As a result of tax benefits available under German tax law and high returns on investment, German ship funds have enjoyed increasing popularity in recent years, attracting a considerable amount of equity from private investors. Ship funds are vehicles which collect private equity from a limited number of investors to build and operate one or more ships (eg, container ships). The return on investment consists of tax benefits (in particular, losses which can be offset against earnings) on the one hand, and a 'real' entrepreneurial-risk component in form of lease revenue on the other.

While it has not been difficult for initiators of ship funds to attract investors, it may become more difficult in the future to structure such funds in a tax-efficient way. This is because the Federal Ministry of Finance passed new rules on October 20 2003 specifying the tax treatment of such funds. The new decree, which replaces a former decree dating back to 1990, applies not only to ship funds, but also to real estate, wind energy and other assets which are the object of closed funds. The decree sets out the conditions under which investors of such funds are entitled to tax benefits. A similar decree was passed in relation to film funds earlier in 2003.

Ship funds are usually set up as German limited partnerships. One or more (often numerous) private investors take the roles of limited partners - that is, their liability is limited to the amount of their investment and they do not participate in the management of the limited partnership. The business of the limited partnership is managed by the general partner, which in most cases is a private limited liability company. The decree differentiates between funds that produce an asset and those that purchase it. Only investors in the first category are entitled to tax benefits in the form of immediate deductions of the production costs. However, a fund will automatically be considered as purchaser (thus limiting tax benefits for the investors) if the initiator of the fund "dictates" standard contractual arrangements and if the investor has no "substantial influence" on the decision-making process of the fund.

Although the concept of standard contractual arrangements is not clearly defined, it is likely to apply to most ship funds because the initiator - as in the case of other closed funds - uses standard form partnership agreements as the basis for the investment. Thus, the decisive factor for determining entitlement to tax benefits available for producers of assets is the exercise of substantial influence by the investors. Although the decree does not clearly define this concept either, it does indicate that mere passive representation of the investors in the decision-making process by a trustee or advisory council will not suffice, if such trustee or council is "predetermined" by the initiator. In contrast, an advisory council organized by the investors themselves may be sufficient to enable the investors to exercise substantial influence. However, this council would need to have the ability actively to modify the management's proposals and could not limit its activity simply to confirming them.

Some pitfalls which result from the decree relate to the procedure for setting up the advisory council. In particular, the decision as to who will be a member of the council must remain solely with the investors. Also, this decision requires that at least 50% of the amount of capital contribution, as provided for in the prospectus, has been paid up before an advisory council is established. Given that the majority of capital is usually paid up at a later stage - that is, during the production phase of the ship - this requirement could be problematic. It could, for example, result in economic disadvantages if the ship fund were prevented from making important decisions at an early stage in the production process (ie, before 50% of the investment capital is paid up and an advisory board is created).

Establishing a system of corporate governance for a German ship fund that meets the requirements of the decree may prove to be ambitious. However, if handled properly, it can preserve those tax benefits that have contributed to the success of ship funds in Germany in recent years.

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