The alternative investment industry and tax

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There are multiple tax initiatives at present that are changing the way international tax principles would be applicable going forward. This short article aims to describe how the new international and EU tax landscape may impact the use of special purpose vehicles (or “SPVs”) by the “alternative finance industries” (which will also be referred to in this article as non-collective investment vehicles or “non-CIVs”). A starting point is understanding the particularities that make these sector different from multinationals or collective investment vehicles (or “CIV”).

Thus, some of the most notable differences of the alternative finance industries as compared with CIVs include, the long-term nature of the investment and the majority stakes considered on targets (which require inter alia, a distinct manner of managing corporate affairs); the active management of the portfolio (which require inter alia flexible structures to integrate add-ons / execute carve-outs and need to accommodate management incentive plans that align with investors); the different size of target investments, sector specialization and regulatory constraints (not only at targets tier but also at investor’s tier which can be subject to regulatory constraints); the alignment needed with other stakeholders and un-related as management, debt providers or co-investors; the need to return capital to investors within a given period through the divestment of the portfolio; or the use of third-party debt (and the need to provide commercially viable structures for enforcement purposes).

There are, of course, also similarities. Same as CIV’s, non-CIVs aim to provide the highest return possible to their investors base through a proper asset selection, sector expertise and diversification policies. A common feature as well of the alternative finance industry, is the competition on the remuneration to Limited Partners (i.e. management & performance fees) and on this basis, the limited ability to transfer costs of all nature to their ultimate investors.

As highlighted throughout this article, these differences and similarities imply a need for a deeper degree of flexibility which require the further consideration of specific structures that address these varying needs. In this context, the use of SPVs by the alternative finance industry is needed to inter alia, set up a joint-venture vehicle with un-related parties; have a vehicle on which an un-related lender can agree a security package in an efficient manner; protect third-party debtors in a suitable jurisdiction; consider the SPV as the future vehicle for listing debt or equity in a suitable jurisdiction; the need to isolate risks and comply with internal (or external) diversification or concentration requirements, and/or the need to align incentives of the alternative finance industries with management of portfolio companies. All in all, it would be reasonable to state that each case is different, and the balance of tax and non-tax considerations can vary, and - on this basis, that such different fact patterns may give rise to different tax considerations.

Once considered this background, one can comment on how alternative finance industries’ SPVs are impacted by certain international tax developments. 

It is likely that the most relevant development could be the draft Anti-Tax Avoidance Directive 3 “ATAD3” (also known as the “Un-shell” Directive), but there are also relevant references in, inter alia, OECD MLI agreement under the “Principal Purpose Test” (and the reference to this principle to the well-known “Regional Investment Platform”); the application of the “beneficial owner” to CIVs and Non CIVs; and also references within OECD & EU Draft Pillar 2 Directive and EU DAC6 Directive. High Court cases in different jurisdictions have also addressed and considered SPVs in many well-known cases (e.g., ECJ “Danish Cases” are probably the most publicly known but there also some others on which it is suggested the role on non-discrimination rules could play within this industry).

Whilst the aim of these initiatives is, in simplified terms, to offer tax authorities tools in the fight against tax avoidance, in practice it is likely that their fragmented and unharmonized application may have inadvertently administrative and tax consequences for structures that are commonly used in the asset management industry. Let’s begin with ATAD3 (or UnShell Directive).

ATAD3 is an ambitious proposal aiming to introduce an objective set of rules for an otherwise subjective criterion – the “substance” any given entity should have – so that a given company, no matter which sector operates, can have to access benefits under Tax Treaties concluded between EU Member States and specific EU Directives (i.e., EU Parent Subsidiary Directive and EU Interest and Royalty Directive).

With this objective in mind, the initial drafting of the Directive (and the non-binding amendments proposed by the European Parliament in an opinion issued January 17^th, 2023) provided a detailed set of rules based on a minimum degree of “substance indicators” or “economic nexus” within a given jurisdiction so that a given entity is not classified as a “shell” company. Notwithstanding the above, EU Member States could go beyond this minimum standard and within the transposition process consider additional requirements and restrictions.

