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.
