On 21 July 2015, the German Federal Ministry of Finance released a discussion draft for a proposed German Investment Tax Reform Act (such draft, the "InvStGRefG-E"). The discussion draft provides for thoroughgoing and systemic changes to the law of German investment taxation, with two tax systems functioning independently of one another, as well as for the introduction of taxation of capital gains from portfolio shareholdings.
The new rules are proposed to generally enter into force on 1 January 2018.
1. Investment taxation
- The InvStRefG-E provides for an expansion of the scope of application of the German Investment Tax Act ("InvStG"). Going forward, the InvStG is envisioned to cover all UCITS and AIFs as well as certain other investment vehicles. The only exception will be partnerships that are not UCITS (e.g., private equity funds). For these partnerships, the general rules on the taxation of partnerships will continue to apply.
- Going forward, a non-tax-transparent regime is envisioned for retail investment funds that are not specialized investment funds. First, this means that (domestic and foreign retail) investment funds' income from domestic sources will be subject to corporate income tax. Second, this means that an investor's allocable share of income derived from an investment fund will be subject to taxation regardless of the sources of the relevant proceeds.
- For specialized investment funds, the principle of tax transparency for investment taxation purposes (so-called semi-transparency) will largely be limited to capital gains tax. The participation privilege previously available pursuant to § 8b KStG (German Corporate Income Tax Act) is to be eliminated at the investor level. Going forward, natural persons will not be permitted to invest in specialized investment funds either directly or indirectly through partnerships.
2. Capital gains from portfolio shareholdings
- All capital gains from the disposition of portfolio shareholdings (under 10%) realized from 1 January 2018 onwards are to be made fully subject to corporate income tax and trade tax. The participation privilege pursuant to § 8b para. 2 KStG will not be applicable in this regard.
- Tax relief is to be introduced on profits on disposition of investments in start-ups, capped at 30% of the investment amount.
- The discussion draft has been provided for consultation and is not linked to a formal proposed law. It remains to be seen whether the discussion draft will enter into force as proposed and what the individual impacts would be.
- The draft presented should not create an acute need for immediate action by fund investors. Such a need may arise, however, once a draft law has been issued by the cabinet, which will initiate legislative proceedings.
- With regard to the planned elimination of the 95% tax exemption for capital gains from portfolio shareholdings, it may be advisable to realize appreciations in value relating to participations in portfolio shareholdings before 31 December 2017.
- We will of course continue to monitor and follow the evolution of the proposals and keep you up to date. The plans for reconceiving German investment tax law will be a topic at the next Funds Forum Frankfurt this autumn. We will be sending you an invitation separately.
II. RETAIL INVESTMENT FUNDS
For retail investment funds (i.e. all investment funds other than specialized investment funds), the decades-old principle of transparent investment taxation is supposed to be replaced by a non-tax-transparent tax regime. The key legislative aims listed in the InvStRefG-E are:
- elimination of EU law-related risks;
- prevention of aggressive tax structures; and
- a reduction in administrative complexity and an improvement in the comprehensibility of investment tax law.
1. Investment funds
Pursuant to the InvStRefG-E ("InvStG-E"), the scope of application of the Investment Tax Act will largely but not entirely track regulatory law. Investment funds are collective investment schemes (Investmentvermögen) within the meaning of the German Capital Investment Act (Kapitalanlagegesetzbuch, KAGB) with the following exceptions:
- Investment vehicles that have only one investor by the terms of their constitutional documents are also classed as investment funds.
- Partnerships are not investment funds unless UCITS partnerships.
Compliance with product regulation from a tax perspective (cf. § 1 para. 1b sentence 2 InvStG) is no longer relevant for retail investment funds. So-called corporate investment companies (i.e., AIFs that are essentially corporate in organization or contractually organized and which do not conform with the product regulation currently applicable to investment funds) are thus also integrated into the new tax regime.
2. Taxation of investment funds
According to the InvStG-E, both domestic and foreign investment funds will be subject to corporate income tax plus solidarity surcharge (15.825%) on:
- domestic participation income (generally speaking, dividends from corporate entities resident in Germany);
- income from domestic real estate (rental income and disposition profits); and
- other domestic income (generally speaking, profits from the disposition of significant investments); § 6 InvStG-E.
In this connection, the currently available tax exemption for domestic investment funds (§ 11 InvStG) will be eliminated. The intention is to eliminate the prejudicial tax treatment of foreign investment funds, considered to be in violation of European law, pursuant to which foreign investment funds are already now taxable on the aforementioned proceeds from domestic sources.
