Draft legislation (the Draft) issued by the Ministry of Finance on December 4th 2012, and designed, inter alia, to implement the AIFM-Directive into German tax law, will make significant changes to both the scope of the German Investment Tax Act (InvTA) and the taxation of German investors under InvTA. This note explains recent developments in connection with these proposed changes and their potential impact on funds not established under German law. In particular, investors in certain non-German funds may in future cease to qualify for tax transparent treatment and, instead, be subject to a less beneficial lump-sum tax regime.
It should be noted that any changes relating to the future scope of the InvTA which will result from the AIFM-Implementation Act will only apply in relation to funds set-up on or after July 22nd 2013. However, despite this grandfathering provision, the new rules may also have an impact on existing investment structures.
Current German tax rules
Under current rules, foreign entities only fall within the scope of InvTA, if
- they comply with the principle of risk diversification and
- either they qualify as a fund which complies with the requirements of the UCITS-Directive (UCITS) and which is governed by an EU or EEA member state
- or the fund is either subject to qualifying supervision in its home country or – if not – the investors in the fund have a right of redemption (for further details in relation to this, see our newsletter1)
Currently, the scope of application of InvTA is determined by reference to the German Investment Act (InvA). However, following implementation of the AIFM-Directive, the InvA will be replaced by a new ‘German Capital Investment Code’ (GCIC), which will contain the new German legal framework for investment funds.
Pursuant to the Draft, two different tax regimes will apply, one to ‘investment funds’ and another to ‘investment companies’, the latter being a new category of fund for InvTA purposes.
Investment funds are defined as UCITS funds and non-UCITS funds (i.e. alternative investment funds within the meaning of the AIFM-Directive, ‘AIF’), which fulfil additional criteria (such AIFs being ‘Eligible AIFs’). The current tax regime set out in InvTA will in future only apply to UCITS funds and Eligible AIFs. AIFs, which do not qualify as Eligible AIFs, will be treated as ‘Investment Companies’, to which a newly-introduced tax regime under InvTA will apply.
Effect on foreign funds – loss of tax transparency
Under the current rules, whilst the tax regime in InvTA does not normally apply to closed-ended funds, it does regularly apply to foreign security funds and hedge funds. However, to continue to benefit from the current InvTA tax regime (and in particular tax transparent treatment), a foreign fund must either qualify as a UCITS fund or as an Eligible AIF and, importantly, the definition of Eligible AIF is narrower than the definition of ‘foreign investment fund’ under the current rules.
An AIF will only qualify as an Eligible AIF, if the following criteria are met (Eligible AIF Criteria):
- The AIF is subject to supervision in its home country.
- Investors are entitled to redeem their fund units at least once per year.
- The AIF’s business purpose is restricted to the investment and administration of its assets for the collective account of its unit-holders. Active entrepreneurial engagement (e.g. entrepreneurial exercise of influence in relation to portfolio investments) is excluded.
- The fund’s assets are invested in accordance with the principle of risk diversification (i.e. investment in more than three assets with different investment risk profiles).
- Asset limitations:
- a maximum of 20% of the fund’s net asset value (NAV) is invested in companies, whose shares are not admitted to trading at a stock exchange or another organised market
- a maximum of 5% of the fund’s NAV is invested in any one company
- an AIF’s participation in a company may not exceed 10% of such company’s nominal capital. Specific rules apply in relation to real estate funds.
- Only short-term (less than a one year term) debt-financing is allowed and debt-financing may not exceed 30% of the AIF’s NAV. Specific rules again apply for real estate funds.
- Investment Assets: investment is restricted to the following types of assets: securities, money market instruments, derivatives, bank deposits, real property and rights equivalent to real property, specific ‘real estate companies’ as defined in the GCIC, units in domestic investment funds and foreign investment funds as defined in the GCIC, precious metals, non-securitised loan receivables and participations in companies provided that the fair market value of these participations can be determined.
- The investment asset restrictions (set out in the point above) are set out in the AIF’s investment regulations or its articles.
As a consequence of these stricter requirements for non-UCITS-compliant foreign funds set up after 21 July 2013, foreign funds may no longer qualify for the current tax transparent regime for a number of reasons. For example:
- supervision and redemption right requirements: under the current law the InvTA tax regime will apply if the foreign fund is either subject to supervision or if the investors in the fund have the right to redeem their fund units. According to the Draft, both requirements will need to be met under the new regime. The German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin)) has issued a circular (BAFIN-Circular) providing guidance on the requirements for supervision. According to the circular, supervision in this context requires public supervision, which should, in particular, protect the investor. Consequently, the regulatory supervision condition is not met where regulation only serves to promote the integrity and efficiency of the market or involves mere examination of fiscal requirements. In other words, the supervision in the state of domicile must exceed pure registration requirements and include an examination of both the fund's solvency and of the managing persons' expertise and reliability, and ongoing monitoring of compliance with statutory or contractual requirements, as well as observance of the fund's investment criteria.
