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Tax-Efficient Private Fund Structuring An Essay

This article discusses the structuring of international private equity investments in the People’s Republic of China. The authors explain legal requirements and restrictions in both the PRC and investors’ countries, tax efficiency considerations for investors under both PRC and investors’ countries’ rules, tax efficiency at the PRC portfolio company level, and minimizing exit taxation and legal restrictions at both the PRC and investors’ countries’ levels.

Published in the March 2009 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC.

Always searching for superior returns, private equity investors have turned to the People’s Republic of China (PRC) in recent years. As long ago as the first half of 2005 over 35 international private equity funds raised PRC-focused capital, and important international private equity investors continue to focus on opportunities in the PRC.


Private equity investment can take many forms. Much of private equity investment is made by funds. These funds pool money from a number of investors, and the funds then invest this money. The funds typically are managed by management companies that are compensated for their efforts in the form of an asset based fee (a management fee) plus an interest in the fund representing a share of the profits of the fund (the carried interest). In addition, institutional investors — such as pension funds, school endowment funds, insurance companies and others — as well as individuals may make direct private equity investments (often as co-investors alongside private equity funds).

Different types of investment funds generally focus on different types of investments. The prototypical private equity fund acquires controlling or significant equity positions in so-called portfolio or target companies with significant operating histories. The target companies may be public companies that the private equity firm takes private, or significant divisions of larger companies. Notably, much of the investment is used to pay one or more existing owners for their equity interests.

Venture capital firms also invest in privately held companies. However, they typically invest their money directly into the companies in which they invest. The companies may be at different levels in the company history, from pure start-up to late stage growth. Hedge funds generally invest in publicly traded, liquid companies. Mezzanine debt funds typically invest in debt of privately held companies. In addition to a debt investment, they typically acquire some equity components, either options or shares, in the companies in which they invest.

Notwithstanding these general descriptions, there is significant overlap in fund investments. It is common for hedge funds to have a certain portion of their investments in illiquid securities, such as investments in privately held companies. Private equity and venture capital funds may make loans to the companies in which they invest. Venture capital funds may make so-called leveraged buyouts using borrowed funds, just as do private equity firms, and private equity funds may make private investments in publicly-held companies. Accordingly, it often is hard to assign a fund to one of the categories previously described.


Any fund, institutional or individual investor making private equity investments must consider a number of issues in structuring a transaction. These structuring considerations involve both tax and non-tax issues. In the case of an international private equity investment, such issues must be addressed for both the investors’ countries and the portfolio company’s country.

Structuring Considerations — Consider the Exit Before Entry

First and foremost is the fact that, unlike a strategic investment by a company in the portfolio company’s own or a related industry, which may be viewed as a marriage of two companies, eventually there will be an exit event. Private equity investors — be they funds, institutions or even individuals making private investments — acquire a portfolio company, attempt to add value to the company, and ultimately sell the company through either a public offering or a sale to another private equity investor or to a strategic purchaser. Accordingly, any structure must take the ultimate sale into account.

The first exit consideration often is tax cost. For example, where a country such as the PRC imposes a tax on the sale of a local portfolio company, most private equity investments from abroad will be made through holding companies. The holding company may be formed in a country which has an income tax treaty with the portfolio company’s country that eliminates this tax on sale. Alternatively, the holding company may be formed in a tax haven, such as the Cayman Islands, British Virgin Islands or Channel Islands— in this case, the aim is to sell the holding company in order to avoid the local tax.

The structures for private equity investments may become quite complicated in order to take into account the variety of tax, legal and business considerations of the various investors and the portfolio company. However, as the goal of the private equity investor always is ultimately to exit the structure, before implementing a structure the investor must also consider whether a potential buyer will be willing to acquire the investment through such structure, or whether the structure can be unwound in an efficient manner from tax, regulatory, corporate, timing and expense standpoints.

Structuring Considerations — Tax Efficiency at the Portfolio Company

Tax efficiency is an important consideration for any company. It is especially important in planning private equity transactions. Private equity transactions often involve significant debt leverage. Tax liabilities reduce cash flow available to pay debt service. Accordingly, the amount that a lender will be willing to lend likely will be impacted by anticipated tax liabilities with respect to operating income.

Tax liabilities also may impact the value of the portfolio company and, thus, the amount the investors ultimately will reap upon a sale. A subsequent buyer of a portfolio company likely will consider anticipated tax liabilities in determining what it would pay for the company.

Tax efficiency at the portfolio company level first may be accomplished by ensuring that the portfolio company is taking advantage of tax benefits offered in the jurisdictions in which it operates. The private equity investor should determine whether the portfolio company is taking advantage of any such incentives. If necessary, the business may be reorganized or relocated in order to take full advantage of these benefits.

In addition, any available deductions against operating income and credits against tax at the portfolio company level should be claimed. Maximization of these deductions also requires consideration at the structuring stage. For example, depreciation and amortization deductions likely will be maximized if the assets of the portfolio company (rather than its shares of stock) are directly acquired. Of course, the future tax benefits must be weighed against any additional taxes on an asset purchase transaction.

Interest deductions also may be available. As previously mentioned, private equity transactions often are heavily leveraged. Accordingly, in structuring the transaction, it is important that interest on the acquisition indebtedness be deductible against operating profit. Consideration must be given as to whether the debt must reside in the portfolio company itself or whether, by virtue of consolidation, group relief or similar income tax rules, it is sufficient that the debt be in a parent company, such as the holding company used to acquire the investment. In addition, part of the private equity investors’ money may be invested in the form of debt in order to maximize interest deductions, as well as to enable some of the funds invested to be legally senior to the interests of other equity investors.

