Substantial changes to German investment taxation system

The German legislature enacted the Alternative Investment Fund Managers (AIFM) Tax Adaption Act on 24 December 2013 (Federal Law Gazette I, p. 4318). The act finally passed both chambers of parliament, after the initial initiative failed before the September 2013 federal elections in the previous legislative period. The new act essentially is similar to the previous draft.

The new AIFM Tax Adaption Act introduces substantial changes to the scope of the Investment Tax Act (GITA) and is expected to have a significant impact on the taxation of German investors in various regulated and unregulated fund schemes.

Amended scope of investment tax rules

The scope of the GITA has been extended beyond open-ended investment fund schemes to encompass basically all collective investment schemes (Investmentvermoegen), including compartments and subfunds regulated by the Capital Investment Code (Kapitalanlagegesetzbuch, or KAGB).

Special tax rules are provided for German investors in the following: (1) UCITS funds (i.e. all under-takings for collective investment in transferable securities regulated under the European UCITS Directive (2009/65/EC)); and (2) Alternative Investment Funds (AIF). AIF are — in line with the AIFM Directive (2011/61/EU) — collective investment undertakings that raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors, and which are not enterprises operating outside the financial sector.

Certain unregulated companies including, certain holding companies, private pension schemes securitization vehicles, family offices, entities and certain tax-exempt organizations are outside the scope of the GITA.

The new GITA distinguishes between investment funds (Investment-fonds) — which continue to be subject to a semi-transparent taxation regime with tax privileges for German investors, especially with respect to certain undistributed realized capital gains — and investment companies (Investitionsgesellschaften), which do not qualify for the semi-transparent tax regime.

Investment fund taxation

Investment funds are funds that fulfill all of the following criteria:

• The UCITS, AIF or the AIF Manager is subject to state supervision for collective investment schemes in its country of residence. (This requirement is deemed to be fulfilled for any captive fund.)
• Investors are entitled to redeem their fund units at least once a year. (This requirement is deemed to be fulfilled for fund units traded on a stock exchange (ETF).) Any minimum holding period required by law should not prevent a fund from meeting this requirement, according to the AIFM Tax Adaption Act.
• The objective of the fund is limited to passive investment and management of assets for the accounts of the unitholders, and the fund does not engage in active entrepreneurial asset manage-ment (certain exemptions apply to real estate funds).
• The fund invests its assets, directly or indirectly, in accordance with risk diversification principles (which generally require investment into more than three assets with different risk profiles).
• At least 90% of the portfolio is invested in eligible assets listed in a specific asset catalogue. The remaining 10% may be invested in other assets. (The eligible assets catalogue has been amended and now comprises securities, money market instruments, derivatives, cash in bank, real estate and equivalent rights, real estate companies, operating equipment necessary for real estate investments, units in domestic and foreign investment funds, participations in public private partnership (PPP) project companies, precious metals, unsecuritized loans and shares of corporations. Previously, investment funds could invest into “enterprises,” which also comprised partnership interests.)
• Investments in shares of unlisted corporations and enterprises acquired before 28 November 2013 are limited to a maximum of 20% of the fund’s net asset value (NAV). (Real estate funds may, however, invest up to 100% in real estate-owning companies.) Additionally, the fund must not invest 10% or more of the share capital of a particular corporation, except for shares in real estate companies, PPP project companies and German renewable energy companies.
• The fund may obtain short-term loans only up to a maximum of 30% of the fund’s NAV (real estate funds may obtain additional loans, up to 50% of the fair market value of the real estate owned by the fund).
• These criteria must be expressly stipulated in the fund documentation. If the fund changes its investment objective or if it substantially deviates from the investment fund criteria, the German tax authorities will formally reclassify the fund as an investment company (subject to the tax regime described below) for a period of at least three years.

Under transition rules, an investment fund qualifying as such under the GITA rules that applied until 21 July 2013 will continue to qualify as an investment fund, as long as it continues to meet the former investment fund definition.
If a fund fulfills the new investment fund criteria or falls within the scope of the transition rules, the semi-transparent investment regime will apply to its German investors, provided the fund meets the comprehensive GITA reporting and publication requirements. This semi-transparent tax regime usually is beneficial for German investors, as certain undistributed earnings can be accumulated at the fund level without being subject to tax at the investor level.
Fulfillment of the investment fund criteria (or transition provisions) is a requirement for German investment funds to benefit from the exemption from corporate income tax and trade tax, and from the VAT exemption for fund management.

Investment company taxation

The semi-transparent tax regime for investment funds does not apply to investment companies. Investment companies include all AIFs that do not meet the investment fund criteria, especially hedge funds, private equity funds and certain real estate funds.

The tax treatment applicable for an investment company depends on whether it is classified as a tax transparent partnership or a tax opaque corporation.

Partnership investment companies (Personen-Investitionsgesellschaften), especially German KGs or common law limited partnerships, and their German investors are subject to the general tax regime. The income of German partners will be assessed at the level of the partnership and allocated pro rata to the German partners. Such tax assessment also is required for foreign partnerships with more than one German partner. Depending on the business activities of the partnership in Germany, German municipal trade tax may apply at the partnership level, at rates ranging between 7% and 17.2%.

AIFs that do not qualify as investment funds or partnership-like investment companies are corporate investment companies (Kapital-Investitionsgesellschaften). German corporate investment companies are subject to resident taxation, i.e. corporate income tax plus the solidarity surcharge (15.825% combined rate) on worldwide income, as well as the trade tax. Foreign capital investment companies are, in principle, subject to German nonresident taxation, i.e. the corporate income tax plus the solidarity surcharge on certain German-source income. German business or corporate investors may apply participation exemption relief to the dividends or capital gains generated through an investment in a corporate investment company only if the fund is subject to regular corporate income taxation in its state of residence without being exempted; funds resident outside the EEA must be subject to corporate income taxation at a rate of at least 15%.

Contractual-type fund schemes (e.g. Luxembourg FCPs, Irish CCFs or German Sondervermoegen) that do not meet the investment fund criteria also are classified as corporate investment companies. The GITA now expressly states that contractual-type fund schemes may be subject to German nonresident taxation.

Additionally, the German controlled foreign company rules may apply to German investors in investment companies. Under these rules, any low-taxed passive investment income in a foreign investment structure is subject to full taxation at the level of the German investor, irrespective of any actual distributions. Specific tax compliance requirements also apply for German investors.

Application of the new GITA rules

The new GITA rules generally apply to all funds established after 23 December 2013. Under the transition rules, an investment fund established before 24 December 2013 will continue to be classified as such until the end of its first financial year ending after 22 July 2016, if the fund continues to fulfill the former investment fund criteria applicable until 21 July 2013.

Action required

German investors should analyze the tax consequences deriving from any investments in fund schemes established after 23 December 2013. Existing fund investments should be monitored to determine if they continue to qualify for application of the GITA rules. If funds do not continue to comply with the GITA requirements, a German investor may divest or change its investment structures to avoid detrimental tax treatment in Germany.

Fund managers should consider whether their fund structures remain attractive for German investors. This will especially be true for funds resident in jurisdictions without accepted state supervision over the fund (especially offshore jurisdictions).