Germany reforms taxation of investment funds

The principle of tax transparency for investment funds will soon be replaced by taxation at fund level with partial exemption for investors. This will also apply to foreign funds with German income. The new rules have been integrated in the completely revised German Investment Tax Act (Investmentsteuergesetz). This will lead to a complete change in the system of taxation in particular of retail funds as of 1 January 2018. In the case of special funds that are accessible for institutional investors only, the existing semi-transparency will be maintained. Yet, these must also respect new rules and e.g. opt for tax transparency in the future if advantageous for the institutional investors.

The new Investment Tax Act dated 17 July 2016 will get into effect from 1 January 2018 (except as for already effective rules concerning the set-off of withholding tax in the context of so-called “cum/ cum trades”). This new law represents a fundamental reform of investment taxation, aimed at eliminating risks under European law and certain tax arrangements, and limiting the potential for tax structuring. The reform also aims to reduce the administrative burdens, in particular that of determining the tax base for often very large numbers of generally anonymous investors in investment funds accessible by the public.

The currently applicable transparent tax regime

Under the principle of transparent taxation of investment funds currently in force, an investor in a fund should in principle be treated in the same way as a direct investor. Hitherto, the fund iself has not been subject to corporation tax or business tax. Instead, investors (private investors, entrepreneurs, corporations) are taxed in full in accordance with their individually applicable tax regimes on the fund income (distributions, deemed distributions[1], capital gains from the sale of fund shares). Private investors are taxed at a flat rate tax of 25% plus solidarity surcharge of 5.5% thereon (in total 26.375% tax charge plus eventually church tax of 8%/9% depending on the federal state and German residency of the investor). Individuals as entrepreneurs with fund shares in their books are taxed according to their individual tax rate plus 5.5% solidarity surcharge. They can claim a 40% tax exemption on the fund income. Corporations as investors are regularly subject to 15% corporate tax plus 5.5% solidarity surcharge (in total, 15.825%). With the exception of credit institutions, financial services and life and health insurance companies, these even enjoy a 100% exemption (5% of non-deductible operating costs are subject to tax).

The new rules

Scope: Who will be affected?

The new non-transparent tax regime primarily affects investment funds available to the public. The semi-transparent tax regime remains applicable, in principle, to special investment funds. These are funds for institutional investors only (no more than 100). Special funds are not accessible for individuals and in the future even not via indirect investment through partnerships. Yet, institutional investors in special funds should review how their fund income will be taxed from 2018 on. In this context, the option right to transparency on fund level, now integrated in the new law, should be considered.

For the application of the new rules, it makes no difference whether the investment fund is German or foreign.

Partnerships are excluded from the applicable scope of the German Investment Tax Act so that p.ex. venture capital funds in the legal form of a German partnership or comparable foreign legal forms are further treated as transparent on fund level following the taxation of partnerships.

Further, holding companies or REITs (Real Estate Investment Trusts) do not fall within the scope of the new German Investment Tax Act.

The strict catalogue of criteria for an investment fund (requirement for a regular right of withdrawal, existence of investment supervision comparable to BaFin[2], etc.), hitherto in force and required by the law to establish transparency at fund level, will be removed and only applies to special funds in the future.

At fund level: only certain German source income taxed at 15% (plus solidarity surcharge if applicable)

Both German and foreign funds are regarded as taxable entities subject to corporation tax and taxable in full. In future, only the following income categories of German source income will be taxable at fund level:

• investment income generated in Germany (for example, dividends or distributions by a limited liability company)
• German real estate income and
• other German income within the meaning of § 49 EStG[3](Income Tax Act)₁ (= definitive catalogue of taxable German sources in the case of limited tax liability of foreign resident tax payers), with the exception of the disposal of holdings in a capital entity.

German investment income will be taxed at 15% of gross income (flat rate tax, without possible deduction of costs, no offset for losses). German real estate income and other German income will be taxed at 15% of net income, plus the 5.5% solidarity tax.

Income from foreign sources and income not included in the categories above (e.g. interest income from ordinary bonds or any loans, except for loans collateralized by real estate), are excluded from the German investment taxation. May this lead to a shift of the investment strategy? In this case, not only the investment strategy but also the fund documents ought to be revised.