Several further items may affect such interest deductions. Corporate law may preclude very high debt-to-equity ratios, and may also preclude borrowing by a company (or pledges by a company) in order to assist in the acquisition of the portfolio company’s stock. Internal tax laws of the portfolio company’s home country often preclude the deduction of interest on debt if and to the extent that the debt-to-equity ratio exceeds certain  thresholds. Payment of interest to related parties, such as a holding company formed to make the acquisition, also may be subject to special timing rules or limitations. Moreover, if the debt has certain characteristics (e.g., profit participation), the debt may not be treated as debt in the portfolio company’s home jurisdiction. Finally, the treatment of interest may differ depending on whether the acquisition is one of assets or stock of the portfolio company.

Complicated private equity transactions are not inexpensive to implement. Accordingly, significant fees often are paid to banks, investment bankers, financial advisers, accountants, lawyers and other professionals. Deductibility of such fees (whether immediate or as a result of amortization over the life of the investment) should be considered as a means of reducing the portfolio company’s operating profits.

Structuring Considerations — Tax Efficiency at the Investor Level

Private equity transactions should be structured to maximize tax efficiency at the investor level as well as the portfolio company level. These taxes are felt by investors directly. Often there is a difference in what would be most tax efficient from the portfolio company’s standpoint as opposed to what is most tax efficient from the investors’ standpoint.

Private equity funds typically are formed as limited partnerships. This generally avoids income taxation at the fund level. It also generally ensures that the character of the income derived by the fund retains its character in the hands of the investors. Many countries tax different types of income at different rates. For example, the United States currently taxes long-term capital gains and certain qualified dividends earned by individuals at 15 percent, rather than the top 35 percent rate applicable to short term-capital gains and ordinary income. Such favorably taxed income derived by a partnership retains its character in the hands of investors. However, this pass-through effect also can have negative results, as in the case — discussed further herein — of unrelated business taxable income (UBTI) derived by a private equity fund and allocated to U.S. tax-exempt investors.

A private equity structure should take into account various advantageous tax rates on income of its investors. For example, it typically is beneficial to ensure that gain on a complete or partial exit is capital gain or (at least through 2010) qualified dividends, rather than ordinary income.

The structure also should attempt to minimize income in advance of cash receipts. This can happen, for example, if the private equity investor loans (or causes a holding company treated as a partnership to loan) money to the portfolio company or a company in the portfolio company’s group. Interest on shareholder loans often accrues and only is repaid on an exit event, such as a sale or recapitalization, or after the senior debt is repaid. While as previously noted such interest deductions may benefit the portfolio company, accruing interest on shareholder loans may be taxable to investors in the private equity fund in advance of the receipt of cash. Different planning techniques may be available to minimize this.

Additionally, the U.S. and certain other investor countries have rules designed to prevent the deferral of income (such as the U.S. rules on controlled foreign corporations and passive foreign investment companies referred to further below). Under these rules, it is possible that the income of the portfolio company, or one of the holding companies formed to make the acquisition, will be taxed to investors in the funds whether or not the income is distributed. Sometimes the impact of these rules can be avoided by limiting the voting stock held by the fund, or making certain elections that minimize the earnings of the companies for investor country tax purposes.

U.S. UBTI rules deserve further explanation. U.S. tax-exempt investors, such as pension funds and school endowments, are significant private equity investors. They generally do not pay income tax in the United States. They do, however, pay tax on UBTI. UBTI includes income from a trade or business unrelated to the tax-exempt purpose of the organization and regularly conducted. Passive income, such as dividends, interest and capital gains, typically is excluded from the definition of UBTI.

However, income and gains from debt financed investments are specifically treated as UBTI, even if not from a trade or business. As previously
noted, while it may appear generally more tax efficient to operate a portfolio company as a partnership, this income will flow through to tax-exempt investors as such. Thus, if a private equity fund formed as a partnership incurs indebtedness to make its investments, the income and gain from the investments will be UBTI. U.S. tax-exempt investors making private equity investments, and funds that have significant investments by U.S. tax-exempt investors, typically attempt to avoid or minimize UBTI from debt financed investments. This may be done, for example, by investing through a holding company treated as a corporation for U.S. tax purposes, below which any debt financing is obtained and any business operations conducted.

A fund’s investor structure may also include so-called carried interests of its investment advisers. While securities regulation authorities in fund investors’ countries generally regulate fees which may be charged by investment advisers to international and domestic investment funds offered to the public, such regulations often will not apply to fees where the fund’s units or shares are not offered to the public but only to private investors. Such fees are generally fixed at a basic annual percentage — often one percent or two percent — of the fund’s invested assets, plus an incentive fee calculated as a percentage of the fund’s profits in excess of a basic annual hurdle rate of return on its investments —for example, 20 percent of the fund’s profits for a given year in excess of an annual hurdle return of eight percent on its invested assets.

From the standpoint of the investment adviser, the basic fee generally covers minimum salaries of advisory personnel as well as office facilities and staff costs. However, incentive fees based on higher fund returns often may be quite substantial and in turn may be subject to substantial income and other taxes. Accordingly, one feature of advisory contracts may permit advisers automatically to waive—or to notify the fund prior to the beginning of a new advisory year that the advisers wish to waive — fees in excess of a specified amount; these waived amounts instead are treated as being invested in the fund itself along with existing funds of other investors. This may permit such waived fee amounts not to be subject to income tax until a later year when fund profits on such investments are distributed, and may permit such distributions to be taxed as capital gains at lower tax rates than on ordinary fee income. However, such tax benefits are being restricted in the U.S. and elsewhere.

Structuring Considerations — Legal Requirements and Restrictions

Beyond the general tax-related considerations described above, the structure of a private equity investment may be greatly affected by legal requirements or restrictions. These may arise in either the investors’ countries or the portfolio company’s country.

