Abstract ceiling of modern architecture

How a private equity tax function can reduce risk and maximize value

21 minute read 17 Nov 2023
Related topics
Private equity
Tax

The function of the future will support the business objectives of the private equity fund while managing core tax activities.

In brief
  • The private equity tax function faces increasing complexity amid growth.
  • Functions should leverage technology to adapt.

Each private equity firm’s tax function is unique in that it has typically organically grown from a smaller set of tax activities, such as a tax compliance and reporting focus, to a more evolved set of activities meant to address the features that the fund manager’s founders and other business leaders perceive as most important for their business — and now, in some instances, to meet the needs of a regulated entity.

How EY can help

  • Tax services

    Our globally connected tax network can help your tax function address complex issues, making sure you can operate confidently in today’s disruptive landscape.

    Read more

We have observed that there is no standard, “one size fits all” approach to the tax function across fund managers. Nonetheless, we see commonalities among the tax functions.

 

Consequently, we believe that the private equity tax function of the future will be a right-sized, cost-effective, value-adding tax group that supports the business objectives of the private equity fund and manages core tax activities, which most often include:

  • Identifying opportunities and managing the associated risks
  • Structuring investments and restructuring transactions
  • Reporting tax and financial results in multiple jurisdictions to varied investors and government authorities
  • Efficiently outsourcing non-value-adding tax tasks
  • Successfully leveraging processes and technology to access relevant insights from data in a timely manner and to scale analytics as the business grows
  • Timely communicating to key stakeholders vital tax and financial items in a concise and business friendly manner

In our experience, private equity CFOs and heads of tax accordingly view and periodically revisit the tax function with the following questions in mind:

  • What tasks are required, value-adding, core activities of the tax function that support the private equity fund’s business?
  • What core activities should be retained within the organization, and which tasks are not core to the business that should be partially or wholly outsourced?
  • Where are these opportunities to reduce risk, maximize value, and create a scalable, cost-effective, value-adding tax function?

 

This article takes a closer look at the activities of the private equity tax function, with observations of trends and practices related to core and non-core activities, the use of process and technology capabilities (and now even AI) and outsourcing to manage the constantly increasing tax complexity and growth of the business.

  • The first section reviews the activities and tasks that need to be accomplished by the private equity tax function, with our comments on the primary trends we see in the market.
  • The second section outlines a decision framework for building a tax function of the future.
  • Appendix A summarizes common tax function configurations we observe at different-sized managers.
  • Appendix B lists “leading practices” and “notable challenges” for the private equity tax function for a variety of common tasks.

EY Tax function of the future for private equity

PDF (4 MB)
Two happy business colleagues at meeting in modern office interior. Successful african boss in a conversation with young employee in boardroom. Marketing team of two businessmen discussing strategy in meeting room.
1

Chapter 1

Tasks the private equity tax function needs to accomplish

Areas of responsibility include tax policy, fund and manager tax matters and transaction tax.

How EY can help

Tax policy

 

The primary purpose of the private equity tax function is to support the objectives of the business. Tax policy must provide the objective, governance and measure for every issue managed by the tax function to support the business (we highlight just a few of the key decision areas below). As most of these tax decisions may represent only one element relevant to key business or investment decisions, and they are rarely solely made by the tax function, it remains critical to socialize and communicate necessary tax input for decision-makers. In practice, we often see that they are viewed through a risk-based lens.

 

Strategy/policy: The threshold issue concerns defining how a particular organization chooses to weigh opportunity and risk in various situations when supporting the business. For example: What risk areas require professional advice? What level of confidence should such advice reflect (e.g., “will,” “should,” “more likely than not”)? Is the tax advice commercial? What is industry practice? For any given tax activity, does the business want to be “best-in-class” (e.g., with respect to investor-related issues), “best-in-cost” (e.g., for certain reporting issues), or somewhere in between? Is the policy well communicated to and understood by the relevant audience? How is the strategy/policy implemented and documented (e.g., formal opinion, informal correspondence, internal file memo)?

