German Investment Taxation – Reform Ahead
The German Ministry of Finance (Bundesfinanzministerium) circulated a discussion draft bill on the reform of fund taxation (‘Draft Bill’) on 22 July 2015.
The Draft Bill contains significant changes to the German tax environment regarding funds and investment activities, in particular the following:
- A complete revision of the German fund taxation regime; and
- The abolishment of the 95% participation exemption for gains from portfolio shareholdings.
The contemplated changes shall generally come into effect on 1 January 2018.
In the following the most essential aspects of the Draft Bill will be summarized. We expect that the debate of the Draft Bill will be controversial in nature so that intermittent updates on any new development will be provided.
A. REFORM OF FUND TAXATION REGIME
Germany had already seen significant changes to the fund taxation at the end of 2013 (see FSG Quarterly Report, December 2013). Now the Draft Bill again provides for a complete revision of this regime effective as of the beginning of 2018.
I. INVESTMENT FUNDS
Current tax rules provide for two different tax regimes for the taxation of investments in funds – the regime for investment funds and the regime for investment entities. According to the Draft Bill this distinction shall be abolished and almost all funds shall fall under the reshaped term of investment fund (Investmentfonds). The German Investment Tax Act shall apply to all investment funds and their investors.
1. Reshaping of term of investment fund
The term of investment fund shall encompass all UCITS and AIFs. In addition, the following entities will tend to be investment funds: Single investor funds (i.e., no AIFs due to the lack of the criterion “a number of investors”); and Non-commercial corporate bodies that are not subject to or exempt from taxation (e.g., family trusts corporations). The inclusion of single investor funds into the term “investment funds” can result in higher taxation of investments in existing investment platforms as single investors in such platforms may lose the benefit of the 95% participation exemption.
2. Carve-out from investment funds
According to the Draft Bill the following entities are explicitly carved out from the term of investment fund:
- Entities to which the German Capital Investment Code (KAGB) does not apply (e.g., holding companies, securitization special purposes vehicles, etc.); and
- German or foreign funds that take the legal form of partnerships, unless they qualify as UCITS or pension scheme funds (Altersvorsorgevermögensfonds); contractual German and foreign funds (Sondervermögen) specifically do not qualify as partnerships.
Consequently, instead of the investment tax act the overall beneficial general income tax rules shall continue to be applicable to partnership funds in the future; the specific tax effects and advantages from investing into partnership funds, however, depend on the tax status of the investor group (see FSG Quarterly Report, March 2015).
3. Graphical summary
Please find the chart that visualizes the term of investment fund and the application of the investment tax act vs. the income tax act based on the Draft Bill here.
4. Taxation of investment funds
As a rule, all German investment funds shall become subject to corporate income tax (15% plus 5.5% solidarity surcharge). This proposal constitutes a revolutionary concept for fund taxation in Germany.
Taxable items of income: The items of income with which German investment funds shall suffer corporate income tax are
- dividends on unlisted and listed German equities (‘Dividends’);
- fees for and manufactured dividend payments under securities lending and repo transactions in relation to German equities (‘Compensation Payments’);
- income and capital gains from German real estate (for capital gains there shall be a grandfathering); and
- all other German source income not specifically listed already above (i.e., income from certain hybrid instruments, generally not capital gains from equities or bonds and derivatives gains).
The above is an exhaustive list with the consequence that any other income shall not be subject to tax.
Full and partial exemptions: An exemption from the above taxation principles shall apply if and to the extent the German investment fund has qualifying investors such as tax-exempt German charities. Further, German special funds can elect a full transparent treatment in relation to German Dividends and Compensation Payments. In case of such an opt-in, German Dividends and Compensation Payments are directly allocated to the investors on a pro-rata basis and taxed in accordance with the tax status of the relevant investor.
Final withholding tax: In relation to German Dividends and Compensation Payments the corporate income tax due at fund level shall be collected by way of a special withholding tax (‘WHT’). The WHT shall be calculated on a gross income basis (i.e., without deducting related expenses) and settle the tax charge finally. This final WHT on a gross dividends basis is designed to counter-act so-called “Cum/Cum” transactions via German investment funds.
Trade tax: In general, German investment funds shall only be exempt from German trade tax provided that the objective business purpose of the entity is limited to passive investment activities and the active management of the entity’s assets is excluded. By way of contrast, German special funds shall generally be exempt from German trade tax (however, the qualification as special fund always requires a passive activity).
II. RETAIL/MUTUAL FUNDS VS. SPECIAL FUNDS
Under the proposed reformed German fund tax rules, the distinction between retail/mutual funds (‘Retail Funds’) and special funds (‘Special Funds’) shall continue to exist.