With respect to U.S. investors, for example, a fund with significant investors that are U.S. benefit plans generally will have to qualify as a venture capital operating company (VCOC) in order to avoid regulation under the U.S. Employee Retirement Income Security Act. This requires consideration in connection with the structuring of transactions. In order to qualify as a VCOC, at least 50 percent of the fund’s investments must be so-called venture capital investments. A venture capital investment is an investment in an operating company in which the fund obtains direct contractual management rights. An operating company is a company that is primarily engaged, directly or through majority-owned subsidiaries, in the production or sale of a product or service other than the investment of capital. Management rights include the ability to appoint a director (by contract and not merely due to ownership of a majority of the stock of the company) or a bundle of rights including rights to receive certain financial information, periodically meet with management, inspect the operating company’s premises, and review the books and records of the operating company. Although these requirements may seem fairly simple on their face, issues may arise in meeting such requirements under the complicated holding company structures used in private equity transactions.

With respect to the portfolio company’s country, restrictions on investment percentages or forms of investment permitted to foreign investors clearly will affect the structuring of a private equity investment there.

Antitrust and other rules governing mergers or acquisitions in the portfolio company’s country may also require special procedures to acquire control — or may restrict control — over local businesses.


For each of the general structuring considerations described above, selected points affecting private equity investments in the PRC are identified below. For ease of reference, the structuring considerations noted above are considered in inverse order.

Initially it should be noted that both tax and non-tax rules affecting foreign private equity investments in the PRC continue to evolve. For example, a new Enterprise Income Tax Law came into effect on January 1, 2008.1 However, established foreign invested enterprises that have been issued a business license before March 16, 2007, may continue to enjoy the tax incentives available under the prior PRC income tax law (subject to graduated increases by 2012). In addition, a new Anti-Monopoly Law became effective on August 1, 2008, including appointment of an Anti-Monopoly Commission of the State Council in September 2008 to coordinate the work of three agencies responsible for carrying out antitrust policy. Clearly many details under these laws remain yet unclear.

Thus, the points identified below are based in part on prior PRC investment structuring from abroad and in part on new broad statutory provisions. In this regard, the authors are grateful for the special research and suggestions provided by the individuals noted at the beginning of this article. However, reliance upon the matters covered in this article should be preceded by confirmation of evolving PRC and other rules and by consultation with professional advisers appropriately authorized to provide PRC and other relevant legal and tax advice.

Legal Requirements and Restrictions

Is the Business Area Open to Foreign Investment?

The threshold issue for every foreign investor in the PRC — whether by merger or acquisition of a domestic enterprise or otherwise—is whether the business area in which it plans to invest is open to foreign investment and, if so, how open. Specifically, a catalogue guiding foreign investment in industries lists business sectors where the PRC government forbids, restricts, or encourages foreign investment — anything outside of the catalogue is deemed a sector allowed for foreign investment. Current amendments to this list became effective late in 2007.2

For example:

  • encouraged industries currently include high technology and certain service industries
  • purely export-orientated industries are no longer encouraged
  • industries involving non-renewable natural resources are restricted or forbidden
  • business sectors which may impact national economic security such as news websites and Internet access services are forbidden for foreign investment
  • foreign investment in securities companies and futures companies is restricted to one-third or in certain cases one-half ownership, and
  • the operation and financing of foreign invested real estate enterprises is subject to stringent regulation, as part of PRC efforts to reduce real estate price inflation.

In certain countries with limits on foreign ownership percentages of local portfolio companies, one solution is to have part or all of foreign investors’ interest in a local company be evidenced by so-called participating notes, often issued by a bank, which do not carry voting rights in the company but permit the holder to share in financial results of the company in the form of note payments which reflect a percentage of such results. As PRC regulation of foreign investment evolves, such alternatives may become clearer and more attractive.

Foreign Invested Enterprise Rules

Beginning in 2003, provisional PRC rules have permitted a foreign acquiror (1) to purchase the outstanding equity of shareholders of a domestic enterprise or subscribe to newly issued shares of a domestic enterprise or (2) to purchase a domestic enterprise’s assets and then operate those assets through an existing domestic enterprise or contribute them to a newly established domestic enterprise.

However, the acquisition price of equity must be at least 90 percent of appraised value, and of assets must be close to appraised value. Moreover, the acquisition or subscription agreements must be governed by PRC law, except for acquisition of an existing foreign invested enterprise.

PRC law also has required in principle that foreign investment participation in a domestic enterprise — whether in a wholly foreign owned enterprise, an equity or cooperative joint venture, or a foreign invested joint stock limited company — equal or exceed 25 percent. Where the participation is below 25 percent, the approving authority must so note on the approval certificate and a similar note must be placed on the business license issued following registration of the enterprise with the local government administration. Such low percentages are not encouraged and in the past have caused the enterprise to be excluded from preferential tax treatment — largely superseded by the new income tax act noted above beginning in 2008 — and from certain other benefits otherwise available to larger participations.

In addition, in relation to the registered capital of a domestic enterprise, total investment by foreign investors generally is not to exceed three times the registered capital, with lower multiples of registered capital for smaller enterprises.

Other PRC Rules

Other PRC rules may affect the structuring of a domestic enterprise established by merger or acquisition.

In the case of takeover of a PRC public company, a potential purchaser ordinarily is required to make a general offer to all the shareholders of the target enterprise if it intends to control more than 30 percent of the outstanding shares of the enterprise. On the other hand, the target public enterprise is prohibited from engaging in certain dilutive or other steps with the intent to prevent a takeover.

With respect to foreign investment in enterprises listed on a PRC stock exchange, before the end of January 2006 only a limited number of foreign financial institutions could purchase so-called tradeable A-shares of such enterprises.3 Other foreign investors could only acquire privately purchased non-tradeable holdings. Even such foreign institutional investors were — and still are — permitted to hold no more than 10 percent of the issued share capital of a listed enterprise.

Subsequently so-called strategic foreign investors have been permitted to control a PRC listed enterprise. The current qualification requirements are relatively permissive — for example, the foreign investor must own offshore assets of at least U.S.$100-million or manage offshore assets of at least U.S. $500-million. The acquisition may be accomplished even through a wholly-owned subsidiary located outside the PRC. A foreign investor can obtain such listed enterprise shares by a private share transfer agreement with existing shareholders or by a private placement of shares by the listed enterprise, as well as by other methods which may be allowed from time to time by PRC law. However, the target listed enterprise must have reformed its share capital structure in accordance with certain requirements, among which are limitations on percentages of the enterprise’s total shareholdings which can be traded during the first three years after the company’s capital structure reform. Until then, such an investment may need to be made at least partly through private placement by the target listed enterprise itself.

