German tax feud results in uncertainty for LPs

A German tax case has raised questions around the tax treatment of foreign funds.

German limited partners’ commitments to foreign funds could become more complicated following a recent decision by Germany’s Supreme Tax Court. The court classified certain foreign funds as active “trades or businesses” as opposed to being passive investments made by German LPs.

Some German institutional investors, such as certain pension funds and endowments, are restricted from investing in trades or businesses as tax-exempt entities.

The approach of the Court’s decision to the tax treatment of German investors in private equity funds is quite distinct to the interpretation taken by the German tax administration and the majority of the German market over the last years and will be subject to more intensive debate in future

Hans Stamm

The case centres on investments made by a German bank subsidiary into a UK-based private equity fund. Based on some “very generous” criteria according to the court, German tax authorities interpreted the commitment a passive investment.

Not so, ruled the tax court, saying the investment was into a trade or business on account of the fund regularly buying and selling portfolio companies to generate profits. However after reaching this decision the court went on to add that as a consequence of the UK partnership being a “trade or business”, it constituted a taxable permanent establishment of its German LPs in the UK. Hence the investment was bound by Germany’s double tax treaty with the UK, in effect protecting the German LP’s exemption from domestic tax. 

The ruling is a different interpretation from the longstanding set of rules established by German tax authorities in 2003. It has also confirmed that, different to the view of the German tax administration, income from such private equity funds may benefit from the provisions of a double tax treaty between Germany and the country of residence of the private equity fund.

The distinction is crucial as only foreign funds interpreted as a trade or business by German tax authorities would benefit from a double tax treaty, whereas a fund interpreted as conducting a mere investment management activity would be a “pass-through” tax vehicle and thus not protected by a tax treaty.

One consequence of the ruling may be German fund of funds becoming subject to a German trade tax, ranging from 12 to 14 percent of a fund’s income, should the fund take stakes in direct funds considered as passive investment partnerships, said Hans Stamm, a private equity funds- and tax-focused partner at law firm Dechert’s Munich office.

“The approach of the Court’s decision to the tax treatment of German investors in private equity funds (i.e. whether they are managing assets or trading) is quite distinct to the interpretation taken by the German tax administration and the majority of the German market over the last years and will be subject to more intensive debate in future,” said Stamm.

The reaction of the German tax authorities to this decision is not yet known, said Stamm, “however, the Court’s decision clearly indicates that there is a need for a solution to be found to the differing approaches of the German tax authorities and the Federal Tax Court.  As the anticipated implementation of the AIFM directive into German law may also require the German tax legislator to change the German tax regime of investments in domestic and foreign funds, this may also include a change of the taxation of investments into PE funds.”

The court’s decision also implies that German LPs can in certain circumstances take full advantage of tax breaks offered by foreign jurisdictions and not run against a German tax treaty. The case found no foul in German LPs (as a result of the ruling) being exempt from both German and UK tax – the fund accrued no taxes as part of a venture capital scheme designed to encourage investment in start-ups and early stage companies.

In this month's edition of Private Equity Manager, we explore the game-changing tax changes occuring in both Germany and the larger EU community.