At this stage, it is not clear if Member States will be able to agree on the criterion to classify an entity as a “shell” and on the consequences (of entity being deemed a “shell”), which are currently up for debate. The compromise text might be a combination of disallowing EU Directive benefits and issuing a tax residency certificate with a notification that would act as a red flag for the receiving tax authority, therefore potentially prompting them to investigate the structure or payments made to the entity.

Setting aside the discussions held through the French, Czech, Swedish and the on-going Spanish presidency, the presumption of an SPV being a “shell” entity interestingly seems to rely in its material aspects that tie an entity to a given jurisdiction on a first instance (e.g. premises, bank accounts but also employees as the first exclusion criterion), and on the presence, expertise and independence of directors, rather than on the “business rationale” or “economic nexus” of an SPV as commented above. 

Nevertheless, an entity that fails to meet the fixed substance criteria could subsequently have the option of providing evidence as to the valid commercial reasons (i.e. “business rationale” or “economic nexus” as commented above) for which an entity has been established. However, this case-by-case analysis based on specific facts and circumstances, would only be available as a secondary defence. This sort of addressing this issue could result in significant compliance risks if the rebuttal process is not administered in an efficient manner (e.g. given the uncertainty surrounding the consequences of being deemed a shell entity, it is not clear at this stage whether any consequences would kick in despite the entity having submitted a rebuttal claim, meaning that an SPV that has failed the substance criteria may face consequences during the period of assessment of the rebuttal period, despite it being set up for valid business reasons that reflect economic reality). 

To address these issues, guidelines on what is expected of taxpayers in terms of evidence and a well-defined administrative process, including clear deadlines for the taxpayer and tax administration, would be much welcomed and would serve to reduce the uncertainty inevitably associated with the process.

All in all, the discussion is broader and there are also some parallel interesting academic literature debates in this respect.

One of these debates is about the concept of the tax residency itself. There is support in relevant academic literature ¹ (e.g., Escribano, Lipnieewicz) that suggest that one of the current challenges of the international tax framework is agreeing on a commonly accepted “tax residency” concept that works in multiple situations in a world where the concept of the tax residency of corporate entities is diluting due to factors such as decentralized decision-making process, digitalization, remote working, and the future automatization of business decisions within IA. In this author’s view, the attempt of ATAD3 to provide tax authorities in the EU with a harmonized set of criteria to test substance against – although a valid and brave one, could fall short in a few years if only material aspects link to “tax residency” aspects are key to determine the access of Tax Treaties (and EU Directives), and not a link to the business reasons or economic activity developed in each jurisdiction as commented in this article. In this author’s view, the way to address this concern could be to design the rebuttal process in much efficient and alternative manner than considered at present.

Another interesting issue is the relation between ATAD3 and the existing OECD concepts and notably with the OECD “Principal Purpose Text” (the PPT).

It is well known that the Commentaries to the 2017 OECD Model Convention have been enhanced to include several examples specifically addressed to how the PPT applies to the alternative finance industries (e.g., the so-called and well-known “regional investment platform”, securitization vehicle and real estate holding platform). Although this guidance was very welcomed, it is widely criticized as insufficient. Notably, the absence of a list of commercially acceptable business reasons that support the consideration of SPVs and/or a hierarchy or list of minimum substance requirements are particularly problematic in practice as they fail to address several common cases. ATAD3 partially shares this same uncertainty as it does not address the considerations that should be referred to in a rebuttal file submitted by an SPV of an alternative investment fund. It does not refer to OECD guidance in this respect as a possible source of guidance and/or validation.

The risk of this apparent lack of coordination is that two set of rules targeting similar objectives can produce a different outcome. The price to be paid would be the lack of legal uncertainty, and the costs of all kind associated with this uncertainty, notably in Europe.

The purpose of Pillar 2 is a different one from ATAD3. The OECD's Pillar 2 proposals and the corresponding EU Directive seek to introduce a minimum effective corporate income tax at an effective rate of 15% for large groups globally (for the sake of simplicity, we will be referring in this document to the Pillar 2 Directive). In summary, the minimum taxation rules would apply to multinationals (and domestic groups in the case of the EU Directive) that meet a EUR 750 million annual turnover threshold.

As an overarching comment, alternative finance industries may not be affected by the Pillar 2 rules where the “qualifying funds”, or their qualifying SPVs (further comments below), are not required to consolidate their portfolio investments for accounting purposes. As outlined in further detail below, “qualifying funds” would comprise an investment fund, pension fund, or real estate investment vehicle as defined by the Pillar 2 Directive.

