PEGCC Comments on the BEPS Consultation Document on the Treaty Entitlement of Non-CIV Funds
Re: Comments on the BEPS Consultation Document on the Treaty Entitlement of Non-CIV Funds
Dear Sir or Madam:
The Private Equity Growth Capital Council (the “PEGCC”) is pleased to submit these comments on the BEPS Consultation Document on the Treaty Entitlement of Non-CIV Funds released by the OECD on 24 March 2016 (the “Consultation Document”). The PEGCC, based in Washington, DC, is an advocacy, communications and research organization established to advance access to capital, job creation, retirement security, innovation, and economic growth by promoting long-term investment. In this effort, the PEGCC develops, analyzes and distributes information about the private equity and growth capital (together, “private equity”) industry and its contributions to the U.S. and global economy. For further information about the PEGCC and its members, please visit our website at www.pegcc.org.
On 5 October 2015, the OECD published its final report in respect of the OECD/G20’s BEPS Project Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances (the “Final Report”). The Final Report includes a number of recommendations aimed at curtailing treaty abuse, including incorporating into treaties (i) limitation-on-benefits provisions that would limit the availability of treaty benefits to certain “qualified persons” within the relevant jurisdiction (the “LOB Rule”) and (ii) a more general anti-abuse rule based on the principal purpose of transactions or arrangements (the “PPT Rule”). Prior to the release of the Final Report, the PEGCC submitted comments to the OECD in January 2015 and June 2015 in response to public discussion drafts issued by the OECD in connection with its work on Action 6.[1]
While the Final Report recommends the treatment of certain collective investment vehicles (“CIVs”) as “qualified persons” for purposes of determining treaty entitlement, the OECD working group has determined that further evaluation continues to be necessary regarding appropriate treaty entitlements of non-CIV funds. The two general concerns described by the OECD working group in the Final Report and the Consultation Document in relation to granting treaty benefits to non-CIV funds are: (i) that such funds may be used to provide treaty benefits to investors that are not themselves entitled to treaty benefits and (ii) that such funds may provide an opportunity for deferral of income recognition by investors in respect of income on which treaty benefits have been granted.
We take comfort in the OECD working group’s important acknowledgement of the economic importance of non-CIV funds, and the need to ensure that treaty benefits are granted to non-CIV funds in appropriate circumstances. We continue to believe, however, that the concerns described in the Final Report and the Consultation Document are misplaced with respect to private equity funds and their investors. Private equity funds provide investors with an efficient means of accessing global investment opportunities. To perform this function, private equity funds must be able to afford investors tax neutrality in respect of the capital invested through such funds. Investors that pool and deploy capital through private equity funds should be in no worse an economic position than such investors would have been in had such investors invested directly in the underlying portfolio company. We believe that an approach that inappropriately restricts the ability of private equity funds to access treaty benefits and provide their investors tax neutrality could have a chilling effect on the ability of private equity funds to attract and deploy significant amounts of capital for global investment. Therefore, while we welcome the OECD working group’s continued thoughtful evaluation of treaty entitlements of non-CIV funds more generally, we urge the OECD working group to adopt an approach that treats private equity funds in parity with CIVs by providing for a separate category of “qualified persons” under the LOB Rule covering private equity funds and their subsidiary holding companies.
In the event, however, that the OECD working group is unwilling to recommend that private equity funds be treated as “qualified persons” under the LOB Rule, we would support an approach whereby private equity funds that are widely held or that are subject to substantial regulatory oversight and their subsidiary holding companies either be treated as CIVs or as a separate category of “qualified persons” for purposes of the LOB Rule. Section III.A below discusses criteria that we believe are appropriate for evaluating whether a private equity fund is widely held or subject to substantial regulatory oversight.
Furthermore, in such event, we would also support the alternative mechanism discussed in Section III.B below. This mechanism is intended to grant treaty benefits to funds that do not satisfy the widely held or regulatory oversight criteria described in Section III.A so that such funds and their subsidiary holding companies are not inappropriately denied treaty benefits. Under this alternative mechanism, a fund would be eligible for treaty benefits if it certifies that at least 50% of its direct and indirect investors are pension funds, sovereign wealth funds, other governmental entities or instrumentalities and/or investors that would otherwise be eligible for treaty benefits in their own right. We believe, however, that this alternative mechanism should be applied only in cases where a fund does not otherwise satisfy the widely held or regulatory oversight criteria described in Section III.A below.
The PEGCC does not believe that either the inclusion of a derivative benefits provision in the LOB, as currently proposed, or the “Global Streamed Fund” regime (the “GSF regime”) outlined in the Consultation Document is an appropriate or feasible alternative for providing private equity funds and their investors with access to treaty benefits. As discussed in more detail in Section IV below, the proposed GSF regime raises significant practical and administrative concerns for private equity funds.
Finally, we have included as an appendix to this letter our responses to specific questions posed by the OECD working group in the Consultation Document. The responses included in the appendix summarize our comments below as well as certain comments included in our prior comment letters
I. Private Equity Funds are Not Vehicles for Treaty Shopping or for Deferring the Recognition of Income by their Investors
As a threshold matter, private equity funds do not present the treaty-shopping and deferral of income recognition concerns identified with regard to non-CIV funds in the Final Report and the Consultation Document. As described in greater detail in our prior comment letters, private equity funds are closed-end investment vehicles formed for the purpose of pooling capital of a broad base of investors and investing that capital in portfolio companies. These funds are not established to facilitate tax avoidance and do not retain low-taxed or untaxed pools of capital at the fund level. Private equity funds share many of the characteristics of other CIVs as described in the OECD’s 2010 report on The Granting of Treaty Benefits with respect to the Income of Collective Investment Vehicles. Similar to CIVs, private equity funds generally have a broad investor base, invest in a broad range of jurisdictions and industries, and are subject to substantial regulation.
