Germany: Decision Of The German Federal Tax Court Regarding Private Equity Funds

Last Updated: 12 January 2012
Article by P&P Pöllath And Partners

Last week, the German Federal Tax Court (Bundesfinanzhof) published the first decision of a German superior court in which the German Federal Tax Court deals with the differentiation between asset management activities and trade or business activities with respect to private equity funds.

1. Summary

The German Federal Tax Court doubts whether the criteria developed by the German tax authorities for the treatment of private equity funds as being engaged in asset management activities are consistent with the applicable law, but does not explain these doubts in more detail. However, a discussion of the criteria for asset management activities as set forth by the German tax authorities was not necessary for the court decision because in the case at hand the private equity fund did not comply with substantial criteria required by the German tax authorities for asset management treatment of private equity funds.

In the case at hand the suing investors claimed the treatment of a non-German private equity fund to be engaged in trade or business in order to exempt the income derived from such fund in 1998 from German taxation according to the then applicable law. Since such income was not subject to tax in the source jurisdiction, it was completely tax-exempt.

It remains to be seen if and how the German tax authorities will apply the decision of the German Federal Tax Court to other cases. Despite certain amendments of the law in the meantime, in case of business treatment of private equity funds, German investors would be able to benefit from tax advantages in certain structures. Such advantages would result in a deficit in German inland revenue (compared to the taxation in case of asset management treatment).

With respect to the allocable share of non-German corporate investors of the profits and losses of a non-German fund arising from German investments and/or with respect to their allocable share of the profits and losses of a German fund in case of business treatment, the effective tax burden of their allocable share of dividends and capital gains would be approximately 1.5 % and of their allocable share of interest income would be approximately 30 %. The obligation of non-German investors to file tax returns in Germany could be prevented by interposing a "blocker".

If the German tax authorities applied the decision of the German Federal Tax Court to other cases, there will be need for action in due course, in particular to protect non-German investors. P+P, together with the German Private Equity and Venture Capital Association (BVK), will seek to obtain a statement of the German tax authorities in the next weeks, on how they intend to deal with the decision of the German Federal Tax Court. We will promptly inform our clients on this.

2.Subject-Matter and Background

The investors (German corporations) held interests in a private equity (buy-out) fund established in 1994 which was structured as English limited partnership which was managed in the United Kingdom.

The investors claimed that the private equity fund was engaged in trade or business and, hence, that the income realized in 1998 would be exempt from German taxation pursuant to the provisions of the then in effect double taxation treaty between Germany and the United Kingdom.

If the fund had been engaged in asset management activities, the full amount of income realized by the suing investors in 1998 would have been subject to German taxation. However, since the United Kingdom does not impose UK tax on non-UK taxpayers on income arising from private equity funds, such income was entirely exempt from taxation due to the business treatment of the fund.

Facing these facts, the German tax authorities tried to qualify the English fund as being engaged in asset management activities.

This attempt was not successful in the case at hand in both instances.

3.Decision of the Lower Tax Court

The Lower Tax Court stated in its decision that after determination of the relevant facts business treatment of the English fund was not subject to dispute or was established.

However, the Lower Tax Court refused the suing investors the exemption of their (business) income from the fund under the double taxation treaty between Germany and the United Kingdom.

4.Statements of the German Federal Tax Court

Although the German tax authorities did not challenge the business treatment of the English fund before the German Federal Tax Court, the Court discussed the issue.

The German Federal Tax Court confirmed the statements of the Lower Tax Court with respect to business treatment of the English fund. In doing so, it also refers to the criteria set forth in the Administrative Pronouncement of the German Ministry of Finance dated December 16, 2003 on the taxation of private equity funds. The German Federal Tax Court did not discuss whether the criteria set forth in this Administrative Pronouncement – which rather tend towards asset management treatment of private equity funds – is in line with the general definition of "trade or business" in the German income tax act.

According to the facts correctly determined by the Lower Tax Court, the English fund did not comply with substantial criteria as set forth in the Administrative Pronouncement to qualify for asset management treatment (inter alia, the fund made use of leverage and persons acting for the fund were actively involved in the management of the fund's portfolio companies).

The Administrative Pronouncement of the German Ministry of Finance dated December 16, 2003 was not in effect in 1998. However, the criteria set forth therein apply to all pending cases including the case at hand. The English fund was, therefore, to be treated as engaged in trade or business pursuant to the Administrative Pronouncement.

Nevertheless, when referring to the Administrative Pronouncement the German Federal Tax Court doubts whether the criteria set forth in the Administrative Pronouncement are in line with the general definition of "trade or business" in the German Income Tax Act. It is, however, not clear in which cases the German Federal Tax Court would tend to business treatment of a given private equity fund while the German tax authorities would tend to asset management treatment of the same fund, because in the case at hand the German tax authorities accepted business treatment and, accordingly, did not challenge this outcome of the Lower Tax Court. Moreover, the English fund in the case at hand had to be treated as engaged in trade or business even pursuant to the criteria set forth in the Administrative Pronouncement.

