Favorable German tax regime for partnership-type AIFs expanded
The German Federal Ministry of Finance has recently issued guidance that broadens the favorable tax regime for investment partnerships applicable to closed-end alternative investment funds (AIFs). The following Dechert Onpoint summarizes the different tax regimes applicable to investment partnerships and corporations, sets out the guidance given by the tax authorities and provides a view on the impact of said guidance on widely used fund vehicles and structures.
This general overview is in particular relevant for German and foreign investors, which are investing in closed-end AIFs, as well as for fund sponsors, which are setting up fund structure with a potential German investor base.
Tax issues are not the only decisive factor to be taken into account when determining the most appropriate structure. Regulatory demands are equally crucial. It is worth noting that the amended investment ordinance for German insurance companies and pension funds is soon to be published (see for more details DechertOnPoint dated July 8, 2014). We will keep you updated in relation to any new developments.
Investment partnerships vs. investment corporations
In general, investments of German resident investors in closed-end AIFs are taxed according to the newly introduced concept of investment entities since the end of 2013 (see for more details DechertOnPoint dated December 5, 2013). The applicable statutory provisions distinguish between:
- Investment partnerships, which are generally tax transparent; and
- Investment corporations, which are generally opaque for tax purposes.
The specific tax implications of investing in investment partnerships as opposed to investment corporations at the level of German investors depend on different factors, the most important of which is the tax status of the German investor.
Regime for investment partnerships generally favorable for German investors
Having said that, for German taxable corporate investors the tax implications may be summarized as follows, based on the assumption that the AIF is not subject to tax or effectively not taxed in its state of residency:
General: Tax-transparent, investors are taxed on an on-going basis irrespective of distributions by the AIF
Corporate income tax (CIT): Taxable, except for underlying capital gains in equities (= 95% tax exempt)
Trade tax (TT): Tax exempt
Controlled foreign company rules (CFC): Not applicable to AIF
Foreign withholding tax credits regarding underlying income: Available
Treatment under double taxation treaties (DTTs): Tax-transparent, access to DTTs between Germany and target jurisdiction
General: Tax-opaque, investors are taxed only upon distributions by the AIF or sale of shares in the AIF, subject to CFC rules
Corporate income tax (CIT): Taxable
Trade tax (TT): Taxable
Controlled foreign company rules (CFC): Applicable to AIF, resulting in an ongoing taxation of “passive” income
Foreign withholding tax credits regarding underlying income: Not available
Treatment under double taxation treaties (DTTs): Tax-opaque, due to tax exempt nature of AIF often no access to DTTs
In summary, investing in an investment partnership is more tax efficient for a German corporate investor (incl. contractual trust arrangements and property insurance companies) than investing in an investment partnership. In particular, the trade tax exemption might cut the tax bill in half (CIT rate = 15%; trade tax rate = 7 to 17% with around 15% for the major cities).
Generally, an investment in an investment partnership might also be tax-favorable for German life and health insurance companies. While they do not benefit from the CIT exemption for underlying capital gains in equities and the TT exemption, the effective tax burden might be minimized by withholding tax reductions under the DTTs; German domestic withholding tax credits might be available as a fall-back.
Even German tax exempt pension funds (Versorgungswerke) may be better off investing in an investment partnership structure due to the better access to DTTs (e.g., the US/German DTT provides for 0%-withholding on dividends paid to pension funds). Only support pension funds (Unterstützungskassen) could be excluded from investing in an investment partnership since such an investment may endanger their tax exempt status based on older case law.
Regime for investment partnerships generally favorable for in-bound investments
Moreover, the regime for investment partnerships can be favorable for in-bound investments into Germany, too:
- Investment partnerships are not subject to taxation due to their tax-transparent nature.
- Investment corporations in turn will be subject to corporate income tax on source income.
Consequently, income from German real estate, German dividends, income on German hybrids or real estate secured debt or other source income will flow through investment partnerships without German taxation being triggered at the level of the AIF. To the contrary, investing via investment corporations may result in an additional layer of tax.
Revenue expands scope of regime for investment partnerships
According to statutory law, the distinction between investment partnerships as opposed to investment corporations has to be drawn based on whether a German AIF is an investment limited partnership (Investment-Kommanditgesellschaft) or whether a foreign AIF is comparable to a German investment limited partnership. If this is not the case, the AIF automatically qualifies as an investment corporation, even if it is a contractual fund and/or tax-transparent in the foreign jurisdiction (e.g., fonds commun de placement).
This statutory test has raised some uncertainty as to whether German closed-end funds set-up in the past as “simple” limited partnerships (GmbH & Co. KGs) and foreign AIFs in the form of general partnerships or limited partnerships without legal personality qualify as investment partnerships or, per default, as investment corporations.
On February 12, 2015 the German Federal Finance Ministry has issued a circular letter clarifying that the revenue will consider all AIFs that qualify as or are comparable to German partnerships in general to be investment partnerships. This guidance does away with the abovementioned uncertainties and effectively expands the application of the generally favorable tax regime for investment partnerships.
Impact of new guidance on widely used fund vehicles
Based on the above circular and general guidance, the following widely used fund vehicles should qualify as investment partnerships, to which the generally favorable tax regime applies:
Country / Investment Type
- Germany / “Simple” limited partnership (GmbH & Co. KG); Investment limited partnership (Investment-KG)
- Luxembourg / Société en commandite simple (SCS); société en commandite spéciale (SCSp)
- Ireland / Investment limited partnership (ILP)
- UK / Limited partnership (LP)
- US / Limited partnership (LP); Limited liability company (LLC), based on a case-by-case test
- Dubai / Limited partnership (LP)
- Singapore / Limited partnership (LP)
In summary, the recent guidance of the German revenue may have the collateral effect to benefit fund jurisdictions that provide for partnership-type fund vehicles. Currently, many German investors and fund sponsors are looking towards Luxembourg, which offers flexible regulatory and tax regimes and two varieties of fund partnerships. In addition, the Luxembourg tax authorities have recently issued guidance stating, in a nutshell, that fund partnerships may either be tax exempt or not subject to municipal tax (see for more details DechertOnPoint dated January 13, 2015).