Let's not go into specifics

Author: | Published: 1 Apr 2007
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The coalition agreement between the political parties the Christian Democratic Union (CDU), Christian Social Union (CSU) and Social Democratic Party (SPD) of November 11 2005, provides for the introduction of a new legal and tax framework governing private equity funds in Germany. This new legislation, which aims to regularize private equity funds, is still under discussion. One approach is to revise the existing law governing participation in enterprises (the UBGG) into a new private equity law. Experts at the Technical University Munich have furnished an opinion concerning the economic impacts of private equity transactions that should be reflected in the new private equity legislation. They have come to the conclusion that the private equity industry should be provided with many more tax liberties. The Federal Ministry of Finances has established a task force that is working on a respective draft Bill. The Bill will be introduced to parliament by mid-2007 and is due to become effective by January 1 2008.


The German private equity fund industry generally used to exist beyond public perception and the German legislator did not consider a special legal framework for private equity funds to be necessary. The interests and requirements of the initiators and managers of private equity funds on the one side, and those of the private equity fund investors on the other, were considered covered by the existing legal framework. Binding tax rulings of the relevant tax authorities confirming the tax treatment of a particular private equity fund provided, in many cases, an additional level of comfort.

From 1990 to 2000, certain federal states in Germany, in which private equity management companies are resident, provided a pragmatic framework for a number of private equity funds. Tax rulings became particularly relevant beyond the specific case to which they applied because German legal and tax advisers started to consider the findings and restrictions of these tax rulings when structuring other private equity funds. This resulted in legal certainty to a certain extent on the side of the tax authorities, as well as on the side of the private equity industry.

At the beginning of 2001, private equity became the subject of public discussion in Germany for several different reasons. One such reason was an increasing knowledge and perception of the importance of private equity for the general economic development in Germany, as a potential solution for successor and structural problems of particular enterprises, and for the creation of new jobs. This discussion has triggered a general demand for a uniform framework governing private equity funds throughout Germany. Meanwhile, a number of private individual investors were attracted by private equity as an asset class who had previously had no access to it. This in turn entailed a number of regulatory issues, in particular in the context of investor protection. Lastly, private equity became the subject of political discussions. Almost all Germans will remember the comments about private equity investors being regarded as locusts before the general elections in September 2005. This has led to a number of positive and reasonable arguments regarding private equity, in particular involving politicians.

The situation in other countries

Germany is not the only country that has realized that private equity generally has a positive impact on overall economic development – this was recognized by many other countries at a fairly early stage. In respect of their tax framework, countries can generally be divided into two groups: most continental European countries, for example, France, Italy, Luxembourg, Belgium or the Netherlands, have introduced a special regulatory and tax regime for private equity funds. The other group of countries, in particular the US and the UK, does not have special private equity legislation, but does apply general law to the specific facts and circumstances of a private equity fund.

Countries with private equity legislation

From the tax perspective of a private equity fund and its investors, any fund structure seeks to ensure the principle of tax transparency. Tax transparency means that any profits from private equity investments will only be taxed at the level of the investors in their own jurisdiction and in accordance with their personal tax status. Profits will not be taxed on the level of the private equity fund; the qualification of the allocable share of income (profit share) of each investor for tax purposes will not be influenced by criteria that lie within the scope of the private equity fund's investment activities. This would, for example, be the case if the investment activities of a private equity fund were to constitute a trade or business for tax purposes, meaning the entire income derived from the private equity fund would be re-characterized as business income for tax purposes.

It is fair to say that all private equity companies strive to assure the status of tax transparency, irrespective of the jurisdiction in they might be domiciled. The continental European countries have implemented the principle of tax transparency into their respective special private equity legislation (which provides full tax transparency of private equity funds established in accordance with the respective special private equity law).

The regulatory requirements in the respective special private equity laws mostly depend on the question of to what extent private equity investments are made in the particular country from an international perspective. Countries in which only few private equity investments are made generally focus on ensuring an attractive environment for private equity funds that have international investors and are set up to invest mainly in other countries. These countries do not seek to obtain any advantage in the competition for investment capital (in the respective countries) but rather to obtain an advantage for their own private equity industry, which offers services in the context of fund management and fund administration. This explains why such countries generally provide a liberal and flexible regulatory framework and why they generally do not have an issue with implementing legislation that ensures the principle of tax transparency.

