Q&A: tax issues for private equity funds in USA

Taxation

Would a private equity fund vehicle formed in your jurisdiction be subject to taxation there with respect to its income or gains? Would the fund be required to withhold taxes with respect to distributions to investors? Describe what conditions, if any, apply to a private equity fund to qualify for applicable tax exemptions.

Generally, a private equity fund vehicle, such as a limited partnership or limited liability company, that is treated as a partnership for US federal income tax purposes, would not itself be subject to taxation with respect to its income or gains. Instead, each partner would take into account its distributive share of the partnership’s income, gain, loss and deduction. However, liability for adjustments to a fund’s tax returns may be imposed on the fund itself in certain circumstances in the absence of an election to the contrary.

If the fund generates effectively connected income (ECI) with the conduct of a US trade or business, including as a result of an investment in US real estate or certain real estate companies, the fund will be required to withhold US federal income tax with respect to such income that is attributable to the fund’s non-US investors, regardless of whether it is distributed. In general, subject to an exception for investments in certain real estate companies, trading in stock or securities (the principal activity of most private equity funds) is not treated as generating ECI. Gain or loss from the sale or exchange of an interest in a fund by a foreign partner will be considered ECI and therefore subject to US tax to the extent that such partner would have been allocated ECI if the fund sold all of its assets at fair market value as of the date of the sale or exchange. The transferee of an interest in a partnership engaged in a US trade or business to withhold 10 per cent of the amount realised by the transferor on the sale or exchange, and the fund would be required to withhold from future distributions to the transferee if the transferee fails to properly withhold. Funds that hold investments that generate ECI often allow non-US investors to participate through one or more entities treated as corporations for US tax purposes with respect to such investments, in which case such corporations would file US tax returns and pay tax associated with such ECI investments. Non-US investors may still be subject to US withholding tax on dividends or interest paid by such corporations.

The fund will also be required to withhold with respect to its non-US investors’ distributive share of certain US-source income of the fund that is not ECI (eg, US-source dividends and interest) unless, in the case of interest, such interest qualifies as portfolio interest. Portfolio interest generally includes (with certain exceptions) interest paid on registered obligations with respect to which the beneficial owner provides a statement that it is not a US person. A non-US investor who is a resident for tax purposes in a country with respect to which the United States has an income tax treaty may be eligible for a reduction or refund of withholding tax imposed on such investor’s distributive share of interest and dividends and certain foreign government investors may also be eligible for an exemption from withholding tax on income of the fund that is not from the conduct of commercial activities.

The Foreign Account Tax Compliance Act requires all entities in a broadly defined class of foreign financial institutions (FFIs) to comply with a complicated and expansive reporting regime or be subject to a 30 per cent withholding tax on certain payments. This legislation also requires non-US entities that are not FFIs either to certify they have no substantial US beneficial ownership or to report certain information with respect to their substantial US beneficial ownership or be subject to a 30 per cent withholding tax on certain payments. This legislation could apply to non-US investors in the fund, and the private equity fund could be required to withhold on payments to such investors if such investors do not comply with the applicable requirements of this legislation.

The taxation of a private equity fund vehicle as a partnership for US federal income tax purposes is subject to certain rules regarding ‘publicly traded partnerships’ that could result in the partnership being classified as an association taxable as a corporation. To avoid these rules, funds are not commonly traded on a securities exchange or other established over-the-counter market and impose limitations on the transferability of interests in the private equity fund vehicle.

The taxation of a private equity fund vehicle as a partnership for US federal income tax purposes is subject to certain rules regarding ‘publicly traded partnerships’ that could result in the partnership being classified as an association taxable as a corporation. To avoid these rules, funds are not commonly traded on a securities exchange or other established over-the-counter market and impose limitations on the transferability of interests in the private equity fund vehicle.

Would non-resident investors in a private equity fund be subject to taxation or return-filing requirements in your jurisdiction?

Non-resident investors that invest directly in a private equity fund organised as a flow-through vehicle in the United States would be subject to US federal income taxation and return filing obligations if the private equity fund (or an entity organised as a flow-through vehicle into which the private equity fund invests) generates ECI (including gain from the sale of real property or stock in certain ‘US real estate property holding corporations’). In addition, all or a portion of the gain on the disposition (including by redemption) by a non-US investor of its interest in the fund may be taxed as ECI. Similar US state and local income tax requirements may also apply.

