Private Equity Comment – Topical and incisive commentary on legal and tax developments for the European Private Equity community – One of the key objectives of any private fund structure is to eliminate the risk of double taxation. The reason is simple: so far as possible, investors want the same tax treatment as if they had invested directly into the underlying portfolio company. Of course, there will normally be tax to pay at the underlying company level, and – unless the investor is exempt from tax in its home state – when it receives returns on its investment, but fund managers will look for ways to minimise tax at the level of the fund. That is why tax exempt vehicles (such as UK Investment Trusts) or tax transparent structures (such as limited partnerships) are usually chosen.

Unfortunately, it is notoriously difficult to achieve this “tax neutrality” in Europe, despite the fact that there is, in theory, a “single market” across the EU. That is because each of the member states retains sovereignty over its own tax affairs and, except in limited circumstances to ensure compliance with EU laws, the European legislature has no power to intervene. The result is a very fragmented tax system, relying on “double tax agreements” negotiated by individual member states, each protective of its own tax base. This has long been identified as an obstacle to cross border venture capital activity in the European Union.

The European Commission says that it is keen to promote venture capital investment in Europe, and has a number of initiatives – dating back over a decade – to identify ways to stimulate “risk capital markets” (even if that objective seems at odds with some provisions of the more recently proposed Alternative Investment Fund Managers Directive). Aware of the tax issues, in May 2007 the Commission established an “expert group” to review the tax obstacles to venture capital in Europe, and their report, published last week, asks member states to take concerted action.

Solutions to two main issues are proposed in the report. The first is a recommendation that the activities of a venture capital fund manager in a member state should not cause the fund (or its investors) to have a “permanent establishment” – and therefore a local taxable presence – in that state. In practical terms, this would do away with the need for local teams to act as ‘advisers’ to the fund only, which can be cumbersome, and allow local teams to take on a direct management role instead. The recommendation further suggests that management fees would be apportioned between the states in which management takes place in order to ensure that a fair proportion of it is taxed in the local jurisdiction.

The second suggestion is to counter the problem that venture capital funds may be treated in different ways for tax purposes by the different Member States (for example, as transparent or non-transparent, trading or non-trading, and subject to tax or not subject to tax), which can also lead to double taxation. The report recommends that all Member States should recognise the tax classification of a venture capital fund applied by the Member State in which the fund is established.

The expert group argues that these changes in approach by individual tax authorities are the best way to reduce the risk of double tax for investors, and would lower the transaction costs of cross-border investments by rendering complex advisory structures redundant. This would stimulate greater investment in early stage and growth companies across the EU.

The expert group report is an important contribution to the search for a more efficient single market for investment in Europe, and it is to be hoped that national governments will take careful note. Of course, that will require them to take a medium term and enlightened approach to tax policy, something which is perhaps harder – but more vital – than ever.

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