This is different for countries in which a large number of private equity investors are resident and (at the same time) a substantial number of private equity investments are made. The specific private equity legislation of these countries is characterized by a considerably higher degree of regulatory and tax requirements.

The situation in Germany

Germany does not have a special private equity law. Germany applies the same method as the US or the UK: Specific issues relating to private equity are resolved on the basis of general law.

On December 16 2003, the German tax authorities issued an administrative pronouncement that discusses in detail the taxation of private equity funds and their investors (the PE Administrative Pronouncement). The PE Administrative Pronouncement provides a distinction between private asset management and trade or business for tax purposes on the basis of existing German tax laws.

On December 23 2003, the German tax authorities issued a pronouncement that discusses in detail the treatment of compensation paid by partnerships to their managing partners for VAT purposes. This pronouncement applies to all partnerships, including partnerships that have been structured as private equity funds. The criteria set out in the respective administrative pronouncement have since been implemented into the German VAT tax guidelines 2005.

Capital-disproportional allocations of income to the initiators of private equity funds (carried interest) have been privileged by a law of July 30 2004 that seeks to provide for the taxation of carried interest that can reasonably hold up in an international competitive environment for private equity funds.

Recently, a public discussion has arisen in Germany on whether, based on the legislative and administrative regulations above, a special private equity law would still be required or helpful. This subject has been implemented explicitly into the coalition agreement of the government in Germany as an agenda objective.

What has triggered these discussions? There are mainly two reasons. First of all, as of January 1 2004, the Investment Act and the Investment Tax Act have come into force in Germany. Both laws generally do not apply to private equity funds. The explanatory statement on the Investment Modernization Act (which implemented the Investment Act, as well as the Investment Tax Act) expressly states that alternative means of financing enterprises, such as private equity and mezzanine capital, will not fall within the scope of the Investment Modernization Act. This clear statement could be regarded as suggesting that additional legislation is required to fill the legal gap concerning private equity funds.

Another factor triggering discussion about the need for special private equity legislation in Germany could be the uncertainty regarding particular criteria contained in the PE Administrative Pronouncement to ensure the investment activities of a private equity fund not to constitute a trade or business for German tax purposes. A few criteria enclosed in the PE Administrative Pronouncement are considered difficult to comply with by the private equity industry.

Laws and regulations impractical

A new private equity law in Germany would be urgently required if the existing laws and regulations were impracticable and Germany therefore lacked competitiveness concerning the attraction of capital for private equity investments. But before making such a statement as an argument for specific private equity legislation, it is necessary to conduct a differentiated analysis of the existing laws and regulations for private equity funds in Germany.

The PE Administrative Pronouncement of December 2003 has confirmed the tax principles for private equity funds that had been developed by several federal states during the 1990s. The fact that it has taken almost three years to implement the PE Administrative Pronouncement has had a negative impact on Germany's reputation as a domicile for private equity funds. It is difficult to explain to non-German investors, as well as to colleagues from other countries, that private equity fund activities have almost halted in one of the most important industrial nations in Europe, because of lack of legal certainty. It will only be possible to regain any confidence and trust in Germany as a private equity platform, if the financial authorities provide legal certainty (at least for an interim period) by granting binding tax rulings.

The criteria set out in the PE Administrative Pronouncement that need to be fulfilled to ensure tax transparency, that is, the requirements to be met to avoid a trade or business for German tax purposes, are compatible with most private equity investment strategies currently applied. The financial authorities issued a number of additional explanatory notes with reference to specific requirements of the PE Administrative Pronouncement throughout 2004 to create more clarity regarding their application.

It is possible in Germany (similar to the situation in the US or in the UK) to find practicable and acceptable solutions for particular projects in a reasonable dialogue between the respective administrative authorities and the respective initiators.

