Regulatory and jurisprudential developments in the area of private equity structures and funds.

Two recent events have had a positive impact on the ecosystem of private equity structures and funds in the country. On the one hand, Law 2112 of July 29, 2021 "whereby entrepreneurship and the scaling of the national entrepreneurial fabric is strengthened" was issued and, on the other hand, the Fourth Section of the Council of State annulled Concept No. 100208221000521 of March 5, 2019, which prohibited taking as deductible the interest caused by bank loans for the acquisition of shares.

These facts and their relevance to activate and boost the Colombian private equity ecosystem are explained below.

The purpose of Law 2112 of 2021 was to "encourage entrepreneurship and scaling of the Colombian business fabric through the strengthening of private equity funds and/or private debt". Through this law, paragraph 2 of article 100 of Law 100 of 1993 ("whereby the comprehensive social security system is created") was modified, which established the guidelines, limits and prohibitions for the Pension Fund Management Companies (AFP) to invest their resources. After this modification, it was established as a peremptory order that "at least 3% of the resources must be invested in Private Capital Funds and/or private debt (...) provided that these resources are invested in Colombian companies or productive projects in Colombia (...)". This investment mandate will cause a significant amount [1] of resources to be injected from pension fund management companies into private equity and/or private debt funds, turning the latter structures into major players in the market, and thus promoting the business survival of MSMEs, economic reactivation, formalization and an increase in direct employment.

On the other hand, through the issuance of Concept No. 100208221000521 of March 5, 2019, the DIAN had established an institutional position according to which it did not recognize the possibility that interests caused by virtue of credits obtained with financial entities, in order to leverage purchases of shares in companies, could be considered as tax deductible. Additionally, he stated that such non-deductibility would be maintained, even in the event that the acquired company merged with the acquiring company.

The citizen Omar Cabrera filed a simple nullity action requesting the nullity of the mentioned concept on the charge of violating superior norms and false motivation of the administrative act. The plaintiff alleged that the concept violated the current tax regulations because there is no general or particular prohibition therein that prevents taking as deductible the interest paid for the acquisition of shares. He indicated that, according to the general rules of deductions (article 107 of the Tax Statute -E.T.-), it is sufficient that an expense is necessary, proportional and has a causal relationship with the activity generating income, in order for it to be deductible. It added that the special rules that restrict the tax deductibility of interest (E.T. articles 107 and 118-1) only indicate that such interest shall not be recognized for tax purposes when it "exceeds the highest rate authorized for banking establishments"[2] or, if the debt arises between related parties, the payment of interest may only be deducted if the total value of the credit does not exceed the result of multiplying by two the net worth of the taxpayer as of December 31 of the immediately preceding year[3]. Although the above rules limit deductibility in certain cases, they do not prohibit it in a general manner, reason for which the plaintiff alleged that such interpretation would be vitiated of nullity for the referred charges.

In its considerations, the Council of State determined that the interpretation made by the DIAN constituted a generalized rejection of the expense. This situation contradicts the reasonable interpretation of the tax rule that the viability of the interest deduction will have to be considered "case by case" according to the compliance or not of the requirements mentioned above. It also established that the DIAN, with this interpretation, departed from other recent interpretations where -in the case of the analysis of the deductibility of the payment of severance payments for dismissal with or without just cause arising from an employment or regulatory relationship- it had stated that these should be done by analyzing whether "in each case the requirements set forth therein are met" [4]. Likewise, regarding the deductibility of the interest originated in a credit to acquire shares, in the event that the acquirer and the acquired company merge, the court states that "it corresponds to each case taking into account the legal and factual assumptions that are presented in consideration".

The importance of this decision is that it allows, with retroactive effects [5], that the interests caused in credits whose destination is the acquisition of shares in companies may be taken as tax deductions if it is proven that they are necessary and proportional expenses and are related to the income generating activity. The decision reestablishes the leveraged acquisition of companies ("debt finance") as one of the major mechanisms used in the world of private equity. The decision also reestablishes the possibility of leveraged acquisitive reorganizations (mergers and spin-offs) through the "debt push-down" mechanism [6].

In conclusion, with these regulatory and jurisprudential advances in terms of private equity structures and funds, Colombia enters a favorable environment to see its private equity and venture capital industry flourish.

[1] According to the explanatory memorandum of the then bill number 310 of 2020 (House) "(...) as of June 20 (sic) the value of the investment portfolios of the moderate, conservative, higher risk and programmed retirement mandatory pension funds amounted to COP$ 270.4 trillion pesos". Cfr. gaceta_739.pdf (senado.gov.co)

[2] E.T. Article 117.

[3] E.T. Article 118-1.

[4] See Concept No. 108 of March 26, 2021.

[5] As stated by the Constitutional Court in Ruling T-121 of 2016 "The nullity rulings issued by the Council of State have ex -tunc effects, i.e., they return the situation to the situation as it was before the annulled act was issued, without affecting the legal situations that were consolidated".

[6] The "debt push-down" mechanism is achieved when the acquirer constitutes a special purpose vehicle ("SPV") that acquires a debt (with which the seller's shares are paid), and which subsequently merges with the acquired company ("Target"). As the SPV is absorbed by the Target, the latter takes over the obligation to pay the interest, being able to deduct the same for tax purposes if the transaction complies with the aforementioned criteria of article 107 of the Tax Statute.