After confirming the tax treatment of carried interest in trading fund structures with its decision dated 11. December 2018, Germany's Supreme Tax Court (BFH) also recently had to decide on the tax treatment of carried interest in non-trading, purely asset managing fund structures.. Even though the BFH referred the case back to the Lower Tax Court of Munich for a final decision due to procedural errors, it already provides clear guidance as to how carried interest is to be qualified for German tax purposes.
Background
Carried Interest commonly refers to the capital disproportional profit share of the founding partners of a private equity or venture capital fund received when certain return hurdles are exceeded. For both investors and carry recipients, the tax treatment of carried interest has been a point of contention with the German tax authorities for a long time.
According to German tax law, carried interest received from purely asset managing fund structures should generally represent income from self-employment in the form of remuneration received by the founding partners for promoting the purpose of the fund (i.e. their immaterial contribution to the fund partnership). Provided that it is only paid to the founding partners if the investors have at least received their invested capital back, carried interest would generally benefit from a 40% tax exemption (the so-called 'qualified carried interest regime').
Back in 2018, the BFH confirmed that the qualified carried interest regime does not apply to trading fund structures. However, the court also clarified that carried interest is nothing more than a mere disproportional profit share which should generally not be taxed differently from the proportional profit share regular investors receive. Thus, although the special partial tax exemption of 40% available under the qualified carried interest regime in asset managing fund structures should not apply in trading fund structures, the general partial tax exemption of 40% should also be applicable on the carried interest insofar as it is paid from dividends or capital gains (from sale of shares) based on general taxation principles according to the BFH.
This case law is now to be confirmed and continued also in relation to non-trading, purely asset managing fund structures.
Decision and Reasons
During the court proceedings, the German tax authorities argued that – in their opinion in line with German tax law on carried interest – the carried interest represents remuneration for services provided to the investors and should not represent a disproportional profit share of the founding partners for their immaterial, i.e. non-cash, contributions to the fund. Thus, they first allocated all profits of the fund solely on the basis of capital contributed ignoring the agreement made on the carried interest allocations in the Fund's Limited Partnership Agreement (LPA). In a second step, they considered the carried interest as a remuneration to be paid by the investors (i.e. not by the fund) to the founding partners (the direct payment by the fund would, in their view, merely be an abbreviated payment method). Although the German tax authorities admitted that this remuneration should represent income-related expenses for the investors, these are generally not deductible for private investors as the German income tax act prohibits the deduction of costs within the realization of income from capital assets.
However, this view was now clearly rejected by the court. The BFH confirmed that the carried interest was agreed in the fund's LPA as a special profit allocation rule that is independent from the capital contributed. As this special profit allocation was agreed between independent third parties in the context of a natural conflict of interest, it must also be recognized for tax purposes. Thus, investors are only taxable with the profit that is actually allocated to them based on the profit allocation rules included in the funds' LPA, and the carried interest received by the founding partners is – at least at fund level – nothing other than a profit allocation. A reclassification into self-employment income based on the qualified carried interest regime is only to be made at the individual level of the founding partners (if at all) and has no effect on the qualification as a profit share at the level of the fund or for the investors.
Conclusion and Outlook
Although the focus of the court decision was on the treatment of carried interest at fund level and for the investors, it also supports the qualification and beneficial taxation for the founding partners and carried interest holders. With its latest decision, the BFH thus consistently continues its previous case law and contributes to greater legal certainty in the taxation of carried interest.
The BFH decision dated 11. December 2018 on the taxation of carried interest in trading fund structure was never officially recognized by the German tax authorities and it remains to be seen if the German tax authorities will now accept the broader applicability of the taxation principles set out in the court decisions, by publication in the Federal Tax Gazette II (Bundessteuerblatt II). However, in our opinion, the tax authorities should no longer be able to evade the principles laid down by the BFH for long.
The decisions referred to above can be found here (in German language):
BFH-Urteil vom 11.12.2018, VIII R 11/16 (carried Interest in trading fund structures)
BFH-Urteil vom 16.04.2024, VIII R 3/21 (carried interest in asset managing fund structures)
Originally Published 7 August 2024
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