 

Different risks may warrant different approaches. For example, managers must be able to support tax return positions. Other obligations, such as supporting an accounting presentation, or documenting compliance with environmental, social, and governance (ESG) commitments (which often include some tax elements), may require that support to take a particular form. Lastly, we have seen process and technology play a bigger role in risk management, particularly the thoughtful use of integrated document management providing access to useful data from dashboards and analytical reports (without the effort of searching for and sorting through unnecessary details or out-of-date data).

 

Written tax policies and procedures provide the tax function the opportunity to inform the fund manager (and its advisors) about the “rules of the road” for the organization. A tax function often runs smoothly where the tax function implements formal tax policies and procedures. Failure to do so can lead to inconsistencies in PE fund tax policy (even in small fund managers) and ad hoc decision-making that may result in expensive and unexpected tax costs in the future.

 

Fund structuring: When raising capital, a fund manager’s strategy/policy will determine whether, or to what extent, it can or will cater to investors’ tax sensitivities, and whether doing so may merit the creation of structural alternatives (e.g., prevention of US income tax return filings, prevention of taxable income treated by a given investor jurisdiction as derived from a trade or business), which may entail additional structural and administrative liabilities, costs and risks.

 

Management company activity: As with other categories discussed here, management company activity is almost never solely a tax department decision, but it does have important tax consequences and thus ordinarily should involve tax input. Highlights typically include arrangements for local subsidiaries to employ resident professionals (and often their individual tax issues), and the intercompany agreements and associated transfer pricing embodying the relationship between a parent entity and each local entity.

 

Carry plan design: Private equity tax functions typically do not make fundamental carry plan decisions but do need to be involved. Typical issues to be addressed include: whether carry plan participation is uniform across the entire fund portfolio, or per investment; funding options for participants’ capital commitments (e.g., out of pocket and/or with borrowing); and whether, or to what extent, to protect participants from tax return-filing obligations outside their tax residence jurisdiction. These business issues result in tax issues around the world for both the management company itself, and individual carry plan participants.

 

Governance: Decisions, decision-making processes, and implementation must preserve the integrity of a strategy and policy by implementing and maintaining consistency and compatibility, while at the same time accommodating and accounting for potentially competing institutional concerns (e.g., tax vs. legal vs. accounting). Well-documented policies and procedures are important to the private equity fund’s business, but also increasingly to ESG-conscious investors.

Fund and manager tax matters

Tax compliance and reporting are the most traditionally and universally associated activity with the private equity tax function. The timely and accurate reporting of business activity is critical to the fund and manager. Historically, in tax compliance and reporting, the multiple and varied tax data requests by investors and governmental authorities, in different jurisdictions, in various data formats, with varied tax due dates have consumed an inordinate amount of time and effort of the private equity tax function.

Quickly evolving tax process and technology capabilities (and in the future, likely artificial intelligence (AI), as it develops) are a key component of how a private equity fund manages its tax data.

Data development/management: The tax function’s ability to access and manage data is fundamental to every element of tax compliance and reporting, as well as planning and transactions. Unfortunately, we often see tax data stored in spreadsheets, which are not easy to access and are prone to error. Equally unfortunate, the required source tax data almost always reside in other enterprise functions, in different formats, and relate to multiple periods. For example, the financial data required for tax return preparation and provisioning reside in the accounting function, which commonly uses financial data differently (e.g., on a consolidated basis, rather than on the entity-by-entity basis needed by the tax function).

As another example, investor onboarding information needed for investor demographics, distribution tax withholding and tax reporting compliance is typically located in a subscription-document package ordinarily administered by the legal function. Similarly, details of transactions, and legal entity formation and governance, necessary for tax compliance commonly reside with the legal function, deal teams, and/or outside service providers. Nonetheless, the tax function is “responsible” for the development and management of all tax data required for tax compliance and reporting, as well as for planning and transactions. Increasingly, we see private equity funds (although still a minority) exploring the full potential of process and technology capabilities to manage tax data.

Fund compliance and investor tax reporting: Fund-entity return filings and investor reporting are complex enough in the easiest cases but may be complicated further by difficult questions regarding allocations of taxable income as between investors and the carry plan, global obligations such as FATCA/CRS¹ and investors located in multiple jurisdictions. What is more, investors increasingly have tax reporting questions that need to be answered. Inevitably, the tax function is “responsible” for answering these questions.