Private equity funds promote cross-border investment and provide investors with an efficient means of deploying capital for investment across jurisdictions. These investors include corporate pension plans, public retirement plans, foundations, university endowments, sovereign wealth funds, insurance companies, banks and, to a lesser extent, high net worth individuals and family offices. Such investors often would be exempt from tax as a result of their status and/or otherwise entitled to treaty benefits in their own right if they were to invest directly in the underlying investments of the fund.
As discussed in more detail in our June 2015 comments, private equity funds are organized most frequently as fiscally-transparent limited partnerships in order to achieve tax neutrality and the flow-through of the characteristics of the underlying income realized by the fund. Each fund investor is subject to tax, to the extent applicable, on its proportionate share of the fund’s profits. Private equity funds have a limited investment period in which they are permitted to make investments. A private equity fund may form one or more subsidiary holding companies that make these investments.[2] The investment holding period for a particular private equity fund investment, however, is generally between three to seven years prior to exit. During this time, subject to limited exceptions, private equity funds generally are not permitted to reinvest capital. Rather, proceeds received by a fund or a subsidiary holding company in connection with a disposition of an investment generally are required to be distributed promptly to investors. Private equity fund sponsors are incentivized to ensure that such distributions of investment proceeds are made promptly to investors because retention of uninvested capital would reduce investment returns. Accordingly, these structures do not provide the opportunity for taxable investors to defer tax.
II. Private Equity Funds Generally Have a Broad and Diverse Investor Base and are Subject to Extensive Regulatory Regimes
As described in more detail in our January 2015 comments, private equity funds share many of the characteristics of CIVs as described in the OECD’s 2010 report on The Granting of Treaty Benefits with respect to the Income of Collective Investment Vehicles. The 2010 CIV report defines CIVs as “funds that are widely-held, hold a diversified portfolio of securities and are subject to investor-protection regulation in the country in which they are established.” Like CIVs, private equity funds generally have a broad investor base, with any particular fund having a large number of direct and indirect beneficial owners. The governing documents of private equity funds often include provisions requiring such funds to satisfy certain diversification requirements in respect of their investment portfolios. In addition, as described in our January 2015 comments, private equity sponsors and their funds are subject to substantial regulation. Although the regulation of the marketing, management and operation of private equity funds and/or their advisers or sponsors varies from jurisdiction to jurisdiction, regulation focused on investor protection is typically quite extensive.
III. Status of Private Equity Funds for Purposes of the LOB Rule
The PEGCC strongly believes that its comments in relation to the discussion draft preceding the Final Report continue to be relevant to the OECD working group’s evaluation of appropriate treaty entitlements of non-CIV funds. Private equity funds are not vehicles for treaty shopping, nor are such funds designed to provide deferral of income recognition for investors. Private equity funds serve an important role of pooling capital from a broad investor base to facilitate cross-border investment. In order to continue serving this important role, private equity funds must be able to afford investors tax neutrality in respect of the capital invested through these funds.
An LOB Rule that inhibits the ability of private equity funds to access treaty benefits creates a significant barrier for funds and their investors. The PEGCC continues to believe that a properly tailored application of the PPT Rule[3] is a better method of addressing these concerns with respect to private equity funds, as opposed to the LOB Rule, which would substantially and inappropriately limit the ability of private equity funds to provide investors tax neutrality in respect of capital invested in these funds. Moreover, for the reasons stated in our June 2015 comment letter, we do not believe that the inclusion of a derivative benefits provision in the LOB Rule, as currently proposed, effectively addresses the concerns we have raised in respect of treaty benefit access for private equity funds. Therefore, the PEGCC continues to believe that, as a policy matter, private equity funds should be treated in parity with CIVs and that the LOB Rule should include a category of “qualified persons” that covers private equity funds and their subsidiary holding companies.
In the event, however, that the OECD determines not to support the inclusion of private equity funds as “qualified persons”, the PEGCC would support the treatment of private equity funds and their subsidiary holding companies that are widely held or that are subject to substantial regulation as CIVs (and, therefore, as “qualified persons”) for purposes of the LOB Rule. We have summarized below certain criteria that we believe would be appropriate for determining whether a particular private equity fund should be treated as meeting these two requirements. For funds that do not satisfy either the widely held or regulatory oversight criteria described below, and in the absence of a broad inclusion of private equity funds as “qualified persons”, we believe an alternative mechanism could be employed to ensure that such funds and their subsidiary holding companies are not inappropriately denied treaty benefits. Under this alternative mechanism, a fund would be eligible for treaty benefits if it certifies that at least 50% of its direct and indirect investors are pension funds, sovereign wealth funds, other governmental entities or instrumentalities and/or investors that would otherwise be eligible for treaty benefits in their own right.
A. Private Equity Funds that are Widely Held or Subject to Substantial Regulation
1. Widely Held. Private equity funds typically have a large number of direct and indirect beneficial owners, a substantial majority of which are exempt from taxation in their own right (e.g., by virtue of a domestic law exemption for pension plans or other tax-exempt investors or as a result of sovereign immunity applicable to foreign governments and their controlled entities) or that would qualify for the benefits of a treaty. We believe that a private equity fund should be treated as widely held for purposes of determining eligibility under the LOB Rule if such fund and its related fund entities have, in the aggregate, 20 or more different direct investors, with no single investor representing more than 10% of the aggregate investor commitments to such fund and its related fund entities. For purposes of determining whether a particular private equity fund (together with any of its subsidiary holding companies) is widely held, we believe that any interests held by investors in related fund entities should be taken into account. Often, private equity funds are composed of multiple partnerships or other entities formed to accommodate the specific regulatory or other needs of particular investors. For example, it is not uncommon for private equity sponsors to form limited partnerships or other entities that invest in parallel in underlying investments in proportion to the investors’ commitments to each fund vehicle. These “parallel funds” are often formed to accommodate specific regulatory, legal or other commercial considerations in respect of certain groups of investors. In addition, a private equity sponsor may establish a “feeder fund”, organized as a separate limited partnership or other entity that, in turn, invests in the main fund. Interests held by investors in parallel funds, feeder funds and other related fund entities, should be taken into account for purposes of evaluating the investor composition of a particular private equity fund and determining whether such fund is widely held.
