Taxation on Private Equity Funds
This article explains the fundamentals of private equity (PE) and tax structure for private equity funds.
In institutional portfolios, private equity can play a significant role. This is typically only a small portion of the overall return, but it can significantly contribute. Private equity funds finance unlisted companies in exchange for a share of the company’s equity. Assuming a majority stake in the company, the fund’s management team would then work alongside that of the company’s management team in order to achieve growth.
Private equity fund taxation
The US-based private equity fund sponsor must address the tax and other structuring issues at four levels: investor, fund, portfolio investment, and fund manager levels. For the vast majority of US investors, the following tax objectives will guide their decision to invest:
- The fund should be exempt from taxation.
- Passing through capital gains and losses, allowing for lower capital gains tax rates for individuals.
- Minimizing the allocation of “phantom” income (ie, profit allocation to the investor that is included as part of the investor’s taxable income without the investor receiving any cash).
- There are no tax reporting requirements outside of the United States
- Non-US gains are not taxed, or if they are taxed, they can be credited against US tax on the gain.
Understand private equity fund
A private equity fund is a pool of money that can be used to invest in companies that have the potential to generate a high return. In most cases, the PE firm expects to make a profit from its investment within four to seven years after investing. An IPO or sale of the company to another private equity firm or a strategic buyer are two options for exiting the business.
The majority of private equity funds are financed by institutional funds and accredited investors, providing long-term capital. All of the funds are raised and managed by an investment team from a single private equity (PE) firm.
Types of private equity funds
Private equity funds are typically classified into six distinct categories:
- Buyout funds – In contrast to venture capital funds, leveraged buyout funds invest in more established companies, often taking a majority stake in them. Leveraged Buyouts (LBO) funds rely heavily on leverage in order to increase their returns. Compared to VC funds, buyout funds are typically much larger.
- Venture capital funds – Small, early-stage, and emerging businesses with high growth potential but limited access to other forms of capital can benefit from venture capital funds. Venture capital (VC) funds are essential when raising capital for small start-ups with optimistic value propositions and innovative ideas. Although venture capital funds carry risks from investing in unproven emerging businesses, they have the potential to generate enormous returns for investors.
- Real estate funds – Partnerships are formed to raise equity for ongoing real estate investments in private equity funds. The fund is created by a sponsor, a general partner (GP). Limited partners (LPs) are asked to invest equity in the partnership by the sponsor. As well as money borrowed from banks and other lenders, the money they raise will be invested in real estate development or acquisition projects.
- Infrastructure funds – Most infrastructure private equity is the same as other types: companies raise money from outside investors (Limited Partners), use that money to buy assets, operate those assets, and then sell them to realize a high return on their initial investment. Limited Partners (LPs) and the General Partners (GPs) – represent the private equity firm and then divide the profits. All of these sectors fall under the umbrella of “infrastructure”, and they include transportation (roads, rail, airports, bridges, etc.); social infrastructure; utility distribution; and energy.
- Debts and special situation funds – Debt or structured equity investments are made with the goal of acquiring control of a distressed company. Secondary market trading, direct origination, and distressed debt are all examples of special situations in which the manager believes that price dislocation is present.
- Funds of funds – A fund of funds (FoF) is an investment strategy in which capital is invested in other funds rather than directly in assets, stocks, or bonds. A fund of funds is advantageous to investors because it spreads their money across various fund strategies, thereby reducing risk. Mutual funds and hedge funds are the most common investments made in this type of funding. Investors who are unable to meet the minimum capital requirements can gain access to these funds through a backdoor. These funds’ detractors point out the higher management fees (resulting from their composition of multiple funds) and the possibility that diversification without restriction may not always lead to the best strategy for multiplying returns.
How does private equity or fundraising work?
Private equity fundraising can be difficult. Making a checklist of tasks to complete is an efficient way of developing a compelling and consistent investment strategy. To make money, private equity investors do four basic things:
- Raise funds from Limited Partners (LPs), including pension and retirement funds, endowments, insurance companies, and wealthy individuals.
- To acquire a company, you must first find it, conduct due diligence, and finally close the deal.
- Their portfolio companies should improve operations, cut costs, and tighten management.
- Sell portfolio companies for a profit (i.e. exit them).
How does private equity fund taxation work?
Investments in private equity funds can be made in a variety of equity and debt instruments. There are many advantages to private equity funds. Still, one of their most important characteristics comes down to the fact that investors’ money is not traded on the stock market and cannot be purchased by anyone.
To raise private equity funds, institutional investors typically invest large sums of money for long periods of time since private equity funds are not available to everyone. This money can be used to raise new capital, make future acquisitions, fund start-ups or innovative technology, invest in other private companies, or strengthen an existing fund by a team of investment professionals from a specific private equity firm. High returns can be achieved by investing in private equity funds.
Economics of private equity funds
A private equity firm and its investors will negotiate the terms of the fund’s economics during the process of raising capital. It’s worth noting, however, that most funds stipulate how the fund’s earnings are to be put to use (known as the waterfall). As a first step, the fund’s general partner is entitled to a portion of the fund’s profits, which it typically uses to pay its fund manager’s management fee. Following receipt of the general partner’s share, the investors must receive a return equal to their original investment, as well as a return on that investment. To begin receiving their share of a fund’s profits, the fund’s management team will have to wait until the fund’s profits have grown large enough to begin receiving their share of the profits, which is known as a “carried interest”.