There is a rationale for this: investors in “qualifying funds” for Pillar 2 purposes are generally taxed on the return that they obtain from the underlying investments. From a tax policy perspective, these “qualifying funds” were excluded from the scope of Pillar 2 so that the ultimate investors do not suffer the additional tax and administrative costs associated with complying with the Pillar 2 Directive.

With this rationale in mind, the definition and exclusions applicable to the qualifying SPVs of the “qualifying funds” are interesting and can be summarized as follows:

Interestingly it has been reported that under the Czech presidency of the EU Council, a proposal on ATAD3 was made to widen the list on excluded entities to SPVs of certain “qualifying funds”. It is not clear at present how much traction this proposal could receive, but an interesting aspect of this proposal is that it would align the role of the SPVs of the alternative finance industries within the international tax framework. Note in this respect that the exclusion of SPVs for Pillar 2 purposes is not linked to the concept of “substance” or “residency”. It is linked to the wider treatment of the “qualifying funds” for Pillar 2 purposes.  In this author’s view, this holistic approach is better aligned with the rationale that justify the use of SPVs as commented in this article.

On a separate matter, it is worthwhile noting that a previous international tax debate shed some light on the question on whether (and to what extent) CIVs shall be the beneficial owner of income (i.e. 2010 OECD CIV Report referring to commentaries to 2017 Model Convention on Article 1).  

In this Commentary, the OECD concluded that “(...) so long as the managers of the CIV have discretionary powers to manage the assets generating such income (…)”, the CIV shall be considered as the beneficial owner of the income.

The debate on whether non-CIVs (i.e., the alternative finance industries) shall follow the same rationale as CIVs was more complex. As pointed out by authoritative literature² (e.g. Calderon), the critical aspect for non-CIVs (with a reduced investor base as compared with CIVs) would be to prove the effective discretionary powers to decide on investments (and divestments) and manage the assets generating such income is exercised by non-CIV managers, as well as being able to evidence that the non-CIVs does not operate as a passive conduit without powers as regards the management of the underlying assets. Under these circumstances, non-CIVs should be considered as the “beneficial owner” of the income of its investments in a similar manner to CIVs. 

Finally, it is worth noting that many jurisdictions, including Spain, provide an exemption from taxation of qualifying income for local private equity industry within the local tax system.

There are recent pronouncements from High Courts (in Spain and, inter alia, also the lower-level courts in Italy) relating to CIVs (but only on minority shareholdings) that have found that Spanish tax rules that treated non-EU CIVs and non-CIVs differently in comparison to Spanish domestic CIVs were discriminatory from an EU law perspective. In this respect, it cannot be discounted that, in the future, an argument could be advanced that non-CIVs located outside of the EU should be treated equally as domestic private equity funds.

Moreover, in certain cases, the ultimate members of non-CIVs may have been able to access a Tax Treaty that would have exempted certain income, resulting in no taxation where the non-CIVs members had invested directly in the portfolio. In this author’s view, this is one of the most powerful arguments that the use of SPVs (when those SPVs are justified for non-tax reasons) is not abusive from a general tax avoidance perspective. Unfortunately, these arguments have not yet been accepted or included as possible escape clauses in the development of ATAD 3.

As discussions continue at pace on the design of ATAD 3, one of the main challenges faced is the need to achieve a wide consensus so that the initiative can be accepted and approved by each EU Member State. This requirement for consensus is also seen in the development of other EU tax initiative and creates risks of altering the main purpose of each initiative to find consensus, as well as creating at least an appearance of inconsistency and contradictions between different initiatives which were intended to address similar issues. In some cases, the apparent inconsistencies can be justified by the different nature and objective of the new tax initiatives, but there is a risk that the lack of consistency results in distortions and costs. 

It is difficult to predict the final wording of some of the OECD and EU initiatives that we have mentioned in this article above and how these rules would impact the use of SPVs by the alternative finance industries.

All in all, there are sound arguments to emphasize that the purpose and the role of the SPVs (notably when a third-party interests of a stakeholder exist) shall be prioritize when examining its merits; although it may have not yet deserved the proper attention needed to entitle their access to Tax Treaties and EU Directives in an efficient manner.