Omri Marian’s new work highlights the role of private investment funds (“PIFs”) in international tax planning and avoidance by PIF-controlled multinational enterprises (“MNEs”). Marian argues that PIFs active in cross-border investments can take advantage of tax planning opportunities unavailable to purely domestic funds, and provides evidence that PIF-controlled MNEs are more likely to engage in aggressive planning. Consequently, income earned by PIFs can more readily escape taxation entirely, in both the source jurisdiction where investments are made, and in the residence jurisdiction of investors and managers.
This groundbreaking work lies at the intersection of two literatures, on cross-border tax planning by MNEs, and on the taxation of PIFs, and fills critical gaps in both. The MNE literature, Marian notes, generally focuses on tax planning by corporate MNEs, particularly in industries with mobile IP such as technology and pharmaceuticals, but not on the role of investor and PIFs in MNE tax planning. Marian’s work also calls for (and makes significant strides towards) a broader account of the full scope PIF tax planning activities, beyond traditional areas of concern such as manager compensation and carried interest.
As a case study, Marian points to the preponderance of PIF-driven advance tax agreements (“ATAs”) granted by Luxembourg tax administrators to MNEs, as revealed in the LuxLeaks scandal. Marian found that PIFs sponsored more ATAs than any other industry segment, and describes one common scheme, using a classic debt/equity arbitrage. Through the use of a Luxembourg conduit, investment financing is characterized as debt in the jurisdiction of the PIF’s investments (to reduce taxable income at source) and equity in the residence of the fund managers or investors (who benefit from preferential rates, full tax exemption, or participation exemption under a territorial system). Luxembourg is compensated for facilitating the structure with, essentially, “a fee paid for tax avoidance services.”
Of course, ATAs allowing one specific tax-favored structure does not prove a broader pattern of aggressive tax planning by PIFs. The ATAs revealed under LuxLeaks cover the years 2002 to 2010, and presumably a new generation of PIFs has moved on to new tax structures yet to be publicized. Marian argues that the lack of transparency hinders a more thorough policy assessment of PIF-driven tax planning and appropriate responses, particularly given the relatively short lives of many funds. The article therefore concludes with a proposal to increase transparency, and thereby gather the information necessary for more targeted anti-avoidance rules, by broadening the OECD BEPS Project’s Action 13 country-by-country reporting standards to cover PIFs and their MNEs.
The work also offers a series of possible explanation for the aggressive planning undertaken by PIFs. First, the short investment horizon of most funds may lead to strategies that generate after-tax profits quickly, a diminished likelihood of audits, less concern with reputational constraints, and less concern for the economic health of the investments’ source jurisdictions. Marian also suggests that PIF tax planning may be influenced by aggressive or risk-favoring managers, the freedom to operate with no public disclosure obligations, an investor base comprised of tax-exempts and taxable investors subject to territorial taxation, and finally, managers who structure investments to their own advantage (and presumably share any resulting tax benefits with nontaxable investors in the form of reduced compensation).
Increased transparency could allow for more targeted policymaking, and shed light on the prevalence of—and reasons for—aggressive tax planning by PIFs. Transparency could also have unexpected adverse consequences. Joshua Blank (NYU) has argued that, in the context of corporate tax privacy, increased transparency could result in more aggressive tax planning, as managers compete through benchmarking and reverse engineering. Transparency, while undoubtedly valuable, should be managed with care in the case of PIFs as well.
Marian notes that PIFs, as pass-through entities, have not been the natural targets of policymaking in the past. That may be changing. A recent work by a group of academic and Treasury researchers began the daunting task of estimating the effective tax rate on pass-through businesses. Marian’s work also joins recent articles by Donald Marron (Urban Institute) and Gregg Polsky (Georgia)—that similarly call for a broader perspective on tax planning by investment funds. Marian’s work is a significant step in that direction.