To the extent that an investment fund has tax-exempt charitable investors, churches or foundations or to the extent that its shares are held in the context of "Riester" or "Rürup" (German retirement investment) contracts, the investment fund can obtain an exemption from German corporate income tax; cf. §§ 8 et seq. InvStG-E. This is not the case, however, for other tax-exempt investors (e.g., pension funds and professional pension schemes). For these latter investors, the taxation of domestic real estate proceeds and other domestic income at the level of the investment fund would be disadvantageous in comparison to current law and to direct investments.
Investment funds will continue to be exempt from German trade tax in the same cases as at present. Cf. § 13 InvStG-E.
3. Taxation of investors
a) Proceeds from investment funds
The following proceeds from investment funds will be taxed on the investor level (cf. § 14 InvStG-E):
- distributions from the investment fund;
- pre-determined tax bases (Vorabpauschalen), and
- capital gains realized upon the dispositions of investment interests (including profits from the redemption of interests).
These proceeds are defined as their own capital income proceed category. For private investors, such proceeds are subject to all-inclusive withholding tax (Abgeltungssteuer). For business investors, such proceeds are subject to corporate income tax and trade tax in full but subject to partial exemptions (see next item). The tax exemptions for investment proceeds (Beteiligungserträge, § 3 no. 40 EStG, § 8b KStG) do not apply.
b) Partial exemptions
Prior tax impositions on the proceeds (i.e., distributions, pre-determined tax bases and disposition profits) through German corporate income tax at the fund level as well as through withholding tax in the country of the taxable situs of real estate are taken into account through an investor-level typology. Thus:
- 20% of proceeds from investment funds that continuously invest at least 51% of their assets in stocks,
- 40% of proceeds from investment funds that continuously invest at least 51% of their assets in domestic real estate, and
- 60% of proceeds from investment funds that continuously invest at least 51% of their assets in foreign real estate
are to be tax-exempt (cf. § 14 InvStG-E). These exemptions for dividend income (Aktienfreistellung) and real estate income (Immobilienfreistellung) will also be granted to investors in funds of funds predominantly invested in target funds that continuously invest at least 75% of their assets in stocks or relevant real estate. The categorization system of the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) is to be employed in the determination of the scope of application of the partial exemptions (cf. BaFin Fund Categories Guidelines dated 22 July 2013)
c) Pre-determined tax basis
To avoid that proceeds remain untaxed at fund level for an unlimited period of time, investors should at least pay tax on an annual pre-determined tax basis. The pre-determined tax basis is equal to 80% of the base interest rate under the German Valuation Tax Act (Bewertungsgesetz, BewG) multiplied by the value of interests in investment funds. The pre-determined tax basis is applied when the value of the investment fund has increased and the investment fund has distributed to investors an amount less than the relevant risk-free capital market interest.
The pre-determined tax basis is assessed – in this regard like penalty taxation pursuant to § 6 InvStG – on fictive assumptions. Although the pre-determined tax basis is deducted in the context of taxation of profits realized upon disposition or redemption of investment interests, it can result in tax assessments on purely fictive proceeds, for example if the value of the investment interest should subsequently decline.
III. TRANSPARENT TAXATION OF SPECIALIZED INVESTMENT FUNDS
1. Specialized investment funds
Specialized investment funds are investment funds that
- comply with the investment taxation-related product regulation currently applicable for all investment funds (cf. § 1 para. 1b sentence 2 InvStG); and
- do not have more than 100 investors who are not natural persons. In contrast to the current state of the law, in the future indirect investment by natural persons via partnerships will be detrimental to a fund's status as a specialized investment fund as well.
Time-limited grandfathering provisions will apply for natural persons currently investing via partnerships into specialized investment funds. Investments acquired indirectly by partnerships of natural persons after 1 May 2015 may be held until 1 January 2020 without tax disadvantages. Investments acquired indirectly before that date may be held without tax disadvantages until 1 January 2030. In addition, investment by natural persons into a specialized investment fund – including directly – remains permitted to the extent required by regulatory law, for example because the compensation of fund administrators must be made at least in part as shares in the specialized investment fund.
2. Taxation of specialized investment funds, transparency option
The taxation of domestic income that is mandatory for retail investment funds (see above) does not apply to a specialized investment fund if
- the specialized investment fund makes an irrevocable declaration to a party required to make capital gains tax deductions that capital gains tax statements should not be issued in favour of the investment fund but rather in favour of the investors (so-called "transparency option"), § 23 para. 1 InvStG-E; and
- the specialized investment fund withholds taxes on capital proceeds from domestic real estate or other domestic investment sources that are not subject to capital gains deductions when received by the specialized investment fund, § 24 InvStG-E.
If a specialized investment fund does not exercise the transparency option, all-inclusive withholding tax (Abgeltungssteuer) will apply to domestic investment receipts at the level of the fund (as is also the case with a retail investment fund).
