Frst published at Euromoney Global Asset Management & Servicing Review 2012/2013 (p. 39-43).
Like many other jurisdictions, Germany has a system of investment funds taxation based on the idea of tax neutrality. It is also not a unique feature of German tax law that the provision of tax neutrality leads to a certain degree of complexity, especially in cross-border situations. OECD has dealt with this issue extensively. Although the German system has worked well for more than 50 years, a discussion of a new investment funds tax regime has been going on for the last couple of months that might be of fundamental practical impact. This article provides a short overview of certain proposed changes, their potential practical consequences and the status of the current discussion.
During the past 18 months there have been constant rumors concerning a reform of the German investment tax law. The currently valid taxation of the income of domestic and foreign funds had been repeatedly criticized for its complexity. In March 2011, a working group was launched to develop a simple system of investment taxation that ensures adequate tax revenues and treats domestic and foreign funds equally. In the course of its reform efforts, this working group presented two drafts of working papers on a respective new conception. The first version was introduced in December and soon followed by a second thoroughly revised draft in February 2012. In case of implementation the drafts would have significant effects on domestic and foreign investors, as well as on domestic and foreign funds, regarding their investments in Germany. The plans provide for a change from the current system of investment taxation marked by limited transparency. Two co-existing regimes of intransparent and transparent taxation and a decoupling of investment tax law from regulatory law characterize the new conception. At the same time, the tax classification of alternative investment funds, which in the future will fall within scope of the AIFM-Directive, is left open by the draft. However, in the course of the upcoming German federal elections in the fall of 2013 the process of reform efforts is floundering. Therefore it remains in question whether the envisaged measures will be implemented.
2. Basic Principles of Applicable Law
The scope of the current investment tax law is linked to the scope of German regulatory investment funds law, i.e. a domestic or foreign investment fund that is classified as an investment fund for regulatory purposes is also treated as an investment fund for tax purposes. Furthermore, the current regime is based on the concept of semi-transparency, which is based on the idea that the tax burden for investors investing through an investment fund should be similar to the tax burden for investors investing directly. Nevertheless, German tax law does not treat an investment fund as a transparent entity. Accordingly, income of an investment fund is not per se attributable to its investors for German tax purposes, but only where the German investment funds tax regime provides for such attribution. Amounts attributable to investors may include distributions received by a fund, as well as retained income of the fund. Domestic investment funds are granted personal tax-exemption while German law does not provide any such rule for foreign investment funds. The specific tax rules relating to distributed earnings and deemed distributed earnings, as well as certain capital gains realized upon the redemption or sale of investment fund units, only work to the extent the fund discloses certain tax information. If the fund does not comply with the respective requirements, lump-sum taxation may apply at the investors' level, which might have the character of punitive taxation. Although distributed and deemed distributed earnings are formally qualified as dividend income, their recognition and the resulting tax burden depend on the type of income received at the fund's level: In particular, certain types of retained capital gains remain untaxed (so-called fund privilege) and specific privileges apply to dividends and (taxable) capital gains from the disposition of shares in corporations (to the extent investment fund units are held as business assets).
II Proposed Changes
In contrast to the current legislation, the new law is supposed to have an autonomous scope of application. The proposed concept distinguishes an intransparent and a transparent regime of investment funds taxation. Within the intransparent regime, the draft further distinguishes between securities-based investment funds and real estate investment funds.
2. Scope of Application
The concept draft provides for the introduction of an autonomous scope of application of new investment tax law, which is to be consistently applicable to both domestic and foreign funds. The new law would, inter alia, only be applicable to investment funds that are subject to investment supervision in their home jurisdiction and provide redemption rights for its investors. Moreover, funds would have to meet certain diversification requirements and a limitation of debt financing to short-term loans not exceeding 30% of the fund's assets (with an exception for real estate funds, which would be allowed to take out long-term loans not exceeding 50% of the current market value of the fund's assets). As a consequence of the proposed changes, foreign funds marketed into Germany might not be subject to the investment funds tax rules, even if public placement as foreign investment fund units is permitted under German regulatory law. This would apply to unregulated as well as to closed-ended foreign funds, which can currently be subject to investment funds tax law as long as they are regulated or open-ended. Moreover, most hedge funds and certain real estate funds and other types of leveraged funds would no longer be subject to a tax regime that specifically provides tax-neutrality for investment funds.
