Between March 2007 and April 2008, several Sovereign Wealth Funds (SWFs) invested USD $45B in major western banks. The investments were made when the looming global financial crisis (GFC) was putting pressure on banks to increase their regulatory capital, and SWF investors stepped in to assist at favorable investment terms. The investments captured the interest of the financial media and governments, and ultimately foreshadowed the increasing attention that SWFs would continue to attract as they became larger and more sophisticated.
As the world struggles with COVID-19, the global markets will again present investment opportunities for SWF investors. However, the tax landscape of 2020 is much different than before the GFC. Major initiatives like FATCA (Foreign Account Tax Compliance Act) and BEPS (Base Erosion and Profit Shifting) have quickly inspired meaningful changes to tax law globally. The EU is taking a coordinated approach to combat aggressive tax planning. There is a global discussion on how to ensure a global minimum level of taxation as economies become increasingly digital.
SWFs are well positioned to navigate this new tax landscape. In the years since the GFC, many SWFs have developed their in-house expertise with tax professionals embedded in Legal, Finance, Risk and the Business. Many SWFs also built departments to focus on ESG initiatives (Environmental, Social and Governance), Company Secretarial, and Communications to help them grow as active and sophisticated investors. The synergies among these skillsets impart institutional capability to proactively add value, and address and manage tax complexity.
As SWFs analyze investment opportunities, consideration should be given to three important tax dynamics that weren’t prevalent before the GFC and which introduce new structuring complexities.
The world of anonymous investing is quickly becoming a distant memory. Movements within the OECD, EU, and US have increasingly forced tax transparency right to the ultimate beneficial owner through tax reporting or tax return filing obligations. FATCA, country-by-country reporting, and CRS (Common Reporting Standard) have changed the landscape for all investors. Further, DAC6 in the EU requires certain disclosures to governments on transactions that were previously confidential. While some of the tax reporting does not (yet) rise to the level of public regulatory disclosures in terms of the potential for widespread publicity, beneficial ownership is no longer entirely private, and that has increased the risk that investment structures will be part of the public domain. These rules generally apply to all investors, so the playing field is legally flat. However, not all investors are equally newsworthy.
While the potential for, or actual, disclosures may not necessarily be a deal breaker, it does raise the risk that disclosures attract unnecessary attention and cause friction at a time when investment decisions don’t need any additional sand in the gears.
The OECD BEPS Project and the EU blacklist are putting an increased focus on treaty qualification, and tax treaty structuring is becoming more challenging; access to treaty benefits is harder to come by, pursuant to policy or treaty intent.
Under BEPS, many tax treaty countries have signed on to the Multilateral Instrument (MLI). Tax treaties affected by the MLI include an anti-abuse rule to prevent treaty benefits from being granted in unintended circumstances. Countries can choose to either assess treaty qualification under a Principal Purpose Test (PPT) or certain Limitation on Benefits (LOB) provisions. Most countries have adopted the PPT, which generally denies the application of treaty benefits if obtaining the treaty benefit was one of the principal purposes of a structure or transaction.
These efforts to reduce access to treaty benefits have decreased the opportunity to obtain tax benefits using cross-border structures historically seen in the market, and which may have provided tax benefits before the GFC. Thus, achieving the same post-tax returns with limited access to tax treaties may be more challenging in 2020.
SWFs are typically government owned pools of capital, and as such, are not normally subject to taxation in their home country. In addition, it is not uncommon for SWFs to be eligible for certain sovereign tax immunity in other jurisdictions.
For example, the US provides for the sovereign tax exemption under the Internal Revenue Code (IRC Section 892). The exemption comes with many conditions and restrictions, including the restriction that the foreign sovereign will not receive the sovereign exemption on income attributed to a commercial activity.
The US affords some other very helpful tax privileges. For example, some SWFs may also qualify as Qualified Foreign Pension Funds (QFPFs), and accordingly be eligible for a full exemption from the Foreign Investment in Real Property Tax Act (FIRPTA) on gains attributed to the sale of US real property interests. Additionally, the “LP Exception” under the proposed Section 892 regulations generally permits a SWF investor to hold a limited partner interest in a partnership and not be attributed the commercial activities of the partnership, if certain conditions are met. These rules afford additional flexibility to an SWF investor that otherwise may not have entertained such investments.
These tax privileges are valuable, but the current economic climate sees governments facing incredible economic challenges of reduced tax revenues and increasing government expenditures. Under these conditions, it is possible that the media, public or governments could criticize investments which completely avoid taxation on the basis that the SWF investor is not paying a “fair share,” potentially resulting in reputational risk and adverse publicity even when such investment structures are in accordance with the law.
This risk is more than theoretical - only recently the paycheck protection program (PPP) loans made available to US businesses attracted public outcry when some public companies were identified as having received loans. And on the tax front, the US Congress investigated the 2007 SWF investments into banks to ascertain whether there was tax abuse. The current uncertain times raise the risk of similar scrutiny. Accordingly, the potential for negative publicity or scrutiny should be carefully considered.
The 2020 investment and tax landscapes are dramatically different than those which existed before the GFC. SWFs have a history of strategic investing in turbulent times and may find compelling current opportunities. When assessing the structuring options, however, new tax dynamics must be considered. While a tax tail doesn’t historically wag the commercial dog, it will be important to balance these dynamics with the investment opportunities and geo-political climate.