A wolf in sheep’s clothing for private equity?

In fact, the draft bill of May 8, 2019, initi­ally focu­ses on the topic of elec­tric mobi­lity — curiously enough, and this is a perso­nal comment I would like to make here, although elec­tric mobi­lity is still in its infancy in Germany and will not be available for wide­spread use (e.g., elec­tric service vehic­les) in the fore­seeable future.

The draft bill at that time — inclu­ding initial, various amend­ments — was passed on July 31, i.e., the legis­la­tive process has offi­ci­ally been set in motion, although it will proba­bly take some time before it is finally passed by the Bundes­rat, the upper house of the German parlia­ment, and further amend­ments cannot be ruled out. In terms of taxa­tion, the draft — rather unno­ti­ced by the media coverage — goes far beyond the topic of elec­tric mobility.

For private equity, this is a genuine “case law preven­tion act”, espe­ci­ally since some of the new regu­la­ti­ons contra­dict the deve­lo­p­ment of BFH case law, which is actually posi­tive for taxpay­ers; speci­fi­cally, in the case of default on share­hol­der loans or the loss of invest­ments in corpo­ra­ti­ons due to insol­vency. Unfort­u­na­tely, both of these occur occa­sio­nally in private equity funds; private inves­tors in parti­cu­lar (which, by the way, also include the carry holders for the current share of earnings) are at a considera­ble disad­van­tage under the draft law. — In addi­tion, the issue of capi­ta­liza­tion of manage­ment fees, which has actually come to rest in the tax audits of recent years, is to be tigh­tened across the coun­try without neces­sity; unfort­u­na­tely, this also contra­dicts the prac­tice that has often been follo­wed to date.

The German Fede­ral Fiscal Court (Bundes­fi­nanz­hof, BFH) ruled in a posi­tive and other­wise ground­brea­king ruling of Octo­ber 24, 2017 (file number VIII R 13/15) for taxpay­ers that the default of private loan receiv­a­bles is to be taken into account as a loss in the income from capi­tal assets, contrary to the previous view of the tax autho­ri­ties. The case concerns all taxpay­ers with so-called free float, i.e. cases in which the inves­tor has a calcu­la­ted share of less than 1% in the target corpo­ra­tion in ques­tion — thus a frequently encoun­te­red scena­rio in private equity funds. With this ruling, the BFH has also dele­ted in one fell swoop text item 60 from the letter of the Fede­ral Minis­try of Finance on appli­ca­tion issues follo­wing the intro­duc­tion of the flat tax, which had previously exis­ted since 2016.

In another ruling of 12.06.2018 (file number VIII R 32/16), which is also very plea­sing for taxpay­ers, the BFH ruled that the sale of shares at a selling price that just corre­sponds to the tran­sac­tion costs also gives rise to a loss to be reco­gni­zed in the income from capi­tal assets. Also with this ruling, the BFH has in one more stroke erased the previous text para­graph 59 from the letter of the Fede­ral Minis­try of Finance on appli­ca­tion issues follo­wing the intro­duc­tion of the flat tax, which had previously exis­ted since 2016.

In addi­tion, follo­wing the two afore­men­tio­ned rulings, it is very likely that the BFH will also reco­gnize a tax loss on income from capi­tal assets in the pending appeal procee­dings (inclu­ding VIII R 5/19) in the event of the loss of equity invest­ments due to the insol­vency of the corpo­ra­tion, inclu­ding for parti­ci­pants with free float shares held as private assets.

So far so good, but in the current draft law, amend­ments to Section 20 of the German Income Tax Act (EStG) inva­li­date the afore­men­tio­ned case law of the Fede­ral Fiscal Court (Bundes­fi­nanz­hof, BFH) by means of a formu­la­tion accor­ding to which the default of a capi­tal claim or the loss incur­red as a result of dere­co­gni­tion of an equity invest­ment is to be irrele­vant for tax purpo­ses. This regu­la­tion is extre­mely profi­s­cally moti­va­ted, simply put pure “juris­dic­tional obstructionism.”

Last but not least, Section 6e EStG of the new draft law conta­ins a provi­sion on so-called fund estab­lish­ment costs, which will proba­bly result in the very rest­ric­tive regu­la­ti­ons on the capi­ta­liza­tion of income-rela­ted expen­ses incur­red during the invest­ment phase, which were previously only contai­ned in the outda­ted 2003 fund decree — this is based on the even older deve­lo­per decrees of the 1980s and 1990s — now being enshri­ned in law. This — quite coin­ci­den­tally — against the back­ground that the BFH in the very recent ruling of 26.04.2018 (file number IV R 33/15) has also deci­ded that fund estab­lish­ment costs from the end of 2005 — contrary to previous admi­nis­tra­tive prac­tice — are to be trea­ted as imme­dia­tely deduc­ti­ble busi­ness expenses.

As a result, the “Bava­rian model”, in which 2 out of 10 manage­ment fees were gene­rally capi­ta­li­zed as acqui­si­tion costs over the entire term of the PE fund and the rema­in­der — outside the scope of Sec. 8b KStG and Sec. 3c EStG — was reco­gni­zed as a tax-deduc­ti­ble expense, will also be aban­do­ned. Or as a high-ranking repre­sen­ta­tive of the Hessian Minis­try of Finance announ­ced at a tax confe­rence some time ago when asked: The Income Tax Act is fede­ral law and then also applies in Bavaria.

Taxpay­ers and their advi­sors will proba­bly have to prepare for tigh­tening over­all. Cases in which loan losses or insol­ven­cies of corpo­ra­ti­ons were reali­zed before the new regu­la­tion came into force, i.e. presu­ma­bly before Janu­ary 1, 2020, can proba­bly be “saved” with a certain degree of proba­bi­lity. The legis­la­tive process is expec­ted to be comple­ted by the end of 2019. The Fede­ral Coun­cil will in all likeli­hood comment on the current govern­ment draft at its meeting on Septem­ber 20. It is also certain that the mass spread of elec­tric mobi­lity will be a long time coming, but that is only a margi­nal issue in the law anyway.

About Thomas Jäger

Thomas Jäger is a tax consul­tant and share­hol­der-mana­ging direc­tor at LM Audit & Tax GmbH, Wirt­schafts­prü­fungs­ge­sell­schaft, Steu­er­be­ra­tungs­ge­sell­schaft in Munich.
As a tax boutique, LM advi­ses dome­stic and foreign clients in the areas of private equity and real estate, from tax due dili­gence and ongo­ing tax compli­ance to tax audits and — if neces­sary — procee­dings before the tax court. — In the area of private equity, Mr. Jäger and his team advise on the prepa­ra­tion of annual finan­cial state­ments and tax returns for dome­stic share­hol­ders of inter­na­tio­nal fund struc­tures, on tax returns accor­ding to the Foreign Tax Act and the Invest­ment Tax Act as well as on the prepa­ra­tion of Tax Compli­ance Manage­ment Systems (Tax CMS).