3. Taxation of investors
On the investor level, the following proceeds from specialized investment funds will be taxed (similar to the current state of the law):
- distribution proceeds,
- certain proceeds retained by the fund (so-called "proceeds deemed distributed"), and
- profits from the disposition (including redemption) of fund interests.
Proceeds from specialized investment funds (like proceeds from retail investment funds) are defined as a separate class of proceeds in the capital income context. They are fully subject to corporate income tax and trade tax. If natural persons are investing by virtue of an exception, all-inclusive withholding tax (Abgeltungssteuer) at the rate of 25% with all-inclusive effect (Abgeltungswirkung) is generally unavailable. Unlike the current state of the law, the tax exemptions for investment proceeds (§ 3 no. 40 EStG, § 8b KStG) remain unavailable even if the relevant proceeds would be privileged for a direct investment.
a) Investment proceeds
The global exclusion of tax exemptions under § 8b KStG and § 3 no. 40 EStG leads to an unjustified disadvantaging of investors in specialized investment funds in comparison to the previous state of the law and in comparison to a direct investment. Although the continued application of the principle of transparent investment taxation is postulated in the statement of grounds for the InvStGRefG-E, it is evident that this principle will only continue to apply to a very limited extent, namely for the most part only in connection with capital gains tax.
Likewise the exclusion of the tax exemption under § 8b KStG can be explained only to a limited extent by the fact that in the future this tax exemption is only intended to apply to investments of 10% or more in corporate entities, and specialized investment funds are not permitted to have holdings of this kind pursuant to the product regulation under tax law (§ 20 para. 1 no. 6 InvStG-E). In particular, investment funds are released from this 10% limitation in certain cases, e.g. with regard to real estate investment companies.
Similar considerations apply to the exclusion of use of the partial income method (Teileinkünfteverfahren), § 3 no. 40 EStG. Although natural persons are in principle not permitted to invest in specialized investment funds (such that § 3 no. 40 EStG is not relevant in any event), there are exceptions to this principle (see above).
b) Proceeds deemed distributed
The potential to re-invest certain capital proceeds tax-free (the so-called "funds privilege") is capped at 90%. This means that option premiums, profits from dispositions of securities and profits from futures transactions, which under current law are not assessed for tax purposes at the investor level during the re-investment phase, will now be regarded as 10%-allocated to investors and taxed on that basis. This change is counterbalanced to a certain extent by the fact that the opportunity for tax-free reinvestment of profits from dispositions will be extended to all other capital claims (§ 20 para. 2 sentence 1 no. 7 EStG). This eliminates the complex process of distinguishing between taxable products (generally, financial innovations) and tax-free "normal" debt securities.
The discussion draft provides for a further tax intensification on profits from dispositions of real estate. These are included among proceeds deemed distributed, regardless of the period of time over which the real estate asset was held. This means that tax will also be payable at the investor level even if the fund has held a real estate asset for over 10 years.
c) Tax exemptions
In an implementation of the transparency principle (consistent in this context), distribution proceeds and proceeds deemed distributed are tax-free (§ 31 para. 1 InvStG-E) to the extent that they
- are tax-free at the investor level pursuant to a double tax treaty,
- have already been subject to German PFIC / CFC taxation, or
- are derived from the specialized investment fund's investments in non-transparent investment funds (i.e., investment funds other than specialized investment funds) and come under the exemptions for dividend income (Aktienfreistellung) and real estate income (Immobilienfreistellung).
d) Taxation of disposing
In much the same way as the current German Investment Tax Act treats capital gains from stocks and real estate, profits from the disposition (including redemption) of interests in a specialized investment fund remain tax-free to the extent that the relevant proceeds are tax-free in the context of ongoing taxation; cf. c).
IV. TRANSITIONAL PROVISIONS
The new tax rules are to be applicable beginning on 1 January 2018. At that time, interests will be deemed disposed in all investment vehicles that are considered investment funds or corporate investment companies under the current InvStG or that will for the first time become investment funds as defined in the InvStG-E. This will create a uniform transition from current legislation to new legislation at the investor level. The fictive disposition will not result in immediate taxation of all profits from disposition, or to immediate tax adjustments for losses, as the case may be. Instead, these profits or losses on disposition will be uniformly determined, but not assessed for tax purposes until actual disposition or redemption of the investment interests.
The InvStRefG-E also provides for grandfathering of privately held so-called "old investment interests" (interests acquired before 1 January 2009, or in certain cases before 10 November 2009) to be time-limited to 31 December 2018. Increases in value to "old investment interests" prior to this date remain tax-free. All appreciations in value to occur thereafter are subject to tax and will be taxed on disposition or redemption, to the extent not assessed earlier in the context of ongoing taxation.
