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.

During the case, the court needed to decide if the profit-sharing method used by a private equity fund, which is an investment partnership, should be accepted for tax purposes in Germany.

According to Poellath, the fund's profit sharing was conducted as follows. Profits were given back to all investors based on how much they originally invested until they got their initial money back. After that, 30% of the remaining profit went to the fund managers (carry partnership), and the rest was divided among the investors.

The tax authorities disagreed on this method, saying that the carried interest (the 30% given to the managers) should be seen as a service fee paid by investors to the managers.

They wanted to limit how much of this fee could be deducted from taxes under Section 20 (9) of the German Income Tax Act. However, the court sided with the fund and Poellath, agreeing that carried interest is part of the profit distribution and not a service fee. 

Section 20 (9) of the German Income Tax Act (EStG)

Section 20 (9) EStG is concerned with the deductibility of expenses related to income from capital assets. It limits deductions for certain expenses, increasing taxable income.

However, the BFH ruling clarifies that this limitation does not apply to carried interest when treated as a profit allocation, benefiting private investors by allowing greater deductibility of related expenses.

Benefits for Private Investors

Indeed, investors in private asset management funds particularly benefit from this latest decision, according to Poellath.

The rule in Section 20 (9) of the German Income Tax Act (EStG) normally limits how much of your investment-related expenses you can deduct from your taxable income. However, this limitation does not apply to carried interest according to the ruling in April.

The ruling therefore allows investors in private equity and venture capital funds to treat carried interest as a profit distribution rather than a service fee.

This classification typically results in lower taxable income.

Sami Hafez, chief consultant at the German financial brokerage TauRes, notes that the BFH ruling also concerns the avoidance of double taxation and results in higher after-tax returns.

As carried interest reduces investors’ income, they can benefit from a higher after-tax return. The recognition of carried interest as a profit share creates a clear tax framework and facilitates long-term tax planning,

he explained. 

Benefits for Fund Managers

Fund managers could also benefit from the BFH ruling, as carried interest is now taxed more favorably under capital gains tax rates, rather than being subject to higher income tax rates, reducing their overall tax burden on these earnings.

What Happens Next?

According to Poellath, the case has been sent back to the local tax courts for procedural reasons and must be finalized there. It also remains unclear if the ruling by the BFH will be published in the Federal Tax Gazette II (Bundessteuerblatt, BStBl).

The BStBl is an official publication of the German Federal Ministry of Finance. It contains official announcements, administrative guidelines, and judicial decisions relevant to tax law.

Decisions published in BStBl II are recognized as binding interpretations of tax law, meaning tax authorities and courts must apply these rulings consistently across similar cases. If the recent ruling is published in the tax gazette, it would set a precedent for other cases, effectively making it part of German tax regulation.

For a detailed summary check out the POELLATH briefing.