2. Subject to Substantial Regulation. U.S.-based and European-based private equity sponsors and their funds are subject to substantial regulation, regardless of the jurisdiction in which a fund is organized. We have included below a detailed discussion of certain of the regulatory requirements that govern private equity sponsors and their funds. These requirements provide broad investor protections, governing how and to whom private equity funds may be marketed and managed. These regulatory requirements also govern more generally the conduct of private equity sponsors vis-à-vis their investors. For example, as described below, sponsors and their funds typically are required to undertake a comprehensive verification process to ensure that fund investors are, in fact, eligible to participate in such funds in accordance with the applicable regulatory requirements. Given the comprehensive and substantial regulatory regime governing private equity sponsors and their funds, and the particular focus on investor protections, we believe that private equity sponsors and their funds that are subject to either of the U.S. or European regulatory regimes described below should be treated in parity with CIVs for purposes of the LOB Rule
(a) U.S. Securities Laws. Private equity sponsors and their funds are subject to a robust regulatory regime, focused on investor protection, under the U.S. federal securities laws. In the United States, private equity funds, the marketing of interests in private equity funds to investors, and the activities of their sponsors (advisers) and their placement agents are subject to extensive regulation under the U.S. federal securities laws, including the antifraud provisions thereof. The most relevant statutes are the U.S. Securities Act of 1933 (the “Securities Act”) (offer and sale of fund interests), the U.S. Securities Exchange Act of 1934 (the “Exchange Act”) (placing activity and the secondary market), the U.S. Investment Company Act of 1940 (the “Investment Company Act”) (funds and qualification of investors in private funds) and the U.S. Investment Advisers Act of 1940 (the “Advisers Act”) (operations and activities of fund sponsors and general partners).
More specifically, the marketing of interests in private equity funds is predominantly conducted under the private offering exemptions of the Securities Act and, in particular, Rule 506(b) of Regulation D of the Securities Act. This rule, among other things, (i) prohibits a fund from engaging in a general solicitation (e.g., public advertising) and (ii) permits a fund to offer to an unlimited number of “accredited investors”[4] and up to 35 non-accredited investors who have such experience in financial and business affairs as to be able to evaluate the merits and risks of the offering. A fund relying on Rule 506(b) is required to make a filing with the SEC disclosing the offering on Form D. In addition, Rule 506(d) of Regulation D under the Securities Act prohibits a fund from relying on Rule 506 to conduct its offering if the fund or certain related persons (e.g., the general partner, the sponsor, the placement agent and 20% beneficial owners) have committed certain “bad acts” (e.g., criminal convictions and violations of anti-fraud provisions).
The marketing of private equity fund interests is also subject to the antifraud provisions under the Securities Act and the Exchange Act, including Rule 10b-5 under the Exchange Act which prohibits (i) engaging in any act that operates as a fraud or deceit in connection with the purchase or sale of a security and (ii) making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading.
For sales of interests in most U.S. private equity funds, the Investment Company Act requires that (i) the fund does not offer its securities in a public offering and (ii) either (a) its outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons (excluding certain “knowledgeable employees”[5]) or (b) all of the beneficial owners of its securities (excluding certain “knowledgeable employees”) are “qualified purchasers.”[6] A non-U.S. private equity fund is prohibited from offering its securities to U.S. persons unless it satisfies the conditions in clause (ii) above with respect to its U.S. beneficial owners.
Moreover, U.S. investment advisers (which term includes private equity fund sponsors and general partners that control private equity funds) to private equity funds and other alternative investment funds are regulated under the Advisers Act. A U.S. private equity fund sponsor generally would be required to register as an investment adviser with the U.S. Securities and Exchange Commission (“SEC”) under the Advisers Act if it has more than $150 million in private fund assets under management. An investment adviser registered with the SEC is required (i) to adopt and implement a compliance program administered by a chief compliance officer reasonably designed to prevent violations of the U.S. federal securities laws, (ii) to adopt and implement a policy protecting material non-public information (e.g., to prevent insider trading) and to adopt a code of ethics that requires the reporting of personal securities transactions by certain persons and (iii) to maintain a range of books and records. The SEC staff conducts examination of registered investment advisers to review the effectiveness of the adviser’s compliance program, the adviser’s books and records and the adviser’s compliance with the substantive provisions of the Advisers Act.
