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Colombia

Carlos Forero Jiménez
Godoy & Hoyos Abogados
Columbia

In the last five years, direct foreign investment of between $7 billion and $10 billion has flowed into Colombia, often through private equity funds. Carlos Forero Jiménez of Godoy & Hoyos explains the tax rules that apply to such funds

Private equity funds have turned to be into attractive vehicles through which foreign investors can execute their investments in Colombia because of, among other reasons, the tax regime applicable to them. Even with the above, the structure and some of the special features granted to private equity funds have been sometimes misunderstood by taxpayers and the Tax Authority under certain case analysis situations. This may jeopardise the particular business structure of a private equity fund. Therefore, and appropriate tax advice on structuring such funds is desirable.

Private equity funds are defined by Colombian financial regulation as a management and investment vehicle or mechanism which invests at least two-thirds of the investor's sources/contributions (investments) in assets or economic rights other than securities listed in the Colombian Securities and Issuers Registry . Private equity funds are classified by the Colombian financial regulation as a "Closed Collective Fund", this is, a fund that liquidates the participations (investments) to the investors at the end of the period established for the fund without prejudice of the possibility of making advanced distributions before the expiration of the vehicle.

Income tax regime

Income tax treatment for collective funds is understood to be contained in Law 49, 1990, which incorporated section 23-1 to the Colombian Tax Code. However, the truth is that at the time Law 49, 1990 was issued, private equity funds were not created under Colombian financial regulation as they were ruled by Decree 2175, 2007. At the time Law 49, 1990 was issued, certain collective funds existed in Colombia, but none of them had the characteristics of closed collective funds (For example, private equity funds) and, in fact, those collective funds that were intended to be the target of Law 49 are completely different from what we know today as private equity funds. This is the first problem that arises while facing the tax treatment applicable to such funds.

Even with the above, the Tax Authority has ruled that section 23-1 of the Tax Code and the income tax treatment set by it, is applicable to private equity funds. Under article 23-1 of the code, collective funds are not income taxpayers. Therefore, private equity funds are not triggered with income tax or obliged to file income tax returns. Under article 23-1, private equity funds must transfer to the investors of the fund the revenues perceived under the same title as the fund has received them and under the same tax treatment as if the fund investors had received the revenues directly themselves. This later constitutes a kind of transparency principle as the vehicle is not really transparent as explained below.

Withholding tax

Colombian Tax Code and more precisely section 369, commands that payments done to non-income taxpayers must not be subject to income tax withholding.

On the other hand, section 368-1 of the tax code establishes that managers of private equity funds must withhold the income tax (accordingly with the withholding tariff).

Tax authority considerations

Certain tax benefits and special treatments

In some cases the tax administration has understood that benefits or special tax treatments of the investors are applicable to the fund, on the basis of a like "transparency principle" derived from the text of of section 23-1.

For example, under Ruling 108799 of October 31 2008, the Tax Authority stated that the fixed assets special tax allowance set forth in section 158-3 of the tax code , that gave a benefit for the investment in such assets, could be taken when the fixed asset is acquired with sources of an investor and by a compartment of the private equity fund which belongs solely to said investor.

At first sight, the mentioned ruling complies with the tax transparency principle that the Tax Authority has in some specific cases attributed to private equity funds, as long as it allows an investor (taxpayer) to take the fixed assets' special tax allowance via the acquisition of the fixed assets through a private equity fund compartment. However, from the conclusion of the ruling, it is unclear if the Tax Authority has restricted the pass-through of the fixed assets special tax allowance by means of a private equity fund, to the fact that the fund's compartment which acquires the fixed asset belongs exclusively to one investor or if it would also proceed if the compartment belongs to other investors and the fixed assets is acquired with the sources invested by all of said investors.

Transfer of revenues and tax effects to Investors

The tax effect on the revenues received by the fund is the income tax (and the withholding income tax) to be triggered to the fund investors.

After some rulings issued by the Tax Authority related to the time at which the income tax withholding on the revenues received by the fund must be triggered to fund Investors, it seems that a definite ruling has been issued by means of which said moment has been settled. By means of Ruling 069136 of September 20 2010, the Tax Authority established that in the case of private equity funds, investors are taxed only upon distribution of profits. It implies, therefore, that private equity funds can be very efficient mechanisms to differentiate the taxes that affect the investors to the fund. It also implies that such funds are far from being truly transparent tax vehicles.

The tax regime applied to private equity funds

In practice, the tax regime for private equity funds materialises when the mentioned rules are applied as follows:

• Every economic party that enters into an business relationship with the fund (for example, corporations, purchasers and clients) must make the related payments to the private equity funds without levying any income tax withholding.

Rule: Payments to non-income taxpayers are not subject to income tax withholding.

• When payments are made to the fund investors, the fund manager must act as a withholding agent levying the corresponding income tax withholding.

Rule: Only when revenues are effectively distributed to the fund investors, must be taxed. The income tax withholding on the revenues received by the fund must be triggered to the Fund Investors at that time.

• Revenues transferred by the fund to the investors, must be subject to withholding and taxed by the investors accordingly with the kind of revenue perceived by the fund.

Rule: A private equity fund's manager must transfer the revenues to the investors under the same title as the fund has received them, and, applying the same tax treatment as if the fund investors had received the revenues directly themselves. (Tax transparency principle recognition.)

Private equity fund: a hybrid entity

Under the considerations mentioned above, it is easy to conclude that private equity funds are entities granted with features of several kinds that do not allow to classify them under a certain category. Their regulation, despite being attributable to section 23-1 of the Colombian Tax Code, has been in fact elaborated by means of rulings of the tax administration that in some aspects has recognized the application of a transparency principle and in others, such as the crucial fact of distribution of profits, has emphasised the independence between the investors and the fund.

For example, as mentioned, the tax transparency principle is recognised in private equity funds, since: i) fund investors are granted tax allowances or benefits per activities or investments performed by the fund itself, and ii) a private equity fund's manager must transfer the revenues to the investors under the same title as the fund has received them, and, applying the same tax treatment as if the fund investors had received the revenues directly themselves.

However, private equity funds cannot be characterised as pass-through entities, since the tax effect (income tax) over the revenues received by the fund is only triggered to the investors at the end of the fund's period and does not pass to the investor at the moment the fund receives the revenues. This in fact, is one of the benefits of private equity funds as the deferral of the tax effect over the revenues received by the fund, represents a cash flow benefit since such flows could be reinvested in the fund investments. This may signify a financial gain.

More understanding of PE fund's hybrid nature

Undoubtedly, because of the favourable tax regime, private equity funds are very interesting and attractive vehicles to perform investments within Colombia. However the Tax Authority and all the parties related and interacting with private equity funds must conceive and apply the rules established for these funds as particular rules for a hybrid vehicle identifying the special features granted to private equity funds. Perhaps the better way to enable taxpayers and the Tax Authority to conceive and apply the rules in a proper way would be to issue a single regulation that compiles the mentioned applicable rules and under which the application of said rules is set forth in a clear and simple way.

Carlos Forero Jiménez (cforero@godoyhoyos.com) is senior legal consultant at Godoy & Hoyos Abogados