Jos Peters, Senior Tax Partner at Merlyn International Tax Solutions Group, describes a novel idea to reduce carried interest taxation by transforming this income part from locally sourced and locally taxable to foreign sourced and locally exempt.
Introduction
Over the last several years many countries have increased the personal income tax burden on carried interest income, earned by private equity investment managers; other countries are contemplating to do the same in the coming years. This is especially true in the European Union. One may wonder if, apart from the investment manager moving abroad and seeking a new job with an investment management group overseas, where the fiscal attitude towards private equity is more favourable (USA, Hong Kong, Singapore) something can be done about this.
Below I will discuss an idea which may help to - sometimes significantly - reduce carried interest taxation. I will address this tax planning opportunity in some detail, because the Netherlands seems to offer an opportunity to do so. I will focus on the EU, where the problems are clearly visible in the form of a drain of well-qualified investment managers to the USA and Asia.
The starting point of my "Dutch carried interest planning" is that certain income elements, if earned in the Netherlands, cannot be taxed again in the home country of the investment manager concerned, due to the presence of a tax treaty between the Netherlands and that other country. Seen in this light, the new carried interest taxation rules which have recently been introduced or will shortly be introduced in many EU countries may prove to be ineffective.
For example the French "Arthuis" rule which went into effect on 01/01/2011. Until then the French tax on carried interest income was a flat 30% income tax, but today carried interest is taxed in France under the progressive income tax scales, which will often imply that a large part is taxable against 50+%. And carried interest will from 1/1/2011 onwards also be subject to the French social security levies of 20+%. One should therefore not be surprised to see future carried interest rewards in France attracting a combined income tax plus social security contributions rate of well over 70%. The situation in other EU countries may be much the same.
But what would happen if this income comes from a Dutch legal entity in the group and qualifies for avoidance of double taxation in France under the Dutch/French tax treaty? Under the proper circumstances, France may not be allowed to tax such Dutch income elements. France may then only apply its progressive individual income tax rates to the French income parts earned by the French resident investment manager, and must leave the Dutch part untaxed. So under certain circumstances and with careful tax planning, France may often not be able to levy its 70% tax plus social security on carried interest income of French resident investment managers, because its tax treaty with the Netherlands got in the way. The same may be true for many other countries which have unilaterally increased carried interest taxation or are planning to do so.
The obvious next question then is: how high is the Dutch income tax on the carried interest rewards which the Netherlands may tax under the treaty? Is the Dutch tax rate better than 70%? The answer is mind boggling: with precise planning, the Dutch tax rate on carried interest rewards earned by non-Dutch residents with a non-Dutch EU passport can be kept at just 10% even for very considerable carried interest sums. This is true for employment income including some forms of deferred employment income like carried interest "bonuses" of up to €80,000 per year, so over an extended period of time for several hundred thousands of euros. Details of how this might work are not disclosed in this article but are based on the work I have done in the past for many HR departments of multinational enterprises and are available on request (jos@merlyn.eu).
Analysis
The above is just a "basic idea". It requires fine tuning (below) and a word of warning is needed too; with 27 EU countries which all have their own individual income tax and social security tax systems, including different ways to avoid double taxation on foreign income elements, my idea can be made to work in several situations, but not in all. In some EU countries the overall tax savings from routing carried interest rewards or parts thereof via the Netherlands may result in very considerable tax savings, especially those EU countries which apply an "exemption with progression clause" as a result of their tax treaty with the Netherlands, but in other EU countries, especially those where a tax credit system applies to foreign income, the Dutch carried interest planning may not make much difference at all. The question whether the home countries applies a so-called ceiling to the income amount, subject to social security charges is also important: the benefit might even be considerably higher if countries do apply such a ceiling.
For investment managers in non-EU countries, who may also be able to benefit from a tax treaty which their home country has with the Netherlands, the benefit calculation will co-depend on the question whether there is not only a tax treaty with the Netherlands but also whether there is a social security treaty.
So a general outcome cannot be given. Generally speaking the calculations come out best for investment managers from the following EU countries: Belgium/Luxemburg/France/Germany/ the Czech and Slovak Republics/Spain/Hungary and Denmark ("exemption with progression" countries). For non-EU countries calculations will have to be made separately.
Investment managers from EU countries such as Italy/the UK/Poland/ Ireland/Sweden/Greece/the Baltic States may not be able to realise any benefit from the low Dutch income tax which is also true for certain non-EU countries ("tax credit" countries).