The statement of grounds for the InvStG-E states that the scope of application of the VAT exemption relating to the management of investment funds is to be left unchanged. Technical changes are to be made to the relevant rules for this purpose (cf. § 4 no. 8 lit. H UStG). After the entry into force of the new rules, the VAT exemption is to continue to apply only to UCITS and to AIFs that comply with the investment tax product regulation (i.e., to investment funds within the meaning of the current InvStG), and not to other AIFs, such as private equity funds.
The restriction of the VAT exemption to investment funds within the meaning of German investment tax law may already be in violation of European law in view of the uniform regulation of UCITS and AIFs. (This possibility may be confirmed in the near future by the European Court of Justice; cf. case no. C-595/13.) We hope that the German legislature might use the reorganization of investment tax law as an opportunity to expand the VAT exemption to apply to all UCITS and AIFs.
The attempt to retain the VAT exemption's current scope of application also results in a relatively implausible retention of the current investment tax categories solely for VAT purposes, leading to additional frictions.
VI. CAPITAL GAINS FROM PORTFOLIO SHAREHOLDINGS
In spring 2013, the German legislature decided to tax dividends from portfolio shareholdings. Before that time, such dividends were 95% exempt from corporate income tax. The occasion for the change was a European Court of Justice judgment (case no. C-284/09) declaring the differences in tax treatment of dividend income of domestic and foreign companies to be in violation of European law. In the mediation committee of the German legislative proceedings, capital gains from portfolio shareholdings were excluded from tax liability, but tax liability was not decisively ruled out for the future. In the investment taxation reform discussion draft that is now available, the legislature has eliminated the differences in tax treatment of dividends and capital gains from portfolio shareholdings. Portfolio shareholdings are in general present at a holding percentage of less 10%.
1. Tax liability for capital gains from portfolio shareholdings
Beginning on 1 January2018, capital gains from portfolio shareholdings will be fully subject to corporate income tax and trade tax, including capital gains relating to hidden reserves formed before the deadline. Hidden reserves that are part of portfolio shareholdings can be realized under the current tax regime with a 95% tax exemption until 31 December 2017.
For this reason, it may be advisable to realize by way of disposition appreciations in value contained in portfolio shareholdings by the end of 2017.
2. Portfolio shareholdings
The discussion draft sets forth a definition of capital gains from portfolio shareholdings that is nearly identical to the definition already applicable for dividends from portfolio shareholdings. The decisive factors are the holding percentage (10%) and the holding date.
With the holding date, the beginning of the relevant calendar year (not financial year) is determinative. If a shareholder holds at least a 10% participation at the beginning of the calendar year, the participation can be sold 95% tax-free.
The result is that capital gains realized on participations acquired after 1 January of a given year and disposed of within the same year are deemed capital gains from portfolio shareholdings and are fully taxable, regardless of the size of the participation.
3. Loss deduction
The introduction of tax liability for capital gains on portfolio shareholdings is accompanied by another unpleasant change for the taxpayer. Profit reductions from portfolio shareholdings can only be set off against corresponding capital gains from these portfolio shareholdings. Profit reductions are either capital losses or partial write-downs of the participation. The accrued losses can be carried forward by the shareholder for an unlimited period, but are subject to certain loss transfer restrictions when transferring the participation.
4. Exemption for venture capitalists and start-up financings
The discussion draft contains a tax incentive for venture capitalists and start-up financings, which, however, is in our judgment not sufficient. If certain conditions are met, the corporate income tax on capitals gains from portfolio shareholdings is reduced on request by 30% of the participation's acquisition costs. No tax incentive has been provided with regard to trade tax.
The first prerequisite for the tax relief is the requirement that the undertaking in which interests are to be disposed must be an eligible undertaking. The term is defined by the Guidelines on State Aid to Promote Risk Finance Investments (ref. 2014/ C 19/ 04, dated 22 January 2014). Eligible undertakings include small mid-cap companies, i.e., start-up companies. The investor has to be investing for the first time in the company, the shares have to be issued at the founding of the company or at a capital increase, and the shareholder must hold these shares for a minimum of three years before disposition. The tax relief is not available if the shares are listed for official trading or listed on a regulated market or the acquisition of the shares was already sponsored or subsidized by another measure.
The tax relief loses all effect if no corporate income tax liability is incurred by the taxpayer. Any unusable tax relief cannot be reimbursed or carried forward.
The tax incentive and its prerequisites mainly derive from the European guidelines on state aid to promote risk finance investments. Yet the European guidelines also provide a full tax exemption on dividends and capital gains as well as deferred tax liability in case of reinvestment. In this context, the German legislature could have gone significantly farther to create an investment-friendly environment for venture capitalists and start-up financing.
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.