Prohibition Against Enterprise Concentration

Beyond regulation of foreign investment and of public company takeovers, PRC law generally prohibits enterprise concentration that eliminates or limits fair market competition, hinders the development of the national economy, or damages the public interest. Such concentration certainly can arise when enterprises merge or one enterprise gains control over another through the purchase of its shares or assets.

Historically, parties to a PRC merger or acquisition have been subject to additional reporting requirements and prior approval requirements where one of the parties already has substantial PRC market revenue or percentage of the PRC market, or the transaction will result in a party holding a  substantial PRC market share, or a substantial number of mergers and acquisitions of domestic  enterprises in the specific PRC industry have occurred during the past year. Importantly, similar pre-merger requirements for foreign or overseas mergers or acquisitions have been triggered by similar PRC market criteria.

In general, the new anti-monopoly law effective from August 2008 prohibits the consummation of certain concentrations which meet thresholds— to be determined from time to time by government authorities—unless they are reported to and clearances then obtained from the anti-monopoly enforcement agency.4 The agency has 30 days to conduct an initial review, with non-action within that period being deemed clearance for the concentration, but may call for a further 90 days (and even a further 60 days thereafter) for further reviews.

Whether or not foreign investment is involved, the anti-monopoly law also protects certain legal monopolies regulated by the PRC government and state-controlled industries relied upon for the national economy and national security. While the new anti-monopoly law is generally not applicable to the protection of intellectual property rights, it does prohibit the abuse of intellectual property rights to eliminate or restrict market competition.

National Security Review

In addition, any foreign acquisition of a domestic enterprise or other concentration of foreign capital may be subject to a national security review. Regulations for this review will likely include a list of key industries or enterprises in which foreign participation is subject to review.

Currency Considerations

Perhaps the most important remaining PRC legal uncertainty for foreign private equity investors is compliance with limitations on remittances out of the PRC in foreign currencies, since PRC currency is not permitted to be used outside the PRC. These limitations are completely subject to momentary change, unless foreign exchange quotas have been previously agreed to with the government.

In addition, with respect to post-merger or acquisition cash flow planning involving anticipated export receipts, after mid-2008 exporters must deposit their overseas sales revenues in a special bank account for auditing before they can be exchanged into local PRC currency. This is to permit verification that export invoices match genuine transactions rather than being inflated to bring additional foreign currency into the PRC.

Restriction of Onshore PRC Residents’ Private Equity Investments

An additional element which may affect the structuring of a private equity investment into the PRC is the restriction of onshore PRC residents’ participation in such investments through non-PRC entities.

Specifically, no PRC resident may establish or control an offshore company either directly or indirectly without PRC government approval. In addition, a PRC resident must register with local offices when acquiring control of an offshore holding entity which in turn invests in the PRC. Such restrictions are designed to prohibit PRC investors from maintaining capital structures outside PRC jurisdiction, whether separately or together with foreign investors.

Foreign Private Equity Enterprises in Beijing, Shanghai, and Tianjin

More positively, foreign private equity and other investment funds are being permitted in Beijing, Shanghai, and Tianjin to establish PRC limited liability or partnership enterprises. These in turn may be able to raise funds directly from PRC investors, with certain taxation limits on the fund and its investors mentioned further below. Such a domestic enterprise also may be useful in facilitating activities within the PRC by the fund itself.

Tax and Financial Incentives

The PRC has begun to provide tax and financial incentives, such as government loan guarantees and streamlined regulation, for investment funds controlled by PRC managers and investors providing equity capital for startup enterprises.

It is not clear whether such measures contravene PRC commitments under international agreements requiring national treatment for foreign investors. The PRC has maintained the right to restrict PRC market access in securities-related industries, but not with respect to cross-border capital.

Venture Capital Operating Companies

As noted previously regarding investors’ countries’ legal requirements, the need to qualify the private equity fund as a VCOC where U.S. benefit plans invest in the fund may require the fund to obtain direct contractual management rights in PRC operating companies within its portfolio. Thus, legally enforceable methods to obtain such rights must be examined under PRC law.

Tax Efficiency at the Investor Level

Leveraged Structures

As noted previously, structuring a private equity investment as a partnership may permit investors’ shares of income from the investment to be taxed only at their own level, rather than incurring an additional tax at the corporate level before being distributed to the investors. Moreover, tax-exempt
investors in such a structure will likely pay no tax to their countries of residence on such income.

However, under the U.S. UBTI rules, a U.S. tax-exempt investor will be taxed on income from a debt financed investment — thus any debt incurred to finance a private equity investment should be incurred at the level of a corporation below the tax-exempt investor or below a partnership in which it invests. In the case of a PRC private equity investment, this suggests that debt financing should be incurred (1) at the level of the PRC corporation holding the investment or (2) at the level of a non-PRC corporation which in turn makes the PRC investment.

In the first case, PRC legal and/or tax limitations on debt-to-equity ratios of PRC enterprises must be examined as the same evolve from time to time. Historically, foreign invested enterprises have been restricted to borrowing from foreign owners one to three times the amount of their equity investment.

In the second case, interest expense accrued or paid by a non-PRC corporation used to hold the PRC investment may well not be deductible for PRC income tax purposes from the taxable income of the PRC enterprise in which the investment has been made.

PRC Tax Residence

The new PRC income tax law also provides that so-called tax resident enterprises—not just those organized in the PRC—may be subject to PRC corporate income tax on their worldwide income, rather than only on PRC source income.5 Foreign enterprises whose effective management is in the PRC may be treated as tax resident enterprises subject to worldwide PRC income tax.6

Thus, any foreign enterprise organized to hold private equity investments in the PRC should have its effective management—probably including substantial general management and control over tax, operations, personnel, finance, accounting and properties — outside the PRC in order to avoid such worldwide income taxation.

