In its decision dated October 8, 2024 (3 K 37/22), the Schleswig-Holstein tax court ruled that carried interest from asset management funds does not constitute “commercial profits” within the meaning of Art. 7 DTT-USA. Consequently, carried interest can only be taxed in Germany if it is paid to a person resident in Germany.
The tax court’s opinion affects all those carry holders who are also taxed abroad on their carried interest. This is of particular importance in light of the possible change to the taxation of carried interest in the United Kingdom, which aims, among other things, to tax foreign carried interest holders in the United Kingdom.
Executive Summary
- Carried interest principally is income from asset management activities.
- Section 18 para. 1 no. 4 EStG merely rep-resents a fiction applicable under national law, which qualifies carried interest to income from self-employment.
- For treaty purposes, there are no business profits within the meaning of Art. 7 DTT-USA with the consequence that Germany is entitled to full taxation of the carried interest.
- There is a risk of genuine double taxation if the carried interest is also taxed abroad, which should be examined in particular in the context of the UK.
Facts
The plaintiff, a US LLC with its registered office and place of management in the US, was a carry partner in funds in the US and Germany. The funds and the LLC qualified as asset-managing partnerships. Persons resident in Germany for tax purposes also held interests in the LLC.
The LLC declared the carried interest as income in accordance with Section 18 para. 1 no. 4 EStG. Insofar as the carried interest was already taxed in the US, the LLC treated the carried interest as tax-free income but increasing the applicable German tax rate. However, if the carried interest had not been taxed in the USA, it was treated as taxable due to the application of the switch-over clause.
The tax office, however, did not grant tax exemption, as the carried interest did not qualify as profit within the meaning of Art. 7 DTT-USA under treaty law and treated the carried interest as taxable overall (before considering the partial income procedure).
The decision
The tax court ruled that carried interest under national law is income from self-employment in accordance with Section 18 para. 1 no. 4 EStG, but not “commercial profits” in accordance with Art. 7 para. 1, para 7 DTT-USA. The carried interest must be assessed separately under treaty law in accordance with Art. 3 para. 2 DTT-USA, according to which the carried interest must stem from an “entrepreneurial” activity in order to fall under Art. 7 DTT-USA. The qualification under treaty law depends on the type of activity that leads to the income. The classification according to national law only has an auxiliary function.
The tax court held that carried interest is originally income from asset management (Sections 20, 23 EStG), which is only reclassified as income from self-employment under national law due to the fiction of Section 18 para. 1 no. 4 EStG. For treaty purposes, there is therefore no entrepreneurial activity, which is why the carried interest does not constitute business profits, but rather capital gains in accordance with Art. 13 para. 5 DTT-USA or other income in accordance with Art. 21 para. 1 DTT-USA.7
Accordingly, Germany has the full right to tax carried interest to the extent that this flows to a shareholder resident in Germany.
Conclusion
Due to the fundamental importance of the legal question, an appeal to the Federal Fiscal Court was to be allowed. The further course of the proceedings should be closely monitored, as there are opinions in the literature that deviate from the opinion of the tax court, which could lead to more positive results for carry recipients in such situations.
The decision is also of practical relevance for all those carried interest holders who are also taxed on their carried interest abroad. This is of particular importance in light of the possible change to the taxation of carried interest in the UK, which aims, among other things, to tax foreign carry holders in the UK. Affected persons should check their personal tax situation.