The tax treatment of the income stemming from a carried interest is not clearly regulated in the German tax law and often subject to discussions with the tax authorities in Germany. A long-standing approach of the German tax authorities was now (again) rejected by the highest tax court in Germany, which is generally accepting the possibility to give an incentive to managers directly (or indirectly via a carry vehicle) by an increased profit share. The Federal Tax Court is often ruling in favor of the respective managers, accepting that a disproportional profit allocation needs to be accepted by the tax offices. In its most recent decision, the Federal Tax Court has again rejected the approach of the tax authorities and clarified that a German law provision dealing with the tax treatment of the managers does not determine the treatment of the profit allocation itself ((https://www.bundesfinanzhof.de/de/entscheidung/entscheidungen-online/detail/STRE202410121/).
View of German tax authorities
Based on the decree of the Federal Ministry of Finance relating to VC and PE funds dated 16 December 2003, the tax authorities tend to treat a carry as a renumeration for services being paid by the other investors not entitled to a carry by means of an abbreviation of the payment (reduction of their profit share and direct payment to the carry holders – irrespective of whether or not they are partners/shareholders of the paying entity). As a result, the income of the other partners will be reduced, but the respective deemed business expenses are not tax-deductible. Accordingly, the German tax authorities disregard the disproportional profit allocation, but assume a proportional allocation of profits based on the interest held in the capital of the vehicle and, subsequently, a “renumeration” of the carry holders by the other investors in the amount by which their profit shares exceeds a profit share based on the proportional allocation. The approach is often detrimental for private investors, not only because they are precluded to deduct business expenses to a certain extent, but also with regard to the long duration of German tax proceedings, i.e., the case at hand is related to the tax years 2006 and 2007.
Stable case law of German Federal Tax Court
The German tax courts, however, have developed a tradition of case law pursuant to which the carry is generally considered as a profit distribution and not as a renumeration paid by the entity or the other investors to the carry holder.
In the most recent decision which was published on 18 July 2024, the Federal Tax Court (Bundesfinanzhof) has again set out the main principles for the recognition of the carry as a profit distribution and clarified the interaction between the tax treatment on the level of the entity, other investors and the managers being carry holders. It again states that the German tax authorities need to accept the contractual agreement made by the parties to distribute any profit dis-proportional.
It refers to its long-standing case law (since 2002 essentially) pursuant to which a disproportional allocation of profits in case of a (contractually agreed upon) carry has to be accepted by the tax authorities as (disproportionate) profit distribution:
- From a legal perspective, it is feasible to consider the increased profit share as a renumeration for management services, but only if the articles or the partnership agreement state that it shall be treated as a business expense for GAAP purposes and be paid in years in which the vehicle was in a loss position.
- From a tax perspective, the legal perspective is decisive for the tax treatment as long as it is based on a corporate relationship and at arm’s length terms. However, the agreement of a carry is generally based on the corporate relationship given that usually no personal or other economic relationships exist between the investors and the carry holders.
If these requirements are met, according to the Federal Tax Court, another allocation of profits should not be feasible for income tax purposes. Accordingly, the Federal Tax Court reiterated following another decision which was published in February 2024 that it is not willing to disregard the view and the intention of the parties to the constitutional documents of the fund vehicle.
In the case at hand, it additionally rejected one common argument in tax audits pursuant to which the German income tax qualifies the carry as income from a service, if the carry is paid out by an asset-managing (venture capital) company after the investors have received their invested capital back, Section 18 (1) no.4 ITA (Einkommensteuergesetz – EStG). In this scenario, the carry is treated as income from self-employment, but being essential 40% tax exempt (comparable to dividend income received by an individual).
The Federal Tax Court stated that this rule is only applicable on the level of the individual being entitled to the carry, but it does not qualify the nature of the carry on the level of the distributing entity or the (other) investors. Accordingly, it is not relevant for the qualification of the profit allocation. The decision contains clear and helpful interpretation of the purpose of this rule. The purpose of the carry is the recognition of the economic value of the carry holders’ tangible and intangible contribution to the economic success of the fund vehicle’s business.
Accordingly, the decision of the Federal Tax Court again strengthens the view that – disregarding exceptional cases – the carry is a profit allocation of the fund vehicle and – unless the requirements of Sec. 18 (1) No. 4 ITA are met, the income qualification of the carry holders is the same as for any other investors.
Recommendation
It will be interesting to see whether this decision together with the further decisions of the Federal Tax Court relating to the tax treatment of carried interest will help to put an end to the financial administration's discussions on carried interest.
In comparable cases, carry holders and investors may rely on the decision, which is not yet final and the case was referred back to the local tax court because the local tax court missed to involved all investors and hence need to review and decide the case again.
Nonetheless, this, in our view, does not affect the underlying reasons for the decision of the Federal Tax Court – one further step to a clearer and more reliable tax treatment of carried interests in Germany.
Authored by Mathias Schönhaus.
Hogan Lovells (Luxembourg) LLP is registered with the Luxembourg bar.
