Carried Interest Taxation in Germany: Understanding the Latest BFH Decision and Its Implications

The Bundesfinanzhof (BFH), Germany's highest tax court, upheld the classification of a form of compensation for investment managers. 

The new ruling could end the debate over the taxation of carried interest for now, at least.

It may also have implications for your fund management arrangements or your taxable income as a private investor.

So let's take a look at the details.

The BFH has confirmed that carried interest should be considered part of profit allocation for tax purposes, rather than a service fee from investors to fund managers. 

This decision, involving the law firm Poellath, reinforces an earlier decision via a local court in Germany on the tax treatment of carried interest. It's likely to benefit private investors and fund managers alike.

What is Carried Interest?

Carried interest is a share of the profits that fund managers and other partners in private equity investment can receive as part of their compensation. Essentially a performance fee, it incentivizes managers to help increase a fund’s value.

The ruling by the BFH means that this income is classified as a profit distribution and not a remuneration fee. This has tax implications.The classification of carried interest, its advantages, and its taxation is currently a hot topic for debate.

Earlier this year, the Financial Times reported that private equity firms have accumulated more than US$1 trillion in carried interest fees since 2000, taxed at lower capital gains rates rather than higher income tax rates. 

The figures came from new research by Ludovic Phalippou, a professor at the University of Oxford’s Saïd School of Business.

The favorable tax treatment has drawn political scrutiny in the US and Europe as critics argue it is a tax loophole.

On the other side of the discussion, the taxation arrangement on carried interest has been argued as essential for long-term investment strategies and encouraging economic growth through capital investments.

So What Happened in Germany?

On April 16, 2024, the BFH ruled that carried interest is part of a profit allocation rather than a service fee. This decision aligns with the legal opinion of Poellath, who represented an unnamed plaintiff in a tax complaint case and has now reported on the outcome.