How Transparent Is My Partnership?

Limited partnerships have been the vehicle of choice for private equity fund-raising in the UK. They are widely perceived as tax transparent, so that an investor limited partner is taxed in the same way as if he had participated directly. No other UK-based vehicle has the same level of investment flexibility and tax neutrality for private equity deals. However, experience indicates that more lies beneath the surface of "fiscal transparency" than meets the eye.

The foreign angle first. The growth of pan-European funds has revealed that not all jurisdictions recognise partnerships as transparent. Italy and France will in certain circumstances tax not only dividends and interest paid by companies resident there to non-residents, but also gains on disposals of shares accruing to non-residents. In principle, a UK resident would look to the Double Tax Treaty between Italy or France and the UK for some measure of relief or exemption. But an investor in a limited partnership would look in vain. The Italian Treaty confers benefits on "persons" which are resident of one or both of the contracting states, but the definition of "person" excludes partnerships which are not treated as corporate bodies for income tax purposes in either contracting states.

Most French double tax treaties reserve taxing rights in respect of capital gains to the shareholder's state of residence and confer other tax benefits (such as refund of the avoir fiscal and a reduced withholding tax). However, investment through a partnership will block treaty benefits for many non-resident investors, because the French authorities treat a partnership as the "tax owner" of the shares, but deny it treaty benefits as it is not a "person who is liable to tax".

This denial of treaty benefits means that UK private equity funds structured as partnerships need to approach investment in the Italian and French markets through an intermediate vehicle. A Benelux resident company would benefit from the double tax treaty between its home state and Italy or France and would not be taxable there on income or gains derived from its underlying investments by virtue of a participation exemption.

A more exotic possibility might be to invest in Italy through a holding company formed in the free trade zone of Madeira. In France a domestic (rarely used) solution might be to invest through a French Venture Capital Mutual Fund (FCPR) run in parallel alongside the partnership.

Even in jurisdictions where a traditional UK private equity limited partnership would be regarded as tax transparent, like Germany, managers of the fund need to be careful to ensure that the fund does not acquire a presence in the jurisdiction which could expose investors to tax there. German tax law will in certain circumstances impose tax on capital gains if a non-resident investor has a permanent establishment in Germany. The key here is to make sure that any presence of the fund in Germany does not amount to a "permanent establishment", most importantly by ensuring that there is no-one in Germany who has legal power to bind the partnership or who de facto does so.

In the UK, where fiscal transparency is accepted as a broad principle, issues still arise. There is a tax rule that treats partners as "associated" with other partners when measuring the level of a particular partner's stake in a company for certain purposes. One frequently used control test takes economic ownership into account as well as actual legal control and attributes to a person all the rights and powers of his associates (including his partners). This "partnership aggregation" rule can work itself out in some strange ways:

• An investee company may have the potential to be a "small company" (one with taxable profits below £1.5m), so that it pays corporation tax at a lower rate. The thresholds laid down for these purposes are reduced proportionately where a company has one or more associated company. Under the "partnership aggregation" rule, each company which is a member of a partnership that controls (has more than 50 per cent) an investee will be an "associated company" of the investee.
• The profits of a controlled foreign company (broadly speaking, a company resident in a low-tax jurisdiction controlled by UK residents) may be apportioned to and taxed on a UK-resident company which has an interest in the controlled foreign company (CFC). A non-resident company controlled by a venture capital limited partnership with a single UK partner would almost certainly fall within the UK control requirement. The Revenue has, however, indicated that as a general rule for private equity partnerships, there will be no CFC apportionment of profits, only a limited reporting requirement.
• An investee company could be treated as a "close" company (one controlled by five or fewer participators) or "connected" with investors for the purposes of the corporate debt tax regime and this brings certain special rules into play which would not apply if the partnership could be ignored. Two of the most notable are the rules which postpone tax relief for accruing discount on debt issued by a close company until redemption if the creditor is a participator in the company, and those which deny bad debt relief on a non-performing loan between connected parties. The Revenue has tried to deal with the latter point by Extra-Statutory Concession, but its operation is far from clear.

Most limited partnerships recognise income in their accounts on a cash basis, but the corporate debt and forex tax regimes require different bases of accounting so that tax and accounting profits are computed differently, This is a particularly acute issue where the allocation of income and gains between partners changes significantly from one period to another (most obviously, when any "hurdle" is cleared) and profits are taxed on one partner but allocated to another.

"Seeing through a glass darkly" is the phrase that springs to mind in answer to the transparency question: the shape of the image is clear, but the edges a little fuzzy. In time, it is hoped, the limited partnership will become the purely transparent investment vehicle many believe it already is.

This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.