Taxation of returns
Tax transparency is another major factor in the limited partnership’s popularity as a private equity fund’s structure.
Unless the fund is losing money, the partnership does not owe any personal or corporate income taxes on the money it makes. As a result, the general partner, third-party investors, and management team members who hold carried interest should all be subject to the same taxation as if they held their share of the fund’s underlying fund assets in their own individual hands. If a pension fund receives a return from the fund, it would not be subject to tax because it is exempt from tax on investment profits and gains. However, an individual investor who receives dividend income would be subject to tax at the individual rate. Investing in a mutual fund as a group has not resulted in an additional layer of taxation.
Disguised Investment Management Fees (DIMF)
When it comes to taxes on fund managers, the application of DIMF (disguised investment management fee) rules has been critical. Generally speaking, any profit that a fund manager (or certain people associated with them) can realize from a fund for which he or she provides investment management services will be taxed as trading income (which means that income tax and self-employed national insurance contributions will be due), unless the profit:
- Is already a source of income for the economy
- Returns (whole or part) of an investment made directly or indirectly in the scheme or an arm’s length return on such an investment
- Carried interest is exempted under this provision
As a result of provisions in the Finance Act 2016, carried interest is exempt from income-based taxation but not from capital gains taxes (IBCI). When the fund does not hold its assets for a long enough period, HMRC considers carried interest a performance fee rather than an investment return, which is why IBCI rules were implemented.
According to the IBCI rules, if the average holding period of the fund’s underlying assets is less than 36 months, the entire carried interest is taxed as trading income, whereas, if it is more than 40 months, the entire carried interest is taxed as an investment return. At some point between these two points, the amount of the carried interest is taxed as trading income at a rate of 20% per month until the 40-month period has passed. Determining the average holding period of a fund is tricky because it depends on the underlying assets.
Private equity taxation can face a variety of VAT issues. Limited partnerships should not be treated as supplies for VAT purposes if cash is exchanged for a unit or interest in that partnership (i.e., an investment into the fund).
Although the transfer of an interest in a limited partnership fund is relatively simple, the VAT treatment of the transaction is not. When it comes to acquiring an interest in a fund, HMRC doesn’t think that it’s always outside the buyer’s tax bracket. While some partnership interest transfers are exempt from VAT, the HMRC treats others as tax subjects. However, whether or not the supply is exempt or out-of-scope may have an impact on the parties’ exemption methods and VAT recoverability in relation to their acquisition of private equity limited partnership interests.
Stamp duty and the Stamp Duty Reserve Tax (SDRT) must be considered when transferring private equity partnership interests. The following are some of the issues:
- Whether or not a partnership interest can be transferred with a stamp.
- Exactly how stamp duty is calculated.
- The repercussions of failing to stamp.
- It’s unclear whether or not it matters if it’s an international partnership.
- Whether or not partnership transfers are subject to the SDRT rules.
Tax lawyers are frequently tasked with reviewing fund documentation from a pure taxation standpoint.
The fund limited partnership agreement is an important legal document. An agreement that outlines the business and administrative responsibilities of the partners is called a partnership agreement. While it is common for a tax lawyer to review the tax sections of an LPA, it is important to read the entire document and ensure that all tax issues have been addressed.
Private equity tax structure considerations to pay less tax
Investing in private equity funds can be a bit confusing for people who aren’t familiar with the specifics of how the funds are organized and run. Private equity taxation structure considerations are outlined in the following section in order to save money on taxes.
- Structure the funds as a partnership – Limited partnerships are widely accepted as the most common legal form for private equity investments and private funds. Limited partnerships are ideal for private fund investments because of their ability to limit investors’ liability, their contractual flexibility, and tax-transparent treatment.
- Structure the fund as an outside corporation – When a fund is made up of several parallel funds, one or more of the parallel funds organized as a partnership under non-US laws may choose to be classified as a corporation for federal income tax purposes in the United States. Funds that only invest outside the United States should not be subject to US federal income tax as a result of this election. Still, investors who are in certain tax brackets may find it advantageous because it alters the US federal income tax consequences for them.
- Avoid the use of funds entirely – Separate investment management agreements with each investor are a choice made by some sponsors. Eliminating the Fund indeed provides greater fiscal transparency at the Fund level. Still, it also means that taxpayers will no longer be able to claim capital gains treatment for the Carried Interest (which raises deferred compensation issues).
- Organize the fund as a private real estate investment trust – In cases where a fund qualifies as a real estate investment trust (REIT) under section 856 of the Internal Revenue Code and distributes its income and gains within the appropriate time periods, federal income tax liability at the fund level may be eliminated.
- State and local taxes – Thorough knowledge of state tax laws and how they affect their businesses and potential investments is essential for investment advisors and managers. During the due diligence process prior to a purchase or sale, private equity funds must deal with the application of these state and local tax rules, which can have a significant impact on the deal. State and local tax rules can have a long-term impact on an acquired business, even if it is sold at some point in the future.
Manage your Private Equity with Eqvista
This article shows how carefully structuring a private equity investment can reduce tax implications on funds. Specific issues, such as choosing an investment scheme, investment manager compensation, and investor taxation, necessitate complex and detailed analysis.
With Eqvista, you can still make a private equity investment with minimal tax consequences, even as national governments become more aware of tax evasion in cross-border transactions. Effectively manage your private equity funds and shares with Eqvista! For more information, feel free to contact us and we will be happy to assist you.