German Federal Fiscal Court (“BFH”), decision dated April 16, 2024 (VIII R 3/21)
Private investors in private asset management funds in particular benefit from the decision of the BFH, as carried interest should reduce their taxable income, since the expense deduction limitation rule pursuant to Section 20 (9) EStG does not apply. Further, the decision once again confirms the fundamental recognition of capital-disproportionate profit allocations, which should also positively affect the treatment of carried interest from trading funds.
Executive summary
- Carried interest is to be recognized as part of a capital-disproportionate profit allocation at the level of the fund partnership for tax purposes and therefore represents a profit share.
- Section 18 (1) No. 4 EStG, according to which carried interest from private asset management funds is reclassified as income from self-employment at the level of the carry partnership, and Section 39 (2) No. 2 AO do not change the tax treatment of the profit allocation at the level of the fund.
- In the case of private asset management funds, carried interest for private investors is therefore fully deductible for private investors.
- The partial income method or Section 8b KStG should generally be applicable to carried interest from trading funds.
That’s the point
The court had to decide whether the profit allocation according to the LPA of a private equity fund in the form of a limited partnership, which qualified as an asset-managing partnership for German tax purposes, is to be recognised.
The fund’s profits were initially allocated to all investors in proportion to their capital commitments until they had received their capital contributions back. Of the remaining profit, an amount of 30% was allocated to the carry partnership – taking into account a preferred return and a catch-up – and the remaining profit was allocated to the investors in proportion to their capital commitments.
The tax authorities refused to treat the carried interest as a profit share and argued that the carried interest represented a remuneration for services provided by the carry partnership, which was owed by the investors and would be paid directly to the carry partnership. As a result, the tax authorities treated the carried interest as partially non-deductible expense (Section 20 (9) EStG).
The decision
The BFH referred the case back to the Munich tax court for procedural reasons. However, the BFH stated that the tax court first has to confirm whether the agreements in the LPA constituted a profit allocation agreement or a service agreement. As carried interest is neither treated as an expense under commercial law nor is it independent of profit, the tax court should confirm its opinion that carried interest is no service fee. In this case, the capital-disproportionate profit allocation as it is agreed in the LPA should in principle also be recognized for tax purposes, as there is a natural conflict of interests between the partners of the fund and the carried interest is granted for the provision of immaterial contributions by the carry partnership. According to the BFH, such a profit allocation agreement also takes precedence over the fractional consideration pursuant to Section 39 para. 2 no. 2 AO.
Section 18 (1) no. 4 EStG does not change the tax recognition of the profit allocation either, as it is already clear from the wording of the law that the carried interest is a share of the profit that the carry partnership receives for the provision of the immaterial contributions.
The provision merely stipulates that the profit share is to be recognized at the level of the carry beneficiary as income from self employment if the fund is an asset management fund. Finally, the purpose of the provision does not permit any other conclusion, as Section 18 (1) no. 4 EStG was introduced to enable the proper taxation of carried interest.
Conclusion
Even though the case (VIII R 3/21) was referred back to the Munich tax court, the ruling contains encouragingly clear statements on the tax treatment of carried interest. In the case of private asset management funds, the recognition of the profit allocation under the LPA means that private investors can reduce their income from capital assets by the carried interest.
In addition, the confirmation of the profit character of carried interest and the continuation of the principles of case law from the decision dated December 11, 2018 (VIII R 11/16) means that carried interest from trading funds should generally be subject to the partial income procedure or Section 8b KStG.
Both cases, which were referred back for procedural reasons, must be decided by the competent local tax courts and it remains to be seen how the tax authorities will react to the decisions, in particular whether the two BFH rulings will be published in the Federal Tax Gazette II and hence, whether they will be accepted by German tax authorities.