Taxation: Changes ahead
What are the implications of the German Investment Tax Reform Law?
• German tax law will now include single-investor funds.
• Investmentfonds may be a tax-efficient alternative to Spezial-Investmentfonds for institutional investors.
• Investors should review their investment structures and tax exposures but the Investmentfonds regime may still prove beneficial for some.
The German taxation of investment funds and their investors is, again, subject to change. Following the 2013 reform, which was required due to the implementation of the AIFMD, a new and fully revised German Investment Tax Law (GITL 2018) will come into effect as of January 2018. This article gives an overview of the changes to the current investment tax regime as well as the tax consequences and recommendations for institutional investors.
The current GITL applies to UCITS funds and alternative investment funds (AIFs). The taxation regime depends on the qualification of the respective investment vehicle as a so-called investment fund or investment company. To qualify as an investment fund, a fund needs to fulfil a catalogue of investment restrictions, including an annual redemption right, risk diversification, eligible assets, among others. These requirements are often fulfilled by UCITS and special investment funds (Spezial-Investmentfonds) used as bundling vehicles by institutional investors. Investment funds are treated as semi-transparent for investment tax purposes, meaning that so-called deemed distributed income will be taxed in the hands of the investor irrespective of distribution.
In particular, AIFs do not fulfil the aforementioned investment restrictions – for instance as they are closed-ended – and qualify as investment companies. If comparable with a partnership, they qualify as partnership-like investment companies and are treated, in accordance with general taxation rules, as tax transparent.
Investment companies in the contractual or legal form of corporations qualify as tax intransparent corporation-like investment companies. Consequently, it is subject to tax with regard to its income, but the investor only upon distribution (generally without application of the participation exemption). Add-on taxation under the German Foreign Tax Law is applicable.
Generally, tax-exempt investors prefer to invest via corporation-like investment companies in order not to jeopardise their tax-exempt status. For taxable investors, it is preferable to invest via (tax transparent) partnership-like investment companies.
Scope of GITL 2018
Conceptually, the scope of application of GITL 2018 does not change as compared to the current regime. However, there are some modifications. Most noteworthy is the inclusion of single-investor funds, which are currently not subject to the German investment tax regime. Hence, it is no longer possible to structure funds outside the application of the GITL by limiting the number of investors to one. Furthermore, AIFs in the legal form of partnerships will in the future be excluded from the scope of application of the GITL 2018; however, this should not result in significant changes, as the general rules of tax transparency already apply.
The new law does not differentiate between investment funds and investment companies. Investment funds qualify as so-called Investmentfonds (chapter 2 of GITL 2018). Alternatively, they may qualify as Spezial-Investmentfonds (chapter 3 of GITL 2018). This requires the fulfilment of these prerequisites that are similar to the those to be fulfilled under the current GITL to qualify as an investment fund (annual redemption right and so on).
However, there have been modifications. In particular, it should be noted that a chapter 3 Spezial-Investmentfonds may only acquire securities that would also be eligible for UCITS. Such changes prevent so-called repackaging structures via securitisation vehicles. Additionally, no individuals may be invested, even indirectly via partnerships. Hence, the tax regime for chapter 3 Spezial-Investmentfonds will only be applicable in a limited number of cases – such as specialised investment fund under section 284 of the German Capital Investment Code (GCIC) used by German institutional investors. All other vehicles (such as UCITS or corporation-like investment companies) will be qualified as chapter 2 Investmentfonds.
Taxation of Investmentfonds
Chapter 2 Investmentfonds are taxable entities and subject to corporate income tax, but only with regard to their German income. This includes, among others things, German source participation income (such as distributions from German resident corporations, but not capital gains) and German source real estate income. Consequently (and in contrast to corporation-like investment companies), any non-domestic income will be tax-exempt at fund level. Where German source income is subject to withholding tax (such as dividend income), the rate will be 15% and will be definitive; no solidarity surcharge will be added. Trade tax should not apply.
For German institutional investors, it is important to note that chapter 2 Investmentfonds may be partially or fully tax-exempt if they have certain privileged investors (such as charities or pension funds).
At investor level, the income of the investment fund is only subject to tax in case of distributions or the sale or redemption of fund units. However, the investor is taxable with a so-called advance lump sum amount – in other words, an amount that is attributed without a respective distribution. The amount is reduced by actual distributions, so that German investors might (at least to this extent) favour distributing over reinvesting funds. The good news is that add-on taxation under the German Foreign Tax law is no longer applicable, which reduces tax-filing costs.
Additionally, investors may profit from a so-called partial exemption regime, if the respective investment fund qualifies as a stock fund (exemption of 30% to 80%), mixed fund (half of the rate for stock funds) or a real estate fund (exemption of 60% to 80%). The partial exemption rate depends on the qualification of the fund as well as the investor status and requires structuring (for instance as regards holding structures). Furthermore, the fund documentation should be amended with regard to the prerequisites of the partial exemption regime.
Finally, tax-free capital repayments are no longer possible. All distributions by chapter 2 Investmentfonds will be fully taxable. Therefore, German investors might, in case of capital repayments, prefer redemptions, as only the redemption gain will be taxable and the acquisition costs of the redeemed units can be received tax-free.
Due to the tax exemptions and the partial relief regime as well as the greater flexibility (no investment restrictions applicable), the Chapter 2 Investmentfonds is a tax-efficient alternative to chapter 3 Spezial-Investmentfonds. German institutional investors should review their investment structures and analyse the tax burdens under the different regimes.
Chapter 3 Spezial-Investmentfonds are subject to partial tax liability at fund level (as with investment funds) and taxation of distributed/deemed distributed income at investor level. They may apply the current semi-transparent taxation principle with certain modifications compared to the status quo. Such a decision needs to be analysed by each investor with respect to its chosen investment structures.
There is no general answer to the question whether the changes under GITL 2018 will be beneficial to German institutional investors and funds with such investors. Fund documentations and structures need a careful review in light of the new law. For many German institutional investors employing a specialised investment fund under section 284 of GCIC it might be preferential to opt for the Chapter 2 Investmentfonds regime.
Martin Mager is managing associate and Sebastian Leidel is an associate in the Munich office of Linklaters