Lower Saxony Tax Court: Carried Interest Not Subject To VAT

Investors in private equity funds pool their capital to acquire equity interests in companies. A fund manager—often a limited liability company (GmbH)—selects, manages, and sells those interests at a profit. In addition to a fixed management fee, the manager receives so-called carried interest (or “Carry”). This is a disproportionate share of profits, payable only after investors have recovered their invested capital plus a minimum return (the so-called hurdle rate). Until now, Germany’s state tax authorities have taken different views on whether Carry is subject to VAT.

Summary

In its decision of May 7, 2026 (5 K 100/25), the Lower Saxony Tax Court held that neither the Carry nor the fund manager’s share of the liquidation proceeds, calculated in proportion to its capital interest, was subject to VAT. The case involved a liquidation Carry equal to 20% of the profit remaining after repayment of capital and the agreed minimum return (a 9% hurdle rate).

As fund manager, the claimant received a fixed fee of 0.5% of the fixed capital for its activities, regardless of the fund’s results. The fee was subject to VAT.

The claimant used that capital to acquire an equity interest, which was sold at a profit during the liquidation. After deducting the return due to the investors, the claimant received the liquidation Carry described above. The remaining profit was distributed in proportion to the capital interests.

The tax authority treated both the liquidation Carry and the subsequent distribution of profits in proportion to the capital interests as subject to VAT. The claimant’s out-of-court appeal against that treatment was unsuccessful.

The tax authorities argued that the Carry depended not on the amount of profit but on the occurrence of a specific event: an increase in the value of the company’s assets above the annual hurdle rate.

In their view, the hurdle rate distinguished the Carry from an ordinary profit participation and gave it a different economic character. The claimant’s special skills as fund manager had allegedly enabled it to all but ensure that the liquidation Carry would be achieved. The Carry therefore depended not on chance but on the claimant’s performance.

On that basis, Carries were essentially paid for successful performance and the use of “expertise services.” The Carry was thus consideration for a supply subject to VAT. The fact that the documentation did not support that classification was immaterial, because the actual circumstances were decisive.

The tax authority gave no reasons for treating the remaining distribution of profits in proportion to the capital interests as subject to VAT.

The claimant argued that the arrangement involved so-called mixed remuneration. It was undisputed that the fixed fee for its activities was subject to VAT. The Carry, however, was not consideration for a specific service; it was a share of the investment return attributable to the claimant’s status as a shareholder. Whether the Carry arose, and in what amount, depended on external market factors beyond the claimant’s control.

The Lower Saxony Tax Court upheld the claimant’s action. A Carry that was disproportionate to the capital interest and arose only after the hurdle rate had been reached was still a participation in the company’s success. Performance dependence alone did not turn it into consideration for a supply, and therefore it was not special remuneration paid to a shareholder. The mere fact that the payment was linked to a specified performance target that the claimant had influenced through its “activities” did not by itself establish the required direct link between a supply and the payment.

The partnership agreement contained no guarantee of success. The tax authority’s assertion that the claimant could count on receiving the Carry was therefore simply a results-oriented assertion by the tax authority. Even a valuable, indispensable contribution by a shareholder made under the partnership agreement remained a shareholder contribution, so long as the remuneration was measured by the company’s overall economic success rather than by the nature and extent of the performance.

Applying these principles, the remaining distribution of profits in proportion to the capital interests was likewise not subject to VAT.

The Lower Saxony Tax Court allowed a further appeal to the Federal Tax Court on grounds of fundamental importance, particularly because the state tax authorities continue to treat Carries inconsistently. The decision nevertheless became final, so the Federal Tax Court will not rule on the issue.

Practical implications

The Lower Saxony Tax Court’s decision is an important step toward greater legal certainty for carried interest structures. Although the Federal Tax Court will not rule on the issue, the state tax authorities will hopefully now adopt a uniform approach to Carries. A written inquiry (BT-Drucks. 20/13565, 16) specifically identified Lower Saxony as a state that had deviated from the principles of the Federal Tax Court (BFH of December 11, 2018—VIII R 11/16; BFH of April 16, 2024—VIII R 3/21) and treated the Carry as subject to VAT. The Lower Saxony Tax Court’s decision should now provide legal certainty on this point. For the other states, the decision at least has indicative effect.

The Lower Saxony Tax Court’s classification matters because any VAT burden borne by a holding company unable to deduct input VAT would be irrecoverable and would directly reduce the fund’s return.

The ruling highlights the practical importance of properly documenting the agreements and implementing them as agreed. The Lower Saxony Tax Court relied primarily on the agreements themselves. The partnership agreement contained no guarantee of success, and it was undisputed that the liquidation Carry was not treated as an expense.

The Lower Saxony Tax Court also linked its analysis to the Federal Tax Court’s income-tax case law on Carries. Under that case law (BFH of December 11, 2018—VIII R 11/16; BFH of April 16, 2024—VIII R 3/21), remuneration for services (and therefore taxation under para. 18 of the German Income Tax Act) exists only where the payment would be recognized as an expense and would also be payable in the event of a loss. By contrast, payments made out of the company’s result that do not reduce that result indicate that there is no exchange of a supply for consideration.

Mixed remuneration can also create structuring opportunities. In the case at hand, the fixed fee for the claimant’s activities was subject to VAT, whereas the Carry was not. The administrative circular dated May 31, 2007 (BMF of May 31, 2007—IV A 5 - S 7100/07/0031 BStBl 2007 I p. 503) treats fixed advance remuneration as an example of special remuneration and interprets agreements in accordance with their economic substance. The closer a component is to a service fee fixed in advance, the greater the risk that it will be subject to VAT (see also BFH of November 12, 2020—V R 22/19).

From an EU-law perspective, the decision is consistent with the case law of the European Court of Justice (ECJ), under which a general profit participation is not consideration where there is no direct link (ECJ of September 27, 2001—C-16/00, Cibo Participations).

Although the decision addresses only the liquidation Carry, the principles it sets out should also apply to ongoing or exit Carries. The key point is that the remuneration is measured by the company’s overall economic success, not by the nature and extent of the performance.

Funds that have previously paid VAT on the Carry—possibly as a precaution—should check whether any refund claims remain within the limitation period. The decision’s finality provides a concrete reason to act.

The decision sends an important signal for Germany as a fund domicile. In most neighboring European countries, Carry is not treated as a service subject to VAT. A clarification along the lines of the Lower Saxony Tax Court’s decision would therefore strengthen the competitiveness of German fund structures internationally.

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