Potential Impact of the ATAD Implementation Act on Fund Structures

Germany

Despite the Corona crisis, the German Ministry of Finance has submitted a revised bill to implement the Anti-Tax Avoidance Directive ("ATAD-UmsetzungsG") to the other government ministries for approval. The Federal Cabinet is now expected to decide on the draft on 22 April 2020. The key points of the bill are:

  • the reform of exit taxation when an inpidual or company leaves Germany;
  • a reform of the German Controlled Foreign Corporation ("CFC") rules;
  • far-reaching adjustments to the arm's length principle under Section 1 of the German Foreign Tax Act ("AStG") (including the implementation of a special provision on cross-border financing relationships);
  • the introduction of new rules on the tax treatment of hybrid arrangements; and
  • some other adjustments including, for example, the introduction of an accelerated advance mutual agreement procedure with foreign tax authorities.

The following briefing examines the significant impact the proposed changes may have on fund structures.

Background

The draft law transposes the ATAD-Directive (Directive (EU) 2016/1164 of 12 July 2016 as amended by Directive (EU) 2017/952 of 29 May 2017) into German law. The Federal Ministry of Finance had already submitted a first draft of the new law last December, which received extensive criticism resulting in its revision. In the meantime, the EU Commission initiated a formal infringement procedure against Germany in January 2020 for the late implementation of the ATAD-Directive. The initiation of the infringement procedure by the EU is the likely reason why the legislative process has been resumed despite the current COVID-19 pandemic and is expected to be finished before the summer break.

Potential Impacts on Fund Structures

Depending on the further course of the legislative process, the intended reform could have considerable effects on fund structures. This is because a fundamental privilege for investment funds with respect to the application of the German CFC rules is being re-considered in the course of the planned reform of the AStG.

According to the current legal framework, the adverse tax treatment under the German CFC rules outlined below does not apply if the relevant income is subject to the German fund taxation rules. Those rules generally apply to income derived from any UCITS or AIF (except for AIFs organized as partnerships) and are set out in the Investment Tax Act ("InvStG"). As a result, CFC rules are typically not applicable to taxation of fund investors.

The first draft bill of the ATAD-UmsetzungsG provided for a complete abolishment of this principle of primacy of investment tax rules. As a result, fund investments - unlike in the past - would potentially have been subject to the adverse tax treatment under the German CFC rules in accordance with the below principles. Double taxation was to be prevented by reducing the tax base under CFC rules by the tax base under the fund tax rules.

If implemented as planned, this would have caused, among other things, considerable additional administrative expense and in most cases a substantially higher tax burden for German investors.

Following extensive criticism, the current draft generally confirms that fund tax rules will prevail over CFC rules. However, the bill provides for an excemption, according to which the CFC rules will apply in the future if a fund derives more than one third of its passive income from transactions from its German investor(s) or persons deemed to be related to the German investor(s). We expect the scope of this exception to be quite narrow so that the application of CFC rules to funds should become relevant in rare cases only.

German CFC rules

The application of German CFC would cause a number of problems for funds and investors concerned. Namely, CFC taxation triggers burdensome tax filing obligations essentially requiring an income calculation in accordance with German tax accounting rules and annual tax filings in which German investors and their respective shareholding in the fund must be identified. In addition, any income deemed "low taxed" (i.e. if taxed at an income tax rate below 25%) and "passive" (such as interest income and in certain cases also pidends and capital gains) would be taxed in the hands of German investors at regular tax rates. Insofar, corporate investors do not benefit from the tax exemption of 95% of pidends from qualifying shareholdings and capital gains from shares which are available under the regular corporation tax rules. For private inpiduals, CFC taxation means that they lose the benefit of the 25% flat tax (plus currently solidarity surcharge of 5.5% thereon, and if applicable church tax) on investment income which normally applies to fund income and are taxed at progressive rates of up to 45% (plus currently the solidarity surcharge of 5.5% thereon, and if applicable, church tax) instead. It is therefore essential for fund structures to remain outside the scope of German CFC rules.

Outlook and Conclusion

We recommend keeping an eye on the current legislative process and to review existing structures to see whether German CFC rules might apply in the future. Should the provisions of the current draft pass in their current form, there will be little overall impact on fund structures. However, it should be noted that same as under current law, the CFC rules might apply in downstream structures of funds which are not subject to the InvStG (e.g. funds in the legal form of a partnership, such as a Luxemburg S.C.S(p)).