Private Equity: Income tax-related aspects involved in the taxation of carried interest structures

published on 22 August 2023 | reading time approx. 5 minutes

Carried interest, or carry for short, is a disproportionate share of the profit paid as a financial incentive to responsible investment managers in private equity structures. This topic is highly relevant in practice and leads to controversies between tax authorities and taxpayers (so-called carry legislation). It is disputed whether carry is a disproportionate share of the profit from the sale of a share in a corporation or (fully taxable) remuneration for activities.

Background

Investors in private equity/venture capital/hedge funds (so-called venture capital firms) are usually structured as partnerships. Acting as shareholders, they benefit from dividends and profits from the management and sale of corporations with short- and medium-term capital appreciation potential (so-called portfolio companies).

Investors are primarily responsible for providing capital to the company. By contrast, initiators (investment managers) generally contribute a small amount of capital, manage the operational business and provide the fund with know-how, industry knowledge, and network (so-called shareholder contribution of intangible assets) in order to achieve the objective agreed with the investors. If events develop positively (the objective is achieved), the fund achieves profits from its investment, for example in the form of capital gains (exit) from the portfolio companies.

In this process, part of the exit profit can be allocated to the initiators in order to create financial incentives for the responsible managers. In particular, this can be achieved by setting a minimum return for the investors (threshold) (the so-called hurdle rate), which, if exceeded, leads to the additional financial reward for the initiators – the share of the profit that exceeds the capital participation (e.g. 20% of the profit from the fund, after the invested capital is made back, including the preferred return).

Requirements and legal consequences of Section 18 para. 1 no. 4 German Income Tax Act

Section 18 para. 1 no. 4 German Income Tax Act as a statutory provision deals with the evaluation of carried interest for tax purposes in the context of asset management funds. Accordingly, carry qualifies as income from self-employment at the level of the initiators if certain conditions are met.

The provision only applies if carried interest represents an increased share of the profit paid out by asset-managing venture capital firms for services rendered by the initiators in furtherance of the company's or community's purpose after the investors have received their paid-in capital back.

The fund company in which the participation is held must be engaged in asset management by acquiring, holding and disposing of shares in corporations. Insofar as a participation in a commercial company (commercially operating, commercially deemed or infected partnership or corporation) is concerned, the relevant provision on carried interest does not apply. If the fund's activities cannot be classified as pure asset management based on the overall picture of its activities, the corresponding income is classified as income from trade or business (see the Federal Fiscal Court’s decision of 11 December 2018). Profits received are subject to the partial income procedure. However, the classification as income from trade or business may trigger definitive trade tax (if applicable, also after taking into account Section 35 German Income Tax Act).

The claim for compensation may be granted on condition that the shareholders have made back their paid-in capital in full. This is typically accompanied by a preferred return (so-called waterfall model).

Finally, the initiators’ share of the profit must be disproportionately higher than the capital they invested and must be paid out depending on the performance (interim profit). This arrangement must be made in writing in advance under company law.

If all requirements are met cumulatively, carried interest is classified as income from self-employment. The types of income listed in Section 18 para. 1 no. 4 German Income Tax Act are subject to the (privileged) partial income procedure pursuant to Section 3 no. 40a. German Income Tax Act and are thus 40% tax-free.

Judicial decisions

With regard to the application and interpretation of Section 18 para. 1 no. 4 German Income Tax Act, even though this provision has been codified, there are still uncertainties as the opinion of tax authorities on the taxation of carried interest has not yet fully followed the line of case law.

Accordingly, it is questionable whether carried interest should be classified as a share of the profit/loss (distribution of the profit/loss) and thus have the same fate in tax terms as the underlying income or whether it should be reclassified into compensation for an exchange of services, i.e. as a performance-based fee for activities, and thus be fully taxed.

Two judgements provide clarity with regard to the main question:

Judgement of the Federal Fiscal Court (BFH) of 11 December 2018

In its judgement of 11 December 2018, the Federal Fiscal Court (BFH) held that neither commercially operating nor commercially deemed funds fall under the provision of Section 18 German Income Tax Act. The disputed carried interest of a commercially deemed fund could not, as the tax authorities assumed, be accounted for as remuneration for its activity because it was not accounted for as an expense under commercial law and the claim was performance-based (carry only became due once a certain threshold value was exceeded). Thus, carried interest should be classified as a share of the profit from an original commercial business (Section 15 para. 1 sentence 1 no. 2 sentence 1 alt. 1 German Income Tax Act) and was also subject to the partial income procedure, since all other legal premises of the carry provision were also fulfilled.

Despite the clear line, which is also in line with the prevailing opinion in the literature, the tax authorities have nevertheless not recognised the principles yet. In the course of external audits of commercially operating venture capital firms, the tax authorities usually classify carry as fully taxable income without any apparent legal basis.

Judgement of the Munich Fiscal Court (FG) of 17 November 2020

In another judgement of 17 November 2020, the Munich Fiscal Court also found, contrary to the view of the tax authorities, that carry should only be reclassified into income from self-employment at the level of the initiators, and thus is not remuneration for activities, but still a share of the profit/loss.

The view taken by the tax authorities had not only resulted in a different classification of the income, but also would have meant in practice that carry would have been taxed twice. In the first step, the tax authorities increased the proportionally distributed share of the profit at the level of the investors as carry was not recognised as a component of the profit to be distributed. In the second step, the tax authorities assumed that a payment was made by the investors to the initiators and taxed it at the level of the investment managers as remuneration for their activity. Since the investors usually obtain capital gains from their shares held in the asset management funds, a deduction of the (fictitious) payment to the initiators was not deductible as business expenses (due to the lump-sum savings allowance).

However, the Fiscal Court, like the Federal Fiscal Court, recognised the company-law arrangement of carry and classified it as a disproportionate distribution, which is only subject to taxation in the case of the initiators. In addition, also in the present case, carried interest was not accounted for as an expense in a manner reducing profit/loss under company law and was only paid starting from the agreed threshold value.

International aspect

Within the scope of tax structuring consulting, funds can also be structured to contain a foreign element. However, this can lead to certain challenges in the area of international tax law, as the (re)classification of carry into income from self-employment is a purely German notion. It should be checked in advance whether double taxation treaties apply in order to avoid possible double taxation and, if necessary, to anticipate withholding tax aspects.

Should fund structures also carry out their activities in low-tax countries according to the German Foreign Tax Act, the (new ATAD) regulations regarding the CFC-rules should also be observed. In this context, possible trade tax implications should be taken into account. They entail additional compliance obligations that should not be underestimated. Furthermore, when designing foreign fund structures, consideration should be given to a (possible) reporting obligation under DAC6.

Conclusion

In practice, it is advisable to observe the requirements of Section 18 para. 1 no. 4 German Income Tax Act already when designing the structure of asset management funds and to take into account the established principles of case law in order to avoid tax pitfalls ex ante. The decisive factor for how carry will be classified for tax purposes is how the arrangement is regulated under company law and structured. Carry should be recognised as a special share of the profit (profit distribution). However, it cannot be ruled out that the taxation of carried interest will still lead to controversies with the tax authorities.