Management company compliance and reporting: The management company is of course a complete operating business, often with a global footprint, that is separate from any fund entities and is an operating entity with all the attendant tax obligations, e.g., payroll reporting and withholding, local income tax filings (including transfer pricing where applicable), and VAT registration and filings where applicable. In addition, fund managers provide reporting to owners/founders. Some fund managers also provide family office functions to founders and senior executives.

Fund and management company financial reporting: The tax function generally creates and/or oversees the creation of the tax provision and tax accounts for the financial statements, as well as provides the information for notes required by applicable accounting standards. In a public company environment, the tax function may certify the results on a quarterly/annual basis in cases where the risk profile is significantly higher.

Public company compliance and reporting: Fund managers that are organized as public companies (PubCos) do not typically house all the employees in the PubCo; nevertheless, PubCo may exercise control over the fund manager (and possibly the fund), requiring management of the associated tax matters. In particular, the stakes associated with tax provisions require special care and attention.

Tax audits and controversies: Tax notices and audits come first to the tax compliance function, which generally must respond to the tax notices, oversee the tax audit, and advise management regarding options for addressing any controversy that may arise, many times globally.

Transaction tax

Transaction tax is often viewed by the managers of the private equity funds business as the highest value add activity that the tax function provides and often in non-private equity areas of expertise (e.g.,, credit, real estate). We increasingly see managers hiring “partner-level” in-house tax staff, who assist in transaction structuring and risk management.

To the extent fund deal teams attend to tax issues, the tax function may be involved in deal tax points as well as broader issues affecting the private equity platform. For example, the tax function may be asked to consider items that have a clear and direct relevance to valuation, such as a portfolio company’s legacy tax issues/liabilities, and the allocation of tax risks between transaction parties.

However, the tax function is responsible for broadening its focus on potentially important fund- and investor-level issues. For example, the investment holding structure and the fund’s investor composition may affect a portfolio company’s eligibility for such incentives as renewable energy tax credits, accelerated depreciation, or reduced rates of withholding.

More indirectly, but just as importantly, funds generally seek to maintain a consistent approach to managing risks across a wide variety of key tax areas of focus. Examples include the potential for reputational exposure; whether to employ a regional holding company platform, and if so, how it should be implemented; and managing permanent establishment and tax residency risks inherent in board composition, board conduct, and contract execution. We are also increasingly seeing the tax function spend time on transaction matters and tax diligence in preparation for exits of portfolio assets.

How EY can help

  • Private Equity

    EY Private Equity can help you discover new strategies to navigate complex transformations that shape the future and unlock innovative paths to growth and value creation.

    Read more

Portfolio tax matters

 

Most private equity fund tax functions, historically, for various reasons, have left most portfolio company tax matters to portfolio company management. However, the private equity tax function has always needed high-quality tax information well in advance of the fund’s own compliance/reporting deadlines, particularly with respect to portfolio companies structured as fiscally transparent entities.

 

This need for timely and accurate portfolio company tax data has often created tensions with the portfolio company, including consistency of position with the fund on various tax reporting items, information tailored to private equity investor reporting needs (i.e., IRS Schedule K-1/K-3), and the need to develop and disseminate information substantially earlier than the portfolio company may have done prior to acquisition by the fund.

 

A minority of private equity tax functions have addressed specific portfolio company tax from the fund level by engaging one or two tax advisory firms to work with companies across the portfolio; we see this most often with middle market private equity funds. We increasingly see private equity fund managers, particularly those with operations/value creation groups, focusing on portfolio company tax as a differentiator.

 

They understandably tend to focus on portfolio company cash taxes (such as challenging considerations for interest expense limitations or applying for such benefits as the Work Opportunity Tax Credit (WOTC)), but sometimes they look for possible operational efficiencies within the portfolio company tax function (such as whether or to what extent to outsource tax compliance). We also see more private equity funds perform sale side tax diligence (including so-called “tax books,” i.e., a summary of major tax attributes/potential tax issues) to confirm that there are not any value-reducing tax issues when a portfolio company is sold.

