Private equity funds and venture capitalists have long recognized the opportunity for growth and generation of capital through non-U.S. investors. However, the participation of foreign investors can trigger additional reporting requirements. This is typically the case if a fund, which is organized as a partnership, has at least two German tax resident investors.
Fund management is liable for filing of German partnership return
If a fund is organized as a partnership, and has at least two German tax resident investors, the annual filing of a partnership return in Germany is required (“gesonderte und einheitliche Feststellung” comparable to a U.S. Schedule K-1). By law, German investors, and the fund’s management, are jointly liable for the proper filing of the return. The return includes a profit determination according to German tax laws. Financial statements based on U.S. GAAP or other accounting principles need to be converted into German GAAP for this purpose.
German investors typically try to address the reporting obligations in side-letter agreements. Often fund management is, at minimum, obligated to provide German investors with the financial information, which is required for the German return filing. However, if each investor organizes the filing process separately there is a risk of inconsistent or contradicting return filings and the process is not cost-efficient. Moreover, the fund may have to disclose information about individual German investors to every German investor. Therefore, we generally recommend having the German partnership return filing organized by the fund management. The management’s return filing legally exempts the German partners from their filing obligation. The relating costs should be collectively borne by the German investors.
German CFC and PFIC rules can trigger additional filing requirement
If one of the target investments, subsidiaries, or a blocker corporation, qualifies as controlled-foreign-corporation (CFC) under German laws, its low-taxed passive income has to be reported on a separate tax return. The German CFC-rules include regulations regarding passive-foreign investment corporations (PFIC).
The application of German CFC-rules results in an income inclusion of low-taxed “passive income” for the German investors regardless if funds have been distributed to the fund or the investor. Passive income such as interest income is considered to be “low-taxed” if the effective total income tax burden on the specific kind of income is less than 25%.
The rules apply to low-taxed passive income in the following cases:
- The entity in question qualifies as a foreign corporate entity according to German laws.
- German tax residents own directly, indirectly, or constructively more than 50% of the shares in the corporation in question. The German law does not provide a minimum shareholding for each German shareholder for the application of the CFC-rules.
In a case of certain passive investment-related income sources amounting to at least 10% of the corporation’s total income and exceed 80,000 EUR, even German ownership of 1% or less can trigger the German CFC-rules.
The German CFC rules typically do not apply in private equity structures with active business investments. However, given the relatively high threshold for a ‘low taxation’ of 25%, investment structures should be analyzed carefully in order to meet the German compliance requirements as well as potential obligations in side-letter agreements with German investors.