In addition, a private equity fund sponsor that is registered with the SEC is required to file and update a Form ADV and, if the sponsor has more than $150 million in private fund assets under management, a Form PF. Form ADV is divided into three parts: (i) Part 1A requires general identification and financial information about the adviser and its business, including whether it maintains custody of client assets and information regarding the disciplinary history of the adviser and its employees, and information on private funds managed by the adviser, including information on their structure, their assets, the categories of their beneficial owners and their service providers; (ii) Part 2A of Form ADV requires an adviser to describe, in narrative form, its advisory services, fees and compensation, types of clients, methods of analysis and investment strategies (and related risks), disciplinary information, material relationships with other financial industry participants, certain of the adviser’s policies and procedures with respect to compliance matters, brokerage practices, custody arrangements, proxy voting practices, any financial condition that is likely to impair the adviser’s ability to meet its contractual commitments to its clients (and, in certain circumstances, an audited balance sheet) and potential conflicts of interest with clients; and (iii) Part 2B of Form ADV provides information about the educational background, business experience and disciplinary history (if any) of the supervised persons who provide advisory services to the client. Form PF is designed to allow the SEC and other financial regulators to assess the systemic risks related to private funds and the frequency and level of detail required by Form PF depend on the adviser’s assets under management relating to private funds and the types of private funds the adviser manages. A large private equity fund sponsor is required to provide information about, among other things, the performance, categories of investors, and leverage of its funds and the leverage of their portfolio companies.
The antifraud provisions are at the heart of the Advisers Act and make it unlawful for any investment adviser (i) to employ any device, scheme, or artifice to defraud any client or prospective client or (ii) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. The Advisers Act’s antifraud provisions have been interpreted to impose on the adviser an affirmative duty of utmost good faith to act solely in the best interests of its clients and to make full and fair disclosure of all material facts, particularly where the adviser’s interests conflict with those of its clients. A private fund sponsor is also subject to a general antifraud rule (Rule 206(4)-8) that prohibits conduct that defrauds investors or prospective investors in pooled investment vehicles managed by the investment adviser. An investment adviser is required to identify and, if necessary, mitigate and/or disclose any conflicts of interest that it, its affiliates or its employees have with its clients, including, among other potential conflicts, with respect to the allocation of investment opportunities and the allocation of fees and expenses. The SEC has adopted a number of rules under the antifraud provisions of the Advisers Act governing, among other things, advertisements, the custody of client assets, the use of client solicitors, political contributions and proxy voting.
Most placement agents (or certain other persons who are in the business, for compensation, of marketing securities, including interests in private equity funds, to investors) offered in the United States for private funds are required to be registered as a broker-dealer with the SEC under the Exchange Act. A registered broker-dealer is also generally required to become a member of the Financial Industry Regulatory Authority (“FINRA”), a self-regulatory organization responsible for, among other things, issuing rules for and conducting examinations of registered broker-dealers and their representatives. FINRA rules, among other things, impose restrictions on the marketing materials provided by placement agents with respect to private funds.
Additional U.S. federal and/or state statutes and rules regulate, among other things, (i) anti-corruption and bribery concerns (e.g., the U.S. Foreign Corrupt Practices Act), (ii) anti-money laundering and sanctions compliance, and (iii) investor privacy and identity theft with respect to the activities of U.S. persons, including U.S. alternative investment fund sponsors and their affiliates.
(b) AIFMD. European sponsors of private equity funds are subject to substantial, comprehensive and robust regulation as a consequence of the implementation of the European Union Alternative Investment Fund Managers Directive (the “AIFMD”). In summary, the AIFMD regime requires a European sponsor to hold significant regulatory capital, to have in place detailed policies that deal with matters such as risk management, conflicts of interest and remuneration and to disclose information on a regular basis to its regulator, its investors and, in certain cases, portfolio companies and their employees. The AIFMD also extends to non-European sponsors that wish to market their private equity funds in Europe. In addition to other matters, a non-European sponsor must satisfy the disclosure obligations that apply to European sponsors. The AIFMD also contemplates that non-European sponsors marketing in Europe ultimately will be subject to equivalent regulatory requirements to those that apply to European sponsors.
B. Substantial Portion of Tax-Exempt, Government or Treaty Qualified Investors
In the event that a private equity fund does not satisfy the criteria for being treated as widely held or subject to a substantial regulatory regime, as described above, we believe a more narrowly tailored approach could be adopted for granting treaty benefits to such funds in appropriate circumstances. Specifically, we propose that private equity funds and their subsidiary holding companies should be eligible under the LOB Rule for the benefits of a particular treaty to the extent that a fund is able to certify that at least 50% of its direct and indirect investors (based on aggregate investor commitments) are comprised of pension funds and other tax-exempt investors, governmental entities or instrumentalities and their controlled subsidiaries, and investors that would otherwise be eligible for the benefits of the applicable treaty in their own right, and/or other private equity funds (such as funds of funds) that satisfy the requisite ownership threshold in their own right (collectively “Eligible Investors”). While this approach is informed by the inclusion of a derivative benefits provision in the Final Report, it is intended to be applied as a separate exception from the LOB Rule.
We believe that, for purposes of certifying as to whether a fund satisfies a minimum 50% Eligible Investor ownership threshold to qualify for treaty benefits, the fund and its sponsor should be entitled to rely on representations that the fund’s investors provide regarding their status as Eligible Investors for purposes of an applicable treaty. Under this approach, a private equity fund or its sponsors would obtain representations from each of its investors as to the jurisdictions for which such investor is an Eligible Investor. The fund or the sponsor, on behalf of the fund, would then provide a self-certification as to the fund’s eligibility for treaty benefits under a particular treaty each time benefits are sought by the fund based upon the representations from its investors. While private equity funds would be required to track the reported Eligible Investor status of its direct investors across the jurisdictions in which the fund is investing, such funds would not be required to act as a withholding agent or otherwise be required independently to verify the status of its indirect beneficial owners through multiple tiers of ownership. We believe that such a reporting protocol will help to alleviate concerns of treaty shopping, while balancing the administrative and practical realities that many private equity funds encounter, as described in greater detail in our earlier comments. We would be happy to provide assistance in developing a suitable form of self-certification that could be provided by private equity funds under this approach.
