All grist to the mill of Luxembourg limited partnerships?
A recent decision of the German High Tax Court (Bundesfinanzhof, in short BFH) is causing a major uproar among the German private equity houses and is likely to have a substantial impact - far beyond the tax implications for current fund structures - on the future of the German private equity business.
From a mere investor perspective the message of the court decision sounds rather positive, as the BFH1 ruled that any income derived by German tax resident investors in a UK-based private equity fund is exempt from German taxation.
However, German-located private equity structures are adversely affected by the court findings, as their current tax transparency is mainly based on the non-commercial character of their activities, which in turn is key for investors keen on avoiding tax leakage via withholding taxes and formalities like filing tax returns to Germany authorities.
Due to the Alternative Investment Fund Manager Directive – better known as "AIFM"2 –, to be implemented until mid-2013 in all EU/EEA member states, the private equity industry across the European Union is currently revisiting key questions such as alternative legal forms, outsourcing opportunities, different regulatory regimes and - last but not least – the jurisdiction which is best suited for their future AIFM-compliant fund business. The looming tax burden for German fund activities as well as the tax exemption of foreign private equity funds stated by the BFH may well be an important building block in this strategic review of the private equity business in the Federal Republic of Germany.
Background and findings of the BFH - decision
The BFH-case involved two German private limited companies (Gesellschaft mit beschränkter Haftung) which were invested as limited partners of a UK-based private equity fund. The UK-fund was set up under the legal form of a limited liability partnership (LP). This LP held participations in a string of portfolio companies for an average of four years each; the portfolio management and any further administrative tasks were delegated to a separate UK management company, belonging to the same group, regulated by the English financial authority and with offices, staff and technical infrastructure.
As the United Kingdom does not levy any taxes on the income of a UK private equity fund - just as Luxembourg for SICAR- and SIF-structures -, the German limited companies did not file tax returns. However, the investors claimed that the income derived from their investment in the UK-fund must be considered as tax exempt in Germany. They argued that under the double tax treaty concluded between Germany and the United Kingdom their participation in the UK-located fund would be tantamount to a permanent establishment for which the United Kingdom has the exclusive right of taxation. The BFH confirmed that the income from the participation in the UK-fund is business income and therefore tax exempt in Germany under the relevant double tax treaty. The BFH considered that the purchase, ongoing administration and disposal of portfolio companies would qualify as a business activity and not as non-commercial asset management. Several criteria were essential for this qualification, in particular the average holding period of four years, the leverage at the fund level, but also the premises, the personnel and the regulated status of the management company used by the UK-fund, the BFH concluded that the UK-fund was acting as a "trader in portfolio companies' shares".
Consequences for German private equity funds
Besides clarifying the cross-border tax implications, the BFH commented on the criteria as developed and currently applied by the German tax administration to classify private equity funds as non-commercial asset management for German tax purposes. This classification is material for German-located PE funds because commercial limited partnerships are subject to the municipal trade tax (Gewerbesteuer) and – as mentioned above - investors may be confronted with tax returns and withholding tax issues. The criteria set out in a circular issued by the Federal Ministry for Finance in 2003 3 and used by the tax authorities to determine the commercial character of a PE fund are the following: leverage at the fund level, comprehensive organisation needed at the fund level to manage the portfolio companies, use of a market and own professional experience, offerings of the portfolio companies to a broader public, short-term holding of the portfolio companies, reinvestment of the proceeds from the disposal of portfolio companies and active involvement in the (day-to-day) management of the portfolio companies. Only private equity funds that carefully avoid meeting the aforementioned criteria could be sure until now that they qualify as "non-commercial" without detrimental tax impact for the PE fund and its investors.
In contrast, the BFH now takes the position that the typical business model of a private equity fund is not pure asset management following the "buy and hold"- principle. In fact, the court takes the view that the pursuit of capital gains from acquiring and disposing portfolio companies - the "buy to sell"- approach as core-business of all private equity ventures - is always a business activity throughout, with no strings attached.
If, going forward, private equity funds must be generally regarded as "business partnerships", detrimental tax consequences may be triggered for several groups of investors, e.g. tax-exempt institutional investors, private individuals and - last but not least - foreign institutional investors on whose investments the German private equity industry largely depends.