The requirement for both supervision in accordance with the BAFIN-Circular and the redemption right for the investors could lead to the result that German residents invested in funds located in an offshore jurisdiction such as the Cayman Islands or Jersey will no longer benefit from the tax transparent regime as currently applicable to those funds.
- restricted debt-financing: the restricted debt-financing criterion may result in some funds (particularly hedge funds) being treated as Investment Companies.
- discrepancy between principles set out in current BAFIN-Circular and the Draft? Currently, the BAFIN-Circular states that only 90% of the fund’s NAV needs to be invested in qualifying Investment Assets. Furthermore, the BAFIN-Circular has set out criteria regarding the risk diversification criterion. It is currently uncertain whether the principles set out in the BAFIN-Circular will continue to apply in the future.
Taxation of AIFs not qualifying as Eligible AIFs
The taxation treatment of an AIF which does not comply with all of the Eligible AIF Criteria depends upon its legal form.
If such AIF qualifies as a partnership from a German tax perspective, then the income of such partnership is determined and taxed in accordance with general German tax rules at the level of the German investors. Accordingly, there will be no change in the tax treatment of those investors, who equally do not fall under the scope of the InvTA at present.
However, if the AIF qualifies as a corporate entity from a German tax perspective, a lump-sum taxation regime applies. The lump-sum taxation regime will generally apply, irrespective of whether or not the AIF complies with the tax reporting duties under the InvTA.
Under the lump-sum taxation regime, German investors will be subject to tax on the following items:
- distributions of the fund; and
- 70% of the difference between (i) the first redemption price (per share) declared in the relevant business year and (ii) the last redemption price (per share) declared in such business year, subject, however, to a minimum of 6% of the last redemption price declared in the relevant business year (if no redemption price is declared, then the price quoted on an exchange or fair market value should be used).
For the purposes of the lump-sum calculation, the acquisition cost replaces the first redemption price in the year of acquisition and the sale proceeds replace the last redemption price in the year of disposal.
If the relevant shares are held as private assets by an individual, such amounts will be subject to the German flat rate tax at a rate of 26.38% (plus church tax, if applicable).
If the relevant shares are held by a German corporation, actual distributions will, in principle, benefit from the general tax reliefs and exemptions available in relation to dividend income, provided that the investor is able to demonstrate that the AIF is subject to a general tax rate of 15% in its country of residence (without being exempted from such tax) and provided that the investor meets the general requirements under the German corporation tax act for exempting dividends from tax (e.g. the investor is not a credit institution or financial services institution holding the shares in its trading book). If the investor is not able to provide the necessary evidence, then the actual distribution will be subject to German corporation and trade tax at a rate of approximately 30%.
To the extent that any amounts treated as taxable income under the lump-sum taxation regime exceed the amount of actual distributions made by the AIF and received by the investor, a reduction is made to the capital gain calculation to prevent double taxation occurring.
An Eligible AIF may lose its status as such and in consequence become taxable as an Investment Company and, vice versa, an Investment Company may qualify as an Eligible AIF thereby achieving tax transparent status, provided that it complies with the general reporting requirements under InvTA.
Eligible AIF becomes Investment Company
Where an Eligible AIF no longer meets the Eligible AIF Criteria, the competent tax authority (the Federal Tax Office for foreign AIFs) will issue a tax notice. After the end of the AIF’s business year in which the tax notice becomes unappealable, the AIF will be treated as Investment Company for at least 3 years (and its investors will be taxed accordingly). This three year blocking period should prevent AIFs changing their tax status for only a short period.
Investment Company becomes Eligible AIF
Where an Investment Company meets the Eligible AIF Criteria, then upon application its status as an Eligible AIF will be confirmed by a specific tax notice (subject to the three year blocking period mentioned under ‘Eligible AIF becomes Investment Company’ above).
