Industry Comment

BFH rules on the tax treatment of private equity funds, but fails to deal with long standing constitutional issues

Wednesday, February 08, 2012

1. The first Senat of the Bundesfinanzhof (the “BFH”) has ruled [1] that the purchase, ongoing administration and disposal of portfolio companies by a private equity fund qualifies as a ‘business activity’ as opposed to ‘non-commercial asset management’. The court however, failed to rule on the all important and long standing constitutional issue of treaty override.

2. The case in question concerned a UK based leveraged buyout fund (the “Fund”). The Fund was structured as a Scottish limited partnership and had a UK based corporate General Partner. The Fund was managed by a UK FSA registered management company (the “Manager”) which provided the Fund with basic corporate administration services in addition to standard management services.

3. In reaching its decision the BFH applied various elements of the guidance issued by the Federal Ministry of Finance in 2003 [2] concerning the tax status of funds (the “Guidance”). Although this decision is the first one which refers to the Guidance, the BFH did not rule on whether this should be applied in all cases. It will be interesting to see how if at all the German tax administration will react to this decision.

4. Central to this case was the BFH’s interpretation of the 1964/1970 German/UK double taxation treaty. The BFH ruled that the Fund was deemed to have a UK permanent establishment based on the Fund’s relationship with the Manager, and as a result of this the ‘business’ income and capital generated by the Fund was not subject to German tax under Article 18 of the relevant treaty. This, the BFH ruled, was not reversed by either the ‘switch over’ article in the treaty (in any case, only relevant to capital gains) or more importantly, the domestic ‘subject to tax’ provisions of the Income Tax Act, as this required an income qualification conflict which was not present. Accordingly, the BFH did not rule on this issue.

5. Due to the introduction of the new 2010 German/UK double taxation treaty, which contains a ‘subject to tax’ provision in Article 23, the dicta of this case concerning treaty interpretation will not be applicable to German investments in UK funds going forward.

6. The case does however raise significant questions surrounding the tax treatment of German domiciled private equity funds. In this regard, this decision adds to difficulties that German private equity houses are already facing in relation to the adaptation of their business models to future regulatory requirements under AIFMD and will doubtless detract from Germany’s position as a domicile of choice for international private equity funds.

[1]Decision of the first Senat of the Bundesfinanzhof dated 24 August 2011 – I R 46/10
[2]Schreiben des Bundesfinanzministeriums vom 16. Dezember 2003 zur Besteuerung von Private Equity Fonds