Investment funds are generally exempted from the business tax provided that they conduct no commercial activity.

The taxation at fund level may particularly harm certain categories of investors such as tax-exempted corporations. For some of these cases, the law provides relief. To avoid the fund’s obligation to pay corporation tax leading to an increase in the tax burden on investments made by non-profits, charities and religious organisations, funds or classes of units which can be taken up by these investors alone are fully exempt from corporation tax.

On an international level, it will be interesting to know how foreign tax authorities will qualify German investment funds, in particular with view to the question for Double Tax Treaties whether investment funds are tax resident and in consequence can benefit from treaty reliefs. Moreover, also the German tax authorities might review some of their positions regarding the classification of foreign funds (e.g. French OPCI) from a German tax perspective.

At investor level: easy declaration and partial exemptions

Up to now, the tax transparency required the annual publication of the tax bases of the funds in the electronic gazette (Bundesanzeiger) which was in general complex and difficult to determine with up to 33 tax bases per fund. In the future, investors will only need to declare the amount of the distribution, the value of their fund units at the start and end of the year, and the type of fund concerned (equity fund, mixed fund, real estate fund or other).

Equity funds[4] are investment funds which, depending on investment conditions, invest at least 51% of their value in equity interests (shares and units in limited-liability companies). Limited-liability companies should not be exempted from corporation tax. Entities domiciled in a third country must be taxed at a minimum rate of 15%.

A fund qualifies as ‘mixed’ if the investment conditions stipulate that at least 25% of its investments are in equity interests, but this proportion remains below 51%.

Real estate funds must invest at least 51% in real estate or real estate companies. Investments in real estate funds are regarded as real estate at the rate of 51% of the value of the investment shares.

For investors, the following income is taxed:

• fund distributions
• pre-determined tax bases (“Vorabpauschalen”)
• any capital gains

Pre-determined tax bases for retained income[5] are identified on capitalisation and are comparable in principle to the income deemed distributed which is subject to tax. They are determined on the basis of changes in the purchase price at the start and end of the year. To determine the gains on fund investments, the pre-determined tax bases received for retained income during the holding period are deducted, thus reducing the income.

To avoid double taxation of both the investor and the fund, distributions to investors by equity, mixed and real estate funds will be partially exempt, at the rate of 30% for individual investors, 60% for shares held in the company assets and 80% for institutional investors. In the case of mixed funds, half of the partial exemption rate applicable to equity funds is available to investors. Income from real estate funds is exempted at a rate of 60%, and 80% if the majority of the investment is in non-German real estate and non-German real estate companies.

Investors and fund companies: What to do?

In the end, it depends on the type of investor and the type of fund whether the reform brings advantages or disadvantages which can be made visible by comparable studies before and after the reform. In most cases, the investment strategy and the internal risk management should be orientated at the new tax benchmarks if applicable. This might lead to a modification of the fund documents as well.

Validity

The new rules are effective from 1 January 2018.

There will be a transitional period for real estate funds. It guarantees a tax exemption for changes in the value of real estate occurring before the Act comes into force on 1 January 2018. However, this will only apply if a holding period of ten years is observed between the acquisition and sale of the real estate asset. The Act will abolish the existing capital gains exemption on the sale of real estate for individual investors where the ten-year holding period is respected.

[1] These deemed distributions, resulting from a capital investment (e.g. interest, dividends, rental income), are taxed annually and treated as if they were received at the fund year-end, even if they have not actually been distributed.

[2] Bundesanstalt für Finanzdienstleistungsaufsicht

[3] EStG : Einkommensteuergesetz (German income tax code)

[4] Collective investment undertakings investing in equities

[5] The pre-determined tax bases for retained income is the amount by which an investment fund’s distributions in a given year remain lower than the income base for that year. The basic rate is determined by multiplying the purchase prise of the investment unit at the start of the year by 70% of the base rate set out in the German Valuation Act (Bewertungsgesetz ). The base rate is limited to the surplus between the first and last purchase price determined during the year, plus any distributions made during that year. If no purchase price is determined, the stock market price or the current market price is used.