Points of additional attention
I will now guide you through some important implementation details; just a good basic idea is of course never enough: it must be thought out in full, as if it had already been implemented, to the level of the future foreign income tax returns to be filed by the investment managers in their home country in the future which will contain the Dutch income elements. Only then can we be certain what the actual income tax savings for a particular investment manager in a particular country really are.
Challenge 1: the Dutch income must be income from Dutch employment, not from a Dutch shareholding
Not all income earned from Dutch sources is subject to the avoidance of double taxation rules in tax treaties. Especially carried interest, which often takes the form of shares which the investment manager obtains in a given investment fund. Income from shares is always taxable in the country of residence of the investment manager, even if it would come from shares in a Dutch legal entity. So the first step must be to convert future income from carried interest shareholdings (ie. dividends and capital gains) into Dutch employment income. By itself this does not have to be a difficult exercise: the shares allocated to the investment managers should from the outset, before they have any intrinsic value, be allocated to a Dutch legal entity whereby the investment manager, in lieu for these shares, obtains an entitlement to an incentive payment from the Dutch entity, which qualifies as employment income (a "bonus"). This should be neutral to the Dutch entity: it will only have to pay these bonuses to its new foreign employees if and to the extent it will make a profit on the shares which it obtains from these employees. Investment managers who want to continue owning the shares in their fund(s) themselves cut themselves off from the tax treaty benefits described;
Challenge 2: what kind of Dutch employment contract is required: one for an employee or one for a director?
The big difference between income from regular employment as an employee and income from a directorship for the day–to-day application of tax treaties is the issue of where the work may be performed. In situations covered by the regular employment article of a tax treaty (usually article 15, exceptions noted) the foreign employee must perform his activities IN the Netherlands. This may of course practically limit the effectiveness of my tax panning idea. For a director, there is no need to spend time in the Netherlands; he can continue to work in his home country and/or in the investee company countries like before. So, generally speaking, from a tax treaty perspective, a Dutch directorship is "better" from an execution viewpoint than a regular Dutch employment contract as an employee.
But there is of course a general sort of restriction here: one cannot, practically speaking, make all foreign employees who are elected to participate in a Dutch carried interest transformation programme which would replace their original home country carried interest programme, directors of the Dutch legal entity (usually a "BV" company). That just is not workable and also not very logical. The home country may ignore such "directorships" if the person involved is not actually performing a director's function in the Netherlands based on "treaty abuse". The Netherlands would do so in the reverse situation, according to a guideline published by the Dutch Ministry of Finance: Dutch residents who want to benefit from exempt director's income from foreign legal entities but who do not travel to the country of the entity, will be denied tax treaty relief if their directorship is fake (there is no Dutch case law to confirm that this view has ever been the subject of a tax court case in my country, however).
And there is also a tax treaty relevance here: many countries treat foreign income from regular employment in the same manner as foreign directors' fees, but in some Dutch tax treaties, the method to avoid double taxation differs. Notably the Dutch tax treaties with "good treaty countries" France, Denmark and the Czech and Slovak Republics distinguish between employment income and directors'' fees, whereby double taxation on directors' fees is avoided via the tax credit method. As explained above, the tax credit method is not the method which will bring the desired effect. So investment managers from these countries will have to accept a regular employment contract, with the consequence that they must perform their activities IN the Netherlands too. Entering into a directorship agreement would in such cases annihilate the tax benefit.
For social security, there may also be a distinction between an employee and a director: in some EU countries a director is treated as a self-employed person whilst the Netherlands will treat him/her as an employee (my country makes no distinction in these cases). Belgium is a good example here and additional precautions may be needed to avoid double social security levies.
In the French/Dutch situation I have asked my French network partners to make a number of calculations of what French tax and social security contributions savings might be achieved by routing €500,000 of carried interest income via the Netherlands over a 7 year period. As stipulated above, if the income would have been earned in France under the new French rules, these fine people would have paid 70% in France. In the Netherlands they would pay 10% only. Due to the progression clause in the French/Dutch tax treaty and due to the way the social security system in France treats foreign income, there would be some additional 25% French tax plus social security due, which brings the combined Dutch/French levy to 35%. This implies that French investment managers who would obtain their carried interest via a Dutch group entity would save themselves a whopping 50%, or €175,000, of tax NET from the idea as unfolded. How much additional gross income would one have to earn to arrive at a NET additional 175K euros? For some countries (where social security is tied to a "ceiling") the benefit could be even bigger.
