VAT Exemption for Venture Capital Funds
The so-called Act to Strengthen Germany as a Fund Jurisdiction added an exemption to the German VAT Act from VAT for management services rendered to “venture capital funds” (Wagniskapitalfonds) with effect from 1 July 2021. To date, however, it has been largely unclear how the tax authorities interpret the term “venture capital fund” (Wagniskapitalfonds), which is not defined by law, and what type of funds are to be covered by this new VAT exemption.
Now, the Federal Ministry of Finance (BMF) has published a draft of the long-awaited supplement to the German VAT Regulations. Below we summarize material points regarding the definition of the term “venture capital funds” from the draft regulations.
- The tax authorities consider “venture capital funds” (Wagniskapitalfonds) to be, in particular, private equity or venture capital funds that invest predominantly in young SMEs (small or medium-sized enterprises) based within the EU or the EEA in the early stages (seed, early, expansion stage).
- Under these conditions, in particular EuVECA funds should qualify as “venture capital funds”. Special funds (Spezial-AIF) must demonstrate that they compete with UCITS (undertakings for collective investment in transferable securities) and are subject to special governmental supervision to qualify as “venture capital funds”.
- The management of AIFs that do not invest in venture capital is still subject to VAT. The narrow view of the German tax authorities in this respect is questionable under EU law and results in Germany remaining a disadvantageous location for investment funds.
According to § 4 No. 8 lit. h var. 3 of the German VAT Act, management services rendered to “venture capital funds” are exempt from VAT. Prior to the introduction of this provision, the VAT exemption under domestic law was only applicable to management services rendered to undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIF) that resemble UCITS.
The German legislature recognized that this provision – which is very restrictive in the international context – represents a substantial disadvantage for Germany compared to other European countries. For example, in Luxembourg management services rendered to all types of open-ended and closed-ended funds are exempt from VAT (Art. 44 No. 1 lit. d of the Luxembourg VAT Act). The VAT exemption for management services rendered to “venture capital funds” was created with the objective of eliminating this disadvantage for Germany.
The draft of the Federal Ministry of Finance provides that certain AIF, in particular (but not exclusively) “qualifying venture capital funds” within the meaning of the EuVECA Regula-tion (EuVECA funds), are to be regarded as “venture capital funds” under the new law.
However, to benefit from the VAT exemption an AIF must satisfy the following criteria:
- The AIF must invest more than 50% in young, innovative growth companies (target companies) that meet the following requirements: It follows that it is not detrimental to the qualification of an AIF as a “venture capi-tal fund” if the AIF invests less than 50% in target enterprises which do not satisfy the above requirements (a through d above).
The draft does not specify the type of “venture capital financing” or “venture capital participation”. In particular, there is no explicit limitation to equity and equity-related instruments. In addition to private equity (PE) and venture capital (VC) funds, certain debt funds (especially so-called venture debt funds) could also be covered in our view.
- at the time of the first venture capital investment, no more than 12 years of establishment of the company (seed stage, early stage, expansion stage);
- qualify as a small or medium-sized enterprise (SME) (as such term is defined under the EU Commission recommendations) at the time of the first venture capital financing;
- registered office in the European Union (EU) or in the European Economic Area (EEA) – in our view this must be satisfied at the time of the first venture capital financing as well (i.e. subsequent changes of registered office should not be detrimental);
- ongoing economic activities (with the intention of making a profit).
According to the German Federal Ministry of Finance, “venture capital funds” aim to achieve “a significant increase in the value of the target company by way of risk-bearing financing after the intended purpose of such financing has been reached, which at the time of the fund’s exit materially determines its investment return”.
In particular, this describes the typical PE/VC fund that realizes an increase in value in relation to its target companies by selling investments held in the medium to long term.
However, other funds, such as credit funds, also aim to achieve a significant increase in the value of target company in which these funds typically participate by way of profit-participating or turnover-participating interest components.
The description in item 2 above should not be regarded as a restriction by the German Federal Ministry of Finance of the definition of the term “venture capital fund”.
The capital of the AIF can flow directly or indirectly into the target companies.
This should simply clarify that an interposition of acquisition/holding companies which do not fulfil the above requirements (1. a through d above) does not jeopardize a qualification as a “venture capital fund”.
The AIF must compete with UCITS and be subject to special governmental supervision (e.g. by the German Federal Financial Supervisory Authority BaFin) or be registered as a “qualifying venture capital fund” under the EuVECA Regulation
The German tax authorities apparently assume that EuVECA funds compete with UCITS and are subject to special governmental supervision, whereas other AIFs such as special AIFs should demonstrate that these criteria are met. In our view, AIFMs registered pursuant to § 2 para. 4 of the German Capital Investment Code (so-called “subthreshold” managers) are per se subject to special governmental supervision. A requirement to provide specific evidence on a case-by-case basis would seem incorrect.
A group of investors comparable to UCITS (retail investors) is not required.
The taxable person for VAT purposes (i.e.the management company) must demonstrate to the tax authorities that the afore-mentioned requirements are met by means of suitable documentation (in parcicular binding investment restrictions).
As a precautionary measure, it is advisa- ble to take the aforementioned criteria into account when drafting the fund docu-mentation (i.e. in particular explicit restrictions in limited partnership agreements and offering memoranda).
According to the German Federal Ministry of Finance, “venture capital funds” should therefore primarily be certain PE/VC funds investing in early stages and possibly venture debt funds. AIFs with other investment strategies (e.g. PE funds investing in later stages, real estate funds, infrastructure funds, litigation fi-nance funds, etc.) are unfortunately not covered. Already during the legislative process the German Federal Ministry of Finance argued against an extension of the VAT exemption to rendering management services to all AIFs, basing this position on concerns under European law.
In our view, these concerns of the German Federal Ministry of Finance are not justified. Instead, the different treatment of other AIFs is itself questionable under European law. These AIFs differ only with regard to the respective object of investment, which, according to the case law of the ECJ on the legal basis of the VAT exemption (Art. 135 para. 1 lit. g of the VAT Directive), is not decisive and therefore, in our estimation, not a legitimate criterion for differentiation. Moreover, the requirement that a “venture capital fund” must invest more than 50% into certain eligible target companies is inappropriate and may lead to ambiguities in certain borderline cases. Unfortunately, often the only option for AIFs and their management companies that do not satisfy the criteria set forth above and which receive adverse tax assessments remains to bring legal challenges.
To truly achieve the objective of the Act to Strengthen Germany as a Fund Jurisdiction, namely to eliminate Germany’s disad-vantages as a fund jurisdiction, it is necessary to extend the VAT exemption in § 4 no. 8 lit. h of the German VAT Act to rendering management services to all closed-ended AIFs.