3. Intransparent Regime
a) Fund Level
According to the concept of the work group, intransparency of investment funds would be the normal" case of investment fund taxation. Thus, domestic funds would no longer be personally tax-exempt, but would rather be subject to corporate income tax at a rate of 15% with regard to domestic dividends, as well as income and capital gains derived from domestic real estate. However, interest income, foreign dividends and other capital gains would remain tax-free. Foreign funds would be subject to German corporate income tax with respect to German source income, including domestic dividends and real estate income and respective capital gains.
b) Investor Level
On the investor level, current income derived from investment funds and profits derived from the redemption and/or disposal of investment fund units would be subject to German income tax at the uniform tax rate of 26.375% (plus church tax, if any) for private individual investors. For business investors, any income and capital gains from investment funds would result in trade or business income and, as such, would be fully subject to income tax at the individual tax rate or corporate income tax and local trade tax, irrespective of the respective fund's underlying income.
In addition to distributions, the taxable current income from investment funds would include advance lump sums, if any, for securing minimum taxation, and profits derived from the redemption or disposal of interests in investments. The advance lump sum – to be computed annually – would amount to 80% of a base interest rate (fixed annually; currently 2.44%) of the redemption price determined at the beginning of the year with respect to the interests in investments held at the end of the year (pro rata temporis, as the case may be) minus the actual distributions during the assessment period, whereas the advance lump sum would be limited to the amount of the actual increase in value during the assessment period. The capital gain taxable upon redemption or sale of the fund units would be net of advance lump sums.
With respect to the advance burden of tax on proceeds on the level of the fund, the draft provides for a so-called partial exemption of stock and/or real estate for specific funds in each taxation to which the investor is subject (distributions, advance lump sum, final taxation, tax depreciations on individual assets and appreciations). Partial exemption requires a quota of the beneficiary asset class in the amount of at least 51% of the value of the investment fund according to the terms of contract. Thus, the beneficiary funds are subject to the following tax obligations, each with regard to the total amount:
(i) equity funds (i.e. minimum equity portion in fund portfolio of at least 51%): 80%
(ii) real estate funds (i.e. minimum real estate share portion in fund portfolio of at least 51%, as far as there is no foreign emphasis): 60%
(iii) foreign real estate funds (i.e. minimum foreign real estate/real estate companies portion in fund portfolio): 40%.
4. Transparent Taxation Regime
In view of the envisaged introduction of an investment limited partnership within the scope of the implementation of the AIFM-Directive, the draft of the concept provides for a transparent taxation regime in addition to the intransparent taxation regime. This transparent taxation regime, however, shall only be applicable to vehicles that fulfill all application prerequisites of investment tax law and, in addition, the requirements for special investment funds applicable under current law. These are:
(i) maximum of 100 investors per vehicle (irrespective of whether their investment is directly or indirectly held);
(ii) natural persons must not directly or indirectly invest (through partnerships) in the vehicle;
(iii) names and addresses of the investors must be available to the vehicle.
If these prerequisites are fulfilled, investment funds may opt for the transparent regime. This option, on the one hand, may be considered for domestic and foreign special funds and, on the other hand, for investment limited partnerships. In contrast to the original plans of the working group, the scope of the transparent regime shall not be restricted to such vehicles that are transparent according to the general tax rules. Thus, in respect to foreign vehicles, a comparison of the rights categories will not be necessary.
