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Taxation of Venture Capital and Private Equity Funds in Germany |
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 Taxation on Germany's private equity and venture capital funds will
become more favourable to investors if proposals in a recent draft
circular are brought into effect.
Rather than treating funds as commercial partnerships, thereby making
investment returns subject to taxation, the draft circular proposes
that funds become tax-transparent, non-commercial vehicles. Goetz
Wiese, John Walker and Jiyeon Lee-Lim explain the implications of the
‘safe harbour' intended to provide a comfort zone to fund investors and
argue that its reach is far too limited.
On 27 November, 2001, the German ministry of finance issued a draft
circular on the income tax treatment of venture capital funds and
private equity funds in Germany. Market participants have eagerly
awaited this guidance. Previously, the German tax authorities had
signalled their intention to treat funds, to a large degree, as
commercial partnerships and not as tax-transparent, non-commercial
vehicles. If this had become the rule, it would have devastated private
fund investment in Germany, since investment returns (including capital
gains) could have become subject to tax. Fund investments normally are
made on the assumption that capital gains will be received tax-free by
private and (beginning in 2002) corporate investors.
The good news is that the draft circular offers a ‘safe harbour' for
fund structures organised in Germany. This is intended to provide a
degree of comfort to potential fund investors. Notably, the safe
harbour is not as narrow as officials had earlier indicated it might
be. Under the circular, funds that are structured within the safe
harbour guidelines will produce a return that will be taxed as if the
investors were direct shareholders in the investee companies. In other
words, approved funds will be treated as look-through, non-commercial
vehicles for tax purposes. The bad news is twofold: (i) the draft
circular sets forth only one safe harbour for structuring a German
fund, and indicates that a fund must fit tightly within this safe
harbour to ensure favoured tax treatment; and (ii) the circular offers
no guidance for non-German funds. Unfortunately, it remains unclear
whether variations from the elements of the circular's safe harbour
will be tolerated, even if economically necessary.
The circular describes a model fund structure with elements that it
characterises as integral to a German fund. (The circular does not
address funds established in the Channel Islands, Bermuda, or similar
jurisdictions with a favourable regulatory or tax regime.) The circular
establishes different rules for funds with and without incubators. A
summary of the ministry of finance's safe harbour criteria is set forth
below.
Safe harbour criteria
For German funds without incubators, the circular sets forth the following criteria for favoured tax treatment:
A fund must aim at financing (i) start-ups and new ventures, (ii) the
expansion of medium-sized companies, (iii) the spin-off of business
units, or (iv) buy-outs. In each case, a fund shall acquire shares and
equity-like participations in investee companies, which are typically
established in the legal form of a corporation (direct investments) or
a non-commercial partnership (in the case of a fund-of-funds).
For the most part, a fund shall be set up by one or more initiators who
contribute capital, know-how, and experience to the fund through their
networks. A fund is to be organised as a non-commercial partnership for
tax purposes, specifically as a limited partnership
(kommanditgesellschaft), the sole general partner of which is a German
limited liability company (Gesellschaft mit beschränkter Haftung, or
GmbH). The general partner makes no investment and has no economic
interest in the partnership. The investors make investments and hold
limited partnership interests (equity participations).
The day-to-day management of a fund is to be carried out by the general
partner, but the main management activities regarding investment and
divestment decisions are conducted by a separate limited partnership or
by individuals who hold special limited partnership interests
(managers). The general partner typically receives a management fee of
1.5 to 2.5 percent of the fund's subscribed capital, and the managers
receive about 20 percent of the net operating income (betriebsergebnis)
of the fund.
A fund must hold the shares in the investee companies on average for
three to five years. The average term of a fund is eight to twelve
years.
Investments shall be financed out of a fund's own assets, although
special governmental grants (staatliche förderung) may be available as
loans. A fund may not manage the investee companies. The fund's
influence is restricted to the exercise of its statutory and
contractual rights as a shareholder. As to fundamental management
decisions, however, a fund may hold consent or veto rights exercised by
the managers. Also, the managers may have a seat on the supervisory
board of the investee companies.
* The circular's safe harbour for a fund structure
does not apply to either (i) non-German funds or (ii) funds that make
use of independent advisory companies that are part of the group of the
initiator, but that are truly independent from the fund and provide
their consultancy services to the general partner of the fund.
Moreover, the circular does not address German funds organised in the
legal form of a civil law partnership (gesellschaft bürgerlichen
rechts). The circular's reference to a ‘typical' fund structure creates
substantial uncertainty as to the treatment of funds that are not fully
based on the typical structure. The ministry of finance chose not to
promulgate general criteria to be taken into consideration in
determining the tax status of a Fund, but simply established a
one-size-fits-all safe harbour for funds, irrespective of market needs.
Qualification for income tax purposes
Income from a fund investment is treated either as investment income
(einkünfte aus kapitalvermögen) or as income from a commercial trade or
business (gewerbliche einkünfte). This distinction has significant
impact on private investors. This is because private investors are not
taxed on capital gains from a fund that is regarded as a non-commercial
partnership, assuming certain additional requirements are satisfied
(see below). Conversely, investors are taxed on capital gains from a
fund that is regarded as a commercial partnership. In addition, funds
that are found to be commercial partnerships may suffer other adverse
consequences, such as trade tax exposure.
Whether income is classified as investment income or income from a
commercial trade or business depends on the source of the income. In
principle, investment income arises from private asset administration
carried on to preserve existing assets, whereas income from a
commercial trade or business arises from ongoing activities carried on
to generate profits.
