By Javier Rodríguez and Ernesto Lacambra from Cuatrecasas, Gonçalves Pereira
The exponential growth in private equity investment experienced in the United States and Europe over the last decade, until the beginning of the current economic downturn in 2007, seems now to show signs of recovery. Following this changing scenario, private equity investors, including private equity funds, venture capital funds and hedge funds, seeking the highest possible returns on their investments are increasingly focusing on Latin America, not only in Brazil and Mexico, the two largest and most mature markets in the region, but also in other countries such as Colombia, Peru and Chile. Additionally, the traditional lower value of assets in Latin America as compared to the United States or Europe, as well as other factors, such as the economic stability of the region due to the strong growth of its local markets has also had a positive impact in this new focus on the Latin American region.
Targets of private equity firms in Latin America are currently very diverse, including not only companies engaged in high growth sectors such as agro-business, clean-tech or consumer goods, but also more mature industries which need new methods of financing.
Spanish Holding: ETVE
One of the key elements considered by private equity firms when investing in Latin America is how to efficiently structure their investments from a legal and tax standpoint. Given the favorable tax treatment provided by the Tax Treaties in force, the cultural identity and the common historical and legal background, as well as the legal protection offered by the Bilateral Investment Treaties, it has been common for private equity firms to invest in Latin America through Spain, and, in particular, by means of using a Spanish ETVE (“Entidad de Tenencia de Valores Extranjeros”) as a platform for such investments.
Spain has entered into a broad array of tax treaties with the most important countries in the world (more than 70 Tax Treaties) and with almost all the Latin American countries, namely: Argentina, Bolivia, Brazil, Cuba, Chile, Colombia, Costa Rica (not yet in force), Ecuador, El Salvador, Mexico, Peru (not yet in force), Uruguay (not yet in force) and Venezuela.
Additionally, Spain has signed Bilateral Investment Treaties with many Latin American countries. These Treaties aim to protect the investment of foreign (Spanish) investors by declaring that the foreign investments cannot be treated worse than domestic investments. For instance, the Spanish Bilateral Investment Treaties with Bolivia and Venezuela (which recently terminated the Bilateral Investment Treaty with The Netherlands), have played a very important role in solving critical situations in both jurisdictions.
Introduced in 1995, the Spanish ETVE, is a regular entity, subject to Spanish Corporate Income Tax (CIT) at a rate of 30%. The European Union (EU) legal framework, including the Parent-Subsidiary Directive, is fully applicable to the ETVE, as well as the Tax Treaties signed by Spain.
Any Spanish entity (either a Sociedad Limitada (LLC) or a Sociedad Anónima (Corporation)) taxable in Spain for its overall results and with limited liability is entitled to benefit from the ETVE tax regime.
For the applicability of the ETVE regime: (i) the company’s corporate purpose must include the management and control of participations of non-resident subsidiaries throughout the corresponding organization of human and material resources; (ii) the ETVE shares must be nominative; and (iii) the election for the ETVE regime must be notified to the Spanish Tax Authorities.
Taxation of inbound dividends
Under the ETVE regime, dividends and capital gains obtained by the ETVE are exempt from taxation in Spain, provided they derive from “qualifying subsidiaries” that meet the following requirements:
1. Residency requirement: Qualifying subsidiaries must be foreign (non-Spanish) resident entities, but they must not be resident in a tax haven jurisdiction.
2. Participation requirement: Qualifying subsidiaries must meet the following requirements:
- The ETVE must hold, directly or indirectly, a 5% participation in the non-resident subsidiaries or it must have an acquisition cost in the same of at least six million Euros, and
- The ETVE must hold the participation for an uninterrupted period of at least 12 months. The exemption also applies to inbound dividends received before the 12 months period if the ETVE commits to hold the participation for at least such period.
3. Subject to tax requirement: Qualifying subsidiaries must be subject to a domestic tax which is comparable to the Spanish CIT. If the subsidiary is resident in a country with which Spain has signed a Tax Treaty (which includes an exchange of information clause), the subject-to-tax requirement is understood to have been complied with.
