The German Federal Court of Finance (Bundesfinanzhof – “BFH”) revealed its position on the tax treatment of carried interest from business-type fund structures in a judgement of 11 December 2018 (VIII R 11/16).
Different views were taken in the past on the question of the tax qualification of carried interest.
Initially, carried interest was regarded as a disproportionate share of income so that the taxation of the carried interest followed the taxation underlying items of income (capital gains, dividends, interest). With the so-called PE Pronouncement (Pronouncement of the German Federal Ministry of Finance of 16 December 2003, Federal Tax Gazette I/2004, page 40, section 24 et. sq.), the tax authorities took the view that carried interest from a non-business private equity fund should be requalified to a (hidden) service remuneration.
In 2004, the view taken by the tax authorities was codified in § 18 (1) no. 4 of the German Income Tax Act (“ITA”). Pursuant to this statutory rule, carried interest received by a partner of a non-business private equity fund is qualified as income from self-employment and thus generally fully taxable. However, a special tax exemption was created at that time, pursuant to which 40% of such income is tax free (partial income regime, § 3 no. 40a ITA).
However, the question remained in dispute how carried interest should be treated in case of a private equity fund qualifying as trade or business.
In some instances, tax offices took the view that carried interest should be qualified as a (hidden) service remuneration also for business-type private equity funds. However, according to this view the partial income regime applicable to non-business private equity funds should not apply so that the carried interest was regarded as fully taxable.
Other commentators regarded the carried interest from business-type funds still as an item of income, and not as a (hidden) service remuneration.
Moreover, it was not clear whether a private equity fund which only qualified under the deemed-business rules should be regarded as non-business (and hence qualify for the application of the partial income regime) or as a business-type fund.
Key Statements of the BFH Judgement
In its judgement of 11 December 2018 the BFH ruled that the carried interest from a business-type private equity fund is not a (hidden) service fee, but rather a disproportionate share of income. As a consequence, the partial income applies insofar as the carried interest is comprised of capital gains or dividends. This does also apply to private equity funds which are deemed-business or business-tainted only.
The basis of the BFH judgement was a case in which a deemed-business carry pool held interests in several deemed-business private equity funds. The tax authorities regarded the carried interest at the level of the carry pool as a service remuneration and denied the applicability of the partial income regime. This was overruled by the BFH.
According to the BFH, the carry pool received business-type income from the private equity funds, given that the carry pool as well as the private equity funds were partnerships qualifying for business treatment.
The BFH did not agree to a requalification of the carried interest to a service fee. The relevant rule of law (§18 (1) number 4 ITA) requires a “non-business partnership”. Partnerships which are deemed-business or business-tainted, however, are not “non-business partnerships” in this sense.
Furthermore, the BFH held that even under the general rules there was no reason that the carry pool received a service remuneration rather than a share of income. A service fee from trade or business requires that payments are made on a contractual basis and not on the basis of a partnership agreement (e.g. treatment of the fee as expenses at the level of the partnership or payment independent from the profit or loss of the fund partnership). In the case decided by the BFH, however, carried interest was part of the allocation of income, so that it was not regarded as a (hidden) service remuneration payable irrespective of profits or losses.
However, the partial income regime applies according to the general rules insofar as the carried interest (treated as a share of income) results from capital gains or dividends.
Observations / Outlook
The judgment of the BFH is helpful as it clarifies that carried interest received from a business-type private equity fund is not qualified as a (hidden) service remuneration, but as a share of income.
This means that the partial income regime applies also to business-type private equity funds insofar as carried interest is comprised of capital gains from the sale of shares in corporations and dividends.
If carried interest from a business-type private equity fund is received by a corporation, this should also lead to the applicability of the 95% tax exemption pursuant to § 8b of the German Corporate Income Tax Act, insofar as the carried interest stems from capital gains.
It is still an open question whether the judgment will have an impact on the taxation of carried interest from non-business private equity funds. It seems that the BFH will uphold the current rules (requalification into a service remuneration, application of the partial income regime).
The judgment of the BFH has not been published in the Federal Tax Gazette yet and thus is not binding for the tax authorities. It is not yet clear which position the tax authorities will take on this judgment.
- Carried interest from business-type private equity funds generally will not be treated as a service remuneration.
- Rather, the so-called partial income regime applies to those parts of the carried interest which (on a “look-through” basis) are gains from the sale of shares in corporations (capital gains) and dividends, meaning that such parts of the carried interest income are 40% tax exempt.
- This treatment also applies to private equity funds which are business-type not due to trade or business activities, but only due to their legal structure (so-called deemed-business treatment) or due to an interest they hold in another trade or business partnership (so-called business-tainting).