Draft Fund Location Act (Fondsstandortgesetz – FoStoG)
On 20 January 2021, the German Federal Government passed the draft Act on Strengthening Germany as a Fund Location and Implementing Directive (EU) 2019/1160 amending Directives 2009/65/EC and 2011/61/EU with regard to the cross-border Distribution of Collective Investment Undertakings (Fondsstandortgesetz – FoStoG). On 22 February 2021, the German Federal Council (upper house of parliament) committees published their recommendations for amending the draft bill.
The draft bill aims to make Germany more competitive as a financial hub without lowering the existing level of protection. To this end, the following key changes are envisaged:
- implementation of the EU Transparency Regulation and the EU Taxonomy Regulation
- closed-ended contractual fund (Sondervermögen) as a new vehicle for special AIFs
- open-ended infrastructure fund (Sondervermögen) as a new product for mutual funds
- facilitations in the financing of real estate funds
- authorisation of closed-ended master-feeder structures
- regulation of pre-marketing
- digitalisation and electronic communication
- tax reliefs for employee participations
- VAT exemption for the management of venture capital funds
In principle, the Fund Location Act is planned to enter into force on 1 July 2021. However, due to the necessary technical adjustments, the new provisions on electronic communication with the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) are not to apply until 1 April 2023. We summarise the main aspects of the draft bill below.
Implementation of the EU Transparency Regulation and the EU Taxonomy Regulation
One of the purposes of the law is to adjust some provisions of the German Investment Code (Kapitalanlagegesetzbuch – KAGB) to bring it in line with Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (Transparency Regulation) and Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation). The Regulations are part of the European Commission’s Sustainable Finance Action Plan. The Taxonomy Regulation introduced a uniform classification system for environmentally sustainable economic activities in the EU (known as the “Ecolabel”). The Transparency Regulation aims to harmonise the disclosure obligations of participants in the financial markets and of financial advisors across the EU. It includes also sustainability risks, adverse sustainability effects and sustainable investment targets. Furthermore, it regulates the assessment of environmental or social factors in the context of investment decisions and advisory processes. In addition, the Regulation sets out new sustainability-related transparency requirements for financial market participants and financial advisors at company level and in remuneration policies (see also our newsletter on the new ESG requirements arising as a result of the Fund Location Act).
Among other things, it is provided that the annual audit of asset management companies will in future also include an examination of how they deal with the sustainability-related transparency obligations (section 38 (3) sentence 2 of the draft German Capital Investment Code (Kapitalanlagegesetzbuch-Entwurf – KAGB-E). In future, sustainability-related information must also be contained in the annual report (section 101 (1) sentence 3 no. 7 KAGB-E) and in the prospectus of a fund (section 165 (2) no. 42 KAGB-E).
Closed-ended contractual fund as new vehicle for special AIFs
In future, closed-ended special AIFs may also be set-up as contractual funds (section 139 sentence 2 KAGB-E). Under current law, only investment companies in the legal form of stock corporations with fixed capital or investment limited partnerships are possible. However, the investment stock corporation with its fixed capital is not practical. One of the reasons for this is because the inflexible provisions of the German Stock Corporation Act (Aktiengesetz – AktG) apply (section 140 (1) sentence 2 KAGB). The closed-ended investment limited partnership can be structured flexibly from a corporate and investment law perspective. However, depending on the downstream structure, it may pose tax challenges to fund initiators and investors (possible trade tax risk at the fund level as well as commercial infection risk for tax-exempt investors). This is one of the reasons why German fund vehicles have often been outperformed by their Luxembourg equivalents (e.g. SA/SCA, SICAV and SCS/SCSp) in the past.
Against this background, the intended expansion of the product range for closed-ended funds is to be welcomed. Closed-ended contractual funds are very flexible and for tax-exempt investors there is no risk of commercial infection or of complete or partial tax liability (blocker effect). As far as trade tax is concerned, the provisions of section 15 of the German Investment Tax Act (no active entrepreneurial management), which are specifically designed for fund investments, apply. However, in order to further strengthen competitiveness against foreign fund hubs, the legislator should not stop halfway and should improve the draft bill. In particular, a general trade tax exemption for funds (especially for partnerships) – which is a matter of course in other countries – would be welcome.
