The so-called Act to Strengthen Germany as a Fund Jurisdiction added an exemption to the German VAT Act from VAT for management services rendered to “venture capital funds” (Wagniskapitalfonds) with effect from 1 July 2021. To date, however, it has been largely unclear how the tax authorities interpret the term “venture capital fund” (Wagniskapitalfonds), which is not defined by law, and what type of funds are to be covered by this new VAT exemption.
Now, the Federal Ministry of Finance (BMF) has published a circular dated 24 June 2022, adding a definition of the term “venture capital fund” to the German VAT Regulations. Below we summarize material points regarding the definition of the term “venture capital funds”.
- The tax authorities consider “venture capital funds” (Wagniskapitalfonds) to be, in particular, private equity or venture capital funds that invest predominantly in young companies that are not older than 12 years since the company was founded.
- Under this condition, in particular EuVECA funds should qualify as “venture capital funds”. Special funds (Spezial-AIF) must demonstrate that they compete with UCITS (undertakings for collective investment in transferable securities) and are subject to special governmental supervision to qualify as “venture capital funds”. In addition, also in the case of special funds (Spezial-AIF), the size and domicile of the majority of the portfolio companies, determined as at the time of the respective initial investment, must meet the requirements for so-called qualified portfolio companies within the meaning of the EuVECA Regulation.
- The management of AIFs that do not invest in venture capital within the above meaning is still subject to VAT under the current law. The narrow view of the German tax authorities in this respect is questionable under EU law and results in Germany remaining a disadvantageous location for investment funds. Against this background, the announcement by the German government as part of its start-up strategy to “extend the VAT exemption for venture capital funds to the extent permissible under EU law” in order to further strengthen Germany as a location for investment funds is encouraging. It currently remains to be seen whether, when and to what extent corresponding changes will be implemented.
According to currently applicable § 4 No. 8 lit. h var. 3 of the German VAT Act, management services rendered to “venture capital funds” are exempt from VAT. Prior to the introduction of this provision, the VAT exemption under domestic law was only applicable to management services rendered to undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIF) that resemble UCITS.
The German legislature recognized that this provision – which is very restrictive in the international context – represents a substantial disadvantage for Germany compared to other European countries. For example, in Luxembourg management services rendered to all types of open-ended and closed-ended funds are exempt from VAT (Art. 44 No. 1 lit. d of the Luxembourg VAT Act). The VAT exemption for management services rendered to “venture capital funds” was created with the objective of eliminating this disadvantage for Germany.
Conditions for VAT exemption for venture capital funds
The new provisions in the VAT Regulations (Section 4.8.13 paragraph 10) provide that certain AIF, in particular (but not exclusively) “qualifying venture capital funds” within the meaning of the EuVECA Regulation (EuVECA funds), are to be regarded as “venture capital funds” under the new law. However, to benefit from the VAT exemption an AIF must satisfy the following criteria:
The AIF must be obliged by corresponding provisions in the investment terms and conditions (in particular partnership agreements) to invest more than 50% of its aggregate contributed or uncalled but committed capital in growth companies (target companies) that meet the following requirements:
- at the time of the first venture capital investment, no more than 12 years of establishment of the company;
- at the time of the first venture capital financing, the size of the target company corresponds to a so-called qualified portfolio company pursuant to Article 3 letter d) subparagraph i) within the meaning of the EuVECA Regulation. Unlike in an earlier draft from March, the target company therefore does not have to meet the (stricter) requirements of a small or medium-sized enterprise (SME). As a result, unlisted companies may employ up to 499 people (instead of the limit of less than 250 employees applicable to SMEs);
- registered office in an area pursuant to Article 3 letter d) subparagraph iv) of the EuVECA Regulation. Unlike in the earlier draft from March, the target company does not necessarily have to be domiciled in the European Union (EU) or the European Economic Area (EEA). Companies domiciled in certain third countries, such as the United States, the United Kingdom or Switzerland, are also eligible growth companies within the meaning of the VAT Regulation;
- ongoing economic activities (with the intention of making a profit).
It follows that it is not detrimental to the qualification of an AIF as a “venture capital fund” if the AIF invests less than 50% in target enterprises which do not satisfy the above requirements (a through d above).
The draft does not specify the type of “venture capital financing” or “venture capital participation”. In particular, there is no explicit limitation to equity and equity-related instruments. In addition to private equity (PE) and venture capital (VC) funds, certain debt funds (especially so-called venture debt funds) could also be covered in our view. This interpretation would be desirable because such debt funds would equally – in line with the objective of the Act to Strengthen Germany as a Fund Jurisdiction – strengthen the venture capital market in Germany and thus ultimately German start-ups.
