White & Case LLP - News - Germany Prepares for Changes in the Private Equity Market

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Germany Prepares for Changes in the Private Equity Market
A Q&A Discussion with Partner Christoph v. Einem on Private Equity Framework Conditions in Germany
July 2007

The German Federal Ministry for Finance has published a first draft of the "Act for the Modernization of the Framework for Capital Participations" that is slated to go into effect, along with the corporate tax reform, at the beginning of 2008. The following Q&A, with Christoph v. Einem who is a partner in the Munich office and co-author of the expert opinion prepared on behalf of the Federal Ministry of Finance, discusses the role and need for private equity financing in Germany, which currently does not have an established legal or tax framework for such funding, in addition to the advantages of a Private Equity Act that would encourage the use of private equity capital in the German economy.

Q: The expert opinion prepared on behalf of the Federal Ministry of Finance concludes that private equity clearly has a positive impact on the economy as a whole. Does the Federal government still need convincing?

Christoph: Private equity as an alternative financing source is not only needed to finance most technology-based start-ups, which would otherwise leave Germany, as correctly observed by the Federal Chancellor, but also to provide equity to small and medium-sized companies in Germany to enable growth financing or to manage a corporate crisis. Further, under the aspect of a company's succession planning and spin-offs, private equity helps to establish and maintain separate corporate units and thus a wider range of suppliers of products and services. Our expert opinion shows how this will result in creating and maintaining jobs on a disproportionate basis. By introducing strategic and operative measures, private equity investors are able to enhance the profitability of companies, thus fostering a sustainable competitiveness of companies financed by private equity in Germany. Politics should exploit the positive impacts of private equity in Germany. Additional convincing, beyond the Federal Ministries of Finance and Economics, is still necessary.

Q: Why is a Private Equity Act necessary?

Christoph: At this point Germany has no competitive legal and tax framework. This is supported by a study of the European Venture Capital Association, in which Germany ranks 25th among 30 countries and is referred to as a "slowing country." To ensure that most of the monies of German private and institutional investors will not be invested in funds domiciled in European countries other than Germany due to more favorable framework conditions, the framework conditions applicable for German funds and their management must be significantly improved. This would benefit the German economy without spending tax money.

Q: What would have to be included in a competitive Private Equity Act?

Christoph: A Private Equity Act should focus on creating an investment vehicle whose tax transparency is ensured so that the investment companies themselves will not be subject to trade or corporate tax with respect to private equity capital. The income generated by the funds should be taxed at the level of the investors as dividends or capital gains as if the investors had directly invested in the portfolio companies of the funds. In addition, any payments between the funds and companies advising them should be exempt from VAT as in other countries. This would eliminate tax discrimination of funds domiciled in Germany as compared to funds registered in other member states of the European Union.

Q: Should these tax provisions apply to all portfolio companies?

Christoph: For reasons of investor protection and to ensure a certain transparency of the private equity industry, a license should be required for funds and their managers. In addition, a Corporate Governance Code should be established by the private equity industry and the private equity funds should be required to confirm compliance every year by issuing a statement to this effect.

Q: How should any abuses, such as excessive debts or burdening the portfolio companies with unrelated costs, be prevented?

Christoph: The practice of some financial investors to recover the equity capital provided by them by way of special loan-financed dividends as soon as possible from their portfolio companies is certainly questionable. There are legal measures available even today, but not often used to combat this. This applies also to cost burdens, which in part fulfill the requirements of an illegal breach of trust, but would have to be treated at least as hidden profit distributions. The financing banks play a key role in assessing the risks associated with such financing. Currently they are very willing to take risks. The tendency of the financing behavior of the banks will have to be observed and this issue should, in the same way as hedge funds, be negotiated at the G7 level. This is a task for international policy.

Q: What is the impact of the corporate tax reform in this context?

Christoph: The Federal government is right in linking the Private Equity Act to the corporate tax reform. Both laws are aimed at enhancing private equity financing in the German economy. Only the proposed flat rate withholding tax is counterproductive. By treating income from debt and equity capital investments equally, legislation will drive investors from the equity capital market to the debt capital market. In this respect an internationally acceptable tax rate of not more than 20 percent for equity capital investments and approximately 30 percent for interest income would appear more reasonable. The flat rate withholding tax on income from investments and private sales transactions will disadvantage equity capital more than debt capital and will further impair the attractiveness of venture capital. By facilitating financing at an early stage in combination with a competitive framework, there will be a great chance that the arrangers of funds will domicile their funds in Germany and that the monies invested in the funds will also increasingly find their way to German companies.

Q: What is the further time schedule?

Christoph: The Federal Ministry for Finance has published a first draft of the "Act for the Modernization of the Framework for Capital Participations," which ought to become effective together with the corporate tax reform at the beginning of 2008. The draft only allows for a tax relief of venture capital companies, but not a top-to-bottom reform for all investors as originally planned. It remains to be seen to what extent a comprehensive body of regulation will be finally put into legislation.

Christoph v. Einem, partner based in White & Case's Munich office, advises mainly in the areas of corporate law, mergers & acquisitions, private equity/venture capital as well as merger control. He may be reached at cvoneinem@whitecase.com.

"Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with Dr. v. Einem, contact Reilly Starr at rstarr@whitecase.com.

Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.

