Last week the German Federal Ministry of Finance (BMF) submitted the ministerial draft of a German Act on the Adaption of Investment Fund Taxation in Connection with the AIFM Directive ("Draft") to the associations of the investment industry. The Draft provides for significant changes of the taxation of funds and their investors. The proposed provisions of the Draft would have a significant impact on existing structures.
I. Executive Summary
The Draft provides for the taxation of investment undertakings regulated by the draft of the German act on implementation of the AIFM directive (KABG-E). The Federal Ministry of Finance, however, does not intend to implement a single tax regime for all such investment undertakings but creates categories of funds solely for tax purposes which are to be subject to different tax regimes.
1. Closed-End Funds
German and non-German private equity funds and other closed-end funds such as mezzanine, infrastructure and real estate funds are to be treated as "non-qualifying investment funds". For tax purposes differentiation is made between partnerships and corporations.
- The general rules of taxation are to remain applicable to partnerships (e.g. German GmbH & Co. KG, limited partnerships), i.e. there are no changes to the taxation rules currently in force.
- German and non-German corporations (e.g. German limited liability corporation or joint stock corporation, Luxembourg S.C.A./S.A. SICAV, Irish PLC) are to be subject to a new tax regime comparable to the lump-sum taxation (!) under the current German Investment Tax Act. However, a taxation of the actually received income, e.g. due to the reporting of certain tax information or similar measures, is not possible.
2. Open-End Funds
Generally, there will be no changes to the tax regime for open-end funds that fall within the scope of the German Investment Tax Act currently in force. However, certain requirements will be introduced in order for a fund to qualify for this tax regime (e.g. certain redemption rights and investment limitations). Accordingly, open-end funds that do not fulfill these requirements will be subject to the tax regime applicable to closed-end funds.
3. Transitional Provisions
The draft does not contain transitional provisions for closed-end funds organized as partnerships (e.g. German GmbH & Co. KG, limited partnerships) because their taxation does not change.
The new tax rules for closed-end funds organized as corporations (e.g. German joint stock corporation, Luxembourg S.C.A./S.A. SICAV, Irish PLC) will enter into force as of 22 July 2013; they are not not be grandfathered. Such funds would be subject to mandatory lump-sum taxation.
The tax regime currently in place for open-end funds that fall within the scope of the German Investment Tax Act currently in force and that have been or will be established prior to 22 July 2013 remains applicable; they are grandfathered.
4. VAT on Management Fee
Management Fees paid by closed-end funds are intended to remain subject to VAT.
The provisions (including the lack of grandfathering rules) for closed-end funds organized as corporations are not reasonable and constitute a violation of the constitution. In the course of the hearing of the relevant associations and in the legislative procedure P+P will use professional efforts to adapt the provisions of the Draft appropriately.
II. Scope of the Draft
In the course of the regulatory implementation of the AIFM Directive, the scope of the new investment law pursuant to the German Investment Code (Kapitalanlagegesetzbuch) will be extended to all alternative investment funds ("AIF"), including private equity funds and other closed-end funds. Under the Draft, the new system is implemented in German tax law. However, for tax purposes various categories of AIFs will be introduced that differ from the classification under the German Investment Code and that are subject to different tax regimes.
1. Qualifying Investment Funds
The term "Qualifying Investment Fund" includes the European harmonized undertakings for collective investment in transferable securities (UCITS), as well as certain German and non-German open-end AIFs. They are to remain subject to the preexisting German investment tax law with certain modifications. However, German and non-German funds will no longer be differentiated.
Furthermore, certain requirements with respect product regulation must be fulfilled solely for tax purposes in order for an AIF to be treated as qualifying investment fund. The tax related product regulation is not consistent with the regulatory product regulation.
In addition to preexisting requirements with respect to passive investment without involvement in the management of portfolio companies and an investment according to the principle of risk diversification, the following criteria must be satisfied:
- The AIF must be subject to regulation in the state of its statutory seat, and the investors must have a redemption right at least once per year. This requirement is stricter than the requirements under the law currently in force.
- There is a uniform limitation for investments in companies that are not listed on a stock exchange of up to 20%. The respective 30% threshold currently applicable to hedge funds will no longer be relevant. However, the limitation applicable to non-securitized loan receivables and derivatives is to be rescinded.
- In addition, investments in one and the same corporation are limited to 5% of the AIF's value. Furthermore, an AIF may not hold more than 10% of the outstanding shares of a corporation.
- AIFs may borrow up to 30% of the AIF's value (real estate funds up to 10%) short-term. Only real estate funds are entitled to borrow money up to 30% of their value long-term.
Most of the funds established in offshore jurisdictions (e.g., Cayman Islands, British Virgin Islands, Bermuda and Channel Islands) and all closed-end funds, but also hedge funds and certain open-end real estate funds, will no longer be treated as qualifying investment funds, and will be subject to the adverse tax regime for non-qualifying investment funds (cf. the following section III. 2).
