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

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:

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.