Tax considerations fan the private equity boom: amid much publicity and debate about the tax advantages of private equity funding, a U.K.-based attorney covers the basic tax issues and compares tax treatment in the U.S. with that in the U.K.

• Author: Conway, Kevin
• Position: CORPORATE TAX

Editor's Note: Congress isn't always attentive to corporate finance matters, so it's noteworthy that some members have seen a big target arising from the private equity boom: collecting tax from private equity fund partners at a far higher rate than they currently pay. Specifically, a bill would change the treatment of "carried interest" for buyout firms from the capital gains rate of 15 percent to an ordinary income treatment, at 35 percent.

For the following, we asked U.K. attorney Kevin Conway to discuss the structure and tax considerations of PE in the U.S. and U.K.

Clearly, private equity and its tax advantages have been attracting considerable publicity and debate. For the purposes of narrowing the subject, the following briefly considers the tax issues that arise in the context of the setup, investment and distribution by a "typical" leveraged buyout fund ("the fund") investing outside the U.S., and whether the tax savings adopted could be applied outside private equity.

Fund Setup

In setting up the fund, one will seek to satisfy/ease regulatory requirements; be familiar for investors; and have an exit strategy for the interested parties (the fund manager and the investors). The fund is typically established as a limited partnership (LP) with investors investing as limited partners. The fund promoter/manager (the fund manager) is, or is behind, the general partner.

The constitution or form of the general partner (GP) will usually be a limited liability corporation (LLC) in the U.S. or a limited partnership (in the U.K. or U.S.). The fund manager normally makes a substantial smaller capital investment to the fund. In the U.K., the carried interest is normally held by another limited partnership as a limited partner in the fund.

Tax Benefits

A limited partnership is tax-transparent and does not introduce another potential layer of taxation between the investors and their investments and should not give rise to capital duty. LPs also provide certain other tax benefits (as discussed below).

This structure also allows for investors from many jurisdictions to join without having to favor one investor's jurisdiction over that of another. The location and activities of the general partner are important: the GP does not want investors to have a taxable presence outside their own jurisdiction.

In addition, the fund will have to ensure that the partnership is not treated as a publicly traded partnership, and if a non-U.S. partnership is used, an election is made to ensure it is treated as a partnership for U.S. tax purposes. A further benefit of a non-U.S. partnership is that it is not regarded as a U.S. person for U.S.-controlled foreign corporation (CFC) purposes. U.S. investors will also need to consider the passive foreign investment company (PFIC)...