PRC Source Income

The new PRC income tax law provides a withholding tax rate on the gross amount of dividends, interest, rents, royalties and other investment earnings paid to non-resident enterprises — such as foreign owners of PRC private equity investments — at the rate of 20 percent.7 Implementing regulations currently reduce this rate to 10 percent.8

This is as low as withholding tax rates under most PRC income tax treaties with other countries. However, a few such treaties reduce PRC withholding taxes even further to, e.g., five percent on certain dividends. Moreover, any such regulatory concession for non-treaty investors clearly is subject to amendment at any time. Accordingly, attention should be paid to structuring through PRC income tax treaty jurisdictions such as Mauritius or other countries with favorable PRC treaties.9

However, the new income tax law empowers PRC tax authorities to make reasonable adjustments where an enterprise implements an arrangement with no reasonable commercial purpose other than to reduce its taxable income or profit.10

Furthermore, many PRC income tax treaties have a broad limitation-of benefits clause under which the PRC can deny treaty benefits to a treaty resident which is not majority owned by other residents of the treaty country or which pays a majority of its income to nonresidents of the treaty country, unless it is publicly traded in the treaty country.

Alternatively, using a Hong Kong company to own a PRC portfolio company may permit payment of dividends subject to PRC withholding taxes of  only five percent on dividends and seven percent on interest. Hong Kong in turn generally does not impose withholding tax on most company distributions to foreign owners and also has negotiated a very limited number of its own income tax treaties, including a treaty pending finalization with Luxembourg.

PRC Investment Funds

As noted further above, establishment of a PRC investment fund may be permitted in certain local jurisdictions of the PRC. Such a fund may be subject to a maximum PRC income tax rate of 35 percent, but this does not seem particularly favorable compared to the PRC rates applicable to distributions to foreign funds as discussed above.

In connection with taxation of PRC portfolio companies, management fees even between unrelated enterprises generally are non-deductible in the PRC, which may limit the deductibility of investment adviser fees paid by a PRC fund. Moreover, with respect to investment adviser fees which may be waived by advisers and invested in a fund as carried interests as described previously, PRC tax treatment seems currently unclear, so any such arrangement likely should be structured in a non-PRC enterprise.

Taxation of PRC Income in Investors’ Countries

Distributions from a PRC enterprise to foreign owners often are subject as well to income tax in the owners’ countries. For example, dividends paid from a PRC company to a U.S. taxable investor currently may be taxed to a U.S. individual at a 15 percent rate as qualified dividends if certain conditions are met, and otherwise are taxed at U.S. ordinary income tax rates, subject to a U.S. foreign tax credit for PRC income taxes.

One question that may arise as U.S. investors expand PRC holdings is whether a structure can be used to permit distributions from PRC enterprises and re-investment in other PRC enterprises without triggering extra PRC or U.S. income taxation. With respect to PRC taxation, historically a PRC holding company has been permitted under certain criteria to be used to hold multiple foreign invested enterprises and to receive dividends from them without either withholding taxes on the dividends or taxes on the holding company itself. Since the new income tax law does not allow enterprises to pay taxes on a consolidated basis, this may not be available.11

For U.S.-based investors, what about U.S. taxation of intra-PRC distributions and re-investments by a PRC holding company? At least two U.S. federal income tax issues must be addressed: First, if the PRC holding company is a controlled foreign corporation under U.S. income tax rules, such dividends or other passive income payments usually trigger current U.S. taxation of substantial U.S. shareholders of the holding company. However, an exception generally applies for dividends from a related corporation organized and with substantial trade or business assets within the same country — here, the PRC enterprises. Second, if the PRC holding company would otherwise be a passive foreign investment company under U.S. income tax  rules, this usually will trigger current U.S. taxation or unattractive later taxation of any U.S. shareholders of the company. However, passive income and assets generally exclude active business income and assets of a corporation owned at least 25 percent by the holding company— here, PRC enterprises if owned at least 25 percent by the PRC holding company.

Hybrid Financial Instruments

Under U.S. tax principles interest on a shareholder loan usually must be accrued into income over time, even if payment of interest is not required until maturity or another exit event. One way to avoid this is the use of a hybrid financial instrument (i.e., an instrument treated as debt in the country of the  issuer and equity in the U.S.). A good example of such a hybrid financial instrument is the current Luxembourg preferred equity certificate. The terms of the instrument must be carefully reviewed by tax advisers in the issuing company’s home country and the U.S. to ensure debt treatment for the issuer and equity treatment for the U.S. holder. Dividends on stock typically are not required to be accrued into income by U.S. taxpayers prior to the payment of a dividend. However, even if the instrument is treated as equity in the U.S., careful review is required in order to ensure that certain deemed dividend rules applicable to preferred stock do not apply to require acceleration of the taxation of dividends or the conversion of capital gain into ordinary income.

Tax Efficiency at the Portfolio Company

Flat Tax Rate

The new PRC Enterprise Income Tax Law referred to has replaced the former separate income tax laws applicable to domestic invested enterprises and to foreign invested enterprises. Under the latter law, foreign invested enterprises meeting legal requirements as described also obtained numerous tax concessions and preferences not permitted to domestic invested enterprises.

Now a flat tax rate of 25 percent is uniformly applied to the taxable income of resident enterprises, except for small or low profit enterprises meeting certain requirements that benefit from a 20 percent tax rate and high technology enterprises supported by the state which enjoy a 15 percent tax rate.12

It should be noted that, notwithstanding replacement of the former separate tax benefit regime for foreign invested enterprises, if the portfolio company has been a foreign invested enterprise which previously received such benefits, those benefits may need to be paid back if it ceases business within 10 years after their commencement.


