Changes to German taxation of foreign investors in public German open-ended real estate funds

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1 Changes to German taxation of foreign investors in public German open-ended real estate funds Executive Summary > Foreign investors in public German open-ended real estate funds (deutsche offene Immobilienfonds, GOREF ) are as a rule not subject to German income taxation regarding the fund units. > Foreign investors in special GOREF and foreign investors in German real estate assets are as a rule subject to German income taxation at least with respect to the rental income and any capital gains generated within a ten-year holding period. > The German Annual Tax Act 2010 (Jahressteuergesetz 2010, JStG 2010 ), which is currently going through the legislative process, contains provisions that are designed to ensure that in the future investors in public GOREF are also subject to German income taxation at a rate of %. Provided no double tax treaty reduces or excludes such taxation, the investment via a special GOREF should as a rule be more advantageous than the investment via a public GOREF in German real estate. > Details of the new provisions are not fully clear. It is expected that the current draft bill will be further amended. The JStG 2010 contains inter alia provisions which are intended to close down certain structures currently reducing, deferring or excluding German income taxation. One proposed change to German investment taxation hitherto barely noticed concerns foreign investors in public GOREF. It is the intention of the lawmaker that after enactment of the changes foreign investors in public GOREF will be taxed roughly comparable to foreign investors in special GOREF or investors making a direct investment in German real estate assets. However, even after enactment of the new rules, significant differences in the German income taxation of foreign investors in public or special GOREF or German real estate assets will continue to exist. The suggested change of German investment taxation is not linked to other initiatives also coming from the German Federal Ministry of Finance to reform the regulatory framework for public GOREF. This GSK Update is limited to an outline of the investment taxation changes for foreign public GOREF investors currently proposed in the JStG Background: Current fund privilege for foreign investors in public GOREF Foreign investors not subject to German unlimited income taxation are currently as a rule not subject to income tax in Germany regarding the fund units in public GOREF. This applies to the ongoing fund income from renting as well as to any capital gains generated in the fund or with respect to the fund units by the foreign investor. As a consequence the investment through a public GOREF into German real estate is highly income tax-efficient since it in principle allows real estate investments to be made in Germany without any German income taxation. GOREF as such are exempt from German income taxation. Depending on the country of tax residence of such investors and the provisions of any applicable double tax treaty this may even result in so-called white income, i.e. income that is nowhere subject to income tax. However, the resulting German fund privilege is not restricted to 1

2 cases where double tax treaties are applicable, rather it is granted with respect to all foreign investors in public GOREF units, irrespective of the country of tax residence of the investor. In practice, it is possible to create a public GOREF for a limited number of investors only. Although individuals may not invest in a special GOREF, a partnership with individuals as partners may as such be eligible for investment in a special GOREF. The differences between public and special GOREF, therefore, predominantly concern the level of regulation, not the identity of the investors. Socalled foster fund management companies offer the establishment and maintenance of GOREF to unrelated institutional investors. Outline of new provisions The bill of the JStG 2010 in its current version provides that in the future foreign investors in public GOREF are to be subject to German income taxation with the rentals and capital gains realised within a ten-year holding period generated from German real estate in the fund. It appears that capital gains from the fund units will continue to remain untaxed. The new taxation is to be effected through a withholding tax at a rate of % on any such income generated in the fund, whether distributed or not. With respect to foreign investors, withholding tax is, as a rule, definite. Since the public GOREF is exempt from German income taxation, the new withholding tax would be the overall German income taxation of the respective income in the fund. Lack of clarity in the new law The bill, however, also contains some points that are not sufficiently clear. It appears that the new withholding tax on the German real estate income in the fund is to be carried out by the so-called paying agent (auszahlende Stelle). This can be derived from the specific reference technique of the new law. However, a respective paying agent is in general only present in the event that a domestic credit or financial services institution makes a payment to the investor. Any withholding tax requirement of a paying agent, therefore, can in principle be avoided by the investor receiving the payment from a foreign institution. Should this understanding of the new law be correct, the withholding tax could already be avoided by holding the public GOREF fund units in a non-german depository account. It is more likely that the lawmaker intended to obligate the fund management company of the GOREF to withhold the respective withholding tax, which would indicate that the current withholding provisions of the bill would have to be amended. Nevertheless, should the respective wording of the bill not be amended in the further legislative process it could be argued that the new regime would only concern investors holding the units in German depository accounts. In this case it could be expected that the change would not have any major impact on foreign investors. In a recent judgment the Federal Finance Court of Germany ruled that a German paying agent is still present if a German credit institution agrees with a foreign credit institution to pay out capital returns to certain investors when the respective amounts are subsequently paid by the German credit institution directly to the foreign credit institution instead of using one of the usual clearing systems. In these circumstances, it was decided that the foreign credit institution was acting merely as an agent of the German credit institution. The German credit institution was held liable for the withholding tax not having been withheld. The scheme was especially designed to avoid the respective withholding tax requirement of a German paying agent. From the judgment it can be derived that the avoidance of German withholding tax requirements through the use of a foreign credit institution does not generally constitute an abuse and is to be recognised for German tax purposes. Remaining fund tax privileges for GOREF Even after introduction of the new law, German real estate investments through public or special GOREF will still enjoy advantageous income taxation in Germany compared to other inbound investment structures. First of all, public and special GOREF continue to be exempt from German income taxation. This also applies to German trade tax on the level of the GOREF. Thus, provided the investor is not as such subject to German trade tax, the investment through a GOREF can be made without any German trade tax burden, irrespective of the presence of a German permanent establishment at GOREF level and of any details regarding the activity carried out 2