IV. Global Stream Fund Regime
The PEGCC does not believe that the GSF regime outlined in the Consultation Document is an appropriate or feasible alternative for providing private equity funds and their investors with access to treaty benefits and ensuring tax neutrality in respect of invested capital. Under the proposed GSF regime, a private equity fund that elects to be treated as a GSF would be required to (i) distribute 100% of its income and realized gains currently to its investors and (ii) withhold tax on distributions to its investors (other than other GSFs) based upon the applicable treaty entitlements of such investors in respect of the source of the underlying proceeds giving rise to the distribution and (iii) remit such withheld tax to its state of residence for further remittance to the state of source of the underlying proceeds.
This proposal raises significant practical and administrative concerns for private equity funds consistent with the practical and administrative issues that arise in applying the LOB Rule to these funds. As we have commented previously, private equity funds may have hundreds of investors and these investors often invest through tiered entities, including other funds. Private equity funds often make investments in numerous different jurisdictions, each with different treaty rules. For fund investors that do not elect to be treated as GSFs, identifying the ultimate beneficial owners of interests in a fund implicit in such an approach, including interests that are held indirectly through upper-tier entities, and their treaty entitlements in respect of each jurisdiction in which the fund invests would require a level of inquiry that is substantially beyond what is required by currently applicable regimes, including the U.S. FATCA rules. This inquiry would require access to information with respect to indirect investors that the private equity fund may not be able to identify and with which it has no legal relationship.
It will often be impractical, if not impossible, for a fund to determine the treaty entitlements of each of its investors in respect of all sources of income of the fund and effectively act as a withholding agent in respect of such income. Even if this level of inquiry were feasible as a practical matter, it would be a time consuming and daunting process, particularly for funds with large numbers of investors, and would impose substantial additional compliance costs upon funds and their investors. We do not see how such a proposal alleviates in any way the practical, administrative and policy considerations raised by us and other commentators with regard to the granting of treaty benefits to non-CIV funds.
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We would welcome the opportunity to discuss any of the points raised in this letter with you.
Respectfully submitted,
Jason Mulvihill
General Counsel
Private Equity Growth Capital Council
APPENDIX
SUGGESTION THAT TREATY BENEFITS BE GRANTED TO REGULATED AND/OR WIDELY-HELD NON-CIV FUNDS
1. What would be the threshold for determining that a fund is “widely held” for the purpose of such a proposal?
We believe that a private equity fund should be treated as widely held for purposes of determining eligibility under the LOB Rule if the fund and its related fund entities have, in the aggregate, 20 or more different direct investors, with no single investor representing more than 10% of the aggregate investor commitments to the fund and its related fund entities. Related fund entities should be taken into account, including parallel funds and feeder funds.
2. What types of regulatory frameworks would be acceptable in order to conclude that a fund is “regulated” for the purposes of such a proposal? For instance, would these include the types of regulatory requirements described in paragraph 16 of the 2010 CIV report (i.e. “regulatory requirements relating to concentration of investments, restricting a CIV’s ability to acquire a controlling interest in a company, prohibiting or restricting certain types of investments, and limiting the use of leverage by the CIV”) as well as disclosure requirements relating to distribution of interests (e.g. “know your customer” rules)?
We believe that U.S.-based private equity sponsors and their funds that are regulated by the U.S. Securities and Exchange Commission under the U.S. federal securities laws, including the U.S. Securities Act of 1933, the U.S. Securities Exchange Act of 1934, the U.S. Investment Company Act of 1940 and the U.S. Investment Advisers Act of 1940, and European-based private equity sponsors and their funds that are regulated pursuant to the European Union Alternative Investment Fund Managers Directive are currently subject to robust regulatory regimes. Given the comprehensive and substantial regulatory regimes governing private equity sponsors and their funds, and the particular focus on investor protections, we believe that private equity sponsors and their funds that are subject to either of the U.S. or European regulatory regimes described above should be treated in parity with CIVs for purposes of the LOB Rule.
3. Since the proposed exception would apply regardless of who invests in the funds, it would seem relatively easy for a fund to be used primarily to invest in a country on behalf of a large number of investors who would not otherwise be entitled to the same or better treaty benefits with respect to income derived from that country. How would this treaty-shopping concern be addressed?
This question appears to presume that non-CIV funds are primarily established to enable investors to gain access to treaty benefits. We believe this presumption is unfounded. The typical private equity fund has an international investor base, with investors from all over the world, many of which would be entitled to the same or better treaty benefits as the fund or would benefit from relief under domestic laws of the countries in which portfolio companies are located (e.g., foreign government investors and pension funds). The typical private equity fund holds a number of investments across a range of industries and geographies. The governing documents of many private equity funds contain provisions requiring such funds to satisfy certain diversification requirements in respect of their portfolio investments. In addition, investors do not exercise control over the selection of the particular investments that a private equity fund will invest into, or the jurisdictions in which the investments are located. For these reasons, private equity funds are unlikely to be used as a mechanism to obtain treaty benefits for its investors in respect of a portfolio investment in any particular country.
4. Is it correct that investors in a non-CIV are typically taxable only when they receive a distribution? Would there be mandatory distribution requirements for a fund to be eligible for the proposed exception and if yes, would intermediate entities be required to distribute earnings up the chain of ownership on a mandatory basis? If not, how would concerns about deferral of tax be addressed?
Private equity funds are organized most frequently as fiscally-transparent limited partnerships in order to achieve tax neutrality and the flow-through of the characteristics of the underlying income realized by the fund. Under a tax transparent structure, each investor generally would be subject to tax under the rules of the investor’s jurisdiction of residence on its proportionate share of the fund’s income, even if no distribution is made by the fund to such investor. Proceeds received by a fund or a subsidiary holding company in connection with a disposition of an investment generally are required to be distributed promptly to investors. Private equity fund sponsors are incentivized to ensure that such distributions of investment proceeds are made promptly to investors because retention of uninvested capital would reduce investment returns. Accordingly, these structures do not provide the opportunity for taxable investors to defer tax.
