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‘People often forget tax when it comes to ESG, but it has emerged as an important element’

ESG minded investors now expect managers and their portfolio companies to conduct their tax affairs in a sustainable manner, writes Elena Rowlands of law firm Travers Smith.

Over the last few years, we have seen a host of new tax rules aimed at increasing the amount of transparency and disclosure.

Tax authorities have focused on strengthening requirements for disclosure of information, particularly where information must be shared between tax authorities on an international basis. That trend generally started with the US Foreign Account Tax Compliance Act back in 2010 and then it expanded with the Organisation for Economic Co-operation and Development’s Common Reporting Standard and, more recently, mandatory disclosure rules.

Elena Rowlands

These provisions are designed to allow the exchange of information between tax authorities of different countries to help stop tax avoidance and evasion. This created a huge administrative burden for private equity fund managers. New developments, such as the new base erosion and profit shifting framework known as BEPS 2.0, will likely result in firms having to provide even more information.

There are also greater requirements to disclose information to taxpayers who need that information for their own tax compliance purposes. In a private equity context, portfolio companies will often require information about fund structures, as well as the profile of investors, to file their own tax returns, for example where anti-hybrid rules are in point. That has been a real headache, because typically private equity fund managers are reluctant to disclose information about their investors out of concern for confidentiality.

Then there are requirements to disclose tax information to the public. This is quite a new area. For example, the UK introduced rules which require large businesses to publish their tax strategy and set out their approach to tax planning. Similarly, the EU is introducing public country-by-country reporting rules. This will result in enhanced public scrutiny of large businesses and their tax positions.

An ESG issue

People often forget tax when it comes to ESG, but it has emerged as an important element. Investors focused on ESG now expect fund managers and their portfolio companies to conduct their tax affairs in a sustainable manner. That’s measured in terms of good tax governance and in companies paying a fair share of tax. Public disclosure of funds’ approach to tax, the amount of taxes they and their portfolio companies pay and where those taxes are paid are all important elements of sustainable tax practices.

Generally, private equity doesn’t always have the best reputation amongst the public from a tax perspective, particularly where a fund is established in an offshore low tax jurisdiction. But there is a fundamental misunderstanding around how private equity is structured. The key aim from a tax perspective of any fund structure is that investors shouldn’t be worse off going into a fund structure versus going into the underlying portfolio companies directly.

So, there will be more scrutiny, but that should be matched by a better understanding among the public about what private equity is trying to achieve. After all, a private equity fund structured as a Cayman limited partnership will be tax transparent in the same way as an English limited partnership or a Luxembourg limited partnership.

Determining the right approach to tax transparency can be quite complicated and there isn’t yet a commonly agreed standard as to what constitutes good tax transparency reporting. Some investors have introduced their own tax policy and require specific tax terms when investing in private equity funds.

We increasingly see investors asking for side letter provisions on tax, which is a relatively new trend. In the side letter, the investor will outline its tax policy and state its expectation that the manager conducts the affairs of the fund in accordance with that tax policy. This can be difficult in practice given the aim to maximise investor returns and the obligation of the manager to act in the best interest of all investors rather than one particular investor.

This article first appeared as part of a sponsored commentary in affiliate publication Private Equity International.