Germany’s fund taxation regime continues to evolve as the country further refines and reforms domestic tax laws that were subject to significant changes towards the end of 2013 – when Germany introduced new domestic tax rules relating to investments into German funds through amendments of the German Investment Tax Act in the context of the implementation of the Alternative Investment Fund Managers Directive (AIFMD). The new rules apply with effect from 24 December 2013, subject to a limited grandfathering that ends by 2017 at the latest. The following overview is of particular relevance to German and foreign investors investing in German and foreign funds, as well as to fund sponsors setting up fund structures targeting a German investor base. Guidance that has been issued since December 2013 has started to answer some – but not all – of the questions on the breadth of application of these rules.
Different Tax Regimes for Funds
The new fund tax rules provide for two different tax regimes for the taxation of investments in funds – the existing regime for investment funds and the newly introduced regime for investment entities. As far as investment entities are concerned, the law further distinguishes between investment partnerships on the one hand and investment corporations on the other.
The regime for investment funds (Investmentfonds) provides for a special quasi-transparent taxation of German investors. In relation to German funds, this regime only applies to funds regulated under the German Capital Investment Code (i.e., contractual funds (Sondervermögen), investment stock corporations (Investmentaktiengesellschaften) and investment limited partnerships (Investment-kommanditgesellschaften)); for foreign funds, the regime applies irrespective of the legal form of the fund vehicle.
The application of the special quasi-transparent taxation further requires comprehensive tax reporting – certain items of fund income need to be notified on an ongoing basis, all items need to be notified on an annual basis to the investors, and the tax data must be published once a year in the Electronic Federal Gazette (Elektronischer Bundesanzeiger). If these obligations are not complied with, the fund is treated as a so-called “black fund” and a penalty taxation applies to German investors (the annual value increase of the units in the investment fund is taxed at not less than 6% per annum). Because the European Court of Justice (ECJ) recently ruled that such taxation is not in line with EU laws,1 the German Federal Finance Ministry (Bundesfinanzministerium) has issued guidance on when and how the penalty taxation should be applied going forward, to comply with the ECJ ruling.2
In order to qualify for this tax regime, both UCITS and AIFs (i.e., alternative investment funds within the meaning of the AIFMD) must meet each of the following eight conditions:
- The entity or its manager is subject to the rules of collective investment regulation in its state of establishment.
- Investors are entitled to redeem interests in the entity at least once a year.
- The objective business purpose of the entity is limited to passive investment activities (the active management of the entity’s assets is excluded). This condition essentially aims to carve out trading businesses from the definition of an investment fund. Since its application in practice can be difficult, the German tax authorities have provided some non-exhaustive guidance in this regard.3
- The entity invests in qualifying assets4 according to the principle of risk-diversification (as a rule of thumb, more than three qualifying assets).
- The entity may not invest more than 20% of its NAV in unlisted shares in corporate bodies (Kapitalgesellschaften) (so-called “20%-rule”).
- Any investment in a corporate body must be less than 10% of the capital of each such corporate body (so-called “10%-rule”).
- The entity may only raise short-term credit (i.e., credit with a maturity date of less than one year) and such credit may not exceed 30% of its NAV (higher limits for real estate funds apply).
The above criteria are included in the terms and conditions governing the entity (including its constitutional documents and prospectus).
The German tax authorities have provided guidance on the interpretation of some,5 but not all, of the above criteria and uncertainties therefore remain. However as a rule of thumb, UCITS, securities fundsand real estate funds are capable of meeting the eight criteria – by contrast, AIFs will generally struggle. This is certainly the case for closed-end AIFs, which under the new rules cannot qualify as investment funds due to a lack of a redemption right. Consequently, they will either qualify as investment partnerships or investment corporations, which are discussed below.
These entities (Personen-Investitionsgesellschaften) are tax-transparent, with German investors taxed on their share in the profits of the entities, irrespective of distributions or lack thereof. For purposes of determining the profits and the profit shares, the entities must file a partnership tax return in Germany in accordance with German tax rules (so-called “joint and/or separate tax assessment” – einheitliche und/oder gesonderte Gewinnfeststellung).
These entities (Kapital-Investitionsgesellschaften) are generally tax-opaque and German investors are taxed only when they receive distributions or dispose of some or all of their shares in the entities. Distributions and capital gains arising from the disposal of shares will not benefit from the German participation exception (95% corporate income tax exemption), provided the entities are not subject to tax, or are exempt from tax in their EU/EEA state of residency (note that, in relation to entities from non-EU/EEA member states, the participation exception is not available if the entity’s income tax rate is less than 15%). In order to counteract accumulation of gains at the level of the entities, the German controlled company rules (CFC rules) are applicable, which result in an ongoing taxation of accumulated passive income (e.g., interest) at the investor level. In contrast to the original plan of the German revenue, a penalty taxation similar to the taxation of “black funds” (i.e., taxation of the annual value increase of the shares in the investment corporation, not less than 6% per annum) has not been introduced.
The different tax regimes, their preconditions and their consequences are set out in the below chart.
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It is important to note that even UCITS and UCITS sub-funds may not automatically qualify as investment funds.
- New UCITS: For UCITS that were established on or after 24 December 2013, based upon the legislative reasoning6 it is not required to provide for each of the above-mentioned eight preconditions in the fund’s terms and conditions; rather it only needs to be clear from the terms that the fund is a UCITS in order to achieve investment fund treatment. Since the wording of the law itself, however, does not specifically address this point, in our view it would be advisable to accurately provide for each of the above-mentioned eight preconditions in the terms and conditions of new UCITS.7
- Grandfathered UCITS: For UCITS or UCITS sub-funds established on or before 23 December 2013, generally a grandfathering applies until 2017 at the latest. Against the background of the above-mentioned uncertainty, however, these funds may want to amend their terms and conditions in order to avoid the prospect of negative tax consequences for their German investors (i.e., a taxable deemed exchange of shares in the UCITS).