5. States that support the inclusion of LOB rules in their treaties are unlikely to agree to a broad exception from the LOB rule that would apply to any widely-held fund, even if it is regulated, especially since that exception would seem more generous than the exception already provided for publicly-listed companies. What features could be incorporated into a specific non-CIV exception in order to make it more acceptable to these States?
In the event that the OECD determines not to support the inclusion of private equity funds as “qualified persons”, the PEGCC would support the treatment of private equity funds and their subsidiary holding companies that are “widely held” or that are “subject to substantial regulation” as CIVs (and, therefore, as “qualified persons”) for purposes of the LOB Rule. Please see our responses to questions 1 and 2, above, for a description of the criteria for determining whether a private equity fund is widely held or subject to substantial regulation. We disagree with the assertion that this exception would be any more generous than the exception already provided for publicly-listed companies because a publicly-listed company could have a privately held class of shares representing nearly 50% of the company’s voting power and value and still satisfy the exception in the LOB Rule for a company whose principal class of shares is regularly traded on a recognized stock exchange. In any event, regardless of the rules that apply to publicly-listed companies, private equity funds are most analogous to CIVs, and, as we and many other commentators have demonstrated, share many of the same characteristics as CIVs. Therefore, we urge the OECD working group to adopt an approach that treats private equity funds and their subsidiary holding companies in parity with CIVs.
6. One argument that was put forward in relation to suggestions for a specific LOB exception for non-CIV funds was that it would avoid or reduce the cascading tax when investment is made through a chain of intermediaries. In practice, what is the intermediate entity-level tax, if any, that is typically payable with respect to income received from a State of source? Are there special purpose vehicles that are commonly used by funds to invest indirectly? How are intermediate entities typically funded, debt or equity? If debt, is it unrelated party financing?
Private equity funds typically do not hold interests directly in portfolio companies. Instead, a fund will organize one or more subsidiary investment entities to acquire and hold these interests. These subsidiary investment entities may be formed for a number of different commercial purposes, including providing liability insulation for the fund, facilitating financing arrangements in connection with an underlying investment and satisfying local legal requirements. Subsidiary investment entities are not used to facilitate tax avoidance, and granting such entities treaty benefits affords investors in a private equity fund tax neutrality in respect of capital invested through the fund in comparison to a direct investment in a portfolio company.
NON-CIV FUNDS SET UP AS TRANSPARENT ENTITIES
7. Where an entity with a wide investor base is treated as fiscally transparent under the domestic law of a State that entered into tax treaties, the application of the relevant tax treaties raises a number of practical difficulties. Are there ways in which these difficulties could be addressed? Are there other practical problems that would prevent the application of the new transparent entity provision in order to ensure that investors who are residents of a State are entitled to the benefits of the treaties concluded by that State?
As recognized by the OECD in paragraph 14 of the Consultation Document, non-CIV funds are often unable to identify the tax residence of all of their investors. As a practical matter, investors in private equity funds often hold their interests in the fund through tiered entities, including other funds. Identifying the beneficial owners of interests in a typical private equity fund by looking through tiered entities is a time consuming and daunting process and substantially more burdensome than what is currently required by other applicable regimes, including FATCA rules. Accordingly, the PEGCC supports treating private equity funds that meet the “widely held” or “subject to regulatory oversight” standards as “qualified persons”.
8. The rationale that was given for the above proposal refers to the fact that “investors in Alternative Funds are primarily institutional investors, and are often entitled to benefits that are at least as good as the benefits that might be claimed by the Alternative Fund”. What is the meaning of “institutional investors” in that context? In particular, does it include taxable entities or other non-CIVs? Absent a clear definition of “institutional investors”, how can it be concluded that institutional investors “are often entitled to benefits that are at least as good as the benefits that might be claimed by the Alternative Fund”? Also, is it suggested that “institutional investors” are less likely to engage in treaty-shopping and, if yes, why?
Private equity funds typically have a broad base of investors that includes pension funds, tax-exempt entities, sovereign wealth funds, insurance companies, university endowments, foundations, family offices and other investment funds. Many of these investors are exempt from taxation in their own right (e.g., by virtue of a domestic law exemption for pension plans or other tax-exempt investors or as a result of sovereign immunity applicable to foreign governments and their controlled entities).
SUGGESTION THAT THE LOB INCLUDE A DERIVATIVE BENEFIT RULE APPLICABLE TO CERTAIN NON-CIV FUNDS
-QUESTIONS RELATED TO CERTAIN ASPECTS OF THE PROPOSAL
9. Unlike CIVs, which are defined in paragraph 6.8 of the 2010 Report on CIVs, the term “non–CIV” has no established definition. What would be the main types of investment vehicles to which the proposal could apply?
As more fully discussed in our January 2015 comments, private equity funds share many of the same characteristics as other collective investment vehicles, including a broad and diverse investor base and extensive regulatory oversight. Accordingly, the PEGCC supports treating private equity funds as CIVs, or alternatively, including private equity funds in a separate category of non-CIVs that are treated as “qualified persons”.
-QUESTIONS RELATED TO THE IDENTIFICATION OF THE INVESTORS IN A NON-CIV
13. Is the ownership of interests in non-CIV funds fairly stable or does it change frequently like the interests in a typical collective investment fund that is widely distributed?
While the typical governing documents of a private equity fund impose restrictions on transfers, the ownership of interests in a fund typically will change over the term of a fund (typically ten years) as a result of privately negotiated transfers of interests.