Challenge 3: what Dutch legal presence is required? Do we need a Dutch "fund" or just a Dutch legal entity which owns shares in (a) foreign funds(s)?
It would of course be easiest to implement my carried interest transformation ideas in case the Dutch entity which is required to give the foreign investment managers access to the individual income tax benefits described, if the Dutch entity would be the investment fund itself. This would for instance eliminate much of the discussion above on whether there would actually be Dutch work-days, which may, as explained, be a big practical hurdle to affect my tax planning idea if the Dutch entity is not a fund itself. This question is a tough one to answer, however. From practice I know that the private equity sector is generally not keen on Dutch investment funds (exceptions noted!) for various tax and non-tax (regulatory) reasons. I can't comment to the regulatory issues for lack of sufficient knowledge, but from a tax viewpoint this question touches upon all the corporate taxation aspects of Dutch investment funds. Just briefly:
- VAT; with VAT exemptions for banking and insurance activities
(where a lot of the private equity money comes from) there is
considerable risk of non-recoverable VAT; this risk is augmented by
the fact that passive holding companies suffer from VAT exemptions
themselves. Many private equity investor groups will therefore
avoid any EU country to put their funds in and prefer the Channel
Islands or Switzerland to get rid of non-recoverable input
VAT.
Working with several non-EU based funds such as Channel Islands companies creates considerable risks in other corporate tax areas, by the way. Such set-ups bring along the need to interpose all kinds of special purpose companies in between, say, Jersey and the investee countries. But the tax authorities of those investee countries are increasingly challenging such SPC's for lack of substance and lack of beneficial ownership. It is expected that the OECD will soon publish a guideline on beneficial ownership, which will make the situation even worse. Such problems do not exist with investments from most EU jurisdictions, which can be described as "general purpose companies". But a VAT problem is about "known amounts of money today" and a beneficial ownership or substance issue is about "unknown amounts of money tomorrow" so most private equity investors seem to opt for the short term VAT recovery rather than avoidance of future capital gains tax; - The applicability of the Dutch participation exemption to foreign dividends and capital gains on exit; the Dutch tax authorities show an amazing hesitation to apply the Dutch participation exemption to private equity funds, advance ruling are hard to get in my country and the ones I have obtained contain side conditions which make the structure de facto unworkable. Despite the fact that the Dutch tax treaty network all by itself, plus the new participation exemption provisions as from 1/1/2007, would be ideal for private equity investment purposes;
- Some technical opinions I have seen from other tax advisers that comment to "which country is best for investment funds" stipulate that a Dutch legal entity other than a fund would need to own at least 5% of the shares in a foreign investment fund to ensure the Dutch participation exemption on future dividend income and capital gains; this is not true, however: an entity in the group to which the Dutch entity belongs (in fact: the foreign fund) has to own 5% together with the Dutch entity; the Dutch entity itself may own percentages below 5% (the "carry along rule").
So despite the fact that on paper the Netherlands is an almost ideal country to host private equity investment funds, this has not materialized. The corporate tax aspects of private equity will be addressed by me in more detail in a future article. But if the doubt which the private equity industry now has toward putting funds into the Netherlands remains, this may have a drawback on the practical feasibility of any carried interest transformation programme, of course.
Conclusions
The Netherlands offers an opportunity for non-Dutch resident employees and directors of Dutch entities to earn a substantial income part of up to several hundreds of thousands of euros over a period which should coincide with the duration of the investment fund, against a 10% effective Dutch tax plus social security rate.
This rate is not available to Dutch residents, by the way. If structured well, such Dutch income elements cannot again be taxed in the home country of the investment manager, but must be exempted, under the tax treaty of that home country with the Netherlands. Since carried interest income is subjected to ever increasing tax and social security levels in parts of the world, certainly in the EU, such a "transformation" of carried interest income from locally sourced to Dutch sourced, may bring very considerable tax benefits. Both in the areas of the "progression" clause which is usually part of that same treaty and due to the social security system of the home country, part of the initially very large tax differential between the Netherlands and the home country may wash out, but even then, tax savings of 50% on carried interest income seem possible and plausible.
The precise structuring of the tax solution I have described is an exercise all by itself, due to a number of additional constraints which have to be taken into account as explained. But there certainly is hope!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
