Author: | Published: 4 Jan 2001
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Fund investors face considerable risk exposure without their knowledge. All private equity and venture capital funds should structure their business in accordance with the economic and legal environment in the states where the funds act in order to protect their internal rate of revenue (IRR) against local disadvantages. One of the issues to take into careful consideration concerning setting up a private equity or venture capital fund is the domestic tax consequences. Acting in a state, and not considering its fiscal environment, can have a severe effect on returns for the investors in the funds as well as the managers of the funds.

Case-by-case analysis

Fund investors face considerable risk exposure. Through consultations within the private equity and venture capital field in Europe and the US, we have been able to draw the conclusion that a standardized method of adjusting the fund structures to the local environment will lead to a risk exposure towards the imposition of domestic tax. To alleviate these risks we advocate a case-by-case assessment of the fund structure.

Risk of double taxation

Each state is sovereign, and has sole jurisdiction over taxation within its borders. A private equity or venture capital fund resident in one state and conducting business in another could in principle be liable to double taxation on its income and gains. Both the state where the fund is resident, and the state where the fund conducts business, would have an interest in taxing the income or the gain. In order to solve these tax conflicts, most states have entered into double taxation agreements with each other. Under this agreement, the states concede the right to tax in one state primarily; the object is to avoid double taxation on the income or gain. The OECD has compiled a Model Tax Convention on income and capital, and most double taxation agreements are based on this.

Permanent establishment

The notion of permanent establishment is central to the international taxation of enterprises, such as private equity and venture capital funds. This concept has mainly been developed in the negotiations between states in relation to double taxation agreements, but permanent establishment often has its equivalent in the states' internal tax legislation.

The main rule in the Model Tax Convention is that an enterprise resident in one contracting state shall only be taxed in that state on business income. However, if the enterprise carries on business in another contracting state through a permanent establishment based there, the business income of the enterprise attributable to the permanent establishment, may be taxed in that other state.

To exemplify the rule which allocates the right to tax business income, we assume that a private equity fund is set up in the US. One of the fund's investment managers acts on behalf of the fund in Sweden. Through its extensive activities in Sweden, the investment manager creates a permanent establishment for the fund in Sweden. All income from the fund attributable to the permanent establishment may then be taxed in Sweden, according to the applicable double taxation treaty.

The Model Tax Convention defines permanent establishment as a fixed place of business, through which the business of an enterprise is wholly or partly carried on. The requirement of a place of business is satisfied merely through the enterprise having a certain amount of space at its disposal. The place of business has to be fixed in the sense that it has to have a certain degree of permanency, i.e. that it is not of a purely temporary nature. Operations of the enterprise must be carried out through the fixed place of business on a regular basis.

Place of management, offices and branches

The Model Tax Convention states inter alia that the term permanent establishment especially includes a) a place of management; b) a branch; and c) an office. These places still have to be fixed, and the enterprise has to carry out operations through them on a regular basis. Business activities of preparatory or auxiliary character are not regarded as a permanent establishment. Taking the example of a US private equity fund, which has its place of management or a branch or an office in Sweden, if the activities it regularly conducts through the place of business cannot be characterized as auxiliary or preparatory, the business of the fund in Sweden will form a permanent establishment. This means that all of the fund's business income, attributable to the permanent establishment, may accordingly be taxed in Sweden.


Crucial for private equity and venture capital funds is the role of agents. Funds with agents acting in other states must consider that they, themselves, can form a permanent establishment for the fund in the states where the agents act. The activities of such an agent can constitute a permanent establishment even though a fixed place of business is not present. The agent rule therefore constitutes an alternative criterion, according to which a fund may be deemed to have a permanent establishment. In order for a permanent establishment to be formed, four requirements must be meet:

The agent acting on behalf of the enterprise shall be a so-called dependent agent, i.e. a person, whether an employee or not, who is not an independent agent.

According to the OECD, it would not be in the interest of international economic relations to provide that the maintenance of any dependent person results in permanent establishment. Such treatment must be limited to persons who in view of the scope of their authority, or the nature of their activity involve the enterprise to a particular extent in business activities in the state concerned. Such persons may be either individuals or a company, including a partnership and a consortium. The dependent agent can be different people and a group of agents can constitute a permanent establishment.

