The impact of the Principal Purpose Test on the private equity sector

Private Equity Insight/Out #1 | by Audrey Legrand, Tax Director, Deloitte

by Audrey Legrand, Tax Director (specialising in M&A), Deloitte

“Luxembourg will increasingly become the preferred location for funds and investment platforms”

Luxembourg signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”) on 7 June 2017 and indicated its intention to apply it to all its double tax agreements (“DTA”), provided the other party is also a signatory of the MLI and has opted to apply the principal purpose test (“PPT”).

Purpose of the PPT

Article 7 of the MLI and Paragraph 9 of Article 29 of the 2017 OECD model convention set out the principles according to which, the benefits of a tax convention should not be available where one of the principal purposes of certain transactions or arrangements is to secure a benefit under a DTA, and obtaining that benefit in these circumstances would be contrary to the object and purpose of the relevant provisions of the DTA.

What are the benefits that can be denied?

A benefit, as targeted by Paragraph 9 of Article 29, includes all limitations on taxation imposed on the State of source (e.g. a tax reduction, exemption, deferral or refund) or the relief of double taxation, such as, for example, limitations on the taxing rights of a State in respect of dividends, interest or royalties arising in that State and paid to the resident of the other State or over a capital gain realised by the alienation of movable property located in that State by a resident of the other State.

Example of PPT application in the private equity sector

The OECD gave illustrations of how the local tax authorities could assess situations to determine whether the benefit of the DTA should be granted or denied in light of Paragraph 9 of Article 29. According to the OECD, such examples shall not be construed as being more than mere illustrations. Nevertheless, aligning an organisation’s business operating model to resemble the examples given by the OECD cannot per se be detrimental.

The example that appears to be the most relevant to the private equity sector concerns a “regional investment platform”. In this example, a company resident of State R (“RCo”) is a wholly owned subsidiary of an institutional investor, an investment fund established in State T and subject to State T’s regulation (the “Fund”). The example details that RCo operates exclusively to generate an investment return as the regional investment platform, through the acquisition and management of a diversified portfolio of private market investments located in countries in a regional grouping that includes State R. The example further clarifies that the decision for establishing the regional investment platform in State R was driven by (i) the availability of directors with knowledge of regional business practices and regulations, (ii) the existence of a skilled multilingual workforce, (iii) the State R’s membership of a regional grouping, and (iv) the extensive DTA network of State R, including its DTA with State S, which provides for low withholding tax rates.

In terms of substance, the OECD notes that: (i) RCo employs an experienced local management team to review the Fund’s investment recommendations and performs various other functions; depending on the case, the other functions may include approving and monitoring investments, carrying out treasury functions, maintaining RCo’s books and records, and ensuring compliance with regulatory requirements in States where it invests; and (ii) RCo’s board of directors, appointed by the Fund, comprises a majority of State R resident directors with expertise in investment management, as well as members of the Fund’s global management team. RCo pays tax and files tax returns in State R.

While the OECD further elaborates that the intention of DTAs is to encourage cross-border investments, it also outlines the necessity of considering the context in which the investment was made. The context can include the reasons for establishing RCo in State R, the investment functions, as well as the other activities carried out in State R.  The OECD concludes that, on these facts, it would not be reasonable to deny RCo the benefit of the State R-State S DTA in the absence of other facts or circumstances, showing that RCo’s investment is part of an arrangement or relates to another transaction undertaken for the principal purpose of obtaining the benefit of the DTA.

This illustration tends to support the investment scheme having the following core elements located in one single jurisdiction: (i) the regional investment platform whose shares would be held by the institutional investor, (ii) the SPVs holding the investments, and (iii) the service company in which the substance could be pooled and the core commercial activities be conducted and sub-delegated to the SPVs, rather than the old investment scheme where each local investment would be held by a local SPV whose shares would be held by the institutional investor.

The choice of the jurisdiction in which the platform would be established would then be based on multiple factors such as political stability, the legal framework adapted to business needs, the possibility of hiring qualified personnel, as well as, of course, a robust DTA network. At Deloitte, we believe that Luxembourg offers all of this and that, in the future, Luxembourg will increasingly become the preferred location for funds and investment platforms, and it seems that our clients, the major private equity players, are of the same opinion as we accompany them in the different aspects of their move toward an organisational substance similar to that described above.