Markus Roth, KPMG Munich
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Following the high water mark of the technology boom in 1999 and 2000, drastic corrections occurred in 2001 on the world's capital markets. These have left their mark on the German private equity landscape as well and triggered a significant decline both in the number and in the volume of private equity transactions. Nonetheless, Europe and above all Germany remain keenly interested in private equity investment, and enormous growth is anticipated in this sector over the next few years. In recent months, the tax treatment of private equity funds has moved into the centre of interest along with purely economic issues. Major tax issues are still shrouded in uncertainty despite the increased attention that German private equity funds have attracted. It is furthermore generally not possible to eliminate the tax question marks by obtaining the German equivalent of a private letter ruling from the German tax authorities, who have scarcely issued any so-called "binding rulings" in this area.
In response to mounting pressure from private equity houses, industry associations, and tax professionals, the Federal Ministry of Finance released proposed regulations on the tax treatment of private equity funds in November 2001. Following the transformations wrought by the landmark business tax reforms in 2001, the proposed regulations have major implications for the tax structure and treatment of private equity funds.
2. Typical structure of private equity funds
Private equity funds are typically structured as passive asset management partnerships. For liability reasons, limited partnerships with a corporate general partner (GmbH & Co. KG) are almost invariably preferred. Foreign and domestic private and institutional investors subscribe the limited partner interests. Limited partners have no personal liability once they have paid in their designated contributions, but likewise have no management authority. A private equity company also takes a limited partner interest. Management of the fund is effectively vested in this company's members. The capital paid into the fund by the investors is invested by the fund in equity or quasi-equity stakes in selected enterprises (generally corporations).
Carried interest structures are generally established to create performance incentives for the fund's managing partners (fund managers).
Prior to each investment, the investment target (potential portfolio company) is subjected to commercial, financial and tax due diligence and otherwise scrutinised as closely and comprehensively as possible. However, once an investment has been made, the fund does not play an active role in managing its portfolio company. The investment is frequently monitored and administered by causing fund managers to be appointed to the portfolio company's supervisory or advisory board.
The fund does not trade in portfolio investments, nor does it reinvest its earnings in new businesses. These earnings can include interest and dividends, but generally take the form of capital gains. Upon expiration of the fund's term, all investments are liquidated and the fund is dissolved.
3. Commercial status and its negative consequences
Partnerships are treated as transparent entities (conduits) for purposes of personal and corporate income taxes. Hence, these taxes are paid not by the partnership, but by the individuals and institutional investors who are partners in the partnership. However, if the partnership derives commercial business income, the partnership itself is a taxable entity for trade tax purposes and hence liable to trade tax on its income.
A private equity fund operated in partnership form is considered to derive commercial business income where the fund's above described investment activities are "commercial" in nature, as opposed to constituting mere passive asset management.
If the fund's activities are commercial, partners who are individuals will be subject to tax on their distributive share of capital gains from the sale of investments in corporations irrespective of their pro rata shareholding in the corporation in question and irrespective of the holding period of the shares sold. Foreign individuals investing through a German private equity fund can lose their tax treaty protection with respect to capital gains where the fund is deemed to be commercial and hence to constitute a permanent establishment to which such capital gains are allocable. Even though individuals enjoy a 50 % capital gains exemption for taxable capital gains on the sale of corporate shares, this may still be less favourable for foreign investors than taxation under the laws of their country of residence.
Consequently, private equity funds generally have a strong interest in avoiding classification as commercial partnerships. The proposed regulations issued by the German tax authorities identify and provide guidance on the relevant classification criteria, which are discussed below.
4. Business status avoidance criteria
4.1 No debt financing
To avoid classification as a commercial business, the fund should not borrow from third parties. This imposes no restrictions on the fund's management, however, since private equity funds generally invest only their own equity.
Loans from the Kreditanstalt für Wiederaufbau (a public development bank) and other government development loans are excepted from the general prohibition on debt financing. Also, only borrowing by the fund itself is damaging, not borrowing by the companies in which the fund invests. Furthermore, interim financing of outstanding capital contributions may be permissible where the fund has to make an investment on short notice. The proposed regulations are silent on this point, however. Explicit mention of such situations in the final regulations is desirable.
4.2 Limited management organisation
The proposed regulations treat the establishment of extensive management structures as incompatible with non-commercial status. Private equity funds endanger such status if they create organisational structures that go beyond those commonly used to manage large private fortunes. However, a fund does not cross this threshold merely by maintaining offices of its own with a small number of employees. Most private equity funds are able to keep their management structures within the prescribed limits.
4.3 No marketing of professional services
Private equity funds can forfeit non-commercial status if they market their investment services to third parties and use their professional experience on behalf of such persons. The proposed regulations limit the activities of a fund's management to those typically engaged in by a private investor managing an extensive fortune.
4.4 No participation in general economic interchange
A private equity fund may not engage in general economic interchange by offering its investments for sale to the general public or by acting on behalf of third persons. Since most private equity funds act for their own account as a matter of principle and offer their investments only to a limited group of potential buyers, this requirement is also not generally problematic.