A reaction of the German tax authorities to the BFH decision is still outstanding, so there seems to be no need for prompt action or urgent measures for the time being. However, German PE houses and fund promoters are well advised to include this re-qualification by the BFH in their brainstorming and strategic considerations on how to cope with the future AIFM-Directive.
German taxation of UK- and Luxembourg based private equity funds
Since the tax status of a typical UK private equity fund bears a striking resemblance to a Luxembourg tax-transparent fund, it appears worthwhile to summarise the further court findings on the tax exemption of UK-funds for German investors by drawing a parallel to Luxembourg-based PE fund structures:
The United Kingdom does not tax the income generated by UK-based private equity funds, typically set up as tax-transparent limited partnerships. Likewise a Luxembourg private equity vehicle incorporated as a tax-transparent Société en commandite simple under the regulatory regime of the SIF- Law is exempt from any taxes (i.e. municipal business tax, wealth tax and income tax), the typical income generated by a SICAR in accordance with the SICAR Law is also generally exonerated.
The BFH confirmed that the tax-exonerated income derived from their investment in the UK-domiciled PE-fund remains tax exempt in Germany, as the participation of the investors in the PE fund is considered a permanent establishment from an international tax perspective for which the UK has the exclusive right of taxation under the double tax treaty. Unlike the double tax treaty entered into between Germany and the United Kingdom which introduced in the meantime a "subject-to-tax"-clause, any income of a permanent establishment or participation in a Luxembourg SCS – whether taxed or not taxed – should remain tax-free in Germany under the applicable double tax treaty with the Grand Duchy of Luxembourg .
The BFH also clearly stated that a German treaty override rule , which allows German taxation of income, exempt under the relevant double tax treaty but not taxed in the other state, does not apply in the case at hand. The scope of this treaty override rule is limited to situations where the two treaty states construe the provisions of the treaty in a different (that is contradictory) manner. Germany is however not able to claim taxation rights under this rule if the non-taxation of income results from a "unilateral national measure", such as in the case at hand the statutory tax exemption of UK-based private equity LPs or - from a Luxembourg perspective – the tax exemption of SCS set up and authorised by the CSSF as SIFs or SICARs.
Luxembourg initiative to enhance the SCS for PE purposes
In order to foster the attractiveness of Luxembourg as a hub for alternative investments the Haut Comité de la Place Financière singled out the legal form of the Luxembourg limited partnership to be enhanced for private equity structures. The objective of this initiative is twofold: on the one hand the initiative proposes to improve the existing Luxembourg limited partnership regime with legal personality with a view to attracting PE houses to the Grand Duchy through a structure familiar to them. On the other hand a new legal form under the working title Association en commandite simple is proposed, an innovative legal regime without legal personality or commercial taint (gewerbliche Prägung), but with a maximum of contractual structuring flexibility which may benefit from an easier classification and recognition by international investors and fund managers alike.
Upshot and Outlook
the German private equity houses are currently fighting on several fronts, the latest decision of the BFH adds to the difficulties to adapt their business model to the future regulatory requirements under the AIFM Directive. Luxembourg with its highly specialiSed fund industry, custodians and securities service providers is well-positioned to offer efficient and AIFM-compliant solutions for the private equity world. The Société en commandite simple, the Luxembourg-made limited partnership, already offers a flexible and transparent legal framework for PE ventures and will be further improved according to the needs and expectations of the PE industry. Tax advantages, exemptions and alike considerations should by no means be the main reason or trigger to relocate to Luxembourg; notwithstanding, the findings of the BFH on the tax exemption of transparent foreign fund structures - such as UK limited partnerships and SIF-SCS and SICAR-SCS - should be in any case taken into due consideration when comparing and weighing pros and cons of different jurisdictions best suited to do PE business in the future.
Footnotes
1- Decision of first Senat of the Bundesfinanzhof dated 24 August 2011 – I R 46/10
2- Directive 2011/61/EU dated 1 July 2011 on alternative investment funds managers
3- Schreiben des Bundesfinanzministeriums vom 16. Dezember 2003 zur Besteuerung von Private Equity Fonds
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