I. EXECUTIVE SUMMARY
In our Client Info dated 7 August 2015 we informed on the Discussion Draft of the German Investment Tax Reform Act published by the German Federal Ministry of Finance on 21 July 2015 (the "Discussion Draft").
On 16 December 2015 the German Federal Ministry of Finance published an updated draft (the "Draft"). The Draft reflects, inter alia, input of associations of the German investment industry on the Discussion Draft.
The content of the Draft can be summarized as follows:
- Basically, the system of investment taxation introduced by the Discussion Draft remains unchanged. In particular, partnerships are generally not covered by the provisions of the new investment tax act.
- The most important change is not directly linked to investment taxation but to the taxation of capital gains from the sale or disposition of shares in a corporation. Under the Discussion Draft the exemption for such capital gains was to be abolished in case of portfolio shareholding in corporations (i.e. participations of less than 10%). This provision is no longer part of the Draft, i.e. such capital gains remain exempted from (corporate) taxation.
Moreover, there are the following changes between the Draft and the Discussion Draft:
- statutory seat, principal place of management or permanent establishment are no longer relevant for the distinction between German and non-German investment funds which should make cross-border management of investment funds easier;
- generally no taxation of the investment fund with respect to capital gains from significant investments in German portfolio companies (i.e. investments representing 1% or more of the portfolio company's capital);
- specify and increase partial exemptions for the benefit of investors;
- slight reduction of pre-determined tax bases (Vorabpauschalen);
- specifying the definition of "securities" for special investment funds;
- extending the possibility of investments of individuals in special investment funds;
- Facilitation of the so called funds privilege for special investment funds; and
- extension of the existing grandfathering rule for investment funds that were already in existence on 24 December 2013 until entry into force of the German Investment Tax Reform Act.
For details please refer to the following sections.
The Draft does not change the provisions regarding VAT on management services provided to investment funds. Hence, the decision of the ECJ of 9 December 2015 (cf. our client info dated 10 December 2015) has not been reflected in the Draft yet.
Under the Draft the scope of investment taxation remains widely unchanged. The future investment taxation shall only apply to investment funds. Consistent with the Discussion Draft partnerships do not fall into the scope of the German Investment Tax Act. However, investment funds of a contractual type (whether German or non-German) will be subject to investment taxation (as under the Discussion Draft).
1. Investment Funds Within and Out Of Scope
There are the following changes between the Draft and the Discussion Draft:
- It is clarified that investment funds that are parent undertakings or subsidiaries of an AIFM and, as such, are not covered by the regulation under the Capital Investment Code (i.e. the German implementation of the AIFM Directive), will nevertheless be subject to investment taxation.
- Consistent with current law participation companies pursuant to the German Participation Companies Act (Unternehmensbeteiligungsgesellschaften) and companies that acquire participations for the public benefit using their own funds or governmental subsidies are not subject to investment taxation.
- An important clarification is that German REITs and non-German REITs that are subject to the provisions of the German REIT Act are not subject to investment taxation. Hence, the taxation of such REITs and their investors is exclusively governed by the tax provisions of the German REIT Act.
2. German and Non-German Investment Funds
Other than under the Discussion Draft the distinction between German and Non-German Investment Funds no longer depends on the statutory seat, the principal place of management or a permanent establishment of the investment fund or its manager.
Instead, the distinction depends on the law to which the investment fund in question is subject. This is consistent with the regulatory approach. Under this approach the law that governs the fund, its investment policy or its constituent documents is decisive, i.e. the distinction depends on the applicable civil law.
Under the Draft the management of a non-German investment fund by a German manager in Germany does not automatically result in German investment fund treatment. This should make cross-border management of investment funds easier.
III. RETAIL INVESTMENT FUNDS
Going forward, a non-tax-transparent regime is envisioned for retail investment funds, i.e. all investment funds other than special investment funds. Such regime results in potentially two levels of taxation: investment fund and investors.
1. Taxation of Investment Funds
a) Corporate Income Tax
Under the new non-tax-transparent tax regime the following items of income realized by retail investment funds will be subject to corporate income tax plus solidarity surcharge (15.825%):
- 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 (§ 49 para. 1 EStG) except for profits from the disposition of so-called significant investments (i.e. investments representing 1% or more of the portfolio company's capital).
The exception from German tax liability on fund level for profits from the disposition of significant investments in German corporate portfolio companies is new and to be welcomed. It avoids a discrimination of domestic investment funds since this type of profits realized by foreign investment funds is typically exempt from German tax liability under treaty law anyhow. Thus, the notion of taxable "other domestic income" basically encompasses only certain items of income realized by an investment fund which is engaged in a trade or business from a German tax perspective, e.g. interest income earned on a loan that is secured by German real estate.