15. What information do those concerned with the management and administration of non-CIV funds currently have concerning persons who ultimately own interests in the fund (for example under anti-money laundering, FATCA or common reporting standard rules)?
For FATCA purposes, a private equity fund sponsor will typically collect an IRS Form W-9 from each investor that is a U.S. person and an applicable IRS Form W-8 from each investor that is a non-U.S. person. IRS Form W-9 provides information regarding the U.S. investor providing such form, such as the investor’s name, address, U.S. tax classification and U.S. taxpayer identification number. The particular type of IRS Form W-8 provided by a non-U.S. investor generally is determined based upon the U.S. tax classification of the non-U.S. investor providing the form. An IRS Form W-8 provides similar identifying information regarding a non-U.S. investor, including the investor’s FATCA status. A non-U.S. investor that is the beneficial owner of an interest in the fund for U.S. federal income tax purposes and that provides the fund with an IRS Form W-8BEN or W-8BEN-E may also include a claim to the benefits of a tax treaty between the United States and the jurisdiction of residence of such investor in respect of certain types of income received from the fund. A non-U.S. investor that is treated as a flow-through entity from a U.S. federal income tax perspective, or that holds fund interests as a nominee for another person, generally is required to provide the fund with an IRS Form W-8IMY and to attach applicable IRS withholding forms in respect of the owners of such flow-through entity (or, in the case of a nominee, the applicable IRS withholding form in respect of the person for which such interests are held). However, depending on the U.S. FATCA classification of the non-U.S. investor providing IRS Form W-8IMY and the underlying fund income in respect of which such withholding form is being provided, limited or no U.S. withholding information may be provided in respect of the ultimate owners of such non-U.S. investor. FATCA is designed to identify direct and indirect ownership of accounts by U.S. persons in certain foreign financial institutions and is not designed to identify the treaty entitlements of the beneficial owners of any particular entity. As a result, the information collected under FATCA is limited in scope and generally will not provide a fund with sufficient information to identify the indirect beneficial owners in a private equity fund or their particular treaty entitlements.
The common reporting standard rules (“CRS”) require a private equity fund to collect information regarding the controlling persons in relation to certain investors, such as investors that are non-financial entities and certain trusts. Given the limited scope of these disclosure requirements, many investors are not required under CRS to provide controlling person disclosures to the private equity fund in which they are investing. Further, the definition of a controlling person for purposes of CRS does not necessarily identify the ultimate beneficial owner because of its focus on management and control and not on beneficial ownership.
16. Is this information currently sufficient for relevant parties to identify the treaty benefits that an owner would have been entitled to if it had received the income directly? If not, what types of documents and procedures could be used by a non-CIV to demonstrate to tax authorities and/or payors that the residence and treaty entitlement of its ultimate beneficial owners are such that the non-CIV qualifies for treaty benefits under that suggested derivative benefits rule? What barriers would exist to the communication of these documents or the implementation of these procedures? In particular, does intermediate ownership present obstacles to obtaining information about ultimate beneficial ownership and, if yes, how might these obstacles be addressed?
As more fully discussed in our June 2015 comments, identifying and monitoring the ultimate beneficial owners of interests in a private equity fund on an ongoing basis is administratively complex and commercially impractical. Private equity funds typically have limited ability to identify the tax status of indirect investors and have limited or no control over changes of the tax status of indirect investors, with whom the fund is not in privity of contract. As illustrated in Example 2 in the Appendix to our June 2015 comments, a private equity fund typically would have no control over transfers of interests in a fund of funds that is a direct investor in the private equity fund. Therefore, even if the private equity fund obtained sufficient information from the transferor in the fund of funds, and both the transferor and transferee were, in fact, equivalent beneficiaries, the private equity fund may be unable to obtain information regarding the transferee in order to establish that the transferee is an equivalent beneficiary under the derivative benefits rule.
-QUESTIONS RELATED TO THE PREVENTION OF TREATY-SHOPPING
17. Since beneficial interests in non-CIV funds are frequently held through a chain of intermediaries, including multiple subsidiary entities (which is not the case of typical CIVs), how would the proposal overcome the difficulties derived from such complex investment structures with multiple layers and ensure that a fund is not used to provide treaty benefits to investors that are not themselves entitled to treaty benefits?
Please see our responses to questions 3 and 6 above.
18. The proposal would grant treaty benefits if a certain high percentage of a non-CIV is beneficially owned by investors entitled to similar or better benefits. Even a percentage as high as 80% would leave substantial room for treaty-shopping as a 20% participation in a very large fund could represent a significant investment. How could this concern be addressed?
As discussed above, private equity funds are not used by investors as vehicles for treaty shopping. For the reasons explained above, we believe that it is appropriate to treat private equity funds that meet the “widely held” or “subject to regulatory oversight” standards as “qualified persons”. In the event that a private equity fund does not satisfy the criteria for being treated as widely held or subject to a substantial regulatory regime, we believe a more narrowly tailored approach could be adopted for granting treaty benefits to such funds in appropriate circumstances. Specifically, we propose that private equity funds and their subsidiary holding companies should be eligible under the LOB Rule for the benefits of a particular treaty to the extent that a fund is able to certify that at least 50% of its direct and indirect investors (based on aggregate investor commitments) are comprised of pension funds and other tax-exempt investors, governmental entities or instrumentalities and their controlled subsidiaries, and investors that would otherwise be eligible for the benefits of the applicable treaty in their own right, and/or other private equity funds (such as funds of funds) that satisfy the requisite ownership threshold in their own right (collectively “Eligible Investors”).
