Tax co-publishing
Private Equity Tax
By Dr. Michael Best, Dr. Bettina Spilker, P+P Pöllath + Partners, Munich
During the last ten years, private equity has become an important asset class in Germany. International private equity funds have invested large amounts in many transactions, have built up teams in Germany, and German institutional and private investors have invested large amounts of money in national as well as international private equity funds. These activities involve various tax issues, especially when bearing in mind the complexity of such structures. The following provides an overview of the tax aspects to be taken into account when setting up and running a private equity fund in Germany.
Fund Formation and Screening
Especially in an international context, private equity funds are usually set up as a limited partnership, allowing investors from different jurisdictions to invest in a „transparent“ structure for tax purposes, the intention of which is to tax the investor only in its home jurisdiction. However, this requires that the activities of the private equity fund be limited to passive asset management rather than commercial activity. If the private equity fund (or side pool) is set up in Germany (typically as a GmbH & Co. KG) or if investors are resident in Germany for tax purposes, certain criteria must be met in order to avoid the private equity fund qualifying as a commercial business from a German tax point of view. This may already be induced by its formal structure if solely the general partner, set up as a corporation, is entitled to manage the private equity fund (a „deemed business“). This can be avoided by introducing a managing limited partner to the structure. In addition, the private equity fund must avoid conducting commercial activity. Although the overall picture has to be taken into account, in particular the following activities may lead the private equity fund to be categorized as a business: I Short-term investments (weighted average holding period of less than three years); I Leverage of the private equity fund (however, leverage on the level of the acquisition vehicle is accepted); I Active involvement in the business of the portfolio companies. The fund may not take an active role in the portfolio companies but rather has to behave as a passive investor. This limits the influence the
private equity fund may have via boards and approval rights on the day-to-day business of the portfolio companies. Furthermore, the German tax authorities hold the opinion that an advisory relationship (remunerated at arm’s length) with an advisory company related to the private equity fund may cause such involvement of the private equity fund in the operational business of the portfolio companies. In our opinion, there is no reason for such a strict interpretation. An advisory team indirectly related to the fund should not be treated differently from any thirdparty advisor if the professional advisor’s services are provided under arm’s length conditions. I Granting of collateral by the private equity fund in favor of the portfolio company. Especially nowadays, banks demand guarantees from parent companies, or the private equity fund itself, in order to safeguard facilities. In the opinion of the German tax authorities, the granting of such collateral by a private equity fund constitutes commercial activity. In our opinion, this is incorrect and ignores economic reality. Typically, a shareholder must guarantee with private assets the facilities of the company in which he is a shareholder, without assuming business activity on the individual level. I Reinvestment of exit proceeds. Except under certain circumstances, the private equity fund is not allowed to reinvest exit proceeds, but rather has to distribute the funds to the investors. If the private equity fund’s activity were to qualify as a commercial activity, this can create serious German tax burdens: I If the fund maintains a permanent establishment in Germany, all profits to be allocated to such permanent establishment will be subject to German trade tax. I German resident investors – as well as foreign investors in case of a permanent establishment in Germany – will become subject to a (higher) German tax burden. I Carried interest taxable in Germany (German carry holders) no longer qualifies for preferred taxation (see below). Nevertheless, there may be a situation in which the qualification of the private equity
fund as a commercial business can be favorable to German investors. This is the case when the private equity fund partnership is set up outside of Germany (or at least where there is no permanent establishment in Germany) and the German investor himself is subject to trade tax. In such a scenario, the German investor can avoid trade tax on returns from the private equity fund since German trade tax code exempts income on the shareholder level when this income is generated through a business partnership. Besides setting up such structures, German investors often ask for advice on how a private equity fund in which they want to invest qualifies under German tax principles (fund screening). This is especially important if such an investment is intended to be held by the investor in a private asset partnership, since any investment in a private equity fund which qualifies as a commercial activity would taint the whole private asset partnership as a commercial activity.