According to the Draft, the exemption for investment income pursuant to § 8b KStG does not apply at fund level. In this respect, the Draft corresponds to the Discussion Draft. As a result, domestic dividends (including where the investment fund's shareholding in the respective corporations represents 10% or more of such corporations equity capital) as well as profits realized by business-type investment funds upon disposition of participations in German corporations are fully subject to German corporate income tax. The envisaged general non-applications of the exemption for investment income pursuant to § 8b KStG is in our judgment inconsistent, both from a systematic as well as from a practical perspective.
b) German Trade Tax
Investment funds will continue to be exempt from German trade tax in the same cases as at present. Such exemption is granted if the investment fund's purpose is limited to investing its capital and managing such investments and if an entrepreneurial management of such assets is excluded. The latter requirement does not apply to real estate funds due to the specifics of this asset class.
The Draft provides, however, for a new de minimis threshold: A business-type activity of an investment fund triggers a trade tax liability only if the income from such business-type activity represents 5% or more of the investment fund's income in a given business year.
If an investment fund does not comply with the requirements for the trade tax exemption, such fund's domestic income from its business-type activity are supposed to be subject to German trade tax.
2. Taxation of Investors
a) Proceeds from Investment Funds
The following proceeds from investment funds will be taxed on the investor level:
- distributions from the investment fund;
- pre-determined tax bases (Vorabpauschalen), and
- capital gains realized upon the dispositions or redemption of investment fund interests.
For private individuals as investors, such proceeds are subject to flat income tax subject to partial exemptions (see paragraph b) below). For business investors, such proceeds are subject to income tax or corporate income tax and, where applicable, trade tax in full but subject to partial exemptions. The tax exemptions for investment proceeds (Beteiligungserträge, § 3 no. 40 EStG, § 8b KStG) do not apply.
b) Partial Exemptions
Prior tax impositions on the investors' proceeds 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. These partial exemptions apply to distributions, pre-determined tax bases and disposition profits, and are taken into consideration in the context of German withholding taxes. The partial tax exemptions have been increased and are more differentiated than under the Discussion Draft.
- 30%, 60%, or 80% of proceeds from an equity fund (Aktienfonds) are exempt in the hands of private individual investors, business individual investors and corporations, respectively; the increased exemption of 60% or 80% is, however, not available with respect to fund interests held for trading by credit institutions and financial service providers, for certain financial enterprises and for life and health insurance companies.
- According to the Draft, equity funds (Aktienfonds) are investment funds that continuously invest at least 51% of their assets in stocks (Aktien). In our view, shares in German private limited liability companies (GmbH) and other equity shareholdings should also be treated as stocks. Such interpretation is not confirmed by the Draft, and it would be welcome if was confirmed in the course of the legislative process.
- Investors in investment funds that continuously invest at least 25% of their assets in stocks (Aktien) are entitled to a half of the exemptions applicable to equity funds (Aktienfonds).
- 60% of proceeds from investment funds that continuously invest at least 51% of their assets in real estate or real estate companies are tax-exempt at investor level. This tax exemption increases to 80% in case an investment fund is invested in foreign real estate or real estate companies invested in foreign real estate.
- The aforementioned partial tax-exemptions are also granted to investors in funds-of-funds. For purposes of determining the category of a fund-of-funds, 51% of interests in a target equity fund or a target real estate fund are counted as shares or real estate, respectively.
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 70% (i.e. 10 percentage points less than foreseen in the Discussion Draft) of the base interest rate under the German Valuation Tax Act (Bewertungsgesetz, BewG) multiplied by the value of interests in investment funds, less the amount of distributions made in the relevant fiscal year. The pre-determined tax basis is limited to the amount by which the investment fund interest has increased in value in the relevant calendar year.
The concept of the pre-determined tax basis has remained unchanged in comparison to the Discussion Draft: Although the pre-determined tax basis is less strict than the current concept of penalty taxation pursuant to § 6 InvStG and is deducted in the context of taxation of profits realized upon disposition or redemption of investment interests, it can nonetheless result in tax assessments on purely fictive proceeds, for example if the value of the investment interest should subsequently decline.
IV. SPECIAL INVESTMENT FUNDS
The Draft – consistent with the Discussion Draft – provides for a continued limited tax transparency for special investment funds (Spezial-Investmentfonds), but with substantial modifications as compared to the current situation. In particular, the personal tax exemption of fund vehicles is would be replaced by an option to be treated as transparent (Tranzparenzoption), which means, broadly speaking, that the investors in the fund take the fund's place for tax purposes with regard to certain domestic income of the fund.
1. Product Regulation for Special Investment Funds
The Draft provides for a specification of the access to the personal tax exemption (by way of opting for transparency) for special funds which are widely used by many institutional investors (e.g. insurance companies, pension funds, benefit plans). Access requires compliance with a product regulation regime for tax purposes which has been in place since an implementation of the AIFM-Directive (AIFM-StAnpG) has entered into force on 24 December 2013. Accordingly, a fund can only be treated as a special investment fund for tax purposes if, inter alia, at least 90% of the fund's net asset value is invested in eligible assets such as, among others, securities.
