Britain's Prime Minister Gordon Brown may take some comfort from the fact that he is not alone in receiving calls to review and reshape the domestic regulatory and tax environment of private equity. According to an agreement between the German coalition government parties, private equity investment companies will be granted tax benefits amounting to E500m (£336m) per annum in Germany as of 2008. Similar measures have been discussed among experts for a considerable time in Germany, in order to stimulate the market.

So far, however, the German tax administration has been reluctant to accept a reform proposal fearing that losses of tax revenue would arise. Now the German federal ministry of finance has decided to publish a first draft of the so-called Venture Capital Investment Act (Wagniskapitalbeteiligungsgesetz) in due course. The planned Act is not intended to apply to all private equity investment companies, however, but will target companies for investments into young, medium-sized entities, so-called venture capital investment companies (Wagnisbeteiligungsgesellschaften) only.

Such companies are regarded to be beneficial in order to enhance future technical innovation and economic growth. Furthermore, the scope of companies benefiting from the new regime will be limited to those companies whose individual shares amount to at least E50,000 (£34,000). The Act is planned to come into effect at the same time as the German Business Tax Reform Act (GBTRA). The GBTRA contains several changes in tax law which adversely affect, in particular, young, medium-sized entities as of 1 January, 2008.

As a general precondition, venture capital investment companies have to be acknowledged by the German Federal Financial Supervisory Authority (BaFin) and their investments may only be made in corporations with a seat and place of effective management in one or several contracting states of the European market. In addition, these corporations must not have an equity value in excess of E20m (£13m), must not have existed for more than 10 years at the time of investment and must not have securities issued and traded on a regulated or equivalent market.

The tax benefits for those venture capital investment companies which do qualify under these criteria will be twofold: firstly, upon several requirements a trade, or business triggering German trade tax shall not exist at the level of the investment company thereby ensuring a tax-transparent status. Secondly, tax loss carry-forwards existing at the level of qualifying portfolio companies shall not be forfeited upon acquisition or sale by a venture capital investment vehicle. Both benefits shall depend on several requirements being met according to the Act.

As the proposals currently stand, the planned tax benefits offer minor improvements. Under the current tax law, private equity as well as venture capital funds may prevent the payment of trade tax under German tax law if they comply with a guidance letter of the German Federal Ministry of Finance outlining the scope of activities considered as pure private asset management only.

If the requirements of the guidance letter are met, a tax-transparent status of the fund for German tax purposes is ensured. Even though various aspects of the guidance letter are still not clear, the industry has effectively managed to avoid paying trade tax by relying on this.

The provisions in the Venture Capital Investment Act set up a statutory framework under which trade tax may be avoided in this context for the first time. However, the requirements under the new provision are not entirely precise and therefore leave considerable uncertainty – something that affected parties would be well advised to take advice on in the near future.

The preservation of tax loss carry-forwards existing at the level of portfolio companies having a corporate form upon acquisition or sale has been and still is – under several but to a large extent still unclear requirements relating to the so-called business asset test – possible. However, it will be abolished by the German Business Tax Reform Act as of 2008. Under its rules, tax-loss carry-forwards existing at German corporations will be forfeited partially if more than 25% of the corporation's shares are transferred within five years and will be forfeited entirely if more than 50% of the corporation's shares are transferred during this time.

The Venture Capital Investment Act, therefore, only restores the previous status quo. However, it has be acknowledged that the business asset test will not apply any more.

In essence, the new investment vehicle for venture capital is to be appreciated as a small first step in the right direction. So far, however, the tax benefits and the clarifications of the tax framework are too limited, and do not properly mitigate the regulatory burden of the new investment vehicle.

Frank Tschesche is a partner at Dewey Ballantine in Frankfurt.