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Private equity and venture capital rules lack focus

As the German private equity and venture capital investment market has grown, so has the demand for clear rules for the tax treatment of such investments. The recently published draft guidelines address some, but by no means all, of the open questions in connection with private equity and venture capital activities in Germany. Christian Ehlermann of Deloitte & Touche explains further.

Germany has been working on its rules for private equity and venture capital funds. Assessing whether asset managing or trading funds is the activity at hand is one of the key distinctions in this often cumbersome and controversial area.

Recent years have witnessed a tremendous surge in private equity activity in Germany. According to the German Venture Capital Association (BVK), funds earmarked both by German and international investors for the German buyout and venture capital markets amounted to roughly E40bn at the end of 2000, an increase of nearly 50 per cent over 1999.

Although the growth of the market has slowed down recently, in line with the general economic downturn, funds still pour into Germany for this purpose. Foreign funds continue to establish German advisory offices. At the same time, the German retail investor market is being tapped through the use of funds that offer participations - starting as low as E50,000 - in private equity deals. This article identifies and discusses some tax issues that may arise in connection with private equity and venture capital fund activities in Germany.

Classification of fund vehicles

Private equity and venture capital funds are typically structured as limited partnerships, often under the laws of the UK or one of the Channel Islands. If these partnerships are legally comparable to a German partnership, they also will be regarded as partnerships for German tax purposes. Sometimes US funds are structured as limited liability companies (LLCs), usually under the laws of the state of Delaware. The German tax authorities take a case-by-case approach to the qualification of an LLC. As a result, depending on the actual structure of an LLC, it may be found to be more comparable to a German corporation than to a partnership. Similar issues arise regarding the French fonds commun de placements à risque.

Certainty regarding the classification of a private equity or venture capital fund for German tax purposes can be obtained only through a ruling process that is so time-consuming that most taxpayers try to avoid it. As discussed below, the distinction between investments in corporations and partnerships is especially important for German resident individual investors.

Asset managing v trading funds

The distinction between asset managing and trading funds under German tax law is of fundamental importance, particularly for German individuals investing in such funds, but also, potentially, for foreign investors as well. The draft guidelines issued in November 2001 by the German tax authorities (draft letter by the Federal Ministry of Finance, IV A 6 - S 2240 - 0/01 II) on the income tax treatment of venture capital and private equity funds cite a number of factors as indicative of a trading fund. These are:

• Debt is financed at the fund level (ie debt-financed acquisitions of investments where the fund itself is the debtor - the debt financing of an acquisition vehicle owned by the fund, however, does not jeopardize the fund's tax status as asset managing).
• The fund has its own substantial organization (eg personnel and offices).
• The fund offers fund and investment management services to third parties.
• The fund holds short-term investments (generally assumed if investments are held for less than three years).
• The fund reinvests funds.
• The fund actively manages portfolio companies (supervisory board representation is acceptable, but management board representation or veto rights on important management decisions are not).
• The fund engages in incubator activities, such as nurturing of businesses through the provision of infrastructure or substantial business consultancy (incubator funds are always deemed to be trading because they are not passive but, instead, actively influence the portfolio companies).
• The fund has deemed trading due to its investments in trading partnerships. Investment in a trading partnership taints the otherwise asset managing partnership, so that all of its income becomes trading income (EStG, section 15(3)(1)). Targets structured as partnerships should, therefore, always be held through an intermediate holding company. This structure will generally already be adopted for exit planning purposes. A potential issue arises from investments in US LLCs, however, because the LLCs may qualify as partnerships under Germany's tax entity classification rules. It is, therefore, safer for the fund to invest in US LLCs through an intermediate corporate entity.
• The fund has deemed trading due to its structure: ie if the general partner of the fund limited partnership is a corporation and only the general partner has the power to manage the fund, the fund partnership is deemed to be trading regardless of its actual activities (EStG, section 15(3)(2)). This qualification can be avoided by having one or more limited partners co-manage the partnership.

Although the above criteria for distinguishing asset managing versus trading funds are subject to some dispute and are only partially supported by scarce relevant case law, it is expected that these criteria will influence the German tax authorities' position in future decisions. The draft guidelines are likely to become final and binding on the regional and state tax authorities during the course of 2002. Because comprehensive discussions preceded the issuance of the draft guidelines, it is unlikely that the tax authorities will substantially alter their views in the final guidelines.

Taxation of non-resident investors

Foreigners investing through a private equity/venture capital fund (German or foreign limited partnership) in German target corporations are subject to German tax but only under certain conditions.

Foreign investors investing through a private equity/venture capital fund in German targets are subject to German tax if the fund's activities give rise to a permanent establishment in Germany for the fund's partners. This involves an element of risk, particularly if a foreign fund vehicle is using a German advisory company. If the advisory company is managed by and/or controlled by the same individuals that manage the fund, it is conceivable that the German tax authorities will impute the locally performed target selection, monitoring and exit planning activities to the fund. Because of the fiscal transparency principle that applies to partnerships, each fund partner could then be deemed to have a German trading permanent establishment. This, in itself, should not be a great concern for a foreign corporation because, following the 2000 tax reform, even capital gains on share disposals by a partnership with a foreign corporate partner are exempt from corporate income tax (KStG, section 8b(2), (6)). The recent draft guideline on the taxation of private equity and venture capital funds, however, renewed doubts among German tax practitioners as to whether the capital gains tax exemption also extends to trade tax at the level of the interposed fund partnership (partnerships are not transparent for trade tax purposes; rather, they are taxpayers in their own right). This issue has not been entirely resolved.

