74 CHAPTER 5 Legal framework in the US and UK for equity investors LPs. Because they are listed companies, VCTs have no fi xed maturity, hence they are considered as perpetual investments. Only private individuals can subscribe to or buy shares in VCTs, which invest in trading companies by providing them with funds to promote development and growth. VCTs realize their investments and make new ones periodically; however, at least 70% of their investment portfolio is composed of unlisted com- panies. Fiscal incentive like participation exemption and reduction on earnings tax operates wider. VCTs are exempt from corporation tax on any gains arising from the disposal of their investments. The main difference between the VCT and the European closed-end is their transparency level. After investors have transferred their personal wealth into a Investors (private individuals) Trust Private equity investment money in money out FIGURE 5.3 Investing process structure of trusts in the UK. Trustee Investment 1 Investment 2 Investment n Venture capital trust Private investors Public offering and information memorandum Stock exchange FIGURE 5.4 Organizational structure of VCTs. 75 VCT, they are unable to infl uence decisions made by the trust or trustee man- agers. Closed-end funds are completely transparent as defi ned by the EU regu- lating framework, whereas the VCT is completely blind because investors are uninformed about the composition of the investment portfolio. Therefore, there is no disclosure of the trust’s investment activities. Another difference is that a VCT’s trend cycle shows no correlation with the London Stock Exchange. 5.3.3 Merchant banks Direct investment in equity is developed, even though they it is declining in vol- ume, within banks dedicated to merchant banking business. 10 Like the United States, the UK banking system is much more involved in the equity market through dealing and brokerage rather than advisory and placement. However, private equity investments through merchant banking are common during seed, start-up, and early stage fi nancing. 5.3.4 Business Angels As in the US market, Business Angels do not represent a legal cluster but are iden- tifi ed as equity investors devoted to sustaining seed and start-up fi nancing without a profi t goal. Since these investors do not generate profi t, they are represented by ■ High net worth individuals ■ Foundations ■ Research centers ■ Non-profi t societies ■ Corporations acting as donors 5.3.5 Dedicated public institutions These are joint ventures between private investors (corporations or fi nancial institutions) and public partners supported by a special local act dedicated just for them. Management rules are totally private, but some legal/fi scal ad hoc incentives are still in place. Unlike the SBICs operating in the US market, this type of investment vehicle operates at local levels under local laws with direct involvement by municipalities. Even though there is a profi t goal, social valuations are considered during investment decisions. 5.3 Rules for UK equity investors 10 Financial institution that engages in investment banking, counseling, negotiating mergers and acquisitions, and a variety of other services including securities portfolio management for cus- tomers, insurance, the acceptance of foreign bills of exchange, dealing in bullion, and participat- ing in commercial ventures. 76 CHAPTER 5 Legal framework in the US and UK for equity investors 5.4 CARRIED INTEREST AND MANAGEMENT FEE SCHEME: US AND UK SYSTEMS The only complete integration of UK countries with the EU framework occurs during the origin of costs and revenues. As described in Chapter 4, vehicles through which investments generate revenue include: ■ Capital gains from investments ■ Dividends and interests from investments ■ Interest from a deposit bank While costs include: ■ Losses from investment ■ Interest due for loans ■ Management fee to managers 11 ■ Carried interest to managers Considering the case of venture capital funds, revenues to general partners are the ■ Entrance fee from investors ■ Management fee ■ Carried interest While the costs general partners bear are the ■ Operating costs ■ Deposit bank fee ■ Percentage of management fee for the advisor ■ Percentage of carried interest to the advisory company for identifying the best opportunities in the market 5.4.1 Management fee This is a fee charged by the general partners to the limited partners. Management fees in a private equity fund are annual and calculated as a percentage of the 11 When considering LPs, the management fee goes to general partners who manage the company. 77 NAV 12 of the fund. Typically the fee ranges between 2 and 3.5% of the NAV, depending on the type and size of the fund. The general partners ’ management fee may vary over the life of the fund; it might decrease over time as the limited partners ’ original committed capital is paid back from investment returns. However, the higher the management fee, the lower the amount of money left for investment activity. The percentage of the NAV is a matter of negotiation between the general partners and limed partners, since it is in the investors, interest to pay a lower percentage of fi xed costs, which is just the opposite for general partners. Since the percentage is meant to cover all operating costs, it should not be too low. The management fee is a gross fee covering the operating expenses as well as paying the Advisory Company, the Technical Committee, fi xed costs, and the managers ’ remuneration. 