The Location Promotion Act (StoFöG) has opened up the German special investment fund regime to alternative investments – yet in practice, Section 42(3) of the Investment Tax Act (InvStG) (tax pre-burden) is proving to be a key bottleneck. This article examines the issues of interpretation and evidence relating to the prior tax burden test in the context of structuring practice and sets out two demands: legislative parity between fund investments and direct investments, and an amendment to the Investment Tax Decree to include practical rules on evidence.
Background: StoFöG launches the special investment fund – the prior exposure test remains in place
Under the Location Promotion Act (BGBl. 2026 I No. 33), which was promulgated on 9 February 2026, open-ended domestic special AIFs with fixed investment conditions may now, pursuant to Section 26( 4(h) of the Investment Act (InvStG) – in particular in closed-end private equity, infrastructure, venture capital and loan funds organised as domestic or foreign partnerships. The previous 10 % ‘dirty limit’ has been abolished (see our blog post on this subject „Regional Development Act: New tax incentives for specialist investment funds in alternative investments“).
The special investment fund (Chapter 3 of the InvStG) thus becomes, for the first time, a viable vehicle for pooling private equity programmes by institutional investors, such as banks, pension funds or family offices. However, when it comes to the actual structuring work, it becomes clear that the decisive factor determining tax attractiveness lies not in the investment terms, but in Section 42(3) of the InvStG.
The prior liability test under Section 42(3) of the Investment Income Tax Act: Mechanics and economic significance
For investors subject to corporation tax, dividends and capital gains from holdings in companies received through a special investment fund remain in principle 95 % tax-exempt under section 8b of the Corporation Tax Act (KStG) (section 42(2) of the Investment Income Tax Act (InvStG)). However, Section 42(3) of the Investment Income Tax Act (InvStG) denies this exemption insofar as the income derives from a corporation, partnership or estate that has not previously been subject to tax.
Section 42(3) of the Investment Income Tax Act
„Paragraphs 1 and 2 shall not apply where the income in question is investment income within the meaning of section 43(1), first sentence, items 6 and 9, and the second sentence of the Income Tax Act, derived from a corporation, association of persons or estate that has not previously been subject to tax. Corporations, associations of persons or pools of assets that are not subject to income tax, are personally exempt from income tax, or are objectively exempt from income tax to the extent that they make distributions. Sentence 1 shall not apply to pre-taxed REIT dividends pursuant to Section 19a of the REIT Act.“
The legal consequence applies on an income-by-income basis („insofar as“): Only the individual income („insofar as“) from the untaxed corporation is affected in each case; however, this is then subject to the full corporation tax and trade tax burden of around 30 % instead of an effective tax burden of around 1.5 %. In the case of private equity structures, the first corporation below the transparent target fund is generally relevant, i.e. the acquisition holding company as the exit vehicle. In direct investment, this test does not apply: anyone holding the same shareholding directly or via a transparent fund partnership is covered by Section 8b of the Corporation Tax Act (KStG) without a prior taxation test.
Questions of interpretation: What does „not subject to prior tax liability“ mean?