The term "securities" is specified by the Draft to only include such securities as set forth by § 193 KAGB. On the one hand, this specification entails more restrictive material requirements as compared to the current practice of German tax authorities. On the other hand, the envisaged approach provides for more legal certainty with regard to the criteria which need to be met for an investment instrument to qualify as a security.
Effectively, classification of instruments as securities is subject to the same requirements which are in place for UCITS. Such requirements are set forth in the "Eligible Assets Directive" (Directive 2007/16/EC) established in 2007. Accordingly, participations in closed-ended funds are to be treated as securities if they meet certain criteria. This is especially important for special investment funds since participations in business-type partnerships (gewerbliche Personengesellschaften) do not per se constitute investments eligible for special funds due to the implementation of the product regulation regime for tax purposes.
2. Access of Natural Persons to Special Investment Funds
The Draft further entails a substantial change with regard to access to special investment funds. The Discussion Draft excluded natural persons from participating indirectly through partnerships (apart from a grandfathering rule limited in time and certain special exceptions motivated by regulatory aspects). The Draft, however, allows the following constellations:
- direct and indirect participation of natural persons if the units are held as business assets;
- participations of natural persons required for regulatory reasons (consistent with the Discussion Draft);
- indirect participations held before the date of the resolution of the German Parliament.
This amendment is supposed to enable sole entrepreneurs and business partnerships to bundle their capital investments in the same way as businesses structured as corporate entities. As a result, natural persons are only excluded from investments via special investment funds if the fund units are held as private assets.
In conclusion, natural persons are still able to participate in special investment funds which can reinvest certain amounts without a tax burden on the fund or the investors (so called "funds privilege", please cf. the following section 3).
3. Modification of the Funds Privilege
The Draft contains substantial modifications with regard to the so called funds privilege which is an essential component of the principle of limited transparency applicable to special investment funds opting for transparency. According to the funds privilege, and consistent with the rules applying to investment funds as defined for tax purposes thus far, certain proceeds realized by a special investment fund are not taxed at the investors' level as long as they are not distributed.
Pursuant to the Discussion Draft, the funds privilege was supposed to apply to 90 % of proceeds from option premiums and capital gains from dispositions and forward transactions. As a result, such regulation would have caused a time limitation on the deferral effect connected with such provision.
Such time limit is no longer provided in the Draft. However, whereas the Discussion Draft provided a fund privilege for a larger number of kinds of extraordinary income than in current law, the Discussion Draft now distinguishes as follows:
- Irrespectively of distributions, investors have to include in their taxable income current capital proceeds such as interest and dividends as well as proceeds from financial derivates the amount of which is determined by interest or dividends.
- Option premiums, gains from the disposition of shares in corporations or debt instruments or from forward transactions as well as gains from the disposition of investment participations shall be fully covered by the funds privilege.
4. Tax Exemption for Investment Income
Since the exemption for investment income for capital gains from the disposition of portfolio shareholdings in corporations (below 10%) is supposed to remain unchanged for the time being, it is – subject to certain procedures – supposed to also apply to participations held through special investment funds, according to the Draft.
a) Current Investment Income
The exemption for investment income (§ 8b KStG) is generally supposed to apply to the allocation of current proceeds from a participation in a special investment fund in the following manner:
- Income from dividends are covered by the exemption for investment income if it is derived from participations of the special investment fund in real estate companies, PPP project companies, or companies producing renewable energy, provided that the investor indirectly holds at least 10 % of the units of each such corporation (determined on a look-through basis);
- gains from the disposition of participations in corporations are covered by the participation privilege irrespectively of the nature of the company and the percentage of the participation.
b) Exit Taxation
Pursuant to the Draft, the exemption for investment income is supposed to be also applicable if units of a special investment fund are redeemed or disposed of.
The applicability of the exemption for investment income is subject to exceptions:
- The exemption for investment income does not apply to units held by credit institutions, financial service providers or financial enterprises which are (i) attributable to the trading book or (ii) purchased to realize short-time gains from proprietary trading.
- Furthermore, the exemption for investment income does not apply if foreign corporations are not subject to income taxation or are exempted either personally or with regard to income equal to actual distributions.
5. Transitional Provisions
Certain funds that were already in existence on 24 December 2013 are currently taxed according to the principle of limited transparency although they do not meet the requirements of the product regulation regime for tax purposes in place under current law. This grandfathering regime is limited in time and will end between 23 July 2016 and 22 July 2017, depending on the fiscal year of the fund. The Draft provides that the transitional period ends on 31 December 2017 for all pre-existing funds to prevent several regime changes during a short period of time. However, there might be just a short period of time left between the finalization of the legislative process and the end of the transitional period under current law. It is therefore important to closely follow the developments and prepare for a short-term adjustment of the investment strategy and the fund documents for funds the fiscal year of which ends shortly after the 22 July 2017 and that do not yet meet the product requirements for tax purposes.
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.