13 5.4.2 Carried interest Carried interest is the general partner’s share in the profi ts of a private equity fund. Typically, a fund must return the capital received from the LPs before the general partner can share in the fund’s profi ts. The general partners then receive a percentage ranging from 15 to 40% of the net profi ts as “ carried interest. ” Like the EU framework, it is due when the fund matures. Carried interest is a percentage of the difference between the global IRR of the closed-end fund and a fi xed interest rate (hurdle rate or fl oor IRR) as defi ned at the starting date of the closed-end fund. Carried Interest Final IRR Hurdle Rate ϭϪ%[ ] Hurdle rates typically range from 5 to 10%. Carried interest and the fl oor rate are fi xed by the parties involved before the LP agreement is signed. They are determined after long negotiations between limited partners and general partners. By using a private agreement, a predetermined percentage of both the mana- gement fee and the carried interest can be transferred by general partners to the advisory company. There is a strong link between the reputation of the advisory company and the percentage obtained at the end of the disinvestment phase as capital gain. 5.4 Carried interest and management fee scheme: US and UK systems 12 NAV is the total value of the investment portfolio less any liabilities. 13 Salaries but not the capital gain. 78 CHAPTER 5 Legal framework in the US and UK for equity investors 5.5 CLAUSES SIGNED IN AN LP AGREEMENT Contrary to the EU countries, in the UK and the US there are no legal require- ments dictating private equity investment agreements. However, for the US and the UK, the national association of venture capitalists and private equity opera- tors have proposed some “ models ” of legal documents and agreements that can be used for private equity deals. The most common vehicle for private equity investment is the LP. Clauses typically signed in an LPA include: 14 ■ Parties — Identifi es each person or institution who takes part in the initiative ■ Introduction (or Recitals) — Explains why the LPA is signed ■ Defi nitions and Interpretation — A list of references and terms used throughout the LPA ■ Name and Place of Business — These self-explanatory statements are required by law, because an LP must have a name; the name and the principal place of business, together with other details, must be reported in the LPA ■ Establishment — Information in this section is related to the most impor- tant features of the LP organization and key people proposing the deal ■ Purpose of the Partnership — Fund description and the way general part- ners will carry on the fund’s investment activities; description of invest- ment strategy constraints and limitations ■ Duration of Partnership – Termination of Partnership — Life period of the partnership and rules or conditions for its termination ■ Capital and Loan Contributions — Specifi es the role and fi nancial commit- ment of LPs ■ Allocations, Sharing, and Distributions of Partnership Profi ts — Governs the order in which partners are repaid, partnership profi ts are allocated, the ratio in which the partners share profi ts between themselves, and how the profi ts are to be distributed to the limited partners and general partner ■ Carried Interest — How the manager calculates the general partner’s share of a private equity fund ■ Appointment and Removal of the General Partner — Specifi es under what conditions a general partner is appointed and/or removed from his position 14 See the British Venture Capital Association Web site ( http://www.bvca.co.ukwww.bvca.co.wk ) and the American Venture Capital Association Web site ( http://www.nvca.orgwww.nvca.org ). 79 ■ Powers, Rights, and Duties of the General Partner — Rights and duties of the general partner; the general partner is authorized to do everything nec- essary to operate the partnership ■ Powers of Limited Partner — Limited partners are excluded from managing the partnership to ensure their limited liability against creditors; other pow- ers cannot be generalized and are specifi ed in every agreement ■ Withdrawal of Partners — Rules for when a partner wants to leave the partnership or the partnership wants to expel the investor from the partnership ■ Borrowing and Bridge Financing — Rules for the LP fi nancial management ■ Fees and Expenses — Rules concerning the calculation of the management fee, establishment costs, transaction costs, fee income ■ Accounts and Reports — Documents and information prepared by the manager for the limited partners and investors ■ Consents, Meetings, and Votes — Constraints on the general partner’s pow- ers or topics requiring the limited partners ’ consent before the execution ■ Representations and Warranties ■ Deed of Adherence — An extra form (not compulsory) attached to the back of the LPA; it is the formal means by which most investors become limited partners specifying the number of commitment units and