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Alan Kohler is one of Australia’s most experienced commentators and journalists. Alan is the founder of Eureka Report, Australia’s most successful investment newsletter, and Business Spectator, a 24-hour free business news and commentary website. He also hosts Inside Business, a half-hour Sunday programme on the ABC, is the finance presenter on the ABC News - and producer of the nightly graph (or two).
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Australia's big chill?

Stephen Bartholomeusz2 Feb 2010, 12:46 PM

The federal government should heed the warning from Blackstone's Stephen Schwarzman and clear up the confusion surrounding the TPG-Myer private equity tax dispute.

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When the chief executive of one of the world’s biggest private equity groups says the Australian Taxation Office’s attempt to hit TPG with a massive tax bill on the profit it made on the float of Myer will "dramatically chill" future investment, it is worth considering what the impact of a private equity boycott of Australian investment might mean.

The comments by Blackstone Group’s Stephen Schwarzman confirm that the dispute between TPG and the ATO – whose draft rulings on the Myer sale overturned previous treatments of foreign private equity gains – has been broadcast around the private equity world.

While there are differing views about the value of private equity ownership, there is no doubt that the firms are a major source of foreign capital, or more particularly – something that the ATO doesn’t appear to recognise – a major collection point and conduit for foreign capital attracted from around the world.

Would it matter if foreign investor involvement in the Australian private equity sector, which is relatively small by developed market standards but which was growing rapidly ahead of the financial crisis, was shut down by the ATO’s stance?

The Australian Private Equity and Venture Capital Association (AVCAL) provided some perspective on that question in a submission last week to the ATO in response to its draft rulings on the taxation of private equity gains.

The Australian industry has funds under management approaching $25 billion. The 10 largest firms manage about $16 billion, with more than half those funds provided by foreign investors. Most of that investment from offshore is with the largest firms. The top five private equity groups have attracted about $8 billion from offshore.

From that, AVCAL concludes that foreign participation is necessary if the Australian funds are to have scale.

Apart from the capital itself, which is handy for a country with a chronic current account deficit, private equity does provide some useful disciplines to under-performing managements, as well as competition for assets. The new model for private equity, imposed by the financial crisis, will help dampen concerns about the amount of leverage that some pre-crisis transactions involved.

The AVCAL submission also sheds some light on the sources of that private equity capital. Most of the capital deployed by private equity firms is provided by third parties, with the firms themselves acting as fund managers and providing transaction capabilities and management experience for the entities established to acquire the underlying assets.

According to the submission, only about 47 per cent of the funds managed by the 10 largest Australian firms are sourced locally. The US provides about 30 per cent and other OECD countries about 12 per cent. Singapore (3 per cent), the Cayman Islands (3 per cent) and other non-OECD countries (5 per cent) provide the remainder.

The nature of the investors is quite disparate. The biggest contributors are public pension funds, (28 per cent), fund of funds (21 per cent) endowment funds (10 per cent) and private individuals (9 per cent). Sovereign wealth funds, family offices, corporate investors, public sector funds and the like provide the rest.

In other words, most of the funds within the Australian industry are sourced locally, come from OECD countries or countries with which we have tax treaties and most of the investors are institutional.

For international funds that invest in Australia, rather than locally-managed funds, about 60 per cent of the money is sourced from North America, about 19 per cent from other OECD countries, 7 per cent from the UK, 4 per cent from Singapore and 4 per cent from the United Arab Emirates.

Again the investors are varied, although 44 per cent comes from pension funds, 15 per cent from banks and 12 per cent from sovereign wealth funds. AVCAL says Australian institutions have at least as much invested in offshore private equity funds as they have in Australia.

Obviously, if the tax treatment of capital gains in Australian private equity transactions means that after-tax returns are lower here than elsewhere, both foreign and local capital will inevitably flow to those offshore deals and away from this market.

The international funds are often invested around the globe, while fund of funds also invest globally. Hence the use of tax havens likes the Cayman Islands – the structure that triggered the ATO’s action against TPG – to enable the funds to marshal and deploy funds efficiently around the globe. The Cayman Islands, or Guernsey, are staging points and conduits, not end destinations.

The use of collective investment vehicles based in offshore financial centres is designed to avoid extra layers of taxation from moving funds around the world, but the nature of the underlying investors means that the great bulk, if not all, of the profits generated from the funds will end up within the tax jurisdictions of the investors’ home countries.

If federal government policy is, with full knowledge of the implications for the flows of capital, to tax private equity gains – and potentially other foreign collective investment vehicle profits – as income, or to tax capital gains wherever a tax haven is interposed in the corporate chain, that would unobjectionable.

The potential for the ATO’s draft rulings to cause a capital strike means that the government, rather than the ATO, needs to clarify the tax treatment of private equity gains and introduce certainty to the situation.

The Spectators

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