Contributed By P+P Pöllath + Partners
Germany is frequently used by advisers and managers for the formation of venture capital, private equity and similar closed-end alternative investment funds as well as retail funds wherever the manager of the respective investment fund is located in Germany; ie, Germany is generally not used as a domicile for structuring alternative investment funds or retail funds by non-German advisers or managers. Typically, German private equity or venture capital funds are structured as limited partnerships that are transparent for German tax purposes.
German resident institutional investors as well as German family offices are a frequent target of the fund-raising activities of venture capital, private equity and similar alternative investment funds located in Germany or various other jurisdictions around the world.
The typical legal forms of investment funds used in Germany are limited partnerships, investment stock corporations and contractual funds with no legal personality of their own (Sondervermögen). The most frequently used legal form for private funds is the limited partnership, whereas retail funds, Undertakings for the Collective Investment in Transferable Securities (UCITS) funds and, quite often, real estate funds are more often structured as contractual funds. A key difference is that a limited partnership is transparent for German tax purposes, whereas the rules of the German Investment Tax Act apply in respect of corporate fund structures and contractual funds.
The process for setting up an investment fund in Germany has to be described separately for registered sub-threshold managers and fully licensed managers of alternative investment funds. The regulation of investment funds in Germany is primarily exercised through the regulation of the respective manager. The manager is either required to apply for a full licence or needs to be registered with the German supervisory authority for financial services (BaFin) under the German Capital Investment Act (KAGB). The KAGB implements the European Alternative Investment Fund Managers Directive (AIFMD) rules into German law.
Registered Managers: Registration Process
This registration process is available to certain small or medium-sized managers only. The most important category of these small to medium-sized managers is known as “sub-threshold managers” under the AIFMD and KAGB. In practice, most German alternative investment fund managers outside the real estate area fall within this category.
Sub-threshold managers under the KAGB are managers with assets under management of not more than EUR500 million (with no leverage on fund level) or not more than EUR100 million (in the case of leverage on fund level) and who manage so-called special alternative investment funds (Special AIFs) only. Special AIFs are AIFs whose interests or shares may only be acquired by professional investors or semi-professional investors (ie, non-retail funds).
The registration process is relatively simple. It requires the submission of a registration request together with certain documents on the manager and the investment fund(s) the manager intends to manage (such as the fund’s limited partnership agreement and the manager’s articles of association). In addition, a Special AIF may not require the investors to pay in capital in excess of their respective original capital commitment.
Ongoing compliance issues
An advantage of the registration is that only a few provisions of the KAGB apply to “registered-only” managers, mainly the provisions on the registration requirements, some ongoing reporting requirements and the general supervisory powers of BaFin. However, fund-specific requirements do not apply to “registered-only” managers and their funds. In particular, the depository requirements and marketing requirements as well as the additional requirements of the KAGB for fully licensed managers do not apply. However, “registered-only” managers do not benefit from the European marketing passport under the AIFMD. A registered manager can, however, opt up to become a fully licensed manager (or upgrade to an EU European Venture Capital Fund (EuVECA) manager).
Fully Licensed Manager: Licensing Process
Fund managers who do not qualify for a registration or who opt up must apply for a full fund management licence with BaFin under the KAGB. A full fund management licence opens a door for managers to market funds to retail investors as well as to the marketing passport under the AIFMD. Retail investors are investors who are neither professional nor semi-professional investors.
The licensing procedure is a fully fledged authorisation process with requirements equivalent to the requirements for granting permission under Article 8 of the AIFMD or Article 6 of the UCITS Directive. The licensing procedure checks requirements such as sufficient initial capital or owned funds, sufficiently good repute of the directors and shareholders, and organisational structure of the manager.
The licensing of the manager results in the manager being subject to the entirety of the KAGB. This means, in particular, the following:
Investors admitted to investment funds in Germany do typically benefit from limited liability. As limited partners of a limited partnership, as the most frequently used structure for alternative investment funds in Germany, their liability in relation to third parties for obligations of the fund is limited to their respective liability amount registered with the commercial register of the respective fund partnership. The liability amount is typically a small portion (ie, 0.1%) of their capital commitment. Once this portion of their capital commitment has been contributed to the alternative investment fund, their liability in relation to third parties ceases to exist. In relation to the alternative investment fund itself, the liability is restricted to the unpaid portion of the investor’s capital commitment. For fund structures other than limited partnerships, an ever stricter limitation of liability applies. Legal opinions are commonly issued to confirm such limitation of liability.