how these commitments are divided between capital contribution and loans ■ Miscellaneous Legal Issues — Governs law and jurisdiction, power of attor- neys, confi dentiality, notices, etc. 5.5 Clauses signed in an LP agreement This page intentionally left blank 81 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Taxation framework for private equity and fi scal impact for equity investors 6 INTRODUCTION This chapter presents the role of taxation in private equity and venture capi- tal throughout Europe and the US. A deep theoretical and analytical analysis country by country will be demonstrated in the following sections The fi rst sec- tion shows how the private equity and venture capital industry is tax sensitive, underlining the role of policymakers, and that the taxation technique and its application must always be considered together. In Sections 6.2 and 6.3, analyze taxation models and defi ne areas of taxation for investors, vehicles, and com- panies requiring funds who conduct private equity and venture capital deals. Section 6.4 proposes a comparative analysis of the tax system for European countries and the United States underlining the differences between corporation taxes, withholding taxes, and personal taxes applicable to fi nancial incomes. Focusing attention on the private equity and venture capital industry, the EVCA position is analyzed and reviewed. Finally, the last section analyzes taxation on vehicles used to implement private equity and venture capital deals and the interrelation of taxation on vehicles, investors, and companies in the EU. 6.1 FUNDAMENTAL ROLE OF TAXATION IN PRIVATE EQUITY AND VENTURE CAPITAL Policymakers play a fundamental role in private equity and venture capital devel- opment. They must address regulatory and administrative barriers and ensure CHAPTER 82 CHAPTER 6 Taxation framework for private equity and fi scal impact coherent policies. This enables investors to provide a continuous fi nancing cycle for start up, spin off, company development, transition, and buyout invest- ments to create taxable value or returns (see Figure 6.1 ). Investors should be considered in the valuation framework of investment strategies used to allocate fi nancial sources, taxation, and the entire country taxation system. Private equity and venture capital portfolios are structured to trade off the risk and return from diversifi ed combinations of assets and are infl uenced by institutional and regulatory factors where taxation is essential. As noted in previous chapters, the private equity industry is regulated on a national basis in most EU member states: there is no cohesive framework for private equity at the EU level, and a number of EU legislative measures indirectly Saving accounts, pension plans, insurance contracts Institutional investors (insurance companies pension funds, banks ) Private equity and venture capital funds investments commitments savings and pensions pensions and savings repayments + capital gains divestments High-potential companies High growth markets Entrepreneurship Single fund structure Private equity and venture capital funds Institutional investors (insurance companies pension funds, banks ) FIGURE 6.1 Financing cycle of private equity and venture capital ( http://www.evca.com-www-evca-com ). 83 affect the industry, such as MiFID, UCITS, the Pension Funds Directive, and the Basel II Principles or Capital Requirements Directive. The entire fi scal policy is local, so every government and every country legislates autonomously. In this environment, it is very diffi cult to fi nd a strictly defi ned tax system for investments of private equity operators and venture capitalists, because the fi s- cal systems are wider than the regulations of this industry. In a general structure, government policies supporting the development of private equity and venture capital industry may be direct or indirect and related to the supply side rather than the demand side. 1 Figure 6.2 illustrates how important the fi scal environment is and how gov- ernments can make investing easier for both fi rms and fi nancial institutions. Tax policies shape incentives for private equity and venture capital to approve par- ticular types of fi nancing. Whatever these fi rms decide, i.e., capital gains taxes or investment subsidies, it has to solve a double moral hazard resulting from a joint effort. Entrepreneurs tend to focus on technological aspects such as product d evelopment, whereas fi nancial institutions draw on their commercial experi- ence and industry knowledge to provide managerial support and to promote the deve lopment of the fi rm. To reduce all potential risks and biases, an equity con- tract becomes necessary. However, it is ineffi cient when both parties equally invest in a deal, but must share the total results and each party is taxed differ- ently. The effects of taxation are interesting to evaluate; for example, the intro- duction of a uniform capital gains tax on both entrepreneurs and fi nanciers delays entrepreneurship, while increasing incentives for the fi nancier. On the other hand, an investment subsidy boosts entrepreneurship but depresses total returns thereby diminishing incentives for private equity support. 