Open-ended infrastructure fund as new product for mutual funds
In the area of open-ended mutual funds, a new fund vehicle for retail investors enabling investments in infrastructure projects is to be introduced in the form of the infrastructure contractual fund (section 260a et seq. KAGB-E). Subject to certain investment limits, these funds are to be allowed to invest in infrastructure project companies as well as in real estate, securities, money market instruments, bank deposits and money market funds. Investors must be allowed to redeem their shares at least once a year and once every six months at the most.
According to the newly created definition, an infrastructure project company is a company established pursuant to its articles or by-laws to construct, rehabilitate, operate or manage facilities, plants, buildings or, in each case, parts thereof, serving the functioning of the community (section 1 (19) no. 23a KAGB). Compared to a public private partnership (PPP) project company, this definition is broader as it does not require cooperation between the public sector and the private sector. Under certain circumstances, there may be overlaps with real estate companies (section 1 (19) no. 22 and section 235 KAGB). On the other hand, investments in assets other than properties are also allowed (e.g. networks). Furthermore, the assets may also be operated by the infrastructure project company.
The introduction of a new fund vehicle for infrastructure investments is to be welcomed. Compared to the ministerial draft dated 1 December 2020, the draft bill has fortunately been touched up in that infrastructure project companies have been included in the list of acquirable assets for special AIFs with fixed investment conditions (section 284 (2) no. lit. h) KAGB-E). The same applies to the list of acquirable assets for special investment funds (Chapter 3 Funds) within the meaning of section 26 of the German Investment Tax Act (Investmentsteuergesetz – InvStG) (section 26 no. 4 lit. j) of the draft Investment Tax Act – InvStG-E). Furthermore, the exception from the 20% investment limit for participations in companies applying to special investment funds has been extended to cover shares in infrastructure project companies (section 26 no. 5 sentence 2 InvStG-E). Due to these improvements, investments in infrastructure project companies are made accessible not only to retail investors, but also to institutional investors which typically invest via special funds. Under the current law, only PPP companies are provided for as vehicles for infrastructure investments in section 284 KAGB and section 26 InvStG.
Reliefs for the financing of real estate funds
In relation to the financing of real estate companies, the Act provides for reliefs and clarifications.
Under current law it is disputed whether the company-related 50% limit and the fund-related 25% limit specified in section 240 (2) KAGB are also applicable where the real estate fund holds a 100% share in the real estate company that is to be financed. In our opinion, this is not the case, since from an economic point of view it makes no difference whether the real estate company is financed using equity or shareholder loans in these cases. In addition, the fund is entitled to all control rights in relation to the real estate company. Exactly for these reasons, it is now to be legally stipulated that the 50% and 25% limits do not apply if the fund holds a direct or indirect 100% in the real estate company (section 240 (2) sentence 2 ). The relief (and in our opinion the clarification) is only intended to apply to real estate companies that hold real estate directly (and thus not to holding companies). Should the ownership ratio fall below 100%, the above-mentioned limits will apply. If the entire investment in the real estate company is sold, the loan must be repaid before the sale (section 240 (2) sentence 3 KAGB-E).
In addition, the permissible limit for encumbrances on the fund’s assets (section 284 (2) no. 3 KAGB-E) and as the permissible borrowing limit (section 284 (4) sentence 2 KAGB-E) for special real estate funds are to be raised from 50% to 60% in each case. This is intended to give fund managers greater flexibility, particularly in times of crisis. In principle, the increase is to be welcomed. Among other things, this also creates a synchronisation with the debt limit for real estate funds in accordance with Sec. 2 (1) no. 14 lit. c) of the the Investment Ordinance (Anlageverordnung – AnlV); in this regard, see circular 11/2017 (VA) of the Federal Financial Supervisory Authority dated 12.12.2017, section B.4.10 f). Compared to the ministerial draft, the borrowing limit for real estate special investment funds provided for in the German Investment Tax Act is to be adjusted from 50% to 60% (section 26 no. 7 sentence 2 InvStG-E).
