On the 25 January 2018, the German Federal Ministry of Finance circulated the draft of the expected guidance on the application of the new rule on the taxation of manufactured dividends (Manufactured Dividend Rule). It relates to the income from securities lending, repos and similar transactions received by investment funds to the extent these transactions are over German equities (i.e., shares, equity like profit participation rights and depository receipts). The Draft was prepared in response to inquiries from industry bodies (e.g., ISLA, Eurex Clearing).

Income within scope and tax base

The Draft confirms the broad definition of the income items subject to the Manufactured Dividend Rule. Accordingly, it comprises all income in connection with the lending or transfer of German equities payable to the lender/repo-seller/equities provider (together Lender) (i.e., the manufactured dividends, the transaction fees and the income from the investment of collateral payable to the Lender).

However, it should be noted that based on the spirit of the law only the income items from securities lending, repos and similar transactions with a term over the relevant dividend record date of the underlying German equities fall under the Manufactured Dividend Rule. The dividend record date is defined in this context as the day on which the dividends become due or payable.

Moreover, the Draft states that taxation is “capped” at the amount of the original gross dividend; this amount includes any withholding tax. This means that while technically all income items payable to the Lender fall under the Manufactured Dividend Rule, the tax base is capped at the amount of the gross dividend.

Collection of tax

The Draft states that the tax to be levied under the Manufactured Dividend Rule will, as a general rule, be collected by the way of withholding tax. Given that the German tax authorities cannot enforce withholding tax obligations outside of Germany, the Draft provides that no withholding is required if the borrower/repo-buyer/equities receiver (together Borrower) is a non-German resident.

In this case, the Lender (i.e., the investment fund) is required to file a German corporate income tax return, which declares the relevant income on the respective tax base. The competent tax office will assess the tax. Moreover, the Draft emphasizes that the Lender also has a tax filing obligation if the Borrower had a withholding tax obligation but effectively did not withhold any tax.

Treaty aspects

Unfortunately, the Draft does not state whether manufactured dividends qualify as “Dividends” under art. 10 of the OECD Convention or “Other Income” under art. 21 of the OECD Convention. The qualification is fundamental because Germany typically does not have a taxation right over “Other Income” whereas the treaty rate for portfolio “Dividends” is usually 15%.

However, the Draft does touch upon a treaty issue by clarifying that the German Borrower has to withhold tax at the applicable German statutory withholding tax rate (generally 15%). Reductions under treaties shall not be taken into account. If the Lender wishes to claim for such reduction, he has to file a respective claim with the Federal Tax Office. For the sake of simplicity, the reduction may be made in the context of the assessment procedure.

Interposition of CCPs irrelevant

In the case of transactions, in which a Central Counter Party (e.g., Eurex Clearing) is involved in the relevant transactions by way of novation, the Draft disregards this interposition by applying an economic approach. Therefore, for purposes of applying the Manufactured Dividend Rule, only the contractual relationship between the original Lender and Borrower prior to the novation is relevant.