Revised draft of investment tax circular on special investment funds

On 16.06.2020, the German Federal Ministry of Finance (BMF) sent the German industry associations the revised draft of the investment tax circular on special investment funds for comments. The extensive letter is intended to supplement the investment tax circular published on 21 May 2019 (Federal Tax Gazette I 2019, p. 527). In comparison to the last draft dated 16.12.2019 (a summary can be found here) that has been criticised in practice and in tax law literature, the present draft contains some welcome amendments. This applies in particular to facilitations of special investment funds making investments in other AIF. Furthermore, the BMF comments on some recently enacted provisions regarding the partial exemption regime for investment funds. The main revisions and comments of the current draft are presented in the following overview.

Partial exemption for equity, mixed and real estate funds

With regard to the partial exemption regime for equity, mixed and real estate funds, the following points should be noted:

• Shares in REITs: Shares in corporations that (i) invest at least 75% of their assets in real estate in accordance with the statutory provisions or their investment regulations and (ii) are subject to income tax or their distributions are subject to withholding tax of at least 15% and are not exempt from this tax, are counted by 75% as real estate (cf. section 2 (9) sent. 6 InvStG). By way of contrast, a qualification  as an equity investment for equity or mixed funds is excluded (cf. section 2 (8) sent. 5 no. 2 InvStG). In the opinion of the BMF, this also applies to the remaining 25% of the share value, which may not be credited to the real estate quota (mn. 2.33a). However, shares in REITs whose assets consist less than 75% of real estate may qualify as equity investments (cf. section 2 (8) sent. 5 no. 3 half sentence 2 InvStG). According to the BMF, this concerns, for example, shares in US REITs with real estate below the 75%, since distributions by US REITs are generally subject to a withholding tax rate of up to 15% under the US DTT (mn. 2.33b).
  
  
• Equity investments in holding structures: In accordance with section 2 (8) sentence 5 no. 4 InvStG, shares in companies do not qualify as equity investments if the companies themselves hold significant equity investments (pro rata income or pro rata fair market value > 10%) and the issuers of these equity investments are in turn not resident and taxable in an EU/EEA state or are not subject to a tax burden of at least 15%. This is intended to prevent structures with holding companies which are aimed at obtaining the partial exemption regime for equities without a sufficient tax burden at the level of the portfolio companies (mn. 2.33c). Fortunately, the BMF clarifies that investment funds do not have to prove for all their equity investments that the conditions of this anti-abuse rules are not fulfilled. On the contrary, such proof is only required in exceptional cases where a model-like structure is evident. This is, according to the BMF, not the case in relation to investments in equities  which are included in national or international stock indices (mn. 2.33e).

Investment regulations of section 26 InvStG

With regard to the investment regulations of section 26 InvStG, in particular the following points are worth mentioning: 

• Material breach: Whether a breach of the investment regulations is material depends in particular on the degree of fault on the part of the manager, the duration and extent of the breach and the manager's efforts to remedy the breach. The BMF clarifies that in light of the drastic consequences of the reclassification of a special investment fund into an investment fund (section 52 InvStG), a violation of the investment regulations can only be assumed to be material (i.e. harmful) in exceptional cases as ultima ratio. As a rule, the special investment fund must be given the opportunity to remedy the breach (mn. 26.3).
  
  
• Active exploitation of the "dirt limit": With regard to the so-called 10% "dirt limit", the BMF has reacted to the criticism by practitioners . Pursuant to the revised draft, a maximum of 10% of the fund's assets may be invested in assets that are not listed in section  26 no. 4 InvStG. This should also include, for example, interests in commercial or deemed commercial partnerships (for the latter see below). However, the BMF clarifies that in the case of exceeding the "dirt limit", the intentional and planned permanent holding of inadmissible assets shall be an indication for a material (i.e. harmful) breach (mn. 26.21).
  
  
• Closed-end real estate funds as real estate companies: In contrast to the last draft, units in closed-end real estate funds may be acquired by a special investment fund as participation in a real estate company, provided that the respective real estate fund also meets the requirements of a real estate company as defined in Section 1 (19) no. 22 KAGB (cf. section 26 no. 4 lit. f) InvStG). In principle, this is also in line with the opinion of BaFin (cf. interpretation decision of 9 April 2018, WA 42-QB 4100-2016/0005). The additional requirements for real estate companies pursuant to sections 231 et seq. KAGB are irrelevant for tax purposes and have, therefore, not to be met (mn. 26.23). However, for investment law purposes these requirements remain applicable, unless they are waived (section 284 KAGB) or inapplicable from the out-set (section 282 KAGB).
  
  
• Units in alternative investment funds as securities: In addition, units in investment funds that do not meet the requirements of section 26 no. 1 to 7 InvStG (i.e. no so-called qualifying investment funds) may be acquired as securities provided that the requirements of sections 193 and 198 KAGB are met (cf. section 26 no. 4 lit. a) InvStG) (mn. 26.26) or - subordinated - as a participation in a corporation (cf. section 26 no. 4 lit. m) InvStG) (mn. 26.28). This is particularly good news for the acquisition of units in closed-end alternative investment funds in the form of a public limited company (e.g. Luxembourg SA SICAV) or contractual funds (e.g. Luxembourg FCP).
  