In calculating taxable income:

Management fees paid between enterprises are now non-deductible — presumably including hotel management company fees, holding company management assistance, and others.13

Interest charged between units of the same enterprise is non-deductible. This does not apply to interest charged between separate but related parties controlled by the same owners.14 However, interest on loans from a nonfinancial institution — such as a controlling shareholder or foreign or domestic affiliate — to a non-financial enterprise is deductible only at the amount that would have been charged by a financial institution making the same loan.15Furthermore, deduction of interest on loans from related parties — or guaranteed or collateralized by related parties — is prohibited where the loan exceeds stipulated standards. Circular 121 to the new income tax law, released in fall of 2008, sets the prescribed debt/equity ratio at 2:1 for a non-financial enterprise’s related party debt.16

Rents and royalties between operational units of the same enterprise (but not between separate but related parties controlled by the same owners) are also non-deductible.17

Depreciation of capital assets is limited to the straight-line method (although, under certain circumstances, an enterprise may utilize an accelerated method) and excludes an estimated residual value which must be determined by the user at the beginning.18Depreciation periods range from 20 years for buildings and structures to three years for electronic equipment.19

Intangibles such as patents, trademarks and copyrights are to be amortized over not less than 10 years.20

An important asset that cannot be amortized is goodwill arising from an acquisition, which may only be deducted when the entire enterprise is transferred or liquidated.21

Additional deductions and tax preferences are available for enterprises engaged in encouraged activities — currently high technology, service centers, public infrastructure projects, environmental protection projects and others.22

Transfer Pricing

The PRC’s previous extensive transfer pricing regime, requiring arm’s length charges between related parties controlled by the same owners, continues under the new income tax law.23

Appropriate methods for pricing goods and services between related enterprises include the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, the profit split method and others.24 Any transfer pricing adjustment will now bear interest at a specified rate, currently five percent above the interest rate published by the People’s Bank of China.25 However, advance pricing approvals remain available.26

Consider the Exit Before Entry

Structuring for exit from a PRC private equity investment first must take account of potential PRC taxes on exit gains.

Asset Disposition

Disposition of assets of the PRC portfolio company may avoid lengthy negotiations on hidden liabilities of the company which can adversely affect the value of a share purchase or merger. However, clearly the asset sale will generate taxable income for the portfolio company. PRC value added tax— currently 17 percent—and other business taxes on individual asset sales may be avoided where PRC tax authorities agree that the sale constitutes substantially the whole of the business of the portfolio company, but such a ruling may only come after the sale is made or may be decided differently depending upon the applicable local tax bureau. Furthermore, appreciation in the value of land in the hands of the selling portfolio company may be subject to land appreciation tax of up to 60 percent.

Moreover, under the new income tax law, subsequent liquidation income from a PRC company is taxed as dividend income to the extent of accumulated earnings and the balance of any gain as profit from the transfer of investment assets.27 This liquidation tax treatment was originally applicable also to foreign enterprises receiving such profits, but that clause was later deleted in the new income tax law.

It should also be remembered that, as noted further above, if the portfolio company has been a foreign invested enterprise which previously received PRC tax benefits, those benefits may need to be paid back if it ceases business within 10 years after their commencement.

Sale of Portfolio Company

With respect to direct sale by the foreign owner of a PRC enterprise, previously taxation of gain at 10 percent applied and, as noted, under the new income tax law most PRC investment earnings paid to non-resident enterprises are subject to withholding tax at 20 percent, currently reduced to 10 percent by implementing regulations. Shortly before promulgation of the new income tax law the PRC government denied that it intended to impose capital gains taxation on share transfers. Since income derived by foreign enterprises from the transfer of PRC property is generally taxable, if share transactions are not to be taxed, then regulations will need to create an exemption.

Alternatively, under most income tax treaties of the PRC, capital gain from the disposition of property generally is not taxable to a resident of the treaty country if not attributable to a permanent establishment in the PRC of the foreign seller — this argues for using a foreign entity entitled to tax treaty benefits to dispose of a private equity investment in the PRC. However, many PRC treaties reserve the right of the PRC to tax disposition of ownership interests of 25 percent or more and, as noted further above, contain limitation-of-benefits clauses. Moreover, as noted, the new income tax law empowers PRC tax authorities to make reasonable adjustments where an enterprise implements an arrangement with no reasonable commercial purpose other than to reduce its taxable income or profit.

If a PRC investment fund is established to hold the PRC portfolio company, as permitted in certain local jurisdictions of the PRC, apparently capital gain on its disposition of company interests will be taxed by the PRC at 20 percent — again not particularly favorable compared to the PRC rates applicable to capital gains of foreign funds as discussed above.

Foreign Holding Company Disposition

One frequently considered alternative is to dispose of interests in a foreign holding company which in turn owns the PRC portfolio company, as discussed further below. Generally PRC taxation does not apply to gains on such a disposition, except to the extent PRC owners are involved.

However — whether a purchaser acquires the PRC portfolio company’s shares or the ownership interests in a foreign holding company — the new income tax law does not appear to permit the purchaser of a portfolio company’s shares (or a holding company’s interests) to obtain a stepped-up tax basis in the company’s PRC assets without triggering company recognition of profit from appreciation in the assets and possible asset transfer taxes as described above. A PRC enterprise that is reorganized must recognize profit from the transfer of its assets and the tax bases of the relevant assets are then revised according to the transaction prices—thus even the transfer of a subsidiary from one entity to another will be treated as a taxable event.28Similarly, reorganization of a foreign holding company owning a portfolio company may trigger a taxable transfer of the portfolio company’s shares. This suggests that a purchaser which is unwilling to maintain the portfolio or holding company’s structure as is may incur significant PRC taxes.

What of Non-PRC Taxation of Exit Profits at the Investors’ Countries’ Level?

