Do private equity funds need any economic substance?

October 2026 | SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

October 2026 Issue

Private equity (PE) funds pool capital from a range of diverse investors such as family offices, high-net-worth individuals, institutional investors and international financial institutions, all of which are regularly based in different jurisdictions.

Such funds are typically established in a limited number of countries (such as Luxembourg, the Netherlands or the Channel Islands), reflecting investors’ preference for well-tested fund regimes that offer legal and regulatory certainty and protection for their investment.

A PE fund structure typically comprises several separate fund vehicles. The fund itself (usually a partnership) and its general partner, a separate fund management entity in case the general partner of the fund partnership does not itself act as fund manager, a carried interest vehicle, holding entities beneath the fund that hold the underlying investments and a local investment adviser, often in the country of the investment.

The management team that initiated and established the fund manages the fund by actively taking investment decisions through the fund manager or a separate investment committee, while the investors are passive in nature and enjoy only profit participations without being involved in the management of the fund.

Most of the fund vehicles have limited economic substance, such as few or no employees or offices, but, as a consequence, also have limited taxable income. The investment adviser is typically the exception, usually housing staff like the management team and earning advisory fees.

The limited economic substance of these fund structures is sometimes perceived as a sign that funds structures are used for tax avoidance. This article examines that assumption and concludes it does not hold.

Commercial rationale for establishing a fund

Funds (or, more technically, collective investment vehicles) are established for a clear commercial purpose: to pool capital from various investors to realise economic efficiencies for investments.

A fund is able to make investments that are unavailable to individual investors, whether because of the investment size, the risks involved (which are diversified across investors), or a lack of experience in a particular region or asset class. Put differently, participation in a fund is not an end in itself – an investor would invest directly if it could.

PE funds are structures designed to meet the needs of a range of diverse investors, often before any investments are made and before all investors are known. For these reasons, fund managers need a legal structure that is attractive to, and recognised by, a broad range of prospective investors.

Such a structure requires investors that are less familiar with local regulatory environments in the countries where portfolio investments are located, strongly prefer jurisdictions that are widely known and accepted for collective investment vehicles, and which prospective buyers will also be comfortable with if investors later sell their interest.

Also necessary is an internationally recognised jurisdiction for PE funds, with an established base of experienced professional service providers (such as lawyers, bankers and consultants) able to support both fund managers and investors, as well as a legal system familiar to investors that offers a stable legal environment and appropriate dispute resolution mechanisms.

Similarly, the use of holding companies beneath the fund for holding individual or a group of investments is rooted in commercial requirements. These holding companies legally ringfence liabilities per investment by facilitating external debt financing with structural seniority and subordination, and co-investment by third parties or by the management of the portfolio company.

Fund managers often have separate deal teams, who prefer a separation of investments for better performance monitoring to which management incentives are linked.

Tax treatment of fund structures

Fund structures typically combine limited economic substance with limited taxation, achieved through tax transparent vehicles or tax exemptions under specific fund regimes. The only taxable income within a fund structure is generally management fees paid by the fund to the fund manager (often offset by advisory fees), interest and advisory fees.

As a result, the redistribution of operating profits, either as dividends, share redemptions or similar, which are first taxed at the level of the operating portfolio companies, is generally not taxed again within the fund structure. It is instead subject to tax (proportionately) at the level of the investors and the individuals of the management team as distributed profit or carried interest.

The question of how these returns are taxed domestically in the jurisdiction of the recipients is a domestic policy decision, which will not be elaborated in this article to avoid the eternal question of whether carried interest should be taxed as capital gain or regular business profit.

This tax treatment within the fund structure ensures tax neutrality. An investor using a fund is not penalised relative to one investing directly, since a direct investment would likewise be taxed only at the level of the operating portfolio company and the investor.

The absence of taxation within the fund structure, therefore, reflects a necessary precondition for fund investing, not artificial tax avoidance. Jurisdictions that fail to provide such neutrality simply do not attract fund structures.

It is sometimes argued that fund structures and their holding companies create an artificial tax benefit for investors by reducing or eliminating withholding tax on distributions or payments by the operating portfolio company, compared to a direct investment.

However, a single investor has no decision-making power about the location of the fund vehicles, which is decided by the fund manager. In addition, investors are typically tax residents in different jurisdictions, so that a preferable jurisdiction for one investor might lead to an adverse result for another investor.

Any potential tax benefit (compared to a direct investment) is therefore incidental to the driving commercial rationale for participating in the fund and should not be regraded as artificial tax avoidance.

Economic substance

After understanding the commercial rationale for setting up a fund and the effective taxation at the operating portfolio company as well as at the level of the investors and management team, the question is how much economic substance is required for such a fund structure from a tax perspective. ‘Economic substance’ is a widely used but undefined concept in tax law, approached from different angles.

From a profit allocation perspective, economic substance should be commensurate with the activity performed, so that allocated profits reflect a genuine economic activity performed. This is the transfer pricing approach, which allocates profits based on decision-making ability and the assumption of risk (‘OECD Transfer Pricing Guidelines, Chapter I’). It is noteworthy that the OECD Transfer Pricing Guidelines clearly clarify that all activities can be outsourced except the actual decision making, since the control over risk cannot be delegated.

The OECD Forum on Harmful Tax Practices, for its part, defines the economic substance required to benefit from a preferential tax regime as being able to perform ‘core income generating activities’. Further details, however, as to how this translates into employees or premises, is not provided.

The third angle is the tax treaty perspective and the entitlement to treaty benefits as a genuine resident within a treaty jurisdiction. The OECD Model Tax Convention and its Commentary require that a corporate legal entity must be ‘effectively managed’ in a jurisdiction to be considered a resident there.

Applying these principles to a fund structure leads to two observations. First, a fund structure has only a limited pooling function compared to the value-creating activity of identifying, negotiating, performing and managing investments conducted by the management team.

And second, the fund structure incurs only limited taxable income as the distributed operating profits are ultimately taxed in the hands of the investors and the management team.

Therefore, it should be sufficient that the fund vehicles are effectively managed in the fund jurisdiction to substantiate relevant economic substance. In practice, this is generally achieved through the baseline of the following: a majority of qualified local board members, and regular board meetings held in the fund jurisdiction where strategic decisions are taken. Day to day operations can be outsourced to external service providers.

This baseline of effective management should be considered sufficient even when intercompany financing is involved. The strategic decision to decide on the financing and the related conditions should be taken by the qualified board at a local board meeting. Monitoring the loan, tracking interest payments and similar administrative tasks could be outsourced and, increasingly, automated with the help of artificial intelligence.

Conclusion

Concluding that a fund structure amounts to artificial tax avoidance simply because it has limited economic substance is incorrect.

That view overlooks the fund’s underlying commercial rationale and the fact that profits are already taxed twice: once at the level of the operating portfolio company and again at the level of the investors and management team. Effective management of the fund vehicles in the fund jurisdiction should fulfil any relevant economic substance requirement. Own employees or offices should not strictly be required.

Notably, neither the OECD Forum on Harmful Tax Practices nor the European Union (in its proposed Anti-Tax Avoidance III Unshell Directive) were able to agree on a specific employee safe harbour – unsurprising, since economic substance should be commensurate with the activity performed and is a case by case decision.

Norman Wingen is an international tax adviser at the European Bank for Reconstruction and Development (EBRD). He can be contacted by email: wingenn@ebrd.com.