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Taxation of carried interest in Germany

With the German legislature poised to resolve the controversy surrounding the taxation of carried interests, the tax outlook for German private equity professionals is looking good, according to Friedrich Hey and David Hickok of Debevoise & Plimpton.

The new German legislation awaits approval by Germany ’s Second Chamber (Bundesrat), where the states are represented. Approval is widely expected, not the least because some of the states actually introduced the legislation. The new law, if enacted, will apply to all distributions of carried interests with respect to equity funds founded after March 31,2002 or with respect to dispositions by equity funds of investments in portfolio companies acquired after November 7, 2003.

Following last minute amendments, it is expected that the new law will apply to both funds not engaged in trading and funds engaged in trading. Because the distinction between private equity funds that are considered to be engaged in trading (business funds) and those which are not, is controversial and somewhat confusing, this development is particularly favourable for the private equity industry. According to a circular issued by the German Tax Administration in 2003, private equity funds must comply with certain requirements in order to be considered not engaged in trading, including, among other restrictions, not using debt capital (bank loans) and not engaging in public offerings.

The tax treatment of carried interests of funds not engaged in trading was heavily debated because of the absence of statutory provisions on their tax treatment. Generally, Germany recognizes disproportionate interests in a partnership if there is an agreement among unrelated partners. Based on this principle, private equity sponsors historically argued that they should not be taxed at all on the capital gain because (1) a private equity fund is not engaged in a trade or business with respect to the shares it holds, and (2),as a general rule, Germany does not tax personal capital gains provided that shares have been held for more than one year (not long ago the holding period was only six months) and that a maximum shareholding threshold is not exceeded.

Only very recently this maximum shareholding threshold for exemption from capital gains taxation was reduced to one per cent from ten per cent. After reduction of the threshold to one per cent, the potential tax savings were significantly reduced since sales in excess of one per cent would be taxable. The critical question was whether gains on carried interests were fully taxable as ordinary income or as capital gains where a 50 per cent exclusion applied. The issue of a 50 per cent exclusion was significant enough to warrant lobbying by the private equity industry. However, in a shock to the industry, in December 2003 the German Tax Administration issued their long awaited revenue ruling on the taxation of private equity funds (more than two years after issuance of a draft),and took the position that a carried interest always constitutes service income subject to full ordinary tax. It is against this background and the threat that the private equity community would relocate to tax friendlier jurisdictions that the German government felt the need to adopt the legislation passed in mid-June.

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Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Hong Kong and Moscow.