What is the issue?
International tax laws are changing. Using a special purpose vehicle ("SPV") in a "tax-friendly" onshore jurisdiction that has a good treaty network may no longer mitigate local withholding (and other) taxes.
Why is it relevant to me?
Without the necessary "substance", local tax authorities may deny tax relief under their treaties, either under their own domestic practice, pursuant to the principal purpose test ("PPT") or limitation of benefits test ("LoB") in double taxation treaties, or otherwise. In addition, foreign tax authorities may also claim that the SPV is resident for tax purposes in their jurisdiction (for example, because the place of effective management of the company is located in that other jurisdiction), and this could lead to increased tax leakage within the structure and an additional compliance burden for the fund managers.
In more detail…
Whilst offshore substance regulations (discussed in Offshore Tax Substance for Investment Fund Managers) may not apply to SPVs due to the availability of exemptions for collective investment schemes, the use of SPVs without sufficient local economic substance can be seen as "treaty shopping" by tax authorities. As a result, on the back of OECD's BEPS Action 6, and the new PPT and LoB that have been inserted in a number of double taxation treaties, most tax authorities now require evidence that the SPVs located in their tax jurisdiction are not merely "letter box" companies and have adequate (tax) substance.
As is often the case with tax, what is "adequate" depends on a particular case and is likely to increase proportionally to the size, complexity and number of employees employed by the business. However, an SPV that holds investments and receives passive income will most likely have to show that:
- it holds its properly-convened board meetings in its jurisdiction of residence and key strategic decisions in respect of its investments are made there; and
- the company has its own office space, qualified employees and bank accounts in the jurisdiction in question.
Therefore, as a minimum, we expect to see more focus on engaging local employees than before. Whether (and to what extent) local corporate service providers can continue to be used will then depend on the tax and non-tax requirements in the relevant jurisdiction.
For example, in 2018 specific substance requirements for foreign companies holding substantial shareholdings in Dutch companies were introduced in the Netherlands . These requirements provide that, in addition to the existing Dutch requirements (such as having a 50% Dutch board), a foreign holding company may be required to incur annual salary costs of at least EUR 100,000 and have a local office space at its disposal for a period of at least 24 months. Failure to comply with these requirements may, in certain circumstances, result in the foreign holding company being denied an exemption from dividend withholding tax. In addition, from 2020 companies that perform certain specific functions (including Dutch "financial services companies", i.e. companies whose activities comprise of at least 70% of group financing, licensing or rental activities) will have to satisfy comparable substance requirements to avoid spontaneous exchange of information. Lastly, all Dutch companies that wish to obtain a tax ruling or an advance pricing agreement will now be required to have sufficient "economic nexus" with the Netherlands.
As a result, in addition to their daily tasks of managing investments, GPs will have to navigate these new global tax initiatives (bearing in mind any reputational risks ), which may well mean that many existing fund structures are no longer fit for purpose and should be reviewed as a matter of urgency in order to avoid tax costs for the fund and investors. A challenging (but by no means an impossible) task!