New German tax legislation affects private equity funds and their German investors

Change of German/ Luxembourg Double Tax Treaty Affects Private Equity Funds With German Investments

On 23 April 2012, Germany and Luxembourg signed a new double tax treaty (the Treaty) which is to replace the previous double tax treaty dating back to 1958. The new Treaty may affect international private equity funds with investments into Germany. Such investments are often structured by using Luxembourg holding companies (e.g., SOPARFI) for German inbound investments. Some of the relevant chances include the following:

• Certain income from German portfolio companies (including from dividends) is subject to German taxation or suffers German withholding tax. Such German tax may be reduced under the provisions of the Treaty. In the past it was not clear whether certain funds as investors in German portfolio companies would benefit from the relief available under the Treaty. The Treaty now clarifies that, in principle, Luxembourg investment funds (including the so-called SICAR which is often used by private equity funds) is able to claim Treaty benefits.ƒ
• Investment into real estate companies: The Treaty provides for a new provision which covers capital gains from shares in companies which derive more than 50 % of their value directly or indirectly from real estate assets. Hence, investments in German real estate companies, held through a Luxembourg holding company, may be subject to German tax under the new Treaty.
• Hybrid debt instruments (often used by private equity and real estate funds): Investments in German portfolio companies are often capitalized through hybrid debt instruments (e.g. profit participating loans, “PPL”) by which a certain portion of German derived profits is repatriated. Under the current Treaty, interest payments from such financial instruments were (subject to the individual terms) not subject to any German withholding tax. Under the new Treaty, however, Germany is entitled to apply its German withholding tax rate (of 26.375 %) to payments under such financial instruments, if they qualify as so-called “profit participating instruments” (i.e. if the respective “interest” payment under such financial instrument is linked to the profit of the German “borrower”).ƒ
• Application of new rules: It is expected that the new Treaty will be ratified by the Luxembourg and German parliaments in due course and, in principle, will apply as of 1st January 2013.

Thus any restructuring of existing investment structures would need to be implemented during the course of 2012.

Decision by the German Federal Fiscal Court Clarifies Taxation of German Investors in Private Equity Funds

Private equity funds are typically structured in the form of limited partnerships which from a tax perspective are intended to be structured as socalled “flow through entities”. As a consequence profits from investments in portfolio companies should not be taxed at the fund level but rather at the investor level. German tax resident investors as limited partners in private equity funds typically are concerned whether income from foreign partnerships would be qualified as income from a “trade or business” (gewerbliche Einkünfte) or rather as mere income from administrative activities (vermögensverwaltende Einkünfte). Such distinction is particularly of relevance for certain German tax exempt investors. Also for German taxable investors such distinction is of relevance since income from a foreign partnership which would — from a German tax perspective — create income from a “trade or business” (gewerbliche Einkünfte) would be exempt from German trade tax (which is a municipal tax of about 12%–16%). In the past no clear guidance existed in the form of binding tax legislation or court cases. The German Federal Ministry of Finance (BMF) published a tax decree in 2003, which now, however, has been substantially qualified by the new court case.

On October 26, 2011, the German Federal Fiscal Court (BFH) published a landmark decision (dated August 24, 2011) on the fiscal consequences of an investment made in a foreign private equity fund. According to this decision, any profits from foreign private equity fund realized by German investors generally qualify as income from a “trade or business”, for which also the application of the so-called tax exemption system of a tax treaty may be eligible.

Cause for the decision was the participation of German institutional investors in an English private equity fund. The German investors, who had been subsidiaries of a German financial services company, were together with other institutional investors from different countries limited partners in a limited partnership with registered office in London. The English private equity fund involved for the day-to-day investment management a company, which was also located in England. The fund had a four year investment phase with a subsequent realization phase. The investment activities focused on smaller and larger buy-outs with regional focus in the UK. The fund acquired a total of 22 equity participations through leveraged buy-outs with a percentage holding between 3% and 61% with an average holding period of four years.

In essence, the German Federal Fiscal Court has taken the view that in general private equity funds which pursue a “buy-to-sell” strategy and complete an exit of their portfolio investments within four years should be treated as conducting a “trade or business”. Also the court referred to the use of debt financing (although the court case does not distinguish whether such debt financing is being used at the fund level or in the underlying investment structure of the fund) as an indication for such commercial activity.

Furthermore, the Federal Fiscal Court decision generally confirms that also a private equity fund, through its local investment manager, can create a permanent establishment within the meaning of a double tax treaty. As a consequence income from such a private equity fund which can be attributed to such a permanent establishment may even be fully tax exempt for German investors under an applicable double tax treaty. However, the practical implications of the latter point may be limited, since most of the (revised) double tax treaties with Germany provide for a so-called “subject to tax clause”. As a consequence income which is not subject to tax in the foreign permanent establishment (e.g., in case of an English PE Fund) would then be subject to tax at the level of the German investors.