4.5 Holding period
The proposed regulations provide that private equity funds may not acquire short term interests in the companies in which they invest and specify a minimum holding period of three to five years. The proposed regulations regard shorter holding periods as incompatible with holding property as a long-term source of income, which is an essential element of passive asset management. Decisions of the Federal Tax Court are cited in this connection in which the court treated purchases and resale at short intervals as commercial business activity. However, a limited number of short-term re-sales should not be damaging, as the final regulations will hopefully make clear.
4.6 Reinvestment of capital gains
The non-commercial status of a private equity fund is compromised by reinvesting gain on the sale of investments. Such capital gains should instead be distributed to the investors.
4.7 No assumption of management responsibility by investment companies
From a practical perspective, the most important requirement for retaining non-commercial status is the prohibition on active fund participation in the management of its portfolio companies.
Originally, the tax authorities had planned an even stricter rule by which a fund forfeited its non-commercial status by acquiring more than 25 % of the shares in any investment company. This rigid 25 % rule had no foundation in law and was therefore rightly abandoned in the proposed regulations. Unfortunately, the present wording of these regulations subjects investors to considerable legal uncertainty.
The proposed regulations take the position that one may infer damaging management influence by the fund on its portfolio companies from the size of the fund's stake in these companies in conjunction with entitlement by the fund's managing limited partners to a share of profits in excess of their pro rata interests in the partnership (the fund). This position is, however, arguably incompatible with the case law of the Federal Tax Court, which has held that an investor's commercial status may not be inferred from the size of its stake in a portfolio company.
The proposed regulations also fail to state precisely what size stake may give rise to the inference of management influence and cause a fund to be classified as commercial. The various materiality thresholds that apply under German tax law for other purposes are irrelevant to the present context. Since there is no basis for deeming management influence to exist where an investment exceeds certain limits, the issue – properly framed – is whether the fund exercises management influence in fact.
On the positive side, the proposed regulations provide that it is not damaging for the fund to place its appointees on the supervisory boards of its portfolio companies.
4.8 Deemed and communicated commercial status
Private equity funds that qualify as non-commercial entities on the basis of the above criteria may nevertheless be deemed to have commercial status where certain statutory conditions are met, or may be commercially "tainted" by reason of interests held in other partnerships that in turn have commercial status.
Avoidance of deemed commercial status is fairly easy since the statue in question is specific and narrowly construed. Deemed commercial status arises where all of a partnerships' general partners are corporations and management responsibility is vested in these corporations or in persons who are not partners. Deemed commercial status can therefore be avoided for tax purposes by vesting limited managerial authority in an individual (natural person) who is a limited partner.
The rules for commercial "tainting" by reason of interests held in other partnerships are more complicated. Because of the danger such investments pose for a fund's non-commercial status, they are generally avoided in favour of investment in corporations only. With appropriate planning, investments in other partnerships are possible, however. For instance, a target partnership can be reorganised in corporate form without triggering any taxes. The target partnership can also be acquired through a wholly owned subsidiary of the fund (acquisition vehicle).
5. Tax treatment of non-commercial funds
Funds structured as non-commercial partnerships function as completely transparent entities for income tax purposes. The fund's income is allocated to its partners, who pay tax on their distributive interests thereof.
Partners who are individuals pay no tax on their distributive shares of capital gains realised by the fund on the sale of shares in corporations provided two conditions are met: (i) the shares must be held for more than 12 months before disposing of them and (ii) the pro rata stake of the partner in question in the corporation whose shares are sold must be less than 1 %. The partner's pro rata stake is determined by looking through the partnership and multiplying the partner's interest in the partnership by the partnership's share in the corporation in question.
If the distributive share of capital gains constitutes taxable income for a private investor under the above rules, the investor enjoys a 50 % capital gains exemption with respect to the income (so-called "half-income system"). Private investors thus at most pay tax at their applicable marginal tax rate on half of the capital gains earned by the fund.
A private investor's distributive share of dividends earned by the fund is similarly subject to a 50 % dividends-received exemption.
Foreign resident individuals who invest in a German non-commercial private equity fund are subject to German taxation only to the extent the fund invests in the shares of German corporations, in which case the above rules regarding capital gains and dividends apply. Capital gains on the sale of shares in German corporations are not subject to German tax if the holding period exceeds 12 months and the foreign partner's percentage stake is under 1 %. Otherwise, tax is payable on half of the amount of the capital gain unless a tax treaty applies, in which case the gain will generally be exempt from German taxation, since most of Germany's tax treaties assign the right to tax such capital gains to the investor's country of residence.
Corporate investors, both German and foreign, are generally 100 % exempt from German tax on their distributive shares of the fund's capital gains on the sale of shares in corporations. This exemption exists under German corporation tax law and does not depend on a minimum percentage shareholding, a minimum holding period, the application of the terms of a tax treaty, or the fulfilment of the terms of an activity clause.
