Structuring Private Equity Deals inthe RegionGuy Ellis and Iris Cheng, Hong Kong

Private equity investors in the region typically operatevia offshore funds established under tax concessionaryregimes or in countries that impose little or no tax onthe activities of the funds. When making or planningany investment, two key objectives for a private equityinvestor are usually to reduce local and withholdingtaxes within the target group after the acquisition andto establish a structure that would facilitate a futureexit in a tax efficient manner. This article seeks toexplore some common concerns and considerations instructuring private equity transactions in the regionunder this premise.

Typical holding structure

A typical holding structure for regional investmentsusually involves the use of one or more intermediaryholding companies.

In a tax efficient holding structure, Parent will usuallybe located in a jurisdiction that carries some or all ofthe following features: The tax regime of the jurisdiction offers favourable

treatment/ incentives over the taxation of foreigndividends;

The jurisdiction does not tax capital gains arisingfrom the disposal of investment in foreign shares orassets;

The jurisdiction has a wide network of double taxagreements with all or most of the jurisdictionswhere the operating subsidiaries reside;

Profits can be remitted out of the jurisdiction withminimal or no additional tax cost; and

There is no tax on the sale by a foreign owner ofshares in an entity set up in the jurisdiction.

Other tax issues that would also have to be consideredinclude: Does the jurisdiction offer some form of tax relief for

costs, including funding and other transactionalcosts, associated with the acquisition and disposal offoreign investments?

Does the jurisdiction offer some form of tax relief forgoodwill arising from the acquisition of investments?

The Netherlands, for example, has a wide network ofdouble tax agreements with various Asian jurisdictionsand has been one of the more popular locations forsetting up a holding company for groups operating inthe region. Closer to home, with a reasonablycomprehensive treaty network and the added flavour ofrecent changes to the tax regime as proposed in itslatest budget in particular in respect of the proposedexemption from tax of certain foreign dividends andother foreign sourced income Singapore may beconsidered as a favourable location in which to set upa regional holding company.

To illustrate the potential tax benefits of using asuitable holding company, the example belowcompares the possible tax consequences on intra-groupdividend between the use of a Singapore holdingcompany and a holding company incorporated in a taxhaven jurisdiction, say the British Virgin Islands(BVI), in respect of a group of companies operatingin Singapore, South Korea, Japan and Thailand.

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In the above example, as the British Virgin Islandsdoes not have an income tax treaty with any of thesejurisdictions, the domestic dividend withholding taxrates will apply. By using a Singapore holdingcompany, the investors can potentially reduce theirwithholding tax liabilities on dividends repatriatedfrom the operating entities located in South Korea andJapan. As the domestic withholding tax rate ondividends is lower than the rate prescribed by theSingapore-Thailand double tax treaty, the two holdingcompanies will give rise to the same withholding taxconsequences in respect of an investment in Thailand.

As illustrated above, potential tax savings can beachieved by carefully considering the location of aholding company. Obviously, this is but a simpleillustration made on broad assumptions. For example,it has not taken into account potential taxconsequences of other types of fund/profit repatriation,such as interest, royalties or management fees. Also,the illustration has not taken into account potentialcapital gains tax, if any, on exit. These issues areexplored in more detail below.

Financing the investment

In many private equity transactions, there wouldtypically be a mixture of shareholder funds and bankborrowings to finance the investment in the acquiredbusiness. If structured properly, investors canmaximise the tax relief available from the fundingarrangements.

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While commercial factors generally play a significantrole in determining the funding structure in mosttransactions, this part will focus on the common taxconsiderations in shaping funding decisions in mostprivate equity transactions: Are there any regulatory limitations on the level of

debt that can be used in each of the jurisdictionswhere the group operates?

Are there different tax rules for deduction orallowance of funding costs arising from externalborrowings and shareholder loans?

Likewise, are there different tax rules for fundingcosts on the acquisition of shares as against theacquisition of business assets?

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3In most of the jurisdictions within the region, while interest and funding costs (for example front-end fees and other bankcommissions) are typically tax deductible when incurred in the production of taxable income, they are generally subject tosome form of thin capitalisation constraints, which seek to limit the amount of debt that can be applied in funding aninvestment. To provide a quick glimpse into the overall thin capitalisation position in the region, the table below provide asummary of the general deduction restrictions applied in some typical investment locations:

Table 1: Thin capitalisation rules A comparison across the region

Any thincapitalisation rules? Details/remarks

Australia 9 A safe harbour level of total debt at 75% of Australian assets isavailable, although specific rules may apply for financial institutions.