Compared to the current situation, it may become easier for debt and derivative funds and the so-called CAT-bond funds to fall within the scope of qualifying investment fund taxation.
2. Non-Qualifying Investment Funds
All AIFs that do not fulfill the requirements for qualifying investment funds are referred to as "Non-Qualifying Investment Funds". Also in this respect, no differentiation will be made between German and non-German non-qualifying investment funds.
The proposed tax regime for non-qualifying investment funds will primarily cover funds that will be treated as AIF in the future but do not fall within the scope of the German Investment Tax Act currently in force, i.e., closed-end funds, including but not limited to, private equity funds. Furthermore, AIFs that no longer meet the modified requirements for qualifying investment funds (see section 1 above) such as certain open-end real estate funds or hedge funds, will also be treated as non-qualifying investment funds.
III. Rules of Taxation
1. ualifying Investment Funds
The tax rules for investment funds will basically follow the same rules as previously (concept of limited transparency), subject, however, to certain modifications.
a) Tax Exemption
As in the past, Investment Funds are treated as corporations irrespective of their legal structures, provided, however, that they are exempt from German corporate income tax and, where applicable, German trade tax; investment proceeds are subject to taxation only at the level of investors.
Investment stock corporations may receive both capital proceeds as well as income for asset management services rendered. Under the Draft this feature is taken into account as follows:
- Income from asset management activities in the hands of internally managed investment stock corporations will be subject to taxation. However, it is unclear how the portion of the overall profits that is to be allocated to the asset management services are to be determined. In particular, allocation of costs and expenses may give rise to questions.
- Pursuant to the Draft, income allocable to company shares (i.e. shares typically held by the initiators) will be subject to taxation at the level of investment stock corporations. However, this will not apply to special investment stock corporations that exclusively issue company shares. It appears problematic that the Draft includes no special rules regarding taxation of the aforementioned income in the hands of the investors. In the absence of any special rules, the general taxation rules for investment funds would apply; conceptually, these rules presuppose, however, that proceeds are exempt from taxation at the fund level.
b) Domestic Special Investment Funds
The rules for domestic special investment funds essentially continue to apply. In particular, investors organized as partnerships (e.g. family offices) will remain eligible investors in domestic special investment funds.
Special rules apply where a fund ceases to be classified as a special investment fund (cf. paragraph e) below.)
c) Open-End Investment Limited Partnerships
Open-end investment limited partnerships have been introduced in order to make pension asset pooling by international companies more attractive.
- An open-end investment limited partnership is intended to be tax transparent for double taxation treaty purposes, to benefit from reduced withholding tax rates granted exclusively to pension funds.
- An investment in an open-end investment limited partnership does not give rise to a domestic permanent establishment of the investor. The rationale behind this stipulation is to avoid that German tax filing or tax-paying obligations are imposed on investors solely as a consequence of the investment limited partnership deriving business income.
Apart from the above, open-end investment limited partnerships and their investors are intended to be subject to the general investment taxation rules; provided that provisions relating to domestic special investment funds correspondingly apply, including the limitation of the number of investors to 100, as well as the requirement that they must not be individuals.
f) Amendments to Rules of Taxation
The Draft includes a number of modifications to the investment taxation which are unrelated to the transformation AIFMDs. The Draft implements certain requests submitted by the Federal Council (Bundesrat) to the German Government in connection with the annual tax act 2013 (modified deductibility of expenses, deemed order of distribution).
e) Losing Investment Fund Taxation
Contrary to law currently in force, the Draft provides that a fund loses its status as a qualifying investment fund during its term if
- the fund's terms are amended in a way that the fund no longer satisfies the requirements for investment fund taxation; or
- a significant breach of the fund's terms occurs, which is deemed to be the case if there is a breach of an investment limitation actively caused by a single transaction unless such breach is cured within ten business days.
The Draft provides for a specific proceeding to determine the loss of the status as a qualifying investment fund. After expiration of the business year during which the non-applicability of investment fund taxation has been finally determined, the relevant fund will be taxed as a non-qualifying investment fund (cf. section 2 below) for a period of three years.
If a special investment fund no longer fulfills the features of a qualifying investment fund due to a modification of its terms and/or its articles of association or due to actual breaches of its investment limitations, it will be treated as non-qualifying investment fund upon expiration of the business year during which the breach occurred.
f) Entering into Force, Grandfathering
According to the Draft, the new law will enter into force as of 22 July 2013, at the same time as the German Investment Code. Funds that have been established prior to this date and that are subject to the German Investment Tax Act currently in force remain subject to the previous rules. The new law will be applicable to all funds established on or after July 22, 2013. Thus, existing funds would not be subject to the contemplated provisions of the Draft.
