Welcome to our Winter newsletter for 2009/10
The Impact of the Carbon Reduction Commitment Energy Efficiency Sceme Order on Private Fund Managers
The Carbon Reduction Commitment ("CRC") Energy Efficiency Scheme Order ("Order") is due to be brought into force in April 2010 and is likely to have a significant impact upon many private equity and property firms managing UK based investments.
The Order sets out a "cap and trade" scheme, which seeks to reduce carbon dioxide emissions by large non-energy intensive organisations in the UK. It will apply to organisations (Participants) whose annual UK electricity usage exceeds 6,000 MWh (equivalent to an annual bill of approximately £1,000,000).
The scheme works by requiring Participants to pay for allowances in respect of their carbon dioxide emissions. Monies collected through the scheme are then recycled to Participants using a publicised "league table", with the intention of providing benefits to those who are most successful in reducing their energy usage over time.
The Order will require certain organisations to be combined both for the purposes of qualification for, and ongoing compliance with, the CRC scheme. Parent undertakings and their UK subsidiary undertakings (defined by reference to the Companies Act 2006) will be grouped together as "combined participants" to form a single Participant. As currently proposed, liability for compliance with the Order will be placed jointly and severally on all entities within the Participant, although the parent undertaking is likely to be the entity carrying out the compliance obligations and liaising with the Environment Agency.
Consolidating in this manner could have unexpected effects within the private funds industry - which typically has not been required to consolidate in this way for accounting purposes. The ultimate form of, and likely interpretation of, the Order remains unclear at the present time but it is possible that unrelated investee companies within a portfolio will be grouped together as subsidiaries of either the fund or the manager in a single "Participant". This could result in many investee companies which would not, on the basis of their own electricity usage, have qualified for the scheme being required to participate in the scheme as part of the wider Participant. It is also possible that managers managing more than one fund could be treated as a parent of each of the funds - resulting in the grouping of investee companies held in completely unrelated portfolios. Given the joint liabilities established by the Order, there is clearly considerable potential for confusion to arise as to how the costs and liabilities arising from the Order be allocated.
Consideration will also need to be given as to whether any cornerstone investors could be considered to be the parent of the Participant for the purposes of the Order, although this would be unlikely unless such an investor held over 50% of a fund.
Fortunately, the Government has decided in the latest response to consultation that a Participant could be "disaggregated" into a combination of "significant group undertakings" ("SGU"s) as long as, among other conditions, the SGUs and remaining part of the Participant each have qualifying emissions (e.g. over 6000MWh). Advantageously, where an SGU is disaggregated, the remaining entities in the Participant will no longer be jointly and severally liable for that SGU's compliance and will not need to report on its emissions. It appears that disaggregation of SGUs can be done as part of the registration process, at the beginning of subsequent phases or when an SGU is acquired by an existing Participant.
Ensuring that the remaining part of the Participant still qualifies may still however be problematic for private equity and other fund structures for the following reasons:
Effects of the Scheme
Participants will initially qualify for inclusion in the scheme based on their 2008 electricity usage and will need to register with the online CRC Registry during the registration period (1 April 2010 to 30 September 2010). Guidance recently issued by the Environment Agency suggests that, where a Participant wishes to disaggregate any SGUs, registration of the Participant as a whole must be completed by 30 June 2010 to allow the relevant SGUs to register separately by the September deadline.
Emissions to be included in the Scheme
Once a Participant qualifies for the scheme, all consumption of all fuel types will be included within the scheme although there are certain exemptions (such as energy used for transport).
Phases and Cap Setting
The scheme will work on a "cap and trade" basis. This means that a total 'cap' on the amount of emissions in the scheme will be set by way of 'allowances' issued by the Government. Each Participant must buy enough allowances each year to cover its emissions either through fixed price or auction sales of allowances, trading of CRCs on the secondary market or through the "safety valve" mechanism by which Participants can buy allowances under EU Greenhouse Gas Emission Trading Scheme.
An introductory three year "phase" contains a monitoring-only year commencing in April 2010 for which no allowances have to be bought. In the second and third years, allowances will be sold by one-off sale in April each year at a fixed price of £12 per tonne of carbon dioxide emitted. There will be no cap on Participants' emissions; they will simply have to buy sufficient allowances to match their emissions.
