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German tax issues for private equity funds

Private equity funds attracted the interest of the German tax administration when it turned out that significant gains were tax-free under the existing rules. Since then, a debate between the tax authorities, private equity companies and advisers has taken place, with the tax authorities wanting to lay down their principles on the treatment of private equity funds in a public ruling letter. Although the publication of this ruling letter has been postponed several times and only a draft letter has been issued at the time of writing, in this article Christoph Lorenz of KPMG illustrates some of the key issues involved in the debate.

Typical German fund structure as treated in the draft public ruling letter

Description of the structure

A typical way of structuring a private equity fund in the past was to use the form of a kommanditgesellschaft (limited partnership) 

The investors are kommanditisten (limited partners) in the kommanditgesellschaft, the fund manager(s) is (are) geschäftsführende kommanditisten (managing partners) of the kommanditgesellschaft, and the private equity company is the komplementärin (general partner with full personal liability for the liabilities of the partnership).

The fund managers are responsible for the network, deal flow and exit channels as well as investment decisions, and receive the carried interest in their capacity as geschäftsführende kommanditisten. The private equity company is responsible for preparing and implementing the investment decisions and for continuing monitoring of the equity participation, and receives the management fee for these services.

Key tax issues of the structure

Business activity versus asset management activity of the fund

The activities of the fund consist of acquiring equity participations in companies, holding these equity participations and, where appropriate, subsequently disposing of them. Under German tax rules it was argued that this qualifies as asset management and not as the conducting of a business activity. This was important because capital gains from asset management attributed from the fund to an individual or a foreigner would be tax free, whereas profits from business activity would be subject to trade tax and income tax.

Taxation of the carried interest for fund managers

The carried interest represents allocations of capital gains generated by a fund to the fund managers, with these allocations being disproportionately higher compared to the share of capital invested by the managers in the fund.

If the indirect fund manager's interest in the target which was sold was below the minimum level, as defined in Section 17 German income tax code (10  per cent shareholding for years until 2001), the private capital gains involved were supposed to not be taxable as they were regarded as income from tax free asset management activity.

Even if the capital gains were supposed to be income from asset management activity, one would have to reconsider the structures from 2002 onwards because the threshold of Section 17 of the German income tax code was reduced to shareholdings below 1 per cent. For example, a fund manager owning a 20 per cent carried interest in a fund that holds 5 per cent or more of the shares of a portfolio company would indirectly own 1 per cent or more of the portfolio company. Therefore capital gains would not be tax free any more but subject to the half income system, ie 50 per cent of the allocated profits from capital gains would be taxable under the ordinary income tax rates.

View of the german tax authorities according to the published draft public ruling letter

Business activity versus asset management activity of the fund

The tax authorities concede that a typical private equity fund should be deemed to carry out asset management activity and not business activity. However, they list a number of requirements that must be fulfiled in order to avoid the adverse qualification as business activity:

• the fund must not borrow bank loans. Only public subsidies that are structured as loans cause no adverse effect;
• the fund must not run an own administration organization;
  the fund must not exploit a market by the use of professional experience. This means that the fund managers may use their professional experience for their decisions on investments, because this is comparable to the conduct of an individual person managing his own property. However, any further use of professional experience for exploiting a market is detrimental;
• the fund must not offer shares in portfolio companies to a broader public and may only trade in its own account;
• the fund must not hold short-term investments (no investment periods of less than three to five years). The letter does not indicate whether extraordinary disposals before the three-year holding period will be detrimental;
• proceeds from disposals must not be reinvested but distributed to the partners according to the terms of the partnership agreement;
• the fund must not take an entrepreneurial role in the portfolio companies. The explanation given in the draft public ruling on this issue is the following: ‘The fund (itself or via related parties) must not participate in the active management of the portfolio companies. The percentage of shares in the portfolio companies as well as the circumstance that the managing partners receive a carried interest may be indications to suppose that there is influence exercised on the management of the portfolio companies. The exercising of functions of a supervisory board is not detrimental. The granting of approval rights by the portfolio company to the fund - analogously to Section 111 German stock corporation act - can be detrimental, if the fund herewith can intervene decisively in the management of the portfolio companies'; and
• the fund must not be ‘infected' by other business activities. For example, if the fund invests in a portfolio company organized as partnership, the business character of the partnership would infect the whole fund to be deemed as business activity.