Is it necessary or desirable to obtain a ruling from local tax authorities with respect to the tax treatment of a private equity fund vehicle formed in your jurisdiction? Are there any special tax rules relating to investors that are residents of your jurisdiction?

Generally, no tax ruling would be obtained with respect to the tax treatment of a private equity fund vehicle formed in the United States. While there are many special taxation rules applicable to US investors, of particular relevance are those rules that apply to US tax-exempt investors in respect of unrelated business taxable income.

Must any significant organisational taxes be paid with respect to private equity funds organised in your jurisdiction?

There are no significant taxes associated with the organisation of a private equity fund in the United States.

Describe briefly what special tax considerations, if any, apply with respect to a private equity fund’s sponsor.

Special consideration is given to structure the carried interest such that it is treated as a partnership allocation eligible for taxation on a flow-through basis. It is sometimes desirable to separate the general partner (namely, the recipient of the carried interest) and the investment manager (namely, the recipient of the management fee) into separate entities.

Under section 1061 of the Code, the fund must have a three-year holding period (rather than the standard one-year holding period) for an investment or asset in order for carried interest distributions to be eligible for favourable long-term capital gain treatment, and this requirement may implicate gains with respect to capital contributions made by sponsors and their employees. In addition, an individual carried interest participant will only be eligible for long-term capital gain treatment upon disposition of any interests in a carry vehicle (other than capital interests) if such participant has a three-year holding period for the interests. Further, Congress has previously proposed legislation that, if enacted, would result in carried interest distributions that are currently subject to favourable capital gains tax treatment being subject to higher rates of US federal income tax than are currently in effect. Whether such legislation would be enacted in addition to changes in the tax reform legislation enacted in 2017 (the Tax Reform Bill) is uncertain.

In addition, some sponsors implement arrangements in which a sponsor waives its right to all or a portion of management fees in order for it or an affiliate to receive an additional distributive share of the private equity fund’s returns. Proposed regulations, if finalised, could treat participants in such management fee waiver arrangements as receiving compensatory payments for services rather than allocations of the fund’s underlying income. The preamble to the proposed regulations also indicates that existing safe harbours that treat the grant of a ‘profits interest’ as a non-taxable event may not apply to management fee waiver arrangements.

List any relevant tax treaties to which your jurisdiction is a party and how such treaties apply to the fund vehicle.

The United States has an extensive network of income tax treaties. How a treaty would apply to the fund vehicle depends on the terms of the specific treaty and the relevant facts of the structure.

Are there any other significant tax issues relating to private equity funds organised in your jurisdiction?

The Tax Reform Bill has resulted in fundamental changes to the Code. Among the numerous changes included in the Tax Reform Bill are:

• a permanent reduction to the corporate income tax rate;
• a partial limitation on the deductibility of business interest expense;
• an income deduction for individuals receiving certain business income from pass-through entities;
• changes in the treatment of carried interest, which generally requires the fund to have a three-year holding period for an investment or asset in order for carried interest distributions to be eligible for favourable long-term capital gain treatment;
• a partial shift of the US taxation of multinational corporations from a tax on worldwide income to a territorial system (along with a transitional rule that taxes certain historical accumulated earnings and rules that prevent tax planning strategies that shift profits to low-tax jurisdictions); and
• a suspension of certain miscellaneous itemised deductions, including deductions for investment fees and expenses, until 2026.

The partial limit on the deductibility of business interest expense disallows deductions for business interest expense (even if paid to third parties) in excess of the sum of business interest income and 30 per cent of the adjusted taxable income of the business. Business interest includes any interest on indebtedness related to a trade or business, but excludes investment interest, to which separate limitations apply. The impact of the Tax Reform Bill on funds and their portfolio companies is uncertain.

US tax rules are very complex and tax matters play an extremely important role in both fund formation and the structure of underlying fund investments. Consultation with tax advisers with respect to the specific transactions or issues is highly recommended.