	In the Media
Expertise Mergers & Acquisitions Corporate Private Equity Tax Lawyers Prof. Dr. Christoph von Einem Locations Munich	Germany Prepares for Changes in the Private Equity Market A Q&A Discussion with Partner Christoph v. Einem on Private Equity Framework Conditions in Germany July 2007 The German Federal Ministry for Finance has published a first draft of the "Act for the Modernization of the Framework for Capital Participations" that is slated to go into effect, along with the corporate tax reform, at the beginning of 2008. The following Q&A, with Christoph v. Einem who is a partner in the Munich office and co-author of the expert opinion prepared on behalf of the Federal Ministry of Finance, discusses the role and need for private equity financing in Germany, which currently does not have an established legal or tax framework for such funding, in addition to the advantages of a Private Equity Act that would encourage the use of private equity capital in the German economy. Q: The expert opinion prepared on behalf of the Federal Ministry of Finance concludes that private equity clearly has a positive impact on the economy as a whole. Does the Federal government still need convincing? Christoph: Private equity as an alternative financing source is not only needed to finance most technology-based start-ups, which would otherwise leave Germany, as correctly observed by the Federal Chancellor, but also to provide equity to small and medium-sized companies in Germany to enable growth financing or to manage a corporate crisis. Further, under the aspect of a company's succession planning and spin-offs, private equity helps to establish and maintain separate corporate units and thus a wider range of suppliers of products and services. Our expert opinion shows how this will result in creating and maintaining jobs on a disproportionate basis. By introducing strategic and operative measures, private equity investors are able to enhance the profitability of companies, thus fostering a sustainable competitiveness of companies financed by private equity in Germany. Politics should exploit the positive impacts of private equity in Germany. Additional convincing, beyond the Federal Ministries of Finance and Economics, is still necessary. Q: Why is a Private Equity Act necessary? Christoph: At this point Germany has no competitive legal and tax framework. This is supported by a study of the European Venture Capital Association, in which Germany ranks 25th among 30 countries and is referred to as a "slowing country." To ensure that most of the monies of German private and institutional investors will not be invested in funds domiciled in European countries other than Germany due to more favorable framework conditions, the framework conditions applicable for German funds and their management must be significantly improved. This would benefit the German economy without spending tax money. Q: What would have to be included in a competitive Private Equity Act? Christoph: A Private Equity Act should focus on creating an investment vehicle whose tax transparency is ensured so that the investment companies themselves will not be subject to trade or corporate tax with respect to private equity capital. The income generated by the funds should be taxed at the level of the investors as dividends or capital gains as if the investors had directly invested in the portfolio companies of the funds. In addition, any payments between the funds and companies advising them should be exempt from VAT as in other countries. This would eliminate tax discrimination of funds domiciled in Germany as compared to funds registered in other member states of the European Union. Q: Should these tax provisions apply to all portfolio companies? Christoph: For reasons of investor protection and to ensure a certain transparency of the private equity industry, a license should be required for funds and their managers. In addition, a Corporate Governance Code should be established by the private equity industry and the private equity funds should be required to confirm compliance every year by issuing a statement to this effect. Q: How should any abuses, such as excessive debts or burdening the portfolio companies with unrelated costs, be prevented? Christoph: The practice of some financial investors to recover the equity capital provided by them by way of special loan-financed dividends as soon as possible from their portfolio companies is certainly questionable. There are legal measures available even today, but not often used to combat this. This applies also to cost burdens, which in part fulfill the requirements of an illegal breach of trust, but would have to be treated at least as hidden profit distributions. The financing banks play a key role in assessing the risks associated with such financing. Currently they are very willing to take risks. The tendency of the financing behavior of the banks will have to be observed and this issue should, in the same way as hedge funds, be negotiated at the G7 level. This is a task for international policy. Q: What is the impact of the corporate tax reform in this context? Christoph: The Federal government is right in linking the Private Equity Act to the corporate tax reform. Both laws are aimed at enhancing private equity financing in the German economy. Only the proposed flat rate withholding tax is counterproductive. By treating income from debt and equity capital investments equally, legislation will drive investors from the equity capital market to the debt capital market. In this respect an internationally acceptable tax rate of not more than 20 percent for equity capital investments and approximately 30 percent for interest income would appear more reasonable. The flat rate withholding tax on income from investments and private sales transactions will disadvantage equity capital more than debt capital and will further impair the attractiveness of venture capital. By facilitating financing at an early stage in combination with a competitive framework, there will be a great chance that the arrangers of funds will domicile their funds in Germany and that the monies invested in the funds will also increasingly find their way to German companies. Q: What is the further time schedule? Christoph: The Federal Ministry for Finance has published a first draft of the "Act for the Modernization of the Framework for Capital Participations," which ought to become effective together with the corporate tax reform at the beginning of 2008. The draft only allows for a tax relief of venture capital companies, but not a top-to-bottom reform for all investors as originally planned. It remains to be seen to what extent a comprehensive body of regulation will be finally put into legislation. Christoph v. Einem, partner based in White & Case's Munich office, advises mainly in the areas of corporate law, mergers & acquisitions, private equity/venture capital as well as merger control. He may be reached at cvoneinem@whitecase.com. "Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with Dr. v. Einem, contact Reilly Starr at rstarr@whitecase.com. Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.