China 9 Equity level is governed by the minimum registered capital depending onthe size of investment.

Total investment between US$10 and US$30 million would have aminimum registered capital of higher of US$5 million or 40% of the totalinvestment.

Total investment over US$30 million would have a minimum registeredcapital of higher of US$12 million or 33 1/3% of the total investment.

Hong Kong 8 While Hong Kong does not have thin capitalisation rules, there arestringent conditions for the deductibility of interest, which may effectivelyrestrict the use of overseas debt finance.

Indonesia 8 Currently, there are no prescribed debt/ equity ratio limits, although aminimum debt to equity ratio may be imposed through the foreigninvestment regulatory approval process.

Japan 9 The thin capitalisation rules currently permit the use of a ratio higher than3:1, although other conditions may still need to be satisfied.

Korea 9 Foreign controlling shareholder debt/ equity ratio of 3:1 is generallyacceptable for tax purposes, although specific rules may apply forfinancial institutions.

Malaysia 8 While there are no thin capitalisation rules, a debt/ equity requirementmay be imposed by the Malaysian Central Bank for exchange controlpurposes.

New Zealand 9 Generally, total interest-bearing debt/total asset ratio should not exceed75% and 110% of the worldwide group debt percentage.

Philippines 8 While there are no thin capitalisation rules, a debt/equity requirementmay be imposed by other regulatory agencies, e.g. when the taxpayerseeks to apply for a special licence or tax concessions.

Singapore 8 While there are no thin capitalisation rules, the tax authorities maydisallow interest to the extent not used to finance assessable operations.

Taiwan 8 While there are no thin capitalisation rules, the minimum equity capitalrequired for a company limited by share is NT$1 million.

Thailand 8 While there are no thin capitalisation rules, a debt/ equity requirementmay be imposed by other regulatory agencies, e.g. when the taxpayerseeks to apply for tax concessions under the Investment Promotion Act.

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4While not all jurisdictions have specified rules and/orsafe harbours prescribing the level of allowable debtas a proportion of total business assets, in most casessome form of restrictions do apply over the amount ofdeductible funding costs. Investors who look tomaximise their tax benefits from debt financing shouldtherefore carefully consider the implications of theserestrictions in planning their investment in the region.

A further question to consider regarding fundingarrangements is whether there are withholding taxrequirements on interest payable by the operatingentities to a foreign parent or a related party residentin a foreign jurisdiction. As it is possible that some, orall, of the withholding taxes chargeable on interestwill not be creditable against income taxes payableby the recipient, consideration needs to be given tothe withholding tax requirements of each jurisdictionand potential protection under existing double taxtreaties.

Other profit/fund extraction

While not going into detail here, there are otherplanning opportunities in structuring the repatriation ofprofits from an investment. For example, the operatingentities can repatriate profit by way of payments inrelation to the use of intangibles or management/shared services fees. Where properly structured, thesearrangements may help to reduce the net tax cost ofthe business.

Exit strategy

Apart from the above concerns, private equityinvestors in the region are usually particularlyconcerned to structure their investments in ways thatallow a degree of flexibility on exit, usually in theform of a trade sale or possibly through an IPO.Certain structures can be put in place to ensure thatthe capital gains tax and/or other transactional tax onthe exit is minimised.

One common technique is the use of a holdingvehicle set up in a tax haven jurisdiction. When theinvestment is to be sold, the tax haven company canbe sold instead of the underlying investment.

By way of illustration, in example 2 below, using anoffshore holding vehicle in a tax free jurisdiction canpotentially mitigate tax liabilities on capital gainsarising from the sale of the investment and provideflexibility on stamp duty planning.

As one will notice from this example, some double taxtreaties may also provide protection against capitalgains tax imposed by the jurisdiction where theoperating entities are resident.

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Concluding remarks

This article has explored some common considerationsin structuring private equity transactions, includingsome points of particular relevance to investments inthe Asia Pacific region.

A word of caution may however be warranted. Asmentioned above, by carefully considering thelocation of the holding company and the form ofprofit/fund repatriation, substantial tax savings canpotentially be achieved. Nevertheless, withincreasing scrutiny by the tax authorities on treatyshopping and tax avoidance cases, due care has to beexercised in balancing tax efficiency and commercialsubstance in planning a suitable investment structure.