Reflecting decisions made by the German supreme tax court, the draft
circular provides that a fund that holds securities will normally
generate tax-favoured investment income (i.e. it will not be considered
to be engaged in a commercial trade or business) if the following
criteria are met:
1) No use of third-party loans. The fund may not use
third-party loans to purchase shares in investee companies, with the
exception of governmental grants. Any form of debt capital from outside
sources will lead to commercial income.
2) No management organisation. The fund itself may
not maintain its own management organisation for the management of
investee companies. Office space and working staff are allowed to the
extent they are necessary to administer the fund's equity holdings as a
passive investor.
3) No external use of market experience. The
fund may not make use of its market experience for the account of a
non-investor third party. The managers, however, are permitted to make
use of their know-how and practical experience in the course of
managing the fund.
4) No dealing in securities. The fund may not offer
securities to the general public nor may it deal in securities for a
third party's account. Moreover, the fund's investments must not be
made on a short-term basis. That is, the fund must maintain its
shareholdings for three to five years. Capital gains may not be
reinvested, but must be distributed in accordance with the fund's
regulations.
5) No commercial involvement in investee companies.
The fund must not participate in the management of the investee
companies. In this respect, close attention should be paid to the
remuneration of the managers. If the participation of the managers in
the profit of the fund deviates from their share in the nominal capital
of the fund, this may indicate that the managers and the fund
participate in the management of the investee companies.
Holding a seat on the supervisory board of the investee company does
not by itself mean that a fund is conducting a commercial trade or
business. Consent rights may be problematic, however, if they permit
the fund to exercise direct influence on the management of the investee
companies.
* Although the circular indicates that a fund may be
treated as a commercial trade or business if the above criteria are not
met, the circular does not make clear which criteria are flexible and
which not.
For example, the circular does not indicate whether
the use of a short-term interim debt facility would result in the fund
being treated as a commercial enterprise, in a situation where the fund
is fully invested but an investee company needs more liquidity in order
to avoid bankruptcy. The same is true with regard to guarantees.
Similarly, it is not clear what happens if a fund
acquires shares in a company where managers have a duty to actively
advise the management of the investee companies under corporate
governance standards. Nor is it clear when fund-consent requirements
with regard to management decisions of the investee company are
regarded as the conduct of a commercial activity by the fund.
What is clear, unfortunately, is that the
uncertainty created by the circular is likely to limit activity by
German initiators in establishing venture capital and private equity
funds in Germany.
Taxation of investors' profits
If the activities of a fund qualify as commercial activities, the
earnings and profits of the investors will be taxed as income from a
commercial trade or business. As a result, for individual investors,
half of all capital gains and dividends would be taxed (under the
so-called ‘half income system') at ordinary rates. In addition, fund
profits may be subject to trade tax at the fund level.
On the other hand, if the activities of a fund qualify as asset
administration, fund income received by individual investors would be
treated as tax-favoured investment income so long as the investors hold
the Fund interests as part of their private assets (privatvermögen).
Consequently, capital gains realised by such private investors would,
in principle, be taxable only if (i) the investor, indirectly through
the fund, holds or has held, at any point in time during a five year
period prior to disposal, one per cent or more of the stated capital of
the investee company, or (ii) the investor disposes of the fund unit,
or the fund disposes of shares in the investee companies, within one
year after the relevant acquisition. If taxation does occur, again the
half income system (for natural persons) would be applicable.
In the hands of corporate investors, capital gains and dividends are,
in principle, exempt from corporation tax under the new corporation tax
regime in Germany.
Tax-favoured treatment does not apply to the carried interest of the
managers. Only in the unlikely case where the profit participation of
the managers is proportionate to their equity participation does their
profit qualify as investment income. In that case, the general rules
for the taxation of private investors would apply mutatis mutandis. A
disproportionate carried interest will normally be treated as income
from self-employment or from a commercial trade or business. If the
carried interest is regarded as compensation for services, neither the
half income system nor the tax exemption generally available to
corporate investors is applicable.
Venture capital funds and private equity funds with incubators
Assumptions
With regard to funds with incubators, the news is not so good. The
draft circular assumes that incubators are established in the legal
form of stock corporations (aktiengesellschaft). Such incubators
typically advise and monitor start-up companies even prior to
incorporation, acquire majority shareholdings, and give support to
companies on their way to initial listing on a stock exchange.
The incubators and the funds are separate legal entities. However, both
are typically under the influence of the initiators, and there may also
be an identity of shareholders. Some incubators act on the basis of
contractual obligations only, rather than in connection with share
ownership in the investee company.
Qualification for income tax purposes
According to the draft circular, such incubators conduct a commercial
trade or business, and the activities of an incubator, irrespective of
the nature of the relationship between the incubator and a related fund
(whether corporate or contractual), affect the character of the fund
and result in the fund being treated as a commercial trade or business.
Consequently the income of investors received from an incubated fund
will normally be regarded as commercial income not eligible for
favourable tax treatment (see above).
Effective dates
The circular will be applicable to all cases that have not been finally
settled, if application favours the taxpayer. In other words, if a tax
assessment is still subject to appeal, the circular will apply. To the
extent the contents of the circular tighten existing rules and the
administrative practices, the new rules shall take effect only with
regard to funds that are set up (gegründet) after 31 March, 2002.
Summary
While the ministry's circular on funds is surely a step in the right
direction, it does not go far enough. The circular presents a ‘safe
harbour' for fund design, but it does not allow room for market-driven
variations, even as to elements that should not affect taxation. As a
result, the circular will not make German funds competitive with funds
established elsewhere.
Copyright © Latham & Watkins
 Goetz Wiese, John Walker and Jiyeon Lee-Lim are all attorneys with law firm Latham & Watkins.
Latham & Watkins offers clients a global network of resources
through an international grid of 20 offices and more than 1,400
attorneys. To find out more about the company please visit www.lw.com
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