Tax considerations fan the private equity boom: amid much publicity and debate about the tax advantages of private equity funding, a U.K.-based attorney covers the basic tax issues and compares tax treatment in the U.S. with that in the U.K.

Editor's Note: Congress isn't always attentive to corporate finance matters, so it's noteworthy that some members have seen a big target arising from the private equity boom: collecting tax from private equity fund partners at a far higher rate than they currently pay. Specifically, a bill would change the treatment of "carried interest" for buyout firms from the capital gains rate of 15 percent to an ordinary income treatment, at 35 percent.

For the following, we asked U.K. attorney Kevin Conway to discuss the structure and tax considerations of PE in the U.S. and U.K.

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Clearly, private equity and its tax advantages have been attracting considerable publicity and debate. For the purposes of narrowing the subject, the following briefly considers the tax issues that arise in the context of the setup, investment and distribution by a "typical" leveraged buyout fund ("the fund") investing outside the U.S., and whether the tax savings adopted could be applied outside private equity.

Fund Setup

In setting up the fund, one will seek to satisfy/ease regulatory requirements; be familiar for investors; and have an exit strategy for the interested parties (the fund manager and the investors). The fund is typically established as a limited partnership (LP) with investors investing as limited partners. The fund promoter/manager (the fund manager) is, or is behind, the general partner.

The constitution or form of the general partner (GP) will usually be a limited liability corporation (LLC) in the U.S. or a limited partnership (in the U.K. or U.S.). The fund manager normally makes a substantial smaller capital investment to the fund. In the U.K., the carried interest is normally held by another limited partnership as a limited partner in the fund.

Tax Benefits

A limited partnership is tax-transparent and does not introduce another potential layer of taxation between the investors and their investments and should not give rise to capital duty. LPs also provide certain other tax benefits (as discussed below).

This structure also allows for investors from many jurisdictions to join without having to favor one investor's jurisdiction over that of another. The location and activities of the general partner are important: the GP does not want investors to have a taxable presence outside their own jurisdiction.

In addition, the fund will have to ensure that the partnership is not treated as a publicly traded partnership, and if a non-U.S. partnership is used, an election is made to ensure it is treated as a partnership for U.S. tax purposes. A further benefit of a non-U.S. partnership is that it is not regarded as a U.S. person for U.S.-controlled foreign corporation (CFC) purposes. U.S. investors will also need to consider the passive foreign investment company (PFIC) rules.

Foreign limited partnerships are regularly used by U.S.-led international groups to perform a treasury function for the non-U.S. part of the group and to address certain U.S. CFC issues.

The foreign limited partnership enables the investor to repatriate its profit directly from outside the U.S. The investors in private equity are often U.S. tax-exempts (individuals or trusts) and may thus benefit from receiving non-U.S. income and/or gains directly.

Many U.S. international corporations will seek to minimize the U.S. tax on foreign profits or income by either reinvesting these outside the U.S. or repatriating them to U.S. and claiming foreign tax credits (while carefully managing this process).

However, with the U.S. tax rate at 35 percent, there is a risk of further U.S. tax in respect to repatriated income/profits before the shareholders receive their distribution.

The fund manager also commits its (their) personal efforts and investment expertise in return for an annual management fee, a return on their invested capital and an additional share of the profits, if any, generated by the fund, called the "carried interest."

The "carried interest" is a partnership interest that entitles its owner to a disproportionate share of the fund's profits. The carried interest normally entitles its holder to 20 percent of the fund's cumulative net profits after a basic level of return--the "hurdle"--has been achieved.

Sometimes the carried interest will have a "catch-up" mechanism that allows the fund manager to share fully in the fund's net cumulative profits after meeting certain conditions. The carried interest and a limited or reduced annual management fee seeks to align the fund manager's interest with that of the investors.

The receipt of the carried interest on setup is not generally treated as income under section 83 (of the Internal Revenue Code), on the basis of Rev. Proc. 93-27 and Rev. Proc 2001-43, provided certain conditions are satisfied. Draft regulations issued in May 2005 by the IRS propose changes to this treatment unless certain conditions are met, but they are not yet effective. (The tax treatment of the realization of the carried interest is discussed later.)

The annual management fee paid by the fund to the fund manager is treated as ordinary income when it is paid or accrued. Some fund managers have exchanged part or all of this right for an increased interest in the fund's profits. The intended tax treatment is that the fund manager will be taxed on the profit as a capital gain--thus, at a lower rate--and when the profit is realized.

Fund Investment Structure

The structuring of the fund's investments will take into account various regulatory, tax and legal factors. The investment ("portfolio") will normally be made through a combination of debt and equity. The debt may be in different levels of seniority such as senior debt, mezzanine debt and deeply subordinated debt (in the form of payments-in-kind, or PIKs).

The structuring of the portfolio considers all the usual tax procedures that a U.S. group investing abroad should take into account, including minimization of capital duties on entry, reduction of taxable profits (e.g., through the use of debt rather than equity), minimization of withholding tax on interest and dividends paid out of the portfolio and the best structure to deal with local taxes upon exit from the portfolio.

The main difference between many non-private equity-owned groups and portfolios is the amount of debt utilized by private equity. Due to financial assistance rules, acquisition debt cannot always be pushed into the operational companies. However, most jurisdictions allow, to varying degrees, a tax deduction for interest cost against income (whereas the capital cost is not generally allowed).