In respect of usual AIFs that are marketed to non-retail investors, there is no legal requirement to issue a private placement memorandum (PPM); however, the Article 23 AIFMD disclosures must be provided if the fund is marketed under the AIFMD. In any case, a PPM is commonly produced for all AIFs in order to ensure that the investors are informed – completely and correctly, and in a non-misleading manner – about the respective AIF, its management, its investment strategy, the risks associated with an investment and the expected tax consequences of the investment. These disclosures are recommendable in order to avoid liability of the sponsor or managers under general prospectus liability rules.
If the fund is marketed to semi-professional investors, a key information document must be produced.
There are annual reporting requirements for both managers of retail funds and managers of non-retail funds. In addition, there are semi-annual report requirements for contractual funds and investment stock corporations (AG) with variable capital. The reports need to be published.
Furthermore, from 1 July 2020, new notification requirements implementing Council Directive (EU) 2018/822 for cross-border tax arrangements will apply for intermediaries of funds (usually the fund manager) with retroactive effect from 24 June 2018.
Due to the persistently low interest rate environment, alternative funds have experienced a considerable capital inflow from German institutional investors during the last couple of years. A significant portion of the institutional investors are professional pension funds (berufsständische Versorgungswerke) and insurance companies, but also tax-exempt or taxable corporate pension funds (Pensionskassen, Pensionsfonds), professional pension funds (Versorgungswerke) and, increasingly, banks. Furthermore, industrial companies can be found as investors in alternative investment funds, especially in specialised private equity or venture capital funds, which promise strategically interesting investment opportunities for the investing company. Finally, public investors (öffentlich-rechtliche Geldgeber) invest in alternative funds, which is often motivated by reasons of broader structural economy policy.
Legal structures depend on investors’ specific requirements and preferences. The legal structure for private funds in which most types of investors are usually prepared to invest is the limited partnership and, with regard to real estate, contractual funds. However, specific structural requirements apply for certain types of investors.
For example, certain non-taxable or tax-exempt investors, including pension funds (Pensionskassen), can only invest in business-type partnerships under certain conditions. Investments by investment funds intending to be treated as tax-transparent Spezial-Investmentfonds have to check the eligibility of investments in closed-end funds on a case-by-case basis. Based on recent developments of the administrative practice regarding Spezial-Investmentfonds, investments via corporate or contractual-type funds might be challenged in the future in this respect.
German pension funds that are subject to German domestic insurance regulation (Solvency I investors) usually prefer investment funds managed by a regulated manager. Requirements regarding provenience and regulatory status of the fund depend on the classification of the fund. For private equity funds, fund vehicles and managers having their seats within an EU/EEA country or Organisation for Economic Co-operation and Development (OECD) member state and a manager regulation that is at least comparable to the regulation of a sub-threshold alternative investment fund manager (AIFM) are sufficient. For all other types of funds, only EU/EEA vehicles with full-scope AIFMs with an EU/EEA seat are required. For a fund to qualify as a private equity fund, it needs to be closed-ended and may only invest in equity and equity-like instruments (excluding senior debt financing).
Interests in closed-end funds held by Solvency I investors or Solvency II investors need to be transferable without the general partner’s or manager’s or any other investor’s prior consent, as long as the interests are transferred to another institutional (or other creditworthy) investor. At the same time, the fund documents might need to contain specific language clarifying that an interest can only be transferred upon the prior written consent of a trustee appointed by the investor to safeguard the investor’s assets, dedicated to cover a client’s claims against the insurer.
There are no general restrictions for investors investing in investment funds. However, certain restrictions apply to specific types of investors; eg, Solvency I investors may not invest in investment funds that invest in working capital or consumer credits.
German insurance companies (Solvency II investors) have certain transparency requirements due to the prudent person principle under Solvency II. Investors usually require look-through information on the basis of a standardised tripartite reporting template.
Due to recent developments in banking supervisory law, fund managers also have to accommodate transparency requirements of the growing group of banks reaching out for investments in AIF; eg, in order to avoid investing banks having to make deductions from their regulatory own funds in connection with their investments.
Last but not least, environmental, social and governance (ESG) impact is on the agenda of an increasing number of investors. Some institutional investors are already subject to statutory ESG obligations; eg, pension funds have to consider ESG aspects in connection with their business organisation and risk management, and are obliged to be transparent with regard to their handling of ESG factors. Solvency II investors have to consider sustainability aspects as part of the prudent person principle.
BaFin is responsible for regulating funds and fund managers.
The management of investment funds is regulated in Germany by the KAGB, which implements the AIFMD and the UCITS Directive.
The law requires that the manager is fully licensed or registered with BaFin under the KAGB. If a fund is internally managed, then the fund itself needs a licence or registration. For the details on registered and fully licensed managers, see 2.1.2 Common Process for Setting up Investment Funds.
