The mid-sized German private equity scene is mainly centered in Munich. Until recently, local financial investors felt comfortable in the Bavarian capital. However, for some time now, the Munich public prosecutor's office, fed by tax auditors from the tax office, has been investigating around 20 addresses – including consultants, managers, and founders – on suspicion of tax evasion. The question at hand is whether the business practices of private equity firms justify their long-standing and advantageous tax status as asset managers with funds in Luxembourg – or whether they are actually engaged in commercial activities. According to financial sources, there was a raid on a law firm in Berlin about a year and a half ago that had set up many of the fund structures now under investigation or had at least provided legal advice. Several thousand data records were seized. But no charges have been filed to date.

The classification as "privately asset-managing" is the crucial basis for enabling such private equity funds in Germany – or rather, making them "investable" for foreign investors. Because if these funds were deemed commercial, these investors would be treated as if they were participating in a commercial enterprise. This commercial status would require these investors to declare and pay taxes on their income from the affected funds in Germany and file tax returns here. Such a scenario is highly uncommon within the realm of capital investment, almost singular globally, and would probably not be embraced in principle by relevant investors, like US pension funds. Consequently, the position of Germany as a fund location is also at risk.

The Munich I Public Prosecutor's Office remains tight-lipped about the progress of the investigations. "Since tax offenses may be involved, we cannot provide any information due to tax secrecy under the Tax Code", said a spokeswoman for the agency. The legal basis is Section 30 of the Tax Code, which stipulates that officials must maintain tax secrecy.

Due to the complexity of the matter, the proceedings have been ongoing for several years. In particular, the review and evaluation of seized business documents and digital datasets with email traffic is time-consuming. The authority itself initiated criminal proceedings in the matter in the fall of 2020, meaning that specific investigations were launched. Preliminary investigations had started in 2019. As is usual in such cases, the tax investigation unit is also involved.

In June 2022, the Börsen-Zeitung reported exclusively on the case for the first time. About 20 private equity fund companies, mostly located in the Bavarian capital, are under suspicion. Specifically, investigators are examining whether these companies and their managers may have evaded corporate, trade, and capital gains taxes for years to the advantage of foreign capital participation companies, mainly based in the UK and Luxembourg. If charges are brought by the public prosecutor's office, the competent courts – particularly, the Munich I Regional Court and the Munich Tax Court – would have to examine the documents for admissibility to initiate possible proceedings in front of economic crime chambers.

Private equity firms and their advisors fear that the tax authorities and the Munich public prosecutor's office may interpret and apply the sometimes unclear formulations of the old Federal Ministry of Finance (BMF) letter from December 2003 differently or more strictly than the existing and almost 40-year-old practice. "The mentioned BMF letter states, among other things, that the private equity fund and its management may not participate in the active management of the portfolio companies", says a longtime and experienced advisor who wishes to remain anonymous. "The private equity fund will only be treated as asset management for tax purposes if this and a number of other criteria are fulfilled, resulting in the fund and its investors being taxed as capital investors." This means that the fund is not subject to taxation, and the respective investor is only taxed in their country of residence and not in the location country of the respective fund.

However, if the fund is treated tax-wise as a commercial enterprise – as is customary, for example, for a printing company or a screw trading company – the fund is subject to trade tax, and foreign investors are subject to taxation and tax filing obligations in Germany. "This is completely unusual in the field of capital investments worldwide and breaks existing assessments in international tax law", warns the advisor. "The prosecutorial investigations are unjustly criminalizing a practice that has been implemented in good faith for years and accepted by the tax authorities. This primarily affects a number of managers in this area who have been subjected to an ongoing investigation for years and have to live with the fear of imprisonment for tax evasion." This development and the resulting uncertainty also have considerable adverse effects on the fund's presence in Germany.

The Federal Ministry of Finance (BMF) in Berlin has "no information" on "individual criminal tax proceedings" in the private equity sector, according to a spokeswoman. Unlike in the private equity industry, the legal situation is not perceived as problematic by the BMF. "The differentiation between asset-managing and commercial funds is legally feasible on a case-by-case basis, using the criteria outlined in the BMF letter on the income tax treatment of venture capital and private equity funds (referred to as the Private Equity Directive) dated December 16, 2003", the spokeswoman explained further.

In practice, the federal states and their tax authorities are responsible for specific tax cases. BMF letters are issued by the Federal Ministry of Finance in coordination with the states to ensure a uniform interpretation of tax laws throughout Germany. Nonetheless, both the federal government and states are constrained by certain limits on legislation and subordinate regulations, such as BMF letters, which are established by judicial precedents, such as those of the Federal Fiscal Court, and by European directives in subsidy law.

The distinction between tax-exempt asset management and taxable commercial activity is currently relevant in another context in Berlin. The Growth Opportunities Act, which was referred to the mediation committee following resistance from the states, deals with issues concerning investments in renewable energies and infrastructure by open-end funds. The Fund Association BVI has highlighted early on that such financings, desired by the government, will only succeed with a legally secure tax framework for the status of asset management. The mediation committee is scheduled to meet on February 21st.

The lobbying efforts of the private equity and venture capital sector in Berlin are expected to prioritize the tax issue. However, the industry association BVK declined to comment on the matter when approached. It's not unusual for BMF letters, like the Private Equity Directive, which are over 20 years old, to undergo revision. But there are currently no indications of this occurring, although it could potentially enhance the appeal of Germany as a financial hub.