If a fund is deemed to have business activity this would have the following consequences:

• profit allocations of capital gains and dividend income of the fund to investors that are individual persons are taxable under the half income system, ie 50  per cent of the allocated profits from capital gains and dividend income are taxable under the ordinary income tax rates;
• profit allocations of capital gains and dividend income to corporations are exempted from corporation tax at the level of the corporation; and
• capital gains and other income of the fund is subject to trade tax at the level of the fund.

Taxation of the carried interest for the fund managers

As far as the profits allocated to the fund managers correspond to the share of ownership of the fund managers in the jointly-held assets of the fund, these profits will be treated in the same way as the profit allocations to the other investors (in other words, the possibility of tax free capital gains from asset management or taxation under the half income system in cases above the threshold of Section 17 German income tax code).

This means that the larger part of the carried interest will be deemed as fully taxable income of the fund managers, either as income from independent personal services (ie subject to full income tax rates) or from business activity (ie subject to trade tax and full income tax rates with lump sum tax credit for trade tax). The half income system (which is usually applicable to dividend income and capital gain income of individual persons) will not be applicable to this part of the carried interest.

Evaluation

The general message of the draft public ruling letter is that private equity funds have the option to be organized as non-business partnerships. However, the list of requirements is long and some of the criteria leave room for interpretation. It was discussed in the course of the preparation of the draft public ruling letter whether to define a percentage of shareholdings (25 per cent or 50 per cent) in portfolio companies below which the fund would have been safe from being deemed a business fund. This option apparently will not be chosen now. The crucial question will be under which circumstances the local authorities will now grant individual rulings for new funds.

Regarding the carried interest, there is a clear statement that such profit allocations to fund managers will be fully taxable. This will lead to a situation where fund managers will have to pay significantly higher taxes on such carried interest under the German rules than they would have paid in other jurisdictions, where they can often apply the reduced tax rates for capital gains.

Principally the draft letter ruling grants a grand-fathering for funds established before March 31 2002. However, the grand-fathering is limited to such issues where the public letter ruling causes an aggravation of taxation compared to the tax administration practices in the past. As there were no uniform tax administration practices in the past it is difficult to evaluate the actual benefit of this grand-fathering clause.

Thoughts about alternative structures: the use of a German gmbh as a vehicle for a private equity fund

The shareholders of the private equity fund GmbH are the fund managers and the investors.

If the private equity fund GmbH generates profits as a result of the disposal of shares in corporations, such profits will be directly tax free in accordance with Section 8b section 2 German corporation tax act.

When the profits of the private equity fund GmbH are distributed, the fund managers receive not only the profits corresponding to their capital stake in the private equity fund GmbH, but also an interest in the profit, which is equivalent to the carried interest. In accordance with a decision of the German federal tax court, profit distributions which are not consistent with percentage interests in a company's share capital (‘incongruent profit distributions') are permitted. The financial authorities accept such incongruent profit distributions if special services provided by one or more shareholders for the corporation are the reason for such a method of distributing profits which differs from the statutory distribution formula. This is likely to be applicable in this case.

In their capacity as natural persons, the fund managers have to pay tax on the dividends received as compensation for the carried interest under the half income taxation. If a holding company is used for holding the shares in the private equity fund GmbH, it might be possible for the dividends to be received tax-free and for taxation in accordance with the half income taxation to be postponed until the point at which the dividends are finally paid out to the private person. One could therefore considerably improve the tax position of the fund managers as compared to the tax treatment as proposed in the draft public letter ruling. The structure described above ensures that the profits attributable to the disposal of companies in which an equity participation is held remain tax-free at the level of the private equity fund GmbH.

The investors would receive dividends from a corporation. If the investors are corporations the dividend income would be tax free, if the investors are private persons the dividend income generated in this way would be taxable in accordance with the half income taxation. This would be disadvantageous compared to tax free profits allocated from a non business fund in the form of a KG. However, if the fund has foreign investors or investors holding less than 1 per cent of the fund one could create structures where the increase in value is realized by these investors as a tax free capital gain rather than as divided under the half income taxation.