For further details on investment limitations and other rules applicable to alternative funds, see 2.4 Operational Requirements.
There is, in general, no registration or regulation requirement for non-local services providers such as administrators, custodians and director services providers. However, when a German manager outsources portfolio or risk management, the delegate must be authorised or registered in their home country.
If an outsourcing delegate provides services falling under the Markets in Financial Instruments Directive (MiFID), the outsourcing delegate will be subject to a licence requirement under the German Banking Act (KWG) if the delegate actively solicited the relationship with the manager (as opposed to reverse solicitation).
If German regulatory law requires a depositary for a German AIF, the depositary or at least a branch of the depositary must be domiciled in Germany.
EU Fund Managers
EU fund managers are allowed to perform fund management services under the AIFMD passport regime with regard to German Special AIFs. In addition, EU fund managers may use the AIFMD passport to provide other services and ancillary services (such as MiFID investment advice or discretionary individual portfolio management).
Non-EU managers are currently not allowed to perform fund management services in Germany. This might change in the future with regard to AIFMs in those countries for which the passporting regime under the AIFMD for third-country managers will eventually become effective.
Outside of providing fund management services (eg, managed account solutions), non-EU managers may provide in Germany certain regulated services (such as investment advice or discretionary individual portfolio management). This requires either that the services are in the scope of an existing relationship with the German manager or if the relationship is established at the initiative of the German client (reverse solicitation). As an alternative, such service providers may apply with BaFin for an exemption from the German licence requirements (which is a lengthy process).
In the case of a hard Brexit, Germany will likely treat managers from the United Kingdom as non-EU managers.
The registration procedure for a sub-threshold manager is comparatively simple and takes about one month. A full licensing procedure varies between six and even more than twelve months.
Except for the marketing by German sub-threshold managers, the marketing of alternative funds requires an authorisation by BaFin or at least a European marketing passport under the AIFMD.
Germany understands marketing activities as any direct or indirect offering or placement of units or shares in an investment fund. Reverse solicitation is currently not regarded as marketing.
Marketing must relate to units or shares in an investment fund. BaFin concludes from this that marketing in particular takes place with regard to a fund if:
Consequently, there is no marketing if the fund has not yet had a closing with investors and only incomplete fund terms are distributed. This means that, in practice, marketing might start rather early in the investor relationship process.
In the authors' view, currently marketing can only occur if the investor has a legal basis for a subscription or for making an offer to subscribe. Absent such a legal basis, there can neither be an “offering” nor a “placement”. An activity should therefore still be pre-marketing if (i) the investor has no access to the final documents (PPM, limited partnership agreement (LPA) and subscription documents); and (ii) it is made clear that the fund manager is not currently seeking subscriptions and that offers to subscribe will only be possible after BaFin marketing approval on the basis of the final documents (eg, in a disclaimer in the documents).
However, for the pre-marketing of alternative investment funds, a harmonised European regime for pre-marketing is to come into force on 2 August 2021. The new regime will lead to a stricter regulation of pre-marketing activities and of the content of marketing materials. At the moment, this future European marketing regime relates only to the marketing by or on behalf of EU managers. It remains to be seen whether Germany will extend this new regime also to non-EU managers.
AIFs basically can be marketed to retail and non-retail investors. However, alternative funds that are closed-end Special AIFs can only be marketed to professional and semi-professional investors. The EU EuVECA regime and the EU ELTIF regime apply to EuVECA funds and European Long-Term Investment Funds (ELTIF).
As explained under 2.3.1 Regulatory Regime, Germany recognises the concept of Special AIFs, which are AIFs whose interests or shares may only be acquired according to the fund documents by professional investors within the meaning of the AIFMD or by semi-professional investors. Special AIFs themselves are either subject to a lighter regulatory regime than retail funds (in the case of fully licensed managers) or they are not subject to a regulatory regime at all (in the case of a German sub-threshold manager).
As explained under 2.1.4 Disclosure Requirements, there are annual reporting requirements for both managers of retail funds and managers of non-retail funds. In addition, there are semi-annual report requirements for contractual funds and AG with variable capital. The reports need to be published.
BaFin is, in this firm's experience, generally co-operative and open to discussions. Expected timeframes can sometimes be an issue, in particular if BaFin is requested to answer questions on new issues. BaFin regularly takes enforcement actions. BaFin enforcement is usually a proportionate step-by-step approach. Often, BaFin issues just a request for explanations as a warning and takes further actions only if the answers are not satisfactory.
