Private Equity and Venture Capital in Europe_5 doc

As described in Chapter 4, vehicles through which investments generate revenue include: ■ Interest from a deposit bank While costs include: ■ Carried interest to managers Considering t

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)

Venture capital trust

Private investors

Public offering and information memorandum

Stock exchange

FIGURE 5.4

Organizational structure of VCTs

VCT, they are unable to infl uence decisions made by the trust or trustee 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

man-is no dman-isclosure of the trust’s investment activities Another difference man-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 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

5.3.5 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

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:

■ Interest from a deposit bank

While costs include:

■ Carried interest to managers

Considering the case of venture capital funds, revenues to general partners are the

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 IRRHurdle Rate]

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 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

mana-5.4 Carried interest and management fee scheme: US and UK systems

78 CHAPTER 5 Legal framework in the US and UK for equity investors

Contrary to the EU countries, in the UK and the US there are no legal 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

require-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

■ 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 tant features of the LP organization and key people proposing the deal

impor-■ Purpose of the Partnership — Fund description and the way general ners will carry on the fund’s investment activities; description of invest-ment strategy constraints and limitations

■ Carried Interest — How the manager calculates the general partner’s share

of a private equity fund

■ 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

pow-■ 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

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81 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals

Taxation framework for

private equity and fi scal

INTRODUCTION

This chapter presents the role of taxation in private equity and venture 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

AND VENTURE CAPITAL

Policymakers play a fundamental role in private equity and venture capital opment They must address regulatory and administrative barriers and ensure

devel-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

FIGURE 6.1

Financing cycle of private equity and venture capital ( http://www.evca.com-www-evca-com )

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 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

gov-or investment subsidies, it has to solve a double mgov-oral 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 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

experi-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

Direct intervention Public incubators Public private equity or venture capital funds

Tax policy Promotion of enterprise, management, technology park, incubators

Tax policy

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

84 CHAPTER 6 Taxation framework for private equity and fi scal impact

Taxation for private equity and venture capital is analyzed considering the

AND RELEVANT MODELS

There is a strong relationship between taxation rules and private equity market development; evidence demonstrates a strong, worldwide correlation between specifi c tax benefi ts and the increase of private equity volumes Examples include:

Taxation on capital gains

Taxation on earnings and dividends

Fiscal incentive to start up

Fiscal incentive to R & D investment

Capital gain is a value greater than zero defi ned as the difference between the fi nal and the initial value of the equity participation bought by private equity operators Earnings are usually defi ned as the gross difference between revenues and all monetary and non-monetary costs However, the defi nition of earning may be a little different and considers only some of the types of revenues and costs For example, the EBITDA is a type of earning — more precisely, it is the earning before interest, tax, depreciations, and amortizations — while EBIT is the earning before interests and taxes

Taxation of both capital gains and earnings may be different, so there are various modalities of realization:

■ Transparency taxation approach

Participation exemption schemes provide shareholders with an exemption from taxation on dividends received and potential capital gains arising on the sale of shares Dual income tax schemes consider two types of income to tax For every fraction of the whole income a particular percentage of taxation is applied,

In transparency taxation systems generated income is not taxed thus ing transparent from the tax system’s perspective These incomes are relevant for people (or organizations or entities) who receive them, and they are taxed

becom-by different rules

There are various modalities of fi scal incentives to start up a business:

Carry back and carry forward

Temporary taxation rate mark down

Shadow costs usage

Carry back and/or carry forward are tax benefi ts that allow business losses

to be used to reduce tax liability in previous and/or following years In many cases, there is a maximum number of years to recover losses or use tax ben-

efi ts Another entrepreneur incentive is the temporary reduction of the whole tax rate, where the cut is often linked to the amount of invested sources A third way to spur entrepreneurs is the creation of a shadow cost system In this sys-tem, the fi scal provision supports the indirect cost, which is often concealed and linked to investments Examples of shadow costs are downtime, administra-tive costs, learning costs, etc

AND COMPANIES DEMANDING CAPITAL

Taxation and incentive rules may be applied to all companies, vehicles, and investors participating in a private equity or venture capital deal Usually, there

is a distinction between rules for companies and rules for vehicles and tors A different set of rules is applied if one or both of the deal participants are domestic or foreign

Among the companies, investors, and vehicles, companies are the easiest whole to identify Companies are the demand side of private equity business, and from the government’s perspective, they develop deals with the intention

sub-of improving the private equity and venture capital industry So fi scal policies increasing the entrepreneurship trend are specifi c and implemented as fi scal incentives for start up, investments in R & D, or investments in general assets

6.3 Taxation players