Investments and Exits
The acquisition structure when acquiring a portfolio company is usually set up as a multi-tier structure involving various jurisdictions. The lowest tier often involves a holding company in the jurisdiction of the portfolio company in order to allow an offset of the financing costs against the operational income of the portfolio company. This can either be achieved by creating a tax unit between the portfolio company and the holding company or by merging the two entities. However, please note that since 2008, the deductibility of such interest expenses has been limited substantially by the so-called „interest barrier“ according to which the deductibility of interest in Germany is generally limited to 30 percent of the company’s (or group of companies’) EBITDA. There are certain carve-outs (as well as a threshold of € 1 million annually), however, these are difficult to achieve. Upper levels of the acquisition structure are set up for structural subordination of debt financing and in order to benefit from jurisdictions which allow the distribution of proceeds of an exit tax efficiently to the fund, e.g. to the investors. Especially companies under Luxembourg law („LuxCo“) allow the
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realization of tax-free capital gains and repatriation of proceeds free of dividend withholding tax. For that purpose, special instruments like convertible preferred equity certificates (CPEC) or different share classes (alphabet shares) are usually put in place which allow repayments of funds by LuxCo without triggering dividend withholding tax. Please note that under German tax law liquidation proceeds, as well as dividends, are generally taxable, even if the source of such payments are funds which had previously been contributed to the structure. However, German tax law allows corporations that pay the „dividends“ and are resident in the European Community to provide evidence that the proceeds are paid from contributed equity and are thus not taxable, provided this is applied for by the end of the year following the year of distribution. In addition, those structures may be challenged by the tax authorities of the jurisdictions in which the portfolio company or investors are resident if the entities of the acquisition structure do not have sufficient economic substance. From a German tax point of view, this requires office equipment and employees, as well as the usual activities of asset management. In the case of German target companies, German law demands substantial additional economic activities of the foreign holding companies in order to benefit from tax-neutral payment of dividends within the European Community. In the past few years, private equity funds have discovered that structuring an acquisition may not end at the level of TopCo, but has to involve the main jurisdictions of the investors of the private equity fund. Each of these jurisdictions will have their own requirements which must be met in order for it to be a tax-efficient investment. In Germany, particularly the rules under the Foreign Investment Act („CFC“) must be taken into account. Otherwise, there is a risk that income on one of the lower tiers may trigger German taxation without any cash event (e.g. interest income in an offshore vehicle or capital gains realized in the course of a reorganization/merger of lower tiers).
high administrative burden, especially if the private equity fund has many investments/ exits or invests in other funds (fund of funds). To properly establish a German tax return requires the analysis of each transaction in detail, investigation and qualification of any kind of income resulting from the investment, as well as any reorganization in the structure. Often such information is not available to the private equity fund (e.g. in club deals and minority investments). Experience shows that a pure „translation“ of the tax return under the local jurisdiction (e.g. the K1 in the US) may not result in a proper qualification under German tax law since this is frequently based on different principles (e.g. qualification of instruments as debt or equity). German tax returns are binding for the taxation of the German investors. In cases where the tax returns are established retroactively, this may cause unpleasant surprises for the investors if the tax qualification in such tax returns differs from the one the investor has made in his own tax return (e.g. due to a lack of sufficient information).
Carried Interest
The team initiating the private equity fund usually has several (legal) relationships with the private equity fund. They advise the fund on the selection of target companies, as well as on the processing of the investment and the exit (see below „Advisory Company“). They invest their own money in the private equity fund („co-investment“) and they provide their specialist knowledge and network in their capacity as limited partners to the private equity fund. As advisors, they receive fees from the private equity fund; from their co-investment they receive investment income and for their intellectual contributions they usually agree with the private equity fund on special disproportional profit participation if the private equity fund is successful („carried interest“). In Germany, after many years of dispute, carried interest is qualified as remuneration for services and is generally fully taxable income. However, for private equity funds set up before the end of 2008, 50 percent – and for private equity funds set up after this date 40 percent – of the carried interest can be tax-exempt. This requires (among other things) that the private equity fund does not conduct commercial activity and invests only in shares of corporate vehicles.