In general, the investment-type restrictions for regulated general special funds translate only into assets that can be valued at fair value and risk diversification. In practice, regulated special funds are often set up under a specific fund category (eg, special funds with fixed investment guidelines). Accordingly, for these funds, investment-type restrictions apply based on the chosen fund category and individualised investment guidelines (eg, real estate focus or debt fund).
Borrowing restrictions depend on the chosen fund category. For instance, special funds with fixed investment guidelines allow short-term borrowing of up to 30% of their net asset value and with regard to real estate, up to 50% of the real estate value. For German debt funds, the borrowing restriction is 30% of the capital available for investment.
If the fund manager is fully licensed, the fund manager must appoint a depositary or special private equity custodian for each of its funds (as required by the AIFMD).
Valuation and pricing of the fund’s assets must be in line with the AIFMD requirements; ie, fair value.
As for the operational requirements of a fully licensed manager, these are in line with the AIFMD. In addition, fund managers must adhere to rules that apply to all market participants, such as the EU-based rules on insider dealing and market abuse, transparency, money laundering and short selling. Special manager-internal rules apply to the manager with regard to debt funds.
In the case of sub-threshold managers, they are only subject to a regulatory light touch regime. Accordingly, no operational requirements apply in principle from a regulatory perspective (except with regard to debt funds).
Accessibility to Borrowing for Funds
Funds that are eligible for non-business treatment from a tax perspective (see also under 2.6 Tax Regime) are generally not permitted to raise debt on fund level or to provide guarantees or other form of collateral for indebtedness of portfolio companies. As an exception, tax authorities have accepted that funds can enter into a capital call facility and the number of funds making use of this concession as well as the number of financial institutions offering capital call facilities to German funds has increased. Leverage is not permitted for tax reasons and restricted for regulatory reasons.
Restrictions on Borrowings
The criteria for non-business treatment from a tax perspective include a general prohibition of borrowings. As an exception, short-term borrowings to bridge capital calls are accepted by tax authorities. While "short-term" has not been defined, the maximum number of days for which borrowings can remain outstanding shall not exceed 270 calendar days. Fund managers need to issue first the capital call and can thereafter draw down the amount under the capital call facility. The amount so borrowed is then repaid out of the capital contributions.
Lenders Taking Security
Under German law, the investors’ commitment to the capital of a fund is not an asset that can be pledged in favour of the capital call facility provider. As a consequence, capital call facility agreements entered into by German funds normally provide that payments of capital contributions shall be made to a bank account maintained with the facility provider that is pledged in its favour. In addition, the facility provider reserves the right to claim directly from investors payment of capital contributions when due and to enforce the fund’s rights under the fund agreement in the event of default. Assets and investments held by the fund are normally not pledged as collateral.
Common Issues in Relation to Fund Finance
Common issues include the following: financial covenants regarding excused investors in respect of an investment by reference to the number of excused investors and the total amount; and default situations pending at the time of a draw-down under the facility agreement by reference to the number of defaulting investors and the total amount. Investors typically object to the requirement to provide financial information unless publicly accessible. Because of the general prohibition to provide guarantees and other forms of collateral for indebtedness of portfolio companies, equity commitment letters are very often used as an alternative. They should fall outside the scope of application of the general prohibition if structured as an agreement between the fund and its portfolio company where the fund undertakes to provide additional capital in the event the portfolio company is in payment default or in breach of financial covenants. Such undertaking, however, should not be pledged by the portfolio company in favour of its creditors in order to avoid a disguised guarantee of the fund. The portfolio company can undertake in the agreement with its creditors not to change, amend or waive the fund’s equity commitment letter unless with the consent of its creditors.
The tax regime applicable to fund structures depends on whether a fund is organised as a corporate entity or a partnership.
Taxation of corporate-type funds and their investors is governed by the German Investment Tax Act.
A corporate-type fund is a taxpayer as and of itself. Regardless of whether its centre of management is located in Germany or outside Germany, its tax bases only include certain items of German-source income – ie, capital investment income if subject to German withholding tax, income derived from German real estate (not dealt with herein) and business income effectively connected with a German permanent establishment – but exclude capital gains realised upon the sale of capital investments. If the assets belonging to a business that is effectively connected with a German permanent establishment include capital investments, the full amount of income derived therefrom by a corporate-type fund is subject to German tax on the level of such corporate-type fund.
Non-resident corporate investors
Distributions by corporate-type non-German funds to non-resident investors are not taxable in Germany. Distributions by corporate-type German funds to non-resident investors are also not taxable in Germany and, subject to the fulfilment of certain procedural requirements, not subject to German withholding tax.
