Tax disadvantages and need for action for investments in alternative investments by German taxable institutional investors

German institutional investors (insurance companies, banks, companies, pension funds, pension schemes, foundations, etc.) have been investing in alternative investments for some time now. The attractiveness of this asset class has increased further due to the current low interest rate environment. In addition to traditional investments in private equity, infrastructure, hedge funds, renewable energies and private equity real estate, investments in private debt have also recently met with great demand from German institutional investors. In order to save investors the time-consuming search for suitable target fund managers and at the same time guarantee a directly risk-diversified investment, fund-of-funds or basket solutions have proven themselves as investment products. Since the introduction of the Luxembourg special fund regime (SIF regime) in 2007, the investment vehicles required for this have almost exclusively been set up in Luxembourg as SIFs, until 2014 typically using the legal forms SICAV-SIF S.A./S.C.A. (funds in corporate form) or FCP-SIF (funds in contractual form).

From a German tax perspective, institutional investors can be divided into three categories: The tax-exempt investors (pension schemes, pension funds, charitable foundations), which Tax-sensitive investors (life and health insurance companies), which are able to recognise large portions of taxable income in the result without a significant tax burden due to the possibility of recognising tax-effective provisions, and the taxable investors (companies, so-called CTA structures, banks, property insurance companies, taxable foundations, family offices, etc.), whose investment income is typically subject to regular taxation with corporation tax and trade tax (combined tax burden approx. 30%, depending on the investor's domicile).

Taxable investors must therefore assess their investments in terms of the after-tax return. The question of whether the 95%-participation income exemption for dividends and capital gains in accordance with section 8b KStG is of central importance.

• Until the AIFM Tax Adjustment Act came into force on 24 December 2013, alternative investment funds were typically not covered by the scope of the German Investment Tax Act (InvStG). This meant that a SICAV-S.A., for example, was treated as a "normal" corporation under the general tax rules. A German taxable investor received tax-free dividends of 95% on distributions from the SICAV (from 2013: only for holdings > 10%) or tax-free capital gains of 95%. This was also appropriate and equated to an intended direct investment in the target investments (e.g. private equity target funds), which typically provide investors with equally privileged dividends and capital gains.

• This legal situation has changed fundamentally since 24 December 2013 without transitional provisions. Alternative investment funds are now covered by the scope of the InvStG. If these vehicles are not set up in the legal form of a partnership (e.g. KG, Lux SCS), they are to be qualified as so-called capital investment companies pursuant to Section 19 InvStG. This applies in particular to the common Luxembourg vehicles SICAV-S.A., SICAV-SCA, SICAR, FCP etc., which are often held directly by institutional investors. Distributions from such tax-exempt (only a small taxe d'abonnement is payable in Luxembourg) capital investment companies and gains from the sale of shares are no longer tax-exempt from 24 December 2013, which represents a significant deterioration in the situation of German taxable investors compared to the old legal situation. Privileged investment income on the input side of the capital investment company will be reclassified as fully taxable income on the output side and therefore at investor level. Indirect investment via such access vehicles is drastically discriminated against in comparison to direct investment in the target funds. In addition, certain passive income of the capital investment company (e.g. interest income) must be attributed to the German investors annually as unfavourably taxable income (irrespective of a distribution) as part of the add-back taxation pursuant to Sections 7 et seq. of the German Foreign Tax Act (AStG); in this respect, annual AStG declarations must be submitted. This primarily affects taxable institutional investors. In order to avoid these significant tax disadvantages, investments should therefore be structured via tax-transparent access vehicles, i.e. personal investment companies, under the new legal situation. Cf. in detail Elser, Die Investitionsgesellschaften, in: Beckmann/Scholtz/Vollmer: Investment-Handbuch, Erich Schmidt Verlag Kz 420, §§ 18, 19 InvStG (2015).

In the case of existing investments in capital investment companies, it should be discussed with the fund managers whether it is possible to restructure the investment in view of the considerable increase in charges. In many cases, the documentation also provides for corresponding shareholder rights if the (tax) framework conditions change. In practice, numerous Luxembourg AI investment platforms or fund-of-funds have undergone such reorganisations (e.g. additional establishment of a parallel investing SCS with transfer of the investors concerned to the new parallel structure). For new investments to be made, taxable investors should refrain from investing in investment vehicles in the legal form of capital investment companies and choose a tax-transparent parallel access to the target funds via so-called personal investment companies, which numerous fund providers now also offer as an alternative for this group of investors. Your TAXGATE team will be happy to support you in analysing your investment portfolio and in any necessary restructuring measures.

Dr Thomas Elser is a tax consultant at TAXGATE, a tax law firm specialising in transactions, investments and tax compliance.