  
• Transparency of commercial partnerships: Not only for asset-administrating partnerships, but now also for commercial deemed commercial (but asset-administrating; not real commercial) partnerships, a look-through to the assets held by the respective partnership is to be applied when assessing whether the assets are eligible or not (an exception applies to real estate companies, as these are eligible assets pursuant to section 26 no. 4 lit. f) InvStG anyway). This also applies to partnerships that are AIF (mn. 26.29). This is generally favourable, since many alternative investment funds are structured as deemed commercial partnerships and the assets they invest in  (e.g. participations in corporations or unsecuritized loans) are eligible assets in the sense of section 26 no. 4 InvStG. However, this statement is somewhat contradictory to the comments on the 10% "dirt limit", according to which interest in commercial imprinted partnerships are counted towards the limit (see above). As the comments on the "dirt limit" have insofar been copied and pasted from the last draft, we assume that there was an editorial error. 
  
  
• 20% limit for unlisted participations in corporations: According to the BMF, the 20% limit does not apply to units in so-called qualifying investment funds (cf. section 26 no. 4 lit. h) InvStG) and special investment funds (cf. section 26 no. 4 lit. i) InvStG) that are structured as corporations (mn. 26.27, 26.33). On the contrary, the 20% limit must be observed for units in non-qualified investment funds acquired as participations in corporations (cf. section 26 no. 4 lit. m) InvStG) (mn. 26.28). The revised draft does not contain any statement on the question of whether or not unlisted securities within the meaning of section 26 no. 4 lit a) InvStG (including units in non-qualified investment funds acquired as securities) are subject to the 20% limit. In our view, this is the case.
  
  
• 10% single issuer limit for participations in corporations: According to the BMF, the 10% single issuer limit does not apply to units in so-called qualifying investment funds (cf. section 26 no. 4 lit. h) InvStG) and units in special investment funds (cf. 26 no. 4 lit. i) InvStG) (mn. 26.37). A breach of this 10% limit is not regarded as a material breach of the investment regulations of section 26 InvStG (mn. 26.39). Rather, the fund or its investors (only) are being denied any tax advantages that might result from exceeding the limit (e.g. withholding tax reductions under a double tax treaty) (cf. 29 (3) InvStG).
  
  
• Grandfathered holdings of natural persons in special investment funds: In connection with the grandfathering of certain holdings in special investment funds by natural persons (cf. section 26 no. 8 lit. c) InvStG), the BMF corrected an editorial error contained in the previous draft. Accordingly, investments in partnerships after 8 June 2016 (previous draft: 24 February 2016) are not grandfathered d if the partnership was already invested in the special investment fund before 9 June 2016 (previous draft: 24 February 2016) (mn. 26.43). 

Further provisions

• Tax deductions under section 44 InvStG: Due to the taxation system of the corporate income tax law, which in principle does not provide for a denial of tax deductibility of expenses comparable to section 3c (2) EStG, the BMF believes that section 44 InvStG should be interpreted restrictively for corporations. Therefore, on the one hand, no pro rata denials of tax deductions are to be applied to corporate investors insofar as the following tax exemptions are applicable (mn. 44.3):
  
  
  • Tax exemption under section 42 (2) InvStG for certain investment income (dividends benefitting from the participation exemption (no portfolio dividends) and capital gains).
  • Tax exemption under section 42 (4), (5) InvStG for domestic participation and real estate income that has been taxed at fund level already (this requires that the so-called transparency option has not been exercised).
  • Tax exemption under section 43 (2) InvStG for distributed so-called amounts which already have been subjected to tax under the CFC rules.
  • Tax exemption under section 49 (1) InvStG for so-called investor equity gains.
    
    

  On the other hand, the denial of tax deductibility shall apply to expenses in connection with income that is tax exempt under section 43 (1) InvStG (i.e. double tax treaty exemption) or section 43 (3) InvStG (i.e. partial exemption regimes). Furthermore, the BMF clarifies that the lumpsum denial of tax deductibility of 5% under section 8b (3) or (5) KStG remains applicable in the abovementioned cases (mn. 44.3).

The allocation of expenses should be based on the share of the respective "source assets" in the total assets of the special investment fund (mn. 44.4). For reasons of simplification, the ratio of tax exempt and taxable income may also be used as a basis, although the BMF does not permit switching back and forth between the two methods (mn. 44.5).

• Trade tax exemption: The BMF maintains its view, already contained in a letter to the German industry associations, that the (partial) tax exemption pursuant to section 42 (5) InvStG for domestic real estate income and other domestic income that has been taxed at fund level already (this requires that the so-called real estate transparency option has not been exercised) not only applies for corporate income tax but also for trade tax purposes (mn. 45.2).