Resident Corporate Investors
Resident investors are subject to German tax on the following three items of income derived from a corporate-type fund: all distributions, profits deemed retained by the corporate-type fund and calculated in accordance with a specific formula under the German Investment Tax Act, and capital gains realised upon the sale of shares of the corporate-type fund either in a secondary transaction with a third party or in connection with a redemption of shares or a share buy-back by the corporate-type fund.
Because a corporate-type fund is a taxpayer as and of itself, the three items of income subject to tax on the level of resident investors are eligible for a partial tax exemption in order to mitigate double taxation on fund and investor level if the corporate-type fund qualifies as a so-called equity fund or mixed fund. An equity fund is a corporate-type fund whose binding investment guidelines provide that more than 50% of the total net assets is directly invested throughout the entire fiscal year in equity instruments issued by corporations. For a mixed fund, the relevant threshold for direct equity investments is at least 25%.
In respect of equity funds, the partial tax exemptions for taxable resident corporate investors (other than life or health insurance companies) amount to 80% for corporate income tax purposes and 40% for trade tax purposes. In respect of mixed funds, the partial tax exemptions amount to one half of the exemptions applicable to equity funds.
Funds Organised as Partnerships
The tax regime applicable to funds organised as partnerships is the following.
Consistent with international standards, German funds are normally structured as partnerships that are eligible for non-business treatment and avoid that their investment activities constitute a trade or business that is effectively connected with a permanent establishment. The non-business requirements for private equity and venture capital funds are set out in an administrative pronouncement and include the following: (i) no borrowings and guarantees on fund level (other than fund finance described in 2.5 Fund Finance); (ii) no reinvestment of proceeds subject to two exceptions; ie, (a) proceeds up to an amount previously drawn down to fund management fees and fund expenses can be reinvested to achieve that an amount representing 100% of the total capital commitments can be invested, and (b) an additional amount not exceeding 20% of the total capital commitments can be reinvested to fund follow-on investments; (iii) weighted average holding period of investments of at least 36 months; (iv) no involvement in the operating management of portfolio companies; and (v) representation on the supervisory or advisory board of portfolio companies in a non-executive, monitoring capacity is permitted. While the administrative pronouncement has been recently questioned by the courts, it is still applied by the fiscal authorities.
Management of private equity and venture capital funds by German managers is subject to VAT in Germany, which cannot be recovered.
Allocations and distributions to investors
In the case of funds structured as a partnership, taxation follows allocations and not distributions. Non-resident investors of funds that are eligible for non-business treatment are not exposed to a German tax filing obligation in respect of their allocable share of the fund’s taxable profit. The fund files a partnership return setting out separately and uniformly the investors’ allocable share of the fund’s taxable profits. Non-German investors are included in the partnership return only for information purposes. They are subject to tax in their country of residence in accordance with their personal tax status.
Distributions by the fund to investors are not subject to German withholding tax. Dividends received by the fund from German portfolio companies as well as payments by German portfolio companies on certain hybrid instruments (including silent partnership interests, jouissance rights, profit sharing loans) are subject to withholding tax at the rate of 26.375% (including solidarity surcharge) at source on the level of the portfolio company. Generally, portfolio companies are not permitted to apply a reduced rate in respect of the allocable share of investors that are eligible for a reduced rate; for example, under an applicable tax treaty. These investors have to file a refund application with the German federal tax office, which is awarded subject to the fulfilment of certain procedural requirements.
Carried interest participants
The German fiscal authorities characterise carried interest payments as a compensation for professional services, and carried interest payments are not taxed in accordance with the rules applicable to the source from which such payments are derived. Carried interest payments by private equity funds and venture capital funds that are eligible for non-business treatment are eligible for a partial tax exemption of 40% and the remaining 60% is subject to tax at the marginal income tax rate of the carried interest participant. According to German fiscal authorities, carried interest payments by funds that are effectively in business are fully subject to tax at the marginal income tax rate of the carried interest participant. According to a decision rendered by the German federal tax court in December 2018, carried interest payments by funds that are effectively in business are subject to tax in accordance with the tax rules applicable to the source from which the carried interest payments are derived. It is an open issue whether such favourable court decision will be generally applied by the German fiscal authorities.
Carried interest payments are not subject to VAT.
Germany’s Tax Treaty Network and its Impact on the Funds Industry
Germany’s tax treaty network is extensive and covers, among others, all member states of the EU and the OECD. German tax treaties generally follow the OECD Model Convention. German corporate-type funds should be eligible for protection by German tax treaties regardless of the fact that their tax bases only include certain items of German-source income. Because distributions by German corporate-type funds to non-resident investors are not taxable in Germany under German domestic tax law, corporate-type funds are not impacted by Germany’s tax treaty network regarding their investors.