 

At the level of portfolio company holding entities, we see most fund managers outsourcing tax compliance and reporting obligations, often to the same provider(s) that handle fund-level compliance and reporting for the same reasons discussed above.

Casual meeting of smiling diverse business team analyzing financial data
2

Chapter 2

Decision framework for building a tax function of the future

Functions must identify core and non-core tax activities.

In the private equity business model, the tax function is a non-core but essential operating activity. Like other private equity business functions, tax costs must be managed, and its activities (not necessarily the number of tax professionals) need to scale with the business. In recent years, we have heard founders and CFOs comment: “Who are all these non-investment people and what do they do?”

Herein is the tension as the tax function in the face of increasing complexity, regulations and data often needs more headcount, more budget, or both at a minimum for risk management and ideally to support the business. To properly respond, the tax function must present a view on:

  • The core tax risk managing and value adding activities and the non-core tax activities of the tax function
  • How all tax activities will be accomplished (i.e., in-sourced (including members of the team in cost effective locations) or outsourced)

In assessing the tax function, we have seen an emerging risk-based framework whereby the tax function reviews and determines which activities and tasks are “core” tax functions, and then combines the strengths of in-house tax professionals, external tax service providers, and tax processes and technology solutions to accomplish all tax activities. The threshold issue is the identification of high-value-adding activities.

In our experience, the core activities that should be sourced or retained by in-house tax professionals are strategy, risk management (including notably, fund investment transactions), communications, quality control, investor tax sensitivities and issues, data analytics, tax planning, and tax controversy.

The non-core activities that should not be sourced in-house are those activities that are routine, not significant, such as data collection, data cleansing, workpaper preparation, reconciliations, direct and indirect tax return filings. Notably, a significant benefit of identifying and sourcing high value-adding activities to in-house tax professionals is the reallocation of in-house resources to more strategic business activities, the augmentation of in-house skills and the likely retention of in-house talent.

Central to the decision on the sourcing of the performance of the activity with or in combination with in-house personnel, the private equity fund must carefully consider its external advisor/service provider outsourcing strategy including the service provider’s skill sets, their capabilities in data management and technology, and their ability to scale and grow with the business.

We often see middle market funds use a limited number of tax advisors, so the fund is a large enough client for each advisor to merit the proper attention. We often see larger firms use multiple advisors so that they cover the market for the best ideas; competition among advisors often results in better service and pricing.

These potential benefits must be weighed against both the benefits of fewer advisors with deeper client knowledge (also higher quality service and consistency that is more proactive), and the potential distractions of spending too much time managing multiple advisors. Most often we see larger fund managers maintain relationships with many firms but designate one or two primary accounting/law firm advisors.

How EY can help

  • Private Tax Services

    Our private client tax services team can help you maintain your business and personal goals while achieving full reporting compliance. Learn more.

    Read more

Central to all activity within the framework is a plan for, and the use of, tax data processes and technology. We are seeing more inquiry, more use of data governance, data quality standards, and process and technology solutions to replace historic manual, customized processes and technology configurations previously developed ad hoc as the tax function expanded.

 

We are seeing more tax functions implement solutions, either in response to an urgent need, a strategic multi-year tax plan or as part of an enterprise transformation (where tax has a seat at the table), such as: a common data model for increased automation and reuse of data; automated workflow and tax calendaring; standard reporting and analytics; real-time dashboard capability to view all tax activities; one common portal to view all service provider activity; and integrated document management for version control and access.

 

Often, we see these tax solution improvements developed and implemented in collaboration with the funds’ tax compliance service provider due to efficiencies and the cost of software development, which is typically borne by such service provider.

 

Lastly but importantly, we note that the initial wave of outsourcing of tax compliance combined with the heavy use of advisors on transactions, has occasionally created the (mis)perception that “tax has been outsourced” and there is no longer a need for an in-house team. While the performance of many activities can and should be outsourced, there is always the need for an internal team that has institutional knowledge of the business and its positions to perform strategic, sensitive work; make material, significant tax decisions; and review the work of its service providers.

 

The need to manage tax costs as well as tax risk requires a thoughtful review of tax activities to be performed and by whom, the use and performance of tax advisor/service providers, the leveraging of process and technology capabilities, and the “right size” and mix of an internal tax talent (i.e., the skills to address and/or manage the activities and service providers as well as qualifications to assess the associated risks).