The transparent regime provides for the continuation of the previous system of investment tax law alongside certain modifications.
(i) In the transparent regime, investment funds are to be granted personal tax exemption. However, the draft provides for a withholding tax in the amount of 15% regarding domestic dividends and income derived from domestic real estate that is to be taken into account for the taxation of the investors.
(ii) Furthermore, according to the draft, the domestic dividend and real estate portion of a capital gain upon the redemption of fund shares shall also be captured separately.
(iii) Finally, the concept of the transparent regime provides for a limitation of the existing privilege for certain capital retained at the fund level.
III Practical Impact
If the draft concept becomes legal reality, this would mean significant changes for fund sponsors as well as investors, whether in domestic or cross-border situations, both inbound and outbound. However, it is rather uncertain whether the German legislator will have the capacity to complete such a technically challenging project within the remaining legislative period. Nevertheless, it is worth considering what the practical impact of the reform would be.
a) Choice of Different Regimes
One major target of the working group is to make investment fund taxation easier. To a certain extent, the draft concept might allow for certain simplifications. At the same time, realization would make things more complicated due to the implied choice of regimes. Sponsors offering foreign funds to German investors would have to be aware that, depending on the fund structure, investors might be taxed in accordance with different regimes:
(i) the intransparent investment fund regime;
(ii) the transparent investment fund regime;
(iii) the general rules applying to the taxation of corporations, including German anti-deferral rules;
(iv) the general rules applying to partnership taxation.
Fund sponsors looking at the German market should thoroughly analyze which types of investors they are targeting since certain tax regimes are not feasible for certain types of investors. For example, German tax-exempt investors such as certain pension schemes would not invest in intransparent funds due to the tax leakage at the fund level.
2. Change of Taxation
In case of the implementation of the draft, certain investment funds within the meaning of applicable law would no longer be taxed according to investment tax law in the future. In this case, the draft provides for regression to the general taxation applicable to the respective legal form with immediate effect. At present, for example, hedge funds and (if the limits of raising debt that are currently provided for are exceeded) also many real estate funds would probably be affected.
3. Transition from Current Investment Tax Law to Intransparent Regime
Existing investment funds will generally be subject to the intransparent regime in the future, if and to the extent that investment tax law remains applicable. Hence, the question arises how existing holdings of interests in investments will be dealt with upon a potential change. In general, the draft concept provides for a clear-cut solution. However, the working group has not decided on how the interests of private individual investors should be dealt with which were acquired prior to 2009 and therefore can (with certain exceptions) still be redeemed or sold tax-free, whereas German tax law provides for income tax on capital gains upon disposal of investment assets acquired after the year 2008. For dealing with these "old" cases, the draft describes two alternatives:
- Upon the date of the change of the system, a disposal and acquisition fiction is made. Hence, the value enhancement achieved until the change of the system would benefit from grandfathering, whereas future value enhancement would be subject to taxation under the new regime.
- Value enhancement achieved after the change of the system shall still not be subject to taxation. However, advance lump sums, if any, are subject to current taxation on the level of the investors.
The decision is of significant relevance for German private individual investors. Thus, the working group leaves it to the political discussion of which of the two solutions is to be elected in the end. Although the concern of the working group that the second solution would result in considerable tax losses seems to be comprehensible, the first solution inevitably raises the question of the respective investors' protection of confidence.
4. No Concept for Alternative Investment Funds
A substantial weakness of the draft of the concept is that it does not provide for a solution to the integration of funds affected in the future by regulation through the AIFM-Directive. The draft concept points to the possibility of creating a supplementary regime for these cases in order to cover a practical need for further transparent taxation. However, it is not clear if and to what extent tax neutrality is to be established, or if only the timely taxation of fund proceeds is to be ensured.
The current discussion regarding German investment fund taxation shows that fund sponsors and investors involved in the German market might face major changes in this field. Therefore, this ongoing discussion should be carefully observed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.