Germany

Author: | Published: 3 Oct 1999
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

The investments in foreign investment funds by German investors are still growing — 1998 saw the accumulated investment of business and private investors exceed DM160 billion ($86 billion).

German investors in foreign funds are subject to taxation in Germany under the rules of the Foreign Investment Code (FIC). A foreign investment fund in the meaning of the FIC is any foreign property consisting of securities and/or real estate and/or rights in securitized money claims and/or deposits which invests under the principles of risk diversification. The tax rules of the FIC are basically governed by the transparency principle — the German investor in a foreign fund is taxed as if they had held the investment, held by the fund, directly.

Therefore investments in foreign funds basically (with exceptions) do not create any income deferral effects. Income accumulated by the foreign fund is treated as if it had been distributed to the German investor as of the business year-end of the fund (deemed distributed income, DDI). The method to determine the DDI depends on the German tax status of the fund:

  • for funds which are registered for public distribution and fulfil certain disclosure and publication requirements for tax purposes (white funds) the DDI basically comprises the ordinary income; capital gains from the sale of securities are not considered;
  • for funds which are only registered with the tax authorities and fulfil certain disclosure requirements for tax purposes (grey funds) the DDI comprises any realized income (including capital gains);
  • for all other funds (black funds) the DDI is determined on a lump sum basis: 90% of any increase in the net asset value between January 1 and December 31 or 10% of the redemption price as of December 31 (whichever is the higher).

In addition German investors are taxable with the interim profit (IP) upon the sale/redemption of funds. The IP basically represents certain ordinary income of the current business year on a year-to-day basis and must be determined daily. The IP calculation is identical for white and grey funds; for black funds the IP is a lump sum: 20% of the redemption/sale price. For more details on the basic principles reference is made to Ernst & Young's article in the September 1997 and October 1997 issues of International Tax Review.

The German government enacted significant changes in German tax which became effective of January 1/April 1 1999 and may affect foreign investment funds distributed in Germany substantially.

Changes affecting an investment in foreign funds indirectly:

  • The introduction of a 25% withholding tax on the portion of income of German funds resulting from dividends of German corporations.

Effect: this (somewhat) reduces the advantages of German funds over their foreign competitors on investments in German shares.

  • The extension of the speculation period for taxable short-term capital gains for private investors for all assets (including fund units, except real estate) from six months to 12 months for all sales taking place after December 31 1998.

Effect: German private investors will more likely hold fund units after the 12-month holding period expired.

  • Reduction of the annual personal allowance for investment income from DM6,000 to DM3,000 (married: double amounts), as of January 1 2000.

Effect: An increasing number of German investors will look for tax effective investment structures (eg funds focusing on tax free capital gains).

However, the most important changes concern the calculation of the DDI of white funds and the IP of white and grey funds in respect of gains from certain derivative income earned on fund level as of April 1 1999 (the original draft legislation also provided for the taxation of any short-term capital gains realized by the fund; this was eliminated during the hearings).

The amendment in section 17 para 1 FIC states that gains from private capital gains transactions as defined in section 23 para 1 No 4, para 2 and para 3 German Income Tax Code (GITC), are to be considered for DDI calculation. This change of the FIC is identical to the amendment of section 39 para 1 (KAGG/Kapitalanlagegesetz) for German domestic funds. Furthermore the scope of the IP was amended accordingly.

Section 23 para 1 GITC No 4 reads: "derivative instruments from which the taxpayer gains a net settlement or a cash settlement or [other] benefit which is dependent on a variable underlying, provided such right to net settlement, cash settlement or other benefit does not exceed a one-year period. Certificates that represent equities and warrants are considered as derivatives instruments in the meaning of the above". Section 23 para 3 GITC contains (among others) a rule how to determine the gain. It is stated that gains in the meaning of section 23 GITC may not be offset against losses from other ordinary income sources (as defined) of the taxpayer, however they may be carried back (restricted) or carried forward (indefinitely).

According to official sources, eg the following transactions fall under section 23 para 1 no. 4 GITC:

  • forwards, futures, options and swaps on securities, currencies or commodities;
  • index-certificates and warrants; and
  • any other transactions which grant a right on the payment of money or another benefit (such as the delivery of securities) which is dependent on a certain underlying value (eg the value of securities, indexes, futures, interest rates, etc).
Which instruments are affected by the amendment at the FIC?

The new FIC rules have caused some confusion among the German and foreign investment industry — not only did the changes become effective within two weeks after they finally passed Parliament, but there is also still fierce discussions on how to interpret the new rules. So far the tax authorities have not issued an official statement in this respect.

