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).