What U.S. private equity funds need to know about EU Directives

ARTICLE | September 13, 2023

Authored by RSM US LLP

U.S. private equity (PE) funds that invest in foreign portfolio companies should stay abreast of two key EU Directives designed to combat perceived tax avoidance achieved through hybrid mismatch arrangements and shell companies.

The Anti-tax Avoidance Directive II (ATAD II) and Unshell Directive (ATAD III) add complexity to achieving tax benefits in existing structures and potential accounting and compliance costs to tax reporting requirements. While this tax legislation sets goals for all EU countries to achieve, it is up to individual countries to devise their own laws on how to achieve them. Below are answers to frequently asked questions about these new Directives.

ATAD II: Hybrid mismatch rules

Who does it affect?

The Directive can affect U.S. PE funds that have set up tax structures to take advantage of the different tax classification and treatment of entities and cross-border payments in two or more jurisdictions.

What is the purpose?

ATAD II is intended to counteract tax advantages arising from certain so-called hybrid features that may exist in any given structure. One such feature is a hybrid instrument treated as debt in one jurisdiction but equity in another jurisdiction. Another is a hybrid entity treated as tax-transparent in one jurisdiction and tax-opaque in another, resulting in double deductions, deductions without income inclusion, imported mismatches and disregarded transactions.

When did it go into effect?

ATAD II was generally applicable to tax years starting on or after Jan. 1, 2020.

What are the potential tax consequences?

PE funds with hybrid entities (such as foreign corporations treated as disregarded entities for U.S. income tax purposes) may forfeit certain deductions on intercompany payments where there is a deduction on one side and no income inclusion on the other. Deductions may also be lost when a double deduction is available as could be the case with hybrid entities.

What actions could PE funds take?

PE funds should review their existing operating structures which could be tax inefficient because of the introduction of these rules. PE funds should also carefully consider the usage of hybrid entities and instruments in their tax planning. Not recognizing the impacts of ATAD II could drive down the value of the investment due to increased tax costs and tax reserve accruals and uncertain tax positions.

ATAD III: The Unshell Directive

Who does it affect?

This Directive targets PE funds that have set up holding companies without any substance (i.e., shell companies) to hold their non-U.S. portfolio companies. Under current or proposed tax planning, funds may be looking to repatriate cash from their foreign portfolio companies to the United States.?In a typical PE fund structure, we may see one or more holding companies between the U.S. and foreign portfolio companies in order to take advantage of reduced withholding taxes.

What is its purpose?

ATAD III is intended to provide substance requirements for shell companies to prevent their misuse for tax purposes. Examples of misuse include reducing withholding taxes by qualifying for the EU Parent-Subsidiary Directive and the Interest and Royalties Directive or one of the income tax treaties.

When does it go into effect?

Draft ATAD III Directive is currently with the European Council for further consideration. However, the target date for implementation of Jan. 1, 2024, along with the look-back period of two years, seems to have not changed as of the date of this article.

What are the potential U.S. and EU tax consequences?

Where taxpayers are not expected to meet the minimum substance tests, they may be denied the benefit of the EU Parent-Subsidiary and the Interest and Royalties Directive or one of the income tax treaties and be subject to higher withholding tax rates and other adverse tax consequences.

What actions could PE funds take?

Funds should review each country’s substance requirements, and take appropriate action. For example, they might hire local employees or hold in-person board meetings or other substantive activities within their holding companies. Otherwise, holding companies might not be able to obtain a tax residency certificate for subsidiaries to reduce or eliminate withholding taxes, which could affect their ability to repatriate cash. It could also reduce the fund’s value. Consult a tax advisor to review any potential tax structuring or planning in the EU, as well as any tax structures currently in place.

As ATAD II and III emerge as tax focus areas for the EU, PE funds can expect greater scrutiny of their holding structures. RSM’s international tax practice is well-versed in navigating the multiple variables that affect planning for these directives and can work with funds to stay informed and prepared.