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Private Equity Fund Structures: Are There Real Tax Benefits?

27 February 2010   (0 Comments)
Posted by: Author: Ana-Celia Mendes
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Private Equity Fund Structures: Are There Real Tax Benefits?

It all depends on the investors…

One of  the objectives in structuring a private equity fund is to ensure that the liability for taxes is not on the fund vehicle itself but on the investors in the fund. Private-equity funds are therefore usually fiscally transparent, and in South Africa, private equity funds are generally arranged either as an en commandite partnership, or as a bewind trust.

Where all the investors in the fund and all the investments of the fund are local, from a tax point of view, there are, in our view, no significant advantages or disadvantages of one structure over the other. This is different where the fund has foreign investors or makes foreign investments (this situation is not dealt with in this article).

Tax is often raised as a disadvantage of the en commandite partnership structure as realisation gains on the disposal of shares are subject to tax in South Africa. In the context of a private equity fund, realisation gains are usually treated as being of a capital nature even where the relevant shares where not held for a period of three years prior to the date of disposal, and therefore do not qualify for the deemed capital treatment.

When a partner joins or leaves a partnership, which may happen in the context of a private equity fund (particularly on a second closing of the fund), the partnership automatically dissolves and a new partnership between the new partners is established. Under strict common law principles, the partners in the old partnership are considered to have disposed of their interest in the partnership assets to the partners in the new partnership.

As partners in a partnership are considered connected persons in relation to each other, the disposal would most likely be deemed to take place at market value. There-fore, in terms of strict common law principles, if the fund has made investments prior to the second closing and there is an increase in the market value of the partnership assets (from the date that the assets are acquired by the partnership and the date that a new partner enters the partnership), the old partners would be deemed to have disposal of their underlying interest in the partnership assets (at their market value on the date that the new partnership is formed).The result is a potential tax cost to the old partners in a cashless transaction.

However, SARS has indicated in its Comprehensive Guide to Capital Gains Tax (the CGT Guide) that for practical reasons it is not intended that this strict legal approach be followed. Instead, each partner must be regarded as having a fractional interest in each of the partnership assets.

According to the SARS approach in the CGT Guide, when a new partner joins the partnership,the existing partners are treated as having disposed of a part of their interest in the partnership assets and a capital gain or loss must be determined, but only in respect of the part disposed of. As the disposal will be to a partner, it will be to a connected person, which means that it will be deemed to take place at market value. Therefore, even in terms of the SARS practical approach where a new partner enters the partnership (say on a second closing), the old partners may have a CGT liability—even though they do not receive any proceeds from the new partner joining the partnership.

The situation in the case of private equity funds established as bewind trusts is similar. In a bewind trust, the investors in the private equity fund are the trust beneficiaries, who own the under lying trust assets but relinquish control of the assets to the trustees who, in turn, appoint a manager to identify and make investments.

As the investors are direct part owners of the trust assets, if new investors are introduced on a second closing of the private equity fund, and the fund has already made investments, the old investors will dispose of a portion of their interest in the fund assets. Since the disposal will be to a new investor and a beneficiary of the trust, it will be to a connected person, which means that it will be deemed to take place at market value on the date that the new invest or becomes a beneficiary of the trust.

Again, where an investor enters the fund as a beneficiary of the trust, the old investors may have a CGT liability even though they do not receive any proceeds from the new investor joining the fund—but only in respect of the part of the trust assets disposed of.

The SARS practical approach stated in the CGT Guide is not law,and a court could choose not to follow this approach. However, in our view, it is unlikely that SARS would tax partners in a partnership when partners enter or leave the partnership in a manner which is contrary to what is stated in the CGT Guide. Therefore, in our view, there are no significant tax advantages or disadvantages of the bewind trust structure over the en commandite partnership structure for private equity funds, where the investors and investments are all South Africans.The preferred private equity fund structure will therefore depend more on the commercial and other legal (non-tax) considerations.

Source: By Ana-Celia Mendes (Taxbreaks)


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