The German Federal Court of Finance (Bundesfinanzhof - "BFH") revealed its position on the tax treatment of carried interest from business-type fund structures in a judgement of 11 December 2018 (VIII R 11/16).
Carried interest from business-type private equity funds generally will not be treated as a service remuneration. Rather, the so-called partial income regime applies to those parts of the carried interest which (on a "look-through" basis) are gains from the sale of shares in corporations (capital gains) and dividends, meaning that such parts of the carried interest income are 40% tax exempt. This treatment also applies to private equity funds which are business-type not due to trade or business activities, but only due to their legal structure (so-called deemed-business treatment) or due to an interest they hold in another trade or business partnership (so-called business-tainting). A. Background
Different views were taken in the past on the question of the tax qualification of carried interest.
Initially, carried interest was regarded as a disproportionate share of income so that the taxation of the carried interest followed the taxation underlying items of income (capital gains, dividends, interest). With the so-called PE Pronouncement (Pronouncement of the German Federal Ministry of Finance of 16 December 2003, Federal Tax Gazette I/2004, page 40, section 24 et. sq.), the tax authorities took the view that carried interest from a non-business private equity fund should be requalified to a (hidden) service remuneration.
In 2004, the view taken by the tax authorities was codified in § 18 (1) no. 4 of the German Income Tax Act ("ITA"). Pursuant to this statutory rule, carried interest received by a partner of a non-business private equity fund is qualified as income from self-employment and thus generally fully taxable. However, a special tax exemption was created at that time, pursuant to which 40% of such income is tax free (partial income regime, § 3 no. 40a ITA).
However, the question remained in dispute how carried interest should be treated in case of a private equity fund qualifying as trade or business.
In some instances, tax offices took the view that carried interest should be qualified as a (hidden) service remuneration also for business-type private equity funds. However, according to this view the partial income regime applicable to non-business private equity funds should not apply so that the...