There is a current risk for corporate investors that German trade tax will be assessed on gains from the sale of shares connected to a German permanent establishment. For individual investors, there is the additional risk of personal income tax being levied on 50 per cent of the gain. Thus, foreign funds should reduce the risk of creating a German permanent establishment, first and foremost, by documenting that decision making regarding any German investments takes place outside of Germany and that the activities of the German adviser are of a preparatory and auxiliary nature only.

The permanent establishment risk increases exponentially if a foreign investor invests in a German partnership as a fund vehicle. Whether the investment in the partnership creates a permanent establishment then depends only on whether the partnership is deemed to be trading, rather than engaging in asset managing (see above). Investments in trading partnerships unlike asset managing partnerships give rise to a German permanent establishment, with the tax consequences indicated above.

If German investments cannot be attributed to a German permanent establishment, capital gains are subject to German limited tax liability only if the indirect investment of the respective fund investor in the German target amounts to at least 1 per cent of the target's capital (calculated as if the investor were a direct shareholder) and the investor is an individual (for corporations, the German capital gains exemptions apply) resident in a non-treaty country. For example, an individual resident in Monaco who invests E50 in a E1,000 buyout fund partnership is, in principle, subject to limited German tax liability on exit if the fund invests in, for example, a 95 per cent participation in a German GmbH and sells the investment in the GmbH after some time. Interposing a corporate vehicle between the individual investor and the fund partnership may help, but such a step must be properly planned to avoid the application of the German anti-abuse rule (General Tax Code (AO), section 42 and EStG, section 50d (1a)).

Although dividends are rarely a critical issue for private equity or venture capital funds, it should be noted that fund investors can rely on their respective home country's tax treaty with Germany for the application of the lower treaty withholding tax rate, but only if their investment is properly evidenced to the German Federal Finance Agency. Obtaining that lower rate can be a lengthy administrative process.

Taxation of German resident investors

German corporate investors generally benefit from the new corporate income tax regime, which effectively exempts capital gains on the sale of shares from corporate income tax. The exemption is granted regardless of the target's residence, the size of the participation, or the duration of the investment. An issue may arise for banks and other financial institutions, however, because the act of banks trading for their own accounts is not exempted. The exemption is also granted in the case of indirect investments (ie through a fund partnership) (KStG, section 8b(2), (6)).

The generally accepted view is that the capital gains exemption also applies in the context of the trade tax on income, although certain parts of the tax administration seem to disagree with this view with respect to capital gains treatment at the partnership level. Accordingly, if the activities of a fund give rise to a German permanent establishment (see above) to which capital gains can be allocated, there is a risk that the German tax authorities may assess trade tax (typically ranging between 12 per cent-20 per cent, depending on the municipality).

The situation of German individual investors depends on whether the fund is asset managing or trading. If the fund is asset managing, it will be treated as completely transparent for tax purposes. Thus, individual investors holding the fund interest as a private investment are deemed to have a direct investment in the target. Private capital gains on shares are not taxable in Germany if a one-year minimum holding period has been met and the individual's investment does not amount to 1 per cent or more of the target's capital. If individual investors fail to meet any of these conditions (eg the holding period is one year or less, there is a 1 per cent or more investment, the investment is held as a business asset, or the fund qualifies as trading) the investors will be taxed on any capital gain. They will, however, benefit from the semi-income system that replaced the imputation system under the 2000 reform. Consequently, such investors will be taxed on only 50 per cent of the gain at their normal personal income tax rates. Trade tax liability arises depending on whether the investment is in a business property. If trade tax liability does arise, it is partially creditable against income tax.

Germany's Foreign Investment Act may apply, in principle, to foreign private equity and venture capital funds because the Foreign Investment Act is aimed at foreign, risk-diversified portfolio investment funds, trusts and SICAVs. In practice, funds that exercise entrepreneurial influence over their portfolio companies (such as buyout funds) are generally exempt from Foreign Investment Act provisions. Absolute certainty on this issue can only be obtained by receiving a certificate issued by the German banking regulators that the fund is not covered by the Foreign Investment Act (so-called Negativtestat). Few funds have achieved such certainty, however, because obtaining the certificate entails a cumbersome and lengthy administrative process.

If the Foreign Investment Act applies, the tax consequences for German investors could be disastrous, because the tax exemption under corporate income tax rules and the 50 per cent tax exemption under personal income tax rules do not apply to distributions from a vehicle covered by the Foreign Investment Act. Moreover, if the fund vehicle is not registered in Germany or represented by an appointed fiscal representative resident in Germany, and if the income of the fund cannot be documented to the satisfaction of the German authorities, the tax office may estimate the German investor's income on a deemed profit basis. To avoid this risk, many German investors have, in the past, preferred to invest through German (co-investment) vehicles.

Carried interest taxation

One of the most controversial areas in German fund taxation is the treatment of the management's carried interest, ie the disproportionate (compared to the equity investment) share of gains allocated as an incentive to the fund's management. In the absence of relevant case law, opinions range from essentially complete tax freedom for the management (private capital gain on less than 1 per cent shareholding) to the tax authorities' recently expressed view that the carried interest is a hidden service compensation and, thus, regularly taxable at full personal income tax rates (up to 51 per cent) under EStG, section 18(3). Planning in this regard, therefore, remains focused for the most part on the hope that a tax court will reject the authorities' position on this issue.

Conclusion

As the German private equity and venture capital investment market has grown, so has the demand for clear rules for the tax treatment of such investments. The recently published draft guidelines address some, but by no means all, of the open questions in connection with private equity/venture capital activities in Germany. Any of the tax authorities' more controversial positions that appear in the final guidelines are likely to be subject to challenge in court.

© Copyright Deloitte & Touche 2002

First published in International Tax Review