5.Impact of the Decision of the German Federal Tax Court

As there was no dispute on business treatment of the English fund in the case at hand there is no doubt that the decision of the German Federal Tax Court is correct. In 1998 the exemption for dividends and capital gains pursuant to § 8b of the German Corporation Tax Act was not in effect. Therefore, the allocable share of the profits and losses of the German investors from the English fund was finally tax exempt in both jurisdictions.

Notwithstanding the foregoing, the decision of the German Federal Tax Court results in a substantial uncertainty on the tax treatment of private equity funds, because the Court expresses doubts about the Administrative Pronouncement of the German Ministry of Finance dated December 16, 2003. Apparently there seem to be cases where the German Federal Tax Court would tend to business treatment while the German tax authorities would tend to asset management treatment. However, this was not subject to dispute in the case at hand and, accordingly, there was no reason for the German Federal Tax Court to discuss this (feasible) dissent in more detail.

6.Consequences for Advisors and the Industry

The German tax authorities apply the criteria set forth in the Administrative Pronouncement, both to German and to non-German private equity funds consistently throughout Germany. On this basis, the German tax authorities issued numerous tax rulings, not only for German but also for non-German private equity funds, and performed tax audits.

In light of these circumstances, it seems to be necessary to identify those cases where according to the view of the German Federal Tax Court the criteria set forth in the Administrative Pronouncement for asset management treatment are too broad. Similarly, it is important how the German tax authorities respond to the doubts regarding the Administrative Pronouncement expressed by the German Federal Tax Court.

If, due to the decision of the German Federal Tax Court, the German tax authorities were to change their practice consistently applied until the date hereof and qualify private equity funds that have been subject to asset management treatment in the past as being engaged in trade or business, feasible grandfathering rules and transitional provisions become of increased importance.

With respect to the consequences of such fundamental change in the practice of the German tax authorities for the investors, the following distinctions have to be made:

  • obligations to pay taxes and to file tax returns; and
  • German and non-German private equity funds.

a) German Investors in German Private Equity Funds

A fundamental change in the practice of the German tax authorities would have very few consequences for German investors in German private equity funds:

(i) In contrast to the legal situation in 1998, tax exemptions applicable to corporate investors for dividends and capital gains pursuant to § 8b of the German Corporation Tax Act are in effect since 2001. In case of asset management treatment of the private equity fund the effective tax burden for these investors (corporation tax and trade tax) is approximately 1.5 % with respect to their allocable share of capital gains and approximately 15.75% with respect to their allocable share of dividends (each without solidarity surcharge).

In case of business treatment of private equity funds, there is no change of the tax burden on capital gains. Moreover, the tax burden on dividends will typically decline to 0,75 % because in most cases private equity funds satisfy the relevant thresholds with respect to holdings in their portfolio companies to qualify for the reduction of trade tax.

There are no differences with respect to the taxation of life and healthcare insurance companies.

The same applies to interest income (if any). In case of asset management treatment the effective tax burden is approximately 30 %. Generally, there is no change in case of business treatment. The only difference is that trade tax will be raised at the fund level, whereas the trade tax base of a given corporate investor of such fund will be reduced by the allocable share of profits of such investor from the fund.

(ii) In case of asset management treatment dividends and capital gains from the sale of shares in corporations which have been acquired on or after January 1, 2009 are subject to the flat tax of 25 % at the level of investors that are individuals. There is no deduction for costs of fund administration available for such investors.

In case of business treatment 60 % of Dividends and capital gains are subject to tax at the marginal rate of the respective investor that is an individual. In case of the highest marginal rate of 45 %, the effective tax rate is 27 %. 60 % of costs of fund administration can be deducted by such investors.

This simply means: in case of asset management treatment a tax rate of 25 % on gross income, in case of business treatment a tax rate of 27 % on net income is applicable (in either case without solidarity surcharge).

There is a tax credit available for trade tax paid by the private equity fund at the level of investors that are individuals.

Solely in case of interest income there is an additional tax burden. In case of asset management treatment, interest income is subject to the flat tax (25 %), whereas in case of business treatment, the personal tax rate of the investor (up to 45 %) is applicable.

(iii) There are no additional filing obligations for German investors in German private equity funds in case of business treatment.

b) German Investors in non-German Private Equity Funds

Generally, most foreign jurisdictions will qualify private equity funds as not engaged in a trade or business. The allocable share of income of each investor will therefore be taxed in its respective country of residence only, pursuant to the tax provisions applicable in such country and in accordance with his personal tax regime.