6. Carried interest
Carried interest refers to allocations of fund profits to the fund's managers that are disproportionately higher than the managers' respective capital interest in the fund. The proposed regulations contain provisions that significantly tighten the tax treatment of carried interest compared with prior tax practice. In the past, carried interest has generally been tax exempt to fund managers provided the arrangement was properly structured. To the extent the carried interest is proportionate to a fund manager's capital interest, taxation follows the general rules for individual and corporate investors and will generally result in either a 50 % or 100 % tax exemption.
However, the proposed regulations treat the disproportionate portion of the fund manager's profit share, which is generally the greater part, as fully taxable income from the performance of independent personal services or from the conduct of a commercial business. In addition to income tax, trade tax is owing on income from the conduct of a commercial business. The 50 % exemptions enjoyed by individuals on distributive shares of dividends and capital gains do not apply.
This part of the proposed regulations is unacceptable from an economic perspective and of dubious validity from a tax viewpoint. The proposed rules are economically unacceptable because, by denying capital gains treatment to the internationally established carried interest incentive system, they would discriminate against the managers of German-based private equity funds, hence making Germany an unattractive location for such funds. In the United States and Great Britain, the two leading private equity investment countries, carried interest is totally or at least largely exempt from taxation. The success or failure of private equity funds is decided by the personal networks and market knowledge of the fund managers. Imposition of prohibitively high taxation on the fund managers will stifle fund management activity in Germany, with devastating economic effects. The introduction of the new rules could also not come at a worse time for the German economy, where unemployment is rising and growth dwindling.
From a purely legal perspective, there is reason to suppose that the proposed tax treatment of carried interest would not be upheld in court.
7. Alternative fund structures
Funds organised as limited liability companies (Gesellschaften mit beschränkter Haftung – GmbH) can be an interesting alternative to limited partnership funds. Under this model, the investors and fund managers become shareholders of a GmbH, a corporation with separate legal identity.
A GmbH is a discrete taxpaying entity for German tax purposes, not a conduit, as are partnerships. The GmbH's taxation is separate from that of its shareholders (the investors). The tax consequences are outlined below.
7.1 Fund taxation
Capital gains realised by the GmbH (the fund) on the sale of shares in other corporations are exempt from German tax. Dividends received from portfolio companies are likewise free of corporation tax.1
7.2 Shareholder taxation
If investors sell their shares in the GmbH, the German tax treatment of the resulting capital gain follows the rules outlined above with respect to capital gains realised by non-commercial funds operated in partnership form. For investors who are resident individuals, the tax consequences depend on whether they respect a one year holding period and hold 1 % or more of the GmbH's shares. For foreign private investors, the terms of a tax treaty are also important.
Capital gains derived by the GmbH can be retained indefinitely in the GmbH without triggering tax. If the GmbH liquidates its investments and distributes its profits to its shareholders, these constitute taxable dividends to the individual shareholders. Domestic and foreign individuals enjoy a 50 % dividends-received exemption. German taxation of dividends payable to foreign shareholders may be further limited by the terms of an applicable tax treaty.
7.3 Institutional investors
Organisation of the fund as a GmbH is particularly advantageous for institutional and other corporate investors. A private equity fund in the form of a GmbH can sell shares in other corporations free of German corporation tax irrespective of any holding period or minimum stake requirement. The same tax exemption applies if a corporate investor sells its shares in the fund GmbH. Corporate investors receive dividends paid by the fund free of German tax, though foreign investors will generally need to file a request for refund of withholding tax, depending on the applicable tax treaty.
7.4 Carried interest
Carried interest structures can also be implemented for the fund managers with tax effect where the fund is organised as a GmbH. With proper planning, these structures will be accepted by the German tax authorities.
Carried interest constitutes a dividend paid by the GmbH to its fund manager. If the fund manager holds a direct stake in the GmbH, such dividends benefit from the 50 % dividends-received exemption enjoyed by individuals. However, it is also possible to hold the stake indirectly by interposing a corporation between the fund GmbH and the fund managers. This interposed corporation subscribes shares in the GmbH and is owned by the fund managers who are entitled to carried interest. The interposed corporation receives dividends from the fund GmbH free of tax, thus postponing taxation of the carried interest until it is distributed by the interposed corporation to the fund managers. The position of the tax authorities with regard to such structures is uncertain, however. The tax authorities are expected to issue final regulations in the near future.
8. Concluding remarks
The German tax authorities are to be praised for their efforts to promote planning certainty in the important domain of private equity funds by issuing administrative regulations. The proposed regulations issued in November 2001 are a step in the right direction, even though numerous issues remain unsettled. The international tax treatment of capital gains derived by fund investors and carried interest derived by fund managers will become increasingly important in the future when decisions are made as to the location and legal structure of private equity funds. It is ultimately up to the tax authorities to create a tax climate that makes Germany an attractive location from which to operate private equity funds in international comparison. In their present form, the proposed regulations fall short of this objective, however.
Editorial cut-off date: 20 March 2002
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1 Regarding trade tax, see sec. 2.2 ff. of the article on p. 31 of KPMG German News no. 1/2002 (article no. 248) regarding the 2001 Business Tax Development Act.