Approval of closed master-feeder structures
Sections 272a to 272h KAGB-E are intended to enable master-feeder structures for closed-ended funds. To date, such structures have not been permitted. The expansion is intended to make Germany more flexible as a fund hub and give fund managers and investors a wider choice of products. The new regulations are largely based on the regulations for open master-feeder structures in sections 171 to 180 KAGB. However, adjustments will be made to reflect the features of closed-ended funds and the rules specifically applicable to UCITS funds will not be adopted.
Legal provisions for pre-marketing
As a preliminary step to the sale of funds (i.e. offer and placement), “pre-marketing” is now to be regulated by law. The proposed provisions are based on the AIFM Directive, which was amended in 2019. The aim is to standardise the very different national regulations on approaching investors in the run-up to sales. The regulations apply to domestic and foreign fund shares as well as domestic and foreign capital management companies.
Pre-marketing is defined in the government bill as activities (i) carried out by or on behalf of an AIF management company (ii) involving direct or indirect provision of information or communication on investment strategies or concepts (iii) to potential professional and semi-professional investors resident in or with their registered office in Germany or professional investors resident in or with their registered office in an EU/EEA member state (iv) with the objective of determining the extent to which investors are interested in an AIF or a sub-investment asset (section 1 (19) no. 29a KAGB-E).
This does not include situations where the AIFM is approached by the investor (reverse solicitation), since in this case the initiative to acquire fund shares comes from the potential investor. According to the explanatory memorandum of the government bill, the mere advertising of its own capabilities by an AIFM is also to be considered separately from the advertising of a specific investment fund, meaning that in our opinion there is no pre-marketing in this case either.
On the other hand, it is clear from section 306b KAGB-E when no pre-marketing is to be deemed to exist and sales activities are to be assumed instead. This is the case when the investor is provided with information that:
- is sufficient to enable investors to commit themselves to the acquisition of units or shares in a specific AIF,
- are subscription forms or similar documents, whether in draft or final form, or
- are constitutive documents, information pursuant to section 307 (1) sentence 2 KAGB, prospectuses or final versions of offer documents of an AIF that has not yet been authorised.
Where information is included in drafts, it must not be extensive enough to enable investors to make an investment decision. Therefore, the relevant information must make clear that it does not constitute an offer or an invitation to subscribe for units or shares in an AIF and that the information must not be considered reliable as it is incomplete and subject to change.
In practice, the following points should be particularly noted:
- The AIFM must ensure that no fund shares are subscribed for as a result of the mere pre-marketing activities (section 306b (2) sentence 1 KAGB-E). Beside this, fund shares may only be subscribed for by the investors approached within a period of 18 months after the start of the pre-marketing if the notification procedure for the relevant fund has already been carried out (section 306b (2) sentence 2 ).
- In addition, there are extensive documentation and reporting obligations regarding the activities carried out in the context of pre-marketing. Breaches of these constitute regulatory offences (section 340 (2) no. 79a and 79d KAGB-E).
- It should also be noted that third parties involved in pre-marketing activities must either be regulated companies themselves or meet the requirements of a contractually bound intermediary pursuant to section 2 (10) of the German Banking Act (Kreditwesengesetz – KWG) (section 306b (6) KAGB-E); the requirements of the German Trade, Commerce and Industry Regulation Act (Gewerbeordnung – GewO) are therefore no longer sufficient.
Digitalisation and electronic communication
The legislator is reacting to increasing digitalisation by allowing text form for agreements between market players in which the emphasis is on information and documentation. In addition, communication with investors and market players by electronic means will also be allowed.
All communications with the Federal Financial Supervisory Authority (BaFin), starting with the application for authorisation or registration as a capital management company, are also to be carried out only electronically in future (section 7b KAGB-E). However, the electronic communications procedure provided by BaFin must be used for this purpose. This also entails the obligation for market players to check regularly (every five calendar days at the latest) whether the authority has provided them with notifications via the electronic communication procedure.
Tax relief for employee share schemes
The new section 19a of the German Income Tax Act (Einkommensteuergesetz – EStG) is intended to promote employee shareholdings in start-up companies by a deferred taxation of the financial benefit resulting from the granting of the employee shareholding. In principle, this is intended to prevent the granting of shares from leading to a tax payment without the employee having received any liquidity (dry income tax).