We believe that, for purposes of certifying as to whether a fund satisfies a minimum 50% Eligible Investor ownership threshold to qualify for treaty benefits, the fund and its sponsor should be entitled to rely on representations that the fund’s investors provide regarding their status as Eligible Investors for purposes of an applicable treaty. Under this approach, a private equity fund or its sponsors would obtain representations from each of its investors as to the jurisdictions for which such investor is an Eligible Investor. The fund or the sponsor, on behalf of the fund, would then provide a self-certification as to the fund’s eligibility for treaty benefits under a particular treaty each time benefits are sought by the fund based upon the representations from its investors. While private equity funds would be required to track the reported Eligible Investor status of its direct investors across the jurisdictions in which the fund is investing, such funds would not be required to act as a withholding agent or otherwise be required independently to verify the status of its indirect beneficial owners through multiple tiers of ownership. We believe that such a reporting protocol will help to alleviate concerns of treaty shopping, while balancing the administrative and practical realities that many private equity funds encounter, as described in greater detail in our earlier comments. We would be happy to provide assistance in developing a suitable form of self-certification that could be provided by private equity funds under this approach.
SUGGESTION OF A “GLOBAL STREAMED FUND” REGIME
24. Although the above proposal for a “Global Streamed Fund” regime is very recent and has not yet been examined by Working Party 1, the Working Party wishes to invite commentators to offer their views on its different features. In particular, the Working Party invites comments on: (i) whether the approach would create difficulties for non-CIV funds that do not currently distribute all their income on a current basis; (ii) whether the approach would create difficulties for non-CIV funds that cannot, for various reasons, determine who their investors are; (iii) whether the suggestion that tax on distributions be collected by the State of residence and remitted to the State of source would create legal and practical difficulties; and (iv) what should be the consequences if, after a payment is made to a GSF, it is subsequently discovered that the fund did not meet the requirements for qualifying as a GSF or did not distribute 100% of its income on a current basis?
The PEGCC does not believe that the GSF regime is an appropriate or feasible alternative for providing private equity funds and their investors with access to treaty benefits and ensuring tax neutrality in respect of invested capital. This proposal raises significant practical and administrative concerns for private equity funds consistent with the practical and administrative issues that arise in applying the LOB Rule to these funds. As we have commented previously, private equity funds may have hundreds of investors and these investors often invest through tiered entities, including other funds. Private equity funds often make investments in numerous different jurisdictions, each with different treaty rules. It will often be impractical, if not impossible, for a fund to determine the treaty entitlements of each of its investors in respect of all sources of income of the fund and effectively act as a withholding agent in respect of such income. Even if this level of inquiry were feasible as a practical matter, it would be a time consuming and daunting process, particularly for funds with large numbers of investors, and would impose substantial additional compliance costs upon funds and their investors. We do not see how such a proposal alleviates in any way the practical, administrative and policy considerations raised by us and other commentators with regard to the granting of treaty benefits to non-CIV funds.
[1] See The PEGCC comments on the Public Discussion Draft Follow-up Work on BEPS Action 6: Preventing Treaty Abuse, 21 November 2014 (January 9, 2015) and The PEGCC comments on the Revised Discussion Draft on BEPS Action 6: Prevent Treaty Abuse (June 17, 2015).
[2] Private equity funds typically do not hold interests directly in portfolio companies. Instead, a fund will organize one or more subsidiary investment entities to acquire and hold these interests. These subsidiary investment entities may be formed for a number of different commercial purposes, including providing liability insulation for the fund, facilitating financing arrangements in connection with an underlying investment and satisfying local legal requirements. Subsidiary investment entities are not used to facilitate tax avoidance, and granting such entities treaty benefits affords investors in a private equity fund tax neutrality in respect of capital invested through the fund in comparison to a direct investment in a portfolio company.
[3] Contrary to the recommendations of the PEGCC and other commenters that the PPT Rule apply in cases where “the principal purpose” of an arrangement or transaction is inappropriately obtaining the benefits of a tax treaty, the OECD working group has included in the Final Report a more subjective PPT Rule that applies in cases where “one of the principal purposes” is inappropriately obtaining the benefits of a tax treaty. The PEGCC continues to believe that this more subjective standard may lead to varying interpretations across jurisdictions of the same set of facts and circumstances and may create uncertainties in determining how a particular jurisdiction could apply the PPT Rule. The PEGCC welcomes the OECD working group’s continued evaluation of the examples submitted by the PEGCC and other commentators last year regarding inappropriate applications of the PPT Rule, and encourages the OECD working group to release further guidance on the specific application of the PPT Rule in light of these examples.
[4] “Accredited investors” generally are (i) certain regulated entities (e.g., banks, insurance companies, registered broker-dealers, and registered investment companies), (ii) certain U.S. state pension plans or employee benefit plans with more than $5 million in assets, (iii) certain legal entities with more than $5 million in assets, (iv) any director, executive officer or general partner of the issuer of the securities being offered or sold (or of the general partner of that issuer), (v) any natural person with an individual net worth, or joint net worth with that person’s spouse, exceeding $1 million (excluding that person’s primary residence), (vi) any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year, (vii) any trust with total assets in excess of $5 million and (viii) any entity in which all of the equity owners are accredited investors.
[5] A “knowledgeable employee” is generally (i) an executive officer, director, trustee, general partner, advisory board member or a person serving in a similar capacity of the private fund or the private fund’s investment adviser (or certain of the adviser’s affiliates) and (ii) an employee of such entities who, in connection with his or her regular functions or duties, participates in the investment activities of such entities (and who has been performing substantially similar functions or duties for at least 12 months).
[6] A “qualified purchaser” is generally (i) a natural person with $5 million or more in investments, (ii) a family company with $5 million or more in investments, (iii) a trust whose trustees and grantors are all qualified purchasers, or (iv) a legal entity with $25 million or more in investments.
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