German Federal Fiscal Court Confirms Tax Treatment of Carry Income as Disproportionate Profit Allocation

The German carry taxation regime pursuant to Section 18, paragraph 1, number 4 in the German Income Tax Act (referred to hereafter as “Section 18”) provides for a beneficial tax treatment of carry income of German resident fund professionals, subject to certain strict limitations. If said carry holders meet the statutory requirements, they are eligible to an income taxation at about 28.5% in the highest tax bracket (€278,000 and above), as opposed to an income taxation at ordinary rates, which comes to about 47.5%.

Historically, the beneficial taxation was acknowledged by German tax authorities strictly within the limits of Section 18 and thus with respect to only carry income received from partnerships that are structured and operated as asset managing funds rather than trading funds. That is, if a fund partnership qualified as a trading fund according to German tax law, German tax authorities rejected to grant German resident fund professionals the benefit of carry taxation. Instead, German tax authorities argued that fund professionals would be receiving income from services, so authorities treated such proceeds as ordinary income (i.e., tax rates up to about 47.5%) when carry was received through a trading fund.

The issue: German tax authorities determine whether a fund qualifies as asset managing or trading by relying on the so-called private equity circular (or, simply, the “circular”), a long-standing but binding decree of the Federal Ministry of Finance, dating back to 20 November 2003. According to the circular, establishing and running an asset managing fund involves specific structuring and operational effort as well as discipline that often contradicts commercial needs and/or limits strategic opportunities for a fund, such as the prohibition from assuming (co-)management functions (even temporarily) in portfolio companies or even, with very limited exceptions, reserving consent rights or partaking in management decisions. Another restriction that often creates strategic and operational disadvantage is the prohibition to take up leverage at fund level, such as funding for net asset value facilities.

Apart from stipulating an onerous framework, the circular suffers from many unclear and unhelpful guidelines due to vague wording or impractical limitations based on outdated assumptions. The uncertainties caused by the circular for the German fund and carry taxation are further aggravated by a decision of the German Federal Fiscal Court from 24 August 2011. While tax authorities continue applying the circular, the Federal Fiscal Court insinuated in its decision that private equity fund partnerships generally qualify as trading partnerships, thereby contradicting the circular and potentially nullifying the carry taxation regime under Section 18.

In practice, the German tax environment urged fund initiators to choose between enabling domestic professionals to benefit from German carry taxation pursuant to Section 18 at the cost of cumbersome and expensive German specific fund structuring (with a remaining risk of such funds qualifying as trading nonetheless in the eyes of the German tax courts) or accepting a less advantageous taxation of German resident fund professionals with the downside of potentially lower incentivization.

Change of Carry Taxation in Light of Recent Tax Court Decisions

Considering the above, it is not surprising that the German tax treatment of carry income has been a traditional source of dispute with the domestic tax authorities. On a surface level, most proceedings circled around questions as to whether a certain fund partnership complied with the circular’s guidelines or if a specific carry scheme satisfied the requirements stipulated in Section 18. However, at the center of the dispute was the question of if and under what circumstances carry income constitutes income for services performed or is a disproportionate share in (partnership) profits.

According to the German tax authorities, carry income constitutes a remuneration for services. This is why, in their view, carry income benefits from the advantageous tax treatment in Section 18 exclusively if the statutory conditions in said provision are complied with. One of those conditions is that the carry income flows from an asset managing fund partnership. Any deviation from the statutory rules, even a minor one, means that a fund professional does not benefit from preferable tax treatment in respect of the carry income earned.

If, on the other hand, carry income constitutes a disproportionate profit share, it does not merely come from asset managing partnership funds (that is, within the limits of Section 18) but also comes from trading partnership funds, where disproportionate profit allocation is equally common. Section 18 would stipulate just one carry income scenario, specific to asset managing fund partnerships. However, advantageous carry income taxation would generally also be applicable to carry income earned in trading fund partnerships.

The legal nature of a carry entitlement therefore has an enormous impact on the carry entitlement’s tax treatment. It was observed with great interest among tax professionals in Germany when the German Federal Fiscal Court insinuated in its decision from 11 December 2018 (docket no. VIII R 11/16) that carry income arrangements represent a disproportionate profit allocation if certain parameters are met and that such carry income could also be earned by a carry holder in a trading fund. However, the issue with said decision was that German tax authorities remained silent on whether they concurred with the Federal Fiscal Court’s reasoning in the above-referenced decision, which is why tax practitioners have been looking for additional guidance in relation to a subsequent case that gave the Federal Fiscal Court the opportunity to confirm its view, this time with respect to carry income earned within an asset managing fund.

Indeed, in its decision from 16 April 2024, the Federal Fiscal Court followed the plaintiff’s position that carry arrangements constitute entitlements to a disproportionate profit share provided that (i) such entitlement is granted in consideration of a fund professional’s (intangible) contribution (e.g., daily work, business relationships, know-how, and network) to the fund partnership; (ii) the carry is not treated as a deductible in the partnership’s bookkeeping; and (iii) is only payable out of a sufficient profit or surplus of the partnership or otherwise is subject to a claw back.

If these conditions are met, carry income can also be earned via participation in a trading fund partnership, with the benefit of being taxable at an income tax rate of about 28.5%.

How Should Fund Initiators and Fund Professionals React to the Changed German Tax Environment?

It is not yet clear how German tax authorities will react to the new decision of the Federal Fiscal Court. But it is clear that the predominant part of tax practitioners support the position of the Federal Fiscal Court, and an increasing number of professionals are considering the Federal Fiscal Court’s view in their daily practice as well as for their fund and carry structuring.

German resident fund professionals can benefit from advantageous carry income taxation whether they receive carry income via asset managing or a trading fund as long as such income follows the legal requirements for qualification as a disproportionate profit allocation. For those professionals, a major reason for establishing and maintaining an asset managing fund falls away. (Note, however, that establishing and operating an asset managing fund may still be required or desired by certain German resident investor types.)

If the German tax administration rejects the position of the Federal Fiscal Court or continues to stay silent on whether the Federal Fiscal Court’s view is considered generally sustainable (a strategy that is often pursued by the German tax authorities for decisions that are perceived as legally justified but fiscally “inopportune”), fund initiators and professionals may seek other means through which to achieve tax structuring comfort, such as obtaining an affirmative tax ruling that may be achievable with “investor-friendly” tax offices. Otherwise, German resident carry holders may have to factor in the residual uncertainty in relation to the taxation of carry income derived from a trading fund.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.