The German Association of Investment Funds (BVI) issued (internal) letters on the changes of the KAGG. Even though the amendments in the wording of KAGG and FIC are identical, the consequences for German and foreign funds are unclear:

Fundamental difference in the definition of DDI for German and foreign investment funds?

The DDI definition of the KAGG differs from the wording of the FIC. According to section 39 KAGG (old) only income in the meaning of section 20 GITC (ie interest and dividend income) constitutes DDI. In contrast, section 17 FIC (old) states that interest, dividends and other income constitutes DDI. The term "other income" is not defined. The tax authorities hold the opinion that any kind of proceeds resulting from investments (including investments in innovative financial instruments) or activities are taxable including realized gains from currency forwards and futures, gains from option trading and option premiums for writing options. For German domestic funds it is generally accepted that such income did not form part of the DDI prior to April 1 1999. With respect to foreign funds domiciled in an EU country the tax authorities' position could conflict with the anti-discrimination rules as it favours German domestic funds over their EU competitors. However, this issue has not been brought to court so far.

The amendment now made in section 17 FIC left the term other income unchanged and only added the reference to section 23 GITC. According to the tax authorities (see above) such gains already constituted taxable income in the past as other income. Therefore it is now questioned whether the amendment of the FIC has constitutive effect or was made for clarification purposes only (in contrast to the amendment of the KAGG, for which it is undisputed that it has constitutive effect).

Consequences for DDI and IP calculation

Assuming that the tax authorities will claim the amendment in the FIC was made for clarification only it is to be reviewed whether an instrument must be considered for the daily IP calculation and what the treatment for the annual DDI calculation is.

For the IP, only instruments which are exclusively covered by Section 23 para 1 No 4 GITC have to be considered such as:

  • forward exchange contracts with a remaining time to expiry upon purchase of no more than one year with cash settlement;
  • currency and interest rate swaps with a remaining time to expiry upon purchase of no more than one year with cash settlement;
  • non-securitized options with a remaining time to expiry upon purchase of no more than one year with cash settlement;
  • futures with a remaining time to expiry upon purchase of no more than one year with cash settlement; and
  • non-securitized warrants with a remaining time to expiry upon purchase of no more than one year with cash settlement.

With respect to the DDI, in view of the longstanding opinion of the tax authorities on the definition of the DDI for foreign funds the following items have to be considered:

  • any of the instruments to be included in the IP;
  • any of the above instruments with a remaining time to expiry upon purchase of more than one year; and
  • option premiums received (for writing options).

As already mentioned there are serious doubts whether the treatment of foreign EU funds as opposed to German domestic funds is in accordance with European law.

The realized or unrealized gains from the following instruments should not constitute taxable income even after the amendment of the FIC:

  • transferable securities (equities, bonds etc);
  • securitized warrants, index-linked securities;
  • convertible bonds;
  • fund units (apart from IP and DDI of such fund units); and
  • gains on cash balances denominated in different currency.
Losses from private capital gains

According to section 23 para 3 GITC private losses may not be offset against other ordinary income but only with private capital gains. Capital losses (ie losses realized within the 12-month speculative period) may be carried forward (indefinitely) and carried back (restricted) against similar income. The new wording of section 17 para 1 FIC also refers to section 23 para 3 GITC. However the consequences of this reference are disputed:

Loss offset restrictions are applicable
For the (daily) IP calculation a net private capital loss may not be offset against other IP relevant income.

For the (annual) DDI calculation there is no provision whether a carry forward is possible on fund level or on investor level. In the latter case, the investor would need to get information on the net private capital gain/loss from all their funds as of respective business year end, combine such information with other private capital gains/losses he or she made directly and arrive at a net figure for the year. This would require that such information is communicated efficiently, ie in a standardized way by a majority of the funds, which is not (yet) the case. A loss carry-back on fund level would be very time consuming as the fund itself does not pay any taxes (but the German investor does), a loss carry-back would necessitate o informing all investors to amend their income of the loss carry-back years (even if tax returns were filed and assessments were issued already). Therefore a loss carry forward on fund level is the only feasible solution.

Loss offset restrictions are not applicable

According to an opinion also supported by the BVI there are no restrictions to offset losses from private capital gains against ordinary income. As a result the treatment of net loss as of business year end is no problem any longer — any losses from private capital gains are offset against ordinary income, ie a net loss is part of the total DDI for the year.

Conclusion

In view of the above it is obvious that the German tax treatment of investments in foreign funds is still subject to continuous changes and therefore, continuing careful review is necessary.


Contact Details:

Dr Felix Klinger

Tel: (49) (69) 1 52 08 458

Fax: (49) (69) 1 52 08 450

Email: felix.klinger@ernst-young.de