1. New regime for Retail Funds
As regards Retail Funds the Draft Bill provides for significant changes, namely the following:
Abolishment of tax deferral: In case of an accumulating investment fund, the existing system allows for a tax deferral in relation to inter alia capital and derivative gains. This tax deferral shall be (partly) eliminated through the introduction of a new lump sum taxation in the case of accumulation (i.e., a lump sum tax base of 80% of the so-called basic rate (Basiszinssatz) – currently 0.99% p.a. – multiplied by the pro rata NAV, capped at the actual increase of the pro rata Retail Fund’s NAV shall be subject to tax on an annual basis; Vorabpauschale; ‘Lump Sum Taxation Amount’).
Taxation of investors: Investors in Retail Funds shall be taxable with the following exhaustively enumerated earnings:
- any distributions from the funds;
- the Lump Sum Taxation Amount; and
- any capital gains from the disposal of units in the funds.
Corporate and business investors shall be fully subjected to taxation with respect to the above-mentioned earnings. The application of the 95% participation exemption and the so-called partial income taxation regime (i.e., 40% tax-exemption, Teileinkünfteverfahren) is explicitly excluded.
In relation to private individual investors, however, the 25% flat-tax shall still be applicable.
Partial tax exemption: In order to compensate (partly) for the corporate income tax burden at fund level and the additional above-mentioned increases in taxation, the investors in Retail Fund shall benefit from the following tax-exemptions:
- 20% exemption for equities funds;
- 40% exemption for funds investing in German real estate; and
- 60% exemption for funds investing in non-German real estate.
These exemptions all require at least 51% of the Retail Fund’s NAV to be invested in qualifying assets. They shall apply to all taxable earnings realized or received in connection with the investment in the Retail Fund.
2. Amended regime for Special Funds
Compared to Retail Funds, the Draft Bill provides for only a few changes in relation to Special Funds.
Conditions for qualification as a Special Fund: As under the current regime, the investor base has to be limited to not more than 100 investors, which are not private individuals, in order to qualify as a Special Fund. In addition, the Draft Bill provides that a Special Fund must meet each of eight specific conditions (these conditions currently have to be fulfilled by all investment funds, incl. special funds). Moreover, the Draft Bill contains certain (anti-abuse) provisions which shall prevent private individuals from investing in Special Funds via tax transparent partnerships that are themselves regarded as institutional investors.
Reshaping of deemed distributed income: For Special Funds the existing system, which allows for a tax deferral in relation to inter alia capital and derivative gains in case of an accumulating fund, shall – very broadly speaking – continue to be applicable. However, going forward certain details will change (e.g., deemed distribution of 10% of the capital and derivative gains).
Taxation of investors: Investors in Special Funds shall be taxable with the following exhaustively enumerated earnings:
- Any distributions from the funds;
- Any deemed distributed income; and
- Any capital gains from the disposal of units in the funds.
Corporate and business investors shall be fully subject to tax with the above-mentioned earnings (again the application of the 95% participation exemption and the partial income taxation regime is explicitly excluded).
Notably, for private individual investors all earnings from Special Funds shall no longer benefit from the 25%-flat tax but be subjected to the individual progressive tax rate.
III. TIME OF APPLICATION
Generally, the reform of the fund taxation regime shall enter into force on 1 January 2018. As a rule of thumb, no grandfathering shall be available.
B. TAXATION OF GAINS FROM PORTFOLIO SHAREHOLDINGS
The other important proposed change to the German tax environment regarding investment activities, is the abolishment of the 95% participation exemption for gains from portfolio shareholdings.
I. CURRENT PARTICIPATION EXEMPTION
Under currently applicable laws, only 5% of the capital gains from the disposal of equities are taxable for corporate income and trade tax at the level of a corporate shareholder. This 95% participation exemption applies – unlike the exemption for dividends – irrespective of a minimum shareholding.
II. FULL TAXATION OF PORTFOLIO HOLDINGS
In line with the rules for portfolio dividends, the Draft Bill provides for a full taxation of capital gains if the corporate shareholder holds less than 10% of the share capital on 1 January of the relevant year.
III. RING-FENCING OF CAPITAL LOSSES
Accordingly, capital losses from portfolio shareholdings can only be offset against dividends and capital gains from portfolio shareholdings (in other words they shall be ring-fenced). The interaction of this ring-fencing with hedging from a tax perspective is likely to be problematic.
IV. TIME OF APPLICATION
The above changes shall apply with effect as of 1 January 2018 for the first time. As it currently stands, there is no grandfathering and no plan for a tax-free step-up in relation to portfolio shareholdings already held prior to the effective date.
