Private Equity and Hedge Funds: The Tax Challenge

1. Third International Tax Dialogue Global Conference Financial Institutions and Instruments Tax Challenges and Solutions Private Equity and Hedge Funds: The Tax Challenge October 26-28, 2009 Philip R. West Steptoe & Johnson LLP Washington, DC

2. Funds and the Current Financial Crisis • Did private equity and hedge funds contribute to the current financial crisis? If so, how? • The financial crisis has been attributed to numerous factors, including some associated with private equity and hedge funds – • High degree of leverage (corporate and personal) • Complex financial arrangements • Lack of transparency • Assumption of inordinate amounts of risk • How does tax policy play a role? • Preferential tax treatment of debt over equity • Performance-based compensation. Does the tax treatment of carried interests exacerbate the problem?

3. Hedge Fund– Basic Structure Domestic Investors Foreign Investors Feeder Fund Feeder Fund GP Master Fund Investment

4. Private Equity Fund – Basic Structure Investors GP Fund SPV Target

5. Source Country Perspective • The source country dilemma • Attracting capital often believed to require light taxation and even tax competition • Potentially adverse revenue impact • Self-help planning by investors may also adversely effect revenue even in the absence of active tax competition by revenue authorities • Funds structured to avoid / minimize taxes imposed by the source country • Funds often organized as a non-taxable entity in a low-tax jurisdiction • If treaty benefits can be obtained in tax favorable jurisdiction, results can be even better • Capital gains by source country often avoided by foreign investors (directly or through a SPV) because capital gains often taxed on residence basis • Distribution of earnings from target may avoid withholding tax through the use of treaties (treaty shopping?) and pass-through entities • Deductible interest in highly leveraged transactions may offset income earned by the target corporation • Debt may be provided by related foreign parties (e.g., private equity fund, sponsors) subject to thin cap rules • In the funds context, are most tax issues residence country issues anyway? • See discussion of tax havens in Panel XIII– “Aggressive Tax Planning Using Cross Border Financial Instruments”

6. Source Country Perspective • Taxation of Capital Gains • Where should investment income be taxed – source or residence country? • Should the tax treatment of funds differ from a direct investment that incurs one layer of tax? • Source country generally will exempt capital gains of non-residents • Treaties favor taxing capital gains in country of residence • Qualification for treaty benefits? • Challenges to treaty shopping • A PE may subject the fund and investors to source country taxation • What level of presence would constitute a PE? • If there is a PE, how much income will be attributed to a PE? • Distributions to Funds / Investors • Source country may impose withholding taxes subject to availability of treaty benefits • Tax classification – look-through vs. taxable entity • Residency – are treaty benefits available? • Limitation of benefits provisions in treaties • Tax avoided and/or deferred through treaty shopping and use of SPVs

7. Source Country Perspective • Leveraging • Target companies and potential target companies • Target companies can limit or effectively eliminate CIT • Potential target companies can leverage as a “puffer fish” defensive tactic • Tax vs. non-tax policies regarding leverage • Tax policy measures addressing leverage • Minimize disparity between debt and equity • Lower rates • Equalize debt and equity treatment • Application of thin-cap rules • Third parties • Guarantees by related parties

8. Understanding the Role of Tax Havens/Offshore Financial Centers • Why are OFCs used? • To aggregate capital for productive investment elsewhere • No greater taxation or compliance obligations than would be imposed on a direct investment from the investor jurisdiction to the destination jurisdiction • Efficiencies in using the same vehicles in the same jurisdiction with known results • Sometimes used by investors to facilitate tax evasion

9. Understanding the Role of Tax Havens/Offshore Financial Centers

10. Understanding the Role of Tax Havens/Offshore Financial Centers • How OFCs are used for Legal Tax Minimization: • Double taxation may occur where a “source” country (the country of the investee company) imposes tax on the venture’s income and/or distributions and the “residence” country of an investor also taxes the investor’s income from the investment • Low-tax collective investment vehicles exist in investor jurisdictions, but they may not be completely tax free and may create compliance obligations that non-local investors would rather avoid.

11. Understanding the Role of Tax Havens/Offshore Financial Centers • How OFCs are used for Illegal Tax Abuse: • Tax evasion • OFCs may have secrecy rules that investors in an entity organized in an OFC may use to help them evade their tax obligations in their residence jurisdictions by failing to report income (if taxed on worldwide basis) • “Round-tripping” • If investment vehicle invests in the jurisdiction of residence of the investor, the investor may turn local income into exempt foreign income • Tax authorities in an investor’s jurisdiction could be hampered in learning the investor’s identity if a secrecy jurisdiction were interposed between a local investor and a local investment

12. Taxation of Carried Interests • What is a carried interest? • The “2 and 20” model of compensation of general partners in a fund • The “2” is an investment management fee based on net asset value and is taxed at ordinary income rates • The 2% return does not depend on the performance of the fund • The “20” – or the “carried interest” -- is the fee based on the overall return on the investment and is taxed at capital gain rates. • The carried interest is typically paid after the limited partners receive a return on their investment. • The 20% return depends on the performance of the fund. • Capital treatment of carried interest under current law • A partner generally does not recognize income upon the receipt of a profits interest for services • The character of income items pass through to the partners • Commentators have suggested that the carried interest be taxed at ordinary rates

13. Taxation of Carried Interests • Is the carried interest debate based on fairness, revenue, or other tax policy grounds? • Arguments in favor of taxation at capital gain rates • Individual efforts of general partner comparable to other investors and sole proprietors • An investor is taxed at capital gain rates on investment gains • If the investor joins with others to form a partnership, the character of the partnership’s investment gains is retained at the partner level • This holds true even if some partners contribute capital and some partners contribute services • Converting to ordinary rates will not raise significant revenue • Reduction in return for limited partners • Increasing tax burden will cause funds to move offshore • Unnecessary complexity in tax law • Targets a narrow class of taxpayers • Arguments in favor of taxation at ordinary income rates • Individual efforts of general partner comparable to service income • Carried interest is similar to a stock option (e.g., deferral, value tied to performance) • Disparate tax treatment creates unintended tax preference • Is there a middle ground? If so, how can it be achieved? • Should deferral of the carried interest be permitted? • What will be the effect of taxing the carried interest at ordinary rates?

14. Taxation of Carried Interests • Recent developments in the taxation of carried interests • U.K. developments • Memorandum of Understanding (July 25, 2003) -- Respect amounts paid for carried interest if certain conditions are met • Absence of main or significant tax avoidance purpose • Structure of fund described in the memorandum • Fund is not varied • Carried interest holder pays the same per unit of capital as the investors • Permitted restrictions include leaver, vesting, and general transfer restrictions • Accept that amount paid equals unrestricted market value if carried interest acquired before initial investment or, if after, when the aggregate value of fund’s investment increased above aggregate acquisition cost • U.K. budget proposal (2007) to impose ordinary income rates not adopted. • U.S. developments • Obama administration’s budget proposal includes taxing carried interests at ordinary rates • Revenue estimate (JCT) -- $23.1 billion over 10 years. • H.R. 1935 (Apr. 3, 2009) • Most recent version of carried interest bill. • Applies to “investment services partnership interest” – an interest held by a partner reasonably expected to provide certain investment services • General rule – carried interest taxed at ordinary income rates • Exception where (i) allocations made in the same manner as allocation to non-service providers and (ii) the allocations made to the non-service providers are significant as compared to the allocations to the service provider • Recent health care legislation does not contain a provision on carried interests