Some of the conditions that must be met for the deferred taxation include:
- The employee’s share is granted in addition to the wage already due (i.e. in particular not as deferred compensation).
- The tax deferral can only take place in the wage tax procedure and only with the employee’s consent. Deferring the taxation later in the context of the income tax assessment is excluded.
- The employer’s undertaking must be a micro, small or medium-sized enterprise (SME) (i.e. with less than 250 employees, max. turnover €50 million, max. balance sheet total €43 million) and its incorporation must not date back more than ten years.
If the relevant conditions are met, taxation does not take place until (i) the shareholding is transferred against payment or free of charge or is contributed into business assets or (ii) the employment relationship with the employer ends, (iii) however, no later than ten years after it was granted. So although dry income tax is not completely ruled out, its timing is postponed.
When determining the financial benefit, the allowance may be deducted under the conditions specified in section 3 no. 39 EStG. The allowance limit is to be increased from €360 to €720 p.a. by the Fund Location Act. At the time of taxation, should the value of the interest be below the original value, only the reduced value is to be used as basis for determining the financial benefit (except, for instance, in the case of distribution-related impairments).
The new regulations essentially do not change the taxation of the financial benefit as salary based on the standard tax rate. However, the reduction for extraordinary income under section 34 (1) EStG (the “one-fifth rule”) is applied under the conditions specified there if at least three years have elapsed since the employee received the shares. Therefore, employees are well advised to take into account possible effects on their tax rate (for example, as a result of increases in income or losses from other income) when claiming deferred taxation, as well as in terms of future taxation. Based on the draft bill, the new arrangements do not affect social insurance, i.e. the financial benefit resulting from the granting of the employee participation is immediately subject to the obligation to remit contributions, without any time delay.
In their recommendations of 22 February 2021, the German Federal Council committees proposed a variety of changes to the planned section 19a Income Tax Act. One of them includes increasing the allowance under section 3 no. 39 EStG to €5,000. The start-up’s incorporation is to be allowed to be fifteen years ago instead of ten (section 19a(3) draft EStG), the shareholding is to be taxed no later than fifteen years later instead of ten (section 19a (4) sentence 1 no. 2 draft EStG) and a change of employer is to be struck out as an event triggering taxation (section 19a (4) sentence 1 no. 3 draft EStG). Furthermore, the committees advocate examining whether the principle of deferred taxation can also be extended to social insurance.
VAT exemption for the management of venture capital funds
The VAT exemption for fund management services under section 4 no. 8 lit. h) of the German VAT Act (Umsatzsteuergesetz – UStG) is to be extended to cover the management of venture capital funds (Wagniskapitalfonds).
Under current law, the VAT exemption for fund management services is only applied to the management of UCITS funds and AIFs that are comparable to UCITS. The tax authorities have drawn up a list of criteria to be used to assess comparability (section 4.8.13 (8) of the VAT Application Guidelines – UStAE), which in our experience is applied in a rather restrictive manner. Only in the case of special AIFs with fixed investment conditions, as defined by section 284 Investment Code, certain reliefs apply and the management of this type of funds are regularly exempt from VAT in practice. In the light of the above, the extension of the VAT exemption to cover the management of venture capital funds as well is to be welcomed.
At the moment, it remains unclear which funds are covered by the term “venture capital funds” (Wagniskapitalfonds). The law does not contain any legal definition. Taking the explanatory memorandum to the 2004 Act on the Promotion of Venture Capital as a basis, private equity and venture capital funds are at least included (Bundestag Document 15/3336, 1). Since from a regulatory point of view funds are now also allowed to provide venture capital in the form of debt or mezzanine capital (section 20 (9 KAGB), debt funds should also be included. In our opinion, the same applies to funds that invest primarily in such funds. In their recommendations published on 22 February 2021, the Federal Council committees proposed defining the term “venture capital fund” more precisely and examining whether the term should to be put in more concrete terms (also to ensure that it is compatible with the EU rules on tax neutrality and State aid law).