From 2013, the scheme will run in five-year capped 'phases' with a steadily reducing number of allowances (set by the Government) available over time. Allowances will be auctioned in this phase.
A Participant emitting more than its purchased allowances during the year (either in the introductory or capped phases) will need to buy allowances on the secondary market or through the "safety valve". There will be a 4 month window for Participants to trade allowances following the end of the compliance year. Each Participant will need to have an online account at the new CRC Registry, which will allow trading of CRC allowances.
Recycling Payments and the Performance League Table
The scheme is intended to be revenue neutral. As such, receipts from allowances in any compliance year (paid in April) will be returned to Participants in October by way of a recycling payment.
Administration, Reporting and Monitoring
The Government's emphasis is intended to be on minimal administrative burden for business. For example, there will be reliance on self-certification of emissions (backed up by an independent risk based audit regime). In addition to registration (see above), there are significant ongoing reporting obligations (such as submission of an annual report collating CRC emissions) which will be satisfied through an online registry.
The CRC regime will be funded by a number of charges placed on Participants including registration and annual subsistence charges.
The application of the Order to funds containing investment property portfolios will cause additional complexity and cost as a result of the attribution of responsibility for emissions. This will, in particular, affect multi-let properties. In broad terms, the responsibility for CRC falls on the person who pays the electricity bill. In multi-let properties, landlords may well pay the bills for common areas and for tenant's leased areas and recharge the monies through service charges. Depending on the particular circumstances, difficulties may well arise for landlords who will be responsible for tenant's emissions without clear ways of either being able to charge tenants for CRC costs under their leases, or of forcing tenants to reduce their energy usage (and thereby the costs of compliance). Added to this, the complexity of calculations involved and the fact that the Order operates at group level, is likely to lead to disputes and litigation between landlords and tenants in some cases. The property industry is currently trying to identify equitable and consistent ways for landlords and tenants to deal with CRC administration and costs to mitigate these problems.
Next Steps For Fund Managers
The Environment Agency is currently in the process of writing to organisations it believes will be Participants and has recently issued guidance on the registration process. Potential Participants should commence preparations (to the extent they have not already done so) to compile data necessary for registration under the scheme and identify relevant individuals to take ownership of CRC within participating organisations. At the same time, organisations should be starting to think about how the scheme will work in practice for them and to consider what sort of changes they might need to make to relevant contracts. For example, consideration should be given to adding indemnities into investment agreements relating to investee companies to provide that each investee company will be responsible for its own liabilities under the scheme. Other administrative arrangements will need to be made to facilitate compliance with the Order and these may also need to be legally documented.
Managers should begin discussing the issues and relevant timetables with their investee companies as soon as possible. Specifically, Participants should be taking the following steps:
The New Offshore Funds Taxation Regime
A new offshore funds taxation regime comes into force on 1 December 2009, details of which are now set out in the recently published Offshore Funds (Tax) Regulations 2009 (the "Regulations").
For the last 25 years HM Revenue and Customs' ("HMRC") main objective in taxing of offshore funds has been to prevent UK investors from rolling up income earned offshore and converting it into capital. Today with the marginal top rate of income tax rising to 50% next year, whilst capital gains tax remains (so far) at an attractive 18% rate, it is not difficult to see why the conversion of income to capital has increasingly become an HMRC target.
Two years ago the Government published a discussion paper proposing changes to the taxation of offshore funds so far as UK investors were concerned. The stated objectives of this discussion paper the clarification, simplification and modernisation of the existing regime.
However, on review of the legislation it becomes clear that the subtle changes actually have the effect of increasing the tax base, blocking loopholes and increasing the likely tax take. Indeed the Explanatory Memorandum to the Regulations state that "the purpose is that, as far as possible, UK investors make their investment decisions for commercial reasons and not to obtain unintended tax advantages".
At present, UK offshore fund investors are taxed wholly on an income tax basis unless their fund is categorised as a "distributing fund". In order to obtain distributor status, a fund has to distribute at least 85 per cent of its income. This income is liable to UK income tax. It however leaves 15% (a not inconsiderable figure in the current low interest environment) which can be accumulated together with the fund's capital gains. Furthermore, if the fund is one where investors are unlikely to be able to realise their investment within seven years, a common feature of many private equity and real estate fund structures, it currently avoids the whole regime.
