Global directives and PE

China

While China may be on the radar of every worldwide private equity investor, foreign LPs have traditionally been barred from contributing to the RMB funds that their global GP counterparts have launched. That right has been reserved for domestic investors, but, according to Kevin Ban, Partner at Weil, Gotshal & Manges LLP based in Shanghai, the potential liberalization of foreign exchange laws in 2011 can be a game changer in this area. "This is one of the widest areas that, once opened up, will lift the final obstacle to even the playing field between USD funds and RMB funds."

Local governments are contemplating pilot programs in metropolises such as Tianjin, Beijing and Shanghai that will allow foreign investors to convert their overseas currency into reminbi for the first time - Qualified Foreign Limited Partner or QFLP programs. While reports of such movements have been rampant, Ban said nothing concrete has been announced. "I'm optimistically hopeful that it will happen in 2011."

The approval by China's State Administration of Foreign Exchange (SAFE) of a $3 billion quota for the Shanghai municipal government is perhaps the most widely anticipated. However, the latest developments carry no further details on the taxation structure surrounding such investments, nor on the status of funds under the scheme when seeking to invest in companies in China's FDI-restricted sectors. Nonetheless, one fundraising source says that with China's private equity industry continuing on a fast growth curve, "The ‘slope' of this ‘curve' is what the government is trying to manage."

Another key area of Chinese regulation is the issue of taxation on transactions made by the overseas SPVs of Mainland funds. According to Ban, anti-avoidance laws for these vehicles were adopted in 2007, taxing PRC funds for selling shares and companies overseas. Yet, authorities have not been clear on the taxation guidelines pertaining to IPO exits - which Ban said he is frequently questioned about. "These types of enforcement actions are hopefully going to be flushed out or loosely sorted out over the year," he said.

US and Europe

Regulations imposed on alternatives investors by Western countries feeling more acutely the effects of the global financial crisis could well have a lasting impact on Asia-based firms as well. In Europe, new requirements for EU-domiciled managers as well as managers fundraising in the EU could regulate both fundraising and reporting.

HarbourVest's Amanda McCrystal told AVCJ, "Assuming that you are a fund domiciled in the EU, managed by a European fund manager, in theory such a fund would be regulated under the new regime and European investors would be free to invest in them. But there could still be restrictions, including what the fund itself could invest in, if it is to be compliant."

That becomes more complicated, however, if a fund is based outside the EU - as with any Asia Pacific funds. In this case there would be additional regulatory obligations as to how they would be able to market a fund to European investors.

While the original attempt appears to have been to encourage as many alternative fund managers as possible to bring everything they do within the confines of the EU, "that's unlikely to happen for a number of reasons, not least the taxation considerations." Only time, and considerably lobbying on the part of the industry, will tell.

In the US, regulations on filings and fundraisings certainly could be affect Asian firms, as outlined by David Litt, a Tokyo-based partner with Morrison & Foerster. "The Dodd-Frank Wall Street Reform and Consumer Protection Act that entered into law in July 2010 eliminated and modified some long-standing exemptions which historically permitted many Asian PE and VC managers to avoid registration with the SEC, even if they raised money from US-based investors," he explained.

For an Asia-based manager that does not have any presence in the EU or the US, the Dodd-Frank requirements may compel registration even if the manager does not raise any additional funds in the US in the future, simply because of its existing funds. This is stricter than the new European AIFM requirements, which would not apply unless new money is raised within EU jurisdictions after the regulations are implemented.

India

Punit Shah, Executive Director & Head of Financial Services & Private Equity Tax Practice at KPMG, told AVCJ that uncertain taxation, litigation and earning regulations have worn on the PE and VC industries in recent years. In particular, he points to the retail, real estate, and print and broadcast media sectors as among the most fickle. Although regulators have become "considerably liberalized" over the past decade, Shah labeled the tax reforms in India "a bit slow" and "uncertain," creating an unstable atmosphere for investors and especially for private equity players looking to invest in India."

Shah specifically notes that "sectors where there are FDI [Foreign Direct Investment] restrictions, and therefore, private equity and venture capital is not able to fully invest and to take full advantage of the growing sectors."

More fundamentally, new anti-avoidance regulations with respect to taxation in India are changing the way that fund establishment may work. To date, most funds are set up out of Mauritius, with a handful in Cyprus and other jurisdictions, allowing them to leverage certain tax benefits. Proposed changes to the Direct Tax Code (DTC) propose General Anti-Avoidance Rules (GAAR) that will make claiming benefits under the existing tax treaties more difficult.

Cutting through much of the legal jargon, there are effectively two points that funds need to pay attention to: One is that offshore companies that are deemed to be set up simply to avoid taxation may now be taxed onshore, and will be impermissible under any previous arrangment. Secondly, if the "place of effective management" of the foreign company lies in India (i.e. - MDs are all located in Mumbai), a fund may be considered an India-based company and liable to onshore taxation.

Legal experts say that going forward, it is essential that the activities of the advisory arm, and its relationship with the offshore fund be structured very carefully to avoid the fund being deemed a tax resident in India. This, of course, is notwithstanding other precautions that are necessary to mitigate any permanent establishment exposure for the private equity fund.

The SEBI draft takeover regulations are also looming on the horizon... still. But much has been said about these and until there is more clarity, there remains very little hope that privatization of a company will be a real investment possibility.

Australia

Many believe that the lack of real momentum in Australian private equity in 2010 was due to the uncertainty around the Australian Tax Office's (ATO) position on the taxation of capital gains on private equity investments as profits. Justin Cherrington, a tax partner with Mallesons Stephen Jaques explained that effectively, the ATO has ruled that "If you make an investment, you start with the premise that it's capital that you've invested for the income, rather than for generating a profit from the investment itself." In the case of private equity, making a profit is "part of your ordinary activity" and would thus be classified as ordinary income, not capital gains.

A number of groups, particularly the Australian Private Equity & Venture Capital Association (AVCAL), have been working with the ATO to ensure that the underlying investors - Limited Partners - do not end up being double taxed as a result. The ATO appears committed to a fair and equitable tax structure. In that vein, an increasing number of GPs operating in Australia are accepting that they will have their own carried interest on the income account, while the underlying investors remain on the capital account through a Management Investment Trust (MIT) arrangement.

There are still questions, and both non-resident and domestic investors are far from seeing the transparency they would like. That said, AVCJ has yet to hear of any cases of LPs withholding commitments based on the new regulations. The buyout market still has many an opportunity that are too good to pass up.

Japan

Japan in 2009 introduced under-publicized reforms to tackle the heavy tax burden private equity firms were facing, which was starving local GPs of foreign LP support. Prior to 2009, international LPs faced double taxation, but in April last year, the country introduced new regulations backed by the Ministry of Economy, Trade and Industry (METI) and Financial Services Agency (FSA) granting tax exemptions for foreign LPs investing in domestic Japanese GPs. Specific conditions require the investor to hold less than 25% in the fund, not to be related to the GP (as in a family member), to be considered an Investment Business Limited Liability Partnership and not to be involved directly in the business of the fund. While this is a step in the right direction, the new regulations have still been seen as difficult for foreign LPs to understand, and burdensome to meet where documentation and approval are concerned. As such, some PE professionals have pressed for an even simpler system.

While there was certainly was no immediate ramp-up of commitments to Japanese PE firms - with most international institutions still seeking their exposure to Japan through pan-regional funds - because the new regulations coincided with the downturn in the economy, it is difficult to weigh the effects of each separately.

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• Topics
• Regulation
• Greater China
• North Asia
• North America
• South Asia
• Australasia
• HarbourVest Partners