There were no fundamental upheavals in 2019 and are not expected in 2020 either – but changes in many individual issues that show light and shadow: EuVECA has proven to be attractive, but is losing an important sub-market due to the brexit; pre-marketing and reverse solicitation are being regulated much more strictly throughout Europe. In Germany, the taxation of carried interest from commercial venture capital funds has improved, but there has been little movement on the central issue of VAT on the management fee.
EuVECA on the road to success – But does the brexit harm?
EuVECA has proven to be a sensible supervisory regime for managers of venture capital funds and can be considered a success story of financial market regulation. According to the statistics of the EU securities supervisory authority ESMA, 157 EuVECA managers (18 of them German) currently distribute 281 EuVECA funds (33 of them German) throughout Europe. The attractiveness of registration as an EuVECA manager can be attributed to three main reasons: Compared to a full AIFM licence, it is relatively easy and inexpensive to obtain, distribution is possible to investors with a capital commitment of EUR 100,000 or more – and above all, registration in the home country opens up distribution to all other EU countries (European passport). A revision of the EuVECA Regulation, which came into force in 2018, has also helped: among other things, it has clarified the capital requirements for EuVECA fund managers, for which there was previously no uniform administrative practice, and banned administrative fees charged by other member states for distribution. The new maximum deadline for the registration process (two months from the date of submission of all documents) has proved to be particularly effective. Combined with BaFin’s growing experience with EuVECA applications, the registration process has been noticeably accelerated.
The positive picture is somewhat clouded by the brexit. The withdrawal of the United Kingdom (UK) from the EU on 31 January 2020 will also affect EuVECA fund managers. This applies initially to the distribution of EuVECA fund units to the UK, which will no longer be covered by the European passport after the brexit. Existing EuVECA funds that have registered (online) with the UK Financial Services Authority FCA by 30 January 2020 may use the European Passport for up to three more years. Otherwise, the sale of EuVECA fund units will be subject to the national placement requirements of the UK in future. However, these are considered comparatively liberal. Conversely, the launch and management of EuVECA funds by UK registered managers will no longer be possible. The brexit is unlikely to have any impact on existing or future EuVECA funds that (also) want to invest in the UK, as the EuVECA Regulation does not stipulate that the investments of an EuVECA fund must be made within the EU.
Stricter rules for pre-marketing and reverse solicitation
Managers (and their advisors) of venture capital funds are regularly faced with the question of whether the planned approach to interested parties represents already regulated distribution (i.e. requiring registration or permission from the relevant regulatory authority) or as yet unregulated pre-marketing. This important distinction is now to be harmonised throughout the EU. To this end, the European legislator has issued an amending directive to the AIFM Directive to be implemented by autumn 2021. The new regulation significantly limits the scope for pre-marketing for fully regulated fund managers: In future, they will have to report pre-marketing activities to the supervisory authority.
In addition, the mere acceptance of investor enquiries (reverse solicitation) will almost completely block their way out of the distribution regulations. Any subscription accepted within 18 months of the start of pre-marketing will be considered a distribution. Pre-marketing activities must also be adequately documented. Small fund managers, which in Germany are only subject to an obligation to register with BaFin (sec. 2 para. 4 KAGB), are not directly affected by the new regulation. It is conceivable, however, that BaFin may change its administrative opinion on pre-marketing according to national law to the future European rules. It is also expected that the new pre-marketing rules will be incorporated into the EuVECA Regulation. Although there is a general interest in standardising the pre-marketing rules at EU level and specifying terms for reasons of legal certainty, the tightening and additional documentation requirements are unlikely to meet with much enthusiasm among fund managers.
Carry with commercial private equity and venture capital funds
Positive news was heard in mid-2019 regarding the taxation of carried interest: In a highly regarded ruling, the Federal Fiscal Court (BFH) has clarified the long disputed question of its tax treatment of carried interest from commercial private equity and venture capital funds. The BFH clarifies that in this constellation carried interest is not to be treated as (hidden) remuneration for activities. Rather, it is to be classified as a disproportionate share of profits, which – insofar as it derives from capital gains or dividends – is taxed under the partial income method (60% basis). For fund managers, this means that carried interest from commercial funds is just as advantageous in terms of earnings as from asset management funds (partial income method). This development is particularly helpful for those managers of venture capital funds who are barred from entering an asset management fund structure due to a commercial investment strategy (incubation, company building and similar).
VAT on management fees
Less pleasing is the (almost non-existent) development in the area of sales tax on management fees. The German tax authorities see the management of private equity and venture capital funds predominantly as a VAT-liable service provided by the fund manager. VAT on management fees is a considerable disadvantage for Germany as a fund location and one of the main reasons why many funds relocate abroad, especially to Luxembourg. This is because the VAT on the management fee represents an additional cost item for the fund, which reduces investors’ returns. Even at the beginning of 2020, it is at best only beginning to show that Germany could align its position with that of all other EU member states and recognise the management fee as VAT-free. Legally, most observers believe that this would be necessary: The European Court of Justice (ECJ) has already decided in 2015 that the management of investment funds subject to special state supervision is exempt from VAT.
However, this ruling has only been implemented very restrictively in German law (sec. 4 no. 8 lit. h UStG from 2018). Two years after the amendment of the law, it has become apparent that only individual tax offices have recognised the VAT exemption and that there is no uniform application throughout Germany. It would be desirable for Germany as a fund location if a uniform practice throughout the country were to prevail with the tax authorities in favour of VAT exemption. Otherwise, the matter is unlikely to get moving again until a German court refers the question of compatibility with the European VAT system directive to the ECJ for a decision.
This article was first published in: VentureCapital Magazine, 1-2020, pages 32-33
Read more about Venture Capital Funds:
Reporting obligations for cross-border arrangements – Implications for PE and VC funds