According to the German Federal Ministry of Finance, “venture capital funds” aim to achieve “a significant increase in the value of the target company by way of risk-bearing financing after the intended purpose of such financing has been reached, which at the time of the fund’s exit materially determines its investment return”.
In particular, this describes the typical PE/VC fund that realizes an increase in value in relation to its target companies by selling investments held in the medium to long term.
However, other funds, such as credit funds, also aim to achieve a significant increase in the value of target company in which these funds typically participate by way of profit-participating or turnover-participating interest components.
The description in item 2 above should not be regarded as a restriction by the German Federal Ministry of Finance of the definition of the term “venture capital fund”.
The capital of the AIF can flow directly or indirectly into the target companies.
This should simply clarify that an interposition of acquisition/holding companies or target funds (in the context of funds of funds), which in turn invest in the target company and which may not themselves fulfil the above requirements (1. a through d above), does not jeopardize a qualification as a “venture capital fund”. However, it should be noted, at least in new cases, that the investment conditions of the venture capital fund must nevertheless contain the criteria summarized in points 1. a. to d., which may require the agreement of corresponding side letter provisions with the target funds, particularly in the context of funds of funds.
The AIF must (i) compete with UCITS and be subject to special governmental supervision (e.g. by the German Federal Financial Supervisory Authority BaFin) or (ii) be registered as a “qualifying venture capital fund” under the EuVECA Regulation.
The German tax authorities apparently assume that EuVECA funds compete with UCITS and are subject to special governmental supervision, whereas other AIFs such as special AIFs should demonstrate that these criteria are met. In our view, AIFMs registered pursuant to § 2 para. 4 of the German Capital Investment Code (so-called “sub-threshold” managers) are per se subject to special governmental supervision. A “sub-threshold” manager is also subject to various duties under regulatory law (in particular limitation of the value of the assets pursuant to section 2 (4) sentence 2 no. 2 of the German Capital Investment Code, Art. 3 of Delegated Regulation (EU) no. 231/2013, supervisory powers of BaFin pursuant to section 42 of the German Capital Investment Code, limitation of the granting of monetary loans for the account of the AIF, reporting obligation vis-à-vis BaFin pursuant to section 44 (1), (4) to (9) of the German Capital Investment Code, obligation to audit annual financial statements pursuant to section 45a of the German Capital Investment Code). A requirement to provide specific evidence on a case-by-case basis is incorrect
A group of investors comparable to UCITS (retail investors) is not required.
The criteria mentioned above in points 1 a. to d. must be reflected in the investment terms and conditions, at least in new cases (newly established funds), and the taxable person for VAT purposes (i.e. the management company) must be able to demonstrate that the above requirements are met to the tax authorities by means of suitable documentation (in particular binding investment restrictions). This must already be taken into account when drafting the fund documentation (i.e. in particular explicit restrictions in limited partnership agreements and offering memoranda).
In old cases, i.e. in the case of funds already established prior to the amendment of the VAT Regulation, we believe that it must suffice that the above requirements are actually met. This is because the investment terms and conditions in these old cases could not yet reflect the criteria for venture capital funds.
Conclusion and consequences for practice
According to the German Federal Ministry of Finance, “venture capital funds” should therefore primarily be certain PE/VC funds investing in early stages and possibly venture debt funds. AIFs with other investment strategies (e.g. PE funds investing in later stages, real estate funds, infrastructure funds, litigation finance funds, etc.) are unfortunately not covered. Already during the legislative process the German Federal Ministry of Finance argued against an extension of the VAT exemption to rendering management services to all AIFs, basing this position on concerns under European law.
In our view, these concerns of the German Federal Ministry of Finance are not justified. Instead, the different treatment of other AIFs is itself questionable under European law. These AIFs differ only with regard to the respective object of investment, which, according to the case law of the ECJ on the legal basis of the VAT exemption (Art. 135 para. 1 lit. g of the VAT Directive), is not decisive and therefore, in our estimation, not a legitimate criterion for differentiation. Moreover, the requirement that a “venture capital fund” must invest more than 50% into certain eligible target companies is inappropriate and may lead to ambiguities in certain borderline cases. Unfortunately, often the only option for AIFs and their management companies that do not satisfy the criteria set forth above and which receive adverse tax assessments remains to bring legal challenges. It currently remains to be seen whether, when and to what extent an extension of the VAT exemption for venture capital funds recently announced as part of the German government’s start-up strategy will be implemented.
To truly achieve the objective of the Act to Strengthen Germany as a Fund Jurisdiction, namely to eliminate Germany’s disadvantages as a fund jurisdiction, it is necessary to extend the VAT exemption in § 4 no. 8 lit. h of the German VAT Act to rendering management services to all closed-ended AIFs.