In our opinion, the qualification of carried interest as service income does not reflect the factual situation, but rather is a legal fiction for tax purposes. Therefore only limited consequences can be drawn from the qualification of carried interest as service income. For example, we are of the opinion that this does not allow the carried interest claim to be qualified as a business asset. Furthermore, the treatment of carried interest as deemed service income cannot be transferred to other taxes like VAT and inheritance tax. We therefore believe that carried interest is not subject to VAT and represents a separate (legal) asset which can be transferred as a gift, e.g. within the context of a family partnership. In such situations, the question arises of what value such a transferred carried interest claim would have (which may trigger gift tax). In our opinion, as long as the carry is not due, e.g. the requirements under which carried interest is paid to the carry holders are not met, the value of such a claim is very low, probably zero. As is obvious in today’s crisis of the financial markets, the value of companies has come down substantially within weeks and thus the likelihood that carried interest might be paid in the future is very hypothetical, especially when bearing in mind that, before carried interest is paid, the investors usually receive repayment of all contributions (full pay-out) plus a minimum interest on the contributions made (hurdle rate). The longer the investment period, the more minimum interest will have to be paid, running against any possible carried interest payment. Finally, one has to be aware that the qualification of carried interest under German tax law as a (deemed) service income can cause double taxation in an international context. For example, the Austrian tax authorities have explicitly expressed their opinion that under Austrian law, carried interest is to be qualified as investment income. If a carry holder who was initially resident for tax purposes in Germany moves to Austria, this results in a situation in which Germany will still claim tax rights under the assumption that carried interest represents previous service income, and Austria claims tax rights based on the rules to tax investment income under the double taxation treaty in the country of residence.
Tax Reporting
Even private equity funds that are set up as limited partnerships in foreign jurisdictions are obliged to establish and file German tax returns if there is more than one German investor. This may result in an unreasonably
Local Advisory Company
Private equity funds usually only have experienced boards to decide on investment opportunities, in addition to administrative employ-
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ees. Therefore, the private equity fund needs professional advice in order to investigate the market and to select possible portfolio companies. Such advice requires a team of experts which usually has branches/subsidiaries in the countries of the main activities of the private equity fund. Such local advisors (sub-advisors) provide advice to the top-level advisor, while the latter in turn provides advice to the general partner of the private equity fund. The fee agreed upon between the sub- and top advisors must conform to arm’s length principles. The German tax authorities usually request transfer pricing documentation. Generally, a cost plus service agreement is accepted since the local advisors only have limited functions and risks. In various tax field audits, a cost plus margin of 5-6 percent has proven to be adequate. The local advisory group does not represent the private equity fund; they are advisors to the top-level advisor only. Otherwise, the tax authorities could assume a permanent establishment of the private equity fund in Germany. The activities of the local advisory group are therefore usually based on detailed rules (dos and don’ts) limiting the functions to advisory services rather than acting on behalf of the private equity fund.
P+P PöllaTh + ParTnErS Dr. Michael Best is a partner and tax advisor with P+P Pöllath + Partners in Munich. He focuses on tax structuring, national and international tax law, tax planning, private equity and real property investments (funds). He has published numerous articles in professional journals on these subjects. He was admitted to the German Bar in 1988, studied at the University of Munich and obtained a Dr. Juris degree at the University of Augsburg. He has been a tax consultant since 1992 and a partner in German law/tax firms since 1996. Dr. Bettina Spilker is a tax associate with P+P in the Munich office. She focuses on domestic and international tax, tax structuring, tax planning, private equity funds and investments. She was admitted to the Bar and joined P+P in 2007. She studied law in Cologne (Ph.D.), Lausanne (Switzerland) and Regensburg.
Dr. Michael Best
Dr. Bettina Spilker
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