Insight Center: Publications

Frontline: Trouble Zones in Tax Planning

Author: Steven D. Bortnick

This article first appeared in the February 8, 2012 issue of Private Equity Manager, published by PEI Media. It is reprinted here with permission.

One of the primary goals in planning a private equity transaction is to ensure that investors in the private equity fund are taxed (if at all) only in their country of residence on an exit. Unlike the United States (which generally does not tax foreign residents or corporations on gains from the sale of U.S. companies other than U.S. real property holding companies) many foreign jurisdictions do tax such gains. Failure to accomplish this primary goal can result in double taxation or in the taxation of gains recognised by tax-exempt organisations.

Avoidance of this tax on capital gains often is accomplished by forming a holding company in a low or no-tax jurisdiction through which the private equity fund invests. The goal then may be to sell the holding company and avoid tax on the capital gains. Alternatively, the holding company may be located in a jurisdiction that has a tax treaty with the country in which the portfolio company is located and which exempts capital gains.

Below we describe some of the steps various countries have taken to prevent the avoidance of taxation on gains from the sale of portfolio companies.

Recent Anti-Treaty Shopping Rules and Cases


In December of 2010, the Australian Tax Office (the ATO) released four tax determinations in response to Texas Pacific Group’s (TPG) sale of the Myer Group (Myer). Prior to the sale, TPG owned a Cayman Islands entity (Cayco), which owned a Luxembourg entity, which owned a Netherlands entity (Dutchco), which owned Myer, an Australian company.

The purpose of the first two determinations is to treat profits from private equity transactions – like TPG’s profits from the sale of Myer – as ordinary income, rather than capital gain. This distinction is important. Foreign investors are exempt from paying tax on capital gains in Australia; foreign investors are not exempt from paying tax on ordinary income in Australia.

The first determination provides that profit from the disposal of shares in a company group acquired in a leveraged buyout may be included in the vendor’s taxable income in Australia where the profit is ordinary income. The determination goes on to state that profit made by a private equity fund from the disposal of shares in an Australian company acquired for the purpose of realising a gain on an exit will be ordinary income. However, the determination states that a private equity fund will not be subject to Australian income tax if it is a resident of a country that has a tax treaty with Australia and the transaction does not involve treaty shopping.

The source of profit from the disposal of shares in an Australian company is important because a foreign resident’s taxable income in Australia only includes ordinary income that is sourced to Australia. The second determination provides that the source of income is determined with regard to all the facts and circumstances of the particular case. Accordingly, the location of all of the activities in furtherance of the sale of the Australian company, and not just the location of the signing of the contracts, should be considered in making such determination.

The third determination is intended to eliminate tax treaty benefits from the use of holding companies. It provides that, if an entity is interposed in a structure solely to take advantage of tax treaty benefits, then such benefits may be denied. Accordingly, a private equity fund that acquires an entity in a low-tax jurisdiction that does not have a  tax treaty with Australia – like Cayco – which acquires an entity in a jurisdiction that has a tax treaty with Australia –like Dutchco – which acquires an Australian company – like Myer – can be denied tax treaty benefits.

The net results of these determinations are that profits from the sale of an Australian company may be taxable in Australia and that treaty benefits may be denied if a holding company is used in the sale.

People's Republic of China

In late 2009, the State Administration of Tax (the SAT) of the PRC released Circular 698, effective retroactively to January 1, 2008. Circular 698 permits taxation of gain from the sale of a PRC company by a non-PRC holding company. The buyer is required to withhold the tax. If there is no withholding and the non-PRC holding company is located in a jurisdiction with an actual rate of tax less than 12.5 percent, then the seller must file a comprehensive information return, which focuses on whether the non-PRC holding company was formed for reasonable business purposes, and pay the tax due within seven days.

In a June 2010 China Taxation News publication, the SAT applied Circular 698 to the sale of a PRC company located in Jiangsu province (the JS Company) by a U.S. investment group (the U.S. Group). Prior to the sale, the U.S. Group owned a company in an offshore jurisdiction (the Offshore Intermediate Company), which owned a Hong Kong entity (the HK Company) which owned 49 percent of the JS Company.