To date most PRC private equity investments have been held through companies established in the Cayman Islands or British Virgin Islands.29Accordingly, as noted above, one alternative exit for investors is to sell their interests in the foreign holding company.30

For U.S. investors, if the foreign holding company is a controlled foreign corporation, gains may ultimately be taxed as ordinary income up to the accumulated earnings of the corporation—thus this classification should be avoided by assuring that the foreign holding company is not owned more than 50 percent in voting power or value by U.S. persons each owning 10 percent or more of the voting power. In addition, unfavorable U.S. taxation of U.S. shareholders in case the foreign holding company is treated as a passive foreign investment company can be avoided if the foreign holding company owns at least 25 percent directly or indirectly of PRC enterprises with active business income and assets. In these circumstances, disposition gains to taxable U.S. investors should receive capital gains treatment for U.S. income tax purposes.

As previously noted, U.S. tax-exempt investors will not be taxed on such disposition gains, if any debt financing incurred for the private equity investments is incurred by one or more entities classified as corporations for U.S. income tax purposes below the level of the investors themselves or below a partnership through which they hold their interests.

For investors in other countries, measures should be considered to assure similar favorable capital gains treatment or tax exemption on such disposition gains.

Tax-Free Reorganization

Alternatively, a disposition which qualifies as a tax-free reorganization for U.S. and/or other foreign investors may be considered. For example, recently liberalized U.S. tax rules may enable a tax-free acquisition of a Cayman company with PRC operations in a so-called reverse subsidiary merger. In this approach, the acquiror may establish a Cayman acquisition subsidiary that can utilize a local Cayman scheme of arrangement to be amalgamated with and into the target holding company. This also may permit payment to selling shareholders by a combination of (non-taxable) voting shares of the acquiror plus (taxable) cash or other non-share consideration.

In such a transaction, the existence of the target foreign holding company continues, so that PRC regulatory and tax issues regarding change of ownership of private equity investments in one or more PRC portfolio companies will likely be avoided.


Structuring international private equity investments in the PRC involves a number of planning opportunities:

  • meeting legal requirements and restrictions in both the PRC and the investors’ countries
  • obtaining tax efficiency at the investor level under both PRC and investors’ countries’ rules
  • obtaining tax efficiency at the PRC portfolio company level, and
  • minimizing exit taxation and legal restrictions at both the PRC and investors’ countries’ levels.

As PRC legal and tax rules — as well as those of foreign investors’ countries — continue to evolve, structures for international private equity investments in the PRC will likely become even clearer and more efficient.


1 The Enterprise Income Tax Law (Decree No. 63 of the President of the People’s Republic of China) (EITL) was promulgated on March 16, 2007 and effective on January 1, 2008. The Implementation Rules of the Enterprise Income Tax Law (Decree No. 512 of the State Council of the People’s Republic of China) (EIT Regs) were promulgated December 6, 2007 and became effective January 1, 2008. Although the EIT Regs provide a road map for implementing the EITL, a number of issues remain unresolved and are expected to be clarified when the Ministry of Finance and the State Administration of Taxation issue supplementary tax circulars. (Note that the EITL applies to the territory of the People’s Republic of China, which does not include Hong Kong, Macao and Taiwan.).

2 The Catalogue for the Guidance of Foreign Investment Industries was promulgated by the National Development and Reform Commission and the Ministry of Commerce on October 31, 2007, effective as of December 1, 2007.

3 That is, foreign investors were and are permitted to access the A-share market through the qualified foreign institutional investor scheme (introduced in 2002).

4 The Anti-Monopoly Law only sets out broad principles with details to be developed in subsequent regulations and guidelines through the State Council.

5 EITL Art. 2 states that a resident enterprise includes an enterprise established within the territory of another country or other tax region pursuant to that country or that region’s laws whose actual management or control is located in the PRC.

6 EIT Reg 4 supplements EITL Art. 2 by stating that effective management refers to establishments that exercise substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. of an enterprise.

7 EITL Art. 4. However, EITL Art. 27(5) states that this rate may be reduced.

8 EIT Reg 91.

9 Presumably the intermediate treaty enterprise should be established without actual management within the PRC to avoid being treated as a PRC resident enterprise as described further above, unless a different treaty definition may preclude such treatment.

10 EITL Art. 47; see also EIT Reg 120.

11 EITL Art. 52 states that, unless otherwise stipulated by the State Council, enterprises shall not be allowed to pay enterprise income tax on a consolidated basis. But see EITL Art. 17 which states that, when calculating the enterprise income tax on a consolidated basis, losses incurred by an enterprise from its overseas operating unit shall not be deductible.

12 EITL Art. 28; see also EIT Reg 93.

13 EIT Reg 49 provides, inter alia, that management fees paid between enterprises shall not be deductible.

14 EITL Art. 46; see also EIT Reg 119 (stating, in part, that specified interest rates will be separately stipulated by government authorities).

15 EIT Reg 38(2).

16 The Ministry of Finance and State Administration of Taxation have jointly published a circular, Caishui [2008] No.121 (Circular 121), in fall 2008. The prescribed debt/equity ratio for financial enterprises’ related party debt is set at 5:1, while the ratio for non-financial enterprises is set at 2:1. Furthermore, where the ratio of the debts from related parties to the equity exceeds the prescribed debt/equity ratio in a year, the interest expense pertaining to the debts from related parties shall not be deductible in that year and, generally, there is no carry forward of the disallowed deductions to future years.

17 EITL Art. 49.

18 EITL Art. 32 states that an enterprise holding fixed assets subject to advancements in technology, etc. that require accelerated depreciation may shorten the depreciation period or apply an accelerated depreciation method. EIT Reg 98 limits the shortening of the depreciation period, if applicable, to no less than 60 percent of the minimum depreciation period as cited in EIT Reg 60. Furthermore, EIT Reg 98 states that where an accelerated depreciation method is applied, either the double declining balance method or the sum-of-the-years’-digits method may be used. In addition, EIT Reg 59 provides, in part, that the net residual value of a fixed asset shall be reasonably determined by an enterprise according to the nature and condition of the fixed asset and may not be changed once determined.

