BFH rules income from U.K.-based private equity fund exempt from German taxation

The Federal Tax Court (BFH) recently published a decision (case reference: I R 46/10), concluding that income derived by German tax resident investors in a U.K.-based private equity fund is exempt from German taxation. The decision is likely to have a significant impact on the taxation of German investors in domestic and foreign private equity funds, as well as on the taxation of German-source income received by nonresident investors via private equity funds.

In its decision, the BFH commented on the criteria to distinguish between business partnerships and asset management partnerships and, for the first time, expressed doubts that the criteria applied by the German tax authorities are correct.

Background of the case

The case involved two German tax resident limited liability companies (GmbHs) that were – amongst other institutional investors – limited partners of a U.K.-based private equity fund in the legal form of a limited liability partnership (E-LP).

E-LP owned shares in several portfolio companies which it held on average for about four years. E-LP did not have its own office premises in the U.K.; instead, it concluded a management agreement with EV-Ltd., which belonged to the same group as the general partner of E-LP and which had office premises and personnel in the U.K. The directors of the general partner of E-LP were also directors and non-executive directors of EV-Ltd. EV-Ltd. or its directors, respectively, obtained the necessary permission to arrange financial transactions for E-LP.

The GmbHs did not file U.K. tax returns because the U.K. does not levy tax on the income of investors in a U.K. private equity fund. However, the GmbHs claimed in their German tax returns that the income derived from the participation in E-LP is tax exempt in Germany because it is allocable to a U.K. permanent establishment (PE) and, therefore, the U.K. would have the exclusive right to tax the PE income under the Germany-U.K. tax treaty.

BFH decision

The BFH agreed with the GmbHs concluding that the income from the participation in E-LP is business income that is allocable to a U.K. PE and, therefore, tax exempt in Germany under the treaty.

The BFH held that the acquisition, management and disposal of the portfolio companies by E-LP qualified as “own business activities,” and that the activities exceeded what would be considered a pure asset management function; in particular, the length of time of the holdings (i.e. four years) and the leverage at the fund level supported the conclusion that E-LP traded the shares in the portfolio companies. In addition, E-LP used the premises, personnel and regulatory authority of EV-Ltd.

According to the BFH, the business activities of E-LP are allocable to a U.K. PE, the results of which are attributed pro rata to the limited partners of E-LP. The BFH attributed the office premises of the management company to E-LP and, therefore, to the investors. Hence, it is not necessary for the fund itself to be the owner or lessee of the office premises to create a PE.

The BFH also made it clear that a German domestic treaty override rule (section 50d paragraph 9 of the German Income Tax Act), which seeks to allow German taxation where income is exempt under a treaty, but is not taxed in the other contracting state, does not affect the U.K.’s exclusive right of taxation with respect to any income deriving from a U.K. PE, even if the income will not be taxed in either state. The scope of the treaty override rule is limited to situations where the contracting states have different interpretations of the provisions of the treaty. As a result, Germany will not be able to claim taxation rights if the non-taxation of income is based on a unilateral measure.

Potential impact for private equity funds

In addition to clarifying the international taxation issues, the decision of the BFH is important because, for the first time, the court has commented on the criteria for classifying a private equity fund as either a business fund or as asset management fund for German tax purposes. This classification is significant for German-based private equity funds since business partnerships are subject to the German municipal trade tax, and certain investor groups may be subject to tax disadvantages when investing in business partnerships.

In a decree issued in 2004, the German tax authorities set out the criteria for qualifying as a pure asset management fund:

• No leverage at the fund level;
• No comprehensive organization needed at the fund level to manage the portfolio companies;
• No use of a market and no use of own professional experience;
• No offerings of the portfolio companies to a broader public;
• No short-term holding of the portfolio companies;
• No reinvestment of the proceeds from the disposal of portfolio companies; and
• No active involvement in the (day-to-day) management of the portfolio companies.

The BFH has taken the position that the typical business model of a private equity fund is not pure asset management (“buy and hold”), but rather the realization of capital gains from the disposal of portfolio companies (“buy to sell”). Without providing any further explanation, the BFH analogized the tax treatment of private equity funds to that of aircraft leasing funds, which are regarded as business partnerships by both the German tax authorities and the BFH. Hence, it is likely that the BFH will classify as business funds private equity funds that, under the criteria developed by the German tax authorities in the past, would qualify as asset management funds.

If, in future, private equity funds would be treated as business partnerships simply on the basis of their business model (which represents a deviation from the current practice of the German tax authorities), German trade tax would apply at the level of the fund if the fund is deemed to have a PE in Germany. This may have detrimental tax consequences for German tax-exempt investors, private individual investors and nonresident investors of domestic private equity funds.

Foreign private equity funds should examined to determine whether they create a PE in Germany, the results of which would be attributed to their investors, especially where the investors have entered into management agreemens with German resident entities.

Market participants will have to await the reaction of the German tax authorities, as the view taken by the BFH contradicts the view taken by the German tax authorities as set out in decrees that are still in effect. Although there is no need for immediate action to restructure existing fund structures, structures should be reviewed to analyze the potential impact resulting from a potential re-qualification for the funds and their investors.

Contacts

Christoph Röper I Düsseldorf
Marcus Roth I München