In applying Circular 698, the SAT disregarded the HK Company because it had no employees, no operations, and no assets and liabilities other than investments in the JS Company. The SAT treated the Offshore Intermediate Company as having sold the JS Company directly, and also treated gain from that sale as PRC-sourced income that is subject to withholding. In making this decision, the SAT did not ignore the PRC-Hong Kong tax treaty because that treaty explicitly permitted the PRC to tax the HK Company’s gains from the sale of the JS Company.


On 20 January 2012, the Supreme Court of India overturned a ruling from the Bombay High Court that Vodafone was liable for up to $2.6 billion for failing to withhold capital gains on its $11 billion acquisition of Hutchison Essar, an Indian company, in 2007. Vodafone Group owned Vodafone International Holdings, a Dutch company, which paid $11 billion to Hutchison Telecommunications International to acquire CGP Investments, a Cayman Islands entity. CGP Investments directly owned a Mauritius subsidiary (Maurco) and indirectly owned a 67 percent interest in Hutchison Essar. In the sale, CGP investments and Maurco assigned inter-company loans that they held to various companies in the Hutchison group.

The Bombay High Court’s ruling state d that the transaction involved not only the transfer of shares of CGP Investments but the transfer of other assets, such as control premium, the right to use the Hutchison brand in India, a non-compete agreement with the Hutchison group, the assignment of intra-group loan obligations, and certain option rights in relation to specific Indian entities. The court also stated that these diverse rights and entitlements had sufficient nexus with India. As a result, the court concluded that Vodafone Holdings was liable for up to $2.6 billion for failing to withhold on capital gains in connection with its purchase of CGP Investments.

In overturning the Bombay High Court’s decision, the Supreme Court concluded that India did not have jurisdiction over the transfer of CGP Investments. Specifically, the court held that the transfer of CGP Investments occurred outside of India and Indian authorities do not have jurisdiction over transfers that occur outside of India. Accordingly, Vodafone was not liable for withholding capital gains.

The Vodafone case will have rippling repercussions. For instance, it gives investors like Adidas AG hope that it will not be liable for similar taxes. Adidas AG was assessed tax for its receipt of insurance payments under a global insurance policy with respect to damages that occurred at facilities in India owned by its Indian subsidiary. In addition, although the Indian officials have yet to comment on the case, the ruling is likely to play an important role in the negotiations surrounding the pending general anti-avoidance rule legislation in India.

South Korea

In 2006, South Korea adopted anti-treaty shopping rules. There are three important aspects of the rules. First, where a treaty applies, the “substance over form” doctrine must be applied. Second, tax is withheld on dividends, interest, royalties, and capital gains received by offshore entities established in certain designated tax haven jurisdictions, regardless of whether the jurisdictions have relevant tax treaties with South Korea. Third, even if a tax treaty provides for an exemption from or reduction of the applicable income tax, the company or person paying dividends, interest, royalty or consideration for share purchase to an offshore entity in a tax haven must withhold the full tax. However, withholding can be avoided through prior approval for exemption by the South Korean National Tax Service.

South Korea’s anti-treaty shopping rules eliminate the tax benefits of having a Belgium holding company directly hold a South Korean entity. Prior to 2006, private equity funds that acquired South Korean entities usually would insert a Belgium holding company in the ownership structure directly above the South Korean entity to take advantage of the treaty benefits in the Belgium-South Korea tax treaty. South Korea’s anti-treaty shopping rules eliminate the benefits of this structure because they prohibit the Belgium entity from receiving benefits under the Belgium-South Korea tax treaty.


The new rules and cases above show that a private equity fund looking to invest in a foreign portfolio company may have difficulty achieving its desired tax results. Private equity funds generally must establish that holding companies have real substance and are not merely shell companies. The tax rules and cases in a foreign jurisdiction can be complex, create uncertainty, and even be counterintuitive. Therefore, it is essential that private equity managers consult with their tax counsel before investing in a foreign portfolio company.

Steven D. Bortnick and Paul D. Pellegrini

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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