Final taxation in case of a change of the tax status
At the end of the calendar year in which the tax notice accepting the change of the tax status from an Investment Company to an Eligible AIF, or vice versa, becomes unappealable, the shares in the Investment Company or Eligible AIF respectively are deemed to be sold and shares in the Eligible AIF or Investment Company respectively are deemed to be acquired. The redemption price at the end of the relevant year or - if no redemption price is assessed – the stock exchange or market price will be used to determine the deemed sale proceeds and deemed acquisition costs. Upon application, any tax triggered by the deemed sale will be deferred until an actual disposal of the relevant shares occurs.
Special investment funds
These rules are modified in relation to ‘special funds’ i.e. funds having no more than 100 investors and no individual investors. If a special fund ceases to meet the Eligible AIF Criteria, then investors are deemed to have sold their shares in the special fund at the end of the business year preceding the business year in which the special fund ceased to comply with the Eligible AIF Criteria. A specific tax notice is not necessary. After such deemed sale, investors are deemed to have acquired a share in an Investment Company and will be subject to the tax regime applicable to Investment Companies (see paragraph “Taxation of AIFs not qualify as Eligible AIFs” above) for at least three years.
Impact on closed-ended funds
Since closed-ended funds do not have necessary redemption right, closed-ended funds can never qualify as Eligible AIFs, and will be treated as Investment Companies. This will not have a detrimental effect if the closed-ended fund structure uses a partnership as fund vehicle, however, closed-ended funds using a corporate structure will fall to be taxed under the lump-sum regime.
Introduction of a pension asset pooling vehicle
Efficient pension asset pooling for international groups requires, from a tax perspective, a vehicle which is tax transparent for double tax treaty purposes. For this purpose, the so-called ‘investment limited partnership’, which is a tax transparent partnership, has been introduced as a new type of domestic investment fund for InvTA purposes. The ‘investment limited partnership’ should now permit the pooling of pension assets in a German fund entity.
Other non-AIFM related changes
Coupon stripping: The Draft contains specific rules for the treatment of coupon stripping at the fund level. In future, stripping coupons will be treated as a deemed sale of the bond at fair market value and the deemed acquisition of both the bonds (without coupon) and the coupon. The fair market value (deemed sale price) will be allocated between the bond and the coupon. The new rules will apply if the coupon stripping occurs after the 2nd and 3rd reading of the Draft in the German parliament.
Deductible expenses: The allocation of expenses at fund level will be modified. These new rules will be applied in business years beginning after 31 December 2013.
Distributions: The Draft contains new rules both for interim profit distributions and annual profit distributions, which will apply in relation to distributions which occur 8 months after the entry into force of the new law.
Reporting of certain (partially) tax-exempt profits: In future, certain tax-exempt profits may only be reported if the respective ‘equity gain’ and ‘property gain’ is published on any valuation day together with the redemption price.
Lump-sum taxation: In future, a more detailed explanation of the transitional calculation from the profit as determined for regulatory purposes to the profit as determined for tax purposes will need to be provided.
The scope of InvTA in relation to foreign funds will be broadened. This should not have a detrimental impact on UCITS funds and closed-ended funds, provided the latter are structured as partnerships.
However, due to the new distinction between Investment Companies and Eligible AIFs and the fact that the requirements for benefitting from transparent taxation will be tightened (due to the Eligible AIF Criteria), various existing structures under which German investors benefit from tax transparent treatment, will in future be subject to the lump-sum taxation regime applicable to Investment Companies. This also means that affected funds will need to take into account strict asset limitation rules and debt financing restrictions applying to an Eligible AIF.
Importantly, despite the existence of a grandfathering provision, even existing structures may be detrimentally affected, where the relevant fund does not currently fall within the scope of InvTA, but will in future be treated as an Investment Company with the effect that German investors will be subject to the lump-sum taxation regime.
Heiko Stoll and Dr. Bernulph von Crailsheim are partners and tax advisors and lead together the Frankfurt tax department of Simmons & Simmons LLP, an international law firm with over 1,500 people and 20 offices located in major business and financial centres throughout Europe, the Middle East and Asia.
Heiko Stoll and Dr. Bernulph von Crailsheim advise on German national and international tax matters, in particular in relation to fund formation und fund-related issues regarding German inbound and outbound investments. Their experience includes advising on the structuring and establishment of real estate funds, private equity funds, infrastructure funds and renewable energy funds for private and institutional investors. The practice area is broad based, focusing on acquisitions, restructuring, tax-optimised products and cross-border tax planning. Other special areas of advice include the tax aspects of acquisition finance, real estate finance and tax-efficient structured finance transactions (e.g. securities trading and repo transactions). For more information, please visit www.simmons-simmons.com.