Funds organised as partnerships are transparent for income tax purposes. German investors benefit from Germany’s tax treaty network because the geographic focus of funds typically relates to tax treaty countries. Funds investing in Germany benefit from Germany’s tax treaty network because their fund-raising very often relates to investors resident in tax treaty countries.
FATCA and CRS Regimes in Germany
Germany has entered into an intergovernmental agreement with the USA and has incorporated the reporting and disclosure requirements under the Foreign Account Tax Compliance Act (FATCA) into German domestic law. Accordingly, German fund managers have to submit the FATCA reporting and disclosure to the German federal tax office, which forwards such information to the USA. As a consequence, German fund managers do not have an obligation towards the USA regarding FATCA reporting and disclosure.
Germany also incorporated the Common Reporting Standard (CRS) into German domestic law. As a result, German fund managers have an obligation under German domestic law to submit to the German federal tax office the information under the CRS.
Tax Impact on Allocations to and Receipt of Distributions by Investors from Domestic and International Partnership-Type Funds
The following description is limited to funds organised as a partnership.
Domestic funds eligible for non-business treatment
Taxation follows allocations and each investor’s allocable share of the fund’s taxable profits will be determined separately and uniformly by the fund’s tax authority. Income tax is then levied on the investor level in accordance with its tax status. A distribution by the fund is a non-taxable event.
Resident corporate investors
Ninety-five per cent of a resident corporate investor’s allocable share of equity capital gains is exempt from tax and the remaining 5% as well as all other items of income (interest, dividends) is subject to German corporate income tax and trade tax. The 95% exemption does not apply to life and health insurance companies.
Non-resident corporate investors
A non-resident corporate investor’s allocable share of German equity capital gains is effectively exempt from German tax. German dividends received from portfolio companies and payments on certain German hybrid debt instruments bringing along a profit share are subject to withholding tax at the domestic rate. Tax treaty-protected investors may claim a refund under the relevant tax treaty upon application with the German federal tax office. Income derived from non-German portfolio companies is not taxable in Germany.
Regardless of the qualification of their investment activities, non-German funds are normally deemed to be in business from a German tax perspective due to their legal structure.
Resident corporate investors
Their allocable share of a non-German fund’s total taxable profits is subject to German tax. Ninety-five per cent of equity capital gains is exempt from corporate income tax and 100% is exempt from trade tax. These exemptions do not apply to life and health insurance companies. The full amount of interest and dividends is subject to corporate income tax, but trade tax is levied only on interest and not on dividends.
Non-resident corporate investors
The deemed business status of a non-German fund does not affect their taxation in Germany. Their allocable share of German equity capital gains is effectively exempt from German tax. They are only subject to tax in Germany in respect of items of income derived from German sources that are subject to German withholding tax; ie, German dividends and payments on certain German hybrid debt instruments bringing along a profit share. Tax treaty-protected investors may claim a refund under the relevant tax treaty upon application to the German federal tax office.
As a starting point, retail investors are investors who are neither professional nor semi-professional investors (see 2.3.1 Regulatory Regime).
Retail funds are typically set up as UCITS funds or as so-called Public AIFs (as opposed to Special AIFs). Legal vehicles are mostly contractual-type funds (Sondervermögen) for open-end structures and the investment limited partnership for closed-end retail funds. Corporate structures are less common in the retail sector as corporate structures are more complicated.
The choice of the vehicle is in principle dependent on whether an open-end fund or a closed-end fund is desired.
Arrangements and Vehicles for Open-End Funds
For open-end funds, the contractual fund and the investment corporation with variable capital structures are available. They can have different classes of units or shares. They can also establish sub-funds (umbrella structure). Most fund managers prefer for open-end funds a contractual fund to a corporation as the setting up and the operation is easier.
Vehicles for Closed-End Funds
For closed-end funds, the only available vehicles for retail funds are the investment corporation with fixed capital and the closed-end investment limited partnership.
Both vehicles can issue different classes of shares or interests, but they cannot establish sub-funds (no umbrella).
The contractual fund is established by the fund manager on a contractual basis with the investor. The contractual fund is a pool of assets separated by statute and contract from the (other) assets of the fund manager. The investment guidelines for contractual funds set out the details of the contractual relationship between the fund manager and the investors, in particular the applicable investment restrictions.
Investment corporations and investment limited partnerships are basically corporations and limited partnerships with some modifications required by investment law. They are established in accordance with the applicable procedures for establishing corporations and partnerships (with some modifications because of investment law). In addition to the articles of incorporation or the LPA, separate investment guidelines are necessary.
The investment guidelines of retail funds, as well as the marketing of retail funds, need BaFin approval. In addition, BaFin has to approve the selection of the depositary for the respective retail fund. The approvals are usually obtained in parallel with each other.
