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
Similar Articles
Relevancy Powered by MondaqAI
 
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”

Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
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 (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

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 or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq 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 of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

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