Finally, in order to qualify as an investment fund, a UCITS also must factually meet the requirements contained in the German investment fund regime. For example, since one of these requirements is risk-diversification, it is not entirely free from doubt whether a foreign UCITS that invests in only one swap or other derivative, which in turn has more than three underlyings, would qualify as an investment fund.
By contrast, most AIFs will be treated, from a tax perspective, as either investment partnerships or corporations. These two tax regimes are compared below.
Investors’ Perspective: Investment Partnerships vs. Corporations
The specific tax implications for German investors regarding investing in investment partnerships as opposed to investment corporations depend on a number of different factors, the most important of which is the tax status of the German investor.
Summary of Tax Implications
Having said that, for German taxable corporate investors, the tax implications may be summarized as follows, based on the assumption that the AIF in question is not subject to tax or effectively not taxed in its state of residency:
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Advantages Based on Type of Investor
In summary, investing in an investment partnership is generally more tax efficient for German investors. The specific tax effects and advantages, however, vary from investor group to investor group:
- Corporate investors: Investing in an investment partnership is clearly more beneficial for a German corporate investor (including contractual trust arrangements and property insurance companies) than investing in an investment partnership. In particular, the trade tax exemption might (depending on location of the investor) cut that investor’s tax bill in half.8
- Life and health insurers: Generally, an investment in an investment partnership might also be tax-favorable for German life and health insurance companies. While they do not benefit from the CIT exemption for underlying capital gains in equities or the trade tax exemption, the effective tax burden might be minimized by withholding tax reductions under applicable DTTs; German domestic withholding tax credits might be available as a fall-back.
- Tax-exempt investors: Even German tax exempt pension funds (Versorgungswerke) may be better off investing in an investment partnership structure – due to the better access to DTTs (e.g., the US/German DTT provides for zero percent withholding on dividends paid to pension funds). Only support pension funds (Unterstützungskassen) could be excluded from investing in an investment partnership, since such an investment may endanger their tax exempt status based on older case law.
- German special funds: These are also important direct investors in funds in Germany as, traditionally, institutional investors often invest via such funds as pooling platforms. Fund sponsors therefore seek to design interests in funds, which they want to market to Germany, as eligible assets for German special funds (so-called Masterfondsfähigkeit). Pursuant to the regulatory and tax laws, interests in investment partnerships, as well as shares in investment corporations, are eligible assets provided they qualify as “securities”.9 Having said that, in this respect interests in investment partnerships may offer advantages, since certain investment limitations (inter alia, the 20% and 10% rules described above) should not be applicable to them – however, this has not yet been confirmed by BaFin or the German tax authorities.
In-bound Investments: Investment Partnerships vs. Corporations
The tax regime of investment partnerships can also be favorable for in-bound investments into Germany:
- Investment partnerships are not subject to taxation due to their tax-transparent nature.
Investment corporations in turn will be subject to corporate income tax on source income.
Consequently, income from German real estate, German dividends, income on German hybrids or real estate secured debt or other source income will flow through investment partnerships without German taxation being triggered at the level of the investment fund vehicle.
By contrast, investing via investment corporations may result in an additional layer of tax.
Scope of Regime for Investment Partnerships vs. Corporations
According to statutory law, a distinction between investment partnerships and investment corporations needs to be drawn based on whether a German AIF is an investment limited partnership (Investment-Kommanditgesellschaft), or whether a foreign AIF is comparable to a German investment limited partnership.
This statutory test has raised some uncertainty as to whether German closed-end funds set up in the past as “simple” limited partnerships (GmbH & Co. KGs), and foreign AIFs in the form of general partnerships or limited partnerships without legal personality, qualify as investment partnerships or, by default, as investment corporations. The German Federal Finance Ministry has issued a circular letter clarifying that it will consider all AIFs that qualify as, or are comparable to, German partnerships in general to be investment partnerships.10 This guidance does away with the afore-mentioned uncertainties and effectively expands the application of the generally favorable tax regime of investment partnerships.
By contrast, if an AIF is not a partnership or comparable to a partnership, it will automatically qualify as an investment corporation. This holds true for corporate bodies as well as for contractual fund structures (e.g.,fonds commun de placement) – the latter even if they are transparent in their jurisdiction of residency.
Classification of Widely Used Fund Vehicles
Based on the above circular and general guidance,11 the following widely used fund vehicles should qualify as investment partnerships, to which the generally favorable tax regime applies:
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By contrast, the following fund vehicles should, or are at least likely to, qualify as investment corporations:
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Outlook: Reform Ahead
On 19 December 2014, the Federal Government (Bundesregierung) announced that it will consider a draft bill on the reform of the taxation of funds by the end of the second quarter of 2015. Based on past proposals and recent developments, points provided for in such a reform act might include:
- Introduction of an opaque taxation of German retail/public investment funds (Publikumsfonds);
- Changes to the penalty taxation for “black funds” to comply with the judgment of the ECJ; and
- Expansion of the full taxation of portfolio dividends (<10%) to portfolio capital gains.
It is currently anticipated that the taxation of German special investment funds (Spezialfonds) will generally remain unchanged. However, drafts of the announced reform bill are not yet available. Also, according to reports, the tax authorities are considering whether to introduce a 15% withholding tax on German dividends paid to investment funds, in order to comply with EU law requirements.