19 EIT Reg 60 lays out the minimum number of years for computing depreciation of fixed assets as follows, except to the extent government authorities of the State Council in charge of finance and taxation stipulate otherwise: 1) 20 years for houses and buildings; 2) 10 years for airplanes, trains, ships, machinery, mechanical apparatuses and other equipment used in manufacturing; 3) five years for apparatuses, tools, and furnishings used in connection with manufacturing and business operations; 4) four years for transportation vehicles other than airplanes, trains and ships; and 5) three years for electronic equipment.

20 EIT Reg 67.

21 EITL Art. 12; EIT Reg 67.

22 EITL Art. 36 states, in part, that the State Council shall tailor enterprise income tax incentive policies, to be filed for recording purposes with the Standing Committee of the National People’s Congress, in accordance with economic and societal development needs. The EITL, in effect, eliminates many of the prior tax incentives for foreign invested and other enterprises. Furthermore, various EITL Articles and the EIT Regs stipulate tax exempt/reduced industries, activities and regions. For instance, EITL Art. 27 allows for tax exemptions for income earned from major State-supported public infrastructure projects (see also EIT Reg 87) and qualifying environmental protection projects. EITL Art. 29 provides for the governments of autonomous areas to reduce or exempt taxes (see also EIT Reg 94). Additionally, increased deductions are allowed for research and development expenses incurred during the development of new technology, new products and new techniques (see EITL Art. 30 and EIT Reg 95).

23 EITL Art. 41 and EIT Reg 112 discuss cost sharing agreements between related parties (since the PRC does not have much experience in implementing cost sharing arrangements, it remains to be seen how this provision will be dealt with in practice); EITL Art. 43 and EIT Reg 114 discuss necessary documentation such as requirements to submit annual related party transaction reports with an enterprise’s annual tax returns; EIT Reg 115 provides that where an enterprise fails to supply information or provides false information with respect to related party transactions, the tax authorities have the right to adjust the taxable income of the enterprise based on appropriate arm’s length standards.

24 EIT Reg 111.

25 EIT Reg 122.

26 EITL Art. 42 provides that, if an enterprise desires to enter into an advance pricing agreement, it can provide pricing principles and computation methods used in business transactions between the enterprise and its related party to the tax bureau for discussion and negotiation about entering into such an agreement. See also EIT Reg 113.

27 EIT Reg 11.

28 EIT Reg 75 states that enterprises shall recognize capital gain or loss on relevant assets in the course of a reorganization when the transaction is executed and re-determine the tax basis of the relevant assets in accordance with trading prices, unless the government authorities of the State Council in charge of finance and taxation stipulate otherwise. This treatment seems contrary to previous PRC tax law.

29 Additional currently favorable holding company jurisdictions include Hong Kong, Mauritius and Singapore.

30 One such sale strategy is to list the foreign holding company on the Hong Kong Stock Exchange. The Hong Kong Stock Exchange may be favorable for a public offering of shares in such a holding company because of the inapplicability of requirements under the U.S. Sarbanes-Oxley Act. However, only Bermuda, Cayman Islands, Hong Kong and PRC companies are currently approved for listing on the Hong Kong Stock Exchange (neither British Virgin Islands nor U.S. companies are approved).

Steven D. Bortnick and John I. Forry

Mr. Forry (jforry@eisnerllp.com) is a principal with the accounting and tax advisory firm of Eisner LLP based in New York. The authors are grateful for the special research provided by Steven C. Schinko at the University of San Diego School of Law and the suggestions provided by Stephen Nelson, head of the tax department of King & Wood, PRC, lawyers.

When embarking on any new business, it's important that one not only engages professionals with deep industry knowledge but also commercial knowledge to support the various stages of business growth. For anyone establishing a hedge fund, their needs are going to change as their business evolves from launch to maturity.

"If a manager launches with USD10 million, their tax situation maybe far different compared to some point in the future if the fund's assets have risen to USD200m. If a manager derives profit from their management fee, proper structuring of the management entity may reduce self-employment tax," explains Ron Geffner (pictured), partner at Sadis & Goldberg LLP, one of New York's leading financial services-focused law firms.

Geffner heads up the Financial Services Group, comprised of 13 attorneys that have each spent a significant amount of their career practicing in the private fund space, providing a compelling roster of seasoned legal advisers. 

They routinely handle a diverse range of enquiries providing legal counsel to over 800 funds including domestic and international financial institutions, family offices, hedge funds, private equity funds, venture capital funds, real estate funds and commodity pools. 

Geffner says that the majority of hedge fund launches in the United States launch a domestic fund and that the majority of domestic funds are organised as a Delaware limited partnership. "Nonetheless, a significant number of our clients establish an offshore Cayman master feeder structure at launch. In this instance, the Cayman master fund is established as an exempted corporation for US non-taxable investors (i.e. public pension funds) and non-US investors. Deciding on whether to go offshore will often be dictated by the perceived level of assets available to the manager." 

Whilst the manager will be taxed accordingly based on the profits derived from the management fee, there are different considerations in respect to the performance allocation fee. Receiving a percentage of the profits as an allocation or a fee is also driven by tax considerations, which are primarily driven by the portfolio construction and harvesting of profits. 

When selecting legal counsel to structure the fund entity, managers should consider making it as viable a commercial proposition to prospective investors as possible. Last year, for example, Sadis & Goldberg launched approximately 80 new funds. 

"The work we do ranges from structuring the fund product to make it viable to prospective investors and guiding Sadis & Goldberg clients in respect of regulatory, tax and corporate related issues. The offering documents should reflect a structure that matches the intended investment strategy and management, as well as terms regarding liquidity fees, valuation and expenses, to name a few, that conform to commercial standards. Based upon the number of hedge funds which we represent, we have the commercial experience to guide managers on these issues," explains Geffner. 

He adds that the appointed legal counsel should establish a "close rapport" so that the client can appreciate the practical guidance they are providing. "A lot of professionals in this industry have lost touch with their clients. What makes Sadis & Goldberg unique is that we've had considerable experience working with start-up managers, middle market managers and large, established managers," concludes Geffner.

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