Extending the Tax Base
Prior to the Finance Act 2009, the definition of an offshore fund was based on the regulatory definition of a "collective investment scheme" constituted by a non-UK company or a unit trust scheme where the trustees are non-UK resident.
The new definition, inserted as section 40A Finance Act 2008, detaches the tax definition of an offshore fund from a circumscribed regulatory definition to a definition, in HMRC's words, based on "characteristics". Broadly speaking an offshore fund is now to be any vehicle which (i) enables investors to participate in and receive profits from, the acquisition, holding, management or disposal of property where (ii) the investors do not have day to day control of the management of the property and (iii) a reasonable investor would expect to be able to realise their investment by reference to the net asset value of the property or an index of any description.
The exemption for funds where an investor could not reasonably expect to realise all, or part, of their investment within seven years has been dropped.
A number of offshore vehicles which were not previously offshore funds may now fall within section 40A.
The exact scope of section 40A is uncertain. In particular, there is now no reason why hedge funds and funds of funds should not be caught. Managers will have to look urgently at their individual investment vehicles on a case by case basis.
Extending the Tax Take
The new regime replaces the concept of distributor status (i.e. distributing and non-distributing funds) with that of reporting and non-reporting funds.
An offshore fund can apply to HMRC to be a "reporting fund". For UK investors, gains realised on the disposal of investments in reporting funds will, in most circumstances, be subject to tax on chargeable gains. By contrast gains realised on disposals of investments in "non reporting" funds will be subject to income tax.
The downside is that, to secure reporting fund status, all of an offshore funds income attributable to a UK investor will be taxed in the hands of the UK investor to income tax. This is now the case whether the income has been remitted to the UK investor or not. Not only has the 15% retention margin been abolished, but UK investors may find themselves being taxed on income they have not received.
In view of the current significant rate differential between income tax and capital gains tax for UK individual investors and the exemption from tax for many UK institutional investors (for example authorised funds, investment trust companies and pension funds), the ability to offshore fund managers to obtain reporting fund status may be critical for funds targeted at UK investors.
Becoming a Reporting Fund
In order to become a reporting fund, the manager must apply to HMRC within three months of the first day of the period of account for which it is to be a reporting fund. The application must include documents such as :
Once HMRC have given reporting fund status, the Regulations set out in detail how the accounts are to be prepared and how the fund's reportable income should be computed. If a fund has no, or negative, income it will be required to make nil returns.
Reporting funds will also be required to prepare and send a report to each investor who is resident in the UK, within six months of the end of the reporting period, detailing the amount actually distributed to investors (which is taxable to income tax), the excess of the amount of the reporting income over the amount actually distributed (which is also taxable to income tax), the dates of distributions and a statement as to whether the fund remains a reporting fund. The income figures are used as the basis for the UK investor's self assessment tax return.
Reporting funds will also be required to provide to HMRC audited accounts, a computation of reportable income, a copy of the report made available to investors, the reported income of the fund and a declaration that the fund has complied with its obligations. This information must, again, be provided within six months of the end of the period of account.
Although the Treasury's Impact Assessment on the Regulations refers to the anticipated costs as being limited to "some small one-off costs for managers who will need to familiarise themselves with the new rules" and generally to a "reduction in administrative burdens", the new regime is likely to result in significantly increased administrative costs for two reasons. Firstly because most UK investor offshore funds will now probably be established as reporting funds (and new funds may be brought into the net), and secondly because of the necessity to provide information both to investors and HMRC.
With the abolition of the 15% retention and the 7 year rule and income taxation on an accrual rather than a receipt basis, it is difficult to see why a UK investor would want to invest in a non-reporting fund. Investing in a fund outside the Regulations is another matter and promoters may be tempted to try and find a way round the definition of an offshore fund. They should be aware that Section 40G Finance Act 2008 enables the Treasury to rewrite the only stated exception from the Regulations, broadly a fund with non-income producing assets which are only accessed on a winding up of the fund.