Section 42(3), second sentence, of the Investment Income Tax Act (InvStG) sets out three alternative categories. The test is an abstract status test – according to the wording, neither a minimum tax rate nor an effective tax burden is relevant:
| Case group | Typical examples | Classification |
|---|---|---|
| No taxation of income | Cayman Islands, BVI, Bermuda (exempt companies) – commonly used in US/Asia programmes | Harmful; open to interpretation under the 0 % standard tax rate (e.g. Jersey, Guernsey, Isle of Man) |
| Personal liberation | Tax-exempt fund vehicles in the form of companies (e.g. Luxembourg SICAVs/SIFs), tax-exempt sovereign and pension vehicles | Detrimental despite general taxation of income in the country of incorporation |
| Distribution-dependent exemption in kind | Dividend-paid deduction schemes: US REITs, US RICs, French SIICs, UK REITs (PID), Luxembourg securitisation companies | Detrimental; reverse exemption for pre-tax REIT dividends (Section 42(3), third sentence, of the Investment Income Tax Act (InvStG) in conjunction with Section 19a of the REIT Act (REITG)) |
| Not recorded | Holding companies subject to standard taxation with a ‘Schachtelprivileg’ / participation exemption (e.g. Lux Soparfi, NL B.V., UK Ltd) | Harmless: non-distribution-dependent exemptions in kind, e.g. for income from shareholdings; abstract tax liability is sufficient |
The final category is particularly significant in practice: according to the prevailing view in the commentary literature, the corporation’s abstract tax liability is sufficient; actual tax payments are not required, nor is taxation specifically in the state of residence. Tax exemptions based on the nature of the income rather than on distributions – such as typical exemptions for income from shareholdings (e.g. in Germany pursuant to Section 8b of the Corporation Tax Act (KStG)) – are not detrimental, even where the company derives exclusively or almost exclusively income that is exempt on a substantive basis, as is typically the case with foreign holding companies (e.g. Lux SARL/Soparfi) (see Bindl/Stadler in Beckmann/Scholtz/Vollmer, Investment, Section 42 of the Investment Income Tax Act (InvStG), margin note 29; link in Herrmann/Heuer/Raupach, EStG KStG, Section 42 InvStG). Acquisition holding companies, which are typical of European buyout structures, are therefore generally subject to prior taxation. However, there is as yet no confirmed administrative interpretation on this matter.
The real practical problem: reporting and ongoing recording in the fund’s share profit
In the case of private equity fund-of-funds, the audit workload increases exponentially: ten to fifteen target funds, each with ten to twenty portfolio companies, quickly add up to 150 to 300 holding companies per fund-of-funds commitment – a portfolio that fluctuates continuously over the life of the fund. The burden of proof regarding prior tax liability rests with the investor, coupled with an increased duty to cooperate in relation to foreign matters (Section 90(2) of the German Fiscal Code (AO)). At the same time, the investor has no contractual relationship with the entities below the fund of funds: the necessary information is held solely by the general partner of the fund of funds and by the target funds.
In addition, there is a formal prerequisite for its application that is often overlooked in the discussion: Under section 48(2), first sentence, of the InvStG, the tax exemption under section 42(1) to (3) of the InvStG applies only if the special investment fund calculates and discloses the fund’s share profit – or if the investor provides evidence of it. Pursuant to section 48(1) of the InvStG, this calculation must be carried out at each valuation of the fund’s assets – i.e. on each valuation day – as an absolute value in euros per unit. As the fund’s share profit reflects only the income and changes in value eligible for relief under Section 42(1) and (2) of the InvStG, the pre-tax classification under Section 42(3) of the InvStG must be incorporated into this calculation on an ongoing basis – for each valuation date and each equity investment – be incorporated into this calculation. This substantive documentation issue thus has a procedural counterpart in fund administration: private equity holdings are typically valued only quarterly and with a considerable time lag, whilst the fund management company must update the share profit on each valuation date. The law does not specify how to deal with delayed reporting from target funds, interim exits and retrospective reclassifications.
Need for reform I: Legislative equivalence between fund investments and direct investments
Section 42(3) of the Investment Income Tax Act (InvStG) results in a structural disadvantage for fund investments compared with direct investments: The same exit gains which, in a direct holding, remain tax-free at a rate of 95 % under Section 8b of the Corporation Tax Act (KStG) without any prior tax liability assessment, are subject to a status test in a special investment fund involving a considerable burden of proof. This unequal treatment raises concerns from the perspective of tax system logic, as it contradicts the principle of decision-neutrality in taxation (as expressly stated by Bindl/Stadler in Beckmann/Scholtz/Vollmer, Investment, Section 42 of the Investment Tax Act (InvStG), margin note 33).
