale of the holding company, it is imperative that the jurisdiction of the holding company does not impose tax on non-residents when disposing of shares in the holding company. While many jurisdictions do not tax non-residents on gains from the disposition of shares in resident companies, there are numerous jurisdictions that do if the holding company holds significant real estate assets, and some (e.g., India and China) that tax sales of shares of companies regardless of whether any real estate assets are involved.
What does CohnReznick think?The issues presented here do not encapsulate all issues to be considered but highlight a few important ones. Holding companies can be useful for tax and business reasons, and choosing an appropriate holding company jurisdiction should be done in conjunction with a company’s tax advisors, attorneys, and relevant PE fund personnel.
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Strategic Tax Issues for Capital Markets
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.