A reporting fund may be required by HMRC to leave the reporting fund regime if it is in breach of its obligations and the breach is serious. It can also be required to leave if it has made four minor breaches (a breach for which there is a reasonable excuse or which is inadvertent and is remedied as soon as possible) within a period of ten years beginning with the first day of the period of account in which the first minor breach occurs.
If a fund is required to leave the reporting fund regime by HMRC it will be unable to apply to rejoin the regime at a later date. Clearly this may have serious repercussions for UK investors.In the run up to the peak in real estate values there were a large number of collective investment schemes (CIS) where the law deemed that an operator was required. In some cases, the fund manager which set up the scheme did not perhaps fully understand the role of the operator or was unable to judge their competence.
Langham Hall has been delighted to participate in a number of successful and thought provoking seminars during the last quarter.
We have recently co-hosted a series of seminars on Non-Executive Directors responsibilities in the current economic environment. These seminars held in London, Jersey and Guernsey were hosted jointly with Howden Insurance Brokers, Reynolds Porter Chamberlain, Gibson Dunn and Bedell Group and covered both the legal and regulatory obligations and responsibilities of non-executives directors together with advice on practical administrative and operational best practice and an update on the current insurance market and trends.
We also jointly ran a seminar with SJ Berwin and Campbell Lutyens titled "Harnessing Returns in Infrastructure". This introductory seminar explained the investment opportunities the sector presents, typical structuring considerations and discussion around best practice operations and administration.
Please contact us on firstname.lastname@example.org to be included in invites for forthcoming seminars or to obtain slide packs of our previous events.
Update to International Private Equity and Venture Capital Valuation Guidelines
Update to International Private Equity and Venture Capital Valuation Guidelines (“IPEVCVG”).
After extensive review and collaboration, the International Private Equity and Venture Capital Valuation Board have released updated PE valuation guidelines. The guidelines, which have been endorsed by more than 30 trade associations, take into account the evolution of fair value accounting requirements and practices around the globe, in particular as promulgated by the FASB in the USA and by the IASB.
The new guidelines take effect for reporting periods after 1 July 2009.
The updated guidelines reflect the IPEV Board’s November 2008 call for greater transparency, sophistication and the application of tailored, informed judgment rather than a rigid application of a mechanical process in determining Fair Values.
Per IPEV, the principal changes relate to:
- Clarifying how the marketability discount should be applied
- Eliminating any reference to the one year period used in practice for retaining investments at ‘Price of Recent Investment’, to ensure there are no conflicts with accounting rules
- Additional guidance on how to include additional milestone analysis into the ‘Price of Recent Investment’ concept
- Guidance on the valuation of interests in funds
Following is a synopsis of each of the proposed changes:
The implied requirement to apply a Marketability Discount for the lack of ability to sell a business has been removed, along with the suggested percentage ranges for the marketability discount.
All aspects of the investee enterprise should be considered, and the lack of marketability or liquidity is to be considered in estimating the Fair Value of the enterprise. Suggested approaches include reducing comparable multiples for lack of marketability under the Market Approach to valuation.
Price of Recent Investment
Under the Price of Recent Investment approach, Fair Value equals cost in the case of an initial investment or the price of a new investment where there has been subsequent investment in the entity.
The old guidelines indicated a maximum period of one year from the transaction date and, in practice, this timeframe was seized upon as a standard 12 month period during which all investments were to be held at cost.
The 12 month timeframe has been removed from the new guidelines, and Fair Values will need to be assessed at each reporting date for any changes since the transaction date that result in a change in Fair Value.
Where there are no comparable transactions or companies, particularly in early-stage enterprises, the updated guidelines have introduced “milestone analysis” whereby changes in significant milestones trigger potential changes in the fair value of the investment.
Interests in Private Equity funds (‘Funds of funds’)
LPs with interests in Private Equity funds should estimate the Fair Value of their interest in that fund by applying the attributable proportion of the reported NAV.
The valuer should determine that the reported NAV is based upon appropriate valuation principles. The valuer may also adjust the investee fund’s reported NAV for several aspects including, but not limited to, an accrual for performance allocation or fees, if the reporting period of fund differs from investing LP’s reporting period, or for fund-specific characteristics including distributions as outlined in the LPA.
Secondary transactions may be considered in the valuation process if the valuer can confirm the details as transparent and accurate.