German tax resident investors holding fund units as private assets must prepare for the introduction of a supplementary exit taxation. The expected new rules are described below where the (limited) significance for typical private equity structures is also considered.
Background of the proposed legislation
Under German exit tax provisions, the migration of individuals resident in Germany (i.e. the termination of German unlimited tax liability) only triggers a deemed disposal of shares held as private assets if the individual holds shares in a corporation amounting to at least 1 percent of the corporations share capital. By contrast, no comparable exit tax currently applies to units in investment funds in contractual form (Sondervermögen). For shares in investment funds in corporate form it remained uncertain whether they are covered by the German exit tax regime or not. According to the statutory reasoning to the planned new exit tax regulation, cases have been identified in which shares in young companies were contributed into investment funds at an early stage in order to avoid taxation of capital gains upon the subsequent exit migration. This "taxation gap" identified by the legislator is now to be closed by supplementing Sec. 19 and 49 InvStG by the Annual Tax Act 2024.
Requirements and legal consequences of the planned exit tax
According to the draft bill, the planned rules cover individuals with unlimited tax liability holding fund units as private assets
- who have directly or indirectly held at least 1 percent of the fund units issued by an investment fund in the last five years or
- whose acquisition costs for the units in an investment fund amounted to at least EUR 500,000.
The fund units referred to in the planned new rules are units in a (domestic or foreign) investment fund, irrespective of the legal form of the units or the fund (Sec. 2 (4) InvStG). The provisions stipulated in Sec. 1 (2) and (3) InvStG must be considered when determining whether an investment vehicle qualifies as an "investment fund" (and shares as investment units). It is particularly important to note that partnerships and comparable foreign legal forms are excluded from this investment fund definition (unless they qualify as specific pension funds or UCITS by way of exception). In consequence, typical private equity structures, which are primarily established via domestic or foreign partnerships, should therefore not be affected by the planned new regulation. The planned regulation likely primarily affects units in contractual funds (such as Sondervermögen) or foreign investment funds in contractual form (such as FCPs under Luxembourg law) as well as investment funds in corporate form.
A corresponding new rule is also planned for units held as private assets in special investment funds within the meaning of Section 26 InvStG. However, the practical significance of this provision is likely to be very limited, as private investors may only invest in a special investment fund on a transitional basis or if required by supervisory law.
In the case of publicly traded investment funds, it is generally possible to determine whether the 1% threshold has been exceeded on the basis of the published semi-annual or annual reports. However, practical difficulties may arise if the number of investment units issued fluctuates due to (daily) issuances or redemptions. Not least against this background, an additional and possibly more easily ascertainable criterion was included with the acquisition cost threshold, which does not exist under the current general exit tax regime (for shares in corporations that are not investment funds). According to the legislator, this is because there are more untaxed hidden reserves in investment funds than in conventional corporation due to the limited scope of taxable income at fund limit. Whether the limit of EUR 500,000 is reached or exceeded must be considered separately for each investment in different investment funds. The acquisition costs of units in different investment funds are therefore not to be added up.
Exit taxation is triggered if the unlimited tax liability is terminated (e.g., due to the cessation of a domestic residence or habitual abode) or if the German right to tax the units is excluded or restricted. The fund units are then deemed to have been sold and the unrealized appreciation in the units is subject to income tax with an effective tax rate of appr. 26,4% including solidarity surcharge (whereas the deemed capital gains are not subject to withholding tax). Depending on the type of fund, partial exemptions should apply (e.g., profits from equity funds (Aktienfonds) are 30% exempt). However, exit taxation only applies if the (deemed) capital gains triggered by the exit are positive overall. Losses from a reduced value of the fund units are not taken into account. Whether the units are held in a domestic or foreign custody account should not be relevant for the tax liability in case of an exit.
The general exit tax provisions are planned to apply accordingly to the accrual, lapse and due date of the exit tax claim as well as the notification and cooperation obligations. A withholding tax mechanism on the deemed capital gain is not planned. The gain would therefore have to be disclosed as part of the income tax return. A deferral of the tax payments could be considered upon application and if appropriate security is provided.
Further course of the legislative process
The Bundestag passed the Annual Tax Act on 18 October and submitted it to the Bundesrat for approval. The latter could probably approve the draft as early as November 22, 2024, i.e. the law will probably be able to come into force despite the collapse of the German “traffic light” coalition. In terms of timing, the new regulation is then envisaged to apply to cases where the exit migration occurs after December 31, 2024.
For further discussion or assistance on this topic, please contact our German tax team or your usual Freshfields contact.
A downloadable version of this article is available here.