If the German tax authorities would change their practice consistently applied until the date hereof, private equity funds would be engaged in a trade or business from a German tax perspective. Whereas foreign jurisdictions would still treat them as not engaged in a trade or business.

The case at hand decided upon by the German Federal Tax Court illustrates that such different qualifications may lead to income which is taxed in neither jurisdiction (so called "white income").

It goes without saying that each advisor has to structure and safeguard the particular circumstances of his or her client in a way which limits the tax burden of the respective client. Investments in private equity funds are, however, not "tax-driven". If the qualification of private equity funds in Germany and according to German tax laws is consistent with the respective qualification in a foreign jurisdiction, there is no chance for investors to receive non-taxable "white income".

Furthermore, the German legislator has introduced a provision which seeks to avoid such non-taxable "white income" into the German Income Tax Act. The German Federal Tax Court discusses the application of such provision in its decision as of August 24, 2011, concludes, however, that the provision may not be applied in the case at hand. There will be other cases of non-German private equity funds where the new provision is not applicable. Therefore, as a consequence of such trade or business treatment there might also be a tax deficit for the German tax authorities.

Based on the assumption that the new special provision would apply, the income of German resident investors, derived from non-German private equity funds and qualified as trade or business income for German tax purposes, would be taxed exactly the same way as outlined for investments in German private equity funds above.

As outlined above, the tax differences resulting from a trade or business qualification as opposed to a non-business qualification are not substantial.

c) Non-German Investors in German Private Equity Funds

Non-German investors in German private equity are generally corporations and not individual investors.

If in future all private equity funds would be treated as engaged in a trade or business, the share of non-German corporate investors in the income of German private equity funds would be taxed in Germany exactly the same way as outlined in subsection Error! Reference source not found. Error! Reference source not found. for German corporate investors.

In light of the fact that the return from investments in private equity funds mainly consists of capital gains, to some extent also of dividends, but only to a limited degree of interest income, the effective tax burden for non-German corporate investors in German private equity funds should also be de minimis.

It is however important that non-German investors are subject to a tax filing obligation in Germany, if they receive trade or business income which is effectively connected with a German permanent establishment. Hence, Germany applies the same concept as the U.S. for so-called "ECI" (i.e. "effectively connected business income").

Similar as in the U.S., the tax filing obligation of each particular non-German investor could be avoided if the investment of the non-German investor group would be pooled in a separate corporate vehicle (so-called "Blocker"). The interposition of the Blocker would not avoid the German tax burden as outlined above, i.e. capital gains and dividends would be taxed at an effective rate of 1.5 % and interest income at an effective rate of 30 %. The tax filing obligation would, however, apply in respect of the Blocker only and not in respect of each particular non-German investor.

Due to the fact that the Blocker would be subject to exactly the same tax burden as the non-German investors, if they had invested directly, the pooling in the Blocker vehicle should not be regarded as evasive.

For the same reason, namely the taxation of the Blocker in accordance with German tax laws, the Blocker may be established in a country which has not entered into a double tax treaty with Germany, i.e. Guernsey or Jersey. Dividend distributions made by the Blocker are not subject to any withholding in such jurisdictions.

d) Non-German Investors invested in non-German Private Equity Funds

This group of investors will be affected if the private equity fund in question invests in Germany and either maintains a permanent establishment or a permanent agent in Germany in respect of its German investment activities.

The German tax consequences outlined in subsection Error! Reference source not found. in connection with subsection Error! Reference source not found. Error! Reference source not found. above would also apply in respect of this group of investors (and should be rather limited).

In order to avoid that non-German investors are required to file a German tax return, in respect of their allocable share of income of the non-German private equity fund derived from its German portfolio, the non-German private equity fund must hold its German portfolio through an interposed blocker vehicle.

7. Further Development, Need for Action

As outlined above, it will be crucial how the German tax authorities will react in respect of the decision of the German Federal Tax Court. In light of the practice consistently applied by the German tax authorities since December 2003 it might be expected that the German tax authorities will comment on the decision of the Federal Court rather sooner than later.

If the German tax authorities will follow the new regime, the consequences for most German resident groups of investors invested in German and/or non-German private equity funds regarding their respective tax burden will be rather limited.

The effective amount of any tax burden in Germany in respect of income allocable to non-German corporate investors resulting either from German resident private equity funds or from non-German private equity funds in respect of their German portfolio should be rather limited.

A need for action is however given insofar that a German tax filing obligation for each non-German investor can be avoided only if a blocker structure is implemented.

If the German tax authorities will follow the new regime, immediate action will be required. The specific requirements in each case will depend on the particular facts and circumstances.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions