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Time to throw away the lifebelt?

The increasing number of foreign private equity investors in Germany has long posed a problem for the tax advisers to private equity funds. These funds are typically structured as limited partnerships and the level of activity in Germany means that the management organisation will need a local team to help it to source deals there. The issue is, of course, how to structure a local presence without jeopardising the position of the fund and its investors under German tax law. John Watson and Klaus Herkenroth of Ashurst Morris Crisp offer some guidance.

A note on the German tax treatment of private equity funds and their managers

There are two aspects;

• First, although a corporate partner in a fund which carries on business through a German permanent establishment will, as a rule, not be subject to corporate income tax on its share of profits, other partners will be reliant on the double tax agreement between their jurisdiction and Germany to avoid German taxation. Such agreements do not give protection where the profits arise from a business carried on through a German establishment;
• Second, a fund is itself a taxable entity for purposes of trade tax on income, and it is presently not clear whether trade tax will arise on fund profits, in particular on profits from disposals of participations in  portfolio companies. This trade tax can be avoided if the fund does not carry on a business through a permanent establishment in Germany.

There are two ways in which the carrying on of business in Germany can be avoided  The first is not to have a business: the second is to restrict the activity in Germany so that there is no establishment of the fund. Since the second is inconvenient to arrange, any route through which the absence of a business can be achieved would be embraced by almost all participants in the industry.

Avoiding a business

Because the absence of a business would make it possible for the German activities of a fund to be managed from Germany, considerable effort has been devoted to persuading the German authorities that the activity of investing in private equity is not a business for the purposes of German tax law. Some Länder are said to have given rulings on the point - generally on differing criteria: others have reserved their position in a sinister manner. Clearly rationalisation is called for and the industry has been waiting for guidance from the Ministry of Finance in a state of trepidation and expectancy.

A draft of that guidance was published in November 2001 and is currently out for consultation. It sets out factors which are to be taken into account in determining whether the activity of a private equity fund is or is not a trade or business. The criteria to be observed if business status is to be avoided, can be distilled from the following selected extracts from the draft guidance note.

• The fund itself must finance the acquisition of shares in the equity investment company exclusively from its own capital resources
• The fund itself may not have any extensive organisation of its own. If the fund runs its own office and employs a small number of persons, this will not be deemed detrimental provided that the scope usual in the case of large private property is not exceeded.
• The fund may not make use of a market and become active for the account of another whilst employing professional experience. According to the German Federal Supreme Fiscal Court, the utilisation of relevant professional knowledge for the fund's own account does not constitute commercial activities.
• The fund may not offer any participations/securities to the general public or act for the account of another.
• The fund is required to hold the participations for a period of at least three to five years.
• The realised sales proceeds may not be reinvested but must be distributed in accordance with the arrangements made in the [articles of association].
• The fund may not itself or through affiliated third parties be involved in the active management of the portfolio companies.

In addition the fund must not carry on a ‘deemed' trade or business due to a commercial imprint, and must not hold interests in another partnership which carries out a trade or business or a deemed trade or business.

On the face of it, it would seem difficult to be certain that any private equity fund will come out on the right side of all these criteria. Although the commercial imprint which would give rise to a deemed business can be avoided by structuring, most of them depend on the way in which the fund operates in practice. Typically, some of the conditions will be satisfied, others not and others ‘perhaps'. Although it might be possible to obtain a ruling by reference to the way a fund expects to conduct its affairs, that leaves no flexibility to meet changing circumstances. No-one would willingly put a fund into that sort of box and, if artificial constraints were to be placed on a fund's operations by reference to tax rules, it would clearly be necessary to disclose that to investors.

In the end, the proof of the guidance will be in the eating. It may be that the draft letter represents the beginning of a fundamental shift by the authorities away from treating funds as businesses and towards the position taken in the UK and the US, so that in a year or so's time the investment status of private equity funds will have become a given. What is clear, however, is that we are not there at the moment and that managers of UK funds would be foolish to throw away the protection of their advisory structures because they feel they can rely on ministerial guidance which takes the form of the draft.

Ensuring that there is no establishment through an advisory structure

The second approach is to design the operations of the fund so that even if a business is being carried on in Germany, it is not being carried on through an establishment there. That means that the team in Germany must not act as agent for the fund or its manager but can only give that manager advice. This is a considerable constraint on operations - particularly when you bear in mind that an establishment could be created by the German team negotiating on behalf of the fund even though the documents were ultimately signed in London.

Because pure advisory structures can undermine the credibility of the local team in the German marketplace a modified advisory structure may be preferable (see diagram below). This involves the local team (in the diagram via German Service Co) taking two separate roles. It provides advice to the fund itself but it provides management (probably through appointment of its members to the board) of the German acquisition vehicle. The structure of this hinges on the way buy-outs work:-

The purchaser in a German buy-out will normally be a German company (the German Acquisition Vehicle) owned by the private equity fund in question. It is that company which will sign the contract for the acquisition and will raise the finance with which to pay for it. Technically the fund's involvement is restricted to the provision of funds for that vehicle and entry into a subscription agreement. Provided these activities are reserved to London the negotiation and agreement of the purchase and outside funding can be carried through by executives from the local team as agents for the German Acquisition Vehicle. As that company is already resident in Germany, a German presence cannot possibly do it any harm!

Exiting from the fund

Although this arrangement gives far more flexibility of operation than a straight advisory contract, it does have its limits. Where there is no IPO, a fund will usually exit by selling the German Acquisition Vehicle and here the sale contract will have to be entered into by the fund itself. It follows that the sale will have to be arranged from London although the local team can carry out those functions which would fall to a target company, such as providing information for due diligence and warranties. The local team may also provide advice to the
fund both in relation to specific transactions and also on when and whether realisation should take place.

Value Added Tax

The other tax problem posed by a German presence is its effect on the VAT structure of the fund. Typically, the manager will have set up a German subsidiary ("GmbH" in the diagram below) and that subsidiary will make VATable supplies to the manager in the form of advisory services provided to the fund itself and perhaps the provision, at the manager's request, of management services to acquisition vehicles. When it is borne in mind that the manager of the fund is part of a single VAT entity (see shading in the diagram) which also includes both the general partner and the fund itself  and that this entity is likely to be partially (and usually, largely) exempt from VAT, it will be appreciated that much of the VAT arising in respect of the fee charged by the German subsidiary  will not be recoverable.

To some extent it is possible to mitigate this by charging acquisition vehicles direct for services provided to them. If then the acquisition vehicle and its group make taxable supplies VAT on this element should be recoverable. It will not usually be possible, however, to channel all the remuneration to the GmbH in this way - particularly when it is borne in mind that GmbH will have to meet its costs whether or not it is actually doing deals at the time.

An alternative approach, which avoids these problems, is to replace the GmbH by a German branch of the manager (see diagram below). That has the effect of bringing the German team within the management company so that the management company pays remuneration to them directly (that remuneration, of course, not bearing VAT).

The effect of this is to replace a taxable supply into the UK VAT 'entity' (comprising management company, general partner and fund) by the services of employees. Since the former would bear VAT and the second would not, any VAT loss on this element is eliminated.

Carried interest

As regards the tax treatment of the carried interest, it should be noted that the German tax administration does not seem to be inclined to grant a more favourable taxation of the income under the carry. In the draft guidance, the German tax administration takes the position that the managers of the fund can only generate tax free capital gains and tax-privileged dividends to the extent of their interest in the partnership. To the extent that the carry exceeds their interest in the partnership, the income from the carried interest will not constitute tax-free capital gains or tax-privileged dividends but rather remuneration taxable in full for the services rendered by the managers (or advisers) for the benefit of the other partners. Remuneration here does note take the form of a direct payment but rather the waiver of a portion of the profit shares due to the other partners, this simply amounting to payment in a different form.

There does not seem to be an obvious way to mitigate the tax of a manager resident in Germany on his share of the carried interest.

John Watson, Klaus Herkenroth, Ashurst Morris Crisp

Ashursts is an international law firm with offices in Brussels, Frankfurt, London, Madrid, Milan, Munich, New Delhi, New York, Paris, Singapore and Tokyo, acting for European and other international clients.