Carried interest payments are highly significant, particularly in international private equity and venture capital investments. As soon as fund structures are designed cross-border, or a relocation to another country (in our case: from Germany to the U.S.) is imminent, the question arises as to which country has the right to tax these payments. We explain why the correct categorization of the fund structure is crucial to answering this question.
Carried interest as a share of profits in international tax law
Carried interest refers to the disproportionate share of profits that fund sponsors receive for their special contribution to the investment’s success. Although German law qualifies this profit share as income from self-employment, this is purely a domestic legal fiction. For international tax law, particularly the double taxation agreement (DTA) between the U.S. and Germany, this domestic regulation is not irrelevant. In fact, we believe that carried interest payments are not rooted in compensation for services, but rather in the partner status and the distribution of profits disproportionate to capital.
Carried interest case law strengthens categorization as a profit share
German case law supports this assumption for cross-border scenarios. In several decisions, the Federal Fiscal Court (BFH) has clarified that carried interest payments from asset-managing funds must be treated as profit shares and not as compensation for services (BFH, judgment of April 16, 2024, VIII R 3/21; BFH, judgment of December 11, 2018, VIII R 11/16). Furthermore, the Schleswig-Holstein Fiscal Court expressly ruled that the domestic categorization under Section 18 of the German Income Tax Act (EStG) is not binding for the Germany-U.S. double taxation agreement. Instead, the actual fund income (which generally consists of capital gains, dividends, or interest) remains decisive (FG Schleswig-Holstein, judgment of October 8, 2024, 3 K 37/22).
Relocation to the U.S.: shift of taxation rights under the DTA
One of our clients was a German resident for many years and held interests in various Limited Partnerships (LPs) in the U.S. and the Cayman Islands. From a German perspective, these qualified as asset-managing partnerships, and the carried interest payments were taxable in Germany.
However, after the client relocated to the U.S., the right to tax these profit shares shifted entirely to the U.S. under the U.S.-Germany DTA. Germany then only took them into account to determine the applicable tax rate (progression clause) because an unlimited tax liability continued to exist in Germany. The decisive factor for this outcome was that the LP structure was correctly categorized as an asset-managing partnership – a point that we always review comprehensively for our clients in practice.
Special tax consequences for commercial partnerships
On the other hand, significant tax consequences can arise – particularly in connection with a relocation from Germany – if the structure is not an asset-managing partnership. This applies, for example, to a commercial entity or a company that generates commercial income within the meaning of § 15 EStG, or even an investment fund within the meaning of the German Investment Fund Act (InvStG):
- If the fund sponsor relocates their residence abroad and the permanent establishment previously located in Germany is deemed to have been relocated as well for tax purposes, this can lead to a substantial tax burden. The reason for this is a special type of exit taxation (Entstrickungsbesteuerung). Under this rule, pro-rata, previously unrealized capital gains on the target companies held by the fund are treated as a fictitious sale and must be taxed accordingly at the investor level.
- In addition, an exit tax can be triggered if a partnership exists but fulfills the requirements of a (special) investment fund due to its specific structure as a “segregated asset” (Sondervermögen) and other characteristics. In this case, unrealized appreciation may be subject to taxation pursuant to Section 19 (3) InvStG or Section 49 (5) InvStG in conjunction with Section 6 of the German Foreign Tax Act (AStG).
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Even without a relocation, the correct tax categorization of both ongoing and already received income is of essential importance. Investment funds are subject to special tax rules under which certain income is deemed to have been received regardless of an actual distribution. This income must be declared and taxed at the investor level (specifically, “distribution-equivalent income” or the “advance tax allowance”).
Tax categorization of the fund structure and international taxation rights
Our experience shows that the tax treatment of carried interest depends heavily on the correct structural categorization of the fund. Anyone investing cross-border or planning a relocation should have the tax qualification of the fund company and the respective country’s taxation rights reviewed at an early stage.
Ambiguities such as the existence of permanent establishments, exit taxation, or the categorization of foreign LP structures should ideally be coordinated with the German tax authorities in advance, or at least within an explanatory cover letter to the tax return. In certain cases, structures may also constitute so-called special investment funds under the InvStG. This carries far-reaching implications, such as a possible exit tax on special investment fund units, which was introduced by the legislature effective January 1, 2025.
Customized tax advice with WINHELLER
Do you receive carried interest payments from U.S. or other third-country structures and want to clarify which country has the right to tax them? Do you want to know whether your fund structure actually qualifies as an asset-managing partnership from a German perspective? Are you planning a relocation and want to avoid tax disadvantages or double taxation? Our Private Clients team will be pleased to assist you with a customized analysis and structuring.
