How the Bavarian taxman has spooked the region’s private equity industry

In Munich, capital of the southeastern German state of Bavaria, a situation is playing out within the private equity industry there that has got some practitioners nothing short of spooked.

Affiliate title Private Equity International has been told there are at least four private markets firms under investigation on suspicion of tax evasion by omission, that is, that they fail to comply with tax filing obligations in Germany due to their offshore fund structures.

Tax disputes are hardly unheard of in the financial services world, but industry insiders tell PEI these cases are far from run of the mill. For one thing, the cases feature shifting goalposts when it comes to the interpretation and application of tax law.

For another, there have been reports of private markets firm founders spending time in the local lock-up.

Lawyers we spoke to said firms they are advising are having discussions on whether they should stay in Munich or leave.

Bavaria’s tax authority has been probing PE firms for tax evasion since 2015, focusing on their favor of low-tax foreign jurisdictions. Authorities have not said what prompted these tax investigations but one clue may lie in what’s known as the cum-ex scheme – a tax scandal in which banks and investors in Germany and other EU countries used a form of dividend arbitrage to claim multiple tax rebates for the same dividend payout. Since that scandal – the loophole was closed in 2012 – tax authorities in Germany have become much more active in their audits of international transactions, sources tell PEI. While the scandal was not related to the private equity industry, further cross-border tax fraud probes have taken place since then, the sources say.

Munich’s tax authority now appears to be taking issue with private equity’s use of offshoring. Specifically, the core issue here centers around the effective place of management of a business and the exact site of value creation. The authority claims that fund structures set up abroad are in fact managed in Germany. In these cases, the Munich tax investigation unit has been looking into whether the directors installed in a foreign jurisdiction are simply there to sign documents, while the place of management and day-to-day business decisions are made in Germany. If deemed to be so, it follows that taxes in Germany have therefore not been paid properly by the German-managed fund.

It is common for fund structures to be set up in jurisdictions that are different from where investment teams are based, a London-based partner at a global law firm tells PEI.

“That is often a function of the private capital industry being international in nature, so investment teams will be spread across a number of different jurisdictions. But it has also been a longstanding requirement to show that: the regulatory activity of advice or management is being carried out in the right jurisdiction; that the economic substance of any activity in the jurisdiction where the fund/GP/management vehicle are domiciled – eg, Luxembourg or the Channel Islands – can be clearly demonstrated.”

This means showing that investment decisions are actually made there, with senior decision-makers present at the meeting, and that there is proper remuneration for any investment advisory services from the investment team, the partner adds.

This burden often doesn’t apply to global firms and pan-European firms, PEI understands. Their ‘fly-in fly-out’ business model means decisions on multi-billion-euro or dollar deals are often done by people flying in from places such as New York or London where such firms may be headquartered, sources point out.

Mid-market in the crosshairs

PEI understands several well-known, mid-market private equity firms are engaged in discussions with Munich’s tax authority on offshore fund domicile or the legal jurisdiction in which an investment fund is incorporated and operates – a component of fund structuring that has largely been accepted in the industry over many decades.

The tax authority in Munich began investigating foreign fund structures used by German residents from 2015. The proceedings started normally also as a tax audit, while some of the cases developed into investigations. PEI understands many of these cases are still pending.

A tax assessment is either accepted by the firm or contested via a court proceeding, which usually ends in a settlement. Munich’s tax authorities appear to have taken a different direction in some cases by effectively starting criminal investigations, rather than treating them as tax audits.

With so many mid-cap private equity funds having their advisers based in Munich, this has become a huge issue for the industry, says Christian Hollenberg, founding partner at Perusa, a Bavaria-based mid-market firm.

As more LPs discover this, it could affect their appetite for German private equity structures, according to Hollenberg.

Perusa exited its latest fund’s assets in 2022 and will now shy away from launching any international private equity structures in Bavaria. “If you do that, you’re doing so with one leg in jail, the way it is now,” Hollenberg says. “That is going to be a total shift in the LP environment.”

Another Munich-headquartered fund manager says private equity firms in the state are facing an about-turn in how offshore fund structures are treated.

“It’s a really unpleasant situation,” the fund manager says. “It’s not people intentionally avoiding tax, it’s doing things by the letter of the law for 15 years and then suddenly being told [by the tax authority], ‘We’re going to review it’ with no legal justification.”

PEI understands there are about 150 investment firms based in Munich, including 85 buyout or growth firms and 75 venture capital firms.

Ascertaining ‘place of management’

Germany’s General Tax Code defines the place of management as the “center of the business management,” that is, “where the relevant will of the management is formed and the measures of some importance necessary for the management are ordered.” The place of management is decisive, where business activities are carried out for the normal operation and day-to-day management of the business.

Germany-based private equity practitioners PEI has spoken to say they are perplexed as to why there is now uncertainty around how Munich’s tax authority is interpreting the law in terms of where value is created and who is subject to German tax filings. “Unique,” “nonsense” and “totally bizarre” are how participants have defined the situation, in discussions with PEI.

The authority’s view also appears to differ from the consensus on fund structuring around the world. Cross-border fund structures have been a component of private equity funds for decades, used to entice a diverse group of investors to commit to their funds. Another driver for utilizing offshore structures is that the vehicles can be used to optimize investor participation in a fund, particularly for those that fall into tax exempt or overseas categories.

Two Germany-based lawyers PEI spoke to who are advising their clients on a number of active investigations say the situation doesn’t follow established legal principles. As one noted, it would have been much easier for all parties if they had gone into a tax dispute. As a criminal matter, the justice ministry is involved, which makes it lengthier and more complicated, the lawyer said.

To add another layer of complexity, the local tax offices operate independently and administer taxes without the supervision of Germany’s Federal Central Tax Office. The Federal office also cannot influence the outcome or take over any tax cases – this is not allowed under constitutional law, lawyers tell us.

For its part, Munich’s tax authority says it is simply carrying out its raison d’être.

“In Germany, the tax administration has the task of assessing all companies – regardless of sector – in accordance with the applicable federal law; this applies not only to the Bavarian tax administration, but to all state administrations,” a spokesperson from Bavarian state’s tax office told PEI. “Bavaria continues to work to maintain, strengthen and promote the attractive conditions of Bavaria as a business location.”

And what of the German Private Equity and Venture Capital Association? PEI understands its hands are tied and that it will not interfere in any ongoing prosecution processes. It did, however, publish a statement in mid-February calling for the introduction of a clear legal framework on tax transparency. It urged Germany’s Federal Ministry of Finance (BMF) to “act quickly” and fix tax transparency in law, arguing that the BMF should take into account the development of the fund management business and its market reality.

“This current situation leads to legal uncertainty and, in the worst case, to the absence of international investors,” the Bundesverband Beteiligungskapital (BVK) wrote. “[This is] a situation that has a lasting impact on the mobilization of private capital to finance the challenges of transformation and inhibits growth.”

The BVK did not comment when approached for this article.

Most participants PEI has spoken to note that the lengthy investigations are likely to harm Germany as a place for private equity, where capital commitments may fail to materialize and worse, that private equity managers might leave Bavaria. Others think that it is par for the course that the authorities review fund structures in the best interests of appropriate legal taxation.

Do the lawyers have any advice for firms, at a moment when the outlook for the Bavarian private equity industry itself looks uncertain?

“First, if they want to continue operating in Munich, I will conduct a due diligence of their process to make sure they can’t really be attacked,” says one legal expert who advises concerned clients. “Second, sometimes it might be better to just leave Bavaria as this trend continues here.”

– Adam Le contributed to this report