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German carried interest rules: the new regime

On 6 August 2004, new rules on the taxation of carried interest came into force in Germany. The new law is intended to improve the environment for private equity, says SJ Berwin. That is critical: according to an EVCA study published in May, Germany has the fourth worst legal and tax environment for venture capital and private equity in Europe, beating only Austria, Denmark and Slovakia.

The main reason for this result was the uncertainty surrounding the tax treatment of private equity funds in Germany. This includes the taxation of carried interest, which will now benefit from the new law.

However, the new carry taxation is only an initial milestone in a larger plan to enhance the tax environment for private equity investments in Germany.

History of the law
In a “Guidance Letter” issued by the Ministry of Finance on 16 December 2003, the German tax authorities classified carried interest as a “professional service fee” instead of capital gain. Consequently, carried interest was subject to full taxation (at around 50%). In this respect, the Guidance Letter was in contrast to the previous practice, and the industry’s view, that carried interest would be taxed as capital gains. The Guidance Letter provoked keen debate and several proposals for new rules. In the end, the new carry taxation is a political compromise, but overall a success for the domestic private equity industry.

New carry taxation
Like the Guidance Letter, the new law classifies carried interest as a professional service fee. It applies only to “non-trading funds” that are engaged in the acquisition, holding and disposal of corporations. The carry holder must carry out services to promote the purpose of the fund, and the carried interest can only be paid after capital contributions have been returned to investors. But, even though carried interest is qualified as a service fee, it will benefit – like capital gains would do – from the half-tax- exemption-regime.

This gives a total tax burden for carry of approximately 25%, the same as for capital gains. The half-tax-exemption- regime applies to individuals as carry-holders, as well as to corporations or partnerships. In particular, the half-tax-exemption- regime is applicable to carried interest irrespective of the source of the payment. Therefore, it is not necessary to pay the carried interest from capital gains in order to benefit from lower tax rates. The law includes a “grandfathering” rule. This rule should ensure that the half-tax-exemption- regime applies to funds established after 31 March 2002, as well as to older funds to the extent that carried interest will be paid on a disposal of shares acquired after 7 November 2003.

For “old” carried interest (arising from the disposal of shares acquired before 8 November 2003), a full tax exemption may apply; provided such exemption is in line with the practice of the local tax authority (for example, it will apply for funds located in the state of Bavaria).

International tax aspects
For non-resident carry-holders deriving interest from a German non-trading private equity fund, carry is taxable as follows: Tax treaty protection German tax treaties say that income of a non-resident taxpayer from professional services (as the new law characterises carried interest) is taxable in Germany only if such professional services are performed or attributable to a permanent establishment in Germany. Generally, there are neither services performed in Germany, nor there is a permanent establishment there, and therefore the “professional service fee” should, in principle, not be taxable in Germany.

No tax treaty protection
If there is no tax treaty protection, carry is subject to ordinary German tax law. The German Income Tax Act requires that professional services subject to tax are either performed in Germany, or the results are utilised in Germany. In most cases this requirement should not be met. Therefore, in general, carried interest which qualifies as professional service fee should not be subject to German taxation for non-resident carry holders.

Open issues
As the new rules only apply to non-trading funds, it is unclear whether carried interest deriving from “trading” funds will also benefit from the half-tax-exemption-regime. In particular, this uncertainty applies to non-German funds which may not clearly meet the criteria for a non-trading fund under the Guidance Letter dated 16 December 2003. Consequently, a non-German fund should achieve certainty about its non-trading status under German law. If a German or non-German fund is “trading” under German law, one has to apply certain structures in order to ensure tax efficiency.

For more information on the impact of German carried interest rule on private equity please email the author, André Gloede (andre.gloede@sjberwin.com).

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on its services to the private equity industry please contact Jonathan Blake or Simon Witney in its London office +44 (0)20 7533 2222 or visit our website at www.sjberwin.com