Global Tax Alert | 7 June 2013

German State Council requests stricter tax rules for AIFM Tax Adaption Act - Action required to secure marketability of foreign mutual and hedge funds in Germany

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On 7 June 2013, the German State Council (State Council) rejected the AIFM (Alternative Investment Fund Managers) Tax Adaptation Act in its current form and requested the inclusion of certain stricter tax rules. Despite the vote, there is consensus to tighten the definition of fund vehicles that are eligible to provide the favorable “German fund reporting” to German investors. In particular, the new rule will likely exclude certain mutual funds and most foreign hedge funds from this fund taxation regime. However, there are grandfathering rules to allow tax reporting for existing funds that do not meet the new standards, but qualify for the wider definition of a foreign investment fund set forth under current German law.

Given the importance of tax reporting for German investors, the State Council vote emphasizes the need for managers of mutual and hedge funds to consider taking steps to preserve the flexibility to market to German investors in the future. This is even more important if mutual funds or hedge funds are not yet marketed in Germany. Necessary measures should be implemented before the law takes effect on 22 July 2013.

Practical relevance of German fund reporting for marketing in Germany

By preparing German tax reporting, a foreign fund gives German investors access to a favorable taxation regime for the income derived from the fund. In general, the applicable tax regime is akin to a “flow through taxation” but at the same time provides for, as an example, a deferral of the taxation of capital gains or gains from derivatives accumulated at the fund level until such gains are either distributed to the investor or the investor sells/redeems its fund units.

Tax reporting is available to all fund vehicles that qualify as an investment fund as defined in the German Investment Tax Act. When looking into investing in a foreign fund, German investors usually request the investment manager to take necessary measures to make the fund compliant with that definition and to prepare aforesaid tax reporting.

AIFM Tax Adaptation Act will limit access to fund reporting

According to the proposed new law, only those fund vehicles will be eligible to prepare tax reporting that meet the new, narrower prerequisites of an “alternative investment fund.”

It will be very challenging for US mutual funds or offshore hedge funds to satisfy these criteria, in particular because the new definition calls for a limitation of short term leverage to 30% of the NAV (net asset value) and for the fund documentation to detail this and other limitations.

Less favorable tax regime applying on returns from “investment entities”

If funds do not satisfy the new criteria, as per the terminology used by the law, they will now be considered so called “investment entities.” The returns from investment entities will be taxed under German tax reporting rules no longer. Instead, in the hands of German investors, flow through taxation rules apply which are based on German CFC rules and do not provide for the deferred taxation of capital gains available under fund taxation rules.

In its vote, the State Council requested a lump sum type taxation of retained earnings to be added to the taxation of corporate type investment entities. Whether this feature will ultimately be part of the legislation remains to be seen. However, already in its current form (now rejected by the State Council), the proposal is considered less favorable than the current investment tax reporting.

Grandfathering rules

There is consensus that the new law shall contain grandfathering rules that preserve the benefit of providing investment tax reporting for foreign funds that do not meet the new criteria of investment fund definition but that (i) were established before 22 July 2013 and that (ii) meet the current law’s (wider) definition of an investment fund. Grandfathering only extends to fiscal years ending after 22 July 2016.

It should be noted that many foreign funds meet the requirements of the current fund definition only on a factual basis, but not formally (i.e., fund documentation does not provide the necessary language). This should not be sufficient to qualify under grandfathering rules.

Action points

Given the importance of investment tax reporting for marketing funds in Germany, mutual and hedge funds interested in German investors should take necessary steps now to as a minimum meet the requirements of the grandfathering rules. In particular, this applies to funds that are not yet marketed in Germany, but for which marketing is anticipated going forward.

Therefore, mutual funds and hedge fund managers should:

  • Review fund documentation and investment structure.
  • Determine whether the criteria of a foreign investment fund will be met going forward.
  • If not, determine whether the fund qualifies for the grandfathering rules, i.e., does it meet the criteria of a foreign investment fund under current law?
  • If not, model additional tax charge under investment entity taxation rules.
  • Determine whether efforts should be taken to either qualify for the grandfathering rules or for the new fund definition.

To qualify for the grandfathering rules, necessary measures must be implemented before the law takes effect on 22 July 2013.

Regulatory constraints as a result of the AIFM implementation

When looking into marketing in Germany, investment managers should also consider the new regulatory restrictions introduced as part of the AIFMD implementation. In that regard, Germany went beyond the mandatory minimum required under the Directive.

Amongst other rules, Germany has introduced provisions limiting the private placement of fund units. Under these rules, the distribution of investment fund units as private placement comes with obligations to notify the German Federal Financial Supervisory Authority (BaFin) and to provide further information to investors. This will also apply on marketing distributions to professional and semi-professional investors (albeit there is some relief worked into the rule here). An Alert outlining these rules in more detail is forthcoming.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, EMEIA Financial Services German Tax Desk, New York
  • Christian Rengier
    +1 212 773 1149
    christian.rengier@ey.com
Ernst & Young LLP, German Tax Desk, New York
  • Jorg Menger
    +1 212 773 5250
    jorg.menger@ey.com
  • Thomas Eckhardt
    +1 212 773 8265
    thomas.eckhardt@ey.com
  • Simone Guter
    +1 212 773 4350
    simone.guter@ey.com
  • Robert Polatzky
    +1 212 773 7853
    robert.polatzky@ey.com
  • Theresa Seitner
    +1 212 773 0635
    theresa.seitner@ey.com
  • Daniela Ahrling
    +1 212 773 4752
    daniela.ahrling@ey.com

EYG no. CM3517