It also runs counter to the stated aim of the Location Promotion Act: It makes no sense to use the StoFöG to create new opportunities for Germany as a fund location in terms of investment conditions – whilst at the same time erecting objectively unjustified barriers in terms of tax consequences that do not exist in direct investment, which is functionally identical. Anyone wishing to promote fund investment must not treat it less favourably for tax purposes than direct investment. We therefore advocate that Section 42( 3 of the Investment Income Tax Act (InvStG) to be reviewed as part of the next amendment and for fund investment to be placed on an equal footing with direct investment – for example, by aligning it with the framework of Section 8b of the Corporation Tax Act (KStG) or, at the very least, by restricting the provision to specific arrangements involving untaxed vehicles.
Need for Reform II: Amending the Investment Tax Exemption to include practical rules on providing evidence
Irrespective of any legislative solution, the tax authorities should ensure legal certainty in the short term. The Investment Tax Ruling (BMF letter of 21 May 2019, as amended by supplementary letters) has so far only clarified Section 42(3) of the Investment Tax Act (InvStG) in specific instances, primarily in relation to REITs. There is a complete lack of guidance on the key issues in the practice of alternative investments. It would be desirable to supplement the relief, in particular with the following points:
- Clarification of the constituent elements of the offence: Confirmation that the abstract liability to income tax is sufficient, and that non-distribution-dependent exemptions (nested company privileges, participation exemptions) are harmless.
- Positive/negative list: A (non-exhaustive) list of typical legal forms and regimes – pre-determined / non-pre-determined / case-by-case – would considerably simplify the classification of hundreds of holding companies and reduce the number of contentious individual assessments.
- Standardised list of supporting documents: Determining which documents serve as proof of prior tax liability in cases of doubt (e.g. certificate of residence, articles of association or extract from the register, local tax assessment notices) and in which cases structured confirmations from the fund manager or a tax reporting service provider are sufficient.
- Simplification and materiality rules: Limiting the requirement for full evidence to holdings relevant to exit or distribution, and protecting legitimate expectations in the case of plausible, documented manager confirmations – combined with a clear default rule for cases where clarification is not possible.
- Simplifications in the calculation of share profits (Section 48 of the Investment Income Tax Act): Practical rules for determining the fund’s share profit on the valuation date for illiquid private equity holdings – such as updating figures based on the most recent available target fund reporting, with adjustments made as new valuations become known, as well as clarifications regarding the treatment of prior-period classifications and subsequent reclassifications within the share profit.
- Blind pool arrangements: Guidance on the treatment of new subscriptions, where the future ownership structures are, by their very nature, not yet determined, including the interplay with the binding information requirement under Section 89(2) of the German Fiscal Code (AO).
Conclusion and recommendation for action
The Location Promotion Act has opened the way for special investment funds to make alternative investments – Section 42(3) of the Investment Fund Act (InvStG) determines whether this route is actually taken in practice. Pending the legal equalisation of fund investments and direct investments, or an amendment to the legislation, the following applies: Anyone wishing to bundle private equity programmes within a special investment fund should quantify the pre-existing exposure for each target fund programme prior to subscription, based on the jurisdictional profile of the investment structures; make reliable reporting commitments from the fund manager a condition of subscription; clarify the administrability of the fund’s share gains (Section 48 of the Investment Income Tax Act) with the capital management company at an early stage, and obtain binding guidance to resolve any outstanding questions of interpretation. Whether the fund solution is more cost-effective than a direct investment is always a matter to be assessed on a case-by-case basis and should be examined in a structured manner in advance.
The TAXGATE Investment Team We would be happy to advise you on all matters relating to the structuring of alternative investments via special-purpose investment funds, Section 42(3) of the Investment Income Tax Act (InvStG) and binding rulings. Should you have any queries, please do not hesitate to contact us at any time: info@taxgate.com, · Tel. +49 (0) 711 540 90 29-0.
Legal notice: This article is intended solely for general information purposes and reflects the legal situation at the time of publication. It does not constitute tax or legal advice and is no substitute for individual advice. Despite careful research, TAXGATE accepts no liability for the completeness, accuracy or timeliness of the information. Tax regulations may change at short notice. The legal situation applicable at the time of individual planning is always decisive.
