What is carried interest anyway?
Carried interest (or carry) is a performance fee to which the fund initiators of venture capital/private equity funds are entitled after the investors have first received their paid-in capital and, if applicable, a preferred return. As a rule, the fund initiators then receive around 20% of the profits; there may also be an initial “catch-up” in favour of the fund initiators until they have received a certain proportion of the investors’ preferred return. In some cases, there are several carried interest stages depending on the earnings situation or when certain thresholds are reached.
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Taxation of carried interest under previous legislation
Prior to the 2004 tax period, it was disputed whether carried interest was taxable at all. The prevailing opinion in the legal literature was that carried interest represented a capital-disproportionate share of profits. As the flat-rate withholding tax did not exist at the time, carried interest was either only taxable under section 17 of the German Income Tax (Einkommensteuergesetz – EStG) – for which, however, a shareholding of at least 1% in the portfolio company was required, which is generally not the case – or under section 23 EStG – for which a sale within one year is required, which is also generally not the case. The carried interest was therefore generally not taxable.
Introduction of section 18 (1) no. 4 EStG for carried interest in asset management funds
The introduction of section 18 (1) no. 4 EStG then ensured that the carried interest of non-commercial (vermögensverwaltenden) funds is at least partially taxable (then half-income method (Teileinkünfteverfahren), now partial income method (Teileinkünfteverfahren)).
However, it was not yet clear how carried interest should be treated from the investors’ perspective (see below under “Legal situation for non-commercial funds”).
Legal situation for commercial funds
In the case of commercial funds, the tax authorities categorised the carried interest as fully taxable activity remuneration in accordance with section 15 (1) sentence 1 no. 2 sentence 1 alt. 2 EStG.
In its ruling dated 11 December 2018 (VIII R 11/16), the Federal Fiscal Court (Bundesfinanzhof – BFH) ruled that carried interest is to be classified as an original profit share in accordance with Section 15 para. 1 sentence 1 no. 2 sentence 1 Alt. 1 EStG and that the partial income method should be applied accordingly. This was not a remuneration for work, as the carried interest only arose if there was a corresponding profit and was not recognised as an expense (under commercial law). Furthermore, the BFH ruled that even “only” commercially characterised or commercially infected funds are not asset-managing funds within the meaning of Section 18 (1) no. 4 EStG. The judgement has (unfortunately) not yet been published in the Federal Tax Gazette (Bundessteuerblatt – BStBl.).
Legal situation for non-commercial funds
The tax authorities took the view that carried interest was a remuneration for the activities of the fund initiators, which corresponds with a waiver of profit by the investors and which was paid by the fund to the fund initiators in an abbreviated payment method (instead of the corresponding profit being distributed to the investors first and the investors then paying the remuneration to the fund initiators). For the investors, this therefore constitutes income-related expenses (Werbungskosten), which are generally not deductible for private investors pursuant to section 20 (9) sentence 1 EStG. In this respect, this resulted in double taxation of the carried interest for both the fund initiators and the (private) investors.
In a ruling dated 17 November 2020, the Munich tax court (12 K 2334/18) ruled that the carried interest is not a remuneration for activities but an original profit share due to a capital-disproportionate profit distribution agreement and that there are no corresponding income-related expenses or operating expenses for the investors. Consequently, the investors realize income reduced by the carried interest and there is no double taxation. Section 18 (1) no. 4 EStG (only) causes a reclassification as independent income at the level of the fund initiators or the carry recipient. The tax office (defendant) lodged an appeal against the ruling of the tax court.
The BFH recently ruled on the appeal (judgement of 16 April 2024 – VIII R 3/21), which was justified from a procedural point of view. In terms of material law, however, the BFH followed its statements in the judgement from 2018 and the opinion of the Munich tax court at first instance.
Status quo and outlook
This means that the tax treatment of carried interest for both non-commercial and commercial funds has now been clarified by the highest court. It is to be hoped that the tax authorities will generally follow the BFH’s opinion in practice.
Remaining legal uncertainties for non-commercial funds
Carry-holder corporations
It has not yet been conclusively clarified how the carried interest paid by a non-commercial fund to a corporate entity (Kapitalgesellschaft) as a carry recipient is to be treated for tax purposes.
The explanatory memorandum to section 3 no. 40a EStG, which partially exempts income in accordance with section 18 (1) no. 4 EStG, states that the provision also applies to corporate entities, as do the corporate tax guidelines.
However, it is questionable whether section 8b of the German Corporate Tax Act (Körperschaftsteuergesetz – KStG) is also applicable, which would allow (almost) complete tax exemption for capital gains. In my opinion, this is the case, as it (only) depends on whether the income actually comes from disposal gains from the sale of shares in a corporate entity. Any reclassification as independent income cannot be detrimental, as otherwise the reclassification in accordance with section 8 (2) KStG would also result in Section 8b KStG not being applicable for all corporate entity subject to the unlimited tax liability (unbeschränkte Steuerpflicht) – this cannot be the intention (see also Lauer/Dürr, Ubg, 435, 442). In any case, it is already questionable whether a reclassification pursuant to Section 18 (1) no. 4 EStG actually takes place in the case of a corporation or whether Section 8 (2) KStG ultimately takes precedence in this respect, so that the corporate entity realizes (comprehensive) commercial income. In this respect, Lauer/Dürr convincingly argue (p. 441) that it would not have been necessary to order the non-application of section 15 (3( EStG if section 18 (1) no. 4 EStG took precedence over the other statutory provisions anyway.
Otherwise, a structure with a carry-holder corporation would be at a disadvantage without good reason, as not only the carry itself would be taxed, but also the distribution to the shareholders of the company, i.e. the actual fund initiators as individuals. If you wanted to use a carry-holder corporation, you would have to take structuring measures to ensure that the fund becomes commercial only because of this uncertainty, which in turn could be disadvantageous overall from a tax perspective (e.g. due to the lack of full creditability of trade tax against income tax for private investors).
Section 8b KStG is likely to be the more specific provision (also according to Lauer/Dürr), which means that there is no double preferential treatment (which would be the case – slightly – if section 3 no. 40a EStG applied to all income and then section 8b KStG applied to disposal gains).
It would be desirable if this uncertainty could be resolved as soon as possible. The topic is also very relevant in practice, as capital gains are generally the main economic focus of venture capital/private equity funds and not dividends or interest.
Deal-by-deal carry and carry clawback
Furthermore, it has not been conclusively clarified to what extent a deal-by-deal carry, which can already generate carry per individual deal (i.e. if the investors have received back their paid-in capital with regard to the respective individual investment), is compatible with section 18 (1) no. 4 or section 3 no. 40a EStG. Section 18 para. 1 no. 4 EStG requires that the shareholders or investors “have received back their paid-in capital in full” with regard to the carry claim. In my opinion, this requirement is also met in the case of a deal-by-deal carry if a carry clawback is agreed, which cancels the entitlement to the carry (condition subsequent) if the investor does not receive (or receives less than) the capital paid in.
Clarity on this would also be desirable. To play it safe in this regard, the carry must be incurred on a portfolio basis (which is often the case).