3 by the GOREF with respect to the German real estate. The requirements for a German real estate investment not being subject to German trade tax currently cause considerable issues for, and require major structuring and compliance efforts from, foreign investors. After all, the German trade tax burden may well be comparable to the German (corporate) income tax burden or even higher due to special German trade tax add-back provisions for debt interest expenses. Using a GOREF means not having such headaches. Furthermore, investments through GOREF allow for a divestment via sale of the units without any German tax burden in the case of foreign unit holders. German income taxation should not apply. Since German real estate transfer tax with respect to GOREF real estate is as a rule triggered only in the events of a change of the fund management company and the acquisition of real estate by the fund management company, changes in the unit holders may not trigger German real estate transfer tax. In comparison, divestments through asset deals will always trigger German real estate transfer tax, whereas divestments through share deals without triggering German real estate transfer tax will at the very least require an independent minority co-investor and may as well only be achievable after major restructurings. The German real estate transfer tax amounts to at least 3.5% of the purchase price in the case of asset deals. Since the German real estate transfer tax rate has recently been increased in several parts of Germany (e.g. in Hamburg, Berlin and Saxony-Anhalt to 4.5%, in Brandenburg to 5%) and might be increased inter alia in Saxony, Lower-Saxony, Bremen and Saarland, German real estate transfer tax considerations might gain in importance for investors. If the German real estate is transferred to another GOREF managed by the same fund management company it can be argued that at least in cases where this is effected after a ten-year holding period in the GOREF the change should result for German income tax purposes in a tax-free step up regarding the respective real estate assets. In comparison: in the case of a direct investment into German real estate through a company structure, capital gains will be income taxed regardless of any holding period. Individuals as private investors may enjoy a tax-free exit after a ten-year holding period. However, such an exit will usually either trigger German real estate transfer tax or require major structuring. Furthermore, the rules governing the calculation of the income generated through a GOREF are different to the rules applicable to other investment structures. For example, the German so-called interest barrier (main rules for the interest deductibility in German income taxation) does not apply to GOREF investments, but may apply to direct investments made through corporate structures. However, with respect to GOREF there are regulatory leverage restrictions (50% at fund level), so that it needs to be determined in each particular case whether this fund privilege actually results in an advantage for the investment as a whole. Finally, there are also differences regarding the details of the German income taxation of foreign investors in special and public GOREF. Certain foreign investors in public GOREF may still be able to invoke protection of a double tax treaty entered into by Germany. Unlike the existing rules for the German income taxation of foreign investors in units of special GOREF, the new law does not contain any provisions as to the applicability and application of double tax treaties in the case of public GOREF investments. Therefore, a double tax treaty protection available to foreign investors with respect to public GOREF fund units may still reduce or exclude German income taxation with respect to the income generated in the fund. For foreign investors in special GOREF the withholding tax on the income generated in the fund from rentals and capital gains within the ten-year holding period is only provisional, since it will be credited or refunded on the basis of a German income tax assessment procedure to be carried out with respect to the fund income. If the foreign investor is a company, the then applicable German corporate income tax rate is only %. It is questionable whether foreign 3

4 corporate investors in public GOREF subject to the new income taxation regime would be entitled to a reduction of the German withholding tax on the income from the fund in view of the German corporate income tax rate. Even if this should be the case, it could be expected that German antiavoidance provisions and substance requirements might be applicable, which would constitute an additional hurdle for such investors. As a result, following the change in the German income taxation of foreign investors in public GOREF, it will be necessary in each individual case to determine the appropriate investment structure. It appears, however, that in case of institutional investors not being able to invoke double tax treaty protection, the investment via a special GOREF might in the future be preferable to the investment via a public GOREF. Dr. Rainer Werum Rechtsanwalt Standort Frankfurt/M. werum@gsk.de Valentina Farle, LL.M. Rechtsanwältin, Fachanwältin für Steuerrecht Steuerberaterin Standort Frankfurt/M. farle@gsk.de 4

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