6.1 Fundamental role of taxation in private equity and venture capital 1 See Caselli S., Gatti S. (2004). Venture Capital. A Euro-System Approach. Springer-Verlag, Berlin London. Demand side Supply side Direct intervention Public incubators Public private equity or venture capital funds Tax policy Promotion of enterprise, management, technology park, incubators Tax policy Indirect intervention Upside leverage schemes Promotion of financiers’ network Exit or fund’s operating scheme Downside protection scheme FIGURE 6.2 Government options to improve the private equity and venture capital industry. [...]... demand side of private equity business, and from the government’s perspective, they develop deals with the intention of improving the private equity and venture capital industry So fiscal policies increasing the entrepreneurship trend are specific and implemented as fiscal incentives for start up, investments in R&D, or investments in general assets 86 CHAPTER 6 Taxation framework for private equity and. .. equity and venture capital industry Necessity of permanent establishment Presence of any fiscal incentive meant to encourage investments in private equity and venture capital Capital gains and income tax for private individuals and entities Taxation of carried interest Figure 6.5 illustrates that the European fiscal system is still far from being standardized The fiscal policy does not develop the private equity. .. R&D investments are not relevant for investors and vehicles They are only relevant for Vehicle to invest Capital gains Earnings Investors Capital gains Earnings Companies Incentives for start up and R&D Comparative advantages D/E Domestic or cross border environment FIGURE 6.3 The link between taxation and private equity players Vehicles to invest Investors Company demanding capital Taxation on capital. .. than for investing in R&D In the United States different ways to invest in private equity and venture capital can be found Deals can be run by ■ ■ ■ Venture capital funds SBICs (small business investment companies) Business Angels Venture capital funds refer to a pooled investment vehicle, very often a limited partnership (LP) that primarily invests the financial capital of third party investors in enterprises... from the investment and asset side of the balance sheet, but also to provide incentives or disincentives to use a particular source of funding, i.e., debt rather than equity Taxation rules for investors and vehicles are primarily defined by earnings and incomes related to private equity or venture capital investments and capital gain or loss, potential or effective, coming from the purchase and the sale... framework for private equity and fiscal impact Taxation for private equity and venture capital is analyzed considering the ■ ■ Taxation technique Application area Section 6.2 analyzes the taxation technique and taxation, while Section 6.3 defines areas of taxation for investors, vehicles, and companies requiring funds who conduct private equity and venture capital deals 6.2 TAXATION AND EQUITY INVESTORS:... 6.7) Investment vehicles, investors, and companies demanding capital round out the fiscal picture Private equity and venture capital investment each have different vehicles (i.e., closed-end funds or investment firms) and the presence of two fiscal frames: ■ ■ Flat tax system for closed-end funds Participation exemption on capital gains and earnings for investment firms Closed-end funds do not pay ordinary... sale of a firm In Figure 6.3 the links between domestic and foreign groups are outlined Relevant models of both taxation and incentives can be linked to many players in the private equity market (see Figure 6.4): Vehicles to invest (closed-end funds, limited partnerships, etc.) Private and corporate investors Corporations demanding private equity capital Generally measures implemented as incentives to... Taxation framework for private equity and fiscal impact If income originates from closed-end funds, private investors (domestic or foreign) do not pay taxes on capital gains, whereas domestic legal entities pay taxes using a tax credit of 15% on the capital gain Foreign legal entities do not pay taxes in Italy, only in their domestic country If incomes originate from investment firms, private investors (domestic... dividends and capital gains is exploitable only under certain conditions, including a holding period longer than 18 months where the main activity of the company acquired is not real estate There are two ways to compare investment vehicles in Italy Investment firms have higher revenues coming from capital gains and earnings, whereas closed-end funds have a higher increase in market value of shares during . dealing in bullion, and participat- ing in commercial ventures. 76 CHAPTER 5 Legal framework in the US and UK for equity investors 5. 4 CARRIED INTEREST AND MANAGEMENT FEE SCHEME: US AND. wealth into a Investors (private individuals) Trust Private equity investment money in money out FIGURE 5. 3 Investing process structure of trusts in the UK. Trustee Investment 1 Investment. funding, i.e., debt rather than equity. Taxation rules for investors and vehicles are primarily defi ned by earnings and incomes related to private equity or venture capital investments and capital