Depending on the type of fund, the process can be rather short in the case of a standardised fund product or it can be rather lengthy and expensive in the case of a bespoke alternative asset retail fund, in particular, a closed-end fund.
As further described under 2.1.3 Limited Liability, investors admitted to investment funds in Germany benefit from limited liability.
An extensive disclosure document (prospectus) is required if an AIF is marketed to retail investors.
The prospectus must contain the following minimum information, where applicable: general information on the investment fund; information on the investment policy of the investment fund; information on risks and investor profile; information on the manager, depositary and auditor; information on outsourcing; information on the issue, redemption and conversion of units; and information on past performance. In addition, there are specific minimum information requirements for the prospectus of closed-end Public AIFs.
In addition to the prospectus, so-called key investor information must also be provided. The key investor information was supplemented by the Key Information Document (KID) in accordance with the European PRIIP (packaged retail and insurance-based investment products) Regulation.
For UCITS, Germany follows the disclosure rules of the UCITS Directive but requires an additional German-specific “country addendum” for non-German UCITS.
As described under 2.1.4 Disclosure Requirements, there are annual reporting requirements for both managers of retail funds and managers of non-retail funds. In addition, there are semi-annual report requirements for contractual funds and AG with variable capital. The reports need to be published.
Retail funds can be subscribed by retail investors as well as professional and semi-professional investors.
For open-end funds, the contractual fund and the investment corporation with variable capital structures are available.
For closed-end funds, the only available vehicles for retail funds are the investment corporation with fixed capital and the closed-end investment limited partnership.
For details concerning operational requirements regarding retail funds, please see 3.1.1 Fund Structures and 3.1.2 Common Process for Setting up Investment Funds.
There are no restrictions for investors investing in retail funds.
The main law governing retail funds is the KAGB, which is based on the AIFMD and the UCITS Directive and which is supplemented by German-specific rules for retail funds. In addition, several lower-level ordinances apply (the Derivative Ordinance, the Organisational and Rules of Conduct Ordinance and the Mediation Ordinance).
This set of laws is supplemented by self-regulatory standards, mainly the Rules of Good Conduct issued by the German Investment Funds Association and the Association’s sample investment guidelines.
As described under 2.3.1 Regulatory Regime, a full fund management licence opens the door for a manager to market funds to retail investors.
Please refer to the explanations under 2.3.2 Requirements for Non-local Service Providers.
The management of a retail AIF is not permitted for non-local managers.
Concerning UCITS, management by non-local UCITS managers is possible under the cross-border passport under the UCITS Directive.
Timing of the licensing procedure varies from six months to sometimes even more than twelve months.
Retail funds can be marketed only by the following three categories of "marketers":
If the retail fund is marketed by the fund manager itself, the fund manager must make available to the prospective investor the fund documents and the latest semi-annual and annual fund reports. In addition, certain ongoing publication requirements apply (such as publication of fund documents and fund reports on the manager’s website).
With regard to MiFID firms, Germany considers the prospective investor as the regulatory client of the MiFID firm. Accordingly, the MiFID firms have to adhere to the MiFID II rules of good conduct towards the prospective investor (requiring items like suitability or appropriateness checks). This applies in a broadly similar fashion to the above-mentioned “GewO” firms. The MiFID application further means here that marketing materials provided by the fund manager must comply with the MiFID II requirements on marketing materials (eg, with regard to past or simulated performance).
Retail funds can be marketed to any investor in Germany (regardless of whether the investor is professional, semi-professional or retail).
In addition to the above investor protection rules, civil law prospectus liability rules offer an effective protection for retail investors. Basically, civil law prospectus rules impose a liability on the manager and initiator of the fund. The measuring stick is whether the prospectus is incomplete or misleading in aspects that are material for the investment decision of a typical investor.
As further described under 2.3.8 Approach of the Regulator, BaFin is, in this firm's experience, generally co-operative and open to discussions.
Germany offers different types of retail funds (eg, UCITS, real estate funds, fund of funds, hedge funds and closed-end funds). The fund types are based on the UCITS investment and borrowing restrictions as the default rules. The investment and borrowing restrictions are then modified to fit each fund type.
The KAGB contains a catalogue of assets in which a closed-end Public AIF may invest. The investment in other funds by a closed-end Public AIF is restricted (ie, the structuring of a fund of funds as a retail fund).
For an overview on further operational requirements, see 2.4 Operational Requirements.
The explanations given in 2.5 Fund Finance (regarding alternative investment funds) also apply to fund finance for retail funds.
