Non-German funds, including U.S. managed funds, have an opportunity to gain enhanced access to the German market as a result of two new laws recently adopted
in Germany. In particular, U.S. funds that are distributed privately, such as private equity funds and hedge funds, may benefit from the new rules.
The new German Investment Act and the Investment Tax Act, which became effective Jan. 1, overhaul the tax treatment of investments in non-German investment funds. The purpose of the new laws is to provide a level playing field for German and non-German funds with respect to German investors and to provide a legal framework for hedge funds in Germany. Under the new tax rules, German investors generally would receive beneficial tax treatment if the non-German funds in which they invest comply with certain reporting requirements. Furthermore, the new Investment Act allows German regulated open-ended funds to offer funds of funds and to include non-German hedge funds in their investment portfolios.
German investors in a non-German fund generally would benefit if income from the fund were taxed on a transparent basis, meaning that the income and its character would flow through to investors and be currently taxable regardless of whether the income is repatriated by the funds to the investors. This tax treatment would allow German investors to enjoy full or partial exemptions on capital gains and dividend income, and other preferential tax treatments.
Under the new Investment Tax Act, the taxation to the German investors would depend upon whether the fund qualifies as a foreign investment fund and whether the fund (its manager/sponsors) complies with the reporting requirements set by the act. This alert focuses on the reporting requirements and their effect on the taxation of the German investors.
The Investment Tax Act defines three categories of funds, each of which would subject the German investors to different tax regimes in Germany.
Transparent Funds. A fund is considered to be transparent if it complies with all of the reporting requirements set by the act. As such, the fund’s income is attributed to the investors and is treated as though the investors owned the assets directly. The character of the income (i.e., capital gains, dividend income, income exempt under a tax treaty, etc.) is preserved at the investors’ level, allowing investors to enjoy the preferential tax treatment of capital gains, dividend income and other tax attributes.
For example, corporate German investors generally would enjoy a 95% tax exemption on dividends and capital gains, while individual German investors would enjoy a 100% exemption on long-term capital gains and a 50% exemption on dividend income. German investors would be eligible for certain treaty benefits and for foreign tax credits concerning foreign taxes paid on the respective income. Thus, investors in a foreign “transparent fund” generally may now be able to achieve tax benefits that previously were available only to investors in German funds.
To be fully transparent, the fund must report income details relating not only to the fund’s directly held assets but also to the assets of any sub-funds in which the funds invest (i.e., in a fund of funds structure). Therefore, it is very important for the fund manager to obtain the required data so that the fund can be treated as transparent.
Semi-transparent Funds. A semi-transparent fund complies with all the reporting requirements except those relating to capital gains, dividend income and foreign taxes. Investors in a semi-transparent fund, therefore, would not be entitled to the exemption for capital gains, dividends and foreign tax credit benefits. Other income of the funds, in principle, would be directly attributed to the investors.
Non-transparent Funds. A fund that does not comply with the reporting requirements is considered non-transparent, and German investors in such a fund would be subject to a penalty tax. In addition, investors would have to include in their taxable income 70% of the appreciation in the net asset value of the fund during the taxable year, with at least a minimum of 6% net asset value of the fund determined at year-end.
In a fund of funds structure, it is possible that a German investor may be subject to taxation under all three tax regimes. For example, if a sub-fund does not comply with the reporting requirements, income from that the sub-fund may be treated as the income of a non-transparent fund, even though the income from another sub-fund is treated as income of a transparent fund because it has complied with the reporting requirements.
“Special funds” are not subject to the penalty tax regardless of whether they comply with the reporting requirements. A “special fund” is defined as any fund whose organization documents stipulate that the fund will neither admit individual investors nor have more than 30 investors. For example, depending on the specific facts, special fund tax status might be available to German insurance companies investing in a non-German equity fund.
Transparency Reporting Requirements
For the fund to be treated as transparent, it must itemize, on a per share/certificate basis, certain income details for each distribution (and deemed distribution) as computed under German tax accounting principles. This information must be submitted electronically, in German, along with the annual report, for publication in the Federal Bulletin Database (Elektronischer Bundesanzeiger). The information also is required to be distributed to the investors.
The fund is required to provide a certificate issued by a German licensed tax adviser or German certified public accountant stating that the income items have been determined under German tax accounting principles. Furthermore, the fund is required to furnish “full” evidence of the correctness of the published income data at the request of the German Federal Tax Office. While it is not clear what constitutes “evidence” for this purpose, presumably it might require that income information be based on financial reports that have been audited by a reputable certified public accounting firm.
Information to Be Reported
To be treated as “transparent,” the fund manager is required to report certain income details for each distribution, computed on a per share/certificate basis under German tax accounting principles. The year’s undistributed income is deemed distributed at year-end. Disclosure also must include the investment income derived by the fund during the year, whether or not distributed. The income details that must be listed include:
Distributed amounts before withholding tax.
Deemed distributed income (interest, dividends, rental income, other income and gains from sales transactions).
Amounts included in the distribution, such as:
- Income deemed distributed in prior years.
- Capital gains from the disposition of share sales and derivatives, which are tax exempt for individual investors.
- Dividends and similar income taxed at 50% for individual investors.
- Dividends and similar income that are 95% tax exempt for corporate investors.
- Capital gains from the disposition of shares taxed at 50% for individual business investors.
- Capital gains from the disposition of shares that are 95% exempt for corporate investors.
- Capital gains realized from the sale of bonus shares, unless such income qualifies as ordinary investment income under German law.
- Gains from the disposition of real estate, which are tax exempt for individual private investors (i.e., after the lapse of a 10-year holding period).
- Foreign-source income exempt from German taxation based on a tax treaty.
- Foreign-source income subject to foreign taxation and not exempt from German taxation and for which the fund manager did not elect to deduct foreign taxes.
- Foreign-source income not exempt from German taxation and for which a tax-sparing credit is granted based on a tax treaty.
Amount of the distribution that includes German income subject to German (domestic) withholding tax imposed at a 30% (e.g., interest) or 20% (dividends) rate.
Amount of creditable or refundable German withholding tax imposed at a 30% (e.g., interest) or 20% (dividends) rate.
Foreign taxes paid on distributed taxable income that are (a) creditable against German income taxes unless the fund manager elected to deduct as an expense, (b) deductible from taxable income unless the fund manager elected to deduct and (c) deemed paid, based on a tax treaty (tax-sparing credit).
Depreciation and amortization of investment assets (e.g., buildings) computed under German tax accounting rules.
Tax credit granted to a German corporation distributing pre-year 2000 earnings (i.e., German dividends distributed out of pre-year 2000 earnings).
Impact on Non-German Funds
The new German Investment Tax Act has considerably leveled the playing field for non-German funds, including U.S. managed funds, with respect to German investors.
However, the reporting requirements that must be satisfied for the fund to be considered “transparent,” and thus for German investors in the fund to be eligible for favorable tax treatment, can be onerous in some cases. In particular, fund of funds managers may not be able to obtain the necessary information from the sub-fund managers to reach full “transparency” status for the fund. For hedge funds, added complexities may arise because there may be no established German tax treatment of certain derivative investment products or structures in which the fund may invest.
Fund managers need to consider the benefits of attracting new investors from the German marketplace while contemplating the feasibility and associated costs of obtaining the necessary information to qualify for the new benefits.
Howard Leventhal is co-national director of the firm’s Asset Management Tax Practice and a partner in Ernst & Young’s Global Hedge Fund Practice based in the New York financial services office. Joyce Hsu, an international tax partner, is the director of the International Tax Group for Ernst & Young’s New York financial services office.