Examples of independent agents are brokers and general commission agents. However, these agents need to be legally and economically independent of the principal, and act in their ordinary course of business when acting on behalf of the principal. Whether a person is independent of the enterprise represented depends on the extent of the obligations which this person has vis-à-vis the enterprise. A person cannot be regarded as independent of an enterprise, if its commercial activities are subject to detailed instructions or comprehensive control. Another important criterion when judging degree of dependence is which party bears the entrepreneurial risk. Agents cannot be said to act in the ordinary course of their own business if they perform activities which economically belong to the sphere of the principal, rather than that of their own business operations.

The dependent agent shall have authority to conclude contracts in the name of the principal.

The dependent agent use the authority to enter into contracts on behalf of the principal habitually, not merely in isolated cases.

However, the agent does not have to enter into the contracts literally in the name of the enterprise. These requirements can also be satisfied by an agent who concludes contracts which are binding on the enterprise, even if those contracts are not actually in the name of the enterprise. A caveat shall be set out in relation to these requirements. Whether or not sufficient authority is habitually exercised by the agent in the other state should be determined with reference to the commercial realities of the situation. A person who is authorized to negotiate all elements and details of a contract binding on the enterprise, can be said to exercise the necessary authority in the other state, even if the contract is signed by another person in the state in which the enterprise is situated. Hence, substance is regarded above form. It is, however, not necessary that the agent has negotiated all terms and conditions of the contract or even has had the authority to negotiate the contract, if the agent actually concludes the contract. The entry into one contract is not sufficient to create a permanent establishment, generally speaking, but if the frequency corresponds to the normal frequency of the relevant business, the condition may be deemed to be satisfied.

The authority to conclude contracts must cover contracts relating to operations which constitute the proper business of the enterprise.

For example, if the agent is only authorized to conclude contracts in the name of the fund that relates to its internal operations, that activity cannot form a permanent establishment. The agent does not form a permanent establishment for a fund if the activities performed by the agent are of preparatory and auxiliary character, even if the agent has a wider authority.

When all four requirements are fulfilled, a permanent establishment of the fund exists, according to the Model Tax Convention, to the extent to which the agent acts for the fund, i.e. not only to the extent that the agent exercises the authority to conclude contracts in the name of the enterprise.

Aggressive tax authorities

The treatment of permanent establishments, in practice, is accompanied by major difficulties. An assessment has to be made in each case. From Scandinavian case law, the conclusion may be drawn that the local tax authorities are eager to determine that a permanent establishment is present. The demands on a fixed place of business are very low and a mere space is enough. We can expect that the requirements of agency will be treated in a similar manner for consistency. The tax authorities will look into the realities of a fund structure and favour substance over form.

Offshore and onshore fund structures

A distinction has to be made between offshore and onshore private equity and venture capital fund structures. Offshore structures, with a manager situated in a tax haven, and investment managers acting for example in Sweden, run a risk that the authorities will conclude that the activities of the investment managers in Sweden constitutes a permanent establishment in Sweden. The risk is increased if the manager in the tax haven lacks substance in the form of an office and employees. Colloquially, this has been termed 'a letter-box company'. With these structures, the conclusion of the Swedish tax authorities could realistically be that the entire business of the fund is in fact conducted in Sweden. Where there are offshore fund structures, there are rarely any double taxation agreements. According to most double taxation agreements, the tax authorities in the states concerned are obliged to negotiate how the structure is considered. Onshore fund structures appear less aggressive in avoiding tax, and can often also benefit from a double taxation agreement.


Once again, it must be emphasized that an evaluation has to be made of each individual fund structure, and that standardized methods of adapting fund structures to the domestic tax environment in various countries must be avoided. If one approaches the establishment of fund structures on a case-by-case basis, one reduces the risks of the imposition of local tax, thereby maintaining the IRR. One can expect private equity and venture capital funds fuelling progress in the economy will attract the interest of the tax authorities. It is commonly held knowledge that the tax authorities in the Scandinavian region are keen on correcting schemes, in order to find those schemes liable to local taxes. Local knowledge of the legal, as well as the financial environment is essential to the success of a private equity or venture capital fund. Once we approach the fund structuring in correct manner, we can expect that the IRR will not be reduced by unnecessary tax.

Mannheimer Swartling

Norrmalmstorg 4
PO Box 1711

Tel: 46 8 613 5500
Fax: 46 8 613 5501