German tax law does not provide for a specific tax regime applying to funds targeting retail investors. However, in respect of taxation on investor level, different tax rules apply to institutional corporate investors and retail individual investors. The rules for retail individual investors are as follows.
Non-resident retail individual investors
Their income derived from German or non-German corporate-type funds is not subject to tax in Germany.
Resident retail individual investors
The three items of income described in 2.6 Tax Regime and derived by them from a German or non-German corporate-type fund are subject to German income tax at a flat rate of 26.375% (including solidarity surcharge) plus church tax, if applicable. The partial tax exemptions for which they are eligible amount to 30% in respect of equity funds and 15% in respect of mixed funds. Resident retail individual investors are not subject to trade tax.
Funds Organised as Partnerships
Domestic funds eligible for non-business treatment
Resident retail individual investors
A resident retail individual investor’s allocable share of interest, dividends, capital gains relating to debt instruments and equity capital gains of shareholdings representing an indirect interest of less than 1% is subject to German income tax at a flat rate of 26.375% (including solidarity surcharge) plus church tax, if applicable. Equity capital gains of shareholdings representing an indirect interest of 1% or more are subject to German income tax levied at the marginal tax rate, but 40% is exempt from income tax.
Non-resident retail individual investors
A non-resident retail individual investor’s allocable share of interest (other than profit-sharing), dividends from non-German portfolio companies, capital gains relating to debt instruments and equity capital gains aside from shareholdings in German portfolio companies representing an indirect interest of less than 1% is exempt from German income tax. Equity capital gains of shareholdings in German portfolio companies representing an indirect interest of 1% or more are subject to German income tax at the marginal tax rate, but 40% is exempt from income tax. Tax will be levied by way of assessment based upon a German tax return to be filed by the non-resident retail individual investor. Such German tax filing and tax-paying obligation does not apply to non-resident retail individual investors who are protected by a tax treaty. A non-resident retail individual investor’s allocable share of dividends from German portfolio companies is subject to German dividend withholding tax at the rate of 26.375% and investors protected by a tax treaty can themselves file with the German federal tax office an application for a refund of the excess of the German withholding tax over the amount permitted under the respective tax treaty.
Resident retail individual investors
As explained in 2.6 Tax Regime, non-German funds are typically in business from a German tax perspective. Accordingly, a resident retail individual investor’s allocable share of a non-German fund’s total taxable profits is subject to German income tax as follows: 60% of equity capital gains and dividends, and the full amount of interest is subject to German income tax at the marginal tax rate.
Non-resident retail individual investors
While non-German funds are typically in business from a German tax perspective, such non-German fund’s business is typically not effectively connected with a German permanent establishment (but with its non-German manager). Accordingly, a non-resident retail individual investor’s allocable share of the taxable profits of a non-German fund is subject to German tax only on German-source items of income in accordance with the rules explained above for German funds that are eligible for non-business treatment.
Regarding the issue of VAT on management fees in Germany, as of 1 January 2018, a new provision under the German VAT Act became effective with the purpose of implementing the European Court of Justice’s jurisprudence (in particular, the Fiscale Eenheid case (No C-595/13 of December 2015) by selectively extending this scope of application of the relevant VAT exemption. According to the revised § 4 subs. 8 h of the German VAT Act, the management of UCITS and certain AIFs that are comparable to UCITS is exempt from German VAT. The German legislator has not explicitly stipulated which types of AIFs are comparable to UCITS. The German tax authorities have established the criteria that must be fulfilled in order to benefit from the VAT exemption. It is still under discussion within the German tax authorities and therefore unclear where the typical closed-end venture capital, private equity and other alternative investment funds will benefit from the respective VAT exemption. Over the last year, some German tax authorities granted tax rulings that confirmed that the management fee would not be subject to VAT, while others would take a different view. This question is yet to be confirmed by the German Federal Ministry of Finance or by the representatives of the federal states responsible for VAT issues.
The coalition agreement dated 7 February 2018 of the current German federal government stipulates that the existing flat income tax regime on interest income will be abolished. This relatively brief statement in the coalition agreement raises many questions that will have to be clarified. In the case of an investment in an investment fund, it remains to be seen how the taxation of interest income with the personal tax rate will be ensured. This is unclear as an obligation of investment funds to publish their tax base no longer exists. Currently, all fund income of a private investor is taxed on the basis of the flat income tax regime. If the flat income tax regime on interest income would indeed be abolished, a split between interest income and other income would have to be made. In general, the tax environment is complex and also in Germany subject to constant change.
In the context of Germany’s implementation of the new EU pre-marketing regime due in August 2021, German is currently reviewing its Capital Investment Act for drafting errors and practical amendments. The details are at the moment unclear.