If the investors are foreign, dividends from a private equity fund GmbH may be liable to German withholding tax of up to 20 per cent plus solidarity surcharge only if there is no limitation by a double taxation treaty. A further aspect to be considered for foreign investors is that the taxation of dividend income and capital gains may be subject to different regulations in the country in which they are resident. If the taxation of dividend income is higher than the taxation of capital gains in the foreign jurisdiction, it would be necessary to assess whether the private equity fund GmbH is permitted to be treated as transparent in accordance with the tax law of the country in which the investor is resident (eg check the box).

Implications for foreign investors in german funds

Non-business funds according to the draft public ruling letter

One change becomes relevant from 2002 onwards due to the reduction of the threshold of Section 17 German income tax code from 10 per cent to 1 per cent in the course of the tax reform.

This means that foreign investors in a fund that indirectly hold, via the fund, 1 per cent or more in a German portfolio company will be subject to German limited tax liability on capital gains from the disposal of shares of such a portfolio company unless they are protected by a double taxation convention.

Funds qualifying as business funds according to the draft public ruling letter

Capital gains would be subject to trade tax at the fund level. Further German income tax would be levied under the half income system on profits from capital gains allocated to individual persons. This income tax probably could not be avoided by applying a double taxation treaty because those capital gains might be deemed to belong to a German permanent establishment of the fund. Profits from capital gains allocated to foreign corporation should not suffer any German corporation tax burden, because here the tax exemption for capital gains for corporations should apply.

Implications for foreign funds investing in German portfolio companies

Non-business funds according to the draft public ruling letter

Here the same tax effects as described for foreign investors in German funds (see above) apply.

Business funds according to the draft public ruling letter

Foreign funds qualifying as business funds according to the draft public ruling letter should be aware to not create a German permanent establishment. Otherwise they could run the risk of falling under similar taxation consequences as German funds that are deemed to have a business activity.

Fixed place available to foreign fund manager

According to the draft public ruling letter, the carried interest will be treated as income from personal services. In the case of a fund manager of a foreign fund who has a fixed base regularly available to him in Germany, the German tax authorities might assume that a portion of his carried interest is attributable to this fixed base of business and therefore be taxable in Germany.

German investors investing in foreign funds

In cases of German investors investing in foreign funds, it is important to know which issues may be of importance to German investors in such funds.

In case of a foreign fund that does not fall under the rules of the German law on foreign investments (auslandsinvestmentgesetz) and that qualifies as non-business funds according to the draft public ruling letter principally the same taxation would apply to the German investors as in case of an investment in a German fund.

In case of a business fund according to the draft public ruling letter the question arises, if the foreign fund has a permanent establishment in a foreign country with a double taxation treaty with Germany. This could help to claim a tax exemption in Germany for profits from the partnership allocable to this permanent establishment under the rules of the double taxation treaty.

German law on foreign investments (auslandsinvestmentgesetz)

There is uncertainty as to whether interests in private equity funds fall under the rules of the German law on foreign investments. The risk for the application of the German law on foreign investments is lower the more entrepreneurial influence is exercised by the fund in the portfolio companies. Therefore, the more a fund is structured not to fall under the German law on foreign investments the more it is likely that the foreign fund will be deemed as business fund for German taxation purposes.

If the German law on foreign investments applied, this would have the following consequences:

• certain duties of registration of the fund, if the investment in the fund is offered to a broader public; and
• tax adverse consequences especially in case of a non-registered fund (denial of the half income taxation on capital gains for individuals and tax exemption on capital gains for corporations; taxation on estimated tax base).

Reporting requirements for German investors

If German investors hold participations in foreign business partnerships they might be required to present a balance and profit and loss statement that follows German tax and accounting principles to their tax office.

Especially for corporate investors and individual investors that hold their investment in a business property it will be important to be able to demonstrate to the tax office which portion of the allocated profits are capital gains and dividends. This will be required to claim the tax exemption respectively the half income taxation for capital gains and dividends.

Summary

The draft public ruling letter will not solve all tax issues in relation to private equity funds. Future tax planning will probably have to be specific with relation to country of residence of investors and country of residence of portfolio companies and will have to focus on that the carried interest of fund managers does not become subject to the full tax rate in Germany. The legal form of the fund as well as the place of carrying out the activities will be key parameters here.

KPMG, Marie-Curie-Strasse 30, Frankfurt-am-Main, D-60439, Germany, 49 69 9587 2718, www.kpmg.com
 
© IFLR 2002

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