2) Non-Qualifying Investment Funds
The tax regime for German and non-German non-qualifying investment funds differentiates between a partnership-type non-qualifying investment fund and a corporate-type non-qualifying investment fund.
a) Partnership-Type Non-Qualifying Investment Funds
Partnership-type non-qualifying investment funds are investment limited partnerships that do not fulfill the tax requirements of an open investment limited partnership, and comparable non-German entities.
These funds are not subject to any changes. The Draft merely clarifies that the general rules of taxation shall apply. Tax transparency is applicable, i.e. the direct pro-rata allocation of the fund's items of income. In addition, the criteria used to differentiate between business and non-business activities remain applicable. Finally, the Draft provides for a separate and uniform tax assessment.
b) Corporate-Type Non-Qualifying Investment Funds
A completely new tax regime will be introduced for German and non-German corporate-type non-qualifying investment funds which will bring significant disadvantages in comparison to the rules of taxation currently in force.
(1) SICAVs and Asset Pools
Corporate-type non-qualifying investment funds include not only German and non-German corporations such as Luxembourg SICAVs, but also German and non-German asset pools of a contractual type such as Luxembourg fonds commun de placement (FCP) that (in either case) do not satisfy the criteria for qualifying investment funds.
This provision solves the open issue of how to treat non-German asset pools of a contractual type that do not fall within the scope of the German Investment Tax Act currently in force. The Draft provides for a corporate treatment of such pools. Hence such pools may be subject to limited tax liability with respect to their German source income. The tax non-transparency pursuant to the Draft, however, conflicts with the DTT-transparency agreed between Germany and several countries.
(2) Mandatory Lump-Sum Taxation
The taxable income at the level of an investor in a corporate-type non-qualifying investment fund comprises of all distributions plus 70% of the difference between the last and the first redemption or market price fixed for the relevant business year; provided, however, that at least 6% of the last redemption or market price fixed for the relevant business year will be subject to tax. The mandatory lump-sum taxation concept applies to unrealized profits as well as realized, but retained profits. The Draft is silent how to determine the market price. While this concept resembles the existing lump-sum taxation, it is intended to be mandatory, i.e. taxation of income actually received or deduction of losses would not be possible. The proposed concept of mandatory lump-sum taxation gives rise to considerable constitutional concerns.
(3) Impact of Taxation at Fund Level
The amount taxable under mandatory lump-sum taxation is to be taxed like a dividend at investor level (i.e. partial income taxation for individuals holding their shares as part of their business assets, or tax exemption pursuant to § 8b German Corporate Income Tax Act in case of corporate shareholders), but only in the case of an effective tax burden of 15% at the level of the corporate-type non-qualifying investment fund. If the effective tax burden is less than 15%, the amount taxable under mandatory lump-sum taxation is to be fully taxable. Flat rate withholding tax (Abgeltungsteuer) applies to private investors irrespective of whether there is a tax burden at the level of the corporate-type non-qualifying investment fund.
(4) Inadequate provisions to avoid double taxation
As a matter of "logic", the application of the mandatory concept of the lump-sum taxation to unrealized and realized, but retained profits results in double taxation. The mandatory concept of the lump-sum taxation violates, in our judgement, the constitution unless provisions were introduced to avoid double taxation.
However, the Draft contains inadequate provisions in this respect. Provisions are missing to exempt distributions from tax if and to the extent consisting of retained profits that were already subject to tax. Moreover, despite of the fact that the mandatory concept also applies to unrealized profits the Draft does not address how to deal with subsequent decreases in value. Only in case fund interests are disposed of by a private investor such transferor can deduct the excess of the total taxable income over all distributions actually received upon determining the capital gain. The Draft, however, does not address sales of fund interests that belong to the business assets of the disposing investor. Nor does the Draft address the situation that an investor continues to hold on its investment in the fund until its dissolution.
c) Entering into Force, Grandfathering
In addition to qualifying investment fund taxation, the provisions for the non-qualifying investment funds, and therewith mandatory lump-sum taxation, are also intended to take effect as of 22 July 2013.
The grandfathering rules of the Draft with respect to qualifying investment funds will not apply to non-qualifying investment funds that do not fall within the scope of the German Investment Tax Act currently in force. Accordingly, all SICAV or FCP structures that have not previously been treated as foreign investment funds will be subject to mandatory lump-sum taxation.
IV Value Added Tax
Previous VAT exemption for management of investment funds is to be adapted to conform to the revised Draft terminology. However, the anticipated exemption is only intended to apply to qualifying investment funds, and not to non-qualifying investment funds. The scope of VAT exemption would thus remain for the most part unchanged, in particular, management fees of private equity funds and other closed-end funds would continue to be subject to VAT.
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.