The PE Administrative Pronouncement cannot and will not be the final answer to the discussions on the tax aspects of private equity fund formation. This is because private equity is a changing business subject to ongoing developments. These developments raise new questions from a tax perspective that Germany will hopefully not again take years to answer. We hope that Germany has learned from its experience concerning this matter in the past. From a tax perspective it should be considered that a flexible adjustment to a new situation would be preferable to an inflexible legal solution.

Also, the discussion on tax aspects within the context of private equity fund formation needs to be continued, because the PE Administrative Pronouncement does not contain any, or not enough, regulations with respect to three areas of private equity financing:

  • Tax aspects that arise in the context of the financing and support of enterprises segregating from universities and other research institutes are generally not covered by the PE Administrative Pronouncement. This has caused a financing gap in the seed segment.
  • The PE Administrative Pronouncement does not deal with questions concerning the restructuring of existing enterprises. The German mid-market segment has structural problems that it struggles to cope with. In particular, non-German investors have realized (and have confirmed this view in certain ways) that as a business platform Germany has a better reputation outside of Germany than inside. The German mid-market segment requires the cooperation of private equity investors investing in the respective enterprise. The PE Administrative Pronouncement does not provide for clear guidance in respect of the limitations for this cooperation.
  • Lastly, the PE Administrative Pronouncement does not discuss advisory services provided by private equity companies for their own portfolio companies. This question was discussed in detail in the course of drafting the PE Administrative Pronouncement but it was not addressed in final pronouncement at all. The PE Administrative Pronouncement merely addresses the incubator that provides vitally important management services to its portfolio companies. This is insufficient.

The dialogue with the financial or other relevant authorities will need to be taken up again. This dialogue may be resumed in the process of drafting a new special private equity law. However, this is only one possibility, which might not be the most promising.

View across the border

An overview of the developments in recent years shows, on the one hand, that since December 2003 much positive progress has been made. On the other hand, there is still much work to be done. This could be regarded as inconvenient because it takes time and effort. That might provoke sympathy for the idea of the German parliament introducing a new private equity legislation, which simply provides for full tax transparency without addressing all the difficult details and questions that the reality of private equity fund structuring produces in practice. If Germany's neighbours in continental Europe have done it, why should Germany not do it as well?

The degree of complexity of private equity laws and the dimension of regulatory requirements in other countries depend largely on the question to what extent private equity investments are made in the respective country.

Germany is without doubt part of the group of countries that would have a private equity law with a substantial level of complexity, as well as a considerable quantum of detailed regulatory requirements. This is because the tax issues of foreign investors with respect to their domestic investments on the one side, and the tax issues of domestic investors with regard to their worldwide investments on the other, are complex and more difficult than the answers provided by a country that predominantly offers fund administration and fund management services.

Of the countries that already have an existing special private equity law, France is probably the country that has the most similarities to Germany, whereas Luxembourg has the fewest. France and Germany can be characterized as industrial nations, whereas Luxembourg is a good example of a successful and attractive investment platform. Accordingly, the regulatory regime governing the Luxembourg private equity fund vehicles Sicav or Sicar is rather straightforward. In contrast, the regime applicable to the French fund vehicle FCPR is rather complex.

This view (even if cursory) across the border to Germany's neighbours is illustrative. The degree of complexity governing the French FCPR regime does not express the inefficiency of the French legislator, but results from the fact that the issues at hand are more complicated than, for example, in Luxembourg. This should (among all other relevant aspects) be taken into account in any considerations concerning a German special private equity law.

Author biographies

Uwe Bärenz

P+P Pöllath + Partners

Uwe Bärenz is partner with P+P Pöllath + Partners, Berlin, focussing on legal and tax advice for foreign and domestic managers and financial intermediaries in structuring, placing and managing private equity funds and funds-of-funds, as well as for institutional and private investors making private equity investments. Bärenz studied law and philosophy in Berlin and advised insurance companies for several years.

Amos Veith

P+P Pöllath + Partners

Amos Veith is an attorney-at-law with P+P Pöllath + Partners, Berlin. He studied law and philosophy in Bonn and Cologne as well as environmental law at the University of Aberdeen, UK (LLM). He specializes in fiscal and legal advice for domestic and foreign institutional and private investors, and initiators in the field of private equity funds, as well as in the field of funds-of-funds in the private equity, mezzanine and secondary sectors.