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Tax Advice

Investment funds on the scrapheap?

On June 9, 2016 the law to reform the taxation of funds in Germany passed the German Upper House. The bill is intended to eliminate the EU law risks of current fund taxation law in Germany, prohibit aggressive tax structures and reduce the expense of determining the tax basis for mutual funds and the audit expense incurred by the tax authorities. In case the law also passes the German Lower House the new rules are to be taken into consideration generally starting from January 1, 2018 onwards.

The bill intro­du­ces dif­fe­rent taxa­tion regi­mes for mutual funds and spe­cial funds. For mutual funds the bill pro­vi­des for a 180 deg­ree change in the rules gover­ning Ger­man and for­eign mutual funds. In case the law also pas­ses the Ger­man Lower House the new rules are to be taken into con­s­i­de­ra­tion gene­rally star­ting from January 1, 2018 onwards.

Investment funds on the scrapheap? © Thinkstock

Cur­rent fund taxa­tion law in Ger­many is based on the tran­s­pa­rency prin­ciple, which means that inve­s­tors pay taxes on income from the assets held by the fund as if they held those assets directly. The fund its­elf is tax exempt, and there is only taxa­tion at the inves­tor level.

The fund taxa­tion reform does away with this pass-through taxa­tion. In its place, the bill intro­du­ces a 15% cor­po­rate income tax on mutual funds for domestic divi­dends, ren­tal income, gains on the dis­po­sal of Ger­man real estate and other Ger­man source income. Tax-exempt inve­s­tors such as cha­ri­ta­ble foun­da­ti­ons can apply for a tax exemp­tion for the fund. Unlike the situa­tion in a direct invest­ment, gains on the dis­po­sal of Ger­man real estate are to be taxed if the fund has held the real estate for more than 10 years. Howe­ver, chan­ges in the value of real pro­perty until Decem­ber 31, 2017 that had been held for more than 10 years are to be grandfa­the­red and thus exempt from this rule. Regar­ding future value chan­ges the new rule can result in tax disad­van­ta­ges for pri­vate inve­s­tors in Ger­man real estate funds. If the objec­tive busi­ness pur­pose of the fund is to invest in and manage its cash, and it does not acti­vely engage in com­mer­cial busi­ness, it will remain exempt from trade tax.

At the inves­tor level, dis­tri­bu­ti­ons and gains on sale or return will be taxed at the flat-rate with­hol­ding tax, as invest­ment income for a pri­vate inves­tor or as ope­ra­ting income for invest­ments in busi­ness assets. Howe­ver, since funds fre­qu­ently dis­tri­bute very little income or none at all, a lump sum tax must be paid in order to avoid tax defer­ral effects. This replaces the cur­rent taxa­tion of dee­med dis­tri­bu­ti­ons, which are deter­mi­ned and pub­lis­hed by the funds. The lump sum tax is based on the risk-free mar­ket inte­rest rate and is cal­cu­la­ted using a simple for­mula. In order to avoid dou­ble taxa­tion, any lump sum taxes already paid during the ownership of units in the fund are off­set against the gain from the sale or return of the fund units.

The cor­po­rate income taxa­tion at the fund level, the with­hol­ding tax on the fund’s for­eign income, and the tax exemp­tion of cer­tain income when an invest­ment is held directly are to be taken into acco­unt through a par­tial exemp­tion of the taxable income. This exemp­tion will depend on the invest­ment focus of the fund. For pri­vate inve­s­tors, it amo­unts to 30% for equi­ties funds that con­ti­nue to invest at least 51% of their value in sha­res, and 15% for blen­ded funds (at least 25% of the value inves­ted in sha­res). Real estate funds that con­ti­nue to invest at least 51% of their value in real estate are entit­led to a par­tial exemp­tion in the amo­unt of 60% or 80% when they invest solely in for­eign real estate. If the fund units are held as a part of ope­ra­ting assets, the par­tial exemp­tion rates for equi­ties and blen­ded funds apply to the per­so­nal or cor­po­rate income tax. Only half of the par­tial exemp­ti­ons are app­lica­ble for trade tax pur­po­ses.

The new rules are to take effect on January 1, 2018. A fic­ti­tious sale-and-purchase is pro­vi­ded for at the inves­tor level, pur­su­ant to which exis­ting units in invest­ment funds will be dee­med to be sold at the last repurchase price deter­mi­ned in calen­dar year 2017 as of Decem­ber 31, 2017 and then repurcha­sed on January 1, 2018. If this results in a taxable gain, inve­s­tors will not pay tax on the gain until they actually sell their units. If the inves­tor acqui­red the units before January 1, 2009 and could have sold them tax-free under the cur­rent laws, value chan­ges gene­ra­ted as of January 1, 2018 will be gran­ted a €100,000 exemp­tion when the units are sold.

In many cases the reform will likely result in a hig­her tax bur­den. Critics on the pro­po­sed bill have par­tially resul­ted in amend­ments of the now enac­ted bill. But even if the tax regime beco­mes more bur­den­some, retail funds will likely remain a rea­sonable invest­ment alter­na­tive because of the pos­si­ble risk diver­si­fi­ca­tion, espe­cially as inte­rest rates remain low. The rules for spe­cial invest­ment funds will con­ti­nue under the same semi-tran­s­pa­rent regime as before.

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