Now we know everything about legal entities investing in private equity, but to have 100% coverage of all the topics important to understand private equity investors, we have to come to an end discussing about the very tricky and complex topic: Taxation. Taxation is quite tricky because it's different in every country. We are not so lucky as with talking about regulations where I said there are two formats: the European Union and the Anglo-Saxon format. In this case it is not possible. What I want to do, is not discuss some country, but give you what the key elements are that we have to apply to understand taxation if we want to understand a certain country. In a certain sense, I just simply want to give you the tools to understand taxation. What are these tools? To understand taxation we have to combine two different angles to understand the story of taxation. The first angle of the story is, what are the players involved into taxation within the private equity market?, and there are definitely three players involved: The investor, investing its money; the vehicle, investing in private equity; and the company receiving money, the venture-backed company, the company financed by private equity. On the other hand, we have to consider what the areas of impact on taxation are, and there are five areas of impact: first of all, taxation on capital gains; second, even if it's not very relevant, taxation on dividends; third, incentive to start up; number four, incentive to R&D; and last, the incentive or taxation of the debt to equity ratio. So there are three different players and five different areas of the impact. We have to combine these elements in a matrix. Step by step let's start talking about taxation on capital gains. Taxations on capital gains is relevant only for two of the three players. It's relevant for the legal entity investing its money in private equity, and it's relevant for investors putting their money in the legal entity. If we talk about taxation of capital gains for vehicles investing in private equity, we have evidence all around the world of three different mechanisms. The first mechanism is the so-called flat tax mechanism, where the idea is that a vehicle has to pay a lower amount of taxes compared to other legal entities in the country. It’s what happened for example, to closed-end funds in Europe in which most of the countries in Europe closing funds pay a tax rate of 20% that in many cases is lower than the corporate tax we have in that country. The second approach is the so-called tax transparency. Tax transparency is a special case where the flat tax is equal to 0%. That means that the vehicle doesn't pay taxes and cost and revenues pass through the investor. Venture capital funds in the US and UK, or an SBIC in the US are examples of tax transparency. And the last case is so-called PEX (participation exemption). Participation exemption is a mechanism where the level of taxation is reduced accordingly to some types of investments in equity the vehicle runs. A good example of participation exemption is what happened in Italy, in the Netherlands, in Ireland, or in Luxembourg for investment firms investing in private equity. But taxation on capital gains is also relevant for investors putting their money in a closed-end fund, or putting their money in an SBIC, in a venture capital trust, or in a venture capital fund. In this case, it is not possible to give very strict guidelines, but what we can say is that in most of the countries there is a distinction if the investor is a corporation, a legal entity or a private individual, and the other distinction is related to the fact that the investor is domestic, or is a foreign investor. If we move to taxation on dividends, that is not so relevant as the business of private equity is not to receive dividends, but to receive capital gains in this case, we are lucky because mechanisms, both for legal entities and for investors, are exactly the same that we have mentioned for taxation on capital gains. So we can move the issue of incentives to startups and to R&D. In this case, these incentives are not relevant for legal entities investing in private equity, they are not relevant for investors, They are obviously relevant only for the company demanding capital from venture-backed companies in which PEIs are going to invest. For which reason? The idea is very simple. If we stay in the country in which incentives to R&D and to startups are more relevant, probably there will be much more investment in the area of venture capital. For incentives to startup and R&D, around the world we have evidence of three different mechanisms. The first mechanism is this concept of markdown, where the idea is if the company manages a startup, or if the company invests in R&D, just simply the company benefits of a markdown. That means that the decrease of the tax rate. The second approach mentions shadow cost. What is a shadow cost? A shadow cost is a premium the company receives if the company launches a startup or if the company invests in R&D. And typically shadow costs mean the company receive more cost that can reduce the level of taxation within the PNL of the company. The last aspect is mentioned is a tax credit. Tax credit is a voucher, the company receiving proportion of the amount of fixed assets needed to launch the startup or in proportion of the amount of R&D expense. Tax credits act as a voucher the company can use to mitigate the level of taxation not only in one year, but year after year. The last aspect is related to incentive, or taxation to the debt to equity ratio. This mechanism is again relevant only for the company demanding capital. That means for the venture-backed company. In this case, we have evidence all around the world of only two mechanisms. The first one is thin capitalization. Thin capitalization means that there is a limit for the company to use interest rate of debt to reduce the level of taxation. In a certain sense, it’s an indirect incentive to collect equity. For example, we have thin cap in Germany or in Italy. The other one, which is much more powerful, is DIT, dual income taxation. The idea of DIT is to give tax incentives if the company collects money through equity. And in this case, if you have DIT this is a very powerful incentive for the company to use private equity.