Furthermore, those tax jurisdictions allow for companies within the same economic group and tax jurisdiction to share certain tax attributes such that interest costs incurred above the target entity can be used by the operational companies to reduce their taxable profits.

In addition, and subject to local financial assistance laws, private equity will identify a business with existing and regular cash flows operating in a defined market, which enables it (along with other reasons) to raise substantial finance. In effect, and subject to local rules and limitations, the fund has replaced the target's previous equity (held by the selling shareholders) with a combination of tax-deductible debt and a smaller proportion of equity.

Sometimes, the portfolio will borrow to fund a dividend enabling the initial investment (or part of it) to be repaid. Whether the interest on such debt is tax-deductible will depend on the laws of the jurisdictions where the deduction is sought.

For many listed companies, the level of debt adopted by private equity funds would not be acceptable to their shareholders. Listed entities will require some of this income to pay dividends, although the borrowing structures should be available to listed entities. The benefit for the fund is that its investors are buying for a gain in overall capital value of their investment and not an income stream.

Exit Strategies

The exit of the fund from its portfolio can be brought about through many means, including: 1) a public offering; 2) a distribution from profitable entities within the portfolio; or 3) a sale of the whole or part of the portfolio to a trade or other private equity buyer. The tax treatment will vary accordingly, depending on the exit strategy.

* PUBLIC OFFERING/OUTRIGHT SALE: The public offering or outright sale of the portfolio is the simplest exit. The fund sells the portfolio and the investors make a gain or a loss. The gain or loss is not treated as income and thus may qualify for a lower rate of tax for individuals (15 percent, as opposed to 35 percent in the U.S.; 10 percent as opposed to 40 percent in the U.K.).

This tax benefit may be available to U.S. shareholders selling shares in listed entities, but not to U.K. shareholders. In the U.K., relief is available for shareholders in companies listed on the U.K.'s AIM market, provided certain other conditions are met. The advantage of the fund is that its structure does not impose an additional layer of tax, and there should be no local tax on the disposal of HoldCo or Local HoldCo (with Hold-Co having the benefit of a participation exemption, or similar treatment).

An initial public offering (IPO) or outright sale will have part of the debt of the portfolio regularly discharged or replaced; thus, the debt principal can be repaid from a nontaxable source.

* PROFIT DISTRIBUTION: Hybrid instruments (debt outside U.S./equity in U.S.) are often used by funds to bring back profits in a tax-efficient way. The repatriation is treated as a tax-free return of capital or redemption of an investment.

Furthermore, with proper planning, U.S. corporate tax on dividends can be reduced by either a credit for withholding tax or a credit for indirect foreign tax (when the U.S. corporation taxpayer has a minimum of a 10 percent holding in the portfolio), or if the dividends can be treated as "qualified dividends" for U.S. tax purposes for individual investors (but not corporations).

* SALE OF WHOLE OR PART: The U.S.-listed corporation is rarely seeking an exit for all of its investors and is more dedicated to long-term growth of value, combined with providing a level of income. This difference of objectives affects the permissible activities of the listed entity. The main tax advantage for the fund is that the profit is brought back directly to the investor without another entity level of tax (such as a U.S. corporation, even if that entity level of tax is minimized).

Assuming a payment is due in respect of the carried interest, it is taxed as a capital receipt in respect of the partnership interest held by the fund manager. Thus, for individuals subject to capital gains tax, it can be as low as 15 percent in the U.S. and 10 percent or less in the U.K. (This is the treatment being challenged in the U.S. bill.)

Across the Atlantic, U.K. authorities have also been looking at this tax issue, but haven't made detailed proposals and probably wouldn't act until, and if, the U.S. does.

One other strategy seen lately is that the fund manager sells parts of its business to another company and pays tax at 15 percent. The purchaser of the goodwill receives the management fees but amortizes the goodwill over 15 years. This would be difficult for listed entities to arrange.

While the objectives of a private equity fund differ from those of listed entities, there are many opportunities available to listed entities to manage their overall tax liabilities; however, maybe not to the same extent that the private equity firms can manage their affairs. As tax authorities all over the world seek to protect their tax base, tax and finance executives should continue to examine the tax benefits in the different jurisdictions in which they operate, across jurisdictions and particularly in the context of commercial opportunities for their businesses.

KEVIN CONWAY ([e-mail]) is a tax partner in King & Spalding LLP's London office and a qualified solicitor in England and Wales. He advises on the U.K. and international tax treatment of U.K. and cross-border corporate transactions, including private equity funds.

RELATED ARTICLE: TAKE AWAYS

** The tax advantages of private equity investments have attracted publicity on both sides of the Atlantic, where tax rates are favorable, though they differ somewhat in the U.S. and U.K.

** An LBO fund is typically set up for three reasons: to satisfy/ease regulatory requirements; create familiar for investors; and present an exit strategy.

** The main difference between many non-private equity-owned groups and portfolios (the PE investment) is the amount of debt utilized by PE.

** Removing the fund from its portfolio can be accomplished by a public offering, a distribution from profitable entities within the portfolio or a sale of the whole or part of the portfolio to a company or another PE buyer. Tax treatment varies, depending on the strategy deployed.