On 21 May 2019, the German Federal Ministry of Finance (BMF) published its long-awaited circular on the German Investment Tax Act (GITA) in the version effective from 1 January 2018 (the "Circular", BMF letter as of 21st of May, 2019, Ref.: IV C 1 - S 1980-1/16/10010:001). The Circular addresses in particular the provisions for (simple) investment funds (§§ 1-24) and the application and transitional provisions (§ 56 GITA).
These provisions affect, among other things, private equity funds and funds of funds organized as corporations and segregated assets (Sondervermögen) (hereafter "Investment Funds"). We have summarized selected aspects of particular relevance for the private equity sector below.
- A fund-level tax exemption in relation to business income generally now "only" requires, with regard to trade tax and corporate tax alike, that there is not significant active entrepreneurial management of investments. As such, certain business income is detrimental neither for corporate tax purposes nor for trade tax purposes.
- The Circular takes a divergent position on the important question for funds of funds of to what extent Investment Funds are subject to corporate tax and trade tax when investing in target funds structured as partnerships that are engaged in a trade or business for German tax purposes.
- Whether investors invest directly or indirectly in Investment Funds via partnerships is not relevant for the calculation of partial tax exemption rates.
- Beginning in 2020, a list of the actually attained percentages for each business day is to be required to document that the requirements have been met for partial tax exemptions in investors' assessment procedure.
- The financial authorities are adhering (in keeping with current legislative proposals) to their view that holding capital investments via partnerships does not affect whether a partial tax exemption is granted.
- Unfortunately, the Circular leaves open important questions with regard to the taxation of Spezial-Investmentfonds.
1. Qualification of Investment Fund Income for Corporate Tax Purposes
The Circular clarifies that taxable business income for corporate tax purposes, tracking the rules applicable for trade tax purposes, exists at the fund level only if an Investment Fund engages in significant active entrepreneurial management of its assets.
Investment Funds are regarded as taxable entities for corporate and trade tax purposes. In fact, however, only certain income from domestic sources is taxable in Germany on the incoming fund side, in particular investment income, such as dividends from German portfolio companies.
Income from a commercial enterprise maintaining a permanent establishment or permanent representative in Germany is also taxable on the fund level. An express additional requirement for tax liability for trade tax purposes is that the Investment Fund "actively entrepreneurially manages to a significant extent" its assets.
Under these criteria – which are (likely) more generous than the generally applicable income tax provisions – activities that would, for example, constitute taxable business securities trading under general rules will not necessarily lead to the tax liability of an Investment Fund. What will be decisive for private equity funds will be whether involvement in the active management of portfolio companies occurs.
The clarification will make it easier for fund managers to obtain legal certainty in this important tax planning area, as the same standard now applies for the determination of both corporate tax and trade tax liability.
2. Tax Obligations of Investment Funds of Funds
Against the discernible tendency to seek to create consistent provisions for corporate tax and trade tax, the Circular contains divergent statements here on the treatment of investments by an Investment Fund in partnerships that are engaged in a trade or business for German tax purposes.
For trade tax purposes, the investment by an Investment Fund in a partnership that is actually engaged in a business activity or is "infected" with business status will not result in a taxation of the Investment Fund if the Investment Fund solely carries out advisory and control functions or exercises other administrative rights as a limited partner.
For corporate tax purposes, however, every investment in a partnership that is engaged in a trade or business for German tax purposes is to constitute an active entrepreneurial involvement that can potentially lead to tax liability of an Investment Fund.
This prompts a series of follow-up questions relevant for funds of funds, which it is to be hoped that the financial authorities will address.
3. Partial Tax Exemptions for Co-Entrepreneurships (Mitunternehmerschaften) / Partnerships
Investors in Investment Funds can under certain circumstances receive a partial tax exemption (Teilfreistellung) with regard to proceeds when an Investment Fund can be classified as an equity fund (Aktienfonds) or mixed fund (Mischfonds). A requirement is that the Investment Fund be generally obligated by its investment requirements to hold a specific proportion of it is assets in certain equity instruments, in particular interests in non-tax-exempt corporations, on an ongoing basis.
The specific rate of the partial tax exemption depends on the classification of an investor. If an investor is a natural person holding its investment interests as business property, or is a corporation, specific partial tax exemptions apply that are higher than the "general partial tax exemption" of 30% for equity funds and 15% for mixed funds.
Whether only the "general partial tax exemption" is applicable to partnerships in all cases was previously unclear. The Federal Ministry of Finance has now clarified in the Circular that the amount of the applicable partial tax exemption rate is based on the partners of partnerships, such that holding interests in Investment Funds via a partnership will not have detrimental effects on the amount of the partial tax exemption rate.
4. Documentation of Investment Limits
If an investment percentage in corporations is not fixed in the investment requirements of an Investment Fund, an investor can only obtain the benefits of partial tax exemptions by application in the assessment procedure and through documentation that the Investment Fund actually continuously exceeded the relevant corporate investment percentage throughout the fiscal year.
The documentation contemplated by the Circular is to include in particular asset lists and written confirmations by an Investment Fund. Annual and semi-annual reports will not be deemed sufficient by themselves.
From 1 January 2020 onward, such confirmations by Investment Funds are also to contain a list indicating the actually attained percentages for every business day of the relevant fiscal year. It is to be hoped that the financial authorities will further clarify the scope of this documentation requirement. In our view, the documentation requirement should also be satisfied in the absence of valuations on every business day by providing the applicable latest available valuations. Given the fact that private equity funds do not value investments on each business day, the documentation requirement simply cannot be met if a new valuation were to be required each business day. It remains to be seen what position the financial authorities will take in this regard.
5. Significant Obstacles to Partial Tax Exemptions for Fund of Funds Investors
The financial authorities are adhering to their view that holding capital investments via partnerships will not affect the granting of a partial tax exemption. This also corresponds to the contemplated statutory provision contained in the Draft Law on Additional Tax Promotions of Electro-Mobility and Revisions to Other Tax Provisions released in May. In our opinion, the consequence is a systemically inconsistent tax disadvantaging of funds of Investment Funds.
6. Open Questions for Spezial-Investmentfonds
The Circular does not yet address the provisions of §§ 25 ff. GITA on the taxation of Spezial-Investmentfonds. Important questions thus remain open, for example with regard to whether certain assets are permitted to be acquired pursuant to § 26 No. 4 GITA.
Under the final draft of the Circular, interests in closed-ended alternative investment funds (AIFs) are permitted to be acquired as securities if the AIF is subject to corporate governance and the legal body is subject to investor protection regulations. It is to be hoped that pressing application questions of this kind will also receive clarification through final circulars in the near future.
If you have any questions regarding the above points or in general in connection with the German Investment Tax Act, we are at your disposal at any time.
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.