4. Activity requirement: Qualifying subsidiaries must carry out active business activities outside Spain.
The ETVE can also hold Spanish subsidiaries and/or participations in non-resident entities which do not comply with the requirements mentioned above. However, such “non-qualifying” shareholdings will not benefit from the exemption on dividends and capital gains mentioned above. A tax credit for the taxes paid in the foreign jurisdiction (withholding taxes or underlying taxes) may apply.
Capital gains deriving from the sale of the participation in the subsidiaries are also exempt from taxation in Spain if some additional requirements are met.
Taxation of Outbound Dividends
Dividends distributed by the ETVE to its foreign shareholders are not subject to Spanish withholding tax, as long as:
1. The dividends are distributed out of exempt dividends or capital gains obtained by the ETVE from qualifying subsidiaries,
2. Dividends are paid to an individual or to an entity not resident in Spain, and
3. The direct recipient of the dividend is not a resident of a tax haven jurisdiction.
Dividends distributed by the ETVE to its non resident shareholders from non-qualifying participations, or any other type of income, will be either taxed at the withholding tax rate provided in the applicable Tax Treaty, or will be exempt if they are resident in the European Union (EU) and the Parent-Subsidiary Directive applies, or, otherwise, will be taxed at the standard tax rate of 19%.
In any case, it is understood that the income distributed in the first place derives from qualifying subsidiaries.
Other main features from the Spanish ETVE
- Spanish CIT Law states that, in principle, losses derived from the transfer of a participation in a non-resident subsidiary are tax deductible. However, certain limitations apply to participations that were acquired from a company of the same group.
- The adjustment in the value of the participation through a write-off is a tax deductible expense for the ETVE if certain requirements are met.
- Capital gains derived from an eventual transfer of ETVE participations by a foreign shareholder are exempt from Spanish taxation as long as the gains derive from retained earnings which come from exempt dividends and capital gains obtained from qualifying subsidiaries and/or from the increase in value in such subsidiaries, and provided that the transferor is not resident in a tax haven.
- An ETVE could be financed with equity or with debt. If the ETVE is financed with equity, Capital Tax needs to be considered. Cash contributions made to an ETVE would be subject to Capital Tax at a rate of 1%. On the contrary, contributions in kind made to the ETVE may not be subject to taxation in Spain. For example, the contribution of qualifying subsidiaries into the ETVE would not be subject to capital tax. As a consequence, in private equity deals, it is common that an entity other than the ETVE acquires first the shares in the target company, and then contributes them into the ETVE, not triggering Capital Tax in Spain.
- Alternatively, the ETVE could be financed with debt. Thin capitalization rules apply to non-EU related party lenders (including back-to-back loans that go through an EU company). Interest is subject to withholding tax at a rate of 19%, unless it is paid to an EU resident. Tax treaties often reduce the withholding tax rate to 5% or 10%, but rarely to 0%, except long-term banking debt (for instance, the US-Spanish Tax Treaty). Regarding bank debt, generally no restrictions will apply to the interest deductibility (although the above thin capitalization consideration may become relevant if the banking debt is guaranteed by a related non EU party).
Setting up an efficient legal and tax structure is one of the most relevant considerations to take into account when investing in Latin America. The significant legal and tax advantages of using a Spanish ETVE as a platform for investing in Latin America make this vehicle the ideal one for investments in this region of the world.
All in all, the cultural identity and the common historical and legal background as well as the widest network of Tax Treaties and of Bilateral Investment Treaties signed by Spain with the Latin American countries, together with the very favorable tax regime of the ETVE for non-Spanish investors, make the ETVE able to contribute to the primary goal of private equity firms of obtaining the highest possible returns on their investments.
Javier Rodriguez is a Partner in the New York office of Cuatrecasas, Gonçalves Pereira and can be reached at email@example.com. Ernesto Lacambra can be reached in the Barcelona office at firstname.lastname@example.org.