Investments by family offices and asset management firms in private equity firms are typically tax-neutral; however, in fund practice, the repayment of such capital contributions is often wrongly taxed as a “return of capital” for tax purposes.
Return of Capital for Investments in Foreign Private Equity Funds
A popular investment strategy among German family offices and asset management firms involves private equity funds, most of which are based abroad. In particular, the use of partnerships as investment vehicles in combination with private equity funds not based in Germany is a common practice, as partnerships are generally treated as fiscally transparent. This means that income is taxed at the level of the partners, which allows for a certain degree of flexibility in taxation. Before the investment funds raised from the participants are actually allocated to individual investment targets, a holding corporation is typically interposed, through which direct investments in operational targets are made.
However, this investment structure is not entirely free of tax risks and pitfalls. A key issue from a tax perspective is the return of capital contributions—that is, the repayment of capital contributions to the partners or investors. Particularly in cross-border situations—when the private equity fund is domiciled outside Germany—various tax issues can arise. The transparency of taxation for partnerships means that any return of capital to the holding corporations that invest directly in the OpCo is treated for tax purposes as having been received by the partners.
Tax Treatment of a Return of Capital
In the case of domestic German transactions, the treatment of contributions not paid into the par value is governed by § 27 of the German Corporate Income Tax Act (KStG). Since these contributions were originally provided as equity, the repayment of equity should not be treated as taxable income for the shareholders. Contributions not paid into the par value capital are determined annually and assessed separately by the tax office. Pursuant to § 27(1), sentence 3, of the German Corporate Income Tax Act (KStG), the tax contribution account may only be drawn upon after distributable profits have been distributed, regardless of any resolution under civil or commercial law that may be effective to reduce, for example, a capital reserve. In principle, this is intended to allow funds (capital contributions) contributed to a company on a tax-neutral basis to be distributed or withdrawn tax-free; the so-called tax order of use regulates the timing.
Complications Involving Foreign Investments
This highly formalistic procedure for verifying capital contributions becomes problematic in practice when German shareholders represent only a very small free-float percentage in private equity investments. Typically, foreign companies are not required in their respective countries of incorporation to maintain capital contribution accounts or to certify the repayment of capital contributions. While a confirmation of capital repayment could be relatively easily agreed upon and implemented in side agreements to the investment commitment, this is inconceivable for a capital contribution account under German tax law principles. From a business perspective, the additional effort required of the fund companies is unlikely to be worthwhile. German investors are generally aware of this structural lack of disclosure and accept it in light of the commercial prospects.
At the same time, a stricter provision in Section 27(8) of the German Corporate Income Tax Act (KStG), in effect since 2023, results in de facto double taxation specifically for German shareholders unless ancillary agreements regarding the return of contributions are arranged in advance. According to Section 27(8) of the German Corporate Income Tax Act (KStG), the prerequisite for recognizing a return of capital in accordance with German law would be, first, that the fund company in question perform a shadow calculation of the notional capital account under German tax law and, second, that it apply to the Federal Central Tax Office for treatment as a return of capital. This approach regularly fails due to the lack of economic viability and tax expertise on the part of the fund companies. In addition, the application deadline is only twelve months after the end of the fiscal year in which the distribution or return of capital took place. In practice, this means that, due to purely formal requirements, the actual return of capital to the German shareholder must be treated as a regular profit distribution, resulting in income taxation of tax-neutral invested assets.
Possible Solutions
Side-letter agreements entered into at the time the investment is concluded may, where appropriate, offer a solution to this disadvantage faced by German shareholders, in which it is explicitly agreed that the holding corporations will not repay capital contributions. If possible—though this is likely achievable only in a few cases—an agreement could also be reached requiring the fund companies to file the necessary applications on behalf of the German shareholders in order to prevent taxation on the net asset value. Another possible option for addressing such tax-disadvantageous capital return scenarios would be to structure the transaction as an actual repurchase of shares, which would result in a genuine capital gain, whereby the amount contributed could also be treated as acquisition cost and deducted to reduce taxable income.