 

The following is an emerging view on core and non-core activities, by area, taken by private equity tax functions:

 

Tax policy: Tax consideration, tax policy and accountability for tax activities are not outsourced. The tax function strives to have qualified individuals and robust internal processes for identifying and managing tax activities, both as an initial matter and as questions arise in the future. Also, significant investor relations matters (responding to nonroutine, material investor questions) generally are not outsourced and are handled in-house, due to the importance of maintaining investor relationships and a reluctance to insert third parties between investors and the fund manager. Minor or general inquiries are standardized and outsourced.

 

Fund managers and tax matters: We most often see tax compliance and reporting either “co-sourced” or “fully” outsourced. The primary considerations for the tax function in outsourcing concern the loss of control, and to some degree the maintenance of “institutional” memory. Heads of tax evaluating whether and to what extent (or how successful) to outsource compliance and reporting typically focus on whether their current processes and technology allow quick and easy access to tax data (e.g., how much time does the tax function spend chasing data?), and whether outsourcing presents an opportunity to improve, with any attendant considerations.

 

As previously mentioned, tax compliance and reporting have historically relied on highly manual processes centered on spreadsheets and the occasional ad hoc technology solution. The ever-increasing volume of required tax data, additional complexity under changing rules, and the need for scalability drive a centralized, automated, integrated process and technology solution to access and manage the required data.

 

As the private equity business grows, heads of tax see the value of tax compliance and reporting evolving away from spreadsheets and toward databases that serve as an accessible “single source of truth” with data from the various functions primarily responsible for them (e.g., accounting, legal).

 

We have seen how outsourcing tax compliance and reporting can benefit managers in a variety of ways. Service providers are better situated to develop, maintain and continuously improve such expensive and specialized technology as databases and associated tools for developing tax information. As a result, we have seen how fund managers can respond quickly and comprehensively to the tax aspects of new laws and new business without dramatic internal changes.

 

Additionally, service provider fees may constitute a fund expense (which typically must be recouped from investment income before carry entitlements apply), whereas employees commonly are a manager expense.

 

Notably, outsourcing the fund’s tax compliance functions does not mean that there is no internal risk management element to tax compliance. Tax directors should identify the areas that require the most oversight. Consideration should be given to focusing on high-level, big-picture tax issues, while leaving details to the outsourced service providers.

 

Transaction tax: Transaction tax almost always is outsourced for reasons of efficiency and/or subject matter, industry, or geographic knowledge. Even so, and as noted above, we increasingly see the tax function staffing in-house (this is especially true of global investing platforms, but also occurs with middle market fund managers) with at least one highly experienced (partner-level) tax person to “own the facts and decision,” to manage the outside providers and to provide an appropriate degree of tax structuring assistance. Where managers have multiple asset strategies, we often see multiple experienced (partner-level) tax personnel hired to oversee each strategy (e.g., credit, real estate).

 

Portfolio tax matters: Portfolio tax matters primarily remain at the portfolio company level. The analysis of tax activities and the decisioning of outsourcing at the portfolio company level mirrors the framework above. As noted above, we increasingly see the private equity in-house tax function become more active in the assessment of tax skills at the portfolio company level, the communication with the portfolio company tax department and/or service providers of the private equity’s expectations, including a proper understanding of the tax effects to the general partner (GP) and limited partner (LP) investors of the fund as a result of operations occurring at the portfolio company level, and assistance in value creation planning.

Diverse group of young businesspeople laughing while sitting together in a row at an office desk during a meeting
3

Chapter 3

Appendix A

This section summarizes the trends we see in the tax function in three categories of fund manager.

Professional young businesspeople using tablet computer smiling in office
4

Chapter 4

Appendix B

This section summarizes leading practices and notable challenges.


Summary 

Tax functions should prioritize certain tasks that support a decision framework in order to build a function of the future.

About this article

Related topics
Private equity
Tax

